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.
