What is depreciation?

Depreciation is an accounting measure which is used to match the cost of a fixed asset against the revenues it generates over its useful life.

There are different ways to calculate the annual depreciation of a fixed asset but the most common method is known as straight line depreciation. This is when the amount of depreciation is spread evenly over the useful life of the asset. Straight line depreciation is calculated as follows:

Straight line depreciation = (cost less residual value)/Useful life

I find one of the best ways to explain depreciation is to use the example of buying a new car. Most people understand that if they buy a new car it will lose value and will be worth a lot less in three, five or ten years' time.

Just a quick aside here. Cars do not depreciate evenly in a straight line. They tend to lose a significant chunk of value in the first year before the depreciation levels off. I am going to use straight line depreciation to highlight some of the tools of analysis you can use when analysing asset-intensive companies.

Let's take a look at the depreciation on buying a new Audi A3 car.

If you fancy buying a new, high spec Audi A3 Sportback it is going to cost £28,075 today (before discounts). If you drive it for three years and average 10,000 miles per year then internet car valuation guides say that the car is going to be worth £12,900 in three years' time. Note that many assets have limited or residual value because they are worn out at the end of the depreciation period.

We now have all the numbers needed to account for this car asset in the registers of a company's accounts:

• Cost £28,075
• Residual Value £12,900
• Useful life 3 years

If we are using straight line depreciation then the annual depreciation expense in the income statement and asset register will be:

Annual Depreciation = (£28,075-£12,900)/3 = £5,058.33

You can see my analysis below.

Audi A3 2.0L 10k miles p.a.	Year 1	Year 2	Year 3
Cost	28,075	28,075	28,075
Starting depreciation	0	5,059	10,117
Charge for the year	5,059	5,058	5,058
Accumulated depreciation	5,059	10,117	15,175
Net book value (NBV)	23,016	17,958	12,900
Depreciation rate	18%	18%	18%
Asset age	1.0	2.0	3.0
NBV as % of cost	82%	64%	46%
% written off	18%	36%	54%

To keep things simple I have used £5,059 in year 1 and £5,058 in years 2 and 3. As you can see, the asset is depreciated from an original cost of £28,075 to a value of £12,900 after three years.

You can see how depreciation works in an asset register. The main numbers to pay attention to are:

• The original cost of the asset.
• The annual depreciation charge.
• The accumulated depreciation over the life of the asset.
• The net book value (NBV) of the asset. This is the original cost less the accumulated depreciation. This number goes into the fixed or non-current asset number on the face of a company's balance sheet.

One of the most ignored numbers is the one for accumulated depreciation. At the end of three years, the car has accumulated depreciation of £15,175. What this number means in practical terms is that this is the minimum amount of money you would have to spend to replace your three year old Audi with a brand new one (on top of the trade-in value of the existing car).

The point I want to get across here is that depreciation is a real cost. It is an estimate of replacement cost which cannot be ignored unless of course the asset will last forever. This is why ignoring depreciation and basing investment decisions on profit numbers such as EBITDA is unwise in my opinion.

These numbers above also allow the analyst or investor to calculate some very useful ratios:

Depreciation rate = Annual depreciation charge/Original cost of asset

This tells us how quickly an asset is being depreciated. Short life assets should have higher depreciation rates than long life assets.

Asset age = Accumulated depreciation/Annual depreciation charge

An aging asset base can be a sign that a company is cutting back on investing which might have to be put right with a large capex plan in the future. Cutting back on investing is a good way for companies to boost their free cash flow. It would be a mistake for investors to value a company on this basis. They would be overstating the valuation because of the under-investment.

Cumulative depreciation ratio = NBV/Original Cost

As you can see in the table, after 3 years the car has been written down to 46% of its original cost.

Alternatively, you can calculate the percentage of the original cost that has been written off as a way of seeing how worn out a company's assets might be:

Worn out ratio = 1 - Cumulative depreciation ratio

At the end of three years, the value of the car has been written down by 54% of its original costs.

Mitchells & Butlers

Mitchells & Butlers has recently been increasing the amount of money that it spends on its pubs. The information on its fixtures and fittings assets is taken from its annual reports and is shown below.

