R&D Is An Investment, Not An Expense – How capitalizing R&D impacts understanding corporate profitability (GILD, FB, BA, DHR)
- In several of our
recent Seeking Alpha articles, discussions in the comments section have focused
on R&D capitalization, so we thought a piece focusing on this issue and its
impact would help further the conversation for the entire investing community.
- Investors often
assume issues around R&D only matter for technology and biotech/pharma
“R&D intensive” industries, but this issue touches companies across
sectors, including in Tech, Healthcare, Industrials, Energy, and Consumer Discretionary
to name a few.
- Expensing of
R&D flies in the face of one of the most basic of accounting principles,
the matching principle, which states that expenses should be recognized at the
time of related revenue. Capitalization solves this issue – but IFRS guidance
on expensing and capitalizing parts of R&D only muddle the issue more.
- R&D
capitalization does not mean that the impact of R&D magically vanishes from
the income statement. Rather – capitalized R&D is amortized over its life,
similar to how PP&E is depreciated.
- This adjustment represents the smoothing of the
R&D investment stream’s impact and the recognition of the investment made
on the balance sheet.
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R&D Is
a
n Investment, Not
a
n Expense
–
How capitalizing R&D impacts
understanding corporate profitability
(GILD, FB, BA, DHR)
In several recent Seeking Alpha articles Valens has posted, questions about R&D
capitalization and R&D investment have come up in the comments section. As such,
we felt it was worth writing a post about this issue, the theoretical underpinnings
behind
it, and how this impacts companies.
In this article
,
we highlight the impact of these adjustments for companies such as
F
acebook (F
B
)
,
Gilead Sciences (
GILD
)
,
Boeing (
BA
),
and
Danaher
(
DHR
)
.
Throughout
the article we provide links so
that
you can see mor
e about how the companies look
after we adjust the financial statements.
To be able to see how company analysis
looks when you make this and other key adjustments to clean up the financial
statements
,
and get a better picture of corporate profitability and
valuations, click
here
.
To read more about our adjustments
,
click
here
, and to understand how we
think about analyzing companies, click
here
.
The Problem
–
Should R&D be treated as an expense or an investment?
The problem with Generally Accepted Account
ing Principles (GAAP) is that they create
inconsistencies when comparing one company to another, and
can distort a
company
’
s true
historical
profitability
. By making adjustments, we aim to remove the
financial statement distortions and miscategorizations o
f GAAP.
In this article we will
discuss why we capitalize R&D in order to see a clearer, more accurate picture of a
company
’
s historical profitability.
Under GAAP,
firms are required to
expens
e
R&D in the year spent. For many firms,
this leads to extensi
ve volatility in profit and return calculations, and to an inadequate
measure of assets or invested capital. This doubly impacts return on asset
calculations, and not consistently so, thereby creating wildly different calculations of
economic profit.
Some
would argue that IFRS
’
s treatment is superior.
In IFRS, all research spending is
expensed each year.
However, development costs are capitalized once the “asset”
being developed has met requirements of technical and commercial feasibility to
signal that th
e intangible investment is likely to either be brought to market or sold.
This gives the benefit that “successful” R&D is capitalized on the balance sheet, as
opposed to expensed.
However, t
he fact
is, because
IFRS provides more opportunity
for the applica
tion of judgment
, this
only adds to the risk
of distortion of financial
statements as management teams attempt to apply uncertain assumptions to the
implied certainty of the financial statements.
R&D is very often not stable from year to year, and this cr
eates material and
directionally different changes in profit measures. Many companies in the technology
and healthcare sectors succumb to this problem. In the Consumer Discretionary space,
R&D
expense
has
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R&D is very often not stable from year to year, and this cr
eates material and directionally different changes
in profit measures. Many companies in the technology and healthcare sectors succumb to this problem. In
the Consumer Discretionary space, R&D expense
been growing at 8%
+
a year over the past 10 years,
but
with a 25% standard deviation in growth rates. While Technology firms have seen R&D grow at 10% a year
the past decade, we measure a 7% standard deviation among growth rates. This issue is material in many
other industries such as in the Healthcare, In
dustrials, Consumer Discretionary, and Energy sectors
.
Without capitalizing R&D, a firm
’
s earnings can be materially
understated because
the traditional
calculation of Net I
ncome does not recognize the fi
rm
’
s material investments in R&D
as part of its operating
investments. This violates one of the core principles of accounting, where expenses should be recognized in
the period when the related revenue is incurred. R&D investment is an investment in the long
-
term cash
flow generation of
the company, and as such should be capitalized, not expensed. Moreover, the incorrect
deduction of R&D investments as expenses makes it near
-
impossible to objectively compare the firm to its
peers and even to
its own historical performance.
