R&D – More Than the Cost of Doing Business

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 16th, 2015

R&D – More Than the Cost of Doing Business

  • The push for innovation within Industrials & Materials has expanded margins for the highest R&D spenders, but has not afforded them any multiple expansion in aggregate
    • Margin expansion has not been markedly different for the highest spenders versus the lowest
    • As spending as a percentage of sales has steadily increased over the past 10 years, relative multiples have stagnated in most instances and deteriorated in others
  • On the positive side, HON appears to have one of the most effective R&D programs, but current valuation reflects this
    • As R&D spend has increased over the past decade, EBIT margins and relative multiples for the company have risen accordingly
    • The stock looks more than fully valued on our framework
  • On the negative side, this work reflects poorly on DuPont
    • Among the top 10 R&D spenders in Industrials & Materials DD is the only relative underperformer over the past 10 years
    • Its relative multiple has trended lower as its R&D spend has trended higher, and margins have been flat for a decade
  • EMN and PX, two of our Chemical favorites, are unique in showing positive margin trends with declining R&D spend
    • The stocks have seen multiples decline for reasons detailed in prior research (EMN, PX)
  • A full company table is shown in the Appendix

Exhibit 1

Who Is Spending

There is some shake up in the order if we compare spenders over the last 12 months to spenders over the past 10 years but for the most part, the companies that focus on R&D have historically spent and continue to spend. For our purposes we use the 10 year average figures for segmenting the group.

Exhibit 2

Source: Capital IQ, SSR Analysis

Is It Working

Performance

Plotting R&D spend against performance results for the past 10 years shows no real evidence that the higher R&D spending companies outperform lower spending peers. Of note is the meager performance for DuPont – the stock is easily the worst performer among the highest spenders and has even fared worse than the 10 large cap companies that spend the least on R&D.

Exhibit 3

Source: Capital IQ, SSR Analysis

Relative Multiples

As R&D spend has risen as a percentage of sales for the largest spenders, there is no indication that the market is granting any innovation premium – in fact the average multiple for the group of large spenders has deteriorated and has a markedly downward trend. Any way we slice the results here (top 5, top 10, top half) the trends remain consistent – Exhibit 4, left chart. They also hold, albeit with less of a negative slope to the relative P/E line, if we exclude MON, which is easily the highest spender in this group and has a relative multiple that was somewhat distorted in the years of and immediately following the financial crisis. The trends for the lowest R&D spenders (Exhibit 4, right chart) are similar, but the increase in spend is less extreme, and the multiple, while downward sloping, is only marginally lower than it was 10 years ago and has expanded considerably over the past five years (during which time the multiple for the highest spenders has been stagnant).

Exhibit 4

Source: Capital IQ, SSR Analysis

Comparing the highest spenders to the lowest requires some company specific consideration – the inclusion of SHW, which has been on a tremendous run for the past five years, significantly alters the multiple for the lowest spending group – Exhibit 5.

Exhibit 5

Source: Capital IQ, SSR Analysis

Margins

The highest R&D spenders predictably have superior margins compared to lower spending peers (high R&D spending in general being an indication of inherently value-add businesses) and have expanded margins at a faster pace, but the trends over the past 10 years are not very different: +2.0% for the high spenders, +1.7% for the low spenders (Exhibit 6, left chart). As such, the margin differential has expanded over the past 10 years (Exhibit 6, right chart), though this has come in significantly over the past year and is currently just one percentage point higher than it was in 2005.

Exhibit 6

Source: Capital IQ, SSR Analysis

Company Level Standouts

Positive Standouts

Honeywell (HON) bucks the overall trend of higher R&D spend and a lower multiple – the company’s spending has trended higher but it has also seen an enhanced multiple, suggesting it is getting the benefit of its innovation efforts (Exhibit 7). Margin trends also support this premise.

Two of our Chemical sector favorites, Eastman (EMN) and Praxair (PX) are unique in showing a positive EBIT margin trend without a meaningful increase in R&D spend – Praxair’s spend has in fact declined steadily (Exhibits 8 and 9). The concern for Praxair is that opportunities for further margin expansion going forward are limited, particularly relative to APD. Eastman is a poorly understood assortment of complex businesses and, given the trend of its relative multiple, must prove the value of its portfolio with results before the market will take notice of the opportunity.

Exhibit 7

Source: Capital IQ, SSR Analysis

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Negative Standouts

The downward trend in DD’s relative multiple is influenced to a degree by the recent plunge but in absolute terms, its multiple at the 2015 peak was still below the levels seen in the mid 2000s. To be fair, these trends are also evident for MON, so perhaps this is a more general question about R&D efficacy in agricultural chemicals (more a necessary cost of doing business than a growth driver?). Consider, though, that while MON has shown improved EBIT margins over time, DD’s have been flat for a decade – Exhibits 10 and 11.

Exhibit 10

Source: Capital IQ, SSR Analysis

Exhibit 11

Source: Capital IQ, SSR Analysis

Appendix (sorted by R&D spend)

©2015, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

 

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