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Tech R&D spending holds firm--for now

    When Sun Microsystems issued a profit warning in February, it outlined various measures to cut costs. All expenses were on the table, except for one: research and development spending.

    "R&D is the company's lifeblood," Sun President Ed Zander said after the company's warning. Zander explained that R&D spending will grow at a faster rate than revenue.

    The strategy here is clear: Innovate your way out of troubled times. R&D spending often leads to new technologies and products, which can fuel demand for the entire sector.

    But can R&D spending remain strong if the economy continues to struggle? And if those budgets are cut back, what will happen to the innovation that's so vital to the tech sector?

    Texas Instruments apparently isn't in the mood to risk it. CEO Tom Engibous said TI plans to bump up spending to $1.7 billion this year from $1.6 billion in 2000. It plans to pour money into developing new chips.

    "Never before in a downturn have we increased our R&D spending," he said as he explained his company's profit problems to analysts recently.

    If a company hits an R&D home run, it could play the hero for the tech sector--or even the economy. At the very least, a company can use R&D to throttle its competition. Sun (Nasdaq: SUNW), Texas Instruments (NYSE: TXN) and other tech companies have chosen to maintain R&D spending in the current economic downturn.

    "It's virtually a sacred cow," said Prudential Securities analyst Hans Mosesman. "You want to be ready when things pick up. It's the guys that underinvest in R&D that get hurt."

    The R&D upswing
    R&D spending has been on the rise for the last six years after slumping between 1985 and 1994 due to a drop-off in federal spending, according to statistics from the National Science Foundation.

    Overall R&D spending in the United States grew by 5.8 percent per year between 1994 and 1998--the last year for which the data is available--despite virtually no government spending (0.6 percent per year). Corporate R&D spending grew at an annual rate of 8.9 percent for those years, according to the National Science Foundation.

    Economists say R&D spending will remain strong as long as the economy doesn't face a prolonged downturn.

    "A short downturn in the economy would have little effect on technological change," said Samuel Kortum, an assistant professor of economics at Boston University and co-author of a study on the role of venture capital in technological innovation.

    For most years, Kortum said, business-funded R&D doesn't correlate with the growth of gross domestic product, the sum of goods and services produced by a nation and an indicator of economic well-being. The reason for this, he explained, is that "relative to other forms of investment, R&D is one in which the costs of cutting back and restarting again later are very high."

    However, in a severe economic downturn like the one the United States encountered in the 1970s, R&D did track GDP as both fell sharply.

    Possible pullback?
    For now, the R&D bandwagon rolls on, but it could be entering a hangover period. A few companies have already started to trim their budgets.

    Intel recently said it will slice $100 million, or 2.5 percent, from its R&D budget, and Lucent will narrow its R&D spending as part of its plan to trim $2 billion from its total expenses.

    While analysts note that none of the reductions made so far have been significant, they agree that could change if the economic downturn deepens.

    "R&D will be the last to get cut. Companies will cut capex (capital expenditures) before R&D; that happened in ྞ," Mosesman said. In 1998, the Nasdaq fell more than 20 percent amid concerns about devaluation of the Russian ruble.

    "I sense it gets cut back despite what (companies) say. As things deepen, some people are going to throw in the towel," said Chuck Hill, director of research at earnings tracking firm First Call. Hill was a technology analyst in the ྂs and remembers that "back then, in ཱྀ, ྅, ྋ--when we had real downturns in technology--they ended up cutting back."

    Intel Chief Financial Officer Andy Bryant recently said his company's move from a $4.3 billion budget to a $4.2 billion budget was negligible. "While slashing nonessential spending across the company, we are protecting investments we believe will make Intel more competitive," Bryant said on a recent conference call.

    Nevertheless, there are a few doubters.

    "Intel says they'll keep spending through it, but we'll see," Hill said. "It's a smart thing if they can do it."

    Mosesman said Intel's R&D spending hit a low of 8 percent as a percentage of revenue in 1995, but he said it has gone up every year since then to hit a high of 13 percent in 2001. For 2002, it's expected to be 11.5 percent--"if Intel holds their guns."

    As for Lucent, it also insists it's not sacrificing R&D.

    Richard Teplitsky, a Bell Labs spokesman, said the only thing Lucent has cut in terms of R&D is one lab in the Silicon Valley. The lab was established in 1998 to focus on four research projects, which were all completed. The company may have laid off some employees from R&D, Teplitsky said, but they weren't core researchers.

    "There's a certain amount of discretionary spending attached to R&D that can be trimmed--about 5 to 7 percent of it is 'fat,'" said Needham analyst Dan Scovel. Cut "over 10 percent, though, and you're cutting meat and bone."

    Research and develop out of a recession?
    For now, the Sun and TI strategies of maintaining R&D spending has widespread support.

    "Boom times are time to reap. The incentives are to squeeze and milk the things you've got going on now," said Boyan Jovanovic, a professor of economics at the University of Chicago. "Recessions are a time to sow--when people really scratch their heads and think about drastic change."

    Technology company executives know all about change, and that's why they are R&D happy, analysts say. They don't want to be made irrelevant by some new company on the block.

    Perhaps the worst thing a company can do is put off the introduction of new technology over short-term concerns such as inventory gluts and quarterly misses.

    Some analysts have accused today's tech giants, including PC makers and even Cisco Systems, of fulfilling the prophecy of Clayton Christensen's book "The Innovator's Dilemma." In this classic catch-22, dominant companies falter because they cling too long to a business model based on sustaining technologies rather than disruptive ones.

    The lack of current tech innovation--especially in the PC sector--could be what brought on the current tech downturn. Put simply, there's no new big thing. That'll change if companies get hungry enough.

    "The incentive to come up with ideas is bigger when times are not so good," Jovanovic said.>