La Fin Du Tech
There’s a general recipe for megacap success: find a business where the upfront costs are high, the marginal costs are low, and building a copy is much more expensive than building the original. This is the very high-level outline of every large-cap tech success story, but it extends beyond technology. Coca-Cola, for example, invested vast sums of money into ensuring that Coca-Cola was a recognizable brand in every country in the world, and that almost anyone was less than an hour away from being able to buy some.
Doing it once was expensive enough but doing it twice would be murder. If you spent as much money as Coca-Cola did on ads, you’d have good ads that were less memorable than Coke’s because they were associated with a less memorable brand name; if you had the same distribution network they did, you’d be able to make your soft drink everyone’s second choice the world over. To match what Coke has, you probably have to spend at least double what they did.
The return on invested capital of a company with a competitive advantage is basically a measure of how expensive it is to build version two.
Coca-Cola and other big consumer brands have benefited from the compounding returns of having a preferred brand. Technology companies generally benefited from the compounding returns of thinking a few months to a few years ahead of other tech companies.
But, while it’s traditional for consumer brand sellers to pay dividends, tech companies are a little more reluctant to return capital. Coke’s dividend signals their confidence that, between unit volumes and price, they’ll be able to keep delivering decent growth to shareholders indefinitely without requiring much capital.
The “traditional” big tech lifecycle, at least as seen in the cash flow statement, goes like this:
An indefinite period of unprofitability, ideally investing in some durable future competitive advantage. (This is where all tech companies start and where most of them die.)
Self-funding expansion: the company is still investing, but its core business turns a profit. The money gets invested into adjacent businesses. At this stage, the core business has usually reached the point that it’s hard to invest much incremental cash flow, but there are adjacent businesses — moving up or down the supply chain, capturing more of the userbase’s time or money, etc. — that can absorb cash.
Maturity: the free cash flow from the core business outstrips any conceivable place to put it, so the company just piles up cash while desperate investment bankers cold-call to pitch deals of increasingly dubious rationale.
At point 3, a normal company would just say they were going to pay out half of their free cash flow as profits and spend the rest on buybacks, and shareholders would be happy. But a tech company that does this switches from being a bet on technology to a bet against it: a bet that the future looks like the present, with top-line compounding a little faster than bottom-line and no interesting surprises.
This can be a self-fulfilling prophecy. Lower growth expectations can dramatically compress a company’s multiple, and, as the saying goes, journalists are experts at predicting the last six months of the stock market. So if a company starts paying a dividend early, it instantly has trouble attracting the most ambitious employees.
Increasingly, what companies do at this stage is that they try to evolve into a bank. Fintech: La Fin Du Tech.
This is an appealing move, for three reasons:
Banks need information and leads. A tech company is an endless geyser of proprietary information, and it already has customers.
Banks need capital to lend. It should be sticky, stable capital. Lending out your own cash is about the most stable a depositor base you could imagine. It puts limits on scale, sure, but these companies have more cash than they know what to do with (have you seen their cafeterias?!), and earning an extra return is nice.
A tech company that becomes a bank doesn’t become just any kind of bank — it turns into a miniature central bank that can lend more when its borrowers are financially stressed and other lenders are pulling back. This can be pathological — it can just mean pulling next year’s demand forward, which means the demand problem compounds. But it doesn’t have to be so. A company growing 50% faster than GDP barely notices the economic cycle; when growth slows to GDP + 5%, suddenly macro slowdowns show up in quarterly earnings.
So mature tech companies have the means, motive, and opportunity to turn into banks. They have cash, and can reasonably expect more if it; they have data, and can put it to use; and they can smooth out their customers’ spending as a way to smooth their own revenue growth.
In an ideal world, every tech genius would keep on coming up with ingenious ways to reinvest ever-larger sums in new ventures, but most great tech executives have a sort of Midas Curse. For a while, they can keep reinvesting profits at an acceptable return, but the stream of profits from good technology franchises grows in a capital-efficient way. Eventually, however hard they try, they end up with more cash than ideas, and they respond to that dilemma in the most sensible way.