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Examining the R&D Line

Jennifer Openshaw

That would seem obvious, but when I look at the income statements of many of today's companies, I see a lot of money poured into research and development -- billions, in some cases.

But do I see returns on those dollars? That part is not so clear, especially for those of you who invest in research-heavy businesses like pharmaceutical, biotech and general technology. So listen up.

A recent Booz Allen Hamilton study found little real correlation between R&D investment and business performance. The only direct link was between R&D and gross margins relative to the industry.

The study went on to identify 94 of 1,000 companies that were "R&D efficient" -- but this list appeared to include many that just didn't spend much on R&D.

This study just didn't do it for me, though. How else do you bring R&D into the investing equation? It isn't easy, but I'll give it try.

R&D expenditure profiles typically fit a "barbell" model. On one hand, innovation-driven start-ups will spend a ton on R&D at the expense of profits -- probably a good idea.

On the other end, mature companies like Procter & Gamble (PG Quote) may spend a lot on R&D to stay on top of their game, which is OK if they do it well.

What gets me are those in the middle: companies that spend a lot and don't seem to get much for it.

Click here for the video version of this story from Jennifer Openshaw.

Income statements show R&D expenses, but it's hard to really know what's appropriate for that industry -- and whether the business really gets any value from it. So instead, let's look for some outward signs.

Good signs:

• High and expanding gross margins.

  If nothing else, high R&D expenditures should differentiate products, and differentiated products carry higher margins.

• Sustained category leadership.

  The poster child here is Apple (AAPL Quote). It virtually invented a category -- portable digital music -- and has been bringing new versions to market faster than competitors can keep up. Google (GOOG Quote) has done the same in search. It almost doesn't matter what they spend -- it pays to be the 600-pound gorilla, and R&D is part of what keeps them there.

• Short time to market.

  Staying ahead of the competition is a big plus, and it justifies most R&D expenditures. SanDisk (SNDK Quote) is known in tech circles for bringing a leading portable MP3 player to market in six months.

• Useful innovation.

  Ask yourself how important a company's innovations really are. Are they tweaks, or do they bring new value? Are they customer-driven?

  Ford (F Quote) spent more dollars on R&D last year than anyone else. Was that on redesigned fenders and headlights, or on hybrid technology and Windows connectivity? Process innovations also count -- FedEx (FDX Quote) and some other service-oriented firms might score points here.

Bad signs:

• Can't identify breakthroughs.

  This happens a lot with big firms where R&D is more a legacy than a producer, and something a company believes it's supposed to do.

  Hewlett-Packard (HPQ Quote) stayed firm in its commitment to spend 10% of revenue on R&D -- even after the core business changed. Did we see really new products? Just the slogan "invent," but not much else. Since then, H-P has cut back, spending about 4% of revenue on R&D -- while competitor Sun Microsystems (SUNW Quote) still spent some 15% last year.

• Patent-driven mentality.

  H-P was guilty of this one too, along with IBM (IBM Quote) and other stalwarts. Each strived to win the annual patent derby without care about whether products came to market. Individual employees got cash incentives to get patents. That tied up their time -- and that of the company patent office -- on ideas with little hope of payoff.

• Siloed R&D.

  Big lab organizations, distanced from customers, focused on basic science and patents, not profitable products. Examples include H-P again, Lucent (Bell Labs, now part of Alcatel-Lucent (ALU Quote)) and Sun.

While financial measures don't tell the story, the Booz Allen study suggests that process and culture can define R&D success. "It's the process, not the pocketbook" (see the study, Strategy + Business, winter 2006). That's nice, but it's hard to figure how those things work inside a company.

I believe looking at external signs -- like I've just done -- is the best you can do for now. That said, I do hope someday that the R&D line gets as much scrutiny as receivables, inventories and debt in the financial statements.