Friday, May 05, 2006

A Funny Thing Happened on the Way to Unlimited Productivity...

In the longer term, productivity growth appears to be decelerating—a sign that the business cycle, now in its fifth year of expansion, is maturing as companies gradually exhaust their ability to get more out of their workers.

—Wall Street Journal.

No kidding.

A mere week ago, the poster child of Alan Greenspan’s theory of endless rising worker productivity—Microsoft—announced a shocking ramp-up in spending that sent Wall Street’s Finest back to their earnings models and wiped $30 billion off the company’s market value in a few hectic minutes of trading.

Microsoft’s new, higher-cost business model appeared to be a one-off, sparked by Google’s ascent to the top of the Internet pyramid and Microsoft Network’s fast slide into obscurity. Analysts blamed it on Microsoft’s own mistakes—and the world moved on.

And then along came Electronic Arts.

Two nights ago “ERTS” (as Electronic Arts is called on the Street owing to its stock ticker of the same four letters) likewise shocked Wall Street’s Finest by announcing a large ramp-up in costs necessary to deal with the diffusion of gaming hardware choices, which are shifting beyond the simple teenage-boy-on-computer-at-2 a.m. platform to handhelds, cell phones, PDA’s and wirelessly-connected modes of play.

As with Microsoft, this change in “The Model” of a company formerly known, loved, and given an extremely high P/E multiple owing to its ability to beat Street estimates by the proverbial penny no matter what the external environment, was viewed as a one-off.

And maybe it is.

But maybe it isn’t. When we looked at Google’s high capital expenditures—bigger than Caterpillar Tractor, as a percentage of sales (see “Down and Out in Mountain View” from March 9)—it was strictly in the vein of an interesting factoid regarding Google’s business model.

But perhaps the experience of ERTS and Microsoft show that Google may in fact be foreshadowing where the digital world is going. Perhaps the digital economy is just a lot more expensive than envisioned.

In the brick-and-mortar world, physical costs are mainly plant and equipment, lots of sales people and administrative support. Pricing is not always transparent, and inertia plays a part in determining whether customers stay with their old supplier or whether they go with a new one.

In the digital world, the costs are office buildings and lots of computer equipment, and the engineers to run the equipment and design the software and keep it running 24/7 against viruses and spam attacks and network outages. Pricing is highly transparent and speed is essential. Inertia evaporates: with a keyboard click a customer can do an internet search on Google rather than Microsoft; buy a digital camera from Amazon rather than Best Buy; list their car on eBay rather than Yahoo; outsource their back office through an auction to a lower cost supplier that may be next door or may be in Bangalore.

And while all of this transparency lowers costs to the customer, it raises the costs for the companies doing business in the digital world.

A funny thing happened on the way to unlimited cost compression: companies have to pay to play. Perhaps it’s no coincidence that the era of endless productivity enhancements appears to be—appears to be—waning.

Informed opinions and observations on this topic are welcome.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


gvtucker said...

To me, this goes back to Drucker's thought that the technology industry, as a whole, doesn't make a dime. The marginal cost of their products are, in the end, almost zero. Yeah, there are a ton of fixed costs, such as your reference to ERTS. But marginal cost drives the price so low that companies start to bleed to death.

The companies that use the technology get the initial benefit of cutting their costs, and profitability improves for a while. But since everyone has access to the technology, that edge goes away, too. That's what you're seeing now.

Meme chose said...

Fragmentation of hardware platforms (and its opposite) happen all the time.

Over 20 years ago Activision's video game development business (then the fastest company to $100 million in revenues in US history) was hammered by exactly the same phenomenon. In terms of the wider economy, it means nothing. Apple and the iPod, to name one example, just went in the opposite direction.

Google's infrastructure serves an immense portion of the planet's economy. Infrastructure investment in the past, such as canals and railroads, often led to huge over-investment by many companies. While the internet bubble in general fits the pattern, arguably there has been surprisingly little of that so far with search engine infrastructure.

Again, my guess is, implications for the broader economy just about nil.

jucojames said...

From a macro perspective, the data is fully supporting your premise. Corporate profits as a % of GDP is at an all time high. Companies are meeting earnings estimates by buying back shares hand over fist. Earnings have grown at about 6% long term and have been capped by that line over the past 100 years. Earnings are now right at the top of that channel. Finally, profit margins are near all time highs. All of this suggests that there is nowhere to go but down!

JFB said...

"exhausted the ability to get more out of their workers"

WSJ should have substituted the word equipment for "workers".
Ever since the equipment ramp-up pre Y2K, and except for the last year, not much has been spent in this area.
Workers'unlimited brain(idea)-power has expanded beyond the finite-function of equipment. CEO's need a reason to tell stockholders why they need to's easier (as always) to blame the worker.

BTW: I like the 2 businesses you chose, because they are an analogy of which one's will dominate their respective markets in the future:

You mentioned the 2 ways all companies spend cap-ex money:

MSFT is spending most of their cap-ex in a catch-up mode, whereas ERTS is spending cap-ex in an anticipation-mode.

As an investor, I'm looking at the ones in anticipation-mode.

Once again, great post.


Tim said...

Interesting point. That said, I don't think that it's appropriate to make a sweeping statement about the cost structure of these businesses, but rather about the ability of their management to reinvest the cash they are generating.

Google's search business and Microsoft's software business continue to have fantastic margins and limited ongoing infrastructure costs. The "problem" is that they now have a huge amount of cash and their high PE dictates that they need to find better uses for that cash than buying back shares and/or dividending it off. As a consequence they are investing enormous amounts of money pursuing "big bets" like Adcenter, Xbox, universal storage, free Wifi, etc.

While the jury is still out, the slow ramp and high costs of these initiatives seems to imply that their previous track record at creating a single big opportunity does not translate into an ability to pick future tech winners and their entrenched position in their core market is not transitioning into dominance in others.

Stated differently, the "option value" that many tech investors rely on to justify high valuations on the existing business is likely highly overvalued.

bgthej said...

I think to a certain extent your use of the video game industry is a bit misleading. The software publishers are increasingly becoming like movie production companies, with production costs now averaging around $20 million to make a new game. In addition, Electronic Arts is facing a video game market that is maturing and thus the company needs to enter into additional markets to grow given its size (market share gains to a large extent are unlikely given its already large share at over 25%). So you are seeing the company spending on developing MMOG games over the Internet and games to play on your cell phone to expand outside the console business and allow for additional growth.

So bottom line, I think the issue is ERTS trying to fulfill investors' lofty growth expectations for video game companies, which are facing a maturing industry with weakening economics.

However, I liked the MSFT example and really enjoy your blog. Keep up the good work.

csdorotoc said...

I think alot of the capex at Google and Microsoft is, as you've stated in posts before, simply vanity spending by the founders. If Google didn't want to expand into every possible technology market, like Microsoft, capex would be much lower.

SS said...

I'll take the other side of JM's arguement. I believe that we're embarking on an even LARGER productivity boom over the next 5 years. We are just scratching the surface of telecomuting and convergence (ubiquitous connectivity). We become more efficient each month.

This convergence will be the backbone of the next leg of the Technology "S" curve...the last leg is the longest and the most profitable. (Think railraod and auto industries as examples).