TCS Daily


Intangible Opportunities

By Bartley J. Madden - December 11, 2007 12:00 AM

Technology firms offer both analytical challenges and opportunities for investors. More and more of the big winners in the stock market will be tech stocks that have gained their competitive advantage from intangible assets; i.e., knowledge-based assets.

There is solid empirical evidence that corporate investments in intangibles affect stock prices. But today's accounting system is ill suited to measure intangibles and incorporate them into financial statements. Consequently, standard accounting-based analysis is of limited use in picking stocks when a firm's assets are primarily intangible.

Investors would be well served to put on an intangibles thinking hat to gain insight into corporate investments that are expensed for accounting purposes (e.g., R&D expenditures) thereby depressing earnings in the near term, even though they are the root cause of long-term profits. Avoiding an excessive focus on quarterly earnings can be especially helpful to investors in picking technology stocks that critically depend upon investments in intangible assets.

I own a small, high tech company, Luna Innovations (ticker: LUNA) because of its unique, knowledge-based capabilities. What follows is an intangibles thinking template for Luna which also applies to early-stage technology firms in general.

Intellectual Capital and Breakthrough Solutions

Investors need to look at how the most important type of intangible asset — the development and application of knowledge that leads to breakthrough technological solutions — is managed. This requires hiring, motivating, and keeping very smart employees, as well as collaborating with very smart experts outside the firm.

Basically, management's task begins with creating an environment that emotionally ties top talent to the firm's goals. However, having one or more star scientists on the firm's scientific advisory board is not enough. In a recent NBER paper, Lynne Zucker and Michael Darby note the importance to biotech firms of having star scientists publish articles as a firm employee or co-authoring articles with other employees; i.e. deep engagement as opposed to a superficial presence.

Exceptionally skilled human capital can always be hired if management pays a high enough price. Nevertheless, giving away the shop as compensation to key people can easily dissipate shareholder value. Moreover, those experts may lack a long-term commitment and show little interest in teamwork. Therefore, leadership is critical to getting the right people engaged on economic terms that also take care of shareholders' interests.

With his hands-on R&D experience, Luna's CEO, Kent Murphy, appears to be the ideal example of a leader who inspires employee loyalty and secures the emotional commitment indispensable to achieving breakthrough solutions.

Good Will Hunting

Remember Matt Damon as the janitor in the movie Good Will Hunting who writes the solution to a uniquely difficult math problem on the classroom board and then continues cleaning the floors? Luna's Kent Murphy is the real life version. After high school, Murphy worked for many years as a janitor for the Electro-Optical Products Division of ITT. After company engineers recognized his capabilities; he took their advice and went to college. He returned to ITT and received patents for a half-dozen fiber optic innovations. He later became a professor in electrical engineering at Virginia Tech, continued his inventive ways, and eventually launched Luna Innovations.

Murphy is a visionary innovator. His R&D smarts, his willingness to make big investments to build up R&D capabilities, his track record of demonstrated breakthrough solutions, and his setting of audacious goals are, in my opinion, the primary reasons Luna has attracted so many talented employees.

Skill and Risk

Luna's business model is focused on inventing, building, and commercializing novel technologies related to fiber optic test and measurement, wireless sensors, ultrasound, and nanomaterial products. The firm pursues contract research in order to develop intellectual property and uses cross-disciplinary teams to commercialize promising technologies. Luna's skill in implementing this unusual business model is a form of intangible called organizational capital.

Not all small, high tech firms should be painted with the same broad brush for risk. Luna has successfully commercialized more than a dozen significant products in the fields of energy, telecommunications, life sciences, and defense. For example, HIS Energy purchased Luna's wireless/satellite sensor networks and Baker Hughes bought their pressure sensors for down-hole oil monitoring. Due to its advanced shape sensing and position tracking know-how, Luna recently signed a development and supply agreement with Intuitive Surgical, the leader in robotic-assisted, minimally invasive, surgery. That is major validation of Luna's skill. Demonstrated skill in commercializing products reduces risk.

It is easy to disregard skill if one takes, at face value, Luna's likely accounting earnings loss of around $9 million from revenues of about $33 million for 2007. Accounting losses for small firms like Luna can easily mask the process of building intellectual capital, which is the fundamental driver of long-term profits.

Avoid Betting the Farm

Normally, a small firm with a big upside potential, like Luna, is very high risk. A classic example is a biotech startup that bets the farm on a single drug candidate. If the FDA approves the drug, the firm's technology is validated; otherwise the stock craters. Luna doesn't have that kind of downside risk because the viability of its intellectual capital is not dependent on the success of just one product.

At bedrock, Luna's intellectual capital — its primary asset — is actually a web of knowledge for problem solving. Luna's R&D projects build upon, and extend, its existing stock of knowledge capital. In addition to this synergy, projects are selected with an eye toward potential profit in the marketplace. In one sense, Luna's technical skills produce an excess of product opportunities.

