SAM DYSON |
Looking for assets the accountants can’t see
Even well-known companies can have ‘hidden assets’. There could be an undervalued property, for example, or a resilient brand or perhaps an innovative culture. Another, thanks to a somewhat misleading accounting convention, is a company’s research and development (R&D) efforts.
Consider two of Australia’s most successful companies: CSL and Cochlear. They are both high-quality businesses having earned excellent returns on the funds they have employed, averaging 31% since 2009. I would like them to employ some of my funds, please!
However, the market knows about them and their brilliant past: they both look very expensive at first blush, trading at FY18 PEs of 28x and 34x respectively, on earnings estimates 25% and a whopping 87% higher than last year.
Both companies have built a R&D engine that underpins their phenomenal growth. Accounting standards, however, typically require R&D costs to be expensed every year because the future benefits are uncertain. There is no item on the balance sheet that values it, but if spent well in areas that are relevant and economic, R&D is surely valuable.
Perhaps, then, CSL and Cochlear are not so expensive? They respectively spend 10% and 12.5% of their sales on R&D, depressing profits and inflating their PEs. If we add back R&D costs and use ‘pre-R&D’ earnings, then the FY18 PEs are much more reasonable at around 20x (chart 1).
Chart 1. FY18 Price earnings ratio based on headline earnings and pre-R&D earnings
Source: Factset, Vertium at July 2017
That looks much better. And given the adjusted PEs are at similar levels, yet Cochlear spends relatively more on R&D than CSL, then Cochlear should grow faster and be the better bet. Easy.
Hang on though. R&D is an essential cost of doing business, so ‘pre-R&D earnings’ can’t be distributed to shareholders. If R&D efforts were to suddenly stop, and the savings returned to shareholders, then these juicy profits and growth would erode over time as competitors develop better products. This was one of the many sins of Valeant Pharmaceuticals in the US, the serial acquirer and slasher of R&D budgets that has suffered a 95% share price collapse since mid-2015.
We should instead view R&D in the same way as does a management team hell-bent on protecting and improving the business. It is a capital investment – a cost that provides benefits that last well beyond a year – despite its usual accounting treatment as an operational business expense. The ‘asset’ created by a company’s R&D history underpins current and future returns, and it must be maintained by continued reinvestment. It has a historic cost, and a useful life over which that cost is amortised.
This brings us to an interesting question: for how long does R&D last?
1. R&D drives the product cycle
Absent a horde of new entrants, R&D typically leads a normal product cycle, so that is our starting point. As each new product is launched, the R&D that brought it into being becomes obsolete and efforts begin on the next. So the R&D has a useful life equal to the duration of the product cycle.
Looking at CSL, its liquid intravenous immunoglobulin ‘Privigen’ superseded ‘Sandoglobulin’ in 2008; R&D efforts began in 2004 when Sandoglobulin was released. Similarly, R&D on its subcutaneous immunoglobulin ‘Hizentra’ started in 2006 when its predecessor ‘Vivaglobin’ was launched; Hizentra was launched in 2010. Further R&D was required for these two products to treat the immune disorder CIDP, taking another six years for Privigen, while approval for Hizentra is expected in 2018. Approval for new indications for ‘Humate’ and ‘Rhophylac’ each took four to five years, while the latest version of its recombinant haemophilia A therapy/product ‘Afstyla’ took six years to develop. So let’s assume that the R&D and product cycle for CSL is roughly five years.
For Cochlear, the ‘Nucleus’ cochlear implant system has undergone several iterations, the last four of which were launched in 2002, 2005, 2009 and 2013. The three most recent ‘Baha’ bone conduction implant releases were spaced two to two-and-a-half years apart, and the ‘Hybrid’ was first released in 2008 and then upgraded in 2011. So Cochlear’s R&D and product cycle is a bit shorter at around three years.
2. R&D can be disrupted
A second consideration regarding the useful life is the R&D efforts of competitors. A disruptive new technology or a competitor’s powerful first-mover advantage might result in an R&D project being abandoned. More commonly, a promising new technology can accelerate industry-wide R&D efforts, meaning a shorter useful life for past R&D investment.
On this point, both CSL and Cochlear are well-placed. They are leaders in their fields – in profitability and R&D spend – with just a handful of competitors. There are high barriers, in addition to the large R&D budget, that a new entrant would need to surmount. CSL is protected by its ‘scarce’ raw material – its supply and fractionation of human plasma – while Cochlear is protected by its ‘installed base’ of implant recipients and trained surgeons. (Note these are both examples of hidden assets).
Nevertheless, while both companies attract the best talent, the scope and pace of innovation means that there is no room for complacency. CSL simply must spend to look for alternative uses for its plasma or on recombinant technology (which eliminates the need for human plasma), and Cochlear must lead on audio processing and implant design.
3. R&D mix can change
A third issue is the spending mix: the range in duration and risk of R&D projects. There are relatively quick and low-risk projects that improve manufacturing techniques, existing product design or the seeding of new markets. These sustain the existing franchise. Then there are protracted and higher-risk projects targeting a step-change in productivity or solution, or the discovery of an entirely new technology.
