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.