Kirk Klasson

Tech in the Land that Rates Forgot

This one is for all you high rollers that loaded up on low rate margin and went all in on NASD eye candy only to run screaming from the market like a preacher from the local brothel when the church ladies staged a “discovery tour” to find out where their husbands went.

It isn’t every day that a passive minority shareholder goes all activist in public and calls the CEO of one of the tech market’s darlings on the carpet to give them a short course on operations management. But that’s exactly what Brad Gerstner CEO of Altimeter Capital Management did to Mark Zuckerberg in an open letter last week. And if Zuckerberg had his wits about him, he should send Brad a thank you note for providing him the opportunity to get off his ass and address the very real issues outlined in his letter.

But that’s not why we’re here.

We’re here because Mr. Gerstner couched his complaint by suggesting that the entire tech industry has grown fat and lazy and incapable of navigating a non-zero rate environment, an obvious reference to the prevailing changes to the cost of capital. But one has to wonder, as a shareholder whose expectation for returns is predicated on a host of issues and opportunities that lie well beyond the frontier of simple interest rates, what’s the big deal? Nobody bought Facebook looking to beat the 10 year coupon on T-bills. And it’s true that over the near term Facebook’s, aka Meta’s, share price has depreciated more than a triple decker, multi-family in Youngstown, Ohio in the 1980’s. But stocks go up as well as down and Meta has made big bets to seize the laurel in the promising future of the metaverse. (see Metaverse or Bust – October 2022, Metaverse Schmetaverse – August 2021)

So what else is going on?

Well, for starters it probably has a whole lot less to do with Meta’s capital allocation, although that’s clearly called out, or Altimeter’s shares in Meta, also an obvious concern, than it does the allocation of capital to technology from rational actors who expect to realize a return, the buyers. Most tech firms operate in a weird monopoly money universe where allocation of cash flow to R&D is nothing more than pure guess work. So, if you take Meta’s $10B annual burn on the creation of the metaverse it would be impossible to state with any precision what the expected realizable return would be because frankly nobody knows. It’s a form of corporate venture capital. You could take all of the money on Sand Hill Road up to the roof, set it on fire and watch most of it burn. What’s the discount rate on that? Nobody knows. And more importantly, nobody cares. A single liquidity event and all those infernos are forgotten.

But here’s where it gets even weirder. For years technology buyers harbored this intuition that information technology had a measurable impact on firm productivity until guys like Eric Brynjolfsson came along with “Paradox Lost?” and suggested it might be there but couldn’t be found or definitively measured. Kind of threw a wrench into all those opportunity assessments where the average weighted cost of capital hovered around thirty percent. Turns out, it didn’t matter, tech had become table stakes, jacks or better, and those who couldn’t pay didn’t play. There was no one technology, no one application, that afforded chosen visionaries asymmetrical rates of return. Tech was a tide. Boats went up and boats went down. Together. That is until recently when the introduction of AI has once again sparked the notion of game changing discontinuous rates of return. And some point to instances of applications at the peak of the power curve (see AI’s Inconvenient Truth – July 2018), protein folding, cancer diagnosis, plasma engineering, and go “Ahh Haa!” but once blended into the bigger picture and longer term a similar reversion to the mean seems to emerge.

And yet, there’s a nagging kernel of truth to the non-zero rate comment. Business assimilation of technology has remained a steadfast article of faith, almost as steadfast as advertising dollars spent on social media when there is no obvious evidence of realized returns (see The Curse of the Walled Garden – January 2018). So, if you were to look for some kind of confirmation that supports the conjecture that buyers have acquired an increased sensitivity to interest on capital employed, where might you find it?

Well, you might start with a recent survey by Wanclouds concerning the coming decelerating rate of cloud conversions. For the last several years “lift and shift” was the approved mantra for all the navel gazing big metal shops. And the growing interest in Kubernetes development environments, even at the cost of air tight security, would seem to indicate that we have reached a mature phase of the public cloud market, the phase where even big user shops were ready to move legacy bespoke applications, the last domino to fall into the public cloud lap.

A quick glance at this chart would seem to suggest that 81% of C-Suite types would like to see their cloud cost remain the same or decrease, with 42% saying they would clearly like to see those costs reduced. Wonder why? Could it be that they bought into the public cloud when the capital costs to the providers were at an historic, near zero low and now in the midst of replacement and replenishment cycles are about to see those costs go from zero to 5-7%, that’s assuming that the provider doesn’t apply any burden to increased borrowing costs? Could also be that one of the primary benefits of cloud computing, the capture of discrete costs based on business process as well as technology resource consumption, just never materialized.

But given that IT costs as a percentage of revenue can be anywhere from 2-10 percent depending upon industry, geography and size of entity would this increase even matter? Seems like noise. Of course, that would also depend upon how sensitive your business might be to exogenous decreases in revenue attributable to the same rate increase to your business’ customers. A 5 percent increase in interest might result in a 10 percent decrease in revenue. And all of a sudden we’re in the land of pennies per share, a land where careers can change in a matter of minutes on a quarterly conference call, the land that tech forgot.

In one of the inaugural posts of this blog, Forecast, partly cloudy – July 2010, we suggested the the incentive to move to public clouds or service oriented timeshares were as much if not more a matter of switching costs and ownership costs than they were a matter of technology and architectures. Given that users were still sitting on a pile of useful incumbent assets it might prove prudent to wait for those costs to decline before swapping out one architecture for another. More recently, in IBM Eats Its Own Lunch – January 2019, we pointed out that the entire public cloud industry was built on zero rate capital and that simply wasn’t going to be sustainable and if you built your cloud TCO assumptions using those same rates, they weren’t sustainable either.

So now what? If a rising tide lifts all boats then the water is bound to get deeper for everyone. Perhaps. But now would be a good time to determine exactly what the interest rate sensitivities are in your economic model, for both revenue and costs, and to determine what leverage, if any, you might be able to extract from your sources and uses of technology.

And if the folks that provide you information technology can’t understand that conversation, find new ones.

Cover graphic courtsey of Amicus Productions and Wikipedia, out take from “The Land That Time Forgot” 1974 movie based on the 1918 Edgar Rice Burroughs novel of the same name. In this scene, Dactyl gets his man. All other images, statistics, illustrations and citations, etc. derived and included under fair use/royalty free provisions.

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