Five Years Too Late

January 31, 2010

My Friend Who Hates Tech

Filed under: Uncategorized — fiveyearstoolate @ 12:05 pm

Eric Wiesen

Last week I was at party held by my wife’s coworker. The coworker’s husband is a friend of mine who I usually see at these types of events. He runs a hedge fund and is always worth an hour of interesting conversation. Among the wide variety of topics we discussed was why he “hates tech” and why he thinks the lack of an IPO market is the tech industry’s own fault. We’ll call him John.

I should be clear – John doesn’t hate technology. He has tons of it. He doesn’t hate the people in technology. What he hates is the governance he’s observed as a public company investor that he views as commonplace among tech companies. His specific gripe? Tech companies never pay out their earnings as dividends. His view is that there is no way to be a truly long-term investor in tech companies because management never allows companies to transition from growth companies to mature, income-oriented ones. The only way to win is to get in and trade out when you think the cycle is peaking.

I’m not sure John is wrong. The nature of technology is such that for most (not all) companies there is a period of extraordinary value creation followed by a period where the market moves on, at least partially. The rational thing to do at that point is to alter the strategic objectives of the company from rapid growth to efficiency and profit-maximization, but this almost never happens in tech. To use John’s examples, look at Wang, Yahoo and Palm. Each had an extraordinary story at one point and generated significant cash flow. And each in turn reinvested that cash flow into unprofitable businesses rather than pay it out to investors.

Why did they do this? You can take it from one of several directions. The canonical argument is that tech companies always need to be reinvesting, that if they pay cash out they will be left behind. And yet … these companies got left behind anyway. Wouldn’t their investors (in whose interest management supposedly runs the company) be better off with dividends than the outcomes they’ve received in these companies? The alternative argument is that management would rather empire-build than reward shareholders.

Perhaps the best example is Microsoft. Microsoft is a mature tech company and has been operating for about 30 years. It is profitable ($4.5B in operating profit in the most recently-reported quarter). It has been profitable for years. Yet Microsoft, as of today, pays just 1.8% dividend yield and holds $52B in current assets. Why does a business with relatively low CapEx have so much cash? Because it can. And what are they doing with that cash? Mostly they are (in my view) “investing” it in an unprofitable attempt to be an internet company, which they aren’t and never have been. They are buying share for Bing but it’s negative-NPV growth.

I would argue that Microsoft is the perfect example here because it utterly dominated the best businesses to be in from 1980 to 2000 – desktop software and operating systems. For that 20-year period Microsoft was the most profitable company in technology. Now, however, these businesses are flat or in decline. If I’m an investor, do I want Microsoft spending all those retained earnings trying to beat Google or Apple in areas where Microsoft has no advantage? No. I want those retained earnings paid to me, and if I want exposure to the web I’ll go buy Google or Apple stock (or any other company who I think is poised to dominate an important area).

This is a classic agency problem. It is extremely unappealing to Microsoft’s management to acknowledge that the company’s dominance is waning and that the shareholder-maximizing course of action is to run the company efficiently, decrease investment in the web and run a desktop software business as profitably as it can for as long as it can while paying out as much cash to shareholders as possible. How much fun would that be? “Killing Google” is much more fun. Except it doesn’t really work.

Ultimately, I had a hard time disagreeing with John that tech companies fundamentally break the implicit agreement with their shareholders. I’m not at all sure I agree that this is the reason for the weak IPO market (in fact I think it’s a small component at best) but his points were thought-provoking. Tech companies almost never acknowledge that they are dividend stories even though it’s frequently appropriate.

34 Comments »

  1. eric – excellent post. Your friend makes interesting points but is ultimately wrong re IPOs. Most tech companies hit the inflection point when they should just harvest (pay dividends) longs after they IPO. The rational strategy for him is to buy at IPO and sell at that inflection point.

    Second point, I think tech companies have defied gravity but only when they have super CEOs who are usually founders. Sony in its prime, Apple under Jobs etc. See http://cdixon.org/2009/10/10/man-and-superman/

    I completely agree that a neanderthal like Steve Ballmer should just pay out dividends and stop wasting money fighting Google. If Gates came back, that would be another story…

    last point – u need disqus!

    Comment by cdixon — January 31, 2010 @ 12:21 pm

    • Chris – on IPOs: I agree he’s wrong. Harvesting is almost always post-IPO. Further, the real problem is that companies today need to be too far along for a number of categories (cleantech etc…) to get to the IPO window (although Tesla will be an interesting proof point here). Ultimately I think the Grant Thornton piece on the IPO market is more right than wrong, at least in problem definition.

