But Is It Really a Tech Firm?

There are lots of executives who would have you believe that the business they run is really a tech business. With tech firm valuations still at sky-high levels, it's easy to understand why. Tech commands a premium valuation because (a) the potential for non-linear growth relative to investment; (b) low barriers to entry into adjacent markets amplifies that growth; (c) scale of offerings changes the commercial model from transactional to flat-fee subscription, making a tech firm an unregulated utility; (d) payments take place behind-the-scenes of the tech consumption, creating sustainable recurring revenue; and (e) tech industries tend to be winner-take-all.

Translated into investor-bait, here is what this means. Selling access to movies is all well and good. Selling all forms of entertainment - on different media, on different frequencies, for different prices - is even more interesting. Selling access to it as a service on a fixed price makes it an uninterrupted cash flow. Getting a significant number of people on the planet to pay a fixed subscription fee once a month every month is epic scale.

This kind of reach isn't a new or even a recent phenomenon. You may recall a time when McDonald's restaurants used to show the number of burgers they sold on the golden arches signs, in the tens and later in the hundreds of millions. Then it simply became "billions and billions served." You may not recall that twenty years ago, McDonald's (briefly) targeted their sales in terms of the percentage of total meals consumed globally on a daily basis. Around the same time, the largest of the large banks was targeting a total number of accounts across all product categories relative to the entire population of the planet. 'Twas ever thus: Standard Oil achieved monopoly status over American oil in the late 19th century; Rome achieved hegemony over Europe.

Tech didn't invent the economic harvesting of humans at scale, it's simply the current means of achieving it. In Roman times, it was achieved through territorial conquest (tax revenue through subservience of subjects). In the industrial age, it was achieved by selling productivity, e.g., labor-saving machines and the energy to run them (revenue from products to improve productivity of business and household activities). Today, it is achieved by selling entertainment (revenue from selling services that fill the passive time of individuals). At a time in history when conquest is out of favor and productivity gains have slowed, monetizing everybody's abundant downtime from all those labor-saving products of the industrial age is the next frontier.

Not exclusively, of course. There are still plenty of opportunities for productivity gains. Electric vehicles require fewer components, which means less labor is required to manufacture them. Tax compliance is mostly rules, and rules can be implemented as algorithms and therefore replace large number of auditors. And when cars can drive themselves, individual, on-demand transportation isn't limited by the number of drivers but the accessibility of vehicles. There are still plenty of productivity gains to be realized, and their potential still grabs headlines, but productivity is the old frontier; entertainment is the new.

Regardless the source - political domination, economic productivity, or entertainment - the potential for scale drives equity value. Potential is more lucrative to investors than reality. Bond investors are told the company is growing at a predicable rate and spending is under control, which secures the credit rating and coupon; equity investors are told that it isn't the sky that's the limit, but our ability to fathom every quantum reality of where the business could go, and that tech is the enabling factor. Hence there are plenty of CEOs and CIOs alleging they are "tech companies that happen to operate in the [insert-industry-name-here] industry."

You've probably heard this statement hundreds of times from hundreds of executives, to a point that it doesn't merit even as much as an eye-roll any more. I've always thought it would be helpful to have a consistent and objective means of assessing whether they really fit the bill of a tech firm or not.

Andy Kessler wrote an interesting op-ed in the WSJ a few weeks ago cataloging five characteristics that define a tech firm. They are: growth; R&D intensity; margins; productivity; and tech spending intensity. This is a very useful heuristic.

Growth: "Even though prices go down, units go up faster so you get rapid and sustainable growth." Among other things, that means race to the bottom pricing isn't destructive if volume rises ahead of it. A good litmus test of growth: "Beware of fake growth like market-share growth: If you sell seat cushions for a 50,000-seat stadium, you can double sales every year but eventually you’ll run out of seats. Instead look for giant markets." If the company does not have truly exponential growth potential through tech, they are not a tech firm.

R&D: This is a positive and negative indicator. On the plus side, tech firms have to invest for invention and innovation. On the minus side, "Companies often boost earnings by starving research, a serious red flag." A company not investing in original research in tech is not a tech company. But it isn't the creation of tech that matters as much as how effectively it is mainstreamed. Mr. Kessler wrote another op-ed this past week in which he points out the rapid rise of such things as voice command, live streaming and medical monitoring have gone from new to commonplace and, in some cases, depended upon. The ability to create technology simply yields another Xerox PARC or Kodak digital camera; the ability to operationalize R&D is entirely another.

Margins: "the ideal tech product doesn’t cost anything to distribute—roughly zero marginal cost, like software." This is true for bits, silica and advertisements. Whatever a tech firm is selling should have near-zero marginal cost for each additional sale. By this definition, consulting firms are not tech firms: because they rent bodies, they have direct costs proportional to sales.

Productivity: Marginal improvements in productivity have been with us since the dawn of time; replacing entire swaths of labor activity is transformational. Levers and pulleys allowed humans to power simple devices to create incremental labor saving, while the flywheel engine completely replaced the need for people to perform specific tasks. Organizing people to drive their cars to transport others is not a productivity boost; cars that navigate themselves to people in need of mobility without the presence of a driver is a productivity boost.

Tech spend intensity, or the extent to which a company must continuously upgrade core capacity. A company on the technology treadmill has no choice but to spend capital on enhancement and expansion. Note that this does not apply to self-inflicted woes. I've worked with entirely too many firms that are hostage to tech spend commitments due to poor tech lifestyle decisions: vendor spend is directly proportional to cleaning up mistakes made by those very same vendors. Committed spend for purposes of hygiene is not the same indicator of tech intensity as disciplined spend for purposes of improvement.

This simple heuristic makes it easy to score (Mr. Kessler suggests awarding one point for each). By his reasoning, a score of 3 or above qualifies a company as a tech business, while a 1 qualifies them as a tech user, and quickly applying it to firms with which I'm familiar it winnows out the wanna-bes. Next time somebody is touting their tech credentials, apply this simple rating to see how well they stack up. It will be more constructive than an eye-roll.

Muddling Through

British trade in the West was never an instrument of empires. It had no headquarters like the compounds at Montreal and no capitol like the rock-rooted fortress at Quebec. It had no seasonal rhythm like the canoe caravans coming down the rivers on the spring race of water to the tall ships above the quaysides loading their pyramids of peltry. It had no trace of the pagentry of black-robed priests visioning by their campfires in the forest a new empire for the Church, and no imperial plan of feudal seigniories and savage nations submissive to the rule of the Rock. The British trade was sporadic, individual and motivated by simple greed. When forty dollars' worth of trade goods would secure a thousand dollars' worth of peltry, there was incentive enough to bring pack trains to Ohio.

Walter Havinghurst, Land of Promise

In 1959, Dr. Charles Lindblom posited that companies that had disciplined processes for experimentation and discovery had an advantage over those that operated, in the words of Dr. John Kay, against "a single comprehensive evaluation of all options in light of defined objectives". The argument Doctors Lindblom and Kay make is common sense. For those of us without the gift of omnipotence, the ability to reassess objectives and tactics with the benefit of first-hand market knowledge is a handy capability to have.

While this is intuitively appealing to entrepreneurially-minded managers, it is decidedly unappealing to risk-averse capital. Complex corporate strategy derived from analysis and modeling creates the appearance of authoritative expertise. Authoritative experts are in the business of selling predictability. Debt capital likes predictability. As long as there is cheap capital to be raised from risk-averse investors there will be complex business strategies. This doesn't make for good strategy or good investment. This just makes it something that happens.

There is an obvious contemporary comparison between Amazon (financed with equity capital) and WeWork (financed largely with debt capital) and no doubt there will someday be a good case study that sheds light on the differences between the two firms. Suffice to say for now that in the latter's case, somebody tells a good story (Adam Neumann at WeWork), somebody has money burning a hole in their pocket (Masayoshi Son at Softbank). The story makes for an eye-popping valuation, but the story doesn't make it a rational valuation.

Human history is rife with examples of big, ambitious, up-front design that fails to live up to the hype and reward the capital behind it. I've been doing some research into the development of North America from the time of the Renaissance. The opening of the North American continent created a massive trade opportunity for European countries. Although the Spaniards were the first to arrive during the Renaissance, the French were first to pursue opportunities in the North American interior. The interior was rich with wildlife. The indigenous peoples were adept at harvesting the pelts of that wildlife. European manufactured products could be profitably traded for those pelts: $40 of trade goods to $1,000 of prepared pelts, per the opening quote.

