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Archive for October 29th, 2010

Microsoft’s Extraordinary Quarter, Valuations, and “Who Owns the Cash?”

Posted by Bob Warfield on October 29, 2010

As usual, there is another fascinating discussion underway among the Enterprise Irregulars.  And again, as so often happens, there are related discussions.  In this case we have a discussion about whether there are any companies who’ve reached $100M in revenue with 100 employees, and one about Microsoft’s recent quarter, its cash position, relative valuations versus companies like Apple, and the idea that Microsoft’s cash belongs to shareholders.  It’s fascinating to watch these threads come together serendipitously, and then extract further meaning from the gestalt. 

Gordon Gecko at Teldar Paper

Shareholder Gordon Gecko

Let’s start with the $100M/100 employee thought.  Are there any such companies?  Perhaps, but they are certainly private and they are likely insanely profitable.  The profitability piece means there would be a tendency to spend the profits to reduce risk (and what won’t be said, make everyone’s life easier) and explore new growth possibilities.
I think it is very likely doable to build such a company, just that few are motivated to do it and would perceive such a model as very high risk.  I also think some of the technologies you need to do it may not have existed until recently.  The alternative to technology is an unfair market advantage as evidenced by gross levels of profitability.  Let’s talk about each.
Go through the laundry list of $100M businesses, and ask yourself what are the characteristics that drive headcount that have to be minimized:
–  Leveraged marketing and sales–no feet on the street.  So it’s marketing driven, whatever it is, and it’s either sold online or through a dealer channel that doesn’t rake too much off so you can transfer cost to the channel.  But supporting the channel can drive up heads, so you almost would need something they have no choice but to carry.  That leads to an idea that is both an unfairly strong brand and is also something of a monopoly.  Not sure what qualifies today, but back in the day DOS would have been a great example.  More on that in a second.
–  Customer Service:  Amazing how many heads this drives.  You need a product that either requires very little service or a Customer Service methodology that produces very little cost (Social CRM can reduce your costs to 1/3 of what they were, been there, done that). 
–  Product:  Platforms and on-prem drive spurious headcount.  At Callidus, we estimated we could get by with 40% fewer heads if we only had to support the current release on 1 platform and we would have no loss of innovation.  I will go further.  The optimal number of developers is a maximum of 10.  Any more than that and your team loses efficiency due to communication loss.  Give me 10, and I can build almost any single product you can imagine in 12-18 months or less.  Been there, done that.  Quattro Pro kept up with 10 developers against Lotus and MSFT teams of 100 or more.  However, they do have to be the RIGHT 10 developers.  I could write a long post on that, but will spare you here.  To get more than 10 working efficiently, you need a loosely coupled application suite, where each module has its own 10 and the communication requirements between them are modest.
–  Manufacturing and Fulfillment:  Clearly (well, maybe not, I guess I can imagine some cases, sort of) it will be hard to get there with physical goods.  You can outsource it all.  Could a Dell back in the day do $100M with 100 and all the right outsourcing?  Maybe, but we are speaking of software here.
The Internet and technologies like Social CRM make some of this possible.  The alternate model, which is a product with ridiculous margins and brand ubiquity to drive unbridled demand, has also existed.  Back in my Borland days, we used to envy MSFT having a $250-300K ratio of revenue per employee.  We knew that the profitability was very uneven and that the monopoly DOS franchise financed a lot of it.  I have no doubt that DOS could’ve been cut out and scaled to a $1M per employee business.  This is probably true of some Google businesses too.  But, these companies never do that.  They finance the future and they reduce risk by spending the profits today.

Now, one of my esteemed colleagues mentioned that it would be a terrible investment decision for a company with such margins not to embark on a plan of ambitious investment.  That is certainly the conventional wisdom, but the track record says otherwise.  The majority of M&A transactions started out with just such a thesis and wound up net destroying shareholder value.  I would venture to say this is probably also the case for large companies trying to start new businesses.  It is rare that they can get them up to the levels of performance of the core franchise, and hence they are dilutive.  This was certainly true for Oracle and its apps business relative to the DB business, for example.

It will be interesting to see whether today’s technologies and Internet allow some of the bootstrap players who’ve already gotten quite large to get there.  Their motivations as “lifestyle” companies (and I don’t say that like it’s a bad thing), might lead them not to care about this “invest to grow” imperative.  I’m speaking of companies like a SmugMug or a 37Signals.  I suspect their revenue/employee metrics are pretty close already even if the absolute revenue numbers are not.  You don’t have to read many interviews with the SmugMuggers to realize they’re in love with photography and their customers and are unlikely to move too far afield of that.

Now we see pretty clearly the link between the $100M/100 and the Microsoft quarter.  Both are examples of what I will call “unfair profitability.”  These are profits born not just of good ideas and good execution, but of some sort of lock-in effect that inhibits competition over long enough horizons to build such franchises even though the profits are so huge that competitors should be homing on it like heat seeking missiles.  Coincidentally (can there be so many discussion coincidences, or is there more at work in the Universe than we know?), there is a fabulous article by Jim Stogdill on this very issue of unfair profits called Points of Control = Rents.  Worth a read for a good discussion of who has unfair profits in our world today and how did they get them. 

We’re on the downslope now folks, so bear with me. 

Next up for discussion is the statement that the disparity in PE multiples between AAPL and MSFT is crazy given the margins of the two companies and the quarter MSFT just had.  My response is that the disparity in multiples is not crazy at all.  Take your Yahoo stock charts and overlay 5 year performance of MSFT and AAPL:

AAPL vs MSFT Share Price

There should be no doubt in your mind why AAPL gets a higher valuation.  In fact, the contrast is so stark you may wonder why AAPL doesn’t have an even bigger premium.