      To your founder point – agree, although I think those are exceptions that prove the rule (and again, if we’re not cherrypicking, Dell itself should fall into that category, but we’ve seen enormous value destruction there).

      Lastly – you are right, we need Disqus here. Working on it. We need to move platforms first, then we’ll implement.

      Comment by fiveyearstoolate — January 31, 2010 @ 12:34 pm

  2. I don’t entirely disagree, but it does remind me of Michael Dell’s advice to Apple in 1997: “I’d shut it down and give the money back to the shareholders.” Even struggling tech companies are perceived to have a decent probability of hitting a money-spinning share-booster like the iPod, making internal investment a lot more accepted than it is in other industries.

    That said, I’ve also been reading some diaries of people involved in the financial industry in the 1920’s and 30’s, and it’s striking how much focus there used to be on dividends compared to the modern era. I wonder if in general investors have forgotten that a share’s fundamental value comes from the expected future stream of earnings it promises.

    Comment by Pete Warden — January 31, 2010 @ 12:29 pm

  3. Very much agree with “John’s” reasoning.

    My follow-up question applies to startup-land: when is the appropriate time to acknowledge that a startup is self-sustaining and going sideways or only growing slightly (and may have achieved some respectable, if not spectacular, milestones)?

    From the venture side: what’s the decision framework for pulling your money out in that case? And how often do you actually see that happen?

    Comment by chris m. — January 31, 2010 @ 12:31 pm

    • Chris – great questions and probably deserving of their own post and discussion.

      When is the time to acknowledge that you have a “small business” or a “lifestyle business”? Cash-flow positive but lacking explosive growth. It’s a very hard question and I’m forced to fall back on the Potter Stewart “I know it when I see it” answer. One way (although not necessarily the best way) you can figure out what you have is to go to the market for a pricing signal. You can either do that by going to the investment community and seeing what someone would pay to own a chunk of the business. Similarly, you could hire a banker to see what someone would pay to acquire the company. External parties will give you an independent view on the value of the business and that’s certainly directionally useful if you’re not sure where the business is going. But it’s not an easy thing to determine, especially when you’ve been living a business for several years.

      On the VC side, it’s similarly murky. In my experience it usually hinges around future fundraising. You get a sense from outside investors whether or not you have something of interest. If you don’t, you will usually push for cash-flow breakeven (which gives you options) or a sale. But again, I’d caveat all of this that it’s an imprecise method for answering these questions. It just might be better than the alternatives.

      Comment by fiveyearstoolate — January 31, 2010 @ 1:07 pm

  4. Hi Eric,

    Killer post dude. But maybe there’s another angle: maybe Microsoft, Yahoo, etc. just need new CEOs and the profitability of their legacy systems and poor corporate governance allows under-performers like Ballmer & Bartz to stay alive. Sure, so long as Ballmer is there, MSFT should pay out dividends. But the real answer seems it should be: GIVE BALLMER THE BOOT!

    Ditto on the Disqus.

    -Matt

    PS Weren’t we supposed to get together at some point?

    Comment by Matt Mireles — January 31, 2010 @ 12:46 pm

  5. Greenwald calls for the dividends as well in these case. He calls it “dying with dignity”

    great post – applies to media companies past their prime as well

    Comment by Jon steinberg — January 31, 2010 @ 12:51 pm

    • Jon – agree re: media companies (and of course Greenwald does too – that’s the class of his that I took).

      Sometimes the best thing to do is transfer profits back to shareholders. But as several of the commenters here point out, it’s easier identified after the fact and hard to do from inside a company.

      Comment by fiveyearstoolate — January 31, 2010 @ 4:13 pm

  6. I think there’s another factor at work: by acknowledging that they don’t have better investment strategies than cash, their multiples will suffer significantly. Most of the companies you’ve referenced would see more than 50% multiple compression based on their current share prices.

    Would it really be in their shareholders’s best interest to allow the stock to crater by 50%, or continue bleeding (relatively) small amounts of cash to preserve the illusion and multiple?

    Comment by togilvie — January 31, 2010 @ 1:20 pm

    • Well – yes, there will be multiple compression. And eventually the stock will be repriced as growth investors get out, income-oriented investors come in and the dividend yield creates a price floor under the stock. Is that painful? Yes, but better than the alternatives we see in Wang (bankrupt after 40 years), Palm (trades at <10% of peak) or Yahoo (trades at a third of even recent 2006 valuation). MSFT trades at a multiple similar to 3M or McDonalds today so I'm not sure how much collapse would really take place.

