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CHAPTER 9: BALANCE SHEET – MEASUREMENT OF FINANCIAL HEALTH

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How should investors look at depreciation?
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CHAPTER 9: BALANCE SHEET – MEASUREMENT OF FINANCIAL HEALTH
 
[1]. How should investors look at depreciation?

From a business perspective, whenever a company buys an asset or incurs capital expenditure to build a plant or factory, the reality is that the company has already incurred the spending, i.e. the cash has already been spent.

Let’s take a look at Malaysia Airport Holdings Bhd (“MAHB”) as an example.
 

Table 2: Profit Attributable to Shareholders Extracted from MAHB Annual Report from 2010 to 2016 (in RM million)
Year ended 31 Dec 2009 2010 2011 2012
Profit attributable to shareholders 350.4 316.8 401.1 394.5
2013 2014 2015 2016
377.5 663.4 40.1 73.2

 
As can be seen from the profit attributable to shareholders line, MAHB’s profits have been disappointing post financial year 2014. This is ironic, since post 2014, the Kuala Lumpur International Airport 2 (KLIA2) comes into operation (the construction of KLIA2 was completed in 2014).

 

One of the main reasons is the recognition of depreciation charges for KLIA2. Under accounting rules, no depreciation will be recognised while an asset is under construction. However, once the construction has been completed, depreciation charges will start. This is exactly what happened to MAHB.
 
Table 3 shows the depreciation & amortisation expenses and other one-off charges incurred during the period.
 

Table 3: Selected Income and Expenses Extracted from MAHB Annual Report from 2010 to 2016 (in RM million)
Year ended 31 Dec 2009 2010 2011 2012
Depreciation & amortization (150.5) (172.5) (174.4) (221.3)
Impairment of investments in associate – – – (68.9)
Profit attributable to shareholders 350.4 316.8 401.1 394.5
  2013 2014 2015 2016
Depreciation & amortization (277.9) (405.4) (901.7) (852.5)
Impairment of investments in associate (3.7) (9.0) – –
Impairment of investments in unquoted shares – (15.0) – –
Gain arising from re-measurement of fair value of investments – 483.7 – –
Gain on bargain purchase – 314.9 – –
Impairment of goodwill – (231.3) – –
Profit attributable to shareholders 377.5 663.4 40.1 73.2

 
Now if we apply the same concept of arriving to core earnings, adjusting back depreciation & amortisation expenses in this case (i.e. adding back the non-core expenses and deducting non-core income), we will get an adjusted net profit as shown in Table 4.
 

Table 4: Adjusted Net Profit (in RM million)
Year ended 31 Dec 2009 2010 2011 2012
Adjusted profit attributable to shareholders 500.9 489.3 575.6 684.7
2013 2014 2015 2016
659.1 525.4 941.8 925.7

 
Excluding depreciation & amortisation and non-core items, the profits of MAHB reflect the additional earnings coming from the new KLIA2. We are not arguing that depreciation is wrong. In MAHB’s case, the cost for the construction of KLIA2 has been incurred, and depreciation charges merely allocate the cost in the subsequent years. However, in 2014 and 2015, the general investment community was so concerned with the depreciation charges that MAHB’s share price was under selling pressure. Whoever invested during that period, though, would have reaped handsome gains (see Figure 1).
 


 
In the next posting, we will discuss on Goodwill and Inventories.

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