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IT's Marginally Better
A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
May 16th, 2003

By Brent Holliday
Greenstone Venture Partners


"Ooh, we like the big wide spaces,
Yeah, we like a sea of faces,
Time is just a rubber band,
Time is at our command" - Chilliwack, Fly At Night

There comes a time in life when you re-evaluate what you do and why you do it. When you have this moment, you either come away with re-affirmation of what you are doing, or you pitch everything and join a band. I am aware of certain people that have these moments more than once in their lifetime. Some have these moments every five minutes or so, but there is medication to help that.

When the inevitable cycle bottoms and outlooks are bleak, more of this navel-gazing takes place. I'm sure many of you are aware of people that have picked up and left the technology industry, some out of necessity to find work and others that are just fed up.

I had a little to and fro with a "fan" of Something Ventured this week that got me thinking of this subject. This person was sick of my upbeat tone on the Information Technology (IT) industry and why it appeared, at least by my last column, that I was making excuses for it not being rosy today (me: SARS would be a reason that the recovery is not happening and gosh darn it, it's not the IT industry's fault). To paraphrase, this person thought that there were plenty of opportunities for people in other businesses and I should stop giving false hope about an IT recovery soon.

Hey, can't a guy have a poor effort once in a while? I mean, jeez, it was tough writing that one in an airport lounge in Toronto. I know I'll bounce back and deliver solid insight and witty prose sometime soon. Oh-oh. Am I giving you false hope for a better column soon? Dang.

In my moment of conjecture on why to be in the IT industry, I thought about first principles, you know, a return to the basic reasons to be here. First and foremost, I love technology and find it very exciting. I also have a knowledge base and networks. But more than just why this business fits me, I wanted to talk about why it makes sense to invest here. As an investor, I have choices. I could invest in a variety of different industries in a variety of different financial instruments. But I picked IT. Why?

Returns. Profit. Margins. Multiples. There ain't no place better.

Before you think it's all about greed, remember that profit is nature's way of saying you belong (apologies to Mark Anderson). It's a completely natural, Darwinian mechanism to keep a market/economy alive. The shareholders decide on what to do with the profit. If they want to dividend it all out every year to their pockets, so be it. If they want to put it into eradicating smallpox in Africa, go for it. If they want to invest it in bonds, real estate or gold bouillon, bully for them. They can also re-invest it in the company to continue its growth. But running a profitable business is tantamount to survival. Except if you are a government or Air Canada... but I digress.

If you are dreaming up a new business or you have a very cool new technology, it's very important to figure out the basic business model. How much can I sell it for? How much do I make it for? Is there a positive variance in my favour? Simple, huh? Not really. It gets horribly complicated when you consider how you get your product to your customer and the costs associated with that process. But as a back-of-the-envelope gut check very early on in the process of creating a business, you need to do the math on what the accountants and MBAs call gross profit. Total revenue minus the costs associated with making and delivering that product (or service) that you sold. The gross profit as a percentage of total revenue is the gross margin. In the beginning of a business, these are useless numbers because your first product sold costs you a fortune. But projecting to certain volume, you can see what kind of gross margins your business can generate.

Luckily for all of you bored to death with the lesson, the world is full of examples of companies just like yours (might/will be) that are public and reveal their gross margins to all in their income statement. Circling back to the issue at hand, you will see why I like IT:

Gross Margins of selected public companies:

Costco - Distribution service business 13%
Weyerhaueser - Forestry products business 21%
Ford Motor - Automotive manufacturer 23%
Bank of Montreal - Financial services company 25%*
Telus - Integrated services and utility 38%
Creo Products - Advanced manufacturing/hardware 43%
PMC-Sierra - "Fabless" semiconductor company 61%
Cisco - Networking hardware, services 70%
Microsoft - Software 80%
QLT - Biotechnology products 82%
Checkpoint - Security software 92%

* operating margin because gross margin is rarely reported from financial services companies (think about the gross margins on your monthly bank fee... 100% right? Now if they could figure out how to remove the employees...)

In a nutshell, IT companies generally make things that cost less to manufacture and distribute relative to what people are willing to pay. Why? Less competition/substitution to drive down prices. Lower raw materials cost. More automation. Faster product cycles. And 100 other reasons. If IT companies could hold these margins without re-investing in R&D (in other words, milk the cash being generated), they would be immensely profitable. But only for a very short time because competitors would move in and take their customers with more features and benefits for the same or lower price. The Fortune 500 does not rank companies based on gross margins, after all. So, IT companies are not necessarily more profitable than traditional businesses, but they have the inherent ability to be so because of their incredible gross margins.

Within the IT industry, certain business models are more attractive than others. For instance, just look at IBM's breakdown of gross margins in its three key business areas last quarter:

1 - Global Services - IT services and web hosting - 25%
2 - Hardware - PCs and servers - 26%
3 - Software - 85%

If you were the CEO of IBM, where would you like to grow your business? Services looks like a dud, so why are they spending so much marketing and selling effort there? Well, it represented 60% of IBM's total revenue, so they are clearly getting customers. Can they sell them software down the road? You bet.

Before we all jump to the conclusion that low margin businesses are unsustainable, remember that we are talking about percentages, not absolutes. If my software company is selling $4M a year worth of product, has a gross margin of 80% and a net margin (bottom line after all other expenses) of 25%, then the shareholders can decide what to do with a million dollars a year. Yippee! If I am a services business (IT or grocery, doesn't matter) and I am selling $100M a year worth of product and my gross margins are a low, low 20% and my net margins are 3%, I still have 3x the cash that the software company does at the end of the year. Services businesses needn't adopt fast product cycles and therefore have lower operating costs on a relative basis. A good friend of mine runs a flower distribution business. His absolute profit is over a million a year, but his gross margins are scary low (10-15% depending on gas prices of the trucks). He only has 13 employees on the payroll, so his operations are inexpensive. It's a great business for him as he and three other shareholders decide what to do with that profit every year. Don't even get me started about how his investment in IT helps his company have a competitive edge...

From an operating business point of view, I love the margins in most IT businesses. But valuations are based on growth. Whether you are public or private, the multiple of your sales, your margins or your profit is based on the growth prospects for your company in your industry. The market sets the price for your entire operation based on your compound annual growth rates going forward. This is why IT stinks at the moment. Growth has slowed or stalled altogether. IT companies that invested heavily in R&D to continue to grow at expected paces, cut back. But, the margins have pretty much held after the painful corrections were made. The underlying business is solid for the established IT companies. It is much harder for the new companies trying to get customers and establish their place in the world (i.e. become profitable).

So, if I paused to look at the IT industry and why I am here, I have no reason to abandon ship. Growth will return to the industry. With any form of growth will come multiples of margins leading to valuations higher than today. There are many industries that make money and they will continue to do so. However, there is no alternative industry that can offer the margins and overall returns over time. IT is the place to be. And I'm staying. The band can wait.


What Do You Think? Talk Back To Brent Holliday


Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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