As lucrative as the trade opportunities were, the French dreams for the development of the interior were even more ambitious.

Having seen the immense forests of the Ohio and the broad prairies of the Mississippi, La Salle formulated his life's ambition. He would establish French civilization in the rich country between the two rivers. He would begin by systematizing and enlarging the fur trade, using cargo vessels on the lakes, erecting fur depots on the rivers, establishing a chain of warehouses and magazines. It was a bold undertaking that looked to the protection of French interests all the way from the mouth of the Mississippi to the Great Lakes and the establishing of stations of prestige and power at a dozen strategic points.

[...]

It was a dimly comprehended country, but La Salle saw it more clearly than any man of his age. He made the restless [Governor] Frontenac envision it like a panorama from the Rock above the St. Lawrence. And it made the ambitious governor grasp his program of a commercial empire with French goods going systematically to the strategic posts and the fur caravans drawing in over the great web of rivers to the broad sea lanes of the Lakes. Together they drew up a design of occupation, fortification and settlement.

La Salle's big vision needed big execution. It did not suffer from a lack of big execution. He oversaw the construction of the 60-foot long Griffon, the first ship ever on the great lakes beyond Ontario; a vessel of that size could transport larger quantities of trade goods than the largest fleet of canoes. He established trade relationships with interior peoples. He established forts throughout the present day states of Ohio, Indiana and Illinois, reaching as far west as the Mississippi.

What the big vision did suffer from was unforeseen circumstances, to which La Salle was simply unable to respond. Advance traders squandered their French-made trade goods, trading for themselves rather than for their employer. One of La Salle's trusted lieutenants - Louis Hennepin - was taken prisoner by the Sioux. La Salle's men abandoned his key fortification of Fort Crevecoeur. A key trading partner - a village of the Illinois - was defeated by the Iroquiois. A storm over Lake Michigan claimed the Griffon, laden with pelts from the North American interior for Europe. Ultimately, La Salle's detractors were successful in discrediting him in Montreal and Paris, and his creditors closed in on him. While he would ultimately gain support from the French crown for one final expedition, it would fail for the same reasons his previous expedition did: ambition impervious to ground truths.

Though the ensuring years saw scattered new trading posts and mission stations - at Chicago and St. Joseph, at Detroit, Cahokia and Vincennes - there was no bold design of a French civilization encompassing the whole interior country.

The legacy of the French vision lingers on in the names of rivers, cities and counties that bear the names of the influence of the French explorers and of the explorers themselves: Eau Claire, Fond du Lac and St. Louis; Hennepin, Joliet and Marquette; and of course, La Salle himself. But these are just echoes of the past. As Dr. Havinghurst points out, the North American market for European trade goods fell into the hands of those who were not executing in pursuit of a grand design, but content to muddle through.

No surprise, then, that the 20th century instantiations of these 18th century ambitions - Singer Industries and TRW - if they are remembered at all, it is as legacy place names and not 21st century concerns.

The Law of Unintended Consequences

Over and above all, it remains to be seen how far the super-Bank will make use of its immense facilities for credit expansion. This is the aspect of the scheme which deserves the most attention, as it opens up a vista of alarming possibilities. The scheme itself is sound, and it is far from its authors’ intention to make of the Institution a means for international credit inflation. But then, the bank scheme of John Law was also in itself sound....It also remains to be seen whether the scheme of our modern John Laws -- however sound their intention may be -- will not be brought to shipwreck...

-- Is Libra really the world’s most ambitious international settlement system? FT Alphaville

Technology is possibility. Technology is potential. Technology is hope. It drives out inefficiencies. It destabilizes authority. It rights wrongs. We've witnessed examples of all of these things in the last two-and-a-half decades, sometimes in dramatic fashion. They seem to occur at an ever accelerating rate.

Among the things that makes any technology magical is its ability to elevate each and every individual user to the center of the universe. One of the ways a technology does this is by rapidly and iteratively incorporating things users ask for. Short delivery times allow for feedback from a wide variety of current and potential users to be factored, explored, and refined continuously - and equitably - into the software. This gives iterative tech the unique capability of placing every individual at the center of value delivery, as there are many intersection points of features and types of user. When done well, there isn't a single person imposing their vision of what users should do, but community preferences and desires crowdsourced to achieve a goal state. This is the egalitarianism of technology, manifested through a product mindset and Agile practices.

Little wonder that tech sports a halo in the eyes of economists, politicians, and the masses alike. Yet we know from experience that tech is not a one way trip to a universally better tomorrow.

We think of technology as a force for good because of the benefits we have seen it yield, but we do not often consider the problems it is likely to leave in is wake. Cheap capital flooded into sales-tax free e-commerce at the cost of brick-and-mortar firms and their employees, and by extension the municipal & state coffers to which those firms and employees contributed taxable sales and incomes. Using advertising to subsidize innocuous user activities like information or product search gave rise to creepy surveillance capitalism. Energy-efficient buildings don't fulfill their promise because "buildings don't use energy -- people do." It's a phenomenon called the rebound effect: tech-driven advances in energy efficiency result in increased rather than decreased consumption. "[P]redicting what people will do is notoriously difficult."

Tech firms advocate big tech solutions to big economic and societal problems. Somebody thinks people pay too much in fees to transfer money, so they propose to "revolutionize payments" through cryptocurrencies. Somebody thinks that asset prices are too high, so they propose to "revolutionize asset ownership" through fractionalization. Somebody thinks that low-risk borrowers are penalized by being pooled with high-risk borrowers; somebody else thinks that too many high-risk borrowers are excluded from credit markets, so each build technology products targeted at the margins of credit markets.

Because people have limited capacity to comprehend the world in a state differently than how it exists today (a phenomenon known as regulatory capture), the debate focuses on the past and present, not what the brave new world of "revolutionized payments" or "revolutionized credit formation" will mean.

Here is what those things mean. Unrestricted movement of capital across borders is a pro-cyclical driver of capital flight; that amplifies currency fluctuations and interest rate volatility. Siphoning off the extremes of the credit pool removes high quality borrowers and encourages loans to borrowers of extremely low credit quality; that increases interest rates charged to middle- and high-risk borrowers because it takes low-risk borrowers out of the pool. It also enables unregulated institutions to write usurious loans that find their way into the mainstream financial system because the notes are ultimately bought by banks. Banks will not write the loans due to the credit worthiness of the borrower, and banks will not write the loans because regulatory agencies prohibit charging the concomitant interest rate banks would need to charge given the credit worthiness of the borrower. Ironically, banks can (and do) buy the loans ultimately provided to those borrowers by unregulated financial institutions and put the loans on the books as high-yield assets. Fringe financial institutions win, banks win, borrowers lose.

Big tech solutions to problems real or perceived on the margins amplify volatility. That makes them contributors and potentially generators of Black Swan events. The technologies that aspire to increase accessibility or reduce friction in isolation of other market characteristics such as regulation actually contribute to volatility in the markets they allege to optimize. True, they may do so at their own expense: marketplace lenders, dependent on banks to buy the loans they write, are extremely vulnerable to the credit cycle they promised to circumvent. But as big tech is a winner-take-all-loser-take nothing proposition, and as big tech harvests rather than liberates the individual, big solutions from big tech are a one-way proposition that transfers income from the core of an economy to the big tech company that ultimately wins out.

Can technology make improvements in payments and credit formation? Sure. But perhaps better to take an evolutionary approach rather than a revolutionary approach. Lots of innocent people get hurt badly in revolutions. They are powerless to defend their interests.

Oh, and about that quote to start this blog. You might be thinking it's about Libra. It isn't. It was written in 1972 about the Bank of International Settlements. Plus ça change...

The Financialization of Disruptive Technology

It's fashionable to champion an investment-oriented model for software development, particularly around exploratory opportunities. Allocate risk capital, run experiments through software, learn what works and what doesn't work, re-focus, rinse, repeat, reap rewards.

I've been a proponent of companies doing this for a very long time. It twines the notion of devolved decision making with thinking of IT as an investment rather than a cost. Invest in what you know paid off handsomely for Peter Lynch. "Continuously adjust your investment position based on what you learn" seems an apt mantra for today's world. Organize for innovation, re-acquire lost tribal knowledge, challenge - but respect - commercial orthodoxy, and constantly re-apply what you learn to change the rules of engagement in an industry. Every day you're in business is a day you're able to bring the fight, and this is simply the new way of bringing the fight. Better figure it out.

