SMART COOKIES: Money down the drain - There's a bloodbath of red ink on the bottom line. It could be a great investment for the future, or just a thumping loss. Can you tell the difference?

SMART COOKIES: Money down the drain - There's a bloodbath of red ink on the bottom line. It could be a great investment for the future, or just a thumping loss. Can you tell the difference? - What prompted this theme?

by ANDREW WILEMAN, a strategy and organisation consultant;
Last Updated: 31 Aug 2010

What prompted this theme?

Investors are trying to make sense of the recent TMT (technology, media & telecom) boom-and-bust. All that money invested, and so much of it completely wasted. Many of those investments were really just thumping great losses.

And yet ... a few produced fantastic returns, such as AOL, Nokia and e-Bay.

Could investors have been more discriminating? With hindsight, are there any lessons?

The question is compelling in the software industry, where over-investment and subsequent fall-out have been spectacular. Companies that were trading on 100 times revenue are now worth less than their cash-in-bank. Many are in the elite '90% club' - their stock prices are 90% off their high, often 99%. And yet ... you can get a Microsoft, Oracle, Siebel or SAP.

So let's explore software. Why was there such over-investment?

Software looks like an extreme version of a winner-takes-all industry.

Microsoft has 90% global shares in operating systems and desktop business software; Oracle and SAP have more than 60% of the Fortune 500 as clients for databases and ERP. In their core segments, no competitor comes close.

And these core businesses are high-margin cash machines, while also-ran competitors (such as Lotus, Baan, PeopleSoft) have struggled to make money.

This winner-takes-all characteristic is a result of network economics, standard-setting and brand power (as in the battle between AOL and Microsoft over media players and instant messaging).

Investors concluded that the prize for winning was so great that you had to invest heavily and early in any software sector to gain market leadership. For 'invest heavily and early', read: 'lose a lot of money fast'.

But what's wrong with a heavy and early investment philosophy?

Mea culpa, I have sometimes argued for it myself. But despite the impeccable logic, reality just doesn't seem to work that way.

A big clue is that all those great examples of winner-takes-all software companies - Microsoft, Oracle, Siebel, SAP - hardly invested any money on their way to market leadership. They didn't pile up heavy losses in the start-up years. That's why there are all those multi-billionaires - the founders didn't give up 90% of the equity to outside investors early on, for early cash. They went onto the public markets mainly to motivate their employees with stock options.

Too much early cash (and an inflated early stock price) is bad for software companies. It makes them invest in product functionality and roll-out too far ahead of proven customer need and acceptance, or of reliable delivery.

It makes them give away products and services at way below cost to get 'marquee' customers. It tempts them to expand on all fronts (market segments, geographies) before any one front is proven and profitable And it tempts them to go for growth via acquisition, often a disaster in software.

Tell me a horror story.

Take Kana, the once-glowing icon of eCRM. Kana got serious cash from its IPO and made all those mistakes in spades: hyper-active product extension, rapid roll-out, loss-making services, global sales offices. And it went hell-for-leather for acquisitions, building up an integration nightmare of products and code bases. (And it has compounded the problem by merging with a spendthrift competitor, Broadbase, in a deal valuing Broadbase at half cash.)

What did all that heavy, early investment do for Kana? In the first quarter of this year, licence revenue (new sales) was down almost 60% on the previous quarter, and operating loss was minus dollars 59 million on revenue of only dollars 24 million. It IPO'd in late 1999 at dollars 25 a share, shot up to dollars 170, and now it's almost in the 99% club, at dollars 1.80. Will it ever get to breakeven, let alone profitability? Will it survive?

General conclusions?

In business software, slow and steady is the winning game. Get the product working, prove it with a few customers, then roll it out in a measured way. If it delivers value to customers, they'll pay enough for it, now, to let you get cash-positive quickly. Profits are the way the business eco-system lets you know you're healthy.

This is even truer of pure professional services businesses like consulting.

If they say they need cash, sell the stock. (As a consultant, I had a handle on that one and avoided losing on e-consultancies such as Scient and MarchFirst.)

Big losses in business software and consultancy are big losses. They're different from investments in something like telecoms infrastructure or 3G licences. Hey, a 3G licence - now that has to be a licence to print money ... Who said that?

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