As you can see, the value of a company's assets changes for lots of reasons - additions, disposals, revaluations, impairments and exchange rates.

I have highlighted the numbers that you need to take into account to perform the depreciation analysis:

• Opening and closing value of assets at original cost which are £992m and £1,019m respectively.
• Additions (capex) of £111m.
• Depreciation for the year of £89m.
• Accumulated depreciation of £501m.
• Net book value of £518m.

Mitchell & Butlers F&F	2012	2013	2014	2015	2016
Opening	943	953	969	959	992
Additions	92	81	90	103	111
Closing	953	969	959	992	1,019
Average cost	948	961	964	976	1,006
Depreciation
Opening	430	449	480	464	488
Charge for the year	88	87	90	89	91
Closing	449	480	464	488	501
Net book value	504	489	495	504	518
Depreciation % of avg cost	9.3%	9.1%	9.3%	9.1%	9.0%
Capex to depreciation	105%	93%	100%	116%	122%
NBV as % of Gross BV	53%	50%	52%	51%	51%
% written down from cost	47%	50%	48%	49%	49%
Estimated life	10.8	11.0	10.7	11.0	11.0
Estimated age	5.1	5.5	5.2	5.5	5.5

The table above shows how the depreciation ratios have been calculated. I have taken the analysis back to 2003 to get a long-term picture as to what has been going on with M&B's asset base.

Let's look at some of the key depreciation ratios.

Depreciation rate

M&B's depreciation rate has been relatively steady. It was over 11% towards the end of the last decade but is now just over 9%. There are three main reasons for a depreciation rate to fall.

• Management extend the useful life of the asset. This is acceptable if the asset life was too low but extending asset lives can be a source of profit manipulation by lowering depreciation expenses.
• An increase in the amount of fully depreciated assets. This happens when the original cost of assets contains some that have been fully depreciated. They are in the denominator of the depreciation rate ratio but there is no depreciation for them in the numerator. This depresses the ratio. Fully depreciated assets will need to be replaced and so a falling depreciation ratio due to this can be a sign of a big capex bill on the way.
• Estimates of residual value are increased. When it comes to pub fixtures and fitting this is unlikely in my view.

My interpretation of M&B's declining depreciation rate is that it is a sign that its assets are in need of some attention.

Capex to Depreciation

This is what seems to be happening. After a drop in investment during the last recession, investment is picking up. Management have been very open about this. They have told investors that the capex cycle of pubs is shortening. It used to work on an 11 year cycle and this is now coming down to 5 years.

"As I said earlier, getting onto a five year cycle is really key because we have currently been or recently been on an 11 year cycle. So just doing that in itself would make a material impact to our like-for-likes" M&B 2016 interim results

This is despite the fact that M&B's fixtures and fittings assets look reasonably well invested. They are only around 50% written off.

Its accounts state that its fixtures and fittings assets (F&F) are written off over 5-10 years. The estimated age of them is around 5 years.

Yet, M&B is increasing capex up to £200m per year on its pubs because it feels it needs to. It has realised that it cannot starve its pubs of investment and stay competitive. Running the business for cash is not an option as LFL sales fall sharply. CEO Phil Urban explained this with some very candid comments at M&B's 2016 interim results conference call:

"...that would be one reason why the run for cash option over the long run doesn't seem viable. I think if you are running brands you have got to polarise the estate and you have half of it doing very well because it is invested and the other half going backwards, you have to fix it. And I think the market is so competitive, particularly in the restaurant space that if you don't have quality amenity, you are not going to win. And even with great management teams and all those good things, there is too much choice so you have to fix that amenity. Then you can shout about your brand and then the brand adds some value, so that is pretty much the logic."

Generally speaking, the pub market is so competitive, with so much choice, that unless you keep pubs and bars in great condition you will lose custom. This is a very firm acknowledgement from a credible industry source that depreciation is a real cost and cannot be ignored. The finance director also confirmed that the level of capex spending would remain high:

"On capex, yes up to £200 million and probably staying at that level to maintain the 5 to 6 year cycle Phil [Urban] talked about."