What if this is not a viable strategy?

I've danced around this question for the past 7 or 8 years, challenging the invest-for-disruption premise from a lot of different angles. Among the problems:

1. The labor density of new ideas has risen nearly 3x the rate of inflation. As the FT put it, that implies it is getting harder to find new ideas.
2. Investment yields are highly concentrated. There are a plenty of analyses to show that a small percentage of investments yield the majority of the gains. A recent FT Lex article on biotech investing drives the point home: "A 20-year study found only one-fifth of exits were profitable. Just 4 per cent of investments made half the returns." Picking winners is hard.
3. Regulated industries are unappealingly complex, but those complexities exist to protect consumer and provider alike. Denying, ignoring, or circumventing market sophistication results in bad outcomes for everybody: investors are subject to cycles they thought they were immune to, customers get robbed, and in the end management takes the same path their orthodox predecessors did decades ago.
4. Cheap capital makes it easy for anybody to enter the innovation game. The multitude of companies competing to offer home meal kits and ride-hailing show there are no barriers to entry. Unique ideas aren't unique for very long, and the economics of exploiting them are much shorter lived.
5. Deep pocketed investors make it expensive to stay in the innovation game. The WSJ has pointed out quite a few times that We Company, Uber, Tesla, and many other firms subsidize every customer transaction with investor capital. And as this graphic illustrates, that is an extraordinarily expensive investment proposition.

The whole point of the portfolio model applied to captive technology investing was to avoid taking a long position in any one thing. That created nimbleness at the portfolio level such that capital - and the knowledge workers that capital pays for - could be rapidly redeployed to the best opportunity given our most current information. This took advantage of a unique characteristics of software vis-a-vis its industrial (hardware) predecessors: real-time adaptability. Whether it was the accounting department building tools in Visicalc in 1982 or a team of developers creating the company's first e-commerce site in 1997, the ability to rapidly deploy a new capability in software created an operational differentiator. Manufacturing changes took years. Organizational changes took months. Software changes took minutes.

That meant that software had the potential to be lower-case-i-investing: we knew in the early 1980s and again in the late 1990s that applied adaptable cheap technology could create incremental efficiency gains and therefore advantages. The formula was to exploit the adaptability of software and expedite its application: get new code changes deployed every month, every day, every hour when possible. As an operating phenomenon - that is, as it impacted day-to-day operations - this offered tremendous potential for competitive advantage: land punches left, right and center at an alarming rate and you put all your competitors at a disadvantage.

Yet per the above, software is no longer strictly an operating phenomenon. It's a financial phenomenon. Software is now upper-case-I-investing: all positions are long positions, and the stakes are winner-take-all. The incremental nature of the portfolio model has more to do with trench warfare in World War I than it does with sustainable competitive advantage. These are wars of attrition.

I've chronicled this phenomenon over the years, and over the course of that time have written up simple playbooks for strategic responses: i.e., the incumbent-cum-innovator and late movers. These are appropriate as far as they go, but incomplete once the tech has been fully financialized. If the tech business has been fully financialized, the playbook has to reflect the influence of the finance, not the tech.

The Tortoise Strategy

Three years ago, I wrote that the unstoppable forces of Fintech were running into the immovable force of financial orthodoxy. Specifically, the technology cycle wasn't enough to overcome the credit cycle for peer-to-peer lending firms, which were resorting to selling their loan portfolios to traditional lenders, becoming buyers of last resort themselves when no buyers emerged, and offering deposit insurance for lenders.

Earlier this year, I wrote that incumbents had advantages - specifically, access to greater amounts of patient capital - which they can parlay in a multitude of ways to co-opt a would-be disruptors business: make the disruptor financially dependent by becoming one of their biggest customers buy buying their products (e.g., loan books originated by peer-to-peer lenders), licensing their technology, or investing in their business and getting board seats.

Last month, I wrote that being a late mover can be less financially ruinous than being an early mover. A fast-growth business with low barriers to entry attracts a lot of competitors who burn increasing amounts of capital chasing each other's customers more than new ones. Patience and playing to strengths is a better response than betting the balance sheet in an unfamiliar casino.

This week, the Financial Times ran an interesting article on the trials of peer-to-peer lenders. Finding lenders is hard, and finding borrowers is proving even harder. Incumbent banks have lower costs of capital, which allows them to lend at lower rates. In periods of economic uncertainty or downturn, banks offer safety to cash-holders in the form of insured deposits.

What does the FT article recommend? That the survivors will be those who follow a "tortoise" strategy:

That means working with investors with a low cost of capital [...], and avoiding yield-hungry hedge funds. It means not reaching too hard for high returns, which will become high losses in a recession. It means sticking to niches with good borrowers, who are too hard for big banks to serve. Finally, it means not spending excessively on marketing.

All this, of course, implies slow growth: hence the tortoise. But the hares are set for a very nasty couple of years.

'Tis better to arrive late than not to arrive at all.

Late Mover Advantage

Many years ago, I worked with a company that helped big pharma companies distribute free medical samples to doctors. Having pharma products on-hand is a convenience for doctors and patients alike, mainly because a doctor can initiate immediate treatment for a patient. Having pharma products on-hand is also good for big pharma, as starting somebody on a medication is highly likely to lead to a prescription. So pharma manufacturers were motivated to avail free samples of medicines to doctors.

It's a regulated activity. Doctors can only get medicines appropriate for their practice (e.g., a pediatrician cannot get free samples of Cialis) in limited quantities for specific lengths of time (usually every x number of days). Pharma companies keep track of which doctor got what product on what date. Because doctors exhaust their supply of free product within the allocation time frame, doctors create standing re-order requests. The pharma company decides whether or not to fulfill a doctor's reorder request primarily based on when the last order was fulfilled and the quantity supplied. A pharma manufacturer would not supply more free product to a doctor who had received the maximum volume just a week ago if the reorder window is 21 days.

Because doctors obtain pharma samples from multiple manufacturers, a lot of intermediaries popped up to provide a consolidated service. The value prop of the intermediary was that a doctor need only visit one site to replenish samples from multiple drug manufacturers. Again, because doctors exhaust their supply of free product every few weeks, they were encouraged to set up recurring orders through the intermediary, so a doctor might request multiple products from multiple manufacturers with different replenishment rules. The intermediary made money by charging the pharma company for each free sample request they fulfilled. The pharma company treated it as a marketing expense, effectively treating these intermediaries as a channel partner and paying them a commission. The volume aspect made every doctor acquired very valuable indeed.

The theoretical market numbers were eye-popping. Just one of the big pharma firms measured the total product value they gave away in the form of samples, coupons and vouchers to be nearly $2 billion through all channels of distribution. At the time there were about a dozen or so bulge bracket pharma firms. The free pharma product business was big business indeed.

The company I was working with had a division that was one such intermediary. It was supposed to be a growth business in the portfolio: as mentioned above, pharma samples were a big business and the order volume had plenty of room to grow. But the performance was never all that impressive. When intermediaries made enough mistakes (e.g., process the reorder too early or not at all and doctors don't replenish their sample stock in a timely fashion), and the doctors will sign up with another intermediary. Since the pharma companies were the ones managing the replenishment data (what doctor received what product in what quantity on what date) and enforcing the replenishment rules, and since the pharma companies had no exclusive distribution agreements with any intermediary, a doctor could set up the same reorder profile with a dozen different intermediaries. The first intermediary to process the reorder successfully won the business that day. And, not only were there lots of intermediaries competing for the same business, the pharma companies operated their own direct-to-doctor channels as well - and distributed the bulk of the product that way.

Being a crowded field, intermediaries had no pricing power with the pharma companies. By way of example, at the time the internet travel booking business had a take rate of somewhere between 5 and 10% of the value of the travel services they were selling; intermediaries had a take rate of a tiny fraction of a percent of the value of the product order they were submitting.

In short, there was no customer loyalty, no vendor exclusivity, and no pricing power in this business. There was a market, but no obvious winning strategy. Infrequent site visits meant that user experience wasn't going to provide an edge. Orders duplicated across multiple intermediaries meant that even the smartest algorithms and the fastest technology would provide only a fleeting edge as competitors would quickly catch up. Acquisition wasn't an option as every seller would demand too high a price for little value in the form of assets or cash flow. Industry consolidation would simply formalize the value destruction that had already taken place but not been accounted for.

An intermediary couldn't crush the competition with customer love, innovation, tech firepower, or scale. They were in a state of mutually assured destruction. The only strategy was to hope that your competitors ran out of cash before you did.

