Beginning this year, Research and Development (R&D) expenses must be amortized over five years domestically and 15 years internationally. For decades, businesses were allowed to deduct R&D expenses in the same year they were spent to reduce taxable income. This immediate deduction incentivized companies to reinvest and grow through developing new and improving existing products. This change will cost companies an estimated $29 billion in additional taxes in the government’s fiscal year that ended September 30 according to the Joint Committee on Taxation.
U.S. companies invested an estimated $532 billion in R&D in 2020. Ernst & Young LLC, a Big Four accounting firm, forecasts that U.S. R&D spending would be cut by $4.1 billion a year for five years and then by $10.1 billion annually for the subsequent half-decade due to the change. In a recent letter to Congress, 178 finance chiefs said the loss of immediate deductibility potentially could result in a loss of more than 23,000 R&D jobs over a period of five years.
The letter sent by the finance chiefs of the top U.S. companies underscores the importance of R&D spending to the U.S. economy, and it does appear there is some bipartisan sentiment to change the law. R&D spending is one of the key determinants in organic growth, one of Delta Asset’s criteria when evaluating in which companies to invest.
Organic growth is generally achieved through an increase in sales of new or updated products developed through the company’s own resources. This stands in contrast to acquired or inorganic growth derived from mergers and acquisitions. Yet even then, for the acquisitions to be successful, acquirers must be able to generate organic growth to generate a fair return on the purchase price.
We place a high value on companies that historically have made the necessary investments to achieve organic growth. According to studies by McKinsey & Company consultants, at comparable growth levels, companies with more organic growth tend to outperform those that have growth through acquisitions. Its studies looked at the share-price performance of 550 U.S. and European companies over 15 years, which indicated that for all levels of revenue growth, those with more organic growth generated higher shareholder returns than those whose growth was more dependent on acquisitions.
With organic growth, companies do not have to invest as much initially in terms of purchase prices for acquisitions, and neither do they have to pay a takeover premium. In addition, they usually have greater control and predictability of existing strategies and resources. With organic growth, management knows the capabilities, weaknesses and capacity of the existing team. In contrast, a merger or acquisition typically has a period of integration and restructuring as management assesses new employees and assets.
Our process focuses on several factors that drive organic growth, including R&D budgets, R&D staffing, capital expenditures, patents, new marketable products, percentage of sales attributed to new products, marketing expenditures and any comparable sales statistics and trends. Many of the mature, legacy companies in our model portfolio continue to commit significant resources to sustain revenues and introduce new products and improve existing ones.
Representative of this strategy is The Proctor & Gamble Company, which in FY 2021 committed $2.8 billion and $1.9 billion in capital and R&D expenditures, respectively. P&G is taking patented inventions from its R&D labs and teaming up with startup incubators to gain access to customers, facilities and industry experience. Two of its reportable segments experienced organic growth of 9% in 2021. P&G Ventures develops brands and products outside its existing product categories. Ventures helps startups incubate its ideas and obtain resources to scale startups. Over the past seven years, Ventures has rolled out three new brands in health and beauty categories as well as Zevo, a line of household insecticides.
When tax policy changes (such as amortizing R&D expense), it can have a material effect on incentives for companies to grow. This analysis points to the importance of factors, such as R&D, which contribute to organic growth. We feel by focusing on these characteristics we will be better positioned to select portfolio holdings with sustainable business models and returns commensurate with risk.
December 22, 2022
Comments follow regarding common stocks of interest to clients with stock portfolios managed by Delta Asset Management. This commentary is not a recommendation to purchase or sell but a summary of Delta’s review during the quarter.
Microsoft Corporation (MSFT)
Founded in 1975, Microsoft is the world’s largest independent software developer. The company is experiencing a renaissance under the leadership of Satya Nadella. He is the third CEO in the company’s history. Since becoming CEO in February 2014, under his leadership Microsoft has quickly emerged as one of the most important cloud computing firms in the world, having more than doubled its market share in the public cloud space over the past few years. Corporate America continues to adapt to the cloud’s efficiencies. Azure, the firm’s Cloud offering, has established itself as the No. 2 player in the space behind Amazon.