The solution i
s to consistently capitalize R&D over a fixed period of years across an industry group, and
include that in the asset base. The capitalized R&D would be amortized over the same set of years,
effectively smoothing the R&D expense into adjusted earnings. Fin
ally, the capitalized R&D would be carried
net of accumulated amortization of R&D, allowing for far better Adjusted Return on Assets (ROA
’
) measures
of profitability.
To thoroughly explain why
R&D is more an investment than an expense
, and the practical i
mplications of
such an adjustment,
let us
split this explanation
into two parts, one theoretical, and one implementation
and practicality.
Theoretical Rational
e
for R&D Capitalization
–
Pharm
a
sset started investing in Harvoni in 2008, and the
drug didn
’
t
come to market till 2014, and the failure of Facebook Slingshot likely still helped with other
innovation
If a company builds a factory, two things could happen (to be overly simplistic)
:
they could either
end up
using that factory to produce widgets
which create revenue for the business
,
o
r shortly after they build the
factory, widget 2.0 from a competitor comes out, and they never use their factory
.
It
would then get
mothballed and sit underproductive, until the location becomes part of an inner cit
y gentrification and
millennials turn it into lofts
.
In the meantime (pre
-
lofts), the company
may do a one
-
off impairment of the
value of the factory, or they may invest more capex and retool the factory for something else, but no matter
what, they
’
re not
going to
go back and
expense that capex on a periodic basis for the duration of the time it
took them to invest in the factory.
Focusing
on two types of businesses, i
f you think of R&D similarly for pharmaceutical or technology
companies, it becomes onl
y natural to think that you should capitalize R&D. A company invests for a period
of time in a technology, be it the multi
-
year R&D investment
Facebo
ok
has made in Oculus Rift
or that
Gilead
/Pharmasset
made in Harvoni
, and then they generate revenue from that investment.
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Fundamentally,
the
R&D the company invests in during a quarter does not only create
revenue
for the
quarter where that investment took place
. Facebook is still generating revenue from the R&D they spent to
develop
their newsfeed and
ad
-
embedding into
the
newsfeed years ago.
If a company earns revenue from
an investment, then that investment sho
uld be expensed/amortized/depreciated
at the same time the
revenue is recognized.
This
“matching principal” is supposed to be at the core of accounting, though in this
and other places,
the implementation of accounting fails to reflect the philosophy. If we just expense the
R&D, we
’
re not recognizing
the
investment that occurred.
For this reason, as IFRS highlights, R&D
costs
for
successful developments need to be capitalized.
However,
s
ometimes a company invests in a technology, like Facebook
Slingshot (it
’
s ok
ay
,
we
don
’
t
remember that either)
, and it fails.
Yet, o
ften, future development
s
do grow
from that
investment
.
Certainly
some of that technology that went into Slingshot has cont
ributed to the new Instagram story feature, along
with some other healthy copying from Snapchat.
Similarly, t
he knowledge Gilead
and
Pharmasset had from
their R&D investment in
a multitude of
other failed compounds helped them to identify Harvoni
’
s active
compound
.
To understand the total investment needed by the company to create the innovation that succeeds, we
need to also capitalize the innovation that fails, or else we give the company too much credit for their
success in their R&D investment. We
’
d o
nly be including the R&D that succeeded, so when we looked at the
productivity of that R&D we
’
d think the company should always invest more R&D, since their
successful
R&D generates so much revenue. That
,
of course
,
would lead to more unproductive R&D, sin
ce not all their
R&D was historically
productive
.
By capitalizing all
of
their R&D, we can look at the total value invested to generate today
’
s revenue, just like
how we look at all the PP&E
in which
U
.
S
.
Steel has invested to generate today
’
s revenue,
both
unproductive PP&E that currently is sitting idle, and productive PP&E that is at work creating
the
high value
products that U
.
S
.
Steel still produces.
Practical
Rational
e
for R&D Capitalization
–
Boeing
’
s massive investment in R&D in 2009 makes
compa
ring their year over year profitability and returns pointless
without first capitalizing it
Capitalizing R&D actually is more
conservative than expensing it.
When an asset is capitalized, it doesn
’
t just
end up on the balance sheet and its impact on the i
ncome statement vanishes. Once we have a capitalized
R&D asset, we then need to amortize that investment over
the useful life of the asset, j
ust like we
depreciate PP&E. By capitalizing the R&D, we are
growing
the balance sheet, by the value of that capita
lized
R&D, which brings down
Adjusted
ROA and also impacts
Asset Turns.
We also still have an “R&D depreciation expense” impacting the income statement, as we amortize the
value of that investment over its life. This smooths the artificial volatility of R
&D expense and reflects the
R&D investment
that
management would need
in order
to maintain today
’
s operations, separate from the
growth R&D investment that the company may have invested incrementally in any given year. This is much
the same way depreciatio
n expense is a proxy for maintenance capex, but growth capex above that ends up
on the balance sheet and then is depreciated over the life of that investment.