Recent analyses in the financial press on the ride sharing, home meal kits and food delivery industries got me thinking about that company again. They compete in crowded fields amid the challenges of low switching costs, low margins, little differentiation, and no customer loyalty. As the Wall Street Journal put it, these companies are now engaged in "a land grab for overlapping customer bases". Every ride from Lyft and Uber is still subsidized by investor capital. There wasn't enough of a market for home meal kits to support the number of firms competing for it.

The Journal makes the point that the would-be disruptors in home meal kits have done more to disrupt one another than they have to established players in retail food, and that's an important point. That these firms are "disrupting" in a different competitive landscape to their technological forebears: building a business at the expense of sleepy competitors in legacy industries (as firms such as Amazon and Expedia benefited from in the 1990s) is much different than trying to do so with evenly-matched competitors.

This casts doubt on the investment case. The long play for all of these companies is winner-take-all: all the chips go to the last player standing. Reuters Breakingviews estimates that the total current market cap of food delivery firms prices in optimistic growth, profitability and value multipliers. Breakingviews goes on to point out that an "... optimistic ending would be one firm knocking out rivals and boosting its pricing power. A more likely one may be that valuations, far from getting hotter and rewarding venture capitalists, grow cold." And what if it isn't a contest worth winning? Groupon won the online coupon competition. It didn't work out too well on a total-return-on-capital basis.

As mentioned above, I've seen this movie before. The Journal article was titled "Mutually Assured Destruction in Silicon Valley." That's apt.

The chattering classes and management consultants advocate for incumbents get into the disruption game themselves. It's certainly good for the pontificators and suits if the incumbents do, because it generates clicks on articles and contracts for services. But doing so asks established firms to enter into very expensive gambles that don't play to any of their strengths, and may offer no payoff whatsoever. Pundits and consultants are very good at spending other people's money - on themselves. Incumbents need to concentrate on their strengths, not their weaknesses.

The incumbent's response to disruption in financial services offers some insights. Clearly, Fintech has had an impact: things like loan origination are far more efficient at banks today than they were just a few years ago. But the disruption storyline in finance is far more muted, in large part because of the way the incumbents responded to it. Incumbent financial services firms didn't try to enter as competitors to the startups, but employed a combination of tactics including infiltration (experienced bankers dominate FinTech boards), co-option (licensing and integrating new technology), and economic might (buying loan books). It should come as no surprise that today, FinTech lenders look more like banks than banks look like FinTech lenders.

Rather than taking a high-risk position well outside of a firm's comfort zone and competencies, patience can be a better strategy. Enter into non-exclusive partnerships and licensing deals and lightly finance the entrants to encourage competition, penetrate their boards to influence their strategy, and alter their book of business to make them economic dependents, all while cleaning up your balance sheet to have more equity and less debt. The incumbent that can do that will have a stronger risk footing when the time is right to strike in changing market dynamics.

Come On and Take a Free (Regulatory) Ride

Within 24 hours of last month's post on regulation of technology firms, new anti-trust probes into Google and Apple were reported by the Wall Street Journal. Around the same time, Renault stirred up a hornets nest of regulatory furore over its proposed (and subsequently withdrawn) merger with Fiat Chrysler. It's worth examining the prior in the context of the latter to understand why the regulatory free ride Big Tech Media firms enjoy will continue for quite some time to come.

Instead of thinking about companies as financial entities that reward investors, think of them as agencies that fulfill public policy. Let's start by looking at the automotive industry. Economies benefit from the physical mobility of their citizens: the more affordably they can get around, the more flexible they are as a labor force, the more likely they are to get out and spend, etc. To be competitive in the transportation business, a company needs scale; that means transportation companies are large direct employers. The complexity and sophistication of modern cars means that automakers have expansive supply chains, making them large indirect employers as well. Transportation is an industry of great national importance: jobs create middle-class households that spend money, pay taxes, and vote.

But transportation creates a lot of other problems such as energy consumption and pollution, so cars are regulated for their safety equipment, the types and quantities of energy they use, and the amount of pollution they generate. In this way, government can get its citizenry mobile with fewer negative consequences. It isn't a stretch to say that automakers are executors of public policy on the combination of transportation (mobility is good), labor (jobs are good), energy (fuel efficiency is good), and environment (clean air is good).

It takes quite a while for a society to figure out the consequences of its innovations and the price it is paying directly or indirectly for the benefits it enjoys, hence regulation lags commercial innovation for a very long time. For example, corporate financial disclosures were not regulated with the first stock sale or even the first equity market crash: the Philadelphia Stock Exchange was established in 1790, but the Securities and Exchange Commission didn't come into being until the 1930s. Similarly, cars were not subject to emissions regulations with the sale of the first car; delays in emissions regulation stemmed from the fact that the good of affordable mobility outweighed the bad of pollution in the minds (and perhaps the wallets) of policy makers for a very long time.

Let's look at the aborted Renault-FCA merger in this light. Aside from the tantalizing potential for the best buffet cuisine ever in the history of annual general meetings of shareholders, in financial terms this appeared to be a rational merger. A combined Fiat Chrysler Renault with a side order of Nissan and Mitsubishi would have girth in all of the numbers automakers have been traditionally measured on: production volume (third largest, globally); market access (full-scale distribution networks in every major car-buying market including the US, Europe and China); and margin (Dodge and Jeep light trucks.) In short, the proposed merger would have yielded everything except for the specific electronic vehicle technology that governments are adamant that auto manufacturers must deliver. Even there, the combined R&D spend would effectively double, reducing wasteful redundancies: US$8b goes a lot further than US$4b twice over. Given the fact that for the time being EVs are doing more damage to automaker P&Ls than being a source of industry disruption, that combined R&D spend would go a long way to charting a course for a successful future of the two companies.

Unfortunately, the tie-up of the two firms quickly ran afowl of labor policy. Part of the sales pitch of the merger was that Renault would gain access to the US market through Fiat Chrysler dealerships. But it doesn't make sense for a dealer to be selling a Renault Clio side-by-side a Fiat 500, with a Mits Mirage in the showroom just through that door over there and the Nissan Versa in a showroom across the parking lot. It makes even less sense given both dealer and manufacturer are losing money on the wholegoods sale of the small car. There is a stronger argument to be made that these products on nearby showroom floors will simply cannibalize sales from one another, much as the Jaguar F-PACE did to the Land Rover product lineup. If that proves to be the case, than the combined companies will stage their own private fight clubs of their products. Sooner or later, the rationalized product portfolios will result in rationalized production capacity. By way of example, look at the lineup of Fiat Chrysler products: the Chrysler and Dodge brands have no small cars; FCA meets US CAFE requirements with the small Fiats. And, of course, Kraft made similar assurances about maintaining production facilities before acquiring Cadbury only to abandoned them one week after the completion of the merger. The leaders of Renault and FCA said they anticipated no plant closures, but it was difficult to take those assurances very seriously.

In financial terms, consolidation made sense because a consolidated manufacturer can produce just enough small cars (which are by and large unprofitable) to offset their production of light trucks (Chrysler, Nissan pick-up trucks), designer vehicles (Alfa Romeo), performance vehicles (Nissan GT-R, Alpine A110) and exotic vehicles (Ferrari), all categories where automakers make money. But in political terms the merger did not make sense, because it is easier to ramp up production of the facility producing (currently) money-losing small cars to offset any gain in money-making larger cars than it is to perpetuate a lot of factories producing small cars. Gains for a factory producing small Fiats in Italy really would translate into reductions at a factory producing small Renaults in France if the consolidated automotive fight club rewards the Fiat model over the Renault model. While the combination would make financial sense and make it more likely that the two companies would survive the transition to electric cars, the loss of jobs was too great a risk for either the Italian or French governments to bear.

What does this tell us of the ramp-up of anti-trust probes into Apple and Google?

Google is a big media firm which it monetizes through advertising. Google did not invent advertising, mass advertising, or targeted advertising; it found ways to provide a scale of advertising at a level of reach greater than any outlet had ever created before, which it can sell to advertisers at a price lower than what traditional media could offer, with more accurate targeting to boot. Google provides this ad space in media outlets that did not exist previously, ranging from browser-based search, to geographic search (maps), to in-home search (Google Home), to in-car (Android Auto), to many other media outlets. Google's imagination for the possibility of monetizable moments is many decades in front of that of any government.

