New R&D economic data – as an investment

This morning, the BEA released its latest R&D Satellite Account. No, it is not an analysis of R&D in space technology. The “Satellite” refers to the fact that it is a complimentary offshoot of BEA’s regular analysis of the economic – focused on R&D activity. Here is the bottom line from the report – Research and Development Satellite Account:

GDP would be an average of 2.9 percent higher between 1959 and 2004 — or $284 billion higher in 2004 — if research and development spending was treated as investment in the U.S. national income and product accounts,

Right now, spending on intangible assets, such as R&D are counted as costs rather than investments. The BEA data shows how badly that treatment distorts our view of the economy. In fact, researchers at the Federal Reserve and the University Of Maryland have calculated that our economic statistics under count our business stock of capital by $8 trillion and our annual business investment by $800 billion (see our April working paper Measuring Intangibles: A Summary of Recent Activity).
And if you still don’t think this mis-treatment of intangibles has serious consequences, see yesterday’s posting on how the numbers sank the $8 billion buyout of Harman.
The BEA and Fed work is a good first step at correcting the problem. But there are still much more to be done to fully incorporate intangibles into our economic statistics — and into our economic thinking and policymaking.

R&D and M&A – the Harman fiasco

For those of you who haven’t been following it, last week the private equity (buyout) arm of Goldman Sachs and Kohlberg Kravis Roberts (KKR) walked away from a $8 billion deal for Harman International (see KKR, Goldman Cancel $8 Billion Harman Deal). The action sent shock waves through Wall Street. Now we are beginning to see the details. Did an increase in R&D spending scuttle the buyout of Harman? That is what it sounds like – according to the Wall Street Journal’s “Deal” column — Are Goldman, KKR Out of Harman’s Way?:

The Harman release gives a bit of a better sense of why KKR and Goldman told Harman that “a material adverse change in Harman’s business has occurred.” Harman said today that it would have little or no earnings growth next year. Analysts have been forecasting 12% to 13% growth. They blamed the shortfall in part on higher R&D costs, which apparently is one of the reasons the buyout firms decided to walk.

This is what the press release said:

“In light of increases in material costs and faster ramp-up of R&D resources to work on new business awards, equaling the record operating performance of fiscal 2007 is an achievement. The benefits of common platform synergy and scalability will be realized in fiscal 2009 and beyond. Those benefits will strengthen our operating profits,” said [Dinesh] Paliwal [Vice Chairman and Chief Executive Officer]

This is absolutely incredible! Can Wall Street really be so short sighted? Do they only look at current earnings? Do they really believe that R&D is a cost? I thought private equity funds touted their ability to create long-term value. Maybe all they really do, as some claim, is create short-term financial engineering at the expense of long-term value?
Or maybe KKR and Goldman were just looking for a way out of this deal and the lack of growth in earnings this year was the excuse? Or maybe the deal was so leveraged that it couldn’t work without the projected growth in earning?
One of the things this episode highlights is the absolute reliance on growth in earnings. Remember, Harman isn’t saying that earnings will go down. Just that earnings will be flat. In other words, Harman is saying that they are going to take their earnings the projected future growth in earnings for next year and reinvest them in R&D. For that, Wall Street ran away like skittish mice!
The other thing this highlights is the need to start treating R&D and other intangible investments as investments (rather than costs) (see our working paper Reporting Intangibles). I don’t know what Harman’s financial accounts would look like it if they were allowed to book their R&D as an investment. But I can almost guarantee that they would not have ended up with flat earnings.
Sydney Harman has just become the poster child of what is wrong with our 18th Century accounting system.

The Dragon and the Elephant: Understanding the Developing Innovation Capacity in China and India

The Dragon and the Elephant: Understanding the Developing Innovation Capacity in China and India
September 24 and 25, 2007

Athena Alliance and the Board on Science, Technology, and Economic Policy (STEP) of the National Academies, in collaboration with the Urban Institute, the State University of New York Levin Graduate Institute, and Woodrow Wilson International Center for Scholars, hosted a conference comparing and contrasting India and China’s growing science and technology capacity. Topics included broad areas such R&D, education, financing and the legal and regulatory environment as well as key industrial sectors such as aerospace, pharmaceuticals, information technologies, and energy. The agenda and the presentations are available online. The summary of the conference can be read online or downloaded from the National Academies website:

