Ann: Change in substantial holding-SDI.AX, page-26

"Of course, I do accept that in the technology space, what R&D will put you ahead of competitors, and what R&D will simply help you keep up with them (at best), is often hard to distinguish."

@MarsC,

Yes, that is the nub of issue: making a determination of how much R&D investment relates to merely maintaining competitiveness, and how much is to grow the business.

And poor little us sitting here on the outside of the management accounting and the financial audit meetings will never be able to know just how arbitrary this determination (One thing that can be said, is that it is indeed an arbitrary process, but just how arbitrary is impossible to know. My experience is those that do it for a profession seldom really know!)

But there are a few "reasonableness tests" we can conduct in order to get a "feel" for how far the envelope is being pushed, or otherwise.

A bit similar to the ASSET TURN ratio (aka Sales Velocity i.e., how much investment in PP&E is required to support a certain level of Revenue), I like to look at the relationship between Revenue and the level of Intangibles (excluding Goodwill).

To me this provides a crude measure of how hard the IP assets are "sweating".

Obviously, just like the case with Asset Turn, the higher the ratio, the better, because this means higher Return on Capital (ROC).
[Remember: ROC is derived from the product of the ratios of Revenue-to-Capital and Profit to Revenue, i.e., ROC = Asset Turn x Profit Margin]

For SDI, Revenue-to-Intangible (Ex. Goodwill) is a paltry 3.3x.

(By comparison, this ratio for other research-driven organisations that represent best practice is many orders of magnitude higher than this., eg. CSL = 31x, ARB = 51x, and even DLX, where much of the R&D expenditure is more brand supporting than it is for technological advancement, has a much-higher ratio of 18x.)


Put another way; largely because of the scale of the investment in R&D, since 2003, of SDI's cumulative total of reported Net Profit of $52m, less than $7m (i.e, just one dollar out of every seven dollars of Profit) has appeared as FCF.

So this is why I am so sensitised to this R&D capitalisation issue for SDI: proportionally, it is a very material consideration (although, to be fair, viewed over the past 5 years, that stat rises to one dollar out of every five, and 2014 and 2015, it was far more palatable, at $1.00 in $2.50, and $2.30, respectively).


Insofar as testing to what extent investment in R&D is driving growth, well, SDI's top line has grown appreciably over time, by a compound average growth rate of around 4.8%pa since 2004.

The same can't be said for profits, though, which are today essentially at a similar level to 2004 (although that masks the trend, which has seen current profits rise linearly by six-fold from the low point in 2011).

So it's really hard to tell to what extent the R&D spend is really driving underlying profit growth.


Then there's yet another way to slice this stuff, and that is to look at how this Revenue-to-Intangible Assets ratio changes over time.

Because so far we have just looked a snapshot in time, and while that point-in-time snapshot has not flattered SDI, arguably the more relevant question is how the relationship between Revenue and the carrying value of capitalised R&D is changing over time.

If the ratio was improving then, obviously, the IP capital was being made to work harder and to sweat more (a good thing for shareholders, and an indication that the carrying value of capitalised R&D was conservatively struck); but if it was declining, then the IP capital was becoming less productive over time (obviously not a good thing, and a sure sign that the capitalised R&D value was over-stated and needed to be written down)

Put in finance-speak, if Revnue-to-Intangible Asset Value was improving, then, ceteris paribus, that would result in improving ROC and therefore higher intrinsic value.
And vice vera.

So, here are the numbers:

SDI's Revenue-to-Intangible Assets (x)
2004: 5.8
2005: 14.3
2006: 6.1
2007: 3.5
2008: 3.0
2009: 3.4
2010: 3.2
2011: 3.3
2012: 3.1
2013: 3.0
2014: 3.2
2015: 3.3
2016 (my forecast, for what its worth): 3.5

As can be seen post 2006, that is, which probably coincides with the start of the "post amalgam" era, when the company began developing its new-age, non-amalgam products, the measure is relatively constant, ranging between 3.0x and 3.5x.

Meaning that IP capital is neither being made to sweat harder; nor is it becoming more idle.

So here too, it is difficult to be conclusive on this matter, other than to say that the company's financial managers and it auditors have probably got it right (well, as right as one can get something as abstruse and abstract as what R&D spend warrants writing off directly to the P&L, and what should be taken to the balance sheet).

So, yes: I sort of buy (only just, though!) the line that says that reason R&D is being capitalised is because it is driving growth for the organisation.

If I didn't think this, I would not have become, nor would I remain, a shareholder in the company. Naturally, if I notice this metric undergoing dramatic changes, I will adjust my view of the stock accordingly. And if they do crack the non-amalgam market in an even modest way, I suspect the ratio will ratchet up quite smartly.

And ROC with it.
And the valuation multiples will follow.

And when you have a situation of increased profits coinciding with an upward re-rating of the multiple that is paid for those profits, this double-whammy turbocharges share price performance.

But my original point is that, more than any other company for which I maintain a financial model, SDI's P&L needs to be constantly reconciled to its cash flows, if not for the purpose of ongoing monitoring for potential changes which could radically change the investment proposition, then for reasons of general and healthy awareness of financial warts.