      Comment by fiveyearstoolate — January 31, 2010 @ 1:26 pm

  7. The biggest problem with your article is that you are assuming that guaranteed short-term payouts to shareholders is the task of the management, instead of a potential large windfall in the longer term. If Bill Gates had followed your advice and stuck with DOS without investing in Windows, Office, … then Microsoft would long have been history instead of a giant generating 15 billion dollars in profit. Guess, which one would the shareholders prefer?

    Comment by Akshat — January 31, 2010 @ 1:29 pm

    • I think that’s wrong. Investing in Windows wasn’t a different business for Microsoft. DOS was the dominant PC operating system at the time and Windows was the next-generation of that product. Furthermore, Microsoft was better-positioned to succeed in the GUI business than any other company and was well-tooled to succeed here (jokes about Windows aside). Similarly, investing in Office was what Christiansen would call a “sustaining” technology. Again, Microsoft was in the business of desktop software for personal computers. Investing in the expansion of this business was rational and value-creating.

      Comment by fiveyearstoolate — January 31, 2010 @ 1:32 pm

  8. I couldn’t disagree with this more. This is hedgefund manager thinking. All due respect – this post sounds like a financial person looking at a spreadsheet, not a business person looking at a business. It shows no appreciation for what it is like to manage within an actual company, regardless of size. When you’re running a company, or a division, or a department, there is no magical red light that goes on, telling you to give up, because it’s all over.

    What about that tired old cliche about buggy whips and “the transportation business”? I’m sure you’ve heard it and perhaps repeated it on occasion. All companies evolve their businesses to meet the needs of their customers and markets. This is the job of management. Some succeed, some fail.

    Pete

    Comment by Pete — January 31, 2010 @ 2:51 pm

  9. Hi Eric,

    Great post! “John” makes some good points, although he glossed over two important factors…

    First, there is a huge reason why tech firms don’t pay dividends: their employees have stock options. Unfortunately, although dividends paid to shareholders lower the share price, the strike price on employee options is not adjusted for the lower share price caused by dividend payments. Thus, paying dividends hurts the value of employee stock options, so tech firms that use options NEVER pay dividends.

    Second, in terms of returning retained earnings to investors, there is no difference between a company paying dividends and a company repurchasing shares (assuming the shares are fairly valued). Happily, though, when a company repurchases shares, it doesn’t affect the strike price of stock options. Thus, tech firms don’t pay dividends and they repurchase shares instead. So in addition to the “dividend yield”, John also needs to add in all the capital that Microsoft spent on share repurchases, which was $47.7B in the fiscal year ending in June 2009 (http://www.microsoft.com/msft/reports/ar09/10k_fr_fin.html). That ain’t nothing.

    As an aside, Microsoft started paying dividends only after switching from using employee stock options to using restricted stock (the value of which isn’t affected by dividend payments).

    Anyway, these points aside, I take John’s main point, which is that more tech firms should do more to return retained earnings to shareholders.

    -Bob

    Comment by Bob Hiler — January 31, 2010 @ 3:41 pm

    • Bob – great point. I didn’t think of that but I’m not a professional public investor. Can I short “John”‘s hedge fund?

      Comment by cdixon — January 31, 2010 @ 3:53 pm

      • Ah, don’t take it out on John (that is actually his name). His fund does great, he just doesn’t bother with tech. He’s an income-oriented investor, thus his frustration with what he views as the value-destructive empire-building that goes on inside tech companies.

        Comment by fiveyearstoolate — January 31, 2010 @ 4:07 pm

    • Bob – appreciate the great comment.

      Take your point on share repurchases. The interplay between share price and option strike is important. I guess the only counter is that the market can choose to reward or punish companies for doing that. In some sense you have the worst of both worlds here – you have toglivie’s comment above that a company that shows it has no better use for its cash than dividends (or share repurchases) will get punished by the market but you don’t actually have cash going to shareholders. So a company that uses its cash for repurchases may or may not get the linear improvement in share price the math would normally suggest. You might just get multiple compression. To wit, MSFT trades today and about where it did in mid-2008 despite the enormous decrease in outstanding shares you cite.

      Comment by fiveyearstoolate — January 31, 2010 @ 4:06 pm

      • According to finance theory, a company that uses its cash for share repurchases will have an unchanged stock price, unless the stock is over(under)valued by the market in which case the stock price will go down(up).

        In any case, if a management team commits to a large share repurchase, it can be a very strong positive signal to shareholders. Consider a company that everybody thinks will “waste” 100% of its billion dollars of cash on dumb things. Thus, the market will value its cash as worth $0. Now, assume the management team commits to a huge share buyback. That billion dollars is now worth a billion dollars, instead of zero. Thus, the stock price will increase.

