Ignore Intangibles at Your Own Risk

Let me suggest four reasons.

First, self-preservation. Since accountants are more likely to get sued for overstating earnings (and assets) than for understating them, it's in their best interest to err on the side of caution. For green eyeshade types, caution means expensing outlays today rather than at some later date -- even if most of the benefits will be realized down the road.

Second, intangibles are a use of cash.

Third, if a company needs a few more pennies to meet Wall Street's expectations, management might be tempted to include a portion of operating expenses -- say rent -- with R&D.

Fourth, there's no guarantee that the intangibles will produce higher future sales and earnings. Xerox (XRX - commentary - Cramer's Take) is a case in point. As others have asked, has any other company in the history of technology done less with more than Xerox? Over the years its researchers have created, among other things, the first personal computer, color copying and laser printers. Still, Xerox's stock price adjusted for splits is lower today than in 1970.

The Bullish Case for R&D

I buy these arguments, which is why intangibles are expensed in the defensive income statement. Of course, this glum outlook tends to penalize companies in "mind-based industries" that are investing for future growth.

Pfizer is a case in point. In 2001, management invested $4.8 billion, or 15% of its $32 billion of revenue, in search of the next generation of Zithromax, Zoloft, Celebrex and Viagra. In fact, according to the notes in its annual report, at year-end Pfizer was working on more than 160 projects in development and several hundred projects in research.

For these reasons, I'm also bullish on intangibles. That's why, in the enterprising income statement, these outlays are converted from operating expenses to capital assets, then depreciated over an appropriate period.

This adjustment fulfills a key goal of accrual accounting: matching current sales with current expenses and future sales with future expenses. Equally important, it also permits apples-to-apples comparisons of "hard-asset" companies like steel mills with "soft-asset" businesses in drugs, software and technology.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].