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This morning, STEC (NASDAQ:STEC) was acquired by Western Digital (NASDAQ:WDC). The shares are currently trading around $6.72, up 87%. We believe the big premium demonstrates just how much R&D can be undervalued by Wall Street. During my 20 years of analyzing technology stocks, I have found that innovation is often a hidden asset that doesn't show up on most balance sheets. This because most companies treat R&D as an expense -- an instantaneous offset against revenue that immediately disappears into the accounting ether.

In some cases, the accounting treatment matches reality. However, most public companies didn't become successful by frittering cash away on frivolous projects. Accordingly, R&D spending should be viewed as a possible source of hidden value. As a rule, I have found value in profitable software companies trading for less than 3x R&D (EV divided by R&D, with EV defined as market cap minus net cash).

Using those that criteria as a screen, let's look at the top 20 R&D values with a market cap of at least $100 million:

CompanyTickerMkt Cap ($M)EV ($M)EV / R&D
Emergent Biosolutions(NYSE:EBS)525.9457.63.7
Vicor(NASDAQ:VICR)209.0141.23.6
Extreme Networks(NASDAQ:EXTR)330.1141.03.3
QAD Software(NASDAQ:QADA)180.3122.33.1
Emulex(NYSE:ELX)589.7498.13.0
Biodelivery Sciences(NASDAQ:BDSI)168.7105.53.0
Qlogic(NASDAQ:QLGC)867.3411.82.6
Aviat Networks(NASDAQ:AVNW)167.984.82.2
Aastra Tech(OTC:AATSF)238.0120.32.1
Xyratex(NASDAQ:XRTX)276.7183.91.8
Pacific Biosciences(NASDAQ:PACB)175.879.11.7
Avid Technology(OTCPK:AVID)242.1170.81.6
Oclaro(NASDAQ:OCLR)104.7132.51.6
Targacept(NASDAQ:TRGT)161.753.61.4
Ziopharm Oncology(NASDAQ:ZIOP)162.9107.31.2
Zynga(NASDAQ:ZNGA)2278.4707.01.2
Actions Semi(NASDAQ:ACTS)209.026.11.1
Tellabs(NASDAQ:TLAB)775.2203.60.9
Sigma Designs(NASDAQ:SIGM)167.482.20.8
StecSTEC161.128.20.4
Source: PoisedToTriple.com

A few things stand out here:

  1. The number of companies trading for less than 3x R&D is much smaller than I would expect. Traditionally, this screen produces many more candidates. This is likely a function of the recent heights reached in the stock market.
  2. Several of the stocks are involved in biotech. This is a much more speculative industry segment than technology. Development-stage biotech companies go public often. In contrast, IT vendors are usually well-established before they IPO. Accordingly, investors should be extra careful about investing in the biotech names on this list.
  3. Several companies on the list are IT (information technology) hardware vendors. In that segment, the technology life cycles are more compressed than in others, like software. As a result, the residual value of R&D isn't as long-lasting as in other segments. Ditto for Zynga -- video games have a very short life cycle.

Speaking of software, two such names made the list: Avid Technology and QAD Software. Avid is a leading provider of digital media content-creation products for audio, film, video, and broadcast professionals. Their products have won numerous Hollywood awards and have been used to create some of the globally regarded titles, like "Iron Man." The company has been struggling against larger competitors, along with lower-end solutions in the marketplace. The company is also undergoing management turnover. That said, the company has a rich history of innovation and continues to invest in R&D at a rapid pace. Video is red-hot right now, so AVID may catch a bid if the company can start executing or attract potential buyers.

QAD is a software vendor that caters to the unique needs of product manufacturers. I have conducted many in-depth analyses of this company. In short, we see a revival occurring in the economy and U.S.-based manufacturing. With more competitive labor costs and natural gas prices, we believe a resurgent U.S. manufacturing sector signals a commensurate revival of fortune for QAD. In recent years, QAD didn't allow the economic malaise to crimp its dedication to innovation. In our opinion, this 1) understated the company's earnings potential, and 2) set the company up for continued growth and profitability.

With a EV/R&D of 3.1, QAD is the 17th cheapest stock (out of several thousand) we could find and appears to be the cream of the crop among the names on our R&D screen. Over time, we expect that this will lead to a higher share price or perhaps an M&A event if/when management decides the time is right.

Source: Western Digital Buys STEC - Who's Next?