Companies rightly see research and development (R&D) spending as a key measure of whether a product line is fresh and capable of capturing impressive pricing and margins. When that figure is low, it's a sure sign a company is relying on older, possibly antiquated products to carry the day. And when this happens, the company often needs to cut prices to stay competitive.
Of course, a heavy reliance on newly released products can only come through old-fashioned R&D spending. Companies such as Cisco Systems (Nasdaq: CSCO), Amgen (Nasdaq: AMGN) and even mighty Apple (Nasdaq: AAPL) have their massive R&D spending efforts to thank for their eventual success.
Heavy spending on R&D takes guts. It means that you're overspending in the near-term to build a better future. And high current expenses scare off many investors focused on short-term profits. If you've got a long-term view, you should always see how a company views R&D. Heavy spending now can deliver robust growth in the years to come.
With that in mind, I screened for companies that spend at least 35% of their revenue on R&D, focusing on companies that are expected to boost sales by at least 15% in 2012. If their R&D moves pay off, growth can stay elevated well beyond 2012. To narrow down the list, I also excluded companies with a market value below $350 million and insisted on 2010 sales of at least $50 million.
Here's what I found...
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Biotech has no choice
If you operate in the pharmaceutical industry, R&D is a fact of life. More than half of the companies on the table above are making big R&D bets on new drugs. As an example, I recently profiled Human Genome Sciences (Nasdaq: HGSI), which is finally seeing a big payoff after earlier heavy R&D investments. Since my profile, Human Genome secured Food and Drug Administration (FDA) approval for a key drug that treats Lupus. The company can afford to keep stepping on the gas with other new products as well, with nearly $1 billion in the bank. Shares have risen only modestly on the FDA approval, but analysts have been increasingly warming up to the stock.
Timing is everything
A123 Systems (Nasdaq: AONE) highlights the risk of heavy R&D spending without the accompaniment of revenue. This maker of advanced batteries went public in 2009 and has already needed to raise more money on two more occasions. That really punished shares, though I as I note in this article, shares may finally be poised for a rebound.
Unlike A123 Systems, Codexis (Nasdaq: CDXS) has met or exceeded all of its anticipated milestones since coming public one year ago. Codexis provides enzymes that can catalyze biofuel production. [Andy Obermueller, editor of Game-Changing Stocks, first turned me on to the stock.]
The company's technology is also being applied to the manufacture of pharmaceuticals. Codexis still has more than $70 million in the bank. Also unlike A123, it has not needed to raise more money and may just make it to profitability without the need for any capital raising.
Codexis' revenue has been rising, moving past $100 million last year, but that's a bit deceiving. Most of that revenue has come from payments from key partners such as Shell (NYSE: RDS.A). To really impress investors, the company will need to show rising product sales, a process that has already begun: sales rose from $11 million in 2007 to $33 million in 2010.
Right now, Codexis is emerging as a pharmaceutical play. Drug makers are increasingly using the company's enzymes to help alter or expedite biological processes, in effect letting naturally occurring organisms more quickly digest feedstock into more productive molecules. The enzymes have been used especially in the production of anti-viral drugs.
But it's the biofuels market that holds the promise of generating major revenue by the middle of the decade. Shell worked with many young biofuel start-ups before deciding to work closely with Codexis. The two companies signed a collaborative research agreement in 2006, which has netted Codexis ongoing milestone payments. Yet it's another deal struck with Shell last August (in conjunction with Brazil's Cosan (NYSE: CZZ), a major producer of sugar-based ethanol) that has caught my eye. Shell and Cosan now jointly hold a 14% stake in Codexis and plan to use its technology to ramp up output of biofuels that can be made from other raw materials such as wheat grass or sugar cane fiber. Codexis shares rallied on the news but have since pulled back and are now below the April 2010 IPO price of $13.26.
This is a high-risk/high-reward play because there is no assurance the company's heavy R&D spending will translate into massive revenue. But if you're a believer in alternative fuels (and you have to at least consider them with the current price of oil being above $100 a barrel), then this may be the best horse to ride.
Tivo (Nasdaq: TIVO)
Tivo's heavy investments in R&D just started to pay off for investors. The company was an early leader in the field of digital video recorders (DVRs), which are now found in many homes. The technology is backed up by 200 patents, with another 350 patents pending. A key court ruling recently found that Dish Networks (Nasdaq: DISH) had indeed infringed on Tivo's patents, sending Tivo's stock up nearly 30% during April 20 trading. But the rally may not be finished. The favorable ruling could embolden Tivo's position in pending cases with giants AT&T (NYSE: T) and Verizon (NYSE: VZ) as well.
On the operations front, the picture is a bit cloudier. The company's early lead has been lost as major cable operators such as Time Warner Cable (NYSE: TWC) have moved on with their own proprietary DVRs. This has led Tivo to lose about 20% of its customer base during the past year, which generated persistent operating losses.
But the tide may be turning. In recent quarters, the company has signed agreements with a large range of second-tier cable companies such as RCN, which are incapable of pursuing their own DVR technology platforms. Analysts now think Tivo will start boosting its customer base later this year. Yet continued high R&D investments will lead to continued losses in the near-term.
Tivo is spending heavily to advance the DVR technology to more seamlessly integrate web content with traditional TV programming. A rebounding business, coupled with positive resolutions to the still-pending lawsuits, could push shares from a current $12 into the upper teens.
You should check out all of the stocks in the table above. Get a clear read on where R&D investments are going and when they're expected to pay off. You may just come across the next Amgen or Cisco.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.