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Fool On The Hill

Friday, February 26, 1999

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

Financial Karma, Part 2

Would you like to know how much a company is earning before you invest in that company? You should, because without that information, it gets difficult to understand how to value that company. By that, I don't mean just coming up with a P/E that seems right and plunking down your cash. I mean, it's difficult to assess how much to pay for a company if the form of earnings does not portray the economic substance of a business.

This frames the issue I put forth in yesterday's Fool on the Hill. In that column, I discussed the issues behind the Financial Accounting Standards Board's (FASB) decision to recommend a change in the method of accounting for mergers and acquisitions for research and development-intensive companies. Today I want to first look at the cash flow aspects of the issue, and then on Monday I'll deal with the balance sheet aspects of merger and acquisitions accounting.

To begin with, the issue of in-process R&D write-offs has generated a lot of light and heat because executives believe the market is preoccupied with reportable earnings. Anything that reduces reportable earnings is undesirable, the thinking goes, because the market discounts earnings. As an ontological framework, that's not correct. Many CEOs and CFOs contemplating their company's place in the financial universe think "earnings and EPS growth." Many Wall Streeters do, too. The enlightened investor, however, thinks "free cash flow." And that is where your thinking should be directed.

At issue is this: If I am Dale Systems Inc. and I make data switches using superconductor technology, I might want to acquire another company whose software will really advance my product. Say this acquisition target has $15 million in revenues but the going price for such a concern is $200 million. The target company has $20 million in appraised book value. Most of the value of this company lies in its intellectual property. I'm obviously not buying it to liquidate its workstations, desks, leases, and other hard assets.

As the CEO of Dale Systems, I want to attribute 90% of the excess purchase price over book value to "in-process R&D" and expense that immediately. So this year I take a write-off equal to 90% of the $180 million excess. For the purposes of this example, let's leave taxes out of it. So that $162 million write-off reduces my net income by the same amount and it also reduces my company's book value by $162 million because it reduces retained earnings by that amount. Not to worry here, as "the Street" looks at "earnings before extraordinary items."

Now, say my company earned $100 million before the write-off this year and next year it will earn $200 million because the product synergies we forecast were extremely well received by customers. Let's also say Dale Systems would have earned $150 million next year without the new software. Wall Street's happy, my options are worth a whole lot more, my employees are happy, my engineering classmates know now that I'm The Man and not the geek they thought I was, and my kids are bouncing around like little kangaroos because they can get the G.I. Joe with the kung-fu grip for Christmas.

But now the accountants and economists at FASB and the Securities and Exchange Commission want to change all that. I can't write off the in-process R&D when I make the acquisition. I have to capitalize the acquired R&D and amortize the asset over a number of years. In this case, let's say by standard industry practices and our best judgment that turns out to be five years. So, on the acquisition date, I have to mark up on the asset side of the balance sheet an intangible asset of $162 million called "in-process R&D." On the liabilities and equity side of the balance sheet, my shareholders' equity is $162 million higher because there was no write-off to reduce my retained earnings.

Nothing is different with the product synergies. Silicon Valley is still quaking because some upstart company from Buffalo, New York, just strengthened its market share in the extremely important superconductive data switching market. I'm bummed, though. These accountants and FASB ninnies caused my earnings to be $32.4 million lower than they would have been had I been able to write off the R&D. How that works is simple. If I have to capitalize the $162 million of in-process R&D and I must write it off over its useful life of an estimated five years, then each year I charge off 20% of that capitalized asset. That's $32.4 million per year charged to earnings. So my earnings this year are $167.6 million instead of $200 million. Ninnies.