Microsoft is not only a leading cloud infrastructure provider; it also sells a multitude of software programs hosted on the Cloud, which provides differentiation for Azure to exploit. These products include Windows operating systems, Office business solution applications, Enterprise Resource Planning and Customer Relationship Management applications, LinkedIn talent, marketing and sales solutions, video games and its online search offering Bing. We believe the benefits of cloud computing – such as efficiency, flexibility, scalability, and cost savings – will continue to drive enterprises away from on-premises computing to the Cloud. Microsoft is positioned to continue to lead in this transition due to its massive installed base of enterprise solutions that allow its customers to remain in the same Microsoft environment as they transition to the Cloud.
Office, Microsoft’s productivity software, has been reinvigorated by the launch of a cloud-based, subscription version known as Office 365. Around 1.2 billion workers globally use Office or Office 365 accessed through Azure. For mature businesses, such as Windows and Office, the company is moving from a transaction model to a subscription model, extending the lives of these businesses, expanding the market and setting the stage for a stronger recurring revenue structure. Updates and software fixes will be easier, and there will be a higher capture of revenue as leakage from piracy is reduced. Microsoft’s transformation to a cloud-based software company should allow it to lower its distribution costs and strengthen profitability while focusing on its strengths in serving enterprise customers.
Microsoft’s cloud business faces diverse competition from companies, such as Amazon, Google and Oracle, as well as software-centric companies, such as Salesforce and VMware, Inc. As such, the company must continue to innovate even as it prolongs the life of its legacy products. Approximately one-third of the company’s workforce of 221,000 is dedicated to research and development (R&D). The company continually adds capabilities to its cloud offerings, enterprise productivity software suite and gaming while investing in advanced technologies, such as Artificial Intelligence (AI) and machine learning. Microsoft’s strategy is to apply innovations across its product portfolio where possible. Microsoft spends 12% of its revenue on R&D, a key differentiator for the company.
The company is acquisitive and does not shy away from making occasional large acquisitions. Its most recent large acquisition target is Activision Blizzard, a leader in video game development, for $69 billion. Microsoft is a leading game provider through its Xbox 360 console and owns some of the most popular games, such as Halo and Minecraft. The acquisition would significantly increase Microsoft’s gaming content offerings and help the company further transition to a digital cloud gaming provider, allowing gamers to stream across PCs, consoles and mobile devices. The Federal Trade Commission is suing to block the deal on anti-competitive grounds, which will likely lead to an expensive court battle for Microsoft. Though competitive, the gaming market remains robust with three billion people actively playing games. Microsoft will continue to invest to improve its content and services to gain market share.
We anticipate that Microsoft will continue to internally develop and acquire a wide range of technologies and products while continuing to be a leading provider in fast-growing enterprise cloud computing. We expect its faster-growing businesses combined with its more mature business lines to lead to average growth of approximately 9% over our 10-year modeling period. With its increasing shift to high-margin revenue subscription software services, we believe operating margins of 40% can be achieved. Our valuation model indicates that at its present stock price, Microsoft offers a potential long-term average annual rate of return approaching 10%.
Wells Fargo & Company (WFC)
Wells Fargo is one of the largest community-based, diversified financial services companies in the U.S., with nearly $2 trillion in assets. The bank offers a full range of consumer banking, commercial banking and investment banking services. Wells Fargo has 247,000 employees, a 7.7% decline from 2020. Founded in 1852 and headquartered in San Francisco, it is consistently one of the top deposit gatherers in the U.S. The Wells Fargo model delivers a vast product set through approximately 4,700 branches.
Wells Fargo is largely a conventional lender. The bank’s $1.4 trillion-plus deposit base and near dominant market position in fast-growing markets are its biggest advantages. The bank has consistently paid less for balance sheet funding than most of its competitors over the last decade. It is also able to generate more revenue per dollar of assets than most peers. This low-cost funding has continued through the bank’s recent regulatory challenges to its reputation. Account closures did not spike during the worst of the sales problems, underscoring customers’ willingness to stick with the bank.
The company has a leading position in the national mortgage market. The firm benefits from economies of scale in both origination and servicing as well as a scaled technology platform. An additional strength is the diversification of revenue from the more stable revenue generated by its retail brokerage, advisory and asset management businesses. Unlike its major competitors, Wells is not a major player in the cyclical investment banking and capital markets businesses.
