Wednesday, August 12, 2015

All-in costs, breakeven costs, cash costs

Analysts of deep cyclicals, industrials, commodities would be very familiar with these terms. These terms are invented by the financial industry to try to help analysts analyze real businesses from their desktops, in plush offices, hundreds or thousands of miles away from where the businesses actually took place. It bears little resemblance of how real ops managers actually thought about their costs or how businesses actually operated. 

All-in costs refer to all the costs that are needed to start and ramp up a business. Take the example of a gold mine, the all-in cost today for digging up an ounce of gold is supposedly $1,000. Today gold trades at $1,100 per ounce. So if gold falls below $1,000, then new gold production should stop since no one would spend $1,100 to dig something and then sell it for $1,000 right?

But wait, all in costs involved sunk cost like exploration, consulting fees, shared costs like HR, R&D and needless to say, actual operation costs like building the mine facilities, transportation etc. Maybe we shouldn't include some of these. What's important is the breakeven costs. This takes out the sunk and shared costs. Breakeven cost is the true operational expenses including depreciation, utilities, transportation etc. So maybe the true bottom for gold prices should be $600-800 per ounce, which is the estimated breakeven cost range.

Ok that made sense, which is why gold has not even come close to those levels in the last few years. But in another familiar highly cyclical industry close to home, we saw how prices crashed below breakeven costs: shipping. Shipping is a notoriously tough sector. Long time value investors would know to avoid these capital destructive firms. Let's take a look at the breakeven cost again.

While most of us would be familiar with container shipping, which is the bread and butter of our beloved national shipping company: Neptune Orient Lines or NOL, looking at the bulk Capesize shippers for shipping bulk commodities would serve to illustrate today's point better. There are 1,000+ Capesize ships globally shipping bulk commodities like iron ore and coal all over the world and the shipping rates of all these ships are calculated into an index called the Baltic Dry Index or BDI. The chart below from the Economist shows how the index traded over the last 10 years.

The infamous BDI index

During the heydays of 2006-08 the BDI traded at 10,000 levels, 2 digits higher than today's paltry 500. Back then it was impossible to fathom that BDI would fall to today's level. It is yet another manifestation how our primitive homo sapien minds worked (we really cannot think long term) and how unpredictable  the future really is. Just as it is today, can we imagine BDI would again go to 10,000 say 8 years from now?  

It is said that the breakeven cost to run a Capesize ship is about $30,000 per day. This breakeven cost would include depreciation of the ship (a huge part of the cost), the fuel, the crew and other miscellaneous including docking fees etc. This $30,000 per day translates to roughly 3,000 on the BDI and it does form a strong support over the last 10 years. Notice the support in 2005-06 and again the resistance/support in 2009-2010.

But in late 2010, the BDI broke the 3,000 low and fell all the way to 1,000. Nobody could figure out how could this happen. No business should operate below its breakeven cost. It means that for every single day the ship was out there, it was losing money. This is negative margin. It should not happen but it did! So analysts came up with another explanation: cash cost.

Cash cost refers to the cost that is needed to operate a business, on cash basis. This is serious. Breakeven cost has non-cash components like depreciation but cash cost means pure cash in and out. No business should operate below cash cost. So, back with the Capesize ships, the cash cost is estimated to be $15,000 per day, this is the money needed to pay the crew, to pay for fuel, all cash involved. So this should be the absolute bottom for spot prices. If prices fell below this, then all the ships should stop running. No company will burn cash to operate any business.

Then in 2015, the BDI broke 1,000. It fell to 500 and remained around there, a 30 year low. 500 on the BDI translated to just $5,000 per day. So theoretically, we can book a Capesize ship for $5,000 a day for some event, like a birthday party or a wedding! It's cheaper to host a wedding banquet on the ship vs in a Singapore hotel. For all that analysis, BDI broke the cash cost level and remained there.

What happened? 

Why did shippers operate below cash cost? Didn't they know that they are burning money every day? Yup they did, but that was not part of the equation the real business operators were working with. All-in costs, breakeven costs and cash costs exist only on spreadsheets. In the real business, Capesize ships have to run every day, it would take a few weeks just to reach anywhere and a few months to fully stop operations. Even worse, these ships were funded with credit. They could not be stopped even if revenue fell below whatever costs.

Stopping ships from running might trigger default and meant paying back the banks whatever loans that was used to finance buying the ships in the first place. So shipping co.s had to operate as long as revenue was not zero. ie as long as the BDI was not zero. Also there was always the hope element. Managers would always be hoping that things would turn. If they bled for just three months, maybe enough ships would be off the market and prices would turn up again. But since everyone thought the same, that didn't happen and BDI remained at 500. That was the reality. 

This is the same story for many, many cyclical industries. We saw that with semiconductors, with commodity prices and even crude oil. There was not such thing as breakeven cost level or cash cost level. The only true real level is zero and market forces determine when the rebound would be. In the end, the message is this: stay away from commodity businesses where companies do not have pricing power but take prices from spot markets. Buy strong businesses with great global franchises. These are the best bets that we could compound our money at above average growth rate over time.

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