In the process of becoming Big Media, companies like Google have become Big Surveillance, both directly (the data they capture and analyze) and indirectly (the multitude of 3rd party firms in the analytics chain). Cross-analyzing data creates infinitely targeted opportunities to pitch a consumer transaction: by capturing payments (Google Pay), Google knows you have an affinity for Mediterranean cuisine; by capturing your location, Google knows you travel to San Antonio and stay in the same hotel every week; by capturing your boarding pass info, Google knows your flight is running a bit late. It might be a great convenience - in fact, it might even delight you - if Google Express not only suggested a Mediterranean restaurant, but built an order based on your previous menu choices and scheduled the order to be delivered to your hotel in time for your late arrival.

Consumers are not the only ones who stand to benefit from such analysis. The accelerometer in the phone and the spacial-temporal data captured by maps mean that Google know whether you drive the rental car you get in San Antonio every week in an aggressive manner. The rental car company and your auto insurer would like to know that, as they could price in the risk of accident based on characteristics of your actual driving patterns as well as the responses by the drivers around you to how you drive. (Yes, Progressive Insurance has offered something like this for years, but with Progressive the insured is making an explicit decision to expose driving data; Google could choose to collect that data and provide it to insurers and rental car companies and law enforcement agencies without consumer consent). The contract between insured and insurer has traditionally been based on reported events, specifically moving violations and accidents. The insured had a great deal of leeway in deciding how to behave as long as the what happened showed no indication of trouble to the insurer.

Western societies. and the United States in particular, are based on the rights of the individual, the wellspring of personal freedom. Individual anonymity is a contributing factor to protecting those rights, as the individual is free to make decisions - what to do, how to drive, what to eat, what to invest in, what to read, how to be entertained - without fear of repercussion for the choices they make. Continuous surveillance all but eliminates the anonymity of the individual, exposing not only what people do but providing potential clues as to why they do them because a person's decisions and actions expose their own preferences, beliefs and values. Plus, any one person's decisions erode the anonymity of the people around them: the data collected on one person may indicate an ailing parent or struggling child. Continuous surveillance raises some thorny questions for western societies. What are the consequences when the individual effectively loses decision rights over how they do things to the companies they do business with? What is to stop a company from predatorily monetizing a condition that a person wishes to keep discreet? What prevents an individual from being targeted for the values they are perceived to hold through the decisions they make? What if the algorithms conclude the wrong things about an individual based on the data that it has?

Western governments have historically intervened (ostensibly) on behalf of the individual to level the playing field with large companies. The rise of the American middle class in the first three decades of the 20th century created a large new category of individual investor, enabling legal but ethically questionable (that is, exploitative) financial reporting practices by corporations; with middle-class investors wiped out by the market crash and confidence in public markets all but non-existent, the US government created the SEC. The shift of the American economy from agrarian to industrial in the 19th century allowed for legal but ethically questionable labor practices by industrial firms; as labor unions arose, government eventually supported (and in many cases, enabled) worker organization. The plot is no different this time around, with Big Media engaging in legal but ethically questionable consumer practices. The scale is much different, though: 20th century Big Industry was large in economic might but still human in scale; Big Surveillance is large in economic might and machine in scale.

The anti-trust probes revealed earlier this month target the commercial activities of Google and Apple. These are regulatory probes within the constructs of established policy stemming from the industrial era. The question any probe has yet to ask is one of public policy: if and how to protect individual freedom against constant surveillance and activity derived from that surveillance at machine scale. Before it can answer that question, government must be able to frame the problem in that light, define what rights individuals really have, can conscionably waive and under what circumstances they can be waived, and what rights the individual has no right whatsoever to expect.

Labor policy is well established, so it wasn't difficult for either the French or Italian governments to conclude the risk of combining state champion companies was too great. Data and information policy is not well established and it will take time for the US government to define it in such a way that companies that rely on Big Surveillance do so in a manner that advances desirable, multi-faceted public policy, and not simply exploit its absence. The scale and complexity of forming that policy, in what is new regulatory territory for every government, means that the regulatory free ride will continue for quite a long time.

The Safe Haven of Regulation

Big tech has historically been lightly regulated. True, both IBM and Microsoft were subject to regulation in 1956 and 2001, respectively, to limit their monopolistic powers. But neither suffered dents in their financial returns as a result (attorney fees notwithstanding), and the tech industry innovated in ways that made their respective monopolistic states very short lived. Today's cash-gushing tech companies such as Oracle, SAP, and ironically the most valuable of them all, Microsoft, are all utility providers that enjoy light regulation. The light-touch regulation party will not end for them any time soon.

Facebook is not big tech, it is big media. Facebook enjoys - for now, anyway - the status of being a lightly regulated cash gushing media utility. Although it has become ubiquitous, it makes money in ways that national regulators of media are still years away from catching up with. That regulatory lag means Facebook is effectively regulated by national and trans-national governmental bodies such as the US Congress, UK Parliament, and European Commission. That has been a boon to Facebook as national legislatures have many more things to concern themselves with than a media outlet.

While the threat of regulation creates uncertainty, the bigger challenge facing Facebook isn't regulation but the threat of being both a tool and political beach ball for many, many more election cycles to come. To the average citizen of any country, it may stand to reason that the nature of media outlet that Facebook has become needs codified regulation spanning everything from what gets published to who has decision and economic rights over user data. But to the political classes, Facebook is heads-I-win-tails-I-win. If people are easily manipulated through Facebook in the actions they take from how they vote to how they immunize their offspring, Facebook is a channel to be exploited. If there is evidence that political opponents have used disreputable tactics to manipulate people through Facebook for their own purposes, Facebook is a convenient punching bag. The downside risk to Facebook is that while it may enjoy light formal regulation for some time to come, it will be continuously on trial in the court of public opinion. That isn't a fun problem for marketing to solve, or for their lobbyists to navigate. Investors get tired of this.

Facebook are evidently considering going into the payments business. By entering into payments, Facebook would be choosing to become a regulated business. Facebook would be regulated by bodies such as the US Fed and the UK's Payment Systems Regulator and their equivalents in every jurisdiction where they offer payment services. That introduces technical jargon that is more specific than political jargon, which is easier for the regulated to succeed under. Where there is regulation by rule the burden is on the regulator to prove non-compliance, whereas today Facebook is regulated by principle, and as a result must argue it is neither out of compliance with societal norms nor complicit in acts by those who use it in ways that are.

Entering into payments is a logical first step into the four functions of finance that John Kay identifies in Other People's Money: facilitate payments, match lenders with borrowers, manage personal finances across lifetimes and generations, and manage risks associated with everyday life. Once in payments, it isn't difficult to imagine Facebook creating a credit function to provide microloans that facilitate purchases. Over a span of a few years, it isn't difficult to imagine Facebook leveraging their trove of data to offer algorithmic solutions to manage personal finance and manage risks. Financial services would offer a lot of growth runway: WeChat derives 60% of its revenue from payments and only 30% from advertising, and payment processors like PayPal and Square write a lot of loans to merchants.

It will not be easy to change from being an unregulated to regulated company (it's a bad idea to break things where people's money is concerned), costs will go up (compliance isn't cheap), and the potential for bad headlines - money laundering, robbed wallets - will only increase. But these are comparatively benign problems for a company with a product that has been used in the commission of numerous felonies.

Facebook has largely escaped regulation to date. However, its enormous size and influence, its economic power, and its existence as a lightly-regulated multi-jurisdictional entity all suggest that regulation is coming. The regulatory lag between old media (print and television) and social media make it clear that governments are not prepared for the task. By redefining its business as a commerce platform rather than a media platform, Facebook would be able to choose its regulators rather than wait for legislatures to pick one - or worse still, create one - for them. It would then have the pick of mature regulators, agencies that are less likely to be politically charged than an upstart chartered specifically for the purpose of regulating social media. A mature regulatory agency would also bring an imprimatur that carries weight with consumers and politicians worldwide.

As a move designed to defend their greatest asset - data - regulating key aspects of the business under the auspices of financial services would be pretty shrewd indeed.

Excellence

“A fishing crew may be organised and understood as a purely technical and economic means to a productive end, whose aim is only or overridingly to satisfy as profitably as possible some market’s demand for fish. Just as those managing its organisation aim at a high level of profits, so also the individual crew members aim at a high level of reward. Not only the skills, but also the qualities of character valued by those who manage the organisation, will be those well designed to achieve a high level of profitability. And each individual at work as a member of such a fishing crew will value those qualities of character in her or himself or in others which are apt to produce a high level of reward for her or himself. When however the level of reward is insufficiently high, then the individual whose motivations and values are of this kind will have from her or his own point of view the best of reasons for leaving this particular crew or even taking to another trade. And when the level of profitability is insufficiently high, relative to comparative returns on investment elsewhere, management will from its point of view have no good reason not to invest their money elsewhere.