Inevitably, Warren Buffet’s name was invoked as was the question of whether one could invest in MSFT for the long haul.  In essence, was MSFT so undervalued as to be an ideal Buffet Tech Stock?  But if you’re familiar with Buffet’s investment thesis, MSFT is not really a Buffet business.  Value is not the only part of the Buffet/Graham equation.  Value is the insurance in case the rest of your thesis fails and there has to be has to be a rest of the thesis.  In particular, for Buffet, there has to be reason to believe earnings growth can go on forever at a rate that amounts to an interesting rate of return.  Industries with disruptive tendencies are not good bets because that growth is not reliable in the long haul.  Hence Buffet will declare self-deprecatingly that he won’t invest in tech because he doesn’t understand it.  What he means is he can’t predict when then disruptions will happen, and they happen often enough he can’t hold for a sufficiently long horizon to be interested.
Lastly, we get to the idea that companies have a responsibility to distribute excess cash because the cash belongs to shareholders.  The idea that the cash belongs to shareholders is also an interesting one.  It’s become something of a cliche, in the Gorden Gecko at Teldar Paper Shareholder meeting-esque sort of sense. 
If shareholders really owned the cash or even the company, they could call up and have the cash sent over.  Companies can trade below their cash value, and it isn’t even all that uncommon for them to do so.  If shareholders owned the cash, they would call up and have it sent over from one of those companies.  If you had a company that had delivered the kind of equity returns that Balmer’s Microsoft has (flat for so long that it has been called a “Value Trap” by one of our EI’s), I suspect you would also like to have a lot more cash sent over.  But you don’t own the company or the cash, so you don’t control the cash, despite it feeling good to claim otherwise.  What you own is a piece of paper that grants you certain shareholder rights.  That’s a steed of a different hue.  There are lots of people in the “That cash belongs to us” food chain that are much closer to being able to pick up the phone and have the cash sent over than the poor common shareholder.
Ask any VC what terms have to be in the deal for the preferred to be able to pick up the phone and have the cash sent over.  Entrepreneurs should make no mistake, it is possible for those guys to own the company and the cash.  In fact it is very likely for that to happen.  I have even personally seen a case where a firm picked up the phone, had the round they’d just put in sent back, and closed the doors.
Ask your banker what terms have to be in their note such that when those provisions are not met, they don’t even have to pick up the phone.  They can sweep the cash.  It was a big concern among startups that this was going to happen a lot very recently.
These people and many others are closer to “owning the cash” than common shareholders.
Common shareholders are not powerless, just almost powerless so that it takes ridiculous numbers of them working together to have a voice.  And even then, what can they really do?  They can jawbone about it.  They can sell their shares.  They can launch proxy fights, which the company will respond to with all sorts of machinery that is efficient at blocking hostile takeovers.  They can launch shareholder suits about failures of fiduciary responsibility.  Yada, yada.  There has to be an awful lot at stake to get enough of them mobilized to go through any of these processes with much chance of success.  Having too much cash on hand is not something that will rise to that occasion.  It’s not enough to mobilize the troops.  If nothing else, the processes are lengthy, the cash is liquid, and quarters are fragile.  If you want to get an envelope full of cash out of a car whose ownership is being contested, you don’t set fire to car to increase your chances.  There has to be some malfeasance, some sense that management is doing something really grossly unfair to the common and well outside their fiduciary responsibility.  We’ve all seen enough shenanigans to know that “grossly unfair” is a very high bar indeed.
In the end of the day, companies that can establish unfair points of control allow them to create artificial scarcity and milk the consumer.  Network effects are the most popular Lock-In 2.0 for the Web World, though they existed in the form of available apps and hardware platforms back in the DOS days, the CP/M days before that, and all throughout the mini and mainframe eras.  Today’s buying marketplace is only slightly more canny in their ability to see the garden wall being built and get upset with the gardener about it.  If they see it in time, they try to steer clear.  Open Source has become powerful for exactly that reason.  I love the Red Hat quote, “We love to turn a billion dollar business into a couple of hundred million dollar business.”
The prior software generation also had an “implementation rent.”  If you just spent $100M to get SAP live, even if the whole experience was terrible, and the end result only just tolerable, it will be a long long time before you consider undertaking anything remotely like that again.  Most careers won’t survive it.  I vividly remember asking a telco senior exec one time how she thought about the ROI of billing systems.  She laughed and told me there was no ROI.  Nobody thinks about that ROI.  They only think about whether their career can survive the process of replacing a billing system should they be unlucky enough that it comes up on their watch.  SaaS companies road into some of these situations with the idea they would be so much easier to install they would defeat the “implementation rent.”  Some of them are encountering the penalty for that largesse in the form of unreasonably high churn.  If it was easy to put it in, it is easy to take it out as well.
So if you are an investor, don’t predicate your success on ownership of the cash.  Rather, choose companies that have unfair points of control that allow them to be unfairly profitable in markets that are growing faster than the S&P 500.  Make sure those unfair points of control and that market growth can continue unimpeded for as far as the eye can see.  Beware disruption.  Does AAPL warrant a higher multiple than MSFT?
Yes, despite the current extraordinary MSFT quarter, it seems the market favors Steve  Jobs’ ability to create these unfair points of control in fast growing long tenure markets over the apparent failure of Microsoft to add any new ones and the evidence their old points of control and markets are at risk.

Posted in apple, business, saas, strategy | 1 Comment »

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