I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Thursday, April 30, 2020

Conserve or Invest?

Both the financial and real economies have suffered quite a few shocks in the last 20 years: the dot-com bubble bursting (2000); September 11 (2001); the Great Recession (2008); and today in 2020 the COVID-19 crisis is wreaking economic havoc. The crises have come with such frequency that executives leading companies impaired by the crisis already know the playbook: suspend the dividend, cancel any non-critical cash investments, negotiate with banks and bondholders to avoid defaults, pressure holders of hybrid securities to convert debt to equity, and progressively retrench business operations to reduced stages of life support. Uncertainty renders standard long-term planning inert, and by extension renders existing long-term plans superfluous since they were based on stable-state economic conditions of the normal credit / economic cycle. No company forecast the economy falling off a cliff in Q1 2020, so all bets are off.

But all bets are not off.

The thing about any crisis is that there's an expectation that there will eventually be a recovery, no matter long it takes to reach bottom and regardless the shape the recovery takes: V-shaped rebound as happened in in 1953, W-shaped as in 1981-82, U-shaped as in 1973-75 and again in 2000-03, or L-shaped as in 2008-2010. It might take some time and it might be a bumpy ride, but recovery will eventually come: free people in free markets are crowdsourcing at its very best.

Of course, in the midst of a crisis, there are no models that forecast economic performance to any useful degree of certainty. Making matters worse, conflicting and often erroneous real-time data leads to false optimism or false pessimism. The day-to-day nature of crisis management inevitably comes down to a focus on the two variables that affect the pattern of macroeconomic recovery: how bad, and how long? The more severe the contraction and the longer it lasts, the more people are out of work and the longer they are out of work. The longer that people are out of work, the greater the erosion to household savings and the greater the erosion of labor skills and subsequently the salary that labor can command once the job market recovers. This creates structural repression of demand. The longer it takes for demand to recover, the softer the labor market; soft labor demand twined with skill erosion means it takes longer for real wages - and therefore inflation, and with it standard of living - to recover. Tactical planning is informed by this negative feedback loop while a crisis is unfolding. To wit: the longer people are out of work, the fewer F150s are going to be driven off dealer lots once people feel recovery is at hand, the longer it will take for suppliers to Ford for the F150 to see a bounce in their business.

Regardless how bad it gets, there is a candle of hope perpetually burning in the expectation is that free human societies are resilient and will respond and innovate in the face of challenge and will ultimately be more productive and more effective on the other side. Recessions come and recessions go and yet despite the privations they bring, humanity has never had it so good. Thank you, economies that are not centrally planned.

Unfortunately, you can't take hope to the bank. In a crisis, everybody from heads of companies to heads of households conserve cash. Yet leaders have opportunities to be opportunistic buyers at prices they won't be able to get later. This is the challenge facing leaders during a crisis: balancing cash burn against an optimal state of the business to ride the recovery wave, whatever form recovery might take. For example, a company may have idle staff today because customers have suspended contracts, but paying for idle staff is a call option on rapid demand recovery and an insurance policy against loss of knowledge and capability. As CEO, you are making sure to signal your stakeholders that you are protecting investors and operations alike. But protecting operations is by definition an investment: if you're paying for idle labor, you're making a bet that preserving capacity will pay off sooner rather than later. And you're using that argument to fend off investors who are saber rattling for the cash on your balance sheet today, by arguing that paying them jeopardizes the sustainability of those cash flows tomorrow.

Another thing about crises is that recovery isn't uniform. The tech economy suffered greatly in the wake of the dot-com bubble bursting in 2000. In the years leading up to 2000, there was aggressive spend on technology: insulation against fears of the Y2K bug (legacy software and hardware with time functions that wouldn't properly roll over to 01/01/2000) as well as development of new business and consumer technology to exploit what was then nascent internet technology. Yet too many of those newfangled dot-com businesses had no real business plans, just naive enthusiastic capital propping them up. When the credit cycle turned in Q1 2000, non-cash-generative-tech-companies were exposed, plunging the tech economy into secular recession. Meanwhile, the emergence of internet technology had availed a skilled global workforce to deep-pocketed corporate IT buyers in Europe and the United States. So Y2K spend ends, dot-com spend ends, a less expensive workforce enters the labor market in massive numbers, all at about the same time. IT companies domiciled outside of the US boomed, the broader US economy hiccuped, and it was a bad time to be a US based software developer looking for work.

It was much different in 2008. The economy fell off a cliff with the Lehman filing in September 2008. Everything cratered, including tech, as banks - which had employed large numbers of tech people - laid them off. Yet while initially pro-cyclical, the tech economy was counter-cyclical by Q2 2009: that is, while the financial and real economies floundered, the tech economy was in full recovery before the first half of 2009 was over. Industrial firms that had laid off aggressively in the wake of the 2008 financial crisis needed to lock-in productivity gains for their reduced staff. Just a year earlier, Apple had introduced the iPhone 3G, which revolutionized smartphone technology and ushered in a new age of computing. Social media was just coming into its own. Tech became a hotbed of investment because tech was a source of opportunity. Demand for tech solutions and particularly demand for tech labor grew very quickly. Tech labor costs rose at a rate far above inflation. Non-tech companies had no real economy inflation to derive pricing power from, yet were forced to import tech economy inflation onto their income statements if they were to engage in meaningful tech investments.

