We're now four years into a bull market. Countless tech
companies have come of age during this long summer, and we know
them generally by their buzzwords: cloud, mobile, social media, big
data. They've grown quickly, as things usually do in favorable
weather. One day, though, a recession will come, and these
businesses will have to prove that they can survive the winter.
Two issues haunt them, and the first is a low return on investment.
Most of the technology firms that went public during this business
cycle remain unprofitable. Streaming audio has been a money-loser
), and streaming software has been unprofitable for
). Big data upstarts like
) are in the red, and social/mobile gaming giant
) has struggled to find profits. Of the current crop of tech
companies, the only ones that seem to enjoy healthy margins are
those that own infrastructure, and rent it out, like
(FB) does with advertisers, or
(RAX) does with cloud developers.
The industry has defended itself to investors, often successfully,
by arguing that losses feed growth. This may be true -- charity
usually finds a willing market -- but it doesn't tell us whether
these products can actually be sold for a profit. It's a bad sign
when new technologies require
(WDAY) to earn operating margins of -30%, while traditional
(ORCL) are pulling in +40%. If cloud software is a great
improvement, then growth shouldn't require such a steep discount.
Perhaps the problem is scale -- Workday is much smaller than Oracle
-- but then losses have risen in step with growth, and there's no
reason to expect large efficiencies of scale in a software company.
For investors, the problem is made worse by misleading earnings
reports. More than a decade after the dot-com bust, the tech
industry still prefers non-GAAP earnings. Cash flow statements
don't always show the actual damage; Pandora reported operating
cash flow of negative $2.3 million in the last quarter, when in
reality, it burned through $14 million. Income statements tend to
be overwhelmed by capital coming in and capital going out. By
watching net current and cash assets on the balance sheet, and
correcting for new stock and debt, capital expenditures and
acquisitions, we can arrive at a better idea of how the core
business is doing.
The picture isn't always pretty. Of the new kids on the block, most
sit in a core cash flow range of -12.6% to 2.5%. By reference,
Rackspace earns 25%, and Facebook earns 20%. Older firms like
(CSCO), Oracle, and
(VMW) also sit around 20-30%. There's a marked gap between the
haves and the have-nots, and it's not always explained by growth;
Facebook has expanded as fast as many of the enterprise cloud
companies, but still experienced healthy and rising margins. I have
no doubt that Marc Benioff, CEO of
(CRM), could offer compelling reasons for why his company is
different, and since he knows his business much better than I do, I
would have to take his word for it.
That makes me uncomfortable -- first of all, because trust is a
poor risk-management strategy. Additionally, his reasons may not
matter in a recession when margins are pushed down even further -
nor do we know how today's Web-based products will fare in the
event of a recession. They may be hypercyclical; their flexibility
might place them first on the chopping block, with clients
believing that they can quickly redeploy once the economy has
turned around. On the other hand, Salesforce's expenses are mostly
salaries, and these are not so easily or painlessly cut.
The second problem facing younger tech companies is a heavy
dependence on outside capital. Long after their IPOs, these firms
are still leaning on debt and stock markets. The three largest
cloud enterprise firms -- Salesforce, Workday, and NetSuite -- have
all issued debt in 2013 to the tune of $2 billion, or an amount
equal to revenue in the period.
(NFLX) and Pandora have also issued new debt, although in smaller
proportion. For companies in the enterprise space, stock dilution
is an even more serious issue. Many of them routinely issue shares
worth 20% of revenue. Stock compensation, employee investment
plans, and new issues all represent an infusion of cash into the
balance sheet, either directly or by lowering cash salaries.
Investors haven't objected, and since stock valuations are
currently so high, the dilution is modest. However, capital markets
are cyclical, and a time will probably come when employees don't
want to be paid in a declining stock, investors don't want to
tolerate further dilution, and bond markets don't want to buttress
an already bloated balance sheet. For some of these companies, a
freeze would basically eliminate their ability to finance new
investments. For others, it could potentially threaten the core
business. Many have generous cash positions, but a few ill-timed
acquisitions could leave any one of them naked in the cold.
Of course, winter might not come. Margins might spontaneously
improve, consumers might reprioritize their lives, the Fed might
have killed the business cycle, and everything might work out. Hope
is gratifying -- but it's not a strategy. Unfortunately, the
pursuit of growth at all costs has left today's tech companies with
little choice but to cross their fingers and pray for a mild
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