When the economy is in crisis, software and hardware manufacturers find it difficult to continue investing in research and development - and in the future
By: By Rick Whiting and Aaron Rikadela, InformationWeek
Bill Gates, the chairman of Microsoft and its chief software architect, at his meeting with Wall Street analysts in July, solemnly promised that he would increase the company's spending on research and development to 5.2 billion dollars in fiscal year 2003, a 20% increase compared to 2002. It's an aggressive approach, but I definitely believe in that approach," Gates said.
Two months later, Sun Microsystems CEO Scott McNeely, in his keynote address at the Sun Network conference, solemnly promised that he would aggressively increase Sun's spending on research and development over the next three to five years - a critical component of the company's strategy, designed to restore its rapidly declining sales. steep.
Gates and McNeely rarely agree. But the importance of spending on research and development in difficult times is something they both agree on. The difficult thing in the tech industries is to do this during a serious slump in sales. The answer, for many companies, is this: cut research and development, but not at the rate at which revenues drop. Among 14 of the leading software and hardware manufacturers, only 3 cut research and development spending this year compared to sales percentages, a common way to measure research and development spending. Even the dollar amounts increased in six of the 14 companies, assuming that the companies will continue to spend money at the same rate in the last quarter of the fiscal year.
The subject is more than academic, as far as information technology managers are concerned. Companies and institutions that used to develop their own applications are increasingly dependent on the manufacturers they chose as partners, says James Roberts, vice dean for finance and administration at Duke University. Today's research and development expenditures are tomorrow's information technology innovations. Businesses may find themselves at a disadvantage when the economy recovers if they tie their future to information technology manufacturers who are drastically cutting research and development spending, and therefore unable to deliver leading edge products when customers need them. "We have put our fate in the hands of subcontractors, and we are dependent on the research and development expenses of the information technology manufacturers," says Roberts. "This is an essential matter in our strategy."
Duke University has been using student management software from PeopleSoft Inc. for five years, and it recently adopted a new application from this manufacturer to report the status of foreign students to the US government. "This is a good example of their ability to be nimble and respond quickly to our changing needs," says Roberts.
Information technology buyers are unlikely to choose manufacturers that are reducing their research and development efforts, says Olivier Hellavid, president of products at BEA Systems Inc., which in fiscal 2002 doubled its research and development spending from two years ago. "They want to make sure that the company is committed to the innovation of its products," he says. "They don't just buy a product, they buy a future, a product plan."
For this reason, smart spending on research and development is important, of course, for the future of the technology manufacturers themselves. "When the economy improves, the companies that have continued to focus on innovation and new product development will be the ones that will accelerate the recovery of the technology industries," says Mark Tolliver, senior vice president and head of strategy at Sun.
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Sun Microsystems has increased its research and development efforts through acquisitions, says Mark Toliver.
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Most information technology manufacturers have tried to maintain significant levels of research and development spending for several quarters after the economy entered a downturn early last year, says Henry Chaseborough, a Harvard Business School professor who is writing a book on innovation and product development. "They tried to do the right thing," he says. But as the economic downturn continues, more and more companies are taking a closer look at their research and development budgets, Chaseborough says.
What is surprising is the moderation in which research and product development budgets have been cut, despite the fact that companies are struggling with unprecedented declines in sales. A review of the financial statements of some of the largest companies in the industry, shows that in most cases, the expenses on research and development increased in relation to the percentage of sales - in the case of Computer Associates, for example, almost to 23%. This increase is mostly the result of sharp decreases in sales (see table below). For Computer Associates' fiscal year 2002, which ended on March 31, it is 23% of sales for research and development expenses, compared to 17% last year. However, the amount of CA's research and development expenses fell during this time from $695 million to $678 million. This is a 2% decrease in research and development while sales fell by 29% compared to last year.
The downturn in purchasing in the field of information technology exacted a heavy toll on the research and development expenses of certain companies in the industry, especially those whose sales dropped significantly. Commerce One Inc cut its product development expenses by 25% in the first six months of the year to $44 million from $58.6 million in the same period last year, in view of the fall in sales of its procurement applications from $271 million to $59.6 million. Competitor Ariba Inc cut its research and development expenses by 32% to $48.6 million in the first nine months of fiscal year 2002, through June 30, from $71.7 million in the same period last year.
At the same time, most manufacturers try to avoid such cuts. "We are all trying to become more efficient, but we understand how important research and development is to our entire business," says Mark Lewis, director of technology at EMC Corp, the manufacturer of storage systems. "Shall we always try to be more efficient? Yes. But we will not take any cruel action. It is clear that when the downturn is over, we are interested in remaining in a competitive position."
