R&D in Industrials and Basics – Just Not Effective

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@sector-sovereign.com

March 6th, 2013

R&D in Industrials and Basics – Just Not Effective

 

  • Valuations in the Industrials and Basic Materials sectors would suggest that the more you spend on R&D the more investors penalize you for it! Plotting R&D expense (as a percentage of earnings) against PE ratio, the best fit line (while a poor fit) slopes the wrong way. The more you spend the lower the PE – Exhibit 1.
  • Most R&D spending does not appear to generate adequate returns on investment, or if it does, it does not generate enough to offset declines in the legacy business. Often what may be touted as R&D is really product line extension/enhancements – products that substitute others in the portfolio – the return looks good in isolation, but not for the company as a whole.
  • At a more micro level the cost to generate each new patent has an inverse correlation with the growth in return on capital – again questioning the effectiveness of the R&D spending. We highlight companies spending a lot and not generating return on capital growth – Exhibit 2.
  • Companies with high R&D spending generally have higher SG&A costs and higher capital spending than their less R&D intensive peers. The returns needed on new discoveries to cover all of these added costs are likely higher than companies assume.
  • R&D spending like other discretionary spending on capital projects and M&A should be carefully assessed in the overall capital allocation decisions to maximize shareholder value.

Exhibit 1

Source: Capital IQ and SSR Analysis: Note that we are using current P/E ratios and a three year average of R&D spending over normalized net income

Exhibit 2

Source: Capital IQ and SSR Analysis

Overview

When we think about R&D spending, we think about industries like healthcare and technology, where innovation is key and drives new product cycles, new devices or molecules etc. In these industries, investors generally give companies credit for their high levels of R&D spend, reflected in a higher P/E ratio of current earnings – Exhibit 3.

Exhibit 3

Source: S&P500 Industry Groups, Capital IQ and SSR Analysis

As shown in Exhibit 1, this relationship is clearly not the case for Industrials and Basic Materials, with companies that have almost no R&D often showing much higher P/E ratios than many with substantial R&D spending. There can be one or a combination of several reasons for this – and we will discuss each in more detail:

  • The R&D spending is ineffective and does not generate an adequate return. This is certainly true for many companies outside Industrials – See Richard Evans’ piece on R&D returns on healthcare (2011). But other sectors do not appear to be as penalized up-front for this from a valuation perspective as Industrials.
  • The rest of the business is declining so rapidly, that R&D is needed to keep earnings growing or stable. This is not obvious, and we will cover this in more detail shortly.
  • The notion that you are a “high tech” or “specialty” company convinces you to run businesses in a more costly way than you would if you labeled them as “cash cows” – so the R&D program causes you to have higher costs (outside the R&D expense)and lower margins than your leaner competitors.

If we take the top ten spenders in the group and reduced their R&D budget by 50%, thereby forcing them to rank R&D projects by expected return and raise the hurdle, we might not see much of an impact on earnings growth. If that 50% reduction was applied to a dividend, we would see an average dividend increase of more than 50% taking the average yield of the 10 companies from 2.3% to 3.9%

The other interesting analysis is to assume that the R&D is effective and that companies do generate an industry average return on capital from these programs – say 10%. If we take that view, we can back into the growth or decline of the remaining portfolio. This analysis suggests that the bigger spenders have core portfolios that are deteriorating faster than the smaller spenders. We find that had to believe and so struggle with the idea that R&D is generating an adequate return in isolation.

We would suggest that companies claiming that their R&D is effective, yet not demonstrating the implied growth in that statement are getting either the numerator or denominator wrong, or both. The numerator should be adjusted to reflect products substituted and any operating efficiency loss that occurs as a result. The denominator needs to be adjusted to fully reflect the cost of the R&D, the higher SG&A costs that the company carries (if any) because of its “higher touch” approach to the business and any incremental capital spent to bring the new product to market.

 

Research and Development – Innovation or Product Extension?

When did the Industrials and Basic Materials sector last come up with a large volume category killer?

Polypropylene?

Glyphosate?

