Capitalizing R&D

Industrial companies reinvest in plant, property, and equipment to grow revenues. Technology companies grow by investing in research and development. However, on an income statement, these R&D investments are treated as an operating expense (instead of a capital investment).

One can reorganize financial statements of such companies by capitalizing R&D expenditures. You can check out this video, and this spreadsheet (look for R&DConv.xls) from Aswath Damodaran to understand the logic and mechanics of this reclassification.

The R&D asset you create goes to the asset side of the balance sheet.

Since assets = equity + liabilities, this increase in assets leads to an increase in the book value of equity, and hence the invested capital.

Similarly, we adjust the operating earnings by adding back the R&D expense and subtracting the depreciation of this asset in the current year.

When we capitalize R&D, we get a more authentic view of the earnings, reinvestment, and returns on capital. This alters the fundamental inputs that go into a discounted cash flow valuation, including earnings, growth and reinvestment rates (sales to capital ratio), and operating margins.

Process

To begin the process of capitalizing, we need the following inputs

• An amortization period, N years, over which R&D is expected to deliver results (software ~ 2 years, hardware ~ 3-5 years, pharma ~ 10 years; Damodaran’s spreadsheet has some numbers for guidance)
• Collect R&D expenses for the prior N (or N+1) years from the income statement. You can get these from company filings or a data service like Morningstar.
• Create a table (see spreadsheet) to determine (i) the net value of the R&D asset on the balance sheet, and (ii) the current year amortization number.
• Recompute operating earnings, net income, invested capital, and reinvestment rate.
• Use these numbers to inform inputs in the DCF analysis

Example

I took Damodaran’s spreadsheet, and modified it slightly to account for partial year data. I did this to understand the spreadsheet better; not necessarily because I think such an adjustment is important. Of course, it uses the latest numbers, so it has that thing going for it.

For prior years, I assumed that R&D expenditures were distributed evenly throughout the year. Thus, if $100M were spent over an year, I assume$25M were spent each quarter. This spares me the burden of having to deal with quarterly filings.

I used this modified spreadsheet to analyze CSCO after two quarters of fiscal 2017.

Cells in yellow are inputs, while those in green are computed. This yields the following calculation for the value of the R&D asset and the amortization.

It also yields some summary statistics. In CSCO’s case, capitalizing R&D did not have a big effect on (i) operating income/margin and (ii) net income/margin. It had a modest effect on the reinvestment rate, which increased. The amount of capex, invested capital, and depreciation increased dramatically, while the return on capital went down modestly.

Valuing Financial Services Companies

Financial services companies are not quite amenable to a discounted cash flow analysis, because there is no wall separating operating and financial assets.

In such cases, it is difficult to figure out an ROIC, because “IC” in this context is a nebulous concept. This problem pops up in one form or another, when one attempts to do a firm level valuation (debt + equity). For example the sales/capital ratio which is handy in modeling reinvestment for growth is not particularly meaningful.

One way out of this quandary is to focus on equity (from Damodaran), and use a (potential) dividend discount model based on the Gordon growth model.

Let us define the relevant terms.

BV = book value of equity
ROE = return on equity
COE = cost of equity
nNI = normalized net income for next year = ROE * BV
g = stable earnings growth into perpetuity

The amount of free cash is determined by the g and ROE. This free cash can be distributed as a potential dividend. The payout ratio of this “free cash dividend” is

p = dividend payout ratio = (1 - g/ROE)

As a reality check, it is useful to compare the historical payout ratio to this value of “p”. One might have to account for all forms of cash return including dividends and buybacks while doing this.

Thus, the value of the equity is:

Equity IV = nNI * p/(COE - g)

Of course, if it makes sense, then the future can be split into explicit stages in which variables vary with time before settling into their terminal values.

On ROIC

ROIC and growth are the two central drivers of value.

ROIC = NOPAT/IC

The numerator comes from the income statement. The denominator comes from the balance sheet.

NOPAT is net operating profit after taxes. It is often modeled as EBIT (1 – tax rate). While depreciation is a real cost, the amortization of intangibles is often added to adjust EBIT. Thus,

NOPAT = EBITA (1 - tax rate)

There is a fair amount of subjectivity in defining the denominator IC (invested capital).

It can be obtained from the asset or operating side of the balance sheet (recommended), or the right or financing side. I found this position paper from Credit-Suisse very useful. The authors present practical tips on how to think about IC, instead of getting caught up in some particular formula.  An illustrative example (CSCO) is used to animate some of these ideas.

Essentially, IC should include all the “capital” (inputs that generate revenue over long time frames).