At the time of its final results in November 2016, M&B's finance director confirmed to analyst Jamie Rollo from Morgan Stanley that depreciation would be increasing over the next few years due to the higher capex and shorter pub refurbishment cycle.

"Depreciation will increase over the new few years Jamie, as we increase the level of capex so I would expect in the current year to be £3-4 million higher than it was last year. Then as we build up to £200 million spend this year it will sort of lag the increase in the capex if you see what I mean. So there will be low single digits escalation in the depreciation charge we put through."

Perhaps M&B's capex and depreciation issues are something to do with its high exposure to pub restaurants. But what implications do its comments have for high street bar operators Revolution Bars and JD Wetherspoon?

JD Wetherspoon

JD Wetherspoon used to be the benchmark setter in terms of prudent depreciation policies. During the early 2000s it was writing off the value of its fixtures and fittings assets at 13-14% per year.

This would have left them fully depreciated in 7-8 years. Now it has one of the lowest depreciation rates in the sector. Possibly because it has some fully written off assets but maybe because it has a depreciation problem as well.

The company went through a very low period of capex spending on new assets - considerably lower than its depreciation charge. Capex has been higher in recent years.

Lower capex than depreciation has seen JDW's assets become significantly written down and what looks to be a very old asset base likely in need of some care and attention.

JDW's accounts are a good read and contain lots of useful information. It always tells readers how much money it spends on its existing pubs and prides itself on keeping them in excellent conditions.

The table below shows the following:

• Maintenance capex spent on existing bars. My guess is that most of this maintenance capex is spent on replacing fixtures and fittings.
• The total amount of fixture and fittings capex for existing and new bars.
• The reported fixture & fittings depreciation.
• Maintenance capex as a percentage of depreciation.

Year (£m)	Maintenance capex	F&F capex	F&F depreciation	Mcapex as % of Dep.
2011	38.4	42.1	20.8	185%
2012	45.2	41.0	23.6	192%
2013	40.9	40.9	25.9	158%
2014	56.2	58.3	28.9	195%
2015	44.8	53.1	33.9	132%
2016	33.5	37.9	35.9	93%

If this is true then JDW's fixtures and fittings depreciation is understated and its profits overstated. If you want to try and work out JDW's true profits then you need to pay closer attention to the cash it spends on maintenance capex.

EBITDA returns on cash spent

My view is that if you are going to look at company profitability and company returns it has to be based on an amount of money that is freely distributable to investors. EBITDA does not meet this criterion because depreciation is a real expense. Assets do not last forever and have to be replaced.

There is also plenty of evidence that the LFL sales and profit performance of pubs is significantly impacted by the amount of money spent on them. You can't take the credit for improving sales without paying the bill for them in the form of depreciation and the associated capex that goes with it.

Pub companies talk a lot about the EBITDA returns they are getting on the cash they are investing. These are often big numbers ranging from 25% to 40%. This can lead some investors to get excited that the financial returns of a pub estate can be transformed and that pubs can go from low or modest returning assets to very high returning assets.

I think this is the wrong conclusion. First and foremost, companies often take the uplift in EBITDA after refurbishment as a percentage of the money spent on refurbishing it. This is not the same as the total EBITDA returns for the pub or bar as a whole.

More importantly, the EBITDA and the assets do not last. Evidence suggests that their lives are getting shorter. Running pubs is akin to painting the Forth Bridge, you finishing refurbishing them and then you have to start again - you have to keep spending the depreciation.

For those of you who respectfully disagree with me on this, I'd point you towards the actual EBITDA (profits before depreciation) returns on cash spent (gross tangible assets before depreciation deducted) and say they are nothing to write home about. RBG is probably the best of a bad bunch but I'd say that there are a lot better homes for investors' money than pubs.

2016	EBITDA (adj.)	Avg gross assets	EBITDA %
RBG	15.6	104	14.9%
MAB	431	4,927	8.75%
JDW	175	1,918	9.12%
Lease adj.	EBITDA (adj.)	Avg gross assets	EBITDA %
RBG	24.5	166	14.72%
MAB	431	4,927	8.75%
JDW	175	1,918	9.12%

In my opinion, investors are better served by using measures such as EBIT or cash profits which at least make some allowance for the fact that assets do not last forever and need to be replaced.