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A great example of this is
Boeing
. It is hard to argue that the multi
-
year investment they make in a plane like
the 787 should be expensed each year, considering they may invest for 10
+
years on a plane that then
generates revenue for the busine
ss the subsequent 20
+
years. However, when we do expense, it isn
’
t just
theoretically wrong, it also ends up giving us bad conclusions. Here is the company
’
s Net Income
from
2008
-
2010:
Year
Net Income
2008
$2.6bn
2009
$1.3bn
2010
$3.3bn
Boeing
G
iven the information above,
Boeing looks like they had a terrible 2009, which makes perfect sense, since
2009 was the bottom for capital spending globally.
But, in actuality, that Net Income trend was entirely
related
to the timing of Boeing
’
s
R&D
investment that was multiple years in the making, and would impact
the company for multiple years in the future, not just in the year it was expensed. Here is the company
’
s
R&D expense
from
2008
-
2010:
Year
R&D
2008
$3.7bn
2009
$6.5bn
2010
$4.1bn
Boeing
If
we adjust their Net Income for that massive volatility in R&D, 2009 was not worse than 2008, it was
actually a better year than 2008. For a quick and dirty version of the math, let us just do Net Income + R&D
(we
’
ll show the actual
Adjusted
Earnings we get
in a moment):
Year
Net Income + R&D
2008
$6.4bn
2009
$7.8bn
2010
$7.4bn
Boeing
Now of course, as we mentioned above, we need to amortize that R&D investment over its life, we cannot
just add it back to Net Income and call it a day. But
,
even when we include that R&D investment
amortization (and the other adjustments we make to clean up accounting distortions), we see the same
picture, a company that had substantially better profitability in 2009
,
not worse:
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Year
Adjusted Earnings
2008
$3.0bn
2009
$4.8bn
2010
$4.4bn
Boeing
Again
, when we do expense, it isn
’
t just theoretically wrong, it also ends up giving us bad conclusions.
Boeing didn
’
t have a bad 2009, they invested heavily in 2009 to finish their work on the 787 to position
themselves for cash flow generation for the next 15
-
20 years.
Also, as an aside, the story that Boeing has had phenomenal earnings growth from 2009 to today with
Net
Income expanding from $1.3bn in 2009 to $3.9bn by 2012 to $5.1bn in 2015 is thrown out when one adjusts
for the cyclicality of their R&D investment through their airplane innovation cycle. In actuality, after
adjusting for the volatility of Boeing
’
s R
&D investmen
t, Earnings
’
has basically ranged from
$4.2
bn
-
$4.8bn
from 2009
-
2015, with n
o actual profitability growth.
I
’
ll now duck as every Boeing bull yells at me about the
order book.
More practical examples
–
Gilead and Danaher
Another
excellent
example
, as previously referenced, is
Gilead
. As
a
biotech company, the firm makes
consider
able investments in R&D as they
research various
compounds and, through both failure and
success, develop life
-
changing drugs. However, these drugs do not reach patients for years after the
research into their basic compounds and chemical structure is done and traditionally expensed
, again
violating the
“matching principle”. This d
istorts historical profitability, making it impossible to accurately
compare their current performance to years prior. For example, here is the company
’
s Net Income from
2010
-
2012:
Year
Net Income
2010
$2.9bn
2011
$2.8bn
2012
$2.6bn
Gilead Sciences
Given just the information above, it appears as if Gilead
had
seen profitability decline over the course of
those three years. However,
this trend was
in large part
related to the firm
’
s
increasing R&D expenses as
they
began invest
ing mor
e heavily in their pipeline
. Here is the company
’
s R&D expense from 2010
-
2012:
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Year
R&D
2010
$937mn
2011
$1.2bn
2012
$1.8bn
Gilead Sciences
If we adjust their Net Income for that
dramatic
increase in R&D, the firm has not seen profitability decline,
but has instead seen it improve. Again, for a quick version we will begin with just Net Income + R&D:
Year
Net Income + R&D
2010
$3.8bn
2011
$4.0bn
2012
$4.4bn
Gilead Sciences
Now, as we
’
ve mentioned previously, we need to amortize that R&D investment over its life.
But even when
we include that R&D investment amortization (and the other adjustments we make to clean up accounting
distortions), we see the same picture, a company that has i
mproved profitability consistently since 2010:
Year
Adjusted Earnings
2010
$3.6bn
2011
$3.7bn
2012
$4.4bn
Gilead Sciences
Again
,
we can see how failing to capitalize R&D can distort our view of a company
’
s historical profitability
and lead us to make inaccurate conclusions.