“Consider by contrast a crew whose members may well have initially joined for the sake of their wage or other share of the catch, but who have acquired from the rest of the crew an understanding of and devotion to excellence in fishing and to excellence in playing one’s part as a member of such a crew. Excellence of the requisite kind is a matter of skills and qualities of character required both for the fishing and for achievement of the goods of the common life of such a crew. The dependence of each member on the qualities of character and skills of others will be accompanied by a recognition that from time to time one’s own life will be in danger and that whether one drowns or not may depend upon someone else’s courage. And the consequent concern of each member of the crew for the others, if it is to have the stamp of genuine concern, will characteristically have to extend to those for whom those others care: the members of their immediate families." (MacIntyre, 1994, pp.284-285)

Now MacIntyre is a moral philosopher, and there is no reason why he should ask the question which would concern a business economist like me: which of these crews catches more fish?

-- John Kay, Ethical Finance

In the early 1980s, Tom Peters and Robert Waterman co-authored a book called "In Search of Excellence." At the time, US products and services were generally regarded as inferior in quality to those from other countries. It was bad enough that American manufactured goods and consumer services were so poor; what really made it annoying were the tens of thousands of corporate bystanders who were unwilling or just flat-out helpless to do anything about it. That inaction in corporate America was brought home with a video of a Japanese manufacturing line worker electively inspecting the windshield wipers on finished cars on his way out of the plant after his shift was over. Needless to say, Peters and Waterman had struck a nerve.

Although In Search of Excellence presented an empirical case for a correlation between economic success and excellence in operations, their case studies didn't stand the test of time as a number of their exemplar companies suffered problems within a few years of the publication of the book. While those companies didn't necessarily underperform for operational reasons, their disappointing results did cast doubt on the causality. Still, that didn't invalidate their thesis: at most, the evidence of causality is fleeting owing to multiple business conditions; at the very least, In Search Of Excellence was the first to articulate some common sense stuff.

There are other ways to look for the relationship between excellence and outcomes. Dr. John Kay has long argued that a company that is in the business of what it does will outperform a company that is in the business of making money. When Imperial Chemical Industries was in the business of "the responsible application of chemistry" and Boeing's purpose was to "eat, breathe and sleep the world of aeronautics" they were dominant firms in their industries. Each changed their focus to be in the business of financial outcomes. Once that happened, the latter lost its previously unassailable grip on commercial aviation while the prior disappeared entirely as an independent company. When a business disconnects the value of what it provides from how it provides it, and connects it instead to the financial results it wants to achieve, it tends to fall well short of goals. Worse still, once that transition happens the business itself can erode very, very quickly.

In his book Good Strategy, Bad Strategy, Dr. Richard Rumelt lays out characteristics of bad strategy, including mistaking goals for strategy. "Bad strategy", writes Dr. Rumelt, "is long on goals and short on policy or action. It assumes that goals are all you need. It puts forward strategic objectives that are incoherent and, sometimes, totally impracticable." Good strategy consists of a diagnosis, a guiding policy, and coherent action. By definition, strategy is execution-focused; without execution, strategy is worthless. Financial results are not a strategy, they are byproducts of identifying gaps and challenges, meeting and overcoming those - and that the hoped for opportunities that lie beyond them do, in fact, materialize.

If strategy is execution, then what a company does and how it does it will drive the outcomes that it achieves. Yet there is a subtle differentiator in the "how" that Alasdair MacIntyre, the author of the introductory narrative, draws attention to. The first fishing crew has incentives to achieve performance targets. They have clear alignment of values, skills, and outcomes, on which they are supervised and measured. The second fishing crew has a social contract with one another. They also have clear alignment of values, skills, and outcomes, but that alignment happens through how they function as a community: they teach and reinforce values, skills, norms, and behaviors, and they extend their duty of care to the families of their members. Whereas each member of the prior group is committed to themselves individually, each member of the latter group is committed to each other. Mr. MacIntyre makes clear that a commitment to excellence is a product of a community, not a group of individuals no matter how like-minded they may be. He also makes clear that the value yielded by excellence is more than just financial remuneration for doing the job.

But does excellence matter?

Given how narrow measures of business value tend to be, the evidence tends to be on the negative more than on the affirmative. Excellence is like governance, in that it is most obvious when it is absent than when it is present. For example, you can argue as Dr. Kay does that American automakers, having never quite leveled up to the quality standards of their Japanese and German peers in sedans and small cars, suffered more acutely in the 2008 recession than perhaps they would have otherwise. American manufacturers couldn't compensate for a big fall-off in demand for SUVs and light trucks by selling more sedans and small cars, and as a result two out of the three took a tour through bankruptcy, wiping out a lot of investors. In the story of the two fishing crews, Dr. Kay cites the case of the Prelude Corporation which tried to bring modern management to the commercial fishing industry, only to misunderstand that excellence in operations matters more to success in fishing than do measurements and supervision. The Prelude Corporation, which had been a large lobster producer, went out of business within a few years of adopting those modern management techniques.

A company can create the appearance of financial mastery over operations through things like aggressive cost management and starving itself for investment. But as Kraft Heinz reminded investors recently, burning the furniture to keep warm only lasts for so long. If you believe financial goals are more likely to be met by the absence of bad (no accidents, no shutdowns, no product failures) and the presence of good (high netpromoter score, high quality ratings, high uptime), then you can accept that excellence in what a company does and how it goes about it will be a contributing factor to both limiting impairments and generating value. Not necessarily as quantifiable as we would like it to be: the counterfactuals aren't provable and customer decision-making rationale is wooly. But it is enough to say that excellence - as a socio-cultural phenomenon - amplifies the upside and buffers the down.

Sometimes the Strategy is Buoy the Credit Rating

These drastic actions provide reassurance to creditors that big companies will do just about anything to keep their investment grade ratings.

FT Lex, US credit ratings: attack of the killer Bs

As a company grows, and the rate of its growth slows, it changes its capital structure. Early-stage capital is speculating on future cash flows, while later-stage capital has expectations of future cash flows. Growth is risk, so early stage capital is equity. Reliable cash flows stem from operational consistency, so later-stage capital tends to be debt.

Equity capital absorbs losses. Equity tolerates downturns, disappointments, failures, we-thought-it-would-work-but-it-didn't-quite-turn-out-that-way by losing value or disappearing entirely. The equity investor takes a risk that a scheme will turn out for the positive. If it does, the investor has a claim on success; if it does not, well, thanks for playing.

Debt capital is loss intolerant. An investor loans money with the expectation that the borrower can regularly pay the interest on the money borrowed and has means of making the lender whole on the principal. A business borrows against future cash flows from its business operations. The credit-worthiness of a business impacts the interest rate associated with its debt.

Stability of cash flows is a major factor in determining the credit rating. The more volatile the cash flows, the lower the rating, the higher the risk to the lender, the higher the interest rate on the debt. The higher the interest rate, the more future cash flows are pledged to debt service and the less cash there will be to distribute to equity owners and employees, and for the company to invest in itself. Because corporate debt is generally rolled-over - that is, bonds that mature are replaced by newly issued ones - a business must sustain its credit rating all the time.

To investors, equity capital is higher risk than debt. But to a company, debt is higher risk than equity. Suspend dividend payments and the company keeps on ticking; default on an interest payment or two and the company will be forced into bankruptcy and sold or liquidated.

Sadly for remaining shareholders, that means slashed dividends, M&A freezes and turning away from growth.

A company with a substantial debt load will prioritize servicing that debt above spending on opportunities that might help it to crawl out from under that debt, e.g., investing for growth. Cash flow is a contributing factor to keeping the credit rating above junk, which keeps the interest payments low and makes it economical to roll over. If the credit rating falls below investment grade, a lot of institutional buyers will not only have to sell the bonds they currently hold, they'll not be able to buy new bonds issued by the company, which makes the roll-over more expensive (fewer buyers == less demand == higher coupons). A challenged incumbent laden with excessive amounts of debt does not have the right capital structure to invest in itself because it is beholden to bond markets.

