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Tough Times Spur Shifts in Corporate R&D Spending

(Adds spending data including R&D outsourced from other U.S. companies and done at domestic locations in 2008 and 2007 in the second paragraph. Corrects changes in Procter & Gamble's R&D spending and net sales between fiscal 2008 and fiscal 2010 in 17th paragraph.)

The fragile state of the U.S. economic recovery has left many companies hoarding cash, deferring hiring, and keeping a close eye on their spending. At such times, research and development budgets can suffer cuts as companies curtail outlays on the creation of new products and services—or enhancement of existing ones—to ride out the economic uncertainty.

Domestic R&D spending by all U.S. companies fell 13.1 percent, to $233.92 billion, in 2008, the most recent year for which data are available, from $269.27 billion in 2007, according to the National Science Foundation. (Including R&D paid for by other U.S. concerns, but performed in U.S. companies' domestic locations, spending rose to $283 billion in 2008 from $269 billion in 2007, according to the NSF.) During the prior recession, which was far milder, domestic R&D spending was down 0.5 percent, to $198.51 billion, in 2001 from $199.54 billion in 2000.

Yet even amid the sharpest economic downturn since the Great Depression, the 232 companies in the Standard & Poor's 500 index for which data were available increased their aggregate research and development expenditures to $163.37 billion in 2008 and $166.42 billion in 2009 from $154.44 billion in 2007, before the recession began, according to Bloomberg data. (Of those 232 companies, 115 spent more on R&D in both 2008 and 2009 than they did in 2007.)

The Technology Component

The ramp-up in R&D investment during the most recent downturn isn't surprising, given how technology is becoming a more integral component of products from all manufacturers, not just within the technology sector.

"Modern corporations of all kinds are more committed to innovation than they may have been 10 years ago," says Mark Blaxill, co-author of The Invisible Edge: Taking Your Strategy to the Next Level Using Intellectual Property. "A lot of the functionality from the technology industry is penetrating other industries. The car is turning into a high-technology device." Yet even as spending is rising, companies increasingly are forming alliances in an effort to make their R&D dollars stretch further.

Cuts in R&D may not signal a reduced commitment to innovation. Even outfits noted for their heavy emphasis on R&D, such as 3M (MMM), have pared their R&D budgets since before the 2008-09 recession. (3M's $1.29 billion R&D budget in 2009 was down 5.8 percent from 2007.) R&D spending often ebbs and flows as specific projects are launched and completed. Declines in R&D in the past couple years may reflect deep cuts that many companies made in employee bonuses during the recession, rather than an actual reduction in headcount for a company's most highly skilled personnel, says Scott Davis, an equity analyst at Morgan Stanley who covers 3M and other R&D-intensive companies. "Confidence in R&D comes down to the [number] of heads you're willing to hire," he says.

More Support Efforts

Even as more industries are becoming dependent on technology, a major shift in R&D spending has taken place from true innovation to product support—the incremental modifications to existing products that are done to serve the changing needs of an established customer base, says Michael Brown, president of StrategyMark, a management consulting firm in Wilmington, Del., that specializes in the chemical industry.

The flat rate of U.S. patent filings over the past three years would seem to confirm that companies are tilting more toward product support R&D and away from innovation, says Blaxill. Companies are more likely to file patents on so-called transformative R&D, which looks beyond existing technologies to future needs and requirements, while a smaller proportion of products that can be classified as support R&D are deemed worthy of a patent, he says.

Total utility patent applications—covering inventions and excluding patents for ornamental design of manufactured goods—have stayed flat at around 456,100 for the past three years, while total utility patent grants have been frozen at around 167,300 per year since 2002, according to data on the U.S.Patent & Trademark Office's website.

A Difference in ROI

Where companies once gave innovators plenty of room to experiment and invent, sometimes without clear commercial applications in mind, they're now targeting products with greater long-term return on investment, says Brown. "The innovative R&D is hard to justify sometimes. It needs a clear strategy like genetics," while product support R&D is more focused and its return is easier to predict, he adds.

Dow Chemical (DOW) says it hasn't retreated from transformative, or what it dubs "disruptive," R&D. Roughly 20 percent of its annual R&D budget is allocated to core projects, which the company defines as "the new new or [conceived to serve] the unmet needs of society." These are ideas so advanced that it's too early to assign them to any of Dow's business units, says Bob Plishka, Dow's director of corporate communications. "[They] have a very long time line, and you need to have a commitment—and to stick with it. You can't fly in and out with your investment dollars, because you won't see it commercialized."

One example of the projects that began under the umbrella of Dow's core R&D is the Powerhouse solar shingle, which integrates a photovoltaic cell into existing building materials, turning roof shingles into generators of electricity, says Plishka. That product is slated for commercial launch in 2011. "All the work on Powerhouse continued through the recession, through our acquisition of Rohm & Haas, and through all the challenges the company faced in late 2008 and 2009," he says.