Nylon?

PET?

The Commercial Jet Engine?

The Bobcat?

PVC Pipe?

Blown Insulation?

Water Based Paints?

Smart Meters?

The answer is that it has been a very long time. What we see in R&D today is more product extension and improved product properties. At times this can be quite destructive as any enhancement that allows your customer to use less of a product comes back to bite you – you might be getting a higher price and you might use that higher price to convince yourself that the R&D is paying its way, but it is not if you lost 10-20% of your original volume as a consequence.

Companies offer metrics that talk about the share of revenues or operating income today that is generated by products that are less than 3 or 5 years old. What they often do not tell you is how much of those markets were previously served by prior generations of products.

We have looked at R&D spend and we have looked at patent filings – the data is interesting in aggregate and we show a couple of data cuts below – in Exhibit 4 we show the average spend by sector as a proportion of normal earnings. In Exhibit 5 we show the average cost of patents filed on a current year basis.

Exhibit 4

Source: Capital IQ and SSR Analysis

In Exhibit 4 we get the picture we would expect, with the more commodity type businesses spending far less than the rest. The Chemical sector is an outlier partly because of the large Agricultural Chemical R&D spending. Note that the Transport sector and the E&C sector do not have any significant R&D and are omitted from the analysis

Exhibit 5

Source: Capital IQ, Cobalt IP and SSR Analysis

There are no obvious conclusions to be drawn from Exhibit 5 – although we do look at an interesting possible relationship to return on capital later in the report. The patent data is only for the US and so we are overstating the per-patent cost for companies and industries with reasonable patent estates outside the US – this is probably most relevant again in Agricultural Chemicals were there is a need to protect a seed or germ plasm or chemicals in many markets. Given that some companies elect to file more patents than others, for a given level of discovery, and given that some discoveries are potentially worth more than others, it is difficult to draw conclusions from the data above except perhaps directionally or anecdotally.

Companies in similar industries spend very differently and their approach to R&D is very different. If we look at Capital Goods for example we have a wide range of approaches to R&D, with companies in similar businesses committing 20-40% of earnings more or less than one and other. The same is also true in the Chemical sector – the only other sector where we have plenty of company data points and can draw comparisons – Exhibit 6.

Exhibit 6

R&D Spending/Normalized Earnings (3 Year Average)

Source: Capital IQ and SSR Analysis

No PE respect, but No Earnings Growth Either, So Not Surprising!

We have shown above that the investment community does not, on average, value the R&D spend at industrial companies. When you look at earnings growth, or any other metric that might interest us, you can see why.

In the Exhibits below (7 through 9) we show EPS growth versus R&D spending and return on capital (ROC) growth versus R&D spending. If the R&D was effective you would expect to see better EPS growth and improving returns on capital. There is a correlation in the Capital Goods, but there is no correlation for Chemicals. Even for Capital Goods, it is not clear that the improvement is worth the level of spending. Note that we have used ten year trend and average data for each group from 2002 to 2011 and we have taken the feed directly from Capital IQ, with no adjustment – in some cases the ROC trend is very influenced by the start and end points, but we feel we have a big enough sample size in both groups to show the results and draw conclusions.

There are obviously companies who are getting it more right than wrong, and we would highlight CMI, CAT and WWD in the Capital Goods space. At the same time we would ask questions about PCAR, IR, GGG and JCI. In the Chemicals space, the positive stories are EMN and MON (MON is not on the ROC chart as it had negative returns in the early years, making the growth calculation difficult). Questions should be asked of DOW, DD, IFF and possibly PPG, although for PPG the ROC trend is impacted by our choice of start an end year – over the longer term, PPG has a slight rising trend to its ROC.

Exhibit 7

Source: Capital IQ and SSR Analysis

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

So this takes care of the first bullet point in the overview – clearly there are plenty of companies who cannot show either the earnings growth or the return on capital improvement needed to justify the level of R&D spending.