Economic flow of rights to intangibles assets

As I noted in my earlier harangue, there is some interesting information on intangibles that can be teased out of this morning, BEA released its Benchmark Input-Output Accounts of the U.S. Economy, 2002 report. One category in the I-O tables is “Rights to nonfinancial intangible assets”. Total intermediate output (i.e. that going into other industries – or essentially other industries paying for the rights) is $87.5 billion.
Thinking of these rights to intangible assets as input commodities, the largest flow of royalties is from the oil & gas industry. This is probably because the category includes oil royalty companies and oil royalty leasing companies. The next larges was to the category of “Management of companies and enterprises.” This sounds like the internal structuring of royalty holding companies into separate entities. Then comes retail trade, food services & drinking places, and wholesale trade. Probably due to franchising agreements. Then comes the broad category of “Internet service providers, web search portals, and data processing” followed by the categories of electronic instruments, telecommunications, and basic chemical manufacturing. I think that makes sense. Those categories account for over 50% of intermediate production.
But there are others that seem a little strange. For example, “monetary authorities and credit intermediation and related activities” gets over a 1% ($930 million). Is that all the securitization process?
All of this is probably worth further investigation.
Here is the entire list for your own perusal:
Industry and percent of total intermediate production
Oil and gas extraction 16.64%
Management of companies and enterprises 10.18%
Retail trade 7.86%
Food services and drinking places 5.02%
Wholesale trade 4.37%
Internet service providers, web search portals, and data processing 2.62%
Electronic instrument manufacturing 2.47%
Telecommunications 2.39%
Basic chemical manufacturing 2.37%
Motor vehicle body, trailer, and parts manufacturing 1.43%
Software publishers 1.39%
Food manufacturing 1.38%
Educational services 1.33%
Management, scientific, and technical consulting services 1.30%
Computer systems design and related services 1.08%
Monetary authorities, credit intermediation and related activities 1.06%
All other administrative and support services 1.06%
Resin, rubber, and artificial fibers manufacturing 1.00%
Semiconductor and other electronic component manufacturing 0.95%
Scientific research and development services 0.95%
Architectural, engineering, and related services 0.92%
Legal services 0.82%
Accommodation 0.75%
Radio and television broadcasting 0.75%
Plastics and rubber products manufacturing 0.74%
Aerospace product and parts manufacturing 0.74%
Other miscellaneous manufacturing 0.71%
Other professional, scientific, and technical services 0.70%
New nonresidential construction 0.69%
Ambulatory health care services 0.68%
Beverage manufacturing 0.68%
Insurance carriers and related activities 0.67%
Medical equipment and supplies manufacturing 0.66%
Accounting, tax preparation, bookkeeping, and payroll services 0.65%
Cable networks and program distribution 0.63%
Other transportation equipment manufacturing 0.63%
Other chemical product and preparation manufacturing 0.63%
Securities, commodity contracts, investments, and related activities 0.62%
Performing arts, spectator sports, museums, zoos, and parks 0.62%
Petroleum and coal products manufacturing 0.58%
State and local government enterprises 0.56%
New residential construction 0.52%
Printing and related support activities 0.52%
Architectural and structural metals manufacturing 0.50%
Paint, coating, and adhesive manufacturing 0.48%
Support activities for mining 0.47%
Converted paper product manufacturing 0.45%
Employment services 0.41%
Advertising and related services 0.41%
Waste management and remediation services 0.41%
Apparel manufacturing 0.39%
Audio, video, and communications equipment manufacturing 0.38%
Other electrical equipment and component manufacturing 0.35%
Travel arrangement and reservation services 0.35%
Pharmaceutical and medicine manufacturing 0.33%
Nonmetallic mineral product manufacturing 0.33%
Electric power generation, transmission, and distribution 0.32%
Coal mining 0.28%
Pulp, paper, and paperboard mills 0.27%
Forging and stamping 0.26%
Manufacturing and reproducing magnetic and optical media 0.26%
Agricultural chemical manufacturing 0.25%
Amusements, gambling, and recreation 0.24%
Consumer goods and general rental centers 0.20%
Boiler, tank, and shipping container manufacturing 0.19%
Nonmetallic mineral mining and quarrying 0.17%
Commercial and industrial machinery and equipment rental and leasing 0.15%
Lessors of nonfinancial intangible assets 0.15%
Textile mills 0.15%
Real estate 0.15%
Maintenance and repair construction 0.15%
Air transportation 0.15%
Wood product manufacturing 0.14%
Crop production 0.13%
Furniture and related product manufacturing 0.13%
Electric lighting equipment manufacturing 0.12%
Personal and laundry services 0.12%
Soap, cleaning compound, and toiletry manufacturing 0.12%
Iron and steel mills and manufacturing from purchased steel 0.11%
Motion picture and sound recording industries 0.11%
Nonferrous metal production and processing 0.11%
Owner-occupied dwellings 0.10%
Tobacco manufacturing 0.10%
Household appliance manufacturing 0.09%
Foundries 0.09%
Social assistance 0.09%
Federal Government enterprises 0.09%
Motor vehicle manufacturing 0.09%
Specialized design services 0.08%
Cutlery and handtool manufacturing 0.08%
Electrical equipment manufacturing 0.07%
Automotive repair and maintenance 0.06%
Automotive equipment rental and leasing 0.06%
Leather and allied product manufacturing 0.05%
Civic, social, professional and similar organizations 0.05%
Water, sewage and other systems 0.04%
Natural gas distribution 0.03%
Metal ores mining 0.03%
Support activities for agriculture and forestry 0.02%
Electronic, commercial, and household goods repair 0.02%
Ordnance and accessories manufacturing 0.01%
Other information services 0.01%
Internet publishing and broadcasting 0.00%
Religious, grantmaking, giving, and social advocacy organizations 0.00%
Forestry and logging 0.00%
Hospitals 0.00%
Nursing and residential care facilities 0.00%
Fishing, hunting and trapping 0.00%
Funds, trusts, and other financial vehicles 0.00%
Animal production 0.00%
Private households 0.00%
General Federal nondefense government services 0.00%
General state and local government services 0.00%
General Federal defense government services 0.00%
Textile product mills 0.00%
Note that this category of royalty rights all activity (see the Census Bureau’s definition – 2002 NAICS Definitions: 533 Lessors of Nonfinancial Intangible Assets (except Copyrighted Works):

