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.

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