Taking another look at the patent data we decided to look at any correlation between the average cost per patent and the return on capital trend of the company. Notwithstanding the shortcomings of the patent cost analysis, discussed earlier, we looked at the 18 largest spenders and got the results shown in Exhibit 10. The correlation is poor, but the best line fit does suggest that the higher the cost per patent filed, the lower the trend growth in ROC and it does suggest that there is an R&D efficiency question to be asked of many companies. Perhaps the scientific/discovery results of the R&D are not all bad; it is just that some companies can get the results at a much lower level of overall spending.

Exhibit 10

Source: Capital IQ, Cobalt IP and SSR Analysis

The Declining Portfolio Argument Generally Struggles Because It Cannot Be Company Specific

For every larger R&D spender not meeting an earnings growth rate or return on capital improvement to justify the R&D spend, we can find another company spending less with better results. If R&D is needed to offset business declines, those in the same business with more limited R&D would be in much worse shape. Exhibits 7 through 9 show some benefit to higher R&D, but not enough to justify the money spent and the correlations are poor.

For example, Praxair spends half as much on R&D as Air Products on our measure and while both companies have very good results generally, PX is ahead on both earnings growth and ROC trend growth. Given the similarity of the portfolios, if there was an industry margin decline story going on they would be more similarly impacted.

 

The industrial gas comparison is easy because of the similarity of the business mix, but less compelling given the small differences, as they may be within the accuracy of the analysis. Compare AGCO and DE, OSK and ETN, OLN and DD, OLN and DOW or ALB and almost anyone else in the chemical space. Look at Monsanto versus any one of the other Ag companies.

How You View Your Business May Be More Key

There is clearly some strength to the R&D productivity argument, and this may be the entire story. We would place little weight on the deteriorating portfolio argument as the right answer is not to pour billions of dollars into R&D to try and turn yourself into something you are not – it is to run those businesses efficiently and maximize the return on what you have.

But we think there is a problem associated with exactly that point – companies that think of them self as “Technology Heavy” or “Science Heavy” maintain costs structures on their less special products or portfolios of products because they think they have a “value added” approach to the business, which requires more infrastructure and higher operating and SG&A costs.

Again this is hard to prove; but if you have high R&D spending which should drive higher capital spending (to exploit the R&D) and you maintain a higher SG&A base you will struggle to get better returns unless the pricing/margin opportunity on the new product(s) is way above your average. We suspect that this is the analysis that is not being done properly by the companies that are clearly not delivering on their R&D spending. Given that this is the majority of companies in our coverage group, it is perhaps therefore not surprising that the negative correlation exists in Exhibit 1.

Again this is not a perfect analysis and we can pick lots of holes in it ourselves (so don’t bother calling!) – but we have plotted R&D spending against SG&A spending to see if the high R&D spenders also spend more generally – Exhibit 11. If we look at R&D spending versus capital spending we do not see any correlation between the big R&D spenders and the big capital spenders – Exhibit 12.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

Questions/Suggestions

We offer the following questions for investors as possible avenues to explore with companies to try and get to the bottom of what is really going on within a company from an R&D perspective. This is not an exhaustive list by any means, but starts directing you down avenues that may help to get some answers.

  • What percentage of new products generated each year, substitute existing products in the portfolio?
    • How many of these can be produced on existing capacity and how many require dedicated capital investment?
    • What has happened to the prior product line (volume/margin) since the new product was introduced?
  • Does a new product have the necessary pricing power to cover its cost of development?
  • Are you over-engineering? Is a less sophisticated product enough?
    • If you can get 90% of the pricing opportunity with a product that takes 50% less cost to develop – that is probably the way to go.
  • Do you benchmark your R&D process/platform against others – if so – how?
    • What are you best in class at?
    • What do you need to improve?
  • Are there large classes of basic R&D that could be more efficiently done collaboratively by companies that ultimately want to take the base work in different directions?
  • How much additional cost does your R&D program create – capital spending and SG&A?
    • Do you consider your return on R&D against all of these?
  • Can you show specific examples of new products, including all associated research, development, incremental sales and capital costs, that generate a positive NPV?

©2013, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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