Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get a bull's-eye painted on their back as they become targets of other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Not only that, but even if a company continues to dominate its particular field, other changes in technology can shift spending away from their products. Think about how Microsoft still dominates PCs but feels pressure from the sales shift toward mobile devices such as smartphones and tablets.
With that in mind, today we're looking at how EMC
Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare EMC's spending in these areas with that of its closest peers and assess whether the company is investing enough in its future.
Research and development
Over the past five years, EMC has spent an average of 15% of revenues on R&D. The following table summarizes how EMC's R&D expenditures relative to revenues compare with some of the company's closest peers.
|
Company |
2006 |
2007 |
2008 |
2009 |
2010 |
LTM |
|---|---|---|---|---|---|---|
| EMC |
16.6% |
15.0% |
15.2% |
16.1% |
15.1% |
15.0% |
| NetApp |
12.2% |
13.7% |
13.7% |
14.1% |
13.6% |
12.7% |
| Seagate |
8.7% |
8.0% |
8.1% |
9.5% |
7.7% |
8.0% |
Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.
In both relative and absolute terms, EMC outspends its storage rivals. The heavy resources needed in high-end storage is evident by how much more both EMC and NetApp have to spend on R&D relative to Seagate, which produces more commoditized hard disks for enterprises and consumers. Last year, EMC spent just a bit less than $2 billion in R&D while its chief rival, NetApp, spent just a bit less than $6oo million. It's a situation not too dissimilar to how Intel can stay ahead of AMD by the massive R&D resources it can pour into advanced semiconductor technologies. As we'll explore, in instances where EMC fails to internally develop products, it fills in holes by way of acquisitions.
Acquisitions
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as the hard-drive and PC segments, while it focused on acquiring additional services and software expertise that have transformed its business model.
On the opposite end of the spectrum, Hewlwtt-Packard is often criticized for underinvesting in R&D, to the point that it has to overpay on acquisitions to catch up with its competitors.
Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow.
Let's take a look at EMC's free cash flow over the past five years against cash spent on acquisitions.
Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.
EMC is a highly acquisitive company, and investors should keep that in mind when valuing it. Cash flows aren't as robust as they might look on a pure free cash flow basis, once cash spent on acquisitions is taken into account. However, while other technology firms have to make acquisitions in large part because of their underfunding of R&D (I'm looking at you, HP and Dell), EMC uses acquisitions to buy key storage technologies in areas where its own internal development hasn't kept pace. That's not an ideal situation, but developing something in-house would be, and it's also a sign of good forward-looking management. As the likes of H-P and Dell might try buying their way into high-end storage solutions, EMC is offering a complete storage solution and using acquisitions largely to plug gaps. In the end, that approach will prove to be the successful strategy in the industry.
Final thoughts
As we've seen, EMC both devotes large resourced to R&D and makes acquisitions of key technologies. These acquisitions have paid off very well in the past. For example, the company purchased VMware
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