Dow's $1.49 billion in R&D spending in 2009 represented a 14.6 percent increase from 2007, while revenue fell 16.1 percent over the same period.

Research Through Collaboration

Chief executives are less inclined to slash their R&D budgets in the face of a downturn, since they realize their future and near-term profitability depends on growth drivers and new products, says Blaxill. At the same time, companies are increasingly open to external innovation through licensing patents, collaboration, or patent pools with other companies, he says.

Procter & Gamble's (PG) Connect & Develop program is a prime example, he says. The program allows the consumer goods manufacturer to access intellectual property developed externally for use within P&G and to share its own know-how with other companies. More than half of P&G's product initiatives entail significant collaboration with outside innovators.

"We're definitely seeing more of that. Large companies are looking at themselves as the hub of a network and allowing themselves to leverage a network of R&D spending, not just their own," says Blaxill. "You don't have to be completely vertically integrated from bench to shelf. You can purchase the right to innovate at different stages."

P&G's R&D spending was nearly $2.0 billion in fiscal 2010 (ended June), up from $1.95 billion in fiscal 2008, when adjusted to exclude its pharmaceuticals unit sold in October 2009. Net sales—adjusted for the disposal of the pharmaceuticals business and the company's coffee business in November 2008—fell 0.4 percent over the same period.

Working Together on Crops

Monsanto (MON) has been creating a new opportunity in the area of genetically modified crops with the help of an R&D collaboration with the German chemical giant BASF. On July 7, the two companies announced they would broaden the partnership to include wheat as a fifth focus crop, joining corn, soybeans, cotton, and canola. They also said they would boost their joint investment by $1 billion, to $2.5 billion. Monsanto and BASF are aiming to commercialize a biotech wheat seed starting in 2020. The blending of crop genetics with crop protection chemistry is creating new variations of crops able to withstand the effects of Monsanto's weed killers. "The strategy here is to create a totally new market," says Brown at StrategyMark. (Monsanto's total R&D spending reached $1.1 billion in 2009, up 14.2 percent from 2007, vs. a 40 percent increase in revenue over the same period.)

Intuitive Surgical (ISRG), which develops robots that replicate a surgeon's hand movements and help hospitals avoid more invasive surgeries for heart, lung, and urology patients, licenses intellectual property from other companies to supplement its internal innovation, says Chief Financial Officer Marshall Mohr. Intuitive's R&D budget has nearly doubled since 2007, to $95.1 million, or 9 percent of 2009 sales, with sales up 75 percent over that period. While Mohr says the company isn't blind to economic conditions, it did continue to raise R&D spending through the recent recession. "We believed there were additional opportunities for us that we needed to invest in … technologies that will allow us to enter new markets and expand in the markets we're already in," he says.

Other companies are sticking with the traditional proprietary approach to R&D spending.

For A Quicker Recovery

Danaher Corp. (DNR) views an economic downturn as a chance to gain market share by maintaining its commitment to R&D investment even as competitors may be cutting theirs. To avoid sacrificing margins, however, the company, which makes analytical testing devices for a range of uses, from water quality to blood samples, requires its businesses to "aggressively manage" general and administrative, as well as manufacturing, costs in order to finance R&D, senior management says.

Last year, at the bottom of the recession, even if a business's revenue was down as much as 15 percent, Danaher made sure that managers were taking steps to stay ahead of competitors. As a result, some of its businesses that lost revenue were down less than the competition, which the company largely attributes to sustained R&D spending. In spite of the economy, Danaher introduced a large number of key new products in 2009 and has recovered more quickly than it would have otherwise.

Danaher's R&D budget rose 5.2 percent from 2007, to $632.65 million in 2009. Danaher has doubled its R&D spending as a percentage of sales over the past 10 years, to about 6 percent in 2010, even as its total revenue has tripled over that same period. That's partly due to acquisitions that have made its portfolio more technology-centric, but it's also a conscious effort to use R&D to drive market share. After its acquisition in 2004 of Radiometer, a Danish manufacturer of instruments that hospitals use to do critical-care tests on kidney and lung functions, Danaher hiked Radiometer's R&D budget from about 8 percent to more than 10 percent of sales, which helped the unit develop more innovative products faster, doubling its revenue growth to more than 6 percent in 2009.

The need for new technologies that can withstand increasingly "hostile environments," such as shale gas reservoirs with much higher pressures and temperatures, is driving Baker Hughes International's (BHI) commitment to R&D investment, regardless of economic conditions, says company spokeman Gary Flaharty. The oilfield service company's R&D budget climbed 6.7% from 2007, to $397 million in 2009, despite a 7.3 percent drop in revenue over the same period.

"You're competing with other industries for PhD chemists, petroleum engineers, [and other R&D specialists], so you can't simply ramp up or ramp down because of the vagaries of the economy," Flaharty says.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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