To the first approximation,

IC = total assets - non-interest bearing current liabilities

It definitely should include current assets, net PPE, and other operating assets. One can make several commonsense adjustments:

1. If a company carries excess cash or marketable securities (over that required to run the business), then that should be excluded from IC. A recommended rule of thumb is cash equal to 2% – 5% of sales (ranging from mature to growth companies) are required in the running of the business. Any excess should be excluded from IC.
2. If M&A is part of the company’s modus operandus, then one should not exclude goodwill, as it represents a true cost of doing business.
3. Capitalize leases and R&D, since they have characteristics of debt and long-term assets, respectively.

Here are some other resources on ROIC that I found useful.

This paper by Damodaran, “Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications”, is quite readable, and presents some useful insights.

John Huber has some of the most well-articulated thoughts on ROIC. He has written several articles (compounding and high ROIC, and legacy versus reinvestment ROIC), which can be found on his website here.

This Bears-Stearns presentation on the role of ROIC in valuation has been floating around in a lot of different places.

Qualified Covered Calls

Early last year, I bought CFR around $53, valuing it at around$75. As it rose to $70, I wrote a$75 covered call expiring in 45 days. CFR promptly climbed to $80, and my call was ITM. Since the stock had risen above my target price, I did not mind selling it. However, I reckoned that if I could somehow hold on to the stock for couple more months, then I would avoid short-term capital gains tax on my profits. At that time, I naively thought that I would keep rolling over my$75 call, and only let it get exercised after I had owned it for 12 months.

It turns out that the rules governing deep in the money covered calls are somewhat complicated.

If you write a call sufficiently deep in the money, you are no longer considered an owner of the stock. This actually makes sense, since you have given away most of the pain, and the gain, associated with the stock’s gyrations that a true owner would feel.

The key phrase here is “qualified” or “unqualified” covered calls. If your covered call is qualified, then no problem.

If it is unqualified, the clock that determines the holding period for the stock stops. It resumes, once the call is closed or replaced by a qualified covered  call.

We need to know five numbers (two of which may not be needed, depending on the situation).

P = stock price at the end of the previous trading day
S = strike price of the covered call
d = number of days till expiry of the covered call
SP-1  = first strike below P
SP-2  = second strike below P

For example, yesterday – May 5, 2017 – AAPL closed at $148.95. On the next working day (5/8/2017), suppose I consider writing covered calls expiring on May 19 (d = 12 days to expiry), at a strike price of S =$150. The two strike prices available below P are $148 and$149.

To determine if a covered call is qualified, I run the five numbers through the following flowchart.

Out of the money calls are always qualified. In the AAPL example above, the call is qualified because the call OTM.

If calls are ITM, they have to have sufficient duration (at least 30 days), and cannot be too deep in the money.

Averaging Down

In 2011, Radioshack was trading at a single digit P/E. It was participating in the “mobile” wave, and sported a superficially healthy ROE. I bought the stock at $15. As the stock price declined, I took a second bite at$6. I thought the market was overestimating the odds that RSH would be zero. Saj Karsan, a blogger who I respect, seemed to think so.

Not long after, I unloaded the entire position at prices between $3-$4. I lost about 2/3 of the originally invested capital.

In 2012, I bought Prosafe SE (PRSEY) at $7.50. Its historical stability, and high dividend seemed attractive. Adib Motiwala, a money manager I followed, had endorsed it. As oil prices declined, I took another bite at ~$4.50. By the time, I realized that oil prices might not snap back right away, and sold my position, I had taken another haircut worth 2/3 of the capital deployed in the position.

At 5% and 6% returns, $1 grows to$1.63, and $1.79, respectively. This is a nearly 10% out-performance. So technically it is true: out-performance is more valuable in tepid markets. But in practice, no “alpha”-generating asset manager is going to work for you free. The extra value (note this 0.5% is not 0.5% compounded) is probably not enough to justify switching investing strategies from passive to active simply based on tepid expected forward returns. Math Aside To understand this apparent insensitivity to market return, lets bring out some low-powered calculus. Let $r$ be the market return, and let $\Delta r$ be the manager out-performance. After n years, the market compounds$1 to $f(r) = (1 + r)^{n}$. If $\Delta r \ll r$, we can approximate the out-performance $f(r + \Delta r)$ by its Taylor series:

$f(r + \Delta r) \approx f(r) +\Delta r\ df/dr$

Taking the derivative, and rearranging terms, we get,

$\dfrac{f(r + \Delta r)}{f(r)} \approx 1 + \dfrac{n \Delta r}{1+r}$

The percentage outperformance is controlled by the last term on the RHS. The factor “n” just shows that any incremental annual outperformance is essentially additive. The remaining term $\Delta r/1 + r$ does have a r in it, which means that technically it does matter whether the market is robust or tepid.

However, in practice, $1 + r \approx 1$. It turns out that the percentage $n \Delta r/1 + r \approx n \Delta r$, and the state of the market effectively drops out of the equation.