Jeff mentioned a few specific stock examples, including the one we highlight below, that are Knowledge Leaders. So today we thought we would look at Becton Dickinson (Ticker: BDX)* and see how intangible investment affects a company's financial statements.
*BDX is a global medical technology company that develops, manufactures and sells medical devices, instrument systems and reagents used by healthcare institutions
Under traditional company accounting practices, intangible investments are treated as a current expense rather than as an investment in a company's future. Thus, investments in research and development, employee training, brand building, and codified information reduce current income instead of increasing the asset base in which a company derives its future earnings from. The academic community as well as government agencies such as the Bureau of Economic Analysis (BEA) are leading the charge in educating the greater financial community about the importance of intangible capital. The most high profile case has been the inclusion of R&D and artistic originals in the calculation of GDP by the BEA instead of treating them as intermediary expense as they previously did.
We have taken over 2400 company financial statements and adjusted them to properly include investments in intangibles going back to 1980 where the data is available. In the tables below, we will look at how much BDX"s financial statements and profitability changes after properly capitalizing intangibles.
At the heart of this story is the fact that intangibles are in investment and should be treated similar to traditional capital expenditures (albeit with a shorter useful life) from an accounting standpoint. Let's begin by analyzing BDX's current investment approach. Under traditional accounting, it looks as if BDX only invests about 7.7% of its sales. A relatively low number considering BDX is in a highly competitive and profitable industry that commands 51% gross margins. However, after including intangibles investments we see that BDX actually is investing nearly 3x that level in order to keep one step ahead of the competition. They spend 6.2% of sales on R&D and 7.4% on brand building and other firm specific resources. In total, they spend 21.4% of sales on investments for future growth.
Traditional Accounting Technique
Intangible-Adjusted Results
By consistently investing about 13.5% of their sales in intangible capital over the past decade, BDX has created a large long-term asset on its balance sheet that will produce income for years to come. We can see this by analyzing their balance sheet before and after you adjust for intangible capital. Under traditional account practices, BDX has about 22% of its assets in cash, 29% of its assets in PPE and 29% of its assets in long-term assets. However, after adjusting for intangibles, we see that BDX has a much greater percentage of its assets in long-term assets. In fact, nearly 42% of its assets are in long-term assets and nearly 18% of its assets are intellectual property and only 23.8% are in PPE.
Traditional Accounting Technique
Intangible-Adjusted Results
These long-term assets increase operating cash flow and increase margins of BDX. BDX looks as if it only generates about 20 cents in operating cash flow for every dollar in sales. However, after adjusting for intangibles we see that it actually generates about 34 cents in operating cash flow for every dollar of sales. In addition, BDX's EBITDA margin increases from 26.7% to 40.3% and net profit margin increased slightly from 14% to 15.4%. This is a more profitable company when intangibles are properly included than is generally perceived.
Traditional Accounting Technique
Intangible-Adjusted Results
Traditional Accounting Technique
Intangible-Adjusted Results
A sustainable competitive advantage, or a large moat as Warren Buffet puts it, is key for a company to deliver future earnings growth. As financial analysts and investors it is our job to understand where that competitive advantage comes from and figure out how sustainable it is. We believe the first step in identify future investments is to properly calculate financial statements that reflect true investments in the future. After doing this, it becomes more apparent why knowledge leaders continue to be industry leaders.
