Valens Research White Papers – the Impact of Capitalizing R&D
Total Page：16
File Type：pdf, Size：1020Kb
Valens Research White Papers – The Impact of Capitalizing R&D | September 8, 2016 Valens Research R&D Is an Investment, Not an Expense – How capitalizing R&D impacts 917 284 6008 understanding corporate profitability (GILD, FB, BA, DHR) In several recent Seeking Alpha articles Valens has posted, questions about R&D Rob Spivey capitalization and R&D investment have come up in the comments section. As such, Managing Director we felt it was worth writing a post about this issue, the theoretical underpinnings 917 284 6008 behind it, and how this impacts companies. Angelica Lim In this article, we highlight the impact of these adjustments for companies such as Research Director Facebook (FB), Gilead Sciences (GILD), Boeing (BA), and Danaher (DHR). Throughout 646 453 7861 the article we provide links so that you can see more about how the companies look Kyle Pinkerton after we adjust the financial statements. To be able to see how company analysis Analyst looks when you make this and other key adjustments to clean up the financial 917 284 6008 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. [email protected] The Problem – Should R&D be treated as an expense or an investment? The problem with Generally Accepted Accounting 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 Valens Research App financial statement distortions and miscategorizations of GAAP. In this article we will Valens has launched a new app. discuss why we capitalize R&D in order to see a clearer, more accurate picture of a company ’s historical profitability. The Valens Research app enables investors to use our cleaned up financial analytics, which shows Under GAAP, firms are required to expense R&D in the year spent. For many firms, over 120 adjustments made to 35 categories of the As-Reported this leads to extensive volatility in profit and return calculations, and to an inadequate Financials of over 3,000 measure of assets or invested capital. This doubly impacts return on asset companies... providing investors calculations, and not consistently so, thereby creating wildly different calculations of and researchers with more accurate numbers that tell the economic profit. story for the companies you are analyzing and investing in. Some would argue that IFRS’s treatment is superior. In IFRS, all research spending is Subscribers to the database have access to both our Valens Equities expensed each year. However, development costs are capitalized once the “asset” Performance & Valuation Prime being developed has met requirements of technical and commercial feasibility to cleaned up cash flow analytics platform, and our Valens Credit signal that the intangible investment is likely to either be brought to market or sold. iCDS and Credit Cash Flow Prime This gives the benefit that “successful” R&D is capitalized on the balance sheet, as debt analytics platform as part of opposed to expensed. However, the fact is, because IFRS provides more opportunity the new app. for the application of judgment, this only adds to the risk of distortion of financial To read more about the new app statements as management teams attempt to apply uncertain assumptions to the and to sign up for access, click here. implied certainty of the financial statements. R&D is very often not stable from year to year, and this creates material and directionally different changes in profit measures. Many companies in the technology VALENS EQUITIES | INSIGHTS & INFLECTIONS 1 425 Fifth Avenue, New York,and New healthcare York 10016 |sectors 212 213 succumb 5070 | info@valens to this problem.-equities.com In the Consumer Discretionary space, R&D expense has Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Valens Research White Papers – The Impact of Capitalizing R&D | September 8, 2016 R&D is very often not stable from year to year, and this creates 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, Industrials, Consumer Discretionary, and Energy sectors. Without capitalizing R&D, a firm’s earnings can be materially understated because the traditional calculation of Net Income does not recognize the firm’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 is 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. Finally, 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 implications of such an adjustment, let us split this explanation into two parts, one theoretical, and one implementation and practicality. Theoretical Rationale for R&D Capitalization – Pharmasset 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, or 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 city 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, if you think of R&D similarly for pharmaceutical or technology companies, it becomes only 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 Facebook has made in Oculus Rift or that Gilead/Pharmasset made in Harvoni, and then they generate revenue from that investment. VALENS EQUITIES | INSIGHTS & INFLECTIONS 2 425 Fifth Avenue, New York, New York 10016 | 212 213 5070 | [email protected] Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Valens Research White Papers – The Impact of Capitalizing R&D | September 8, 2016 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 should 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, sometimes a company invests in a technology, like Facebook Slingshot (it’s okay, we don’t remember that either), and it fails. Yet, often, future developments do grow from that investment. Certainly some of that technology that went into Slingshot has contributed to the new Instagram story feature, along with some other healthy copying from Snapchat. Similarly, the 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 only 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, since not all their R&D was historically productive.