R&D: The Fuel of Future Earnings

- Summary -

Louis Ross (Director, Global Emerging Technology Institute, New York)

Investors are increasingly becoming aware of the importance of following R&D trends and individual corporate R&D spending and strategy when making investment decisions. R&D is the main source of a firm's future earnings potential. It would be sure folly for investors to ignore this vital aspect of how companies maintain earnings growth and profitability. Though valuing companies by analyzing R&D metrics is difficult, since R&D is an intangible asset, such valuation can be supplemented with a more thorough understanding of the company's existing and planned product pipeline and its ability to commercialize innovation and/or turn it into an industry standard. Looking at R&D figures such as "R&D Intensity", which is the percentage of R&D to total sales helps analyst factor in the potential impact of R&D spending on future earnings potential.

R&D intensity ratios are different depending on the sector, since some industries spend much more on R&D than others. In general, R&D spending is the key to not only future earnings growth but, as a consequence, regional economic and job growth as well, since it acts as the seed for new industry creation. High R&D industries are also usually growth industries, which usually the most attention from private equity and public equity investors.

The two largest economies in the world also lead in innovation. The United States and Japan are the world's most prolific spenders of R&D out of all of the most advanced industrialized countries, spending more on R&D as a percentage of GDP. Germany and France follow behind both countries, with Italy, the UK and Canada filling out the rest in terms of G-8 countries. The Japanese lead by a significant margin, especially in non-defense related R&D/GDP expenditures. Japanese companies also now dominate the list of the world's most innovative firms in terms of patents filed. Interestingly enough, even in the midst of a series of recessions over the past 10 years, seven out of the top 10 firms that lead in patent filings are Japanese according to 2001 figures. These firms include Canon, Sony, Hitachi, Matsushita, NEC, Mitsubishi, and Fujitsu. IBM is number one by a significant margin.

Japanese R&D outlays were an issue for the bureaucracy and industry executives during the first half of the 1990's as a lull in economic activity after the deflating of the property and stock market bubbles led to forced reductions. The first recorded post-war reduction in Japan in R&D spending occurred from 1992 to 1994. However, since 1994, Japanese R&D spending as a percentage of GDP has increased significantly, with the bulk of the R&D being in later stage development of technologies, especially that prime for commercialization. Firms in the U.S. and overseas are increasingly realizing the importance of the development part of R&D. The Japanese realized that the life-blood of future earnings were in R&D and decided to forego budget cuts that would negatively impact R&D spending in the face of restructuring. Today, restructuring efforts at Japanese firms are even more intense but innovation that leads to novel product creation are still key priorities that could not be ignored or shelved for too long. The U.S. also experienced a boom from 1994 in R&D spending across the board by nearly 60%. However, percentage wise, the U.S. led in funding for basic research, which catered to the country's strength in innovation in the university lab and much more developed and productive university-industry research cooperation.

The recent less-than-stellar performance of Japan's leading technology companies may lead one to believe that the results of Japanese R&D initiatives led to disappointing returns and were not an efficient deployment of economic resources. However, these results must be understood in the context of the condition of the global macro-economy at large and the destructive decrease in global IT spending by companies. People should expect these firms to return to strong earnings growth based on the fruits of relatively successful R&D efforts and the likelihood of large firms spinning-off promising technologies into subsidiaries and/or creating new firms in which the large firm maintains a controlling or even minority interest. Japanese firms are also increasingly investing in foreign private equity/venture capital funds in order to take advantage of local expertise in identifying promising technologies and are considering making more direct investments. The above helps restructuring efforts as it serves to "outsource" R&D, which can lead to both cost reductions and a more efficient use of R&D funding expenditures.

At this point in time, from an investors perspective, it is reasonable to conclude that some Japanese firm's possess a good deal of under-valued R&D, and that this should be taken into close consideration when valuing their future investment potential. The same would hold true for other firms, which generate strong patent flow, such as IBM, Samsung of Korea and Micron. Product development is important but it's much easier to be profitable with a more innovative product that incorporates new technology.

Though it is difficult for investors to recognize and value R&D, one way is to monitor promising technologies companies are actively investing in and which ones are being supported by the private equity/venture capital community. These provide signs as to what type of R&D will develop into innovative commercial products that lead to increased profitability. They also help to warn the investor as to which technologies may only be the object of a speculative bubble.