At the end of last week, I took a look at Seth Klarman (Trades, Portfolio)’s two largest positions to try and establish if they’re attractive buys for other investors in today’s market environment.
As the Standard & Poor's 500 continues to trade around all-time highs, actual value stocks are few and far between. By looking to Klarman’s portfolio, I hoped to find some stocks that could be trading at attractive valuations and worth buying.
Klarman’s second-largest holding is communications company ViaSat Inc. (VSAT, Financial), and as I concluded in my article last week, a quick glance at the company shows that it’s not the cheapest investment around. In fact, as shares in the group trade at a forward price-earnings (P/E) of 95, the shares look downright expensive. As a result, I concluded there was no apparent reason why Klarman owned the company.
However, as a commenter on the article pointed out if you capitalize the company’s R&D research a different picture appears, one that provides a more favorable view of the business.
Adjusting for value
Accounting for R&D spending is a topic that splits opinions between accountants and analysts. For example, the Financial Accounting Standards Board requires virtually all R&D costs to be expensed in the period they were incurred and the amount to be disclosed. The only exception to this rule is contracted R&D performed for unrelated entities.
Meanwhile, professor Aswath Damodaran, one of the most respected business valuation lecturers at the Stern School of Business, argues in a research paper that:
“Accounting rules clearly specify that operating expenses are expenses designed to generate income in the current period whereas capital expenditures are designed to provide benefits over multiple periods. The current treatment of research and development expenses [as] operating expenses seems to violate this distinction. In this paper, we have argued that R&D expenses are in fact capital expenditures and should therefore not be shown as part of operating expenses. To be consistent, we also argue that research and development expenses create a research asset that has to be amortized over time.”
Just a quick glance at ViaSat’s earnings report will give you an idea that using this approach will have a meaningful impact on the firm’s valuation. The company boasts in its fiscal third quarter earnings release:
“Net income for fiscal 2017 third quarter year-to-date results were essentially flat year over year, despite the $34.2 million year-over-year increase in research and development (R&D) investments.”
Independent R&D costs for the nine months to Dec. 31, 2016 rose to $89.8 million, from $55.6 million in the year-ago period. Net income for the nine months to Dec. 31 was $17.1 million, down approximately $171,000 year on year.
According to the company’s 10Q filed with the SEC, it did capitalize some R&D spending over the last nine months. A total of $17.6 million and $58.3 million of costs related to software developed for resale for the three and nine months ended Dec. 31, 2016, was capitalized.
What’s more, the firm also carries out some R&D on behalf of customers, which cannot be capitalized for obvious reasons. Revenues for funded research and development from customer contracts were approximately 19% and 20% of total revenues in the nine months ended Dec. 31, 2016 and 2015. But these figures aren't included in the independent R&D costs mentioned above. Therefore, substantially all of the independent spending can be capitalized for valuation purposes.
Placing a value on capitalization
Without conducting an audit-style review of ViaSat’s accounts, it’s difficult to come up with an exact adjusted net income figure for the company after capitalizing R&D because the firm benefits from numerous R&D tax benefits which have helped depress the group’s corporate tax rate to 15.5% for the three months ending Dec. 31, 2016.
For the sake of this article, I’m going to assume the firm capitalizes just 50% of its current R&D spend, the corporate tax remains the same and so does depreciation. Clearly, this is not a perfect real world example; it’s only designed to be an illustration, not an investment analysis.
As noted above, ViaSat’s spending on independent research for the nine months to Dec. 31 totaled $89.9 million, indicating a possible gain on the income statement of $45 million. Adding $17.5 million to pretax income for the period, and imposing a tax rate of 15.5% gives an adjusted net income figure for the nine months of $52.8 million or around $1.02 per share – $1.36 annualized.
Based on this rough calculation, ViaSat is trading at a forward P/E of 49. Using a similar calculation on last year’s figures gives an EPS figure of $1.04 indicating year-on-year adjusted EPS growth of 31%.
These figures are only back-of-the-envelope calculations, but they show that there is indeed real value hiding here. Adjusting for R&D spend shows that not only are shares in ViaSat cheap, but they may also offer growth at a reasonable price – something Klarman might believe the rest of the market does not understand.
Disclosure: The author does not own any share mentioned.
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