Following the sales scandals of previous years, the firm’s practices have been examined with a fine-toothed comb by regulators and external auditors. In February 2018, the bank entered into an agreement with the Federal Reserve to freeze asset growth beyond $2 trillion until certain tests and requirements are met. Until these issues are fully resolved, management is unlikely to have full flexibility in capital allocation to optimally deploy shareholder capital. In December 2022, the company reached a settlement with the Consumer Financial Protection Bureau (CFPB) to resolve a number of fees and interest charges that were incorrectly assessed to customers. The CFPB said Wells Fargo has accelerated its efforts to clean up compliance issues since 2020. As part of the settlement, the agency will terminate one of the consent orders placed on the bank in 2016 and review the 2018 consent order.
We feel the bank can rectify its issues and has undertaken multiple steps to restore customer trust. The bank hired Charles Scharf, former head of Bank of New York Mellon almost three years ago to help improve its reputation and get businesses back on track. Scharf has prioritized resolving outstanding regulatory issues, changed the bank’s reporting structure, hired many new managers and committed to cost-cutting to the tune of approximately $10 billion in annual costs.
The bank has initiated several expense savings programs to get its efficiency ratio back under 60%. A bank’s efficiency ratio is a key performance metric used to assess a bank’s profitability. It is calculated by dividing a bank’s operating expenses by its total income. The lower the ratio the more efficient the bank is in generating income. The company achieved its expense guidance in 2021 and expects a net reduction in expenses in 2022.
Wells boasts strong market share positions in many of the largest, fastest growing and wealthiest markets in the country. This standing should help the bank grow organically faster than the banking industry on average once regulatory issues are resolved. In addition, Wells Fargo’s balance sheet strength has allowed it to gain market share from banks needing to reduce assets and raise liquidity. Over time we believe the bank’s net interest margin will expand as interest rates rise and the lending environment stabilizes.
We anticipate the company’s efficiency ratio will improve over the intermediate term as the company benefits from a declining regulatory burden, cost-cutting, a somewhat smaller branch network and annual non-interest income growth. We have assumed Wells will continue to maintain excess capital and liquidity above the required norm. Based on our assumptions, our financial model indicates that at the present stock price Wells Fargo’s stock offers a potential long-term annual return of 9%.
S&P Global Inc. (SPGI)
S&P Global is a leader in credit ratings, benchmarks and analytics that provides essential information and data content to the global capital, commercial and commodity markets.
Its brands include the Dow Jones and S&P indices, Platts Analytics, S&P Capital IQ and Standard & Poor’s. These businesses have a large global footprint, good market penetration, are highly scalable, require little capital investment and generate high profit margins and strong free cash flow.
S&P Global Ratings, which currently makes up 50% of total company profitability, is one of the three dominant firms that rate securities and assess credit risk; the other two are Fitch Ratings and Moody’s Corporation. The three firms issue more than 95% of global bond ratings, a market share virtually unchanged from the pre-2008 period. Barriers to entry are high due to market acceptance and reputation, scale, global distribution, network effects and complex regulations. Credit ratings are used by investors, issuers, investment banks and governments. Credit ratings provide the marketplace with a benchmark to help gauge borrowers’ creditworthiness. Most bond issues need at least one rating from a respected Credit Rating Agency (CRA) for the issuance to be successful. S&P Ratings and other credit rating firms benefit from a unique market structure that favors an oligopoly. Customers want only two or three ratings to minimize the time management must spend with analysts, to diversify their risk in the event that one analyst gets it wrong, and to lower their financing costs.
Until recently, S&P Ratings has been operating with tailwinds at its back due to historically low interest rates and bond issuance activity driven by the COVID-19 pandemic. The volume of rated bond issuance expanded significantly as companies refinanced at low rates and used debt to raise liquidity to manage through the pandemic. Though we expect bond issuance volumes to remain cyclical and temporarily reverse to lower levels as interest rates rise, we believe long-term growth should remain good with over $10 trillion of rated debt, much of which will need to be refinanced and rerated. S&P Ratings’ emerging market presence should continue to provide long-term growth as the company provides transparency and benchmarks to these developing capital markets. In addition, S&P Ratings has become a leader in the growing Social, Environmental, and Governance (ESG) quantification and ratings space.
The company’s S&P DJ Indices and S&P Global Market Intelligence segments are large and highly profitable global businesses with good growth prospects. S&P’s indices provide investors with well-known market benchmarks, including the Dow Jones Industrial Average and S&P 500. The S&P 500 is the world’s most followed stock market index with over $10 trillion in benchmarked assets. Growing investor demand for index-based passive investments has boosted the number of exchange traded funds (ETF) and indexed mutual funds, increasing the fees paid to S&P Indices for the use of its benchmarks.
