Analysts press for underinvestment

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I have noted before that stock analysts need know little about how strategy affects firm performance, so an academic study on the impact of stock analysts on firms’ investment behaviour is intriguing. The unpublished working paper by Benner and Ranganathan at Wharton finds that negative pressures from analysts to improve cash flow and stock price trigger reductions in strategic investments during periods of technological change. Two examples:

  • One analyst continually pressured Kodak to cut costs and investment in digital technology: “…we suspect that investors are growing increasingly restless with the gradual pace of cost-cutting … Kodak’s not a player in digital imaging…we consider the opportunities for Kodak to materially alter its  growth trajectory with digital imaging technology to be relatively slight over the next three to four years…” (Prudential, February 1995) – and “Shareholders will revolt once the meager (and distant) potential returns from electronic imaging become clear…we are eager to see shareholders’ reactions when they realize how much of their money is squandered on ‘digital nonsense’” (Prudential Securities, 1994:7).
  • …difficult secular issues face the US telecom sector. The troubled state of the US telecom industry is not news to anybody…the most supportive valuation measures continue to be dividends and free cash flow yield…we are recommending a switch from Verizon to BellSouth…there are several arguments favoring BellSouth…cash yield at BellSouth is greater than at Verizon… we like the clear policy of returning cash to shareholders that we see at BellSouth.” (Morgan Stanley report on Verizon, April 3, 2003) – and – “Investors are forcefully questioning the wisdom of inflicting earnings and free cash-flow pain through rebuilding of core consumer businesses. If the competitive environment is to remain subdued, then one should clearly reduce the speed of new product roll-outs, contain investment and maximize short term ROIC.” (Deutsche Bank report on Verizon, January 26, 2006)

These analysts clearly believe that both Kodak and Verizon should abandon ‘wasteful’ efforts to develop knowledge and capabilities to respond to the new technological environment and return cash to investors. The paper’s authors wisely recognise [unusually for an academic strategy paper!] that the key concern should be the present value of likely future cash flows and imply that both companies might have been right to invest in new technology.

But were the analysts wrong? Both companies faced decline of their previous core consumer-based business, so doing nothing probably would have led to declining cash flows for investors, perhaps to the point of shutting down completely. Building capabilities to create new lines of business to exploit that consumer franchise could have led to sustained longer term cash flows.

On the other hand, the investment could have been ill-advised, if there was little chance of developing anything that might have led to sustained long term cash flows. Kodak, for example, made $2.2bn operating profit in 1996, after spending $1.0bn on R&D. By 2001, operating profits were only $1.2bn, and the company still spent $0.8bn on R&D. By 2008, profits were negative, but still R&D absorbed $0.5bn of cash flow. Little evidence here that continued investment in R&D helped sustain long term cash flows.

On the other, other hand, Verizon has raised operating income continually from $5.3bn to $16.9bn between 2003 and 2008, so it is hard to make a case that their efforts to rebuild their consumer franchise were ill-advised. Unfortunately, we can’t tell what BellSouth’s more cash-conserving strategy would have delivered, because they merged with AT&T. However, the merged entity seems to have driven strongly to grow the customer-base with up-to-date products and services – could it be that AT&T saw in BellSouth a resource that had been under-exploited though mean development efforts, offering an opportunity for enhanced future growth in free cash flows from reversing that policy?

Without detailed analysis we can’t know exactly what would have been right in either case – but at least someone is asking about how analysts try to change managers’ strategic decisions.

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