        Comment by Bob Hiler — January 31, 2010 @ 4:27 pm

      • Bob – of course, in Chicagoschoolworld you’d have an efficiently-priced stock that includes cash, so exchanging cash for shares would have no effect. But I don’t think we live in that world. I think the signals sent in both directions by these decisions tend to dominate the system.

        Of course the other footnote is that historically share repurchases were tax-advantaged relative to dividends.

        Comment by fiveyearstoolate — January 31, 2010 @ 4:32 pm

      • I don’t think that Chicagoschoolworld assumes that cash is valued at 100%. I mean, if a company is intent on throwing away cash on valueless things, the market will efficiently price that cash as being worth 0%. In any case, I agree with you that a strong signal to return cash to shareholders can create value, particularly for companies that the market has previously assumed will do stupid things with retained earnings.

        Comment by Bob Hiler — January 31, 2010 @ 6:07 pm

      • Bob – I think we agree more than we disagree. You’re right that IF the market assumes management will waste the cash then it gets discounted, perhaps all the way to zero. But if we assume the market has that view of management, finance theory would suggest a shareholder action to remove management.

        Comment by fiveyearstoolate — January 31, 2010 @ 6:28 pm

  10. By that reasoning, Microsoft should not have built the xBox and probably not databases or server OSes or CRM either. After all, their historical expertise at the time was in consumer facing desktop apps and OSes like Office, Excel, Windows/DOS, etc. The enterprise server and database markets were dominated by IBM, Oracle, Siebel, Lotus Notes, and Sun to name a few. And Apple had no business entering portable music players since that was something controlled by someone else. And how can Google justify entering phones? And for that matter, how could Apple justify using shareholder capital to build the iPhone? If we Google shareholders wanted exposure to mobile, we could invest in Apple or RIMM to name just a few.

    Granted, no one likes it when corporate profits are invested at suboptimal or negative returns and I’m not against dividends as a use of capital but these judgments – on the allocation of capital – are very easy to make in retrospect but how do you do this looking forward, not backward? Should Google just dividend out all their profits instead of investing in non-search related activities like a Mobile OS? And where do you draw the line on what benefits search? Can that stretch all the way to building a desktop OS?

    Clearly Microsoft’s results in search and MSN have been bad but for a company as big as they are, they have a surprisingly impressive ability to continue to win in large categories.

    Comment by Elie Seidman — January 31, 2010 @ 3:56 pm

  11. Thought provoking post Eric. The culture of leadership in tech today is one that focuses in on empire building. If you are a start-up, you want to build your company into the segment leader. If you are the segment leader, you want to expand your product reach and TAM, or expand into new areas altogether. This culture can be found in other sectors such as pharma and media. The boards of these companies hire and support the CEO’s with these interests in mind, so is it a concern with management, or a concern with the boards which shareholders elect? Also, the board is the check and balance which authorizes (explicitly or tacitly) management’s skunk works projects for years before they are released to market. As a director, assuming that growth is in fact a prime strategic objective, how does one know if their CEO is pitching the next iPod, iPhone, Android, or acquisition of SunPower, vs. being sold on the idea of the Zune, or acquisition of Skype or AOL?
    At the end of the day, there first has to be a culture change at the board level before there is a culture change at the management level. At the moment, you have empire building managers recruiting empire building oriented new directors to take board seats, so it is a self reinforcing dynamic. In all likelihood, those looking for material dividend yields in the near/mid-term will have to look for opportunities in other sectors.

    Comment by Dylan — January 31, 2010 @ 4:53 pm

  12. I propose a different way to look at things: there is not one Microsoft but several unrelated businesses. The shares of individual businesses are owned by a mutual fund caller Microsoft Corp. and they are not available for sale on the open market. The mutual fund collects profits from its businesses and decides what to do with those profits, including investing into new businesses – just like any other mutual fund.

    The mutual fund absolves its own investors from the need to actually supervise businesses, thus investors can take on a more passive role which is exactly what they want to do. John of course wouldn’t like that – he is a fund manager himself and he would prefer precision and control rather than delegate the management responsibility to someone else. The crux of John’s problem is that he can’t invest into individual businesses because they are privately owned – some other fund manager (Steve Balmer) has snatched the lucrative businesses before him.

    Comment by Denis — January 31, 2010 @ 4:58 pm

    • Denis – I think what you write is descriptively accurate but I’m not sure it represents good corporate governance. What you describe looks a lot look Berkshire Hathaway – an investment in an operating company that’s really a managed fund. But do people really invest in Microsoft hoping to get this type of exposure? This sounds a lot like the conglomerates of the 60s and 70s, and most agree that it didn’t work very well.

