From: Carl W. Gardiner
Sent: April 29, 2016
Subject: Comment submission on S7-06-16: Business and Financial Disclosure Required by Regulation S-K

Here are two topics of supplemental disclosure that I think would be very valuable to securities analysts, like myself (I am a portfolio manager at an investment management firm), and to the investing public generally.

Sustaining or Maintenance Capital Expenditures

The concept here is that management provide a breakdown of their capital expenditures line item from the Cash Flow Statement, simply between Sustaining/Maintenance CapEx and Growth CapEx.  The definition for Sustaining/Maintenance CapEx is the capital required to maintain the current productive capacity of the business, i.e. to ensure that the business’s plant (physical plant and supporting IT) can sustain the current income-generating capacity of the business.  Growth CapEx is then simply Total CapEx minus Sustaining/Maintenance CapEx, though some commentary on the nature of the growth CapEx, especially for specific expansions/initiatives, would be helpful.  Granted, it can be a fine line in evaluating what is Sustaining/Maintenance and what is Growth CapEx, and some projects may have elements of both, but management can exercise judgment in making these estimations as it does for many other accounting items, and this perspective would be useful for the securities analyst.

It is useful for the analyst because we should properly value companies based on their “owners’ earnings”, as first defined by Benjamin Graham and David Dodd in Securities Analysis, as the economic earnings (or free cash flow) or discretionary earnings (or free cash flow) of the company available to the shareholders of the company.  This definition focuses on the earnings (free cash flow) that could be distributed after all expenditures required to sustain the current earnings capacity of the business.  This requires an understanding of Sustaining/Maintenance CapEx, as opposed to all CapEx.  Theoretically, with respect to capital expenditures, all cash that remains after Sustaining/Maintenance could be distributed to shareholders.  This is the figure we should capitalize in estimating the company’s value.  Capital expenditures beyond Sustaining/Maintenance CapEx entails a capital allocation decision made by management and the Board.  They weigh this decision to reinvest organically in expanding the capacity of the business against other possible uses of those funds—dividends, share repurchase, acquisitions, debt repayment.  As it stands, analysts do not have the required information to calculate economic/discretionary earnings (free cash flow) on this basis, because we are not provided the distinction between Sustaining/Maintenance CapEx and Growth CapEx.  This is particularly true for analysts that like to evaluate free cash flow (from the Cash Flow Statement) as well as GAAP earnings (from the Income Statement) in estimating valuation. 

Currently, some management teams will provide a figure at their discretion, actively or upon questioning.  It would be better if this disclosure were subject to the definitional rigor of a prescribed SEC disclosure.

A Table on Cash Flow Impact of Share-based Compensation

Accounting for share-based compensation has been a long-running topic of discussion with respect to SEC disclosure.  Judging the impact on economic earnings (free cash flow) available to the shareholder continues to be difficult and laborious, with respect to identifying the portion of economic earnings (free cash flow) that goes to management and other employees as a result of share-based compensation.

Ideally, here would be the most economic manner to analyze this:

  • Cash Flow from Operations (from the Cash Flow Statement) adds back the impact of share-based compensation (as treated on the Income Statement).  This is a good starting point, but from this figure we then need to subtract the portion of operating cash flow that in fact funds share issuance pursuant to share-based compensation.
  • Methodology for calculating this figure: cash required to repurchase shares on the open market in order to offset shares issued in the period, so as to hold the share count steady.  Shares Issued in the Period would be defined as shares issued (fully-vested) + shares issued as a result of the actual exercise of stock options in the period.  Cash Required to Offset Share Issuance from Share-based Compensation would then be defined as: Shares Issued in the Period multiplied by the average price (preferably, volume-weighted average price, VWAP) of the company’s shares over the period (or, for those companies that actually repurchased shares in the period, the average price at which they did so), less proceeds from exercise price paid in exercising management/employee options.
A table that clearly and simply sets this out would be of enormous benefit to the analyst and the investing public.  It again would provide a more accurate basis for determining “owner’s earnings” (or free cash flow).

I am pleased to have the opportunity to provide this input.


Carl W. Gardiner