S&P Market Intelligence, which includes Capital IQ, SNL Financial and the newly acquired IHS Markit, is a leading global provider of financial research, data and analytical tools for asset managers, investment banks, brokers and analysts. The global capital and commodity markets have become more integrated driving increased demand for data and analytics. Market Intelligence continues to gain market share as it acquires, develops and integrates additional mission critical data and analytics content. This expansion of S&P’s data and analytics business will embed itself further in customer workflows creating high switching costs. This segment’s more consistent revenue streams should help mitigate the cyclicality of the Ratings business over time.
Though S&P Global’s businesses are cyclical, we believe its strong position in each of its businesses that provide mission-critical information to capital, commercial and commodity markets has created a good long-term growth and margin profile. We assume mid-single digit revenue growth with operating margins averaging approximately 45% over the long term. Based on these assumptions, our valuation model indicates an approximate 8% annualized long-term rate of return given the current stock price.
3M is a diversified global technology innovator and marketer of a wide variety of products. With more than 90,000 employees, 3M produces more than 60,000 products, including abrasives, adhesives, personal protection, dental, electronic materials and healthcare products. The company is known for developing technologies that it replicates across multiple product categories. Roughly 90% of its revenues are consumable products creating recurring revenue streams. 3M’s unusual product and geographic breadth shield it against overreliance on any market. The company’s products are available for purchase in over 200 countries.
Going forward, the company is well-positioned to benefit from several themes, including personal safety and hygiene, data centers, healthcare, water and air quality, aging populations, industrialization in emerging markets, electrification, alternative energy and infrastructure upgrades. 3M has consistently reported best-in-class operating margins over the past 20 years. The company’s premium margin is largely attributable to its scale, vertically integrated operations, lean manufacturing processes and differentiated brands.
3M’s culture of innovation has carved a moat around its businesses. Strengthening its innovative roots, the company has increased research and development (R&D) spending as a percentage of sales to 6% versus the median 2% to 3% for many industrial companies. The company positions its R&D and capital expenditure spending with a long-term focus. Over time, 3M has been able to develop not only improvements in products currently being sold but also create entirely new product areas. The company’s vertical integration amplifies its R&D spending.
Although 3M sells thousands of products to wide-ranging end markets, the firm relies on only a few dozen technology pillars that support its vast array of offerings creating significant economies of scale. 3M’s products spring from four main technological competencies: abrasives, adhesives, coatings and filters. Innovation in any one of these four categories drives new product development across all of 3M’s operating segments. We expect this practice will continue to protect profit margins through higher-priced new product introductions.
The company does face challenges. Though 3M has adequate long-term growth prospects and good market positions in most end markets, it is tied to cyclical industries in all of its business lines. Revenue and profitability will weaken during a recessionary period. In addition, as 3M products mature, heavy R&D efforts toward continuous innovation that commands premium pricing and return on investment can become more difficult.
The company’s chemical manufacturing processes have led to environmental lawsuits and may continue to do so with unknown liabilities. The company also faces new litigation from ear plugs made for the U.S. military from 2000 to 2015. The first few trials have ended with mixed results with both the company and plaintiffs winning cases.
Management is taking steps to resolve the litigation by taking the subsidiary that manufactured the ear plugs into bankruptcy. The bankruptcy court has declined to extend a litigation stay that would have shielded the parent company from litigation. The company intends to appeal the ruling.
The headline risk of litigation obscures the value of the company. With strong consumer brands, a track record of innovation and low-cost manufacturing, 3M has competitive advantages over smaller industry players. Given these advantages and our assumptions of low-single-digit revenue growth and 21% operating margins, we believe that 3M’s present stock price offers the potential for an average annual long-term rate of return of 10%.
Dated: December 22, 2022
Specific securities were included for illustrative purposes based upon a summary of our review during the most recent quarter. Individual portfolios will vary in their holdings over time in relation to others. Information on other individual holdings is available upon request. The information contained herein has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy. The opinions expressed are subject to change from time to time and do not constitute a recommendation to purchase or sell any security nor to engage in any particular investment strategy. Any projections are hypothetical in nature, do not reflect actual investment results and are not a guarantee of future results and are based upon certain assumptions subject to change as well as market conditions. Actual results may also vary to a material degree due to external factors beyond the scope and control of the projections and assumptions.