Industries in the Lessors of Nonfinancial Intangible Assets (except Copyrighted Works) subsector include establishments that are primarily engaged in assigning rights to assets, such as patents, trademarks, brand names, and/or franchise agreements for which a royalty payment or licensing fee is paid to the asset holder. Establishments in this subsector own the patents, trademarks, and/or franchise agreements that they allow others to use or reproduce for a fee and may or may not have created those assets.

It does not include establishments primarily engaged in producing, reproducing, and/or distributing copyrighted works; it does not include independent artists, writers, and performers primarily engaged in creating copyrighted works; it does not include establishments that allow franchisees the use of the franchise name, contingent on the franchisee buying products or services from the franchisor are classified elsewhere.
Also note that it captures only establishments that are primarily engaged in assigning rights — not all the leasing activities of companies whose main business is something else (although many of them have set up their own separate leasing entity which should be captured in this data).

Economic data and intangibles

This morning, BEA released its Benchmark Input-Output Accounts of the U.S. Economy, 2002 report. Input-output tables show the flows among the various sectors/industries in the economy. The BEA table details over 400 industries.
Yet, these tables are out of date. Like all other industry-level data, the tables use the current classification system. That system provides great detail in the manufacturing and manufacturing-related areas. But in the intangible and service areas, activities are lumped together. For example, “Flat glass manufacturing “; “Other pressed and blown glass and glassware manufacturing”; “Glass container manufacturing”; “Glass product manufacturing made of purchased glass” are all separate categories with their individual input contributions and output flows from every other industry individually measured. “Internet service providers and web search portals” are thrown together — no recognition that ISPs are a different, though related, from search portals — and that ISPs are different among themselves (dial up versus broadband, simple email versus websites). “Hotels and motels, including casino hotels” are a single category — as if all of those serve exactly the same customers. “Food services and drinking places” are one category – McDonalds, that top-of -the line expense-account restaurant and your local pub are all the same. “Management, scientific, and technical consulting services” are combined in one category. Retail trade is one category. Of the over 400 industries tracks, over 300 are in manufacturing, agriculture, and mining (over 275 in manufacturing). Yet those industries provide less that 30% of total economic output. So three-quarters of the detail of the models are devoted to between one quarter and one third of the economy.
The purpose of I-O models is to understand the connection among economic activities: so much steel goes to auto production, building construction, etc. This is useful in helping policymakers understand both the national economy and regional economies. If auto production declined by 10%, we can see what will happen to the steel industry. But if activities are all lumped together, it is impossible to track those activities precisely. It is as if our measure for the steel-auto example above was simply metals and durable goods.
The economist at BEA and elsewhere understand the problem. It is not their fault. The problem is that updating the model to reflect the shift to the I-Cubed Economy from the Industrial Economy is a huge – and expensive – undertaking. Right now, this is not a priority for either Congress or the Administration. Until it is, BEA will have to do the best it can in updating and revising the numbers. And the rest of us will have to tease out what relevant information we can for the date we have.
More on that in my next posting.

License as an intangible asset

One of the categories of intangible assets is government licenses and rights. For example, everyone in the West knows the value of grazing rights on government land. Here is an example of a very expensive government license here in Washington DC — NewsChannel 8 – The $1.2M Liquor License:

A piece of paper is going on the auction block in the District of Columbia and the opening bid is $1.2 million.
D.C. liquor license 74942 is one of only twenty permits allowing nude dancing and alcohol in the city.
Club Rendezvous owner Eric Whitehead bought the license last year for $200,000. Auction experts expect the license to fetch between $2 million and $6 million.

Not a bad profit margin.

