CSL (ASX) CSL has more downside...and chat

Originally posted by madamswer: ↑

"And what about CSL’s accounting treatment of its R&D? Anyone know how it is treated?"

@Gekkowolf,

Great question, because no investment discussion about CSL is complete without dealing with that aspect of the company.

Hopefully, the following might be of some assistance:

(https://hotcopper.com.au/posts/39985525/single)

"The problem with looking at headline profit results on their own, is that it is sometimes not really an accurate reflection of the true underlying performance of the business.

The reason it is an approximation is because it relies on the use of accounting standards, which in turn, are based on certain assumptions and interpretations, some of which are accurate, while others are tell a less accurate financial story.

There are many possible interpretations of the individual elements of the Profit and Loss Statement (P&L) that could have a material bearing on the Net Profit figure, for example:

- Timing of recognition of sales revenue;

- Providing for certain non-cash expenses, or the timing of bringing of operating expenses to account, or deferring them, as the case may be;

- Differences in depreciation policies and rates;

- Capitalisation of borrowing-related expenses;

- Providing for taxation

In most cases, reported accounting profits are good reflections of true underlying profitability.

However, what I sense few people realise is how much liberty company directors and auditors have in the interpretation and application of the accounting standards.

This means that, for any given company, two different sets of executive and accountants could quite easily come up with two quite different NPAT numbers.

And all perfectly within keeping with the accounting standards, but one NPAT number could be derived from far more conservative assumptions than the other.

In some cases, reported NPAT is a gross over-representation of the financial health of the company, the result of which can be terminal for any investment made by the unwitting investor.

Conversely, in some cases reported profits actually understate the real financial performance of a business, in which case being able to identify this mismatch could result in an investment opportunity.

In CSL's case there is much evidence of very conservative accounting being applied, the most significant example of this being the manner in which the the company's management account for the very significant R&D expenditure (currently US$830m, which is clearly a meaningful figure in the context of US2.6bn in EBIT):

My sense is that 90% of companies would capitalise at least some of that R&D spend, and probably half of companies would capitalise all of it(!), especially given the track record of success CSL has had from its R&D over an extended period of time.

But not CSL; CSL cops it all straight on the P&L chin.

And, as I said, $830m is a big number in terms of the overall scale of CSL's P&L.

Put another way, CSL could very easily, with the stroke of an accountant' pen, make their operating profits be 15%, 20% or even 30% higher than they currently are reported.

Getting to this latest result, it warrants noting that while Revenue increased by 11%, R&D expenditure (all of it fully expensed, remember), rose by a whopping 21%.

This means that not only does CSL account for its profits very conservatively, meaning the quality of its earnings are excellent, but in this particular result, the quality is even more pristine than usual if one adjusts for the acceleration in R&D spend.

So, it isn't the headline result that matters, but its quality and composition.

And on that score, I reckon this latest profit result is even more understated than is usually the case for CSL."

And also:

(https://hotcopper.com.au/posts/39987081/single)

"Although, in the interests of balance, I note that the effective tax rate in this result is around 18%, compared to CSL's usual rate of around 25%, which flattered this result.

(I suspect that this lower tax rate is probably due to some or other tax credits that related to R&D incentives.)

So the best thing to do, I think, is to "normalise" for these countervailing factors, which the simplistic exercise in the table below seeks to do, by considering two scenarios:

Normalisation #1: 50% of R&D expenditure capitalised, Tax Rate = 25%

Normalisation #2: 100% of R&D Capitalised, Tax Rate = 27.5%

As can be seen from this indicative, and not prescriptive, exercise, if CSL chooses to capitalise half of its R&D spend (which, I think, would still be very conservative given the successful nature of the business), and with the commensurate normalised tax regime of 25% effective tax rate, earnings are 8% higher.

And if all R&D spending is capitalised (perfectly plausible, but no longer conservative), and the company is taxed at a full rate (note: not all of its earnings are taxable in Australia; most of it is subject to tax jurisdictions with lower tax rates than Australia's 30%), then net earnings become a full 20% higher.

And, of course, this perennial understatement of earnings has implications for the way people value CSL.

People who baulk at the valuation multiples mostly fail to account for the significant understatement of the company's earnings which I reckon, means that the stock is really 3 or 4 P/E multiple points cheaper than it, prima facie, appears."

.

Expand

Excellent post in highlighting the effect of treatment of R&D on P&L in a single year however I would suggest that by focussing on past/current year PE the entire thread serves only to minimise the cumulative value of CSL's R&D spend.

To put the value of this annual R&D spend in perspective (if I am not mistaken) it is more than 5 times the cumulative annual R&D spend of MSB and PNV combined. The benefits of this (fully expensed) investment will only be seen many years after the initial spend has been made.

However the historical success of CSL gives some comfort in the likelihood of a profitable outcome from this investment. This historical R&D (and success in acquisitions) has been a secret to CSL's long term success.

So, imho it is entirely appropriate that CSL should have a higher PE than most companies due to the value of that nascent pipeline. Consequently I regard it as a highly promising Omni-biotech that happens to cover its own R&D and pay an annual dividend thank you very much.

Those who are valuing CSL purely on past and current year PE are somewhat (massively) missing the point imho.

No.	Vol.	Price($)
1	1000	$300.56

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Price($)

1000

$300.56

Price($)	Vol.	No.
$300.59	836	2

Price($)

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$300.59

836

No.	Vol.	Price($)
1	1000	300.560
1	15	299.920
1	1250	299.690
1	74	299.660
2	1250	299.540

No.

Vol.

Price($)

1000

300.560

299.920

1250

299.690

299.660

1250

299.540

Price($)	Vol.	No.
300.590	423	1
300.600	1250	1
300.630	204	1
300.660	426	1
300.740	486	1

Price($)

Vol.

No.

300.590

423

300.600

1250

300.630

204

300.660

426

300.740

486

(20min delay)
Last $300.58		Change -1.210(0.40%)		Mkt cap ! $145.5B

Open	High	Low	Value	Volume
$300.74	$300.99	$298.81	$240.1M	820.5K

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