HP Responds on R&D Spending Observations

Shortly after posting about HP's latest 10-k, I received an email from an HP internal PR person who wanted to talk about "a few points" with me. Apparently the company didn't like my take on its declining R&D spending and wanted to spin it as not being a decrease at all. Here's what they said and how I pointed out that whether they liked it or not, R&D spending there was dropping, both in absolute dollars and as a percentage of revenue.

First, here's the section of my previous post that apparently caused the irritation:

R&D as a percentage of revenue is down. Absolutely numbers were $3.5 billion, down from $3.6 billion in 2006 and 2007. But revenue in 2006 and 2007 was $91.7 billion and $104.3 billion, respectively. That means R&D as a percentage of revenue was 3.9 percent in 2006, 3.5 percent in 2007, and is now about 3 percent. That seems like a significant trend. If it continues, that could leave HP less effective in developing new products and technologies for future sales. HP holds over 32,000 patents, slightly more than in 2006 and 2007, but there is no easy way of telling their general age or how rapidly they may be running out.

• Companies like HP are happy to undertake acquisitions and then count the new revenue streams as part of their total revenue as quickly as possible. In this case, they were willing to book $10 billion in additional good will -- most of the purchase price. Either EDS is part of HP or it isn't. If it is, and all other signs point to HP treating it as such, then you cannot reasonably ignore revenue from the acquisition when convenient to make the ratio of R&D spending to revenue look better.
• If the acquisition was strategy -- and that is the way HP has presented it -- then it must mesh with the current strategy. If R&D is important, then you might expect an acquisition to provide R&D of its own, or at least some significant intellectual property. But HP acquired EDS as part of "building and expanding" its services organization, according to the 10-k. Clearly that means that the company is putting more emphasis on services. Lacking equivalent increases in product groups, that means that services gets increased attention relative to products. It's certainly a valid strategy, but must stand on its own, and not try to pretend that as the company has scaled upward in size, R&D has followed proportionately.
• The increased relative emphasis on services is obvious when you look at what percentage of total net revenue the service division provides. This year it is a bit over 18.9 percent. According to HP's 2007 10-k, the percentage of total net revenue that the services division provided was just shy of 16 percent. There's a clear increased reliance on services, and so less relative spending on R&D isn't surprising.
• According to this year's 10-k, HP allocated the price paid for acquisitions "to the tangible assets acquired, liabilities assumed and intangible assets acquired, including in-process research and development ('IPR&D'), based on their fair market value." Any payment made over these explicit fair market values is recorded as goodwill. As I noted in the previous post, out of the roughly $13 billion that HP paid for EDS, almost $11 billion was recorded as goodwill. In other words, there simply weren't many hard assets with a significant fair market value, including IP. Certainly services are increasingly important to HP, and that means the business model is changing. That's neither good nor bad, but it means that you can't ignore the shift and pretend that the R&D emphasis is the same as it was in the past.

HP PR: We're not spending less.

ES: But it says in your 10-k that spending has gone down from $3.6 billion to $3.5 billion. That's a difference of $100 million.

HP PR: But those were cost savings.

ES: Cost savings?

HP PR: Yes, cost savings. We've become more efficient in our processes.

ES: But research isn't like operations and you don't necessarily get more efficient in finding and developing new ideas.

HP PR: No, it was definitely cost savings.

ES: But if management cut lines of research that it decided wouldn't be as profitable as it would like, would you consider that cost savings?

HP PR: Yes, those would be cost savings.

ES: So cutting entire R&D areas could be cost savings?

HP PR: Yes.

ES: Even if there were efficiencies, then HP could even pocket the money or reinvest it in additional R&D, right?

HP PR: Are you saying that we could have done more?

ES: Yes.

HP PR: Well -- it was cost savings.

ES: I couldn't say it was all pure savings without doing less actual R&D without some significant details of how you undertook this.

HP PR: I'll see if there are any details I can share.

Let me predict that I'll never get details to back up that spending $100 million less in R&D doesn't result in any reduction in research or in development. And why do I feel a sudden urge to listen to Abbott and Costello do Who's on First?