Monday, February 22, 2010

Treating Research at EA and Coke

When companies spend money on capital expenditures (as opposed to spending on operating expenses such as marketing, salaries, repairs etc.), these amounts are ignored on the income statement. In other words, these capital investments are not subtracted from revenue to come up with the company's net profit, since these investments represent investments which may generate revenue (or losses) in the future. For understandable reasons, however, research and development (R&D) is classified as an expense under GAAP, even though the benefits (if any) of such R&D will occur in the future. How should the prudent investor treat such expenditures in determining a company's earnings power?

As usual, the answer is: it depends. The question comes down to the nature of the R&D expense; is it really an investment that (if successful) would add to revenues in the future, or is it a necessary expense that is needed just to keep up with the competition and keep profits stable? In the former case, the R&D can be rightfully added back to the company's profits in determining the company's true earnings power. In the latter case, however, the "investment" acts more like a current expense: it is needed simply to keep the business running as it currently is.

Unfortunately, distinguishing between these two types of R&D expenditures can be difficult for the outside investor looking in. For this reason, Philip Fisher recommends a technique he termed Scuttlebutt to help make this determination. An understanding of the company's industry can also be useful in this regard.

To illustrate, consider an example using two unlikely candidates for comparison, Electronic Arts (ERTS) and Coca-Cola (KO). EA competes in an industry with short product cycles, requiring companies to continually innovate and come up with successful new software titles, or suffer severe decreases in revenue. On the other hand, Coke's product set is rather stable, and therefore new R&D investments are likely spent on developing products that would add to the company's profits if successful. Coke's R&D spend would therefore be categorized as more similar to a capital expenditure, while EA's R&D spend would more likely be categorized as an expense the company cannot do without.

Of course, rarely is the situation completely black and white. For example, EA does have some software franchises that keep customers returning year-after-year for new versions of popular titles. At the same time, some of Coke's R&D spend is likely spent on improving current products just to maintain consumer appeal in the face of constantly improving competitors. Determining which portion of R&D is 'maintenance' and which portion is an 'investment in the future' is a difficult task indeed.

Only by understanding the business and industry can the investor make a somewhat accurate judgement as to the true earnings power of the company, by determining whether (or which part of) R&D expenditures are investments, or whether they are better classified as ongoing expenses. Nevertheless, such estimates are subject to substantial error due to the lack of information available to the investor; as such, when in doubt, investors are encouraged to remain conservative.

Disclosure: None


nick gogerty said...

nice article. One of the fundamental points of value analysis is to understand how the moat (margin) is maintained relative to competition in terms of cost inputs. Most miss the point of industry and competitive dynamics with regards to this.

R&D as you indicate varies with each industry. Often the red queen runs ever faster to stand still (no moat). Many will miss the rise in earnings as a good thing even when it comes at the expense of some moat.

Anonymous said...

gotta say its a difficult task indeed!
any suggestions for telltale signs or indicators which may prove useful in determining such expenditure?( i know this is a shameless way of asking for a tip but this wot u get for having such lousy readers!!!!!!)

Anonymous said...

hey saj , how bout reviewing a peter lynch book next time?

Saj Karsan said...

Hi Anon1,

The R&D expenditure can usually be determined in the company's annual report.

Hi Anon2,

I'll keep that in mind for the future, but of course the Motley Fool already gives Lynch a fair share of space for readers who are interested.