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.

Guess that’s not happening…

So I wonder how the EADS shareholders feel about taking a hit for a merger that never happened.  Oddly enough, it seems like the German government is actually looking out for shareholders in blocking the deal.  Most analysts couldn’t figure out why they were trying to do this.   EADS / Airbus does well enough on its own when not making blunders like the A380.  BAE does well on its own because it has access to the U.S. defense market in a way that a partially government owned continental firm would never have (see: tanker competition; see also: special alliance).  I’m still puzzled by the logic of this.

There are great mergers out there in our field.  Pittsburgh robotics firm RedZone has gone on acquisition kick and bought up companies that provide software and solutions for larger diameter pipes to build a complete sewer solution.  iRobot has bought Evolution Robotics when it seems like someone else’s mousetrap had some cool features.  Both of these create value for the company and have clear economic rationales underlying them.

Let’s hope that robotics can keep our business combinations on the path to having economic rationale.

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?

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!

Surprise! Robotics Companies Are NOT Capital Intensive

Please allow me to blow your mind and overturn the common sense notion that robotics companies are capital intensive.  Comparing profitable, public, U.S. based robotics companies to a diverse basket of prominent public companies shows that robotics companies do not require a lot equipment and property to make successful businesses.

In fact, robotics companies have the least property plant and equipment of any of the companies I selected for comparison–which deliberately included such tech giants as a chip maker, an operating system maker, and a search engine giant.  Looking at capital expenditure and depreciation, the robotics companies are again among the leanest of the companies on the list.

The only companies that had such low numbers for CAPEX and depreciation had their assets tied up in very long term investments like real estate and aircraft manufacturing facilities.  Also, most of the robotics companies are still growing and may have their capital expenditures boosted as a percentage of revenues by their anticipated growth.  Take a look at the trend line.

Now what people may mean when they say that robotics is ‘capital intensive’ is that the marginal cost of goods sold for a robotics company is greater than $0/per unit that consumer web applications have–but if that’s what they mean they should come out and say it and not be sloppy in their reasoning.

Angels, VCs, and other investors are you paying attention?  Big plays are going to be made on relatively small bets.

As a Percentage of Revenue
Ticker

Company

PPE Depreciation

CAPEX

Robotics

IRBT

iRobot

6.81%

2.42%

3.05%

ISRG

Intuitive Surgical

11.31%

1.68%

6.79%

AVAV

Aerovironment

7.24%

2.76%

4.61%

CGNX

Cognex

9.86%

1.72%

2.43%

Robotics Median

8.55%

2.07%

3.83%

Robotics Average

8.80%

2.14%

4.22%

Diversified

GOOG

Google

25.33%

3.68%

9.07%

MSFT

Microsoft

11.67%

3.95%

3.37%

T

AT&T

84.50%

14.50%

15.87%

INTC

Intel

43.75%

9.52%

19.93%

XOM

ExxonMobil

45.96%

3.34%

6.63%

BA

Boeing

13.55%

2.12%

2.36%

D

Dominion Resources

206.34%

8.96%

25.40%

AA

Alcoa

77.82%

5.94%

5.16%

DIS

Disney

38.99%

4.50%

7.32%

HD

Home Depot

34.54%

2.39%

1.65%

Diversified Median

41.37%

4.23%

6.98%

Diversified Average

58.25%

5.89%

9.68%

Some notes on the analysis:

-Data comes from the companies last 10-K filing.  Some companies include different things in revenue (where possible I tried to exclude revenue from a financing arm), in deprecation (some include amortization of intangible assets), and capital expenditure (Intuitive, for example, includes the acquisition of intangible assets).

-I wanted to look at a diverse basket of public companies and tried to pick companies that might be similar in some ways to robotics companies but whose earnings would not be unduly influenced by robotic related income.  For example, I excluded offshore oil field services companies because they were too close to being robotics companies, but still not pure enough to get a good view of the diversified company.  I did include Disney (which does anamatronics), Boeing (which has a UAV making subsidiary), and Google (which has a robotic car division) because I thought the revenues contributed to the these companies by robotics related activities had no material impact on the financial metrics.  However, their tangential involvement in robotics speaks to their similarity to robotics businesses.

-Future analysis should look at some other places where capital use can be buried.  For example, Cost of Goods Sold can hide capital that is employed on the companies behalf further up the supply chain.  It is possible that current assets like inventory may also need to be higher for robotics companies.  Also, we should compare total assets and liabilities to the revenue generated to similarly sized public companies to see if there is a substantial difference.