That seems like a paradox. Isn't this the very existential threat that leaders of incumbent companies are supposed to be responding to through inventive and innovative means? If the operating numbers tell us we're at a disadvantage, shouldn't we be addressing that disadvantage head-on through transformation, investment and acquisition?

The question here is: how existential is that operating disadvantage? Lex makes another very interesting observation:

The lessons? First, never underestimate institutional inertia. Second, big established companies have more resources and market power to weather a downturn. Bosses and bond investors should be grateful. A downgrade of a few notches to junk status would be devastating for them.

As long as credit rating agencies play ball, lenders will continue to lend at investment-grade interest rates and borrowers will have time to shore up cash flows through disposals, cuts, and efficiency drives. That lending can go on for a very long time.

The longer this lasts, the longer incumbents can use their financial resources to co-opt their upstart challengers. Not many start-ups have access to equity capital that is as patient or as deep as what bond markets offer to incumbents. And, because the market opportunity defined by the disruptors becomes crowded quickly (there are rarely barriers to entry, so a lot of copycats appear before too long), disruptors look for new ways to generate revenue. That creates the opportunity for incumbents to gradually do deals with new entrants to buy their assets, license their technology, take minority positions, or take outright control. All the while, as those start-up businesses mature they begin to resemble their legacy competitors. For example, Fintech firms are under increasing regulatory pressure, as well as applying for banking licenses.

An incumbent may be able to shape the future of its industry as convergence with rather than replacement by new entrants, through the startups ability to attract capital and the incumbent's ability to direct it. If that's a possibility, the start-ups represent less of a threat and more of a path of evolution for the incumbent: a new source of assets it is not able to originate but happy to put on its balance sheet (e.g., banks buying usurious loans made by P2P lenders); a new source of technology that makes its operations more efficient (banks licensing new lending technology to replace their own); financial exposure to the success of new products and services without risking volatility of the cash flows from operations (GM investing in Lyft). The incumbent can reap the benefits of change without needing to lead the change, all through exercising its market power and access to finance.

There are no guarantees that an incumbent can successfully execute any strategy, let alone a strategy of co-option. But betting on its strength - its financial resources and market power - is a safer course of action than doing a massive capital restructure through debt/equity swaps to finance a corporate re-invention.

Sometimes CEOs will concede that working for shareholders means working for bondholders first.

The Lex article serves as a stark reminder that companies are financial phenomenon first, operating phenomenon second. The type of capital invested determines the strategy a company pursues and the way it operates. It also reminds us that institutional inertia is a very powerful force in capital markets, where both incumbents and lossmaking startups have intractable dependencies.

The Obsession with Metrics

In recent decades, what I call “metric fixation” has engulfed an ever-widening range of institutions: businesses, government, health care, K-12 education, colleges and universities, and nonprofit organizations. It comes with its own vocabulary and master terms. It affects the way that people talk and think about the world and how they act in it. And it is often profoundly wrongheaded and counterproductive.

Metric fixation consists of a set of interconnected beliefs. The first is that it is possible and desirable to replace judgment with numerical indicators of comparative performance based on standardized data. The second is that making such metrics public (transparency) assures that institutions are actually carrying out their purposes (accountability). Finally, there is the belief that people are best motivated by attaching rewards and penalties to their measured performance, rewards that are either monetary (pay for performance) or reputational (rankings).

-- Dr. Jerry Z. Mueller, The Tyranny of Metrics

In his book Other People's Money: The Real Business of Finance, Dr. John Kay confirms the fallacy of the beliefs Dr. Mueller lays out. The societal utility that banks once provided to the communities they served evaporated once bank managers familiar with their client's character and intimate with their client's needs were replaced by bank salespeople hawking financial products to clients on the basis of credit-scoring algorithms. An increase in published corporate financial data has led to a decrease in transparency as the data published is beyond the comprehension of all but the most sophisticated consumers of it. Rewarding people for hitting financial targets created trading for trading's sake and runaway bonuses, culminating in an "I'll be gone, you'll be gone" culture that intensified the 2008 financial crisis. The misplaced beliefs pointed out by Dr. Mueller lead to the undesirable outcomes described by Dr. Kay.

Dr. Mueller goes on: "Not everything that is important is measurable, and much that is measurable is unimportant."

The first part of this statement begs the question: what is important in business? I posit that in most enterprises today, the outcomes are actually less important than the means. Let that sink in for a moment. Companies have lost a lot of tribal knowledge about their systems and even their core business. They need to first regain that knowledge to put themselves on a path to make their legacy systems (a) accessible, then (b) extensible, and eventually (c) malleable again. What most enterprises desperately need is learning and growth, not more software endpoints on the fringe of an impenetrable legacy hairball. What truly matters is being able to systemically achieve outcomes; achieving outcomes in isolated instances is not a proxy measure for the intrinsic ability to do so.

This sounds great, but it is easier said than sold: regaining lost knowledge and developing the ability to do different things with it may be important but it isn't really measurable in any meaningful manner. Because boards are financially - not operationally - focused, learning and growth will never be a board priority because it doesn't appear on any financial statement. Or at least, not in a positive way: "learning" is cost bloat on the income statement, while "knowledge" is not a leverageable asset on the balance sheet. Making learning and growth a long-lived business priority is a leadership challenge that goes beyond reporting "training hours" and "number of people trained". It takes persistent, compelling storytelling that relates how successful outcomes have been directly and indirectly enabled by the journey and application of organizational learning and growth - and therefore how these outcomes have become organizationally systemic, and not accidents of chance.

Proponents of metrics champion causality: that for an action to be important it must yield some sort of measurable result. I've written elsewhere that causality can be difficult to establish, particularly in complex business environments where constant and dramatic changes inside and outside a business will create volatility of an observable metric. But the causality argument can work against prudent decision-making. For example, suppose we expect to achieve a specific cost efficiency in several stages: we first make business process change supported by some crude technology, soon followed by major technology change to more comprehensively automate that process change, and along the way we look at the data for stubbornly high-maintenance customers to weed out. Common sense tells us these are all good things to do and that the combination of these events gives us operational lift. Unfortunately, a spreadsheet analysis would conclude that investing in the comprehensive tech is useless as the bulk of the cost efficiency will be captured by the manual changes supported by crappy technology; vulnerability to things like manual error is a thin justification for allocating capital when capital is held dear. The spreadsheet analysis also concludes that efficiency cannot come at the cost of topline growth; to the spreadsheet analysis, every dollar of revenue is the same, so we keep all customers, no matter how inefficient it may be to serve them. Ironic that the spreadsheet-based decision-making makes a company both more valuable and a worse business at the same time.

The second part of Dr. Mueller's statement - "much that is measureable is unimportant" - points to the idiocy of many metrics. First, there are vanity metrics. I've relayed this case in a previous blog, but I once worked with an insurance company that used a nominally dollar-denominated coin called "business value" to measure the total impact of IT projects. In a single year they reported yielding more business value than the market capitalization of the firm. It's entirely possible they were woefully undervalued by markets, but it's more likely that their "business value" was as worthless as the PowerPoints they were pixelated on. Then there are the tenuous proxy metrics. A universal bank that had caught the Agile bug used the number of teams using Jira and Jenkins as the measure of how many teams had "gone Agile". Never mind what was actually going on in those teams, or the fact that nothing else - quality, throughput, customer satisfaction - was being effectively measured, let alone changing. The boss said we're going Agile, these are Agile tools, so once all of our people are using Agile tools we must be Agile, and the rest will follow.

Pursuing measurable value can create bigger problems if it is used to prioritize local optimization over systemic optimization. Consider a technology that accelerates systems integration and therefore reduces the cost of development of individual projects, but will very likely result in redundant integration activity across multiple project teams, a higher total cost of ownership across the portfolio of software assets, and a higher cost of change when a common system changes. A bankable lower cost today will will win out over potentially higher costs tomorrow. The prior can be measured - and managers rewarded - in the context of beating budgets for specific projects. The latter is absorbed into a business-as-usual budget, where the incremental inefficiency cannot be meaningfully disentangled from all the other incremental inefficiency piled into it. Urgent priorities always crowd out good lifestyle decisions; but metrics that justify the urgent are always more compelling than metrics that prioritize the important.

Dr. Mueller makes several recommendations for overcoming a metrics fixation, among them: "... [A]sking those with the tacit knowledge that comes from direct experience to provide suggestions about how to develop appropriate performance standards. [...] A system of measured performance will work to the extent that the people being measured believe in its worth." To do so recognizes that domain familiarity is necessary to determine the appropriate measurable outcomes. That implicitly means a definition of worth is not something that is going to come out of an abstract analysis of value. An ounce of context is worth a pound of measurements.

