Sector Views

Research & Development Spend – is all that glitters really gold?

This is the second article in our series on research & development (R&D) data. My previous article – R&D benchmarking – proceed with caution – looked at the dangers of extracting R&D data for benchmarking purposes. So how should investors use R&D data to assess suitable levels of investment?

Revenue spend ratio is the total reported spend on R&D as a percentage of reported revenue. In the software and technology universe, especially in North America, it is common to see ratios of 15% to 20% reported by the majors – a ‘gold standard’ that separates innovative companies from the laggards.

Careful spend

With a steady capital inflow from trading or equity, it is easy to spend cash on R&D and land in the 15% to 20% range, or even outperform and spend 40%. Many investors will know, to their cost, this spending doesn’t always generate the desired result. A company may achieve a ‘gold standard’ spend ratio of 20% because R&D is over budget and sales are under!

I think a company should evaluate each R&D project on its merits by considering the planned cash return to shareholders. This may mean reviewing discounted cash flows to evaluate whether to proceed with an R&D project, modify the approach, or do something entirely different.

Importantly, a board should approve and then robustly monitor expected cash flows to actual cash flows. It’s acceptable to spend speculatively, but acknowledge you have done so. Project pre-approval promotes control and accountability. Monitoring creates a healthy and challenging environment, preventing scope drift and focusing on investor return. How often have investors been promised that R&D investment will grow sales, only to be delivered a bill for R&D spending that merely sustains current sales?

Lessons learned

Rather than comparing R&D investment ratios, it’s more relevant to compare the company’s R&D process with successful peer companies around the world and learn from this. How do successful peers manage capital allocation? How much are others prepared to write-off each year from creative but failed R&D? How do they understand markets and competition? How do they launch successfully?  How do they manage indicators of failure or underperformance? Can we do better?

Hitting the gold standard R&D investment ratios might be a sign of innovation health but it won’t by itself pay the dividends that investors expect. Cash flow considerations and good R&D project governance are where the real gold is to be found.

Written by Chris Errington, Head of Research – Kestrel Partners LLP

Kestrel’s Sector Views should neither be construed as investment research, nor the provision of investment advice, nor a recommendation. This article should be viewed as short term commentary only based on the latest economic statistics, company results or information on upcoming releases or events. It is only a brief unsubstantiated summary of Kestrel’s opinion on such information as at the date of publication and no reliance may be placed upon any contents of this article by the recipient.

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