Is General Electric Spending Enough on R&D?

| About: General Electric (GE)

On Friday, General Electric (NYSE:GE) reported 4th quarter EPS of .36, ahead of expectations, with increased bookings. Shares rallied to close at 19.74, up 7.11% on the day. CEO Jeff Immelt has been right-sizing the financial and re-emphasizing the industrial, with results that point to a return to the company's former performance and stature.

If GE is indeed to regain its luster as an icon of American industry, advanced technology and innovation will be required. That would mean R&D. In updating my evaluation, I developed some information (and some questions) on the subject which I would like to share with readers.

R&D Expense

GE presented its annual outlook for 2011 on 12/14/2010. In the course of the presentation, Immelt presented the following slide on R&D expense (click to enlarge images):

This is important. With the wisdom of hindsight one can surmise that during the bubble years GE over-valued the excess profits that could be booked in the financial business and shied away from making the investments in R&D that are necessary to drive innovation and growth in the industrial segment. Here in very broad brush strokes we get evidence that the company has seen the error of its ways and will raise R&D expense up to 5-6% of industrial revenue - approximately where it should be.

A More Detailed View

GE does not present R&D as a line item in its financial statements. However, they do provide the information in textual discussions within the financials, and the following information has been extracted from that source. In recent years GE has been presenting two versions of R&D - GAAP and what I have dubbed Broad R&D. Broad R&D includes amounts spent to improve existing products and services, and to improve productivity of plants, equipment and processes. The broader definition is useful and legitimate from an analytical point of view.

In addition, customers (primarily the US government) fund a substantial amount of research, as shown.

The results are consistent with the annual outlook presentation, although I note with some concern that Broad R&D decreased in 2009, opening up the possibility that some expenses may have been reclassified to GAAP R&D. Broad R&D will be an item to check when the 2010 10-K is filed. It should be noted that R&D was protected and arguably increased in 2009 when revenues were down and there may have been pressure to cut expenses in short-sighted ways.

The big picture is that R&D expenditure will increase by approximately 2 billion in 2011 from 2009. This bodes well for future revenue and profitability.

How Much R&D is enough?

Comparing GE to its peers, 3M (NYSE:MMM) spent 5.6% of revenue on R&D in 2009. That is proportionately larger than GE. One suspects that GE presents the Broad R&D statistic as a way of excusing or ameliorating an underfunded activity. Comparisons may not be apples to apples.

My father was in R&D all his life, and developed a thesis, which he presented at a meeting of his peers. After studying growth and profitability of companies that had high technology and R&D, he concluded that 7% of revenue was the appropriate amount to spend on the activity, based on outcomes. He would have been looking at information from a different era, but the estimate is food for thought.

Management's Attitude

GE makes a transcript of the 12/14 presentation available on their website. A number of the larger companies are doing this now, and these documents are well worth reading. It gives the retail investor access to the same information enjoyed by professionals, who may have attended in person. It is also possible to buy some of them from Thomson Reuters at their website.

Searching the document, Immelt seems to have an ambivalent attitude. Research is sometimes referred to as an investment, and sometimes as a headwind. GAAP account requires that R&D be expensed as it is incurred. Entrepreneurial accounting suggests that R&D expenses may be regarded as an investment, which can be expensed over time against the revenue generated by new products. Many entrepreneurs think of it that way, and it's logical, to a point, just not the correct way to keep the books.

The headwind label is usually reserved for pensions, regulations, economic conditions and the like. Here's a sampling:

Good growth in Transportation and Healthcare, kind of flattish growth in Energy and Aviation. A lot tailwinds, but some of the headwinds are in wind and higher R&D and launch costs, as pertains to GEnx engine. But overall, the industrial earnings will be up year-over-ye ar.

So 2010 was really driven by GE Capital. It had a very strong performance and did better than we thought in 2010. As I think about walking from 2010 to 2011, we've got some headwinds in energy. We've got NBC Universal Solution and we've got higher R&D.

We've taken each one of these investments and plugged them into the Global Research center, our service operations, our global sales force. Let me tell you, if you're in oil and gas, Exxon likes to buy from GE. BP likes to buy from GE.

Aviation, we've got launches in the GEnx engine, the LEAP-X, which will go into the narrow-body, new avionics products. What we've basically said is that in 2011 and 2012 we see a heavier investment period, both in terms of NPI spending and launch costs.

Summary and Valuation

GE management has taken a look at R&D and reached a decision to increase spending. The increased expenditures are showing up in the financials and in due course they should manifest in increased sales from new products. While this may depress short term earnings below what otherwise would have been possible, GE investors can take comfort in the improved prospects for long-term growth.

I do have some reservations about the company's overall spending on R&D, suspecting it may not be at an optimal level. The manner in which the information is presented in the financial statements seems to muddy the water: it would be better to present it consistently as a line item, or several line items if the distinctions between R&D and process and design improvements are important. How much are they actually expending on new and improved technology?

I wrote GE up favorably in May last year, when the shares stood at 16.35, setting a short term target price of 22.25 based on the strike price of warrants that Warren Buffett negotiated as part of the loan Berkshire Hathaway made to GE at the height of the financial crisis. My long term target at the time was 30 by the end of 2011. Redoing the computations with up to date information, the target price goes down to 29. However, if it takes two years to reach that level, the investor will still make 21% annualized, plus the dividend, attractive now that the risk from the financial side of the business has abated.

Disclosure: I am long GE, MMM.

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