"With measurement as with everything else, recognizing limits is often the beginning of wisdom. Not all problems are soluble, and even fewer are soluble by metrics. It’s not true, as too many people now believe, that everything can be improved by measurement, or that everything that can be measured can be improved."

The better that we holistically understand our business and the more imaginative we are about our understanding of it, the better we intrinsically understand what it takes to make it a better business. In human systems, the whole is greater than the sum of the parts because of the intangible elements that humans bring. Consider baseball. The game of baseball has entered a stats-heavy era that has changed how people think about the game, but numbers, as Steven Kettmann put it, "eclipse a nuanced understanding of the game." Numbers provide insight and can help to re-think long held assumptions. But numbers don't tell the full story of the game. "Being alert to the twists and turns of a game is vital, since it’s the glimpses of character that emerge during these unlikely sequences that give baseball its essential flavor." Mr. Kettmann cites the example of a player's anticipation for how a play will develop as the deciding factor in a playoff game, and possibly a series. There is no spreadsheet for human decision-making in the moment.

It will take some time for the dust to settle, but results reported by Kraft Heinz last week have brought 3G Capital's management tactics - heavy cost-cutting deduced from heavy data analysis - into severe question. Those management tactics appeared to be successful for a number of years, until they weren't, and quite abruptly so. That sudden change in fortune has drawn attention to things critical to a business - asymmetric exposure to a single consumer market with subtly changing consumer tastes and an irrelevance of the consumer-products marketing model in people's daily lives - that required more than data to perceive, let alone prepare for.

"Managers agree. 'I watch the game,' said Bruce Bochy, the manager of the World Series champion San Francisco Giants. 'You don’t see me writing down a lot of things or having to look down at stats. They’re important, but there are some things that you can’t see on a spreadsheet.'"

Metrics help us to better understand something that we've learned through experience and observation. But we can never appreciate something through numbers alone: we must have the wisdom of experience and observation. Metrics are sources of data and potentially sources of information, but they are not sources of wisdom.

Enterprise Change is Leadership Change

From the COO's perspective, the corporate IT department has hit rock bottom and they keep digging. Very little gets deployed, and the software that does make it live is embarrassingly bad.

IT is not exactly a clean canvas. ERP, CRM, document management and other key systems started life as COTS products but have been configured beyond recognition to a point where they can't be upgraded, and they're so ancient they've been disavowed by their vendors. Adding insult to injury, we're sitting on decades worth of data, but can't point to a single insight we've ever gleaned from it. The COO is not going to be jockeying to get IT reporting up to him any time soon.

The CEO has all but lost patience. She can't understand why she gets the same dead-end answer of "legacy systems" when she asks the CIO "why do we have to spend so much on IT?", "why are our systems not in the cloud?", and "why aren't we mining our data?" The board is asking her these questions, and she's got to have answers, not the same excuse.

* * *

IT knows it has a lot of problems. More than a few believe that the way it works is a big part of reason why. Every delivery team is blocked for reasons of access, authorization, and answers it needs from armies of people spread across a myriad of IT functions. Organizationally, there are silos within silos and shared services within shared services. If teams could work more independently toward a goal they would get a lot more done.

Somebody gets the idea that maybe we can solve this through better process. If we were to adopt Agile we'd have control and predictability and quality and speed-to-market. If we reorganize into cross-functional product teams, we'd get better solutions and some real insights.

A pilot or two here, a consultant or two there, a few slide decks and a site visit to a respected technology firm, and it's decided: we have seen the future, and it works. We're going to change.

We’re a large enterprise, so we need to roll out change at scale, and in a controlled manner. And so we get the enterprise Agile change program...

* * *

Over the years I’ve had the opportunity to examine several enterprise Agile change programs that are well under way. Those that were not living up to their initial fanfare (and quite a few of them were not) share a few common characteristics.

All organizational communication flows still go on one direction. The new "product operating model" bears striking resemblance to the old "program operating model": it moves from analysis to specification to development to deployment, all in a sequence of straight lines going left to right. There are no feedback loops anywhere in this cycle. As a result, there is no tolerance for team-level discovery let alone empowerment to act of its own accord on what it has discovered. Every team is free to build the product they were told to build. People are still bound to the plan, just like always.

Labor is assumed to be interchangeable. The Agile team model assumes there are no silos within a team: once a developer pair is free they take the next highest priority Story. But enterprise IT is loaded with specialist labor: this person only does front-end development, this person Java, this person Tibco, this person ABAP. Creating "cross-functional" teams doesn't cut it: the work distribution will be asymmetric and the team will lurch from blocker to blocker. It doesn't help that enterprise IT is also primarily staffed by contract labor. Contracting firms and their employees have incentives that favor labor specialization. The Agile operating model needs poly-skilled people, but enterprise IT doesn't have many people like that today and there are institutional headwinds against there being more of them tomorrow.

Process is the primary problem we face. No matter how collaborative and encompassing, a different mechanical process will not overcome the rot that plagues enterprise IT organizations: messy and multiple point-to-point integrations, a shortage of systemic knowledge, overloaded data structures, and poor data quality are not problems solved by a change in how work gets done. These problems are much larger than any one delivery team can possibly solve. Worse still, a process that requires a low-friction working environment to be successful doesn't stand much of a chance of taking root when the friction is very high.

As a result, enterprise Agile change programs don't make sense through an Agile lens, but they do make sense through a Waterfall lens. The change is largely cosmetic: Agile has just introduced surrogate terminology for how we’ve always done things. “Intake” and “portfolio management” are new words for “big up front design” and “detailed project plans” and rob the teams of functional discovery. Architecture activity that surfaces technical design before development robs the teams of technical discovery. Cross functional and even co-located teams can’t solve the big problems mentioned above in data, dependencies and system knowledge. Our new process might make us a little better on the margins, but in the main we still have the same integration hell, the same usability shortfalls, the same systemic brittleness and the same quality problems that we always did. The result, as others have written, is Agile in name only.

All right, so top-down change risks getting neither the mechanics nor the values of Agile. Wouldn't a bottom-up change program be more values-centric? A couple of months ago I wrote that bottom-up change - that is, linear scaling of team-level phenomenon - is inadequate for enterprise needs because there are enterprise dynamics and challenges that do not exist at the team level. This means there are classes of need that a focus on team-level process misses entirely.

The answer is not simply "do both top-down and bottom-up at the same time". To change an enterprise requires a change in leadership, not process.

Top-down change must not be charged with trying to answer the questions that enterprise IT has always mistakenly thought it had to solve: those of predictability and control. The only valuable top-down change is cultural. Cultural change is a leadership problem, not a process problem.

If we care about feedback, then by definition we value learning over being right all the time. If we value learning, than our operating model needs to be a picture of knowledge acquisition and application, not a picture of output control. There need to be at least as many (if not more) arrows depicting communication flows going backwards as forwards in the process. More importantly, it must be clear how that feedback is internalized and acted upon in the operating model. In the absence of that, learning is at best an accidental curiosity.

But even cultural change is not enough. Devolving authority and creating a means for genuinely incorporating feedback to team level execution is useless unless people are able to do these things in an unencumbered fashion. That means acknowledging the ground truths of the state of our technology and staff, and taking deliberate action on them. This is not easy to do. Long-tenured people in the organization likely made decisions that contributed to the current state of affairs. It's humiliating for somebody to admit that "past them" contributed to the reality of "present dysfunction."

As hard as that is, acknowledgement only goes so far. As Lisa Simpson pointed out to Homer as he came face to face with the fact that he is a rageoholic, acknowledging the problem is the first step. Dispiriting for Homer, it is not the last step. Acknowledgement has to lead to action that reforms. Without definitive action and lasting commitment to that action, the learned helplessness that plagues organizations with these conditions will erode the will to change.

It's all well and good to champion process, and by looking at process we can understand how ineffective we are and what we can aspire to be. But process will not overcome years of bad choices that have infected our people, assets and data. Process change that ignores these problems or denies they are encumbrances will at best be rendered inert, at worst will result in giving people responsibility without authority.

Leadership is not asking one group of people to make good on another's bad choices. Leadership creates the conditions where the rank and file have a fighting chance. Process is part of that, but in enterprise IT with large legacy estates, process is rarely the primary solution.