IP in magic — or is it magic in IP

First it was fashion, now it is magic. This week’s Economist gives us a heads up about how IP works in the world of magic — The capitalism of magic:

The traditional view is that IP can be protected only by the long arm of the law. But magicians rarely rely on the law, as the very act of describing what they want protected would reveal their secrets. Strong IP laws are supposed to be essential to encouraging innovation, but magicians are extremely innovative, constantly coming up with new tricks. To traditional students of the economics of innovation, this state of affairs seems as improbable as successfully sawing in half the beautiful assistant and then putting her back together again.
Now, the mystery has been solved: Jacob Loshin of Yale Law School has written a fascinating paper, “Secrets Revealed: How Magicians Protect Intellectual Property Without Law”. This will appear next year (out of thin air, presumably) in a book called “Law and Magic”.
According to Mr Loshin, magicians labour in what has come to be known as IP’s “negative space”: creative endeavours to which traditional legal protections of ideas do not apply. Fashion and haute cuisine are among several industries that share this negative space, the study of which has become a hot area in economics.
In fashion, it seems, top designers may not want to protect their IP. When their ideas are copied, they become passé. This in turn creates demand for new ideas from the top, and so on—a process known as “induced obsolescence”.
Magicians, by contrast, very much want to protect their IP, but not through a disclosure-based legal process. To do this, says Mr Loshin, the “magic community” has developed a “unique set of informal norms and sanctions for violators” that protect IP without resorting to the law. These allow magicians to maximise the amount of sharing of ideas and methods within their community, whilst minimising the exposure of their IP to the outside world of their customers.

In a working draft of the paper Secrets Revealed: How Magicians Protect Intellectual Property without Law available online, Loshin warns that this system may not last:

Norms may not always be a reliable savior to the woes of law. Consider the magic community’s imperative of controlling access to its common pool of magic secrets. Without controlling access, the magic community would be vulnerable to outsiders who could misappropriate secrets without being subject to the magic community’s norms. But the easy and growing availability of information on the internet makes it harder to control access than ever before. Wikipedia, for example, already explains the secrets to numerous tricks.

However, these norms seem to me to be rather stable. As Loshin points out, “popular” magic has been available to the public for a long time. It is the high art that is protected by group norms. And that high art is constantly evolving through group innovation.
Another important point is missed in this discussion, however. The value of an intangible asset is not just in the codified knowledge but in the tacit skill. The physics of the curve ball is well understood and commonplace for those who care to look it up. Being able to throw one against a major league hitter for a strike is still a relatively rare skill. Knowing how a magic trick is performed is very different from being able to carry off the illusion.
And even if the trick is understood, the magic of the performance can be intoxicating. After all, to go to a magic show is to suspend disbelief at the outset. Simply because we all know it is a trick does not necessarily lessen the astonishment.

WIPO discovers IP financing

The World Intellectual Property Organization’s (WIPO) education division normally concerns itself with legal and policy issues on the protection on intellectual property. But now, it is wading into the finance area by offering a course on Strategic IP Finance. The description is as follows:

IP has emerged as a strategic corporate asset and a critical value driver in the contemporary knowledge economy. Private firms in the United States of America are reported to be investing over one trillion dollars annually in IP and other intangible assets. Estimates of the portion of corporate value associated with intangibles vary but most professionals ascribe the figure to over fifty percent.
Sophisticated companies have recognized the value of IP and have developed systems, structures and capabilities to harvest rich financial rewards, establish superior market position and enhance company performance. Unlocking the hidden value in IP requires teamwork. Finance executives are playing an increasingly central role in the strategic management of IP assets.
Finance professionals who have mastered the art of IP finance are usually more successful in the valuation and accounting of the firm’s intangible assets, in the optimal allocation of corporate resources, in minimizing risks, in IP securitization and in sustaining investor confidence.
Recent developments in financial regulations and accounting standards, combined with the increasing curiosity of shareholders, investors, analysts and tax authorities, is encouraging companies to provide a more transparent and reliable disclosure of a company’s intangible assets either on the balance sheet, in the Management Discussion and Analysis section of the financial reports, or in a voluntary intangibles report.
Managing IP as a major business and financial asset is a new area of business competence. It is essential that executives and managers develop a good conceptual framework as well as a practical understanding of IP and how it contributes to the firm’s business operations. Effective use of IP as a business asset is one of the keys to corporate sustainability.

Much of that statement I agree with. However, I don’t know about the how recent developments are “encouraging companies to provide more transparent and reliable disclosure.” Yes, there has been progress, but it seems to me that we still have a long, long way to go on that. I am finishing up a paper on the monetization of intangibles assets which will have more on this issue (see also my earlier paper on Reporting Intangibles).
In any event, WIPO’s de facto seal of approval on the topic of IP financing lends a certain air of respectability. Given all the machinations of other new financial instruments (i.e. collateralized debt obligations backed by subprime mortgages), such a discovery by WIPO may be timely indeed.