Geoff Gannon January 30, 2011

Understanding Depreciation: 4 Depreciation Archetypes

A lot of investors don’t give depreciation enough thought. Whenever you compare P/E ratios, you are – to some extent – counting on depreciation between companies being totally comparable.

It’s not.

Forget loans for a second. And forget the idea of “appreciation” and “depreciation” in the sense of a rise or fall in value. Instead, we’re just going to talk about depreciation and amortization as they are used in financial statements.

We’re talking 10-Ks and 10-Qs. We’re talking balance sheets and income statements.

We’re talking accounting.

For our purposes, the words depreciation and amortization mean the same thing. It’s just that we’re going to say depreciation when we’re talking about something we can touch – like a cruise ship. And we’re going to say amortization when we’re talking about something we can’t touch – like a management agreement.

Otherwise, depreciation and amortization are synonyms.

You sometimes hear it said that depreciation is a reserve for the replacement of an asset. That’s wrong. Depreciation is a method used by accountants to spread the cost of an asset over the period in which the asset provides a benefit to its owner.

Basically, we’re talking about matching the costs and benefits – the revenues and expenses – of an asset so they appear on the income statement at the same time.

The basic idea you need to get from reading this article is that no one is attempting to account for the replacement cost of the asset when they determine the depreciation expense. Replacement cost has nothing to do with depreciation.

Instead, they are taking the cost – the expense – of what you are buying today, and then chopping it up and spreading it out over the time you use it.

If you want to think of the difference between buying a car and renting a car to understand depreciation, that’s fine. If you rent a car, you get charged every day. If you buy a car, you get charged once (but it’s a big charge). In a sense, depreciation is about providing the folks who read financial reports with a picture of a business’s performance that shows the car buyer in much the same way it would show the car renter. Each day we’re asking: what did it cost the driver to use his car today?

That analogy is far from perfect. And I’ve made things sound simpler than they really are. But, now, I’d like to move past talking abstractly about depreciation and amortization and move to talking about specific examples you will see in your investing adventures.

I’ve singled out these 4 stocks because they are examples – in fact, rather extreme examples – of 4 types of important depreciation situations you’ll come across when you research stocks.

In a sense, these 4 stocks are archetypes of situations in which depreciation and amortization can be important in picking stocks.

Although I said depreciation is used to match the timing of the expense of owning an asset with the benefits the owner receives, the timing doesn’t always work out that neatly in practice.

The time period over which the asset is depreciated doesn’t always match the period over which the asset provides its benefit.

Here is an actual example of amortization from the 10-K of Birner Dental Management Services (BDMSFinancial):

“The Company’s dental practice acquisitions involve the purchase of tangible and intangible assets and the assumption of certain liabilities of the acquired Offices. As part of the purchase price allocation, the Company allocates the purchase price to the tangible and identifiable intangible assets acquired and liabilities assumed, based on estimated fair market values. Identifiable intangible assets include the Management Agreement. The Management Agreement represents the Company’s right to manage the Offices during the 40-year term of the agreement. The assigned value of the Management Agreement is amortized using the straight-line method over a period of 25 years.”

You should notice 3 things here:

1) Because Birner takes these amortization charges, its net income and free cash flow may be very far apart. You can’t just look at reported earnings in this situation. That would be especially true if Birner once bought many more dentist offices than it does today. If that happened, amortization expenses could be very large and yet cash outflows for new acquisitions could be very small.

2) The term of the agreement and the period over which it is amortized don’t match. Birner takes a 4% amortization charge every year for 25 years. However, the agreement gives Birner the right to manage the offices for 40 years. Birner will still have the management right for 15 years after it has charged off the management agreement to $0.

3) The accounting treatment here is different from what Birner would do if it bought the dentist offices outright instead of signing a management agreement. Yet is the economic reality much different? If Birner bought the dentist offices, it would check the goodwill for impairment instead of charging it off evenly over 25 years. So, Birner’s income statement is not comparable to the income statements of other businesses that grow through acquisitions.

