The Knowledge Economy Cash Anomaly: Part 1

This is part 1 in a three part series about why technology companies hold so much cash on their balance sheets.  Here are Part 2 and Part 3.

The academics disclaim knowledge of a definitive answer as to why companies in the knowledge economy hoard a such a disproportionate amount of cash.   The problem is that the chart below has two branches where our classical understanding would only expect one.

Robotics (Blue) is firmly in the knowledge economy, using very few real assets, but a disproportionate amount of financial assets, to finance the company.

Robotics (Blue) is firmly in the knowledge economy, using very few real assets, but a disproportionate amount of financial assets on the company’s balance sheet–just like software companies.

The Expectation

The companies that form a cluster heading up close to the Y-axis are the traditional economy companies.  They are everything from utilities to content companies to retailers–some of them quite high-tech.  Basically, they have the real assets that they need to their business and a little bit of cash and securities to get them through the shocks of the next couple of months.

This is what financial economists expect companies to look like:  orderly, well managed institutions that collect cash from operations and distribute the operating profits out to shareholders and debt holders.  Since these companies have access to relatively liquid and efficient capital markets, they have no need to hold onto cash.  Good investment projects can simply be financed through issuing new securities or retaining more future earnings.

Tech Companies

Robotics companies and tech companies on the other hand horde massive amounts of cash–spreading out along the X-axis in the chart above.  Many of these companies, already profitable, could forego revenues for over a year.  And, oddly enough, the most profitable and most successful of these companies hold the most financial assets.  Nobody quite understands why companies do this.  The previous discussion, Is a Dollar Worth a Dollar on a Tech Company’s Balance Sheet?, reviewed some of the arguments for and against the value of cash on a company’s balance sheet.

Holding Cash Is Usually Bad

Most investors feel that excess cash in the company is a temptation to value destroying misadventures by management.  Particularly if management has incentives to grow gross profit, management can grow gross profit by deploying the company’s cash in less than profitable ways.  The classic example of this overpriced acquisitions.  Say you were the CEO of HP and you wanted to grow profits.  You might have heard about this company called Autonomy.   So you decide to buy it at market price plus a huge control premium.  Your profits go up, because you have HP + Autonomy’s profits together.  You get a bonus.  But your shareholders get hosed.

If the shareholders wanted to buy Autonomy, they could have owned it without paying the control premium.  Unless these so-called synergies show-up (and synergies are what go up the banker’s chimney after Santa Claus comes down–see I learned something in business school),  there is no reason to pay the control premium.   The control premium just gets pocketed by the previous owners and the bankers with all that value lost to the shareholders of the acquirer–those are your shareholders.

Conversely, if the company disgorges the cash, and you and your management team go to the market to raise new debt or equity to finance the purchase of Autonomy, Instagram, or any of another thousand bad acquisitions–the financial market has a chance to tell you that this is a really bad idea.  But if it is a good acquisition, the market will easily provide you with the money.  So all in all, investors tend to discount cash on the balance sheet and reward paying it out where they can reinvest it.  So why would companies hold all this cash?

Concentrated Ownership

Many tech companies are owned or controlled largely by single individuals or small groups.  The company represents a substantial portion–if not substantially all–of the wealth of the these founders.  Since they control the company, they are willing to take steps to decrease the risk to the company that are not economically maximal to diversified shareholders.

Consider this hypothetical:  Google and Apple are locked in winner take all product war for a small market that is worth $2Bn in market capitalization to Google now, but will go entirely to Apple in year unless Google spends $3Bn.  If all of your wealth is in Google and you couldn’t easilty get it out, you might be willing to have Google spend $3Bn to save $2Bn in wealth.  Your loss is now $1Bn instead of $2Bn.  However, if you are a diversified investor and own both Google and Apple, you want Google to let the business go and refund you the $3Bn.  You still have your share of the $2Bn in your portfolio and the chance to invest your share of the $3Bn somewhere else to earn a return.

Founder Payout Diversified Common Shareholder Payout
Spend money to protect Failing Business -1 -1
Do Not Spend Money to Protect Failing Business and Payout Cash -2 +3Bn

Less sinister, the company may just be conducting tax free diversification on behalf of the founder.  The effective corporate tax rate is below the individual tax rate, especially on capital gains.  While this is tax efficient for a founder, it may not be tax efficient for other investors.  The harm is probably not as stark as the example above, but it does raise the question about who the firm is being run for and rubs our Anglo-Saxon sensibilities about the primacy of the shareholders the wrong way.

