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Biotech / Medical : Biotech Valuation -- Ignore unavailable to you. Want to Upgrade?

To: Harold Engstrom who wrote (1386)	8/4/2000 3:54:16 PM
From: RCMac	Respond to of 52153

>> how can you capitalize R&D? << Harold, Peter will have a fuller and more comprehensive reply (he’s probably drafting it now), but a principal attraction of capitalizing R&D (which has conceptual difficulties, as you point out) is to filter out the distortions created by expensing it, i.e., by treating it like the electricity bill or the janitor’s wages, like money down the sewer as opposed to investment designed to create future value. Biotech/pharma R&D costs, are at least arguably economically similar to, say, building a factory to build more autos, aircraft or computer chips, in that both R&D and factory-building costs are expended to create products to generate future income. A major difference of course is in the risk that the investment won’t pay off, which is why it’s hard to argue for a general principle that they should be capitalized. But most biotech investors, I think, make some similar adjustment to a biotech’s balance sheet in judging its value, just as Peter did in the post that started this discussion. An earlier discussion of these issues, with specific reference to the distortions on the income statements of companies with some marketed products but whose value resides largely in their pipelines, started at reply #512 on the Munch-a-Biotech-Today thread, Message 10707142 , and continued on this thread starting at reply # 318 Message 10711099 . -- RCM

To: Harold Engstrom who wrote (1386)	8/4/2000 4:06:07 PM
From: Biomaven	Read Replies (2) \| Respond to of 52153

Harold, The issue we are talking about is timing. The R&D expense ultimately has to flow through to the income statement at some point or another. The issue is whether it should flow through when you first spend the money (as it does now), or over some longer period (here the life of the drug). Think of a real estate company that owns and rents properties. If one year they spend $100m on a building, clearly you don't want that $100m coming straight off their profits. Instead they capitalize the expense, and amortize it over the life of the building (say 40 years). Each year a portion of that $100m will come off their income. Now for a drug company, things are a little more complicated. Essentially there are two cases. The first is where you get a marketable drug. Here the capitalized asset is the drug itself, and a good case can be made that the "best" accounting treatment (not the current one) is that the R&D costs should be amortized over the life of the drug just like the case of a building. The second case is where the drug candidate flames out. What you should then do is write-down the value of your asset (perhaps to zero), and the income hit comes when the flame out occurs. (Just as would happen to the real-estate company if the building collapsed and was uninsured). Right now, for a company such as AMGN, the R&D simply gets deducted from current profits even though they are "building a new building." Further, nothing at all shows up in the income statement if a drug candidate flames out. You will sometimes see an expression "quality of earnings." This is an attempt to adjust for the idiosyncracies of the accounting system. A company (like AMGN) that expenses a lot of R&D is viewed as having good quality earnings, while a company that capitalises things that should really be expensed has poor quality earnings. (In the early days of AOL a big dispute was whether they could capitalize the costs of all those diskettes etc. they sent out - AOL argued that they were building an asset - the new customers, and as it turns out they were right in an investment sense.) A further issue arises with purchase accounting. Here the R&D of the acquired company (which has been expensed once already) gets magically converted into an asset (called goodwill) and amortized all over again. However that's another story. Peter