There is a fascinating piece of research this morning from Merrill Lynch. I know that this seems like an oxymoron--'fascinating research' and 'Merrill Lynch'--but nevertheless, it applies here.
Tom Astle in the Telecommunications/Equipment wrote the piece. It discusses the strange propensity of Wall Street to completely ignore R&D expenses when they are acquired (and immediately written off) and yet include these R&D expenses when they are internally expended.
This goes back to a post of mine a couple of days ago. CSCO spends relatively little money on R&D because they acquire almost all their R&D. Thus, over the past 3 years, CSCO's R&D expense $3.4 billion, while LU's R&D expense is $11.7 billion. The key here is that CSCO has acquired and written off a much larger sum that Wall Street refuses to include in the operating earnings section. LU, on the other hand, has acquired less R&D than CSCO and spent more internally, and thus LU's operating earnings are penalized excessively. And the net result is a market cap for CSCO of $500+ billion and a market cap for LU of $200+ billion. (The research also looks at JDSU vs GLW, where the discrepancy is even larger. Over the past 3 years, JDSU has spent $100mm on R&D, while GLW has spent $900mm on R&D. JDSU's market cap is $95 billion while GLW's is $49 billion.)
The one place where I disagree sharply with the research is in the conclusion. Astle notes that there are 3 different types of companies in this sphere (I'm quoting here):
"Type 1 Companies: Those that have it as part of their strategy for some time and are currently benefiting from it. We [i.e. ML] believe this would include the likes of Cisco and JDS Uniphase.
"Type 2 Compnies: Those that 'now get it' and are moving from a corporate R&D environment to a more distributed and acquisition-driven R&D culture. We think that NT and maybe GLW may be in this camp.
"Type 3 Companies: Those that have considerable history and culture as a world-class coporate research lab and thus have considerable internal culture that makes outsourcing R&D challenging. We believe Lucent with Bell Labs may fall into this category.
"The upside for investors, we believe, lies in the Type 1 and 2 companies. Type 1 companies can be expected to accelerate product development and leverage acquired R&D. Type 2 companies may be even more interesting, in that they can accelerate their product developement plans while potentially at the same time reducing reported R&D expenditures."
I disagree sharply with that contention. In the long run, Wall Street does indeed adjust to accounting games. In the end, the calculation should be and will be how much money is put into a project, and how much money that project can generate--simple discounted cash flows. The fact that Wall Street currently thinks that acquired R&D is not a true operating expense will slowly go away. This happenend in the Go-Go era of the 60's, when high PE conglomerate companies acquired low PE companies, with the newly acquired earnings getting a higher PE. It was an accounting game then, and the conglomerates paid dearly in the 70's.
This will happen again, but this time a company like CSCO will be in for the hurting. This is an accounting game right now, and sooner or later Wall Street will assign acquired R&D as an operating expense just like internal R&D is now. And when that happens, a company like CSCO will suffer. And if LU can solve their cash flow problems, then LU will be a beneficiary. |