Defense

The story here is that only Apple or Microsoft would ever even think about entering search knowing that Google has the largest market share, the best technology, and is sitting on $45Bn in cash.  If you want to take search from Google, you are playing a long game and an extremely expensive game.  It will fight hard and it has the resources to do this.  Potential competition is scared off, increasing the ability of the company to earn rents in on its primary operations.   While closely related to concentrated ownership story, this is actually favorable to the common shareholder if this is true.   Services like Siri, Wolfram Alpha, and IBM’s Watson cast some doubt on this story, but perhaps at least in the example of general consumer search it is mostly true.

The defensive effect need not be 100% effective to be worthwhile.  This effect is an extra return on the cash that shows up in operations, not financing, because of accounting rules.   Additionally, the company always has the cash, so there is option value.  In our example, if Bing every really started to rule search, Google could decide not to fight, and either sell or wind down search operations.  They still  have $45Bn to distribute even if the value of operations falls to zero, but the option to fight is inherently valuable.  With the cash to execute this option, it becomes more valuable, or credible.

to be continued…   Next up, option value of IP and distress costs

Jump to Part 2

If robotics aren’t inherently capital intensive, does management in robotics just suck? Yes. Here’s why…

Image: Fairchild Semiconductor Successor Companies
Source: Steve Blank’s Testimony to House Science Committee

I was harassing my asset management friends to get them to help me develop the synthetic short instrument I want to put into the robotic stock tracker and we started discussing capital use in robotics.    Their question, was, “Okay,  if robotics are not inherently capital intensive, why does it take more money to get a robotics company up and running?  Isn’t that initial expense an inherent characteristic of the robotics industry?”

In a word, no.  The fundamental problem with robotics companies is that management doesn’t have a well developed process for synchronizing customer and product development to use Steve Blank’s terminology.  Or put another way, a lot of robotics companies spend a fortune on unnecessary engineering when they frankly suck at discovering what customers want.  iRobot has a whole museum dedicated to their market failures.  I contend that much of this engineering effort is not necessary to development of viable robotic businesses–this same learning could be done with vastly less expense.

Much of this problem comes from the difficulty of porting over rapid-cycle software development best practices for discovery of true customer needs.  Most of our hardware development methodology comes from environments where customer needs are relatively well understood and engineering improvements require a lot of time.  Robotics companies still have engineering cycle times (the amount of time to go through the engineering build, test, analyze, decide cycle) that are much longer than pure software companies at least 3 times longer and often much more as best as I can estimate from anecdotal evidence.  Companies are very reluctant to reveal this information, so my estimate may be off by several factors, but it is clearly much longer for robotics companies.

I believe that we in the robotics industry need to tailor the customer and product development methodologies to the peculiar challenges of robotics.  We will need to reduce cycle times of engineering teams down closer to software levels.  3D printing and continuing improvements in supply chain should make this feasible.  Management should make it a priority and a reality, and be willing to incur some expenses to do so.  Even more, management needs to do a lot of work to reduce market risk much earlier in the product development cycle.

iRobot’s museum show that it is proceeding to engineering while far too much of what is required to make a viable commercial product remains unknown.  This isn’t to pick on iRobot, they may be among the  best in the industry, but it is just to show that even the most advanced practitioners in our industry are not very good at understanding customers compared to other industries.  Yes, for some customers, such as the government, just doing research can be a viable business model, but this won’t grow the industry.  We need to develop ways to reduce market risk and we need to get good enough that we’re showing the software industry how they could learn about customers more and code less.

I don’t propose to give a complete answer on how to do this here, but it is clear that there is more than one path to reduce market risk in a product.  Both Intuitive Surgical and Liquid Robotics seem to have taken the approach of building a robot that is so awesome and widely applicable that it will find a use even if it isn’t in the application that management originally intended.  Other robotics companies, like Kiva Systems and RedZone (since Eric Close took over), seem to have taken a more traditional minimally viable product approach and iterated upon the original product.  Both strategies appear to win in certain circumstances and companies that took the opposite approach in the same markets failed.   How do we distinguish which set of market and technical circumstances we find ourselves in?

This interplay between technical and market risk and how it applies to robotics management is only beginning to be understood.  Few people have proposed measurable distinctions that would allow management to make decisions about what risks to accept and what risks to mitigate before committing capital to a project.  This area of research more than any other will unlock the potential for robotics to become the next tech boom.

Is a dollar worth a dollar on a tech company’s balance sheet?

Previously, dear reader, you and I have discovered that robotics companies are firmly entrenched in the knowledge economy and their assets look like other knowledge economy companies’s assets.  Robotics companies only hold only a limited amount of real assets but lots of financial assets.

As a related question, what is the value of the cash (and financial assets) on the balance sheet to investors?  There might be several issues with holding so much cash.  Particularly, money in a company should be employed making more money, ‘earning or returning’ as the saying goes.   Are there valid reasons to hold so much cash?  And if so, how should we value the cash that knowledge economy companies hold?

