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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