The Knowledge Economy Cash Anomaly, Part 2

This is a continuation of Part 1.

Option Value of Cash on the Balance Sheet

This theory of the cash anomaly posits that the returns from R&D are high, but also highly uncertain.  Every once and awhile, the R&D of a company will produce a really high value project that requires massive investment and possibly acquisitions to use in combination with the asset.  The problem with R&D as an economic asset is that it is very difficult to sell or even be exploited by organizations other than the organization that developed it.  Unlike discovering oil, it is not clear even after discovery of a project that another firm could develop the project to create economic returns.

Because exploitation relies on unique capabilities inside the firm that are only poorly understood outside the firm, their economic value is harder to forecast.  This violates the costless symmetric  information condition of efficient markets is violated, unlike the projects of old economy companies, where the market has a reasonable expectation that it will understand the value of the project.  This uncertainty introduces huge frictions if projects need to raise new capital. Therefore, if a company has R&D projects, the value of that project stream is greatly enhanced if the company also has a means of financing the projects that does not require subjecting those projects to the friction of market financing.  These frictions are both directly financial in the form of more returns to new investors and intermediaries, and also temporal.  In winner takes all markets, which many technology markets are, temporal costs are huge.

The option value of cash on the balance sheet could be huge, however, we would expect more tech companies to at least on occasion, expend all their cash and perhaps even borrowing capacity when they exercised options if this were the case.  This is common in growing technology companies.  Mature tech companies, rarely, if ever come close to expending their investment capacity.

I’m skeptical of this explanation.  Why does Google need to hold enough cash to buy Yahoo or Facebook in cash, if they are never exercise the option to do so?  When was the last time you heard that a company was undertaking a project with more than a billion dollars of expenditures in year one of the project?  These kinds of companies can make acquisitions with stock, invest over time out of future cash flows, and they even have relatively low cost borrowing capacity should it be required.

Cash Poor at Home

Recently, much has been made of the U.S. companies that are parking cash overseas to avoid the tax when they repatriate it.  Many companies are cash poor in their U.S. entity, but their consolidated balance sheet shows a lot of cash.  This cash can’t be repatriated for distribution without a large tax bill.  This is the worst of all possible worlds from a policy perspective, but it doesn’t seem to afflict tech companies as much as industrial conglomerates.

(BTW, Congress doesn’t need to capitulate to corporate demands for no tax on foreign earnings.  All it has to do charge the companies income tax on their cost of capital for any overseas investments, then true up when the companies bring cash home.  Particularly if the law slightly over estimated the cost of capital, or ignored the cost of capital on financial assets in the WACC calculation, so that repatriating funds usually triggered a small refund rather than a small bill, you could just sit back and relax and watch them all bring their cash home while still paying tax.)

Distress Costs

The final explanation I’ve heard offered is the idea that since most of the investments of a technology company are in workforce and R&D, the costs of financial distress are huge.  Not only that, but the costs of financial distress can manifest themselves long before bankruptcy is close.  If managers are cutting benefits or tightening R&D activites, and the costs are not properly captured by accounting frameworks.  New talent goes elsewhere, the best old talent leaves, R&D becomes less creative, less real economic capital employed stealthily decreases without the accountants noticing.  However, CFOs are smart, they know this–even if the accountants don’t.  They keep cash on the balance sheet, employee benefits generous, and 10% time meaningful.  This prevents the stealthy erosion of the real assets of the company, by the prospect of distress, which the intelligent and savvy workforce is acutely aware of even if they don’t conduct formal analysis.

But there is one more reason…

In part 3, I will outline how holding cash creates economic value, regardless of and in addition to, all these explanations.  Go to Part 3.

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.