Cash Is King! (Or at least a founding father)

Bottom line up-front:  Valuations are always wrong.  What’s interesting is how they are wrong.  Assuming a dollar is worth a dollar is as good a rule as any, but is almost always wrong.  Nobody is really sure which way (too much or too little) it is wrong.  Below, is an elaboration of some of the issues with valuing cash which may come into play when valuing particular companies.  (And you thought that at least cash of all things had a fixed value  —  don’t we all wish!)

There are various criticisms of excess cash on the balance sheet, below are some of the most common.

1)  Holding the extra cash reduces returns, i.e. to buy into the business you have to buy a pile of cash beyond what is ‘necessary’ to run the business.  Further, the rate of return on cash has been essentially zero and certainly below inflation lately, so holding the portfolio the stock represents of a highly profitable business, plus cash must necessarily produce a lower expected return than just the business.

2)  Because of agency problems, management may be incentivized to use the cash to reduce volatility or ‘save’ the business if it falls on hard times, even if the investors could get a markedly higher rate of return in the market.  From an investor’s point of view this would be systematically wasting money.  Employees, customers, management, and trading partners might have a very different view.

3)  Holding lots of cash is said to signal that the company does not have profitable investment opportunities commensurate with the cash that it is generating and the company’s growth may slow in the future.  Further, holding lots of cash signals that you don’t know, or are ignoring, the traditional Anglo-Saxon business administration.  English speaking investors generally expect management to maximize monetary returns over the forecasting horizon and put shareholder interests ahead of all others.

Some countervailing points that you will often hear are along the following lines. 

A)  Although holding cash reduces returns, for a volatile security like a fast growing knowledge economy company, having cash on the balance sheet dramatically reduces volatility.  If investors want more exposure to the underlying business for the same initial investment, lever-up.  Since we are talking about cash holdings, buying on margin is almost a perfect antidote to management’s lackadaisical cash management policies if you feel that way.  [But seriously, who is their right mind thinks you need to lever-up when buying tech stocks?]

B)  Although management might ‘burn’ cash saving a failing business, which would be better redistributed to investors, more likely, they are going to have the flexibility to engage in acquisitions and new ventures without having to deal with the whims of the security markets.  [Has anyone seen a rational market lately?  Please let me know.]

Or has anyone read the Wall Street Journal?  Tech companies are routinely attacked for having their fixed life fund investors exit—Groupon and Facebook each got front page hatchet jobs over the past two days with nary a mention that these funds had been planning to sell now for, oh say, 8-10 years!  Talk about journalistic malpractice.  Would you want to go to the public markets in that environment?  I sure wouldn’t.  If I was management, I’d say that if investors are that irrational, I’ll keep the cash and do what they should have done with the money.

C)  Finally, although cash on hand may sometimes signal that the companies are running out of investment opportunities, it certainly signals to would be competitors that the said company is in a position to stick around for a long time and bitterly contest any erosion of their market position.  This may greatly enhance the value of the underlying business asset.

D)  This is a successful tech company.  It is run by the founders, for the founders (i.e. management).  If you don’t want the privilege of investing and taking whatever returns the founders deign to give, please step aside and allow the next investor to purchase stock.  But this isn’t really a justification.  Founders are investors too, especially once the company goes public, with theoretically the same motivations as other investors since their stake is highly liquid.

Further research on technology companies and their cash management policies should address the following issues:

I)     Are there structural reasons beyond the creation of new businesses and defense of existing businesses for technology/knowledge companies to hold lots of cash?  It does not occur to me that there is anything about a maturing knowledge business that seems to require massive amounts of cash.  Law firms and accounting firms do not seem to hold too much cash, but they are also typically private and can make much more drastic changes than public companies.

II)   Are there frictions between the interests of various classes of investors?  Particularly when there is a founder controlled/managed company, cash on the balance sheet is probably as good to them from a control perspective as cash in the bank and better from a tax perspective.  Should investment banks or others creating the classes of stock have new mechanisms to deal with this?

III)  What are the true limits on investment opportunities?  My firsthand observation has been that the greatest constraint on growth of robotics companies is management attention.  It may be that most technology companies have massively profitable investment opportunities, but management attention is engaged on current projects and hiring into the management circle is not that easy.  What is the needed resource to change this?  How can cash be used to obtain this resource?  Can it?  Is passion required?

IV)  Are there ways that management could resolve some of the market frictions that require them to hold lots of cash?  The public markets seem to mercilessly abuse tech companies—no they don’t look like utilities, but the highs and lows that they are pushed to seems unjustified—there just doesn’t seem to be enough new information about their future prospects to justify either one.  Can management take steps to make access to public markets, particularly debt markets more reliable?  Could banks make money by providing massive, typically undrawn, lines of credit that would provide much of the same protections to management?

