A new accounting rule went into effect earlier this year, and it is going to change the picture for some companies’ earnings and cash flows.
The good news is that the new rule will boost earnings for many companies. The bad news is that, as a result, those companies will pay more in taxes, and their cash flows will be negatively affected.
Up until 2022, spending on research and development (R&D) was an expense that could be subtracted from revenue. This lowered profits but also taxes owed.
Since January 2022, R&D expenses have been treated in the same way as capital expenditures (the money a company spends on properties and facilities), which are found on the statement of cash flows. That means R&D expenses now count against cash flow.
It sounds complicated, but it’s not.
For example, if a company generates $100 million in revenue and has R&D expenses totaling $70 million, its profit (assuming it has no other expenses) is $30 million.
Under the new rule, the company can deduct only $7 million (10%) in expenses this year and 20% of the remainder in each of the next five years. So in the example above, the company’s profit is now $93 million.
But the $70 million that was spent on R&D has to be accounted for somewhere. It will now be included in the company’s statement of cash flows.
Because the example company is expensing only $7 million of the $70 million it has in R&D costs, the remaining $63 million will be subtracted from cash flow because it represents cash that went out the door but is not being accounted for in the income statement.
Here’s a very simple example of a company with no expenses other than taxes (raising taxes is why the rule was implemented) and no other variables.
You can see that cash flow fell from $24 million under the old rule to $11 million under the new one.
Raytheon Technologies (NYSE: RTX) recently cut its free cash flow guidance from $6 billion to $4 billion as a result of the new law.
It’s important to note that under the new rules, 100% of R&D is not removed from the income statement and transferred to the statement of cash flows. Rather, it is amortized over six years. In the first year, 10% can be deducted as an expense, with the remainder amortized in equal amounts over five years.
I ran a screen to look for companies with high R&D costs compared with revenue. Taking that big expense off the income statement should result in stronger earnings, but it could potentially reduce cash flow.
Over the past 12 months, Electronic Arts (Nasdaq: EA) has spent $2.2 billion on R&D and has earned $7.5 billion in revenue. During that time, the company has generated $1.8 billion in free cash flow while paying out just $200 million in dividends. So that could mean a $2 billion haircut to free cash flow.
Keep in mind, I’m using data from the past 12 months, so it’s just an estimate. The full-year 2022 results will be the real numbers to look at.
After Electronic Arts, the company with the next-highest R&D-to-revenue ratio is Marvell Technology (Nasdaq: MRVL).
Over the past 12 months, Marvell has spent $1.7 billion on R&D against the $5.5 billion it generated in revenue.
Marvell is in the same situation as Electronic Arts. A $1.7 billion hit to free cash flow could be tough to take.
The last one we’re looking at is Eli Lilly (NYSE: LLY). The drug giant paid $8.6 billion on R&D against the $29.1 billion it made in revenue.
Over the past four quarters, Eli Lilly has generated $5.7 billion in free cash flow. So a nearly $8 billion decline in free cash flow will be hard for the company to stomach.
Keep in mind that the lower R&D expenses are on the income statement, the more profitable the company will be. So it’s not an exact dollar-for-dollar decline on the statement of cash flows. But as we’ve already seen with Raytheon, this change will likely have a negative effect on some companies.
Again, these are rough estimates, but you can see how significant this new accounting rule will be for companies’ earnings and cash flows.
It may be worth your while to looking at each of your dividend payers’ R&D expenses to determine whether the new rule is going to meaningfully affect its cash flow or its ability to pay dividends.