I think this is a really important point about evaluating a lot of capital-intensive businesses, maybe the Oil/Mining industries especially, although there are others.
Many people view Shell and BP as strong, reliable "blue chip" companies, and to an extent this is true. But the stereotype of being safe and steady is not true of all large-cap, big name companies.
The turnover and earnings record are typical of a company operating in a commodity-type business. Even the largest of Oil players are price-takers, whether oil is $140 or $35, from one year to the next.
But by nature their business is a hassle, compared to a retailing operation for example. Before a penny of turnover or profit can be made, huge sums need to be spent in the upkeep of operations, through capital expenditure, heavy staffing costs, the deployment of extremely cumbersome machinery, all sorts of technology must be implemented, licenses agreed.
It's like the notoriously difficult Airline industry. You go to huge capital expense muscling into the industry, purchasing and maintaining aircraft, hiring expert staff, keeping pace with rapidly changing technology. And then you're at the mercy of prices set by the lowest bidder in competition. You've done all the hard work, and then you have seats to fill on flights that have already been scheduled. Not to mention the burdens of heavy regulation, risks of large fines and windfall taxes in the case of oil companies. The result is difficult business economics.
Seven-ten year cashflows in the oil industry can be difficult to predict, so defining an acceptable purchase price can be difficult for an oil company. The burden of capital expenditure should be taken into account when evaluating the profits an oil company produces - how much of those retained earnings are required to keep the business operating at a constant level? Increasing earning power over time in those instances is like running on a treadmill - the difficulty in consistency can be seen in the long terms track record.
While a 5% dividend yield is impressive, there are plenty of 4% businesses with stable, long-term growth track records where it's somewhat easier to predict results for shareholders over time. In those cases, the intrinsic value of the business has a comfortably higher probability of increasing over time - they have things a lot easier.
Naturally, knowing how hard the oil business is for a giant like Shell, I have even more sympathy for owners of smaller oil-producing companies. In those cases, capital expenditures are still high, but often profits remain negative, destroying shareholder capital.
While it's a matter of personal preference, I prefer companies with much easier tasks in front of them (thankfully Greggs doesn't have to spend millions sucking sausage rolls out of the ground before selling them on, nor does it have to accept the global going-rate for pasties, or hire geological experts to determine where to open a new store!).
Great article, and good luck to any RDSB holders!