Which VCs are investing in robotics? Here is the list.

the instrument of venture investment

source: SEC.gov

My overview of the Firms Behind the Hizook 2011 VC in Robotic List has graciously been published at Hizook.

Bottom line:  We don’t have a cadre of dedicated robotics investors, but we can get investment from the industries that serve as our customers.

I wish you all luck in getting some of that VC Cash.  …on second thought, no, actually, I don’t–I  wish you all luck in signing up major partners who will give you progress payments to complete your product without diluting your investment.

But whatever your situation I hope that you use the appropriate capital structure to make lots of robots, lots money, and lots of good in the world.

Robotics capital intensive?! What are you smoking? Don’t believe it.

Robotic manufacturing is not capital intensive, contrary to the popular wisdom.  (Looking at you HBS.)

Unless someone can bring data to the contrary, we should treat this issue as thoroughly decided against the  conventional wisdom.  As we saw previously, robotics companies do not need a lot of fixed assets.  Now, we will see why people who blithely repeat the conventional wisdom that robotics companies are capital intensive are wrong–even if they claim robotics companies are hiding their true use of capital.

First off, robotics companies’ balance sheets look like technology companies’–the internet kind, not the aerospace/industrial kind.  Robotics companies have lots of cash and relatively little else.

Second, robotics companies have gross margins that even companies that don’t make stuff would envy.  The robotics gross margin would probably be even higher if iRobot and Aerovironment were not defense contractors.   There is a lot of pressure to bury as much expense as allowed into the cost of goods due to defense contract rules.   Intuitive and Cognex’s margins are around 75%.  They are even beating Google on gross margin!

Although, it does appear that robotics companies have a bit longer cash conversion cycle than the basket chosen for comparison here, their cash cycle appears to be in line with other complex manufacturers.  Plus, the robotics companies are holding so much cash their management may just not really care to push the conversion cycle down.

Look at the cash required to sell aircraft though!  Manned or unmanned it looks like it takes forever to get paid for making planes.

Although robotics companies have physical products, the value of a robot is in the knowledge and information used to create it and operate it.  The materials are nothing special.  Consequently, these companies look like part of the knowledge economy–few real assets, lots of cash, and huge attention to their workforce.   Next time someone tells you robotics companies are capital intensive, ask them to share what they’re smoking–it’s probably the good stuff–because they aren’t using data.

One thing that a venture capitalist may mean when he says that robotics is capital intensive is that it generally takes a long time and lots of money to develop a viable product in robotics.  This may be true, but it is not really the same thing as being capital intensive.   This observation should cause a lot of soul-searching within our industry.  What the venture capitalist is telling us is that we–as an industry–cannot reliably manage our engineering, product development, and business structures to produce financial results.

This is why the conventional wisdom is dangerous.  It suggests that the lack of investors, money, and talent flowing into our industry isn’t our fault and there’s not much we can do about it.  That is what needs to change in robotics.  We need to get better at management.  We need to start building companies quicker and producing returns for our investors.  If we do that the money, talent, and creativity will start pouring into industry.  Then robotics can change the world.

Notes on Data and Method
Data Source: Last 10-k

Method:

Accounts Receivable = All balance sheet accounts that seem to be related to a past sale and future cash, so accounts receivable plus things like LinkedIn’s deferred commissions.

Cash + Investments = All balance sheets I could identify as being financial investments not required to operate.   Assume all companies require zero cash to operate.

Did not account for advances in cash conversion cycle.

U.S. Robotic Stocks: Speculators Wanted (the real kind, not the financial kind)

The first part of the robotic stock tracker is up.  The index is coming!

First observation:  It is amazing how volatile robotic stocks are and how much idiosyncratic behavior each stock has exhibited since the start of the year.   With this much volatility, one would expect robotic stocks to produce market beating performance over the long run, but they certainly haven’t done it so far this year.  In the short run, it is very difficult to value real assets that have uncertain financial prospects.  In the long run, I’m banking on an extremely bright future, powered by robots.

Hizook 2011 Notes

Be on the look out for a forthcoming analysis of the Hizook 2011 VC in Robotic List on Hizook about the funds that invest in robotics.   I’m publishing my research notes here so they don’t foul up the article.  Most of this was sourced from company websites, CrunchBase, local media, or whatever I could find using Google with my limited attention span, I think I even remembered to cite a few as I was making this.

The only thing I’d really like to call your attention to, dear reader, is the complete lack of transparency in the private markets.  You’ll see that there are places I could find a round, or an amount, or fund but nothing else.  A lot of the poor citation is me trying to find a better source.  Private transactions have no organized data so if this can be the faintest candle for finding funding for robotics, then I’ve done my job.

As always, I’d love feedback.  I’m hungry for data!