The firm intends to harvest these opportunities through a sound strategy to seek product license fees and patent royalties. This leverages Luna's intellectual capital while letting other firms handle manufacturing and sales. Expect more and more intellectual-capital-intensive, small firms to avoid big investments in tangible capital (plant & equipment, inventories, etc.) as they grow into more profitable and larger firms.

Luna's big upside opportunities include: real-time shape sensing for medical devices, strain/temperature/shape sensing for a wide range of industrial uses, telecommunications instruments; and innovative nanomaterials. Importantly, Luna's nanomaterials are attracting considerable attention from large firms (potential partners) due to big performance gains in a variety of industrial and medical applications, including solar cells and even a novel therapeutic treatment for allergies.

One use of Luna's patented nanomaterials is as a contrast agent for medical imaging. It has shown increased accuracy with reduced adverse side effects. This may soon lead to a partnership with a leading diagnostic firm, resulting in early and substantial cash payments to Luna, and thereby causing a sharp rise in its stock price. This is a most important point not generally appreciated by investors. That is, large firms, whose R&D lags in certain areas, are very knowledgeable about small firms' intellectual capital and are willing to partner to get what they need. Expect more and more early-stage, lucrative, partnership arrangements that monetize the intellectual capital of uniquely talented, small firms.

The intellectual capital of Luna and other high tech firms is typically reflected in their patent portfolios. But tacit knowledge is also extremely important, and is dependent on the firm's culture of teamwork, commitment to R&D goals, and sharing of insights. Luna's progress over many years with nanomaterials would seem to reflect considerable tacit knowledge.

So, where is the risk for Luna? At its present size, Luna's culture is highly dependent on Kent Murphy. As the founder and owner of 27% of the firm, Murphy certainly has an economic incentive to continue his leadership role. The challenge facing Murphy and his management team is to effectively orchestrate what could be explosive growth. The risk is that management has not yet proven it can: (1) handle rapid growth while (2) generating significant profits and (3) still maintain its culture for attracting and keeping key employees. How well Luna manages its intellectual capital will determine how much wealth is created for its customers, employees, and shareholders.

Intangible Opportunities

Rewarding investment opportunities arise when a firm's stock price is weak because there is an inadequate understanding of intangible assets and/or because of myopic investor attention on quarterly accounting results instead of the long-term profit picture. The astute investor who analyzes a firm's intangible assets can increase the odds of picking a stock market winner.

For additional articles about valuation and intangibles, see Madden's website www.LearningWhatWorks.com.

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6 Comments

Touting
Nice...

There is a thousand companies losing money in "high-tech" markets. All of them have great promise. Most of them are run by crooks. You're selling dreams and trust in a market dominated by assets and thieves.

That may or may not be the case here, but the price reflects the reality that a serious disagreement among the principals, a single lawsuit, or a series of technical set backs could easily see a bankruptcy filing here.

That said, 'Good Luck', one solid breakthrough will fund the rest and then you won't need the blessing of the financial classes.



This article seemed more like a shameless plug for the dude's company, to me
Why doesn't TCS just sell more banner ads to raise revenues instead of wasting our time?

Everyone use this forum to bad mouth Luna Innovations! (ticker: LUNA)

intangible or inscrutable?
The author says thate the "firm's stock price is weak because there is an inadequate understanding of intangible assets". It might be more accurate to say that it's just plain hard place value on such intangibles. All you've got to work with are the normal earnings ratios, etc. This means it's for sure riskier than normal, but many of these outfits do pan out OK, and at lest one Swiss banker gives this counter a 'strong buy' rating.

Vendor
I am a vendor to LUNA and have been following them since the begining. I'm not touting but really feel this one is going to hit one out of the park. They are closely alligned with major universities Science Depts and picking the brains of both students and staff. Do what you want but I'm keeping this one on the back burner to see where she goes over the next 10 years.

a crap shoot
This stock is a crap shoot, not an investment. One invests in a well managed company that offers a good product at a fair price and has a history of turning a profit. Anything else a gamble.

leaves me wanting more
i hope this is the start of what could be a fascinating -- and increasing vital -- discussion of valuing intangibles. as this article implies, many important economic assets (e.g., human capital, consistent spending on R&D, brand, customer goodwill, sales force acumen, other organizational factors) are treated like ordinary expenses and are not capitalized for accounting purposes. at the same time, a growing portion of the economy consists of intangible-intensive service business, which many savvy investors -- especially value investors -- still do not understand or value appropriately.

that said, there is shockingly little discussion of how to put rigor around valuing intangibles. should you artificially reconstruct companies' balance sheets to account for indefinite life intangibles? do you somehow (imprecisely) bake these factors into your cash flow projections? who thinks they have a system that works? these are nontrivial issues...

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