The companies that create the most value in the tech hardware supply chain are innovation machines. Their managers excel at deploying R&D, sales, and marketing to develop products and services that their downstream customers want. These organizations can push back on commodity pricing pressure. And it puts them in the privileged position of being a strategic partner to their downstream customers. The central theme in most of our consulting work is to help clients find and stay in this elite position.
The assets for innovation (R&D and SG&A) are intangible. And according to accounting rules, companies must expense these costs. In other words, according to the bean counters, organizations consume R&D and SG&A instantly but use up tangibles (like factories and equipment) over a useful lifetime.
This financial view doesn't correlate well with the strategic picture. Management teams invest in intangibles like R&D and SG&A to reap returns in the future. And this is especially true for technology firms. Does anyone believe Apple's R&D spending won't derive a future return on today's investment? Or, how about Sony's expertise in image sensors and advanced micro-OLED displays? Is all the value of R&D consumed in the year the company expensed the cost on their income statement?
Over the last decade, there has been a thoughtful discussion on the role of intangibles among economists, financiers, accounting firms, and academics. The experts in this area are Jonathan Haskel and Stian Westlake. Their book, Capitalism without Capital: The Rise of the Intangible Economy, is worth reading. The Economist penned an excellent synopsis.
The fruits of this research have trickled down into the trenches. Wall Street analysts have deconstructed financial statements to account for intangibles as investments. The methodology involves estimating the capital stock and lifespan of R&D and SG&A, and then, amortizing it over a useful life. These investments are moved off the income statement and onto the balance sheet. No one has done a better job distilling theory into practical advice than Michael Mauboussin and Dan Callahan at Counterpoint Global.
Counterpoint Global is writing for financial analysts searching for mispriced securities. But we can use their approach to gain insight into the Tech hardware supply chain. Treating investments in R&D and SG&A the same way as building a new factory is useful. It puts asset-light companies on the same footing as asset-heavy companies. And much like looking at profit pools, it can shed new light on how value is distributed throughout the supply chain.
RCD Advisors reviewed the financial statements from over 180 Tech hardware companies using Counterpoint's approach. The analysis starts with return on invested capital (ROIC) using standard accounting conventions. ROIC is calculated by dividing net operating profit after tax (NOPAT) with invested capital. We then adjust financial statements to capitalize intangibles and calculate an adjusted ROIC. Removing R&D and SG&A expenses from the income statement and putting them on the balance sheet increases NOPAT. At the same time, it increases the invested capital. The net effect usually lowers ROIC.
We organized companies into supply chain sectors. We then calculated sector average ROICs by summing data over seven years. Using a ratio based on seven years of accumulated results reduces business cycles and pandemic-related distortions.
The spread between traditional ROIC and adjusted ROIC (to include intangibles) varies across different sectors. It is most significant for semiconductor equipment makers. Even though these companies are asset-light, their management teams invest heavily in R&D.
There is also a large spread between ROIC and adjusted ROIC for integrated device makers (IDMs) and fabless IC suppliers. The difference makes sense, given the relative level of R&D spending. Interestingly the spread for foundries is negligible. Fab capex spending overwhelms the relatively lower investments in R&D.
The adjusted ROIC is higher for the optoelectronics sector. A higher ROIC suggests that optoelectronic suppliers rely more on intangibles for profits than any other part of the tech hardware supply chain.
Part of the goal was to understand how each sector derives a competitive advantage. One way to do this is to dissect ROIC into profitability and capital turnover terms.
ROIC=NOPAT/Sales x Sales/Invested Capital
Plotting the terms on an x-y scale for each sector helps visualize the analysis. A sector with high operating profit is composed of companies that derive value from customer "stickiness." That stickiness could come from sustained product differentiation through churning out new products. It could also come from strong strategic relationships with customers. Some companies excel at quickly winning "print position' on the BOM with more effective sales channels. In contrast, a company with high capital turnover derives most of its advantages from cost efficiencies.
As expected, the semiconductor industry commands the highest profitability. But this is at the expense of some of the highest tangible and intangible investments. Asset-light fabless IC suppliers have about the same capital turnover as foundries and IDMs when accounting for intangibles.
EMS/ODM industry values suggest that those organizations focus primarily on cost efficiencies. Close peers are power supply manufacturers and automotive electronics. Unsurprisingly, many EMS/ODM suppliers already make power supplies. Most are aggressively pursuing the automotive electronics market. Likewise, passive component and interconnect sectors have similar metrics suggesting natural complementary businesses.
Although not shown, the spread among each of the companies is also informative. There are clear delineations between cost leaders and companies that depend on differentiation.
Management teams can use internal divisional ROIC measures to benchmark against industry averages. Moreover, it may be worth repeating the exercise using different sector boundaries.
Tech hardware development is hard. New components, processes, and systems require capital investments in factories and equipment. But it also requires investing in R&D and SG&A. Companies that can leverage their intangible assets most efficiently generate higher economic value than their peers. We encourage all management teams to use the analysis developed over the last five years in financial circles to recast their R&D and SG&A expenses to measure their performance. Then compare that performance to their peer competitors. At the very least, the analysis will offer another lens to mine for insight. But at best, it could provide new ways to deploy scarce human resources and create more value for your downstream customers.
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