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Acquisitions to mask true R&D expense


Phaceliacapital
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Hi all,

 

I saw this recent clip of Jim Chanos at BB: http://www.bloomberg.com/video/chanos-i-don-t-think-apple-s-a-value-stock-LcVQQA1OSRS4t9vYefyxzw.html

 

where he basically states that a lot of companies (IMB, 3D systems) are masking their true R&D expense through the use of acquisitions, which allows them co capitalize instead of expense their R&D in the financial statements.

 

This of course benefits Net Income and thus Free Cash Flow, distorting the true health of the company.

 

(He made a similar argument concerning HP in 2012: http://www.cnbc.com/id/48228416 )

 

How do you guys look at this in terms of correcting?

 

Do we subract that portion of the acquisition (found in CFI statement) related to R&D from Net Income (before tax)? Do we look into the financials of the target to find their R&D expense and approximate what amount of R&D they bought?

 

Is a company like Yahoo doing this?

 

Thanks in advance for the knowledge

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I try to pull historical data over the last 10 yrs or so and look for patterns. If there is on average some level of acquisition spend that seems sizable I will see what % of sales that is on average and use it to drive up my maintenance capex as % of sales to adjust for it.

 

So for example, if capex is usually 1% of sales but acquisitions average 4% of sales annually over the last 10 years, I will calcuate maintenance capex as 5% of sales.

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Some analysts will argue that acquisitions should not be treated like capex because the acquisitions generate immediate economic returns for the company (as opposed to traditional capex - purchasing and installing equipment, for example - which is expected to generate the preponderance of its returns in future periods).

 

For the typical tech acquisition, which tends to reduce economic returns in the short run (and are dubious to actually create value in the future, particularly at the prices paid), arguing that these should be excluded from calculations of free cash flow is incorrect in my opinion.

 

For example, look at CRM's major acquisitions in recent years - Heroku, paying roughly $215 MM for ~$1 MM of revenue; Radian6, paying $337 MM for a negligible amount of revenue; Buddy Media, paying $745 MM for $32 MM in revenue; and, ExactTarget, paying $2.4 BN for $340 MM in revenue. They've made plenty of other acquisitions on even earlier stage companies, but the acquisitions listed amount to $3.7 BN in cash/stock outlays for roughly $375 MM in revenue - and of course non of that revenue generated any profit. However, because the true cost of these acquisitions are almost entirely capitalized as goodwill or intangible assets, the near-term income statements tend to grossly overstate profitability.

 

And that leads me to reason #257 for shorting CRM - they can't generate GAAP operating profits even with the benefit of merger accounting!

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We ran into this issue looking at Danaher (DRH). All of their "growth" capex goes into acquisitions - actual capex is way under d&a because of the purchased intangibles. Supposedly organic growth is 4 to 6%, which management claims they can achieve without spending a dime above d&a, indicating maintenance capex is at or below d&a. I don't buy it. The "Street" looks at FCF using capex versus penalizing them for intangible amortization via d&a - all that to say, I've found the best way to account for the issue this thread is discussing is to not assume maintenance capex is lower than d&a, such as is tempting to do with a Pfizer....

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I think it really depends on what the company is doing.

 

If a tech company is buying a company that is pretty unrelated to its current products, then it should be considered expansion capex.  Ebay bought Skype... and later sold it off.  That is not R&D capex.

 

Sometimes tech companies will buy companies for their technology instead of building that technology themselves.  You might look at Ebay buying Billpoint and then later buying Paypal (which replaced Billpoint).  But even then... it looks a lot like expansion capex (with the benefit of 20/20 hindsight).

The economic reality was that Ebay didn't succeed in cloning Paypal.  So they bought out Paypal instead... booking lots of intangibles.

 

2- As a strategy, buying R&D isn't something that will work.  A company could fire its existing development team (or just part of it) and try to buy software code from another company.  But that would be completely stupid.  The acquired code can't be combined into the existing product without a lot of work.  And it's highly unlikely that another company will be working on exactly what the acquiring company needs.  From a software development perspective it makes no sense.

 

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