Here the two companies differ somewhat. Cochlear’s focus is squarely on its existing product portfolio, especially now that its fourth product, the ‘Codacs’ acoustic stimulator, is complete. Although this took 12 years to develop, future iterations will be much faster; in its first four years the project floundered within a joint venture structure, and while the initial clinical trials took five years the time required for product upgrades should be considerably shorter. Given that there is no change in mix, we can still estimate the useful life of the R&D asset at three years. Cochlear will grow by adding and up-selling to its ‘installed base’ of implant recipients, for whom it can develop better sound processors, components and software every three years or so.
CSL is taking a different approach: half to two-thirds of R&D is now spent on new products which, if successful and depending on the technology, take 10 to 15 years or longer. ‘Gardisil’ (its HPV vaccine) took 15 years, ‘Idelvion’ (the recombinant version for haemophilia B) took nine years to develop. A raft of new products are in the pipeline, such as the factor VIIa recombinant already nine years in the making with several more to go, and the ‘good’ cholesterol recombinant which, if successful, will have taken over 20 years to develop. Antibodies for types of leukaemia, inflammatory diseases and diabetes are all 15+ year projects. The R&D mix is changing, so we should blend the existing R&D asset (five-year life) with the new, longer-gestation assets being built (15-year life). We can use an average of around nine years.
Adjusting earnings and the balance sheet for R&D
If we are treating R&D as an asset then we need to:
1. Capitalise the R&D cost
We consider R&D as a capital expenditure and increment the asset each year by the post-tax R&D expense. We use the actual cash outlay, which is the post-tax amount given that R&D results in a lower tax bill. We can now see the hidden R&D asset on the balance sheet.
2. Amortise the R&D depletion
Just like hard assets that depreciate, intellectual assets such as R&D waste away over time as it becomes outdated. Based on our analysis, the R&D useful life for CSL and Cochlear is roughly nine years and three years respectively – each year 11% and 33% of past R&D is written off. We now have the historic cost of R&D that is still relevant.
3. Adjust earnings
We add back the R&D expense to determine pre-R&D earnings and then deduct the R&D amortisation expense. We now have an earnings number that better reflects the benefits of building a valuable R&D asset and the ongoing costs of maintaining it.
‘Pre-R&D earnings’ ignores the ongoing costs of maintaining leading-edge products, but with the amortisation charge included we can now calculate a sensible PE. Using earnings estimates for FY18, CSL’s PE is 22 and Cochlear’s is 29 (see chart 2). Cochlear is some 30% more expensive than CSL because of its relatively larger R&D amortisation charge.
Chart 2. FY18 Price earnings ratio with R&D adjustments
Source: Factset, Vertium
Cochlear may have a higher PE, but it might also be higher quality: the PE deals with just half of the story – the earnings and how much we are paying for them. The second half is the balance sheet – the key to quality and growth. Typically, the larger a company’s profits relative to its operating assets, the more easily it can fund further asset growth. And if it can sustain decent returns on a larger asset base, then behold the magic of compounding profits upon profits.
A useful proxy for the quality of a company is its Return on Funds Employed (ROFE), its operating profitability relative to its equity and debt funding. If this is low or volatile, then asset growth can become a burden for shareholders. If it is high, then the money will flow. A high-quality business is one that generates high and sustainable returns that are somehow protected from competition, justified to regulators and considered deserved by customers.
CSL and Cochlear have very high returns, even when we treat R&D as an asset (see chart 3).
Chart 3. Return on Funds Employed
Source: Factset, Vertium
For CSL, the net effect of capitalising R&D is minimal because R&D is growing in line with its asset base. While its R&D pipeline is yet to generate a return, its past investment becomes obsolete very slowly. For Cochlear, however, the adjustment is more pronounced. Its less durable R&D asset is now plateauing; Cochlear has to run faster to stand still. Nevertheless, at 34% its ROFE compares favourably to CSL’s 26%.
A second consideration regarding the quality of a company is its opportunity set for growth investment. High ROFE indicates ease of funding, but funding is not needed if there are no attractive areas in which to invest. CSL and Cochlear are not in mature industries and they show no sign of complacency, but there is nevertheless another comparison to make. We look at the portion of profits each is reinvesting to grow its asset base (chart 4).
Chart 4. Profits reinvested to grow assets
Source: Factset, Vertium
Reinvestment levels are higher when we treat R&D as an investment rather than an expense. Comparing the two companies, CSL is reinvesting significantly more of its profits than Cochlear. We concluded the reverse earlier on, based on R&D as a portion of sales, but here we now have a more meaningful measure. If returns can be sustained, CSL has the superior growth profile.
Assessing value and quality
Regarding CSL and Cochlear, there are further questions worth asking when balancing the risks and rewards (is there over- or under-investment, for example, and how do expectations compare with history), and here we deal just with their R&D efforts. More broadly, value and quality go hand in hand. Unless there is widespread panic, we can’t expect to find high-quality companies at cheaper prices than low-quality companies.
We can, however, find ‘hidden’ value or quality. The R&D accounting convention may mask its value and simply adding back the expense is inaccurate. We need to understand the nature of the R&D spend and its real impact on earnings, assets and growth. This leads us closer to the truth, in terms of a company’s capital generation, quality and value. Only then can we make useful comparisons and determine if the stock offers superior returns for little risk.