Jim Chanos, a well known hedge fund manager has accused technology companies of using acquisitions to maintain revenues while capitalizing R&D. He shorted HP citing this exact reason (see video clip) in July 2012 and in another CNBC interview aired his concerns of inorganic growth and why he is a great fan of companies investing on organic initiatives as opposed to buying growth.
While I greatly admire and respect Chanos, I can’t disagree more of his position and his underlying logic. For one, capitalizing R&D is not a bad thing as long as you are consistent .We all know that the benefits of R&D are typically realized in the long run ( stretching over a 5 year span if not more). Under accrual accounting, the logic dictates that any expense should be incurred in the same period when its associated benefit (or revenue) is realized. So why is that we expense R&D as opposed to amortizing it like we do for other long term investments. The reason we don’t capitalize R&D (though it makes perfect sense to) is because of the conservative nature of our accounting rules and because it is hard to speculate the duration over which R&D benefits are realized.
So the approach we have been using all long for reporting (expensing R&D as opposed to capitalizing it) is inherently wrong. However this gets balanced out in the long run as long as the company is consistent in its R&D spend and is not making drastic changes from year to year – so it not a big concern. The same can be said of acquisitions. Though an acquisition would result in capitalized R&D and hence helps out firms who haven’t spent on R&D in the past, it doesn’t reduce your future expenses - companies typically do not let go of acquired technical talent ( which in my experience is the prized asset they are going after). On the contrary, companies usually end up investing more R&D after an acquisition to integrate and realize synergies. So you are essentially not reducing your future R&D expense and the fact that you capitalized past expenses doesn’t really matter as long as the company has been consistent with its acquisitions, .
So for technology giants like Oracle, IBM or Cisco which have been consistently acquiring companies and are hence capitalizing part of their R&D all along, I see no material impact – The acquisitions should not change their financial metrics one way or the other as argued by Chanos.
In my humble opinion, financial restructuring is the last thing in mind when companies go after acquisitions especially in the technology industry where time to market is key and you can’t afford to be late and out of contention. Further more, acquisitions consume resources to integrate and inflate expenses in the short run and do not turn accretive till one or 2 years at the very least. So it is unfair to suggest that companies like IBM are some how misleading shareholders and that acquisitions are inherently bad. One needs both organic and inorganic investments to be relevant these days and as long as the firm is consistent in its approach and execution, you shouldn’t be concerned.
HP (HPQ) is now trading at ~ $30 almost 50% more than what it was trading in July 2012, when Jim Chanos shorted it. I am not suggesting that this validates my analysis, as stock price can change for a number of reasons. But if HP can recover despite a number of challenges including its bungled acquisition of Autonomy (for which it grossly overpaid ), so can any other company and arguing that all technology acquisitions are financial window dressing is flat out incorrect.
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