Matt Yglesias points to an interesting post by Ron Burk about cash cow disease, an affliction of corporations with extraordinarily large revenue streams from existing businesses. These corporations frequently wind up “wasting” billions of dollars on new ventures that don’t pan out and that likely would not have been financed if the money had to be raised on the open market. They are able to waste this money because the core business is so profitable that shareholders basically don’t notice – and therefore do not apply the necessary discipline.
It’s a provocative argument. A few thoughts:
First of all, this sounds substantially like an agent-principal problem rather than a problem caused by the mere existence of cash cows. There are lots of private businesses out there that are cash cows – car dealerships, for example. Do owners of private cash cows go in for this sort of behavior? I wonder. It occurs to me that a company that has a true cash cow should actually be very cheap to run. If shareholders knew that, their reaction might not be good for management’s own bottom line. (“Why do we need such an expensive CEO? This company runs itself! It’s a cash cow!”)
Relatedly, the “conservative” (from a corporate governance theory perspective) answer to this kind of problem is to say that, in principle, companies shouldn’t hold material amounts of cash – ever. They should return virtually everything they earn, net of costs, to investors, who, in turn, should expect highly variable but sometimes very large dividends. Then, if the company wants to make a strategic investment (either buying a company or developing a new product), they would either need to raise funds on the market (debt or equity) or explain to shareholders why they weren’t getting their full dividend. We’re obviously very far from such a dividend culture, for a variety of reasons (taxes, agent-principal conflict, the longstanding expectation on the part of investors that dividends will be “regular,” etc). But to an extent, one can understand the problem as described to be a problem not of “cash cows” but more broadly of “cash” – there is a real case for the proposition that public companies should be pretty much “fully invested” at all times, returning any cash not needed to run and grow the business to shareholders.
But I can think of an argument for the kind of behavior the author of the piece observes that might better rationally explain this behavior than as simply an instance of “waste” or as an instance of management acting in its own rather than shareholders’ interests. One justification given for investing in ventures that are expensive and unlikely to bear fruit is that said ventures contain embedded “real business options.” What’s a “real business option”? Well, an option is the right to buy or sell something at a specified price on a specified date. It’s a right, not an obligation. So a call option on a stock is the right to buy a certain number of shares of that stock at a certain price per share (the “strike price”) on a certain date (the “expiration date”). A real business option is some business decision that gives one the option to enter into a future business. Thus, for example, suppose that company A sees a bright future for product Q, something that doesn’t yet exist but which is expected to be possible in the future. But when Q comes into being, it’ll probably develop out of P, which also doesn’t exist yet, but which will probably develop out of M, N or O. So this becomes an argument for getting into the M, N or O business – even at an expected loss. Because the value of the M, N or O business isn’t in that business and its projected revenue stream – its in the option to then develop P, which would make it possible to develop Q.
I think most people would agree that such an option is valuable. What’s really impossible to know is how valuable – that depends on what Q turns out to be worth and how valid this path-dependency theory turns out to be, neither of which can be known in advance. But one of the funny things about options is that, so long as the potential upside payoff is unbounded, they become more valuable the more uncertain the outcome is. Why? Because an option has a limited up-front cost and a potentially unlimited upside. A stock today is worth $10. Tomorrow it’ll be worth either $9 or $11. An option to buy the stock for $10, expiring tomorrow, will either not pay off or will pay off $1. Assuming even odds (the correct risk-neutral assumption if the current price is $10 and those are the only possible terminal prices), the option is worth $0.50. Now assume that tomorrow the stock will be worth either $5 or $15. Tomorrow, that same option will pay out either zero or $5. So that option is worth $2.50 – even though the “expected” value of the stock tomorrow is the same in each case, namely: the current price of the stock, $10. Same thing with real business options. The more uncertain the outcome of the speculative future business – the more plausible the scenario by which it becomes a massive cash cow of its own, even if that also means the odds are higher that it’ll never amount to anything and become a huge cash sink – the more the real business option to enter that business is worth, and therefore the more you should be willing to spend to own it.
So apparently wasting money on ventures that are unlikely to yield adequate returns may be the result of an entirely rational calculation of the value of real business options, particularly in a field like technology where there is plenty of historical evidence of some businesses turning into these game-changing gold mines (at least for a while). But here’s the thing: options are negative cash-flow investments. So the only entities who can afford to invest in them are entities with high positive cash-flow from other sources. In other words: cash cows. Entities with more precarious cash-flow streams, or without positive cash-flow streams at all, can’t afford to engage in options-acquisition as a strategy. They need to make money – now. And they can’t afford to put themselves in a position where they are insufficiently liquid to maintain their option portfolio – because then the investment is truly wasted.
But there’s another reason cash-cow companies might behave this way: to protect the cow. Why did Microsoft invest in Xbox – one of Burk’s main examples – after all? Arguably because they thought they’d make a lot of money on Xbox. A better theory is because they thought being in the game console “space” would give them options on future businesses that could be enormously lucrative. But most likely as a defensive move. If game consoles evolved into the new PCs, and those game consoles didn’t run an OS created by Microsoft, then Microsoft’s cash cow would run dry. The option they were buying wasn’t a call on a new cash cow so much as a put on the one they already had – a way of protecting it from a world in which game consoles replaced PCs, and therefore what mattered was who made the OS for the game console, not who made the OS for the PC.
That drive – to protect the cash cow – is what, in my opinion, frequently makes large companies seem to be lacking in innovation. It’s just rationally playing the odds. The odds of hitting a new cash cow are low. The potentially threats to the existing cash cow are many. It makes more sense to spread money around in various ways that do something to protect that incumbent position – say, shoving Windows into as many devices and layers of the global computing infrastructure as possible, even if the ventures don’t make much sense in their own terms, in the hopes that, if a particular device or layer turns out to be the “next” whatever that Windows is still a player – than to do something completely new (to say nothing of doing anything that actually threatens the cash cow).
But that same kind of motivation can drive innovation. Google needs to maintain its share of minds and eyeballs to maintain its profits. So it is constantly developing new products. Even if the new applications it develops bring in no incremental revenue, if they “shore up” that mindshare position, they may well be worth the investment – particularly if Google’s profits depend on having an overwhelmingly dominant position in their core market. Would these applications have been developed anyway – and better – elsewhere? If they aren’t profitable, it seems unlikely that they would have. Does that mean there’s been a net gain to innovation from Google’s cash cow? Well, what else would these developers have been doing if they weren’t working for Google? How can one even assess that counterfactual?
Here’s one way to think about the question. A cash cow is something that makes outsized profits. Anything that makes outsized profits over an extended period of time is an instance of some kind of failure of the market. It might not be a market failure – it might be a consequence of a regulatory intervention (car dealerships? liquor distributors? taxi medallion companies). Or it might be a market failure (a “natural” monopoly, a “network effect” monopoly, whatever). But the mere existence of large, excess returns over a long period from the same activity – that’s what a cash cow is – is a sign that something weird is going on. Those returns should attract huge amounts of capital to that business to fund competitors who, by their actions, will bring down rates of return to more normal levels. If that doesn’t happen, you have to ask why. The answer to that why might tell you something about whether there might be something problematic about efforts to maintain and extend that cash cow.
But I’d really like to know what Jim Manzi thinks.