Thursday, March 5, 2015

For investors, all money isn't created equal

In our most recent discussion of driverless cars, I made the following assertion about Google:
Google has a lot of reasons to want to be seen as a diversified, broadly innovative technology company, rather than as a very good one-trick pony cashing in on a monopoly (possibly two monopolies depending on how you want to count YouTube). A shiny reputation helps to keep stock prices high and regulators at bay.
I didn't really think of it at the time, but this concern is a point we have hit tangentially in the past and which probably deserves a bit more direct scrutiny. Investors often care a great deal about where a company's money comes from. This concern is often neither rational nor consistent and often leads companies to mislead the public about the makeup of their revenues.

Here are a couple of examples. I am going to be rather vague about some details because, you know, lawyers, but the broad outlines are both accurate and the circumstances are common enough that I could always find other cases if pressed . The first involved a financial services company that had products for customers at both ends of the economic spectrum. If you were to look at the company as an outsider or even as a new employee, you might very well assume that the two divisions were roughly equal. You might even suspect that the upscale was more profitable.

In reality a large majority of company's profits came from the low end. It turned out that the profit margin for providing services for poor people in this case was much higher. Stockholders, however, did not particularly like products that served this demographic. Also having a heavily promoted line of products for upper-class people did wonders for the stock price.

Here's another example:
The bank in question was in the middle of a very good run, making a flood of money from its credit card line, but investors kept complaining that the bank was making all that money the wrong way. This was the height of the Internet boom but the bank was booking all of these profitable accounts through old-fashioned direct mail. If it wanted to maximize its stock price, the bank needed to start booking accounts online.

The trouble was that (at least at the time) issuing credit cards over the Internet was a horrible idea. The problem was fraud. With direct mail, the marketer decides who to contact and has various ways to check that a customer's card is in fact going to that customer. With a website, it was the potential customers who initiated contact and a stunning number of those potential customers were identity thieves.

The Internet was an excellent tool for account management, but the big institutional investors were adamant; they wanted to see the bank booking accounts online. Faced with the choice between unhappy investors and a disastrous business move, the company came up with a truly ingenious solution: they added a feature that let people who received a pre-approved credit card card offer fill out the application online.

Just to be absolutely clear, this service was limited to people who had been solicited by the bank and based on the response rates, the people who went online were basically the same people who would have applied anyway. From a net acquisitions standpoint, it had little or no impact.

From an investor relations standpoint, however, it accomplished a great deal. Everyone who filled out one of those applications and was approved* was counted as an online acquisition. Suddenly the bank was using this metric to bill itself as one of the leading Internet providers. This satisfied the investors (who had no idea how cosmetic the change was) and allowed the bank to continue to follow its highly profitable business plan (which was actually a great deal more sophisticated than the marketing techniques of many highly-touted Internet companies).

*'pre-approved' actually means 'almost pre-approved.'
Put bluntly, companies will often pursue strategies or introduce products that are profit neutral or worse because these strategies and products make the companies look diversified or forward thinking or poised to take advantage of some major opportunity. Investors reward these perceptions. With this fact in mind, you can make sense of all sorts of strange business decisions.

For example, Amazon is an innovative, well-run. forward-thinking company, but its  P/E ratio (when it turns a profit) is often in the hundreds,* meaning the company has to be seen as being on the cusp of explosive growth. When you read about the company's online grocery service or its proposed drone-to-door deliveries** and you ask yourself how they can ever make a profit doing this on a large scale, the answer may be that they don't expect to.

* There may be some controversy over how  P/E ratio is calculated for Amazon but that's a topic for another post and probably another blogger.

** I added "drone-to-door" to emphasis the distinction between that proposed technology and large cargo drones. The latter actually does make business sense but would face huge regulatory hurdles.

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