In the current crisis, technology is playing an outsized role in enabling companies to operate under massively distributed conditions. While tech firms are not necessarily profiting wildly - usage of advertising-subsidized services is up but their advertising revenues are down, and there are more users of video conference software than there are paying licensees - usage of technology services, particularly collaboration infrastructure, has skyrocketed. Yes, we've seen that movie many times before in tech, and usage has a nasty habit of not converting into sustainable revenue. But as I've written before, tech doesn't lead disruption, socio-economic change does, and there's good reason to believe that there is lasting socio-economic change being established now ranging from consumer habits (e.g., retail square footage doesn't look like a good investment) to organizational dynamics (office square footage doesn't look like a good investment). If that change is durable, and tech is the enabling factor, then demand for tech - and by extension tech labor - will increase dramatically.

This is the leadership challenge of the current climate: cash flow from operations is down and investors are increasingly nervous, but the period during the crisis presents a prime opportunity to buy, especially if the economics of a tech investment are likely to invert post-crisis as labor prices rise.

To conserve or invest? It's a multivariate problem, and not an easy one. Here are some criteria to consider.

  1. Opportunity fundamentals I: robustness. To what degree is an investment deemed highly beneficial or essential in many-most-all forward looking economic models? A modernization or replatforming of core business operations is worth pursuing if it eliminates barriers to scale and labor intensity of operations such that the business scales down economically just as fluidly as it scales up. Such an investment makes the business more robust to volatile conditions and permanently changed conditions alike, and is worth pursuing.
  2. Opportunity fundamentals II: competitive threat. How easy is it for deep-pocketed competitors to use this time to enter into your space, how low are the switching costs for your customers, and what makes your current business vulnerable to the threat of a new entrant? An investment designed to make the business more resilient to future competition deemed highly probable is an investment worth making.
  3. Opportunity fundamentals III: speculative. To what degree is an investment dependent on criteria that were speculative pre-crisis only to be in gimbal lock today? For example, repackaging existing capabilities to pursue adjacent markets with which you have little familiarity is speculative use of capital. Pre-crisis, cheap capital could be lured to back a modest investment in a hypothesis supported by little intimate knowledge and thin data, as the potential payday of tapping into an adjacent market was worth the capital outlay. During a crisis, a hypothesis outside of your core business is just wishful thinking because you have little connection to those markets and therefore little appreciation for how the very fundamentals of that industry are changing in real time. With market instability and without context, these are not ideal circumstances for the shallow-pocketed novice to become a master.
  4. Asymmetric economics: to what extent is the investment dependent on labor that will become more expensive post-crisis? Few skill sets command premium wage during times of acute recession, but once the worst is over, some quickly appreciate in value due to demand outstripping supply, as happened a dozen years ago. Is the investment opportunity dependent on full-stack engineers? This is a great time to lock them in. Is it dependent on commodity ABAP developers? There is nothing to indicate that post-crisis their market rate will rise above pre-crisis levels, so there is little threat of economic inversion.
  5. Refocus: pre-crisis, it was plausible in many industries to plot strategies that balanced the status quo against a digital future. To wit: purely digital competitors don't suffer the economic burden of physical points-of-presence, but omni-channel experiences can transform physical presences into an experience that digital-only competitors can't match. Clearly, those physical locations and the labor that staff them are of no economic value when customers aren't leaving their homes. This crisis has very likely accelerated the digital trend, permanently moving more commercial activity from physical channels to digital channels. That, in turn, means that wagers on strategies linked to historical forms of customer interaction were at best a distraction at the time they were made, and has rendered them utterly useless investments in the here and now. Today, bunkered-up business leaders who made dud bets should be using this time to plot alternative "new normals" of their industries, and what it will take to succeed. If consumer and business buying patterns will be forever altered, best to be quick to meet the market where it is going; those are investments worth pursuing. Anything else - i.e., waiting to resume a prior investment trajectory, expecting previous demand patterns will return to pre-crisis norms - is value destructive.
  6. Capital mix: the higher a company's debt (assuming it isn't convertible), the greater the extent to which its cash is pledged to debt service. Capital injection isn't an option as investors would immediately conclude that their new capital would be used solely to service old capital. Investment is wishful thinking when your business is highly-levered because debt isn't loss-absorbing capital, it's cash flow absorbing capital. Recapitalization that exchanges debt for equity is an alternative: in times of crisis it gives investors the ability to swap short positions that are increasingly valued at liquidation pricing for long positions that have calls on future - if distant future - cash flows.
  7. Balance sheet strength: how strong is your balance sheet to define the future of your industry? Debt capital will likely be cheap for some time following the crisis. If you expect to come out of the crisis with asset values intact and for operating cash flows to recover quickly, you can expect to be able to go to bond markets and raise a war chest to go on an acquisition or investment spree. The ability to do that gives you the scale necessary to project influence over the future shape of an industry through consolidation, combination of services, pricing power, and innovation. Use uncommitted cash for investments in innovation today (remember, you're suspending the dividend), and cheap post-crisis capital for acquisitions later.
  8. Income statement strength: The balance sheet might be heavily laden with debt service obligations, but the income statement, even though suffering, might still be something you can leverage. Monopolistic or oligopolistic incumbents may very well stand to benefit from being first port of call once crisis conditions relax. Rapidly improving income will enable an incumbent to invade or greenmail upstart competitors who are similarly suffering. Income statement strength allows the incumbent to engage the upstart on the terms of the incumbent.

Conventional wisdom deems that a plausible response to crisis is aggressively retrenching, hoarding cash, and waiting it out. Waiting for what? Economic parameters and commercial patterns on the other side won't return to what they were before, and they will likely start to look considerably different very quickly. A business can survive the crisis only to be completely unprepared for the change that has taken place. Conventional wisdom really does exist so that people aren't required to think.

Baron Rothschild is credited with having said "the time to buy is when there is blood in the streets." This is one of those times. But it isn't just the times, it's where you want your business to be after the times. Simply surviving the present leaves you no better prepared for the future. Now is the time to build a case - rather, a lot of little cases - that project your influence over what the future of your business is to be.