For our third and final example we will look at
Danaher
. Here is the compan
y
’
s Net Income from 2006
-
2008:
Year
Net Income
2006
$1.1bn
2007
$1.4bn
2008
$1.3bn
Danaher
From the information we see above, we may be le
d to conclude that DHR was
just able
to maintain its levels
of profitability in the face of an oncoming global
recession, which may initially seem correct. However, this
ignores that material impact of R&D expenses. Here
’
s the company
’
s R&D expense from 2006
-
2008:
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Year
R&D
2006
$434mn
2007
$541mn
2008
$725mn
Danaher
If we adjust their Net Income for that
steady increase in R&D, the firm did not see profitability falter in
2008, but instead saw continued improvement. Again, for a quick version we will begin with just Net Income
+ R&D:
Year
Net Income + R&D
2006
$1.4bn
2007
$1.9bn
2008
$2.0bn
Danaher
After adjusting for the amortization of R&D investment and other accounting adjustments, we arrive at a
similar picture, with improving profitability since 2006:
Year
Adjusted Earnings
2006
$1.4bn
2007
$1.6bn
2008
$1.9bn
Danaher
Danaher didn
’
t have stagnant
profitability
f
rom
2006 to 2009, or even a plateau shift in 2007 that stabilized.
In fact, they saw earnings growth accelerate each year from 2006
-
2008.
Investors who knew how to see
though the distortions in GAAP accounting knew it too, as
the stock outperformed the market every year
from 2005
-
2010.
Thus again
,
we see a different picture than what traditional metrics would show, and we can see how this
adjustment helps prevent
us from drawing incorrect conclusions.
An Addendum
–
How do
you decide how many years to capitalize R&D for?
Does it matter?
If you are going to capitalize R&D, you need to make some estimate for the life of that R&D.
When making
the determination, the most important issue is that you make sure whatever life you
choose for R&D is
consistent across a comparable universe.
You should not capitalize R&D for
four
years for
one
aerospace
and
defense name, but capitalize it for 15
years
for another, or else you lose comparability.
The same is true
in pharmaceuticals or s
emiconductors.
Of course no one would likely argue the life of R&D in those
three
industries
are
the same, but the life of R&D within the industry is likely to be similar.
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However, in our framework, we didn
’
t just pick numbers that “felt right”.
We specif
ically built our analysis
off of the work of some of the brightest researchers in the space of valuing Intangible Assets.
In particular,
part
of our
framework
comes from the analysis of Baruch Lev at NYU, and the work he has done on valuing
intangible asse
ts and the persistency of the impact on revenue of a dollar invested in R&D for different
industr
ies.
It is unsurprising that after this excellent research, Professor Lev, who is the Philip Bardes Professor of
Accounting and Finance at NYU Stern, has move
d on to write about the flaws of current accounting
standards framework and the issues they create.
Capitalizing R&D solves both theoretical issues with financial statements, and practical issues with
financial statement analysis
To recap,
R&D is
fundamentally an investment. Just because a company needs to invest in R&D to maintain
their business doesn
’
t mean it should be an expense. Companies make investments in their business to
maintain their competitive advantages.
CAT invests in a new plant
to maintain their operating
performance. That doesn
’
t mean
we should expense
all their capex in that plant because they had to spend it to maintain their performance, it was still an
investment to help produce future cash flows. If an investment is going t
o impact revenue growth and cash
flows for a business beyond the current period, that investment should be capitalized, not expensed.
As such, we should be capitalizing that R&D, and showing it as an asset on the balance sheet.
Then, when
we run off the
R&D investment as the R&D
’
s benefit to revenue diminishes, we
’
re still impacting the income
statement. This gives a clearer, more conservative view of a company
’
s true profitability, removing
accounting distortions and allowing for fair comparisons between
the company
’
s historical performance
and the performance of its peers.
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Disclosures
Officers of Valens
Research
have positions in securities of
Facebook
, Inc. (
FB
)
and Gilead Sciences
, Inc. (GILD)
as of the
date of this report.
Officers of Valens
Research
are engaged and have beneficial inter
est in an investment management company,
Kennebec River Capital, which has positions in
The Boe
ing Company (BA) and
Facebook
, Inc. (
FB
)
as of the date of this
report.
As of the date of this report, officers of Valens
Research
are engaged and have beneficial interest in an investment
management company, Kennebec River Capital, which has actively traded, and may trade, in the securities and/or
derivati
ves of the securities of
Danaher Corporation (DHR)
.
VALENS RESEARCH
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Research
and is provided for information purposes only. Th
e information
provided is not intended to provide a sufficient basis on which to make an investment decision. Information and
opinions presented in this material have been obtained or derived from sources believed by Valens
Research
to be
reliable, but Val
ens
Research
makes no representation as to their accuracy or completeness. Valens
Research
accepts
no liability for any loss arising from the use of this material. Any reference to potential asset allocation and potential
returns do not represent and shoul
d not be interpreted as projections.
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