You know what, though? The market doesn't care, because accounting methods don't alter cash flow. Sure, there will be the occasional analyst on your conference call that can't quite get it straight and downgrades you because your earnings growth didn't fit into his or her price-to-earnings-growth model. But the market as a whole isn't going to get hung up on the form of your earnings. The economics of your cash flows are simple enough to see under the two methods of accounting. Let's look at cash flows for the year after the acquisition under the two scenarios (both in thousands of dollars):

Write-off method

Cash flows from operating activities:
Net income.....................................................$200,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation........................................................8,000
Provision for doubtful accounts..........................9,000
Change in operating assets and liabilities:
Accounts receivable........................................(43,000)
Inventories........................................................(13,150)
Prepaid expenses and other current assets......(5,000)
Accounts payable..............................................12,500
Accrued payroll and related expenses................7,000
----------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES...$175,350

Capitalization and amortization method

Cash flows from operating activities:
Net income.....................................................$167,600
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation.........................................................8,000
Amortization of in-process R&D........................32,400
Provision for doubtful accounts...........................9,000
Change in operating assets and liabilities:
Accounts receivable.........................................(43,000)
Inventories.........................................................(13,150)
Prepaid expenses and other current assets.......(5,000)
Accounts payable................................................12,500
Accrued payroll and related expenses..................7,000
------------------------------------------------------------------------
NET CASH PROVIDED BY OPERATING ACTIVITIES...$175,350

There's no difference in the cash flows. That means there's no difference in the cash economics of the business. As for taxes, you might get to record a tax asset if you write off the R&D immediately, but if you only get to use the tax asset at the same rate as the deductible amortization expense over the asset's life it still doesn't make a difference to cash flows. But some IRS rules are even more screwed up than the most demented Generally Accepted Accounting Principle (GAAP) dictates, so we'll just move past the tax issue.

Amortization is a financial accounting memorandum. Some people treat all amortization as the same -- as in "don't worry about it, it's a non-cash expense." To my mind, there's a big difference between the goodwill that gets marked up on the balance sheet in a bank acquisition and the R&D intangible that gets marked up on the balance sheet in an industry with five-year or shorter product cycles. If you're turning over your entire product line in five years and you must replace that intellectual property with new acquisitions or homegrown R&D, the amortization is a memorandum that tells you about the amount of resources you need to expend to maintain your economic position. That assumes the return on future projects exhibits the same return characteristics as aged investments. If returns on future projects are higher, then you'll need to invest less to maintain your position.

For a depreciable asset like a drill press or something, if it's charged off over 20 years, it's not like it's going to fall part in year 21. Generally, though, if your depreciation schedule matches the useful life of an asset and inflation is not raging out of control, your depreciation expense will be directly offset by the amount of cash your need to spend to replace your assets. Goodwill is a little different, though, depending on the company.

For a bank holding company, goodwill amortization does not signify that it needs to spend a like amount of money to keep the customers it gained through the acquisition that gave rise to the goodwill. For a company in the superconductive data switching business, the asset is probably going to run its useful life over a much shorter period of time, during which you'll have to spend money to replace it. The purchased intangibles that arise from the acquisition of Coca-Cola are a lot more durable, if you run the business correctly, than the purchased intangibles in a software acquisition.

These are generalizations and, of course, there are exceptions. The problem with high-tech business is that the cash expended to replace assets shows up on the income statement right away. You're not replacing capitalized assets with more capital expenditures. That seems to be the big hang-up with a lot of executives in R&D-intensive industries. As I showed above, though, the market looks through that problem. When it comes to cash flows, the market is over the long run a suave sophisticate. It doesn't appreciate cartoonish portrayals of earnings. It can tell the difference between GAAP earnings and real cash flows.

Bottom line: The method of accounting doesn't change the gross cash flow, except possibly for small changes to the tax situation. How you think the non-cash amortization expense reflects a need to maintain those assets is something different. The form of the accounting chosen does not change the substance of the gross cash flow you have to work with to reinvest in the business. On Monday, I'll look at some of the balance sheet aspects of acquired R&D accounting and poolings versus purchase. I'll also nail down a little harder the economics of cash flows.

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