To do this, EMC spent $929 million on research and development in the 2001 fiscal year that ended Dec. 31, up from $783 million in fiscal 2001. But EMC will reduce spending on research and development as the economic downturn continues: In the first nine months of the year, The company spent $595 million on research and development, or just over 15% of sales, compared to $712 million, or nearly 13% of sales, in the same period last year.
Oracle has increased its research and development workforce by 10% to 15% over the past two years, says CFO Jeff Henley. Today, almost a quarter of the company's 40,000 employees are engaged in research and development. Research and development expenses as a percentage of sales rose from the 10%-11% range between 2000 and 2002 to more than 14% in the first quarter of Oracle's 2003 fiscal year, which ended August 31. The company's research and development expenses this quarter increased by 13% from the corresponding quarter last year to 286.1 million dollars, while sales and marketing expenses were cut by 12%. If not for the failing economy, Oracle likely would have increased its research and development spending more, Hanley says.
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EMC shifted the research and development focus from hardware to software; 75% of its research and development budget is devoted to software development, says chief technology officer Mark Lewis.
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For now, the nature of R&D spending seems to be more focused. "During the dot.com boom, people were throwing a lot of money at things that weren't part of their core business," says BEA's Halboyd. The risk is that the pendulum swings too far to the other side. Consolidation in markets like application servers means fewer startups with innovative ideas. "This can limit certain technologies," says Halvod.
BEA cannot afford to lag behind in innovation, as IBM is steadily advancing the application server market. BEA, therefore, adopts the "middle of the road" approach to research and development. It focuses its efforts on expanding beyond its core application server technology to topics such as application integration software, portal technology, and reducing the cost of web application development and implementation. In the first six months of the current fiscal year, BEA increased its research and development expenses by more than 5% to $63.3 million compared to the same period last year, even though revenues fell by more than 14% from last year.
In good times, a lot of new technology comes from startup companies funded by venture capital funds. However, there is less venture capital today. Therefore, if in the past a unique startup company would have focused on innovation, today the burden falls on established manufacturers to lead innovation for the information technology industries, says IDC analyst John Gantz.
The focus of research and development efforts changes in certain companies, in some cases as part of a strategic plan and in other cases as a result of the economic downturn. At Cisco Systems, the emphasis last year was on improving existing network systems rather than developing new products. That's because switches, routers and other networking products have a lifespan of five to seven years, and fewer and fewer customers are buying new systems. What's more, Cisco has found that customers are more productive in years four to six than in years one to three, giving them less incentive to purchase new systems every few years.
Based on this, a large part of Cisco's research and development budget is invested in the development of new security technology, such as virus and intrusion detection as well as support for unified networks for voice, video and data. "There is no longer any debate that voice, video and data over IP will come together. The answer is yes," Cisco president and CEO John Chambers said last summer (more on unifying voice and data, read the "Voice of the People" article).
EMC shifted its focus from hardware research and development to the development of new software, such as AutoIS for managing arrays of storage devices. Software is an increasingly important component of EMC storage systems; Stand-alone software such as AutoIS accounted for 22% of the company's sales in 2001, up from 12% in 1999 and 16% in 2000. According to Lewis, 75% of EMC's research and development budget is devoted to software development.
The average expenditure on research and development varies between 5% and 10% of sales among hardware companies and between 10% and 20% among software companies. The research and development expenses of software companies are the same as what pharmaceutical companies spend on developing new products.
The bulk of Oracle's research and development resources are devoted to improving existing software, says CFO Henley, and this has been the case for several years. Oracle develops new products from time to time, such as its recently introduced collaboration suite, or new components to the 11i application suite. However, Hanley says that "engineering over time" - the development of new versions of existing products - takes the largest share of the software manufacturer's research and development expenses.
A significant part of Microsoft's research and development is designed to develop software that will integrate personal computers and laptops more easily into everyday life. Microsoft's ClearType technology for easy-to-eye reading, directly from the screen, appears in the version of Windows for tablet computers (Tablet PC), which saw the light of day on November 7, and in the next version of Microsoft's Outlook email software, which will be launched next year. Tablet computers will include the ability to search and edit handwritten notes. And Gates predicts that people will, one day, vote on desktop LCD monitors instead of using a mouse. The goal of a leading R&D initiative, Always Works, is to create better feedback between Microsoft and its users. And a future version of Windows, known as Longhorn, will include a file system that identifies metadata (information about the data itself) about documents so that users can organize their files dynamically according to their contents, without having to remember folder names.
