Friday, March 23, 2012

R&D With Or Without Earnings?

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 expenditures 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 is also 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 being 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


Anonymous said...


This comment is somewhat off-topic, but it's related to your post today and I wanted to revisit a previous discussion we've had. The issue is, how should an investor treat "amortization of purchased R&D" expenses? Should they be added back or are they real? A great practical example is HP. Its non-GAAP earnings, which add back those expenses, are far more impressive than its GAAP earnings.

I believe it *is* valid to add back those expenses, provided that the company is expensing current R&D and that the purchased IP is, at a minimum, being properly maintained through continued R&D spending. I think we've disagreed on this point in the past, but now I have what I believe to be a rock-solid proof. Let me know what you think.

Let's assume there are two software companies, A and B, which make very similar products and are operationally almost identical. Both of these companies developed all of their software internally, so there are no purchased R&D assets on the books of either company. Now let's say some shell company (C), with no operations of its own but with a bunch of cash, acquires company B. Well, A and C are now economically identical, but C will report significantly lower GAAP earnings than A. Why? Because C will have large "amortization of purchased R&D" expenses and A will have none, even though both C and A are continuing to expense ongoing R&D to maintain their software IP. So I would claim that GAAP accounting is misleading for company C in this case.

The problem with the GAAP accounting rules for IT companies such as these, as I see it, is that acquiring companies are forced to *double count* R&D expenses. They have to pay current R&D expenses to maintain the earnings power of their acquired products, but they *also* have to amortize the R&D asset on their books from the acquisition. That's double counting.

What do you think? Has my rock-solid proof convinced you?

- aagold

Saj Karsan said...

Hi aagold,

I agree with you that GAAP is misleading for C, but only in the case where your major assumption that the purchased intangibles are being maintained is upheld.

For a company like HP, I would argue that a lot of their purchases of intangibles likely just help the company maintain its market position (not grow it) as previous purchases become obsolete.

If that's true for company C's purchase (i.e. it will have to look for a Company "B2" to buy in three years just to maintain current revenue, as Company B1's once innovative product/service has been commoditized by competitors), then I would say C's GAAP is pretty accurate. The truth for HP is probably somewhere in the middle, but where that is I don't know, that's for you to figure out :)

Anonymous said...


Well remember, companies A and B were pretty much identical operationally. So B's engineers are just as good as A's and its product is just as innovative. Since C acquired B, the same holds for C.

Well, if you're correct that C will need to go looking for a B2 because B1 becomes commoditized, the same reasoning applies to A's R&D assets, right? So if C's GAAP earnings is accurate then A's can't be. On the other hand if A's GAAP earnings is accurate then C's cannot be. Either way there's an inconsistency with GAAP accounting, agreed?

The aspect of all this I'm trying to get you to see is that all IT companies have the potential for their R&D assets to become obsolete, not just those that are acquisitive. But it's only those that acquire the R&D assets that have this obsolescence assumed in the accounting; a company that generates the same or similar R&D asset internally has much more favorable accounting.

Ok - now my argument is double-rock-solid, right? You'll have to admit you agree with me now! :-)

- aagold

Saj Karsan said...

Hi aa,

Yup I agree with you that GAAP can describe similar companies differently. In this particular example you raise, GAAP likely doesn't accurately describe the earnings power of at least one of the companies, and maybe both.

One thing I would add though is that C did have to spend some cash to get to the same level as A was already, and so part of that is what is being accounted for in GAAP as lower future profit.

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