A brand new accounting rule went into impact earlier this yr, and it’ll change the image for some firms’ earnings and money flows.
The excellent news is that the brand new rule will enhance earnings for a lot of firms. The dangerous information is that, in consequence, these firms can pay extra in taxes, and their money flows can be negatively affected.
Up till 2022, spending on analysis and improvement (R&D) was an expense that could possibly be subtracted from income. This lowered income but in addition taxes owed.
Since January 2022, R&D bills have been handled in the identical means as capital expenditures (the cash an organization spends on properties and services), that are discovered on the assertion of money flows. Which means R&D bills now rely towards money movement.
It sounds sophisticated, nevertheless it’s not.
For instance, if an organization generates $100 million in income and has R&D bills totaling $70 million, its revenue (assuming it has no different bills) is $30 million.
Beneath the brand new rule, the corporate can deduct solely $7 million (10%) in bills this yr and 20% of the rest in every of the following 5 years. So within the instance above, the corporate’s revenue is now $93 million.
However the $70 million that was spent on R&D must be accounted for someplace. It can now be included within the firm’s assertion of money flows.
As a result of the instance firm is expensing solely $7 million of the $70 million it has in R&D prices, the remaining $63 million can be subtracted from money movement as a result of it represents money that went out the door however just isn’t being accounted for within the revenue assertion.
Right here’s a quite simple instance of an organization with no bills apart from taxes (elevating taxes is why the rule was applied) and no different variables.
You may see that money movement fell from $24 million beneath the outdated rule to $21 million beneath the brand new one.
Raytheon Applied sciences (NYSE: RTX) not too long ago lower its free money movement steerage from $6 billion to $4 billion because of the brand new regulation.
It’s essential to notice that beneath the brand new guidelines, 100% of R&D just isn’t faraway from the revenue assertion and transferred to the assertion of money flows. Fairly, it’s amortized over six years. Within the first yr, 10% will be deducted as an expense, with the rest amortized in equal quantities over 5 years.
I ran a display to search for firms with excessive R&D prices in contrast with income. Taking that massive expense off the revenue assertion ought to lead to stronger earnings, nevertheless it may probably cut back money movement.
Over the previous 12 months, Digital Arts (Nasdaq: EA) has spent $2.2 billion on R&D and has earned $7.5 billion in income. Throughout that point, the corporate has generated $1.8 billion in free money movement whereas paying out simply $200 million in dividends. So that might imply a $2 billion haircut to free money movement.
Consider, I’m utilizing knowledge from the previous 12 months, so it’s simply an estimate. The complete-year 2022 outcomes would be the actual numbers to have a look at.
After Digital Arts, the corporate with the next-highest R&D-to-revenue ratio is Marvell Know-how (Nasdaq: MRVL).
Over the previous 12 months, Marvell has spent $1.7 billion on R&D towards the $5.5 billion it generated in income.
Marvell is in the identical scenario as Digital Arts. A $1.7 billion hit to free money movement could possibly be robust to take.
The final one we’re taking a look at is Eli Lilly (NYSE: LLY). The drug big paid $8.6 billion on R&D towards the $29.1 billion it made in income.
Over the previous 4 quarters, Eli Lilly has generated $5.7 billion in free money movement. So a virtually $8 billion decline in free money movement can be exhausting for the corporate to abdomen.
Remember the fact that the decrease R&D bills are on the revenue assertion, the extra worthwhile the corporate can be. So it’s not an actual dollar-for-dollar decline on the assertion of money flows. However as we’ve already seen with Raytheon, this variation will doubtless have a adverse impact on some firms.
Once more, these are tough estimates, however you may see how vital this new accounting rule can be for firms’ earnings and money flows.
It could be value your whereas to taking a look at every of your dividend payers’ R&D bills to find out whether or not the brand new rule goes to meaningfully have an effect on its money movement or its potential to pay dividends.
Good investing,
Marc
