Turnarounds Don't Work in Tech

Yahoo, Dell, RIM, HP and Computer Associates are all technology companies that are in secular or terminal decline as they continue to lose market share to companies like Apple, Google and Salesforce. When a technology company is in secular decline, then the road ahead is filled with potholes, false hope and empty promises. Only 1 turnaround in the technology sector tends to work each decade in the public markets. Last decade it was Apple only because Steve Jobs returned to the company and in the 1990s it was IBM under Lou Gerstner, the brilliant former McKinsey consultant.  

Once consumers sense that a technology company is in secular decline, they gradually use the product less often regardless of what new products are introduced by the company in secular decline. This is what happened with BlackBerry’s parent Research in Motion. Many executives, especially on Wall Street, used the BlackBerry as their very first smart phone. Then the iPhone and Android handsets were released which had awesome app stores, unlike the BlackBerry. Then for a while executives carried a BlackBerry and either an Android or iPhone device. Then executives phased out the use of their BlackBerries entirely. The biggest problem with the BlackBerry was that its app store paled in comparison to Apple or Google’s app stores. BlackBerry had trouble trying to be a decent software company as well as a decent hardware company. Most companies can’t effectively produce high quality software and hardware products. Apple is probably the only company in the world that can be a great hardware and a great software company at the same time. Google was smart enough to know that it is a software company and therefore partnered with Samsung and other hardware companies to make Android-based smart phones. Google is trying to change this though by acquiring hardware related start-ups including Nest while retaining some of the patents from its Motorola acquisition.

The same argument can be said for enterprises; where there’s smoke there’s fire. Once an enterprise decides that a technology company might be in secular decline, then they no longer purchase products from the company. In many cases they even rip and replace the technology company’s products as they are fearful that they won’t be able to get the proper support for the underlying products in the long run. When I used to work in the technology consulting sector at Accenture as a software engineer, I would always be neutral when it came to the decision of which database to use and I would leave it up to my clients to decide. Clients would always ask me which company is most likely to be in business in the long run. As a result, we usually chose to deal with Microsoft’s SQL Server database or IBM’s DB2 database or Oracle’s database Instead of Sybase, which had a less rosy long term outlook (this was a wise choice as the company was later acquired by SAP). The same can be said for today when it comes to antiquated technology companies like CA (Computer Associates). Forward thinking enterprises prefer to use cloud-based solutions from incredibly forward thinking companies like Salesforce.com, Workday or NetSuite. We all know that the cloud is the future and that the mainframe and antiquated client server products from companies like CA are in secular decline.        

Consumer and enterprise companies will be well served to ask themselves one very basic question before purchasing a technology product, which is this: “in five years is this technology company going to be more relevant or less relevant that it is today”. This is a simple question but it has a lot to do with future technology purchases. As a result, IT purchasers might decide not to use products from companies that have structural or secular issues including Hewlett-Packard or CA, among others.

We can use the same logic when it comes to investing in technology companies. Technology investors should never invest in a company that they believe is not going to be more relevant in 5 years. This is why investors tend to flock to Apple, Amazon, Salesforce and Google instead of HP, Yahoo, CA, RIM or Dell (when it was publicly traded). Quite often we see investors lose their shirts by getting seduced into investing in companies in secular decline because their valuations seem attractive. What we often overlook when chasing ‘value traps’ is the fact that the earnings estimates by Wall Street analysts for these companies for this year and next year and the year after are usually way too high. As a result, the valuations of these companies are incorrect. Investing in a technology company because valuation seems attractive this year or next year is not a winning proposition.

Investors are far better served to create a financial model and value a company on earnings at least five years from today. Why? Once a consumer or an enterprise has decided that a technology company is in secular decline, it is almost impossible to convince them to go back and use the products they thought were once relevant. If you disagree, then why don’t we all wear fashions that were in style in the 70s like bell bottom pants? How many of us that used to use Yahoo as our search engine and then switched to Google have ever switched back to using Yahoo? Exactly! How many of us that used to use a Windows laptop and then switch to using a Mac have switched back to using a Windows laptop? How many of us that used to go to Barnes & Noble and then switched to Amazon have decided to go back to shopping only at Barnes & Noble for books? Lastly, how many of us print more documents using HP printers since we purchased our first tablet? Exactly!

Companies that are in secular growth mode are those with superb customer service too. I have always believed that a company is only as good as its customer service is. The companies that are in secular growth mode like Apple and Amazon have the best customer service. Those that are in secular decline (including Comcast) have very poor customer service. Perhaps this is due to low employee morale given the difficult outlook for the company they work for.        

Smart money investors value companies off of their earnings estimates at least five years in the future. If you disagree talk to hedge fund portfolio managers who have tried to short Amazon over the past decade because the stock seemed expensive. The smart money investors in secular growth companies love Amazon because earnings will be much much higher in at least five years from today. The same can be said for hedge funds that shorted Netflix because valuation seemed lofty. Don’t ever bet against secular growth companies (unless we are in a horrific bear market, in which case almost all tech stocks will fall).

Valuing secular growth tech companies based on this year’s earnings is illogical. What matters much more is valuation based on your earnings estimates at least five years into the future. Many investors get tempted to invest in companies in secular decline given their relative attractive valuation. Most of the time, this is a huge mistake. Investors might be fooled by randomness and profit once or twice from this strategy but this is usually due to the markets rallying and all ships or all stocks rising as well. More often than not, investors buying turnarounds in tech are merely ‘tourists’ and give up investing after realizing that there are better secular growth opportunities elsewhere; they learn their lessons from ‘renting’ and losing money investing in the companies in secular decline.

Given the slippery slope that technology companies face once they enter the secular decline phase of their life, it’s no wonder why value investors are usually not very good investors in technology companies. Rather, growth investors that love to invest in secular growth companies that might appear expensive on this year’s earnings and next year’s earnings do far better when investing in technology companies than value investors do. If you disagree with statement, then look at the historical price earnings chart for Hewlett-Packard over the past decade. Investors that argue the stock might have been cheap at 18 times earnings lost their shirts as price earnings multiple contraction always occurs over time to companies in secular decline. Investing in technology companies because you believe you will see price earnings multiple expansion is not prudent. All that should matter is if your estimates are higher than Wall Street estimates up to five years from today.

So how do we know if a technology company is in secular decline? There are a few ways. If you notice that fewer people are using a technology product today than they did a year or two ago then chances are that the company is in secular decline. Another way to tell if a company is in secular decline is if the company misses several quarters in a row versus Wall Street estimates (unless we are in a recession). When I used to work in the hedge fund industry we would always say that software companies never miss just once. Another way to tell is if many employees start resigning because they are on a sinking ship. Check out www.glassdoor.com and see if the employee reviews of the company they work for deteriorates over time.

So should you invest in technology companies that think they can improve their business prospects once they are in secular decline? Absolutely not. There’s usually only one company per decade that can buck this trend; I don’t like those odds. If a founder comes back to the company then there is a small chance that the company will no longer be in secular decline, but the odds are against it. When you hear Wall Street analysts or other pundits telling you that a technology company is a turnaround play, be very skeptical as the chances of a turnaround working in technology is extraordinarily low. Where there is smoke there is fire; turnarounds almost never work in technology.