      But I agree that your comment reflects what is actually happening inside of a company like Microsoft. I’d just argue that this isn’t investor-friendly unless (as with Buffett and Berkshire) there is an explicit understanding that one is investing in an investing organization, something I think is certainly not communicated effectively by Microsoft or most other tech companies.

      Comment by fiveyearstoolate — January 31, 2010 @ 5:01 pm

  13. I echo everyone’s compliments on the great post. Amazing that Microsoft takes such a beating in these halls. I wanted to mention that coming of age during the original internet boom, and “learning the game” as some of these unbelievable (and ultimately ill-fated) IPO’s exploded in confluence with the boom in internet- and day-trading, it took me until college to figure out a) what a dividend was, and b) that it had been the norm at some point to distribute earnings this way. I always figured that buying low and selling high, and selling back shares and riding out splits, were the ways to make money off of the market.

    Comment by Tim — January 31, 2010 @ 6:37 pm

  14. [...] My Friend Who Hates Tech Last week I was at party held by my wife’s coworker. The coworker’s husband is a friend of mine who I usually see [...] [...]

    Pingback by Top Posts — WordPress.com — January 31, 2010 @ 8:30 pm

  15. If John wants dividends, just sell 8% (or whatever) of his holding every year. Assuming an 8% dividend would have decreased the share price by 8% anyway, he owns 92% as much of the company either way. And there’s a tax benefit since he only pays tax on the capital gain portion of the 8%, not the whole dividend.

    Comment by Peter — January 31, 2010 @ 8:33 pm

  16. See Warren Buffett & Peter Lynch on why companies shouldn’t pay dividends if they’re incorporated in the US until the tax law is changed. Dividends have a higher net tax load than share buy-backs. However, it’s true most CEOs go tilting at windmills, buying other companies they don’t understand and can’t use or that are outright rotten. Too often you get a Novell or AOL-Time Warner when what you wanted was an IBM or Apple.

    Comment by Ugly American — February 1, 2010 @ 2:24 am

  17. I can’t see that it makes any sense to “invest” in tech companies (although trading may work if you assume that other people are irrational). Eventually every tech company will go to zero. In the meantime, it’s unlikely to return any money to shareholders, whether by dividends or share buybacks. The conclusion is that the money invested is ultimately lost.

    Comment by Richard — February 1, 2010 @ 6:17 am

  18. Please you can help me to get a Job!

    Comment by kamilihsan — February 1, 2010 @ 8:58 am

  19. As the anonymous “John” Eric references here I thought I would chime in. First, Eric you are not only a great writer but apparently a fantastic listener to my party ramblings.

    Re: commenters who say that the rational strategy is to buy in the IPO during the growth phase and sell prior to dividend maturity. My point to Eric was not a trading strategy – certainly the real-world investor must obey short-term laws of momentum and nobody but Buffett has the total luxury of always taking the infinite time horizon. But consider for a moment that in theory the price of a financial asset should be its lifetime discounted cash flow returns even if your holding period is a mere fraction of that lifetime. A given technology firm in a period of rapid growth gets a high IPO valuation based on the theoretical expectation that at some point some of the profits from that growth will be returned to the investor in the form of either dividends or an acquisition. Thats it. Even share repurchases only pay for the investor in the discounted expectations that they are eventually (hopefully) accretive to a dividend stream or acquisition value per remaining share. To the extent that the lifecycle of a given company is to create a fantastic product and make tremendous profits but eventually wither and die without ever having paid out a dime in dividends or retaining significant value as an acquisition target its “true” value at time of IPO is zero irregardless of its present growth prospects.

    I’ll also add that I don’t think the ideal solution here is for technology companies to emulate regulated utilities and become steady period dividend payers over decades. Rather, I question whether the current corporate finance paradigm of the firm really fits the technology industry. As a technology investor I would rather have the option in many cases to invest into a specific project or technology rather than a firm — i.e., invest into the IP of a specific processor line rather than Intel. So few technology firms (although they do exist) seem to create franchise value independent of their sum-of-the-parts IP portfolio. The 19th century model of an infinite life equity funded corporate firm just doesn’t seem to appropriately fit the realities of technology or the tech industry. I believe not only would investors be better served but innovation would be multiplied if financial structures were more aligned with the temporary network/IP based model.

    Happy to see my ramblings to Eric spawned so much interesting conversation here.

    Best,
    J

    Comment by John — February 1, 2010 @ 11:02 am

  20. lots of great conversation here… I enjoyed the post Eric.. see you in a few months.

    Punit

    Comment by Punit — February 2, 2010 @ 7:22 pm


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