Acquisitions vs. Internal R&D. Creating riskier companies

The accounting in Big Pharma and its representation can be very tricky:

R&D spending is immediately expensed according to US GAAP (Generally Accepted Accounting Principles), but is largely capitalized in an acquisition. This difference allows acquiring firms to report higher earnings with reduced R&D expense relative to their peers that internally develop their brands and technology.

I utilized this insight to analyze the cost of acquisitions to big pharmaceutical companies, many of which are losing patent protection for their prescription drug products. Despite enticing dividends, investors should look elsewhere. I am not alone in this concern:

The patent cliff in its own right may not be the problem: more the reactions of management to it. For a company facing a patent cliff, a declining share price could even be seen as a sign of a successfully run company - if excess cash is being returned to shareholders via dividends. If a drug company were simply to collect the cash flows and put the money in the bank the share price would remain stable …But because most managers do not follow this business model, they start spending the surplus cash, thereby creating a riskier company, with the assumption that revenues and earnings can be smoothed."

The key word here is “riskier companies” - for sure, no balls – no babies!