Tech Sector: Does R&D Spending Matter?

by: Naveen Selvaraj

Technology sector companies are constantly worried by two things:

  1. The next disruptive innovation which could impact their business model
  2. How to survive/adapt when (1) happens

As evident from the last 2-3 months, the deal flow in the sector has accelerated with Cisco (NASDAQ:CSCO) announcing its next gambit (Read my earlier article on Cisco) and HP (NYSE:HPQ) responding with its intent to acquire 3Com. HP has been on a diversification spree (I've written about it here) and is probably confused about point 1 (above)!! It seems more interested in purchasing 'insurance cover' (read 'additional revenue streams") rather than bother about the small matter of innovating to succeed.

What about core R&D then? Have these companies given up on spending time and money in trying to make cool new stuff or offer cool new services. With tech spending getting affected due to the downturn, we hear more news about mergers, consolidation and collaborations rather than the quest for the next big thing through increased internal R&D. In this context, I thought it would be good to look at how have the Tech sector companies fared in terms of R&D spends. The three questions I wanted to pose and answer were:

  1. Has higher R&D spending in the past delivered results (top-line growth or revenue holds steady despite the downturn in 1H09)?
  2. Has increased R&D spends over the last two years helped them?
  3. How the large Tech sector companies stack up in terms of R&D spends and did they cut/increase their R&D spends in response to the downturn?

Let's tackle them one at a time.

1. Top 25 R&D Spenders (Absolute $ Spends)

Below is a table of the top R&D spenders in absolute dollars based on the latest quarter results (Sep09). Microsoft tops the list and it spent ~$2..06 B last quarter and that works to ~16% of revenue. Due to declining revenues, it has slashed R&D spends by 10% Yoy (or a ~$200M reduction per quarter).

Top R&D Spenders : Revenue, Revenue Growth, R&D Spend and Growth

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Source: Gridstone Research

From the list of top 25 spenders, I tried to zero in on companies which were able to avoid a significant decline in revenues in the September quarters of both 2008 (pre-downturn) and 2009 (recovery phase) indicating that demand for their products/services has held steady. I used a lower cut-off of (-5%) as many companies grew revenues in constant currency and currency headwinds would have led to 3-5 pps decline in revenues. Five companies met this criteria (highlighted above) namely - Oracle (NASDAQ:ORCL), EMC, Broadcom (BRCM), Apple (NASDAQ:AAPL) and Symantec (NASDAQ:SYMC). Of these , Oracle's revenue was boosted by a recent acquisition (BEA systems in Apr08) and so it left only four companies which have grown organically in the last year. So the companies that made the grade are EMC, Apple, Broadcom and Symantec.

2. Top Companies By Growth In R&D Spending

The next target was to identify the top companies in terms of increase in R&D spending. Here, instead of Sep09, I used the Sep08 growth figures as I wanted to see if increased R&D spending prior to the downturn helped these companies in the downturn. My consideration set was all Tech companies which had at least $200 M in quarterly revenues. Here's the list:

Top 25 Companies By R&D Spend Growth (Sep08) And Their Revenue Performance

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Source: Gridstone Research

I used the same criteria as used for the first - companies which were able to grow or maintain steady revenues (with a -5% Yoy growth cut-off at lower end for currency effects). The companies which qualified were naturally bigger than the earlier list this was effectively a list of growth stocks which had unique products or were present in sunrise industries (ex. Solar).

I applied a second criterion to the twelve stocks which passed the first criterion (highlighted in list above) : Which companies grew R&D expenses in Sep09 also indicating that they were confident that their R&D spends would continue to yield results. I chose the companies which had R&D growth rates which were more or less close to the their revenue growth rates in Sep09 (+/- 5%) and had higher R&D spends in Sep09 compared to Sep08. The companies that made the grade are First Solar (NASDAQ:FSLR), RIM (RIMM), Apple, Taiwan Semiconductor (NYSE:TSM), Google (NASDAQ:GOOG), VMWare (NYSE:VMW), Open Text (NASDAQ:OTEX) and McAfee (MFE).

3. Top 25 Tech Companies And Their R&D Spends

I then looked at the top 25 companies by size. I wanted to see who among the biggies would pass the same revenue growth criterion used in the two categories above. Size was also important and the top 25 have achieved this position due to their prior successes (through innovation or smart acquisitions) and therefore due weight needs to be given to that too.

Top 25 Companies In Revenue And Their R&D Spending

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Source: Gridstone Research

The only new additions to the names from the two lists above were Thermo Fisher (NYSE:TMO) and Western Digital (NYSE:WDC). The other interesting thing is that the top six by R&D spending (as % of revenue): Qualcomm (NASDAQ:QCOM), Alcatel-Lucent (ALU), Ericcson (NASDAQ:ERIC), Intel (NASDAQ:INTC), SAP and Microsoft (NASDAQ:MSFT) do not make the grade. Though these companies might have innovative or market-dominating products (Microsoft, Qualcomm), they probably were focused on their existing cash cows and did nothing new to combat the downturn which affected them in 2009.

The consolidated list giving due importance to size of company and revenue performance, size of their R&D spends and increase in their R&D spends in 2008 and 2009 were:

(in no particular order)

  1. Apple (AAPL)
  2. Broadcom (BRCM)
  3. Symantec (SYMC)
  4. EMC Corp. (EMC)
  5. Research In Motion (RIMM)
  6. First Solar (FSLR)
  7. Google (GOOG)
  8. Taiwan Semiconductor (TSM)
  9. VMWare (VMW)
  10. McAfee (MFE)
  11. Western Digital (WDC)
  12. Thermo Fisher Scientific (TMO)
  13. Opex Text (OTEX)

There is a good mix of software, hardware and semiconductor stocks clearly showing that the companies which focus on differentiation and innovation can survive testing times better than others. Going back to the beginning of the article, Cisco and HP have missed the bus in this aspect and that could explain their strategy to enter newer areas as innovation in their existing products/services is not going to guarantee long-term returns.

While investor attention is focused on more high-profile stocks like Apple, Google it would also be worthwhile to look at other stocks such Open Text, Thermo Fisher or for that matter even Taiwan Semiconductor, as long-term picks. Surely they must be doing something right when they can outperform the more high-profile names.

Disclosure: No Positions