The Innovation Boom
John Mauldin's Outside the Box

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Introduction

GaveKal released a new book last year called Our Brave New World and it has been the subject of several Thoughts From the Frontline letters. Steven Vannelli, of Gavekal, offers us another look at platform companies and argues that research and development (R&D), or intellectual property, is much more important that capital expenditures, or manufacturing ability. He then shows several examples of US companies that have increased R&D compared to capital expenditures.

Platform companies have realized that to be competitive in the new global marketplace they must lead innovation. In 2004 the US spent $250 Billion on R&D while China only spent $20 Billion. The US is moving production capacity around the world and GaveKal argues that the important thing to watch is R&D and that is why this piece was picked for Outside the Box.

- John Mauldin

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The Innovation Boom

By Steven Vannelli
February 16, 2006

We are usually loath to quote politicians, especially those on the Far Left, but this paragraph from House Minority Leader Nancy Pelosi's op-ed piece in the Wall Street Journal entitled "R&D Democrats" says it all: "America has always been committed to being number one. Every scientific advance once thought impossible that has been achieved--splitting the atom, landing a man on the moon, mapping the human genome--has been achieved by Americans. We accomplished these extraordinary goals, and then benefited from the jobs, industries and successive innovations they have yielded because our country was willing to make two critical commitments. We invested in the education and ambition of the American people, and we promoted an entrepreneurial culture that supports long term, high risk ideas."

And this is a great point. Where do some of the things we take for granted, the every day items like pyrex cookware, or velco fasteners, or light emiting diodes come from? All around us, from color laser printers to mass spectrometers, from the computer mouse to or open-sided MRIs, from satellite radio to all aluminum engines (which save weight and improve performance), from Teflon pans to "natural light" bulbs... we stand in awe of the products churned out by research and development efforts of companies around the world. Even the ability of our Captain Crunch cereal to stay crunchy for at least fifteen minutes is a testament to the research and development capabilities of General Mills!

BASF, the German chemical company, has a commercial that states "we don't make the things you buy, we make the things you buy better." Increasingly that is becoming more true of platform companies. In our recent book Our Brave New World, we described the three broad functions of companies: to design a product, to manufacture a product and to distribute a product. And successful companies in the Western world are deciding to focus their resources on the first-- designing products.

In the forgone US manufacturing age, growth was achieved by physically producing, with company owned assets, more of the same products. Improvements in quality, whether it be in size or speed or otherwise, was not of primary concern (anyone who owned an American made car in the 1970s or 1980s can attest to that). Increases in volumes, without damaging pricing, were easily achievable with proper planning because there wasn't an abundance of supply relative to demand. With the Cold War, trade restrictions and misguided monetary policies global markets were less efficient and price was easier to realize.

In the 1980s, with the backdrop of a falling rate of inflation and freer trade, vertically integrated companies realized they could enhance profitability by locating productive assets in places like Japan and Korea--they began the process of deverticalization. This relocation of fixed assets drove profitability by allowing companies to shed capital consuming functions and focus on profit producing ones.

Then, in the early 1990s, the opportunity to outsource the manufacture of an entire product availed itself as global borders opened and capital flowed more freely around the world. Highly efficient producers that could fulfill any order with impressive quality and speed sprang up everywhere, from Southeast Asia to Korea, from Central America to Eastern Europe.

The technology revolution was an accelerant to this trend of outsourcing, as far flung participants in a supply chain could be connected and efforts coordinated. Just in time inventories, supply chain management and business process outsourcing become part of the lexicon of business.

Platform companies realized that in a deflationary boom environment, characterized by plentiful physical fulfillment, to sustain profits and to grow, they had little choice but design new features, improve existing products and create whole new products or product categories. In short, they had to become more productive.

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And this meant a different kind of investment. Today, less capital is being invested in the expansion of physical capacity and more capital is being invested in the expansion of intellectual capacity. In the following pages, we look at a cross-section of some of America's largest companies. From technology to auto manufacturers, from drugs to aerospace... And everywhere we care to look, we note the following trends in R&D expenses relative to capital expenditures:
  • They have grown much faster
  • They were unaffected by recessions, mid-cycle slowdown or financial crises
  • The rate of increase, in some cases, is accelerating
  • The trends really diverged in the early 1990s (the beginning of the explosion in the trade deficit)
  • They have led to strong productivity gains.
Reviewing these trends, we have a tough time getting worried about the outlook for US equities, or for the US economy.

Let us start with an industry in which R&D is crucial: pharmaceuticals. Note the divergence in spending trends at Pfizer. In 1991, R&D, at $1 billion was only 25% bigger than Capex of $800 million. But after growing at a near 15% compound rate, R&D is now almost 3x the size of Capex.


At Johnson and Johnson, the surge in R&D relative to Capex is more pronounced as the two costs began the 1990s at parity. But in the past 15 years, R&D has grown at a 12% compound rate while Capex has grown at a 6% rate. Now annual R&D expenses are 2.5x annual capital expenditures. Neither midcycle slowdown nor recession effected R&D, though it definitely affected Capex.


Moving on to technology, Microsoft has grown its R&D at 25% compound over the last 15 years. The 1997 bulge was likely linked to the efforts to get Windows 98 out the door. Which raises the question of whether Vista will cause a repeat?


We witness a similar trends at Oracle, with R&D growing at 22%, while Capex has been in outright decline since 1996. Annual R&D expenses are almost 10x the size of Capex.


And the same is true of industrial companies. Boeing's R&D doubled over the last decade and a half while Capex has been halved. The acceleration in R&D from 2000 to present in the face of a recession and a stock market crash is rather impressive. Apparently, Dreamliner's are very expensive to design...


We witness a similar trend with United Technologies. Despite the fact that durable goods deflation has been highly pernicious in recent years, UTX has still managed to turn in all-time record operating margins last year!


For the first time in its History, Dupont, spent more on R&D last year than it did on Capex. Notice capex is a fifth the level it was in 1991.


Should we be surprised by the fact that Ford spent more on R&D last year than on Capex? Almost $500m more! Capex has been flat for 15 years while R&D has doubled. Unfortunately, Fuel cells, heads-up displays, satellite radios, hybrid engines, airbags, anti-lock brakes, drive-by-wire tech... don't invent themselves.


Another example of stagnant Capex and vibrant research and development can be found at Proctor and Gamble. In the next recession, Capax will likely fall to levels permanently lower than R&D.


As an example of the productivity of the R&D investments, let's review sales per employee at P&G. They were roughly $275,000/employee in 1991. Today, they stand nearer to $525,000/employee--that represents a 4.5% annual growth.


Putting it all together, we find it hard to understand the perma-bears' mantra that the US economy is on the verge of implosion. Looking at capital spending numbers gives a very incomplete picture of the health, and innovation, prevalent across the US corporate sector. In Our Brave New World, what matters is R&D, not capex. And those who do not keep in mind the R&D trends will continue to miss an important piece of the puzzle.

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Conclusion

I hope you enjoyed Steven Vannelli's look at platform companies. You can find out more about GaveKal and information for ordering their book by going to www.GaveKal.com.

Your innovation boom analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

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Posted 02-20-2006 9:54 PM by John Mauldin