Here is another example of amortization. This time it’s from the 10-K of a publisher, John Wiley & Sons (JW.AFinancial):

Product development assets consist of composition costs and royalty advances to authors. Costs associated with developing any publication are expensed until the product is determined to be commercially viable. Composition costs represent the costs incurred to bring an edited commercial manuscript to publication, which include typesetting, proofreading, design and illustration costs. Composition costs are capitalized and are generally amortized on a double-declining basis over their estimated useful lives, ranging from 1 to 3 years. Royalty advances to authors are capitalized and, upon publication, are recovered as royalties earned by the authors based on sales of the published works. Royalty advances are reviewed for recoverability and a reserve for loss is maintained, if appropriate.”

This note to the financial statements makes much more sense if you read it with copies of the balance sheet, the income statement, and – most importantly – the statement of cash flows in front of you. It explains why I’ve mentioned that publishers have an extra line in their cash flow statements right by the more usual “additions to property, plant, & equipment” that’s very important to look at. This added line – which in Wiley’s case is called “additions to product development assets” – is critical to understanding a publisher.

Now, this cash flow item appears under “investing activities”. However, it’s clearly an operating activity in the sense that it’s a regular part of Wiley’s day-to-day operations. In fact, it’s the core part of Wiley’s operations. The company spent an average of $130 million annually on this item. So, although it appears under investing activities, and although it is an investment in the sense that the asset will be used over more than 1 year, it’s really part of the day-to-day business of publishing.

So – in my mind – I move that line up to operating cash flows. When I look at a publisher, I only see their operating cash flows after you subtract the annual cash outlay for product development. If I didn’t do that, I’d be looking at a publisher as if it was in run-off. As if I was going to buy the publisher and immediately put an end to the actual business of publishing new stuff.

And that’s no way to analyze a publisher.

Depreciation and amortization can get very complicated. And they can be very important to evaluating the business. Usually, depreciation isn’t as important as in the case of Birner Dental Management Services or John Wiley & Sons.

But it can be.

Depreciation is important at Union Pacific (UNPFinancial). Union Pacific’s free cash flow is usually about 50% less than its reported earnings. Some of the difference is caused by investments in future growth. But most of the difference is caused by the gap between the original cost of the asset – which is what they’re depreciating – and the replacement cost of the asset. Whenever Union Pacific replaces something it pays more to replace the asset than it charged off in depreciation expense over the years it used the asset.

The reason for this is inflation. The influence of inflation on railroads is explained fully in my article on inflation and depreciation at railroads.

This huge difference between free cash flow and net income at railroads is why it’s so crucial to remember that depreciation is not a provision for the future replacement of assets.

Depreciation has nothing to do with the future.

Depreciation just spreads out the past cost that occurred in one cash downpour and turns it into more of an accrual trickle.

Amortization is important at Netflix (NFLXFinancial). If you’ve never seen Netflix’s cash flow statement, boy you’re in for a surprise.

It’s impossible to understand Netflix without looking at the cash flow statement.

Netflix is like an intangible railroad. It spends huge amounts of cash on buying intangible assets. And those intangible assets – the content library – are every bit as important to Netflix as tangible rails and engines are to a railroad.

I’ve given you some extreme examples here. At most companies, depreciation and amortization are not as important to a potential shareholder as they are at Birner Dental Management, John Wiley & Sons, Union Pacific, or Netflix.

But each of those 4 companies can act as a blueprint in your head for how to think about depreciation in similar situations you come across.

These are 4 archetypes of depreciation.

Hopefully, they’ll stick in your brain and set off a bell whenever you come across a company where depreciation is really important to understanding the value of the business.

Once again, the 4 depreciation archetypes are:

1) The pseudo-acquisition charge offs at Birner

2) The pre-publication expenses at Wiley

3) The inflation induced original cost/replacement cost mismatch at Union Pacific

4) The intangible asset intensive content library at Netflix

You’ll find variations on these depreciation archetypes in lots of places.

For example, cruise lines are quite similar to railroads. The big difference is that cruise lines are not a mature industry. So they look a lot like railroads did back in their growth days. But the basic issue of inflation and depreciation is still an important problem to tackle when analyzing Carnival (CCL) or Royal Caribbean (RCL).

To understand depreciation you should look at the income statement and the cash flow statement at the same time. Print them out and put the two pages on the desk in front of you. Also, you need to read the note on depreciation in the company’s notes to its financial statements.

I can’t stress this last point enough.

Always read the notes to the financial statements.