Sun's research and development to-do list includes creating tools to improve the management and use of the information technology infrastructure and building portal, web server, email, and meeting board applications into the Solaris operating system. The company continues to develop new Java and XML technologies and is increasing research and development investments in storage technology and storage management, Toliver says. At the same time, Sun has not yet fulfilled McNeely's promise to increase development spending: Research and development expenses totaled $437 million, or 16% of sales, in the first quarter of the fiscal year, which ended Sept. 30, compared to 473 Millions of dollars, or 17% of sales, in the same period last year.
Most companies do not separate research expenses from development expenses, and include them together in their income statement as "research and development", but most of this money is spent working on product development. But few companies, notably IBM, Lucent Technologies' Bell Laboratories, and Microsoft, still conduct basic research by scientists to discover new technologies or new processes. Such work is not usually carried out according to a set schedule, says Henry Chaseborough of Harvard. Development, on the other hand, is led by engineers and focuses on turning ideas and technology into products that make money. And it is usually performed within a tight schedule.
But separating research and development activities at IBM is no easy task, says Robert Morris, vice president and director of IBM's Almaden Research Center. Yes, IBM has about 3,000 research people in eight labs around the world, working on everything from new materials for semiconductors through nanotechnology to the way people work with computers. But Morris describes the work from research to development as a continuum, with basic research finding its way to technologies that ultimately function as the basis for new products. IBM's research and development budget has remained stable at around $5 billion, or 6% of sales, in recent years.
Not open to negotiation
Many manufacturers continue to invest in research and development despite the difficult state of the economy
Fiscal Year 2000 Fiscal Year 2001 Fiscal Year 2002
Research and development expenses (in millions of dollars) as a percentage of sales Research and development expenses (in millions of dollars) as a percentage of sales Research and development expenses (in millions of dollars) as a percentage of sales
BEA Systems $61 13% $89 11% $121 12%
Cisco $2,685 14% $3,778 17% $3,301 17%
Computer Associates $568 9% $695 17% $678 23%
Dell $374 1% $482 2% $452 2%
EMC $783 9% $929 13% $595* 15%
Hewlett-Packard $2,634 5% $2,670 6% $2,923** 5%
IBM $5,151 6% $5,006 6% $3,546* 6%
Intel $3,897 12% $3,796 14% $3,012* 15%
Microsoft $3,775 16% $4,379 17% $4,307 15%
Oracle $1,010 10% $1,139 10% $1,076 11%
PeopleSoft $321 18% $299 14% $253* 18%
SAP $910 15% $800 12% $629* 13%
Siebel $146 8% $199 10% $158* 13%
Sun Microsystems $1,630 10% $1,995 11% $1,836 15%
* 9 months until September 30 ** 9 months until July 31; Including the amounts at Compaq
Data: InformationWeek
During the last two years, IBM has transferred resources to the development of technologies and practices, in order to reduce the manpower expenses associated with computing, says Morris. This year the company unveiled a number of independent computing products based on this research, products that help information technology systems manage and repair themselves.
Most of Sun's research and development efforts are directed toward development, but Sun Labs is engaged in more basic research in the fields of information technology. Among other things, this is cooling technology for computers; semiconductor technology; Java Virtual Machine development; and basic reliability, availability and durability. This research is not related to specific products, but according to Toliver, the research is intended to find its way into Sun's products. But Sun Labs is responsible for a relatively small share of the research and development budget, Toliver says, although Sun isn't willing to give the exact amount.
Recently, Sun has increased its research and development efforts through acquisitions. To boost its semiconductor business, Sun bought Afara WebSystems Inc in July in a deal that brings some of the original designers of Sun's UltraSparc chip back to the company. And its acquisition of Pirus Networks Inc., announced in September and expected to close by the end of December, will add to Sun's research and development efforts in data storage, Toliver says.
Leveraging research and development efforts through acquisitions has become a preferred strategy for some companies for some time, including Cisco. Harvard's Henry Chaseborough expects such activities to be more common when stock prices are low for small companies with leading technologies.
To help make the most of its $4 billion research and development budget, Intel has built labs near top research universities such as Carnegie Mellon University, the University of Washington, and the University of California, Berkeley. According to Chaseborough, this indicates that information technology companies are looking for new technologies and ideas for new products, even beyond their development departments.
In tough economic times, customers are more selective about the information technology products they buy, says IBM's Robert Morris. This fact gives an advantage to companies that invest in developing technologies that customers really need. "The chances are smaller that they will jump on technologies with excessive marketing," he says. "This is a wonderful time to invent and innovate."
