How a company can benefit from being capital intensive

Iron ore furnace

The ideal company has zero debt, astronomical growth, an invested management, insignificant competition and isn’t capital intensive (CI). Sadly, these companies are usually high-priced to account for the bounty, as many investors are willing to pay huge earnings multiple for this kind of stock. An example of a company like this is Apple. Most of its costs are downstream in production and assembly, which Apple sub-contracts leaving the low margins to other companies. So, Apple’s money doesn’t need to buy new machinery, improve factory lines, give workers’ healthcare. It only needs to set a margin objective and ask around to who wants to manufacture it. Low money input, high money output.

So, let’s spin it a bit.

What is a CI company? Any company that has to pour its profits back into business just to keep it alive is considered CI. For example, a steel mill company has huge up-front costs (the mill, the iron ore, the workers, the installations, the electricity, the transportation, etc) that need to be reinvested in to maintain the operation. This is a drag on the company’s profits, and when all is accounted for, not much free cash flow is left. Another example, an airline company operates a highly complex system of airplanes, maintenance, workers’ salaries, airports fees, jet fuel costs and so forth. Every dollar the company is able to squeeze out of the normal operation of its business, it tends to already be destined to mend or improve something. This in essence is why most investors prefer owning a company with lots of free cash flow, with few needs to reinvest its profits.

When can owning a CI company make sense? Let’s think about up-front costs. If a steel mill company had to invest early on just to start making some money, then it’s logical that every new-comer will also have to pay those costs. And this is why a CI company can be great if it doesn’t have lots of competition. It can feel safe that whatever it does, new competition won’t popup, and even if it does it will spend lots of money just to set up shop. Such a situation can create a big deterrent to competition.

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