The Complications of Having to Please Wall Street

Executive Summary

• Software companies need to focus on two goals, one bettering their companies the other pleasing Wall Street.
• We will provide a quote of how this second goal interferes with the first.

Introduction

At Brightwork, we have covered false statements presented in quarterly reports, such as in the article Inaccuracies on SAP’s Q2 2017 Earnings Call. In earning calls, the picture presented to Wall Street analysts appears like a fictional world that has little to do with the reality of the software vendors that I cover. I later learned that analysts only ask softball questions because all of the analysts invited on the call work for firms that are long on the stock, as is covered in the article Why Analysts Do Not Ask Challenging Questions on SAP’s Quarterly Calls.

This pressure to conform to Wall Street expectations is enormous. It is equally problematic in that Wall Street firms don’t themselves run companies, and are often confused about how companies function as we cover in the article What Wall Street Does Not Understand About SaaS.

This means that software vendors are having to conform to the expectations of individuals with know demonstrated competence in running software companies.

While reading the excellent book Snake Oil: How Fracking’s False Promise of Plenty Imperils Our Future by Richard Heinberg, there is an explanation of the demands placed on the oil and wildcatting industry by Wall Street, and how it pushed that industry too often counterproductive outcomes. 

Wall Street and the Fracking Industry

This quote is highly instructive.

Investment bankers make money on the way up (as bubbles inflate) and on the way down (as companies sell off assets and submit to mergers and takeovers). Therefore, it is in their interest to support drillers’ exaggerated claims for reserves and future production potential. When the fracking boom inevitably goes bust, it won’t be the banks that will take the hit; it will be the investors who bought shares of stock in oil and gas companies.

BP has been forced to write off nearly two billion dollars in assets. Rex Tillerson, the CEO of ExxonMobil, told the Council on Foreign Relations in New York City in June 2012, “We’re losing our shirts [on shale gas production]. We’re making no money. It’s all in the red.”

Why did the industry shoot itself in the foot by overproducing shale gas? In some respects, the glut resulted in inevitably from a land rush that occurred in the early years of the shale boom, when companies were leasing as much land as possible, as quickly as possible: the term of drilling leases required drilling sooner rather than later, even if that meant oversupplying the market. But this is not a sufficient explanation for the price plunge. For a deeper understanding of the industry’s puzzling self-destructive behavior, we must follow the money.

In a New York Times investigative article (“After the Boom in Natural Gas,” October 20, 2012), Clifford Krauss and Eric Lipton wrote, “Like the recent credit bubble, the boom and bust in gas were driven in large part by tens of billions of dollars in creative financing engineered by investment banks like Goldman Sachs, Barclay, and Jefferies & Company.” The article details how this “creative financing” forced drillers to keep drilling even when each new well represented a financial loss.

Deborah Roger, a former Wall Street financial consultant and member of the Advisory Council for the Federal Reserve Bank of Dallas from 2008 to 2011, has further traced the toxic connections between major investment banks and shale gas/tight oil operators in her report, “Shale and Wall Street: Was the Decline in Natural Gas Prices Orchestrated?”

She writes:

In order for a publicly traded oil and gas company to grow extensively, it must manage only its core business but also the relationship it enjoys with its investment bankers. Thus, publicly traded oil and gas companies have essentially two sets of economics. There is what may be called field economics, which addresses the basic day to day operations of the company and what is actually occurring out in the field with regard to well costs, production history etc.; the other set is Wall Street or “Street” economics. This entails keeping a company attractive to financial analysts and investors so that the share price moves up and access to the capital market is assured.

I ordinarily don’t like using so much of a quote, and I trimmed some of it. But with such a fantastic quote, I could not see using less of it than what I did. I ran into the same problem with the quote I used in conclusion.

Conclusion

This is why software vendors provide so much false information to the market. Wall Street firms demand this false information.

It is why so many vendors cloud wash, that is pretending to be much more involved in the cloud than they are when in reality, they are primarily on-premises vendors.  Wall Street has this type of negative impact on virtually all industries. People that can tell a good story now have much more power than people who know how to run a company. Private equity firms entirely dispense with giving money to companies, and simply directly take over the company, and then raid it for short term profits. In the case of the private equity take over of Remmington, Cerberus Capital Management purchased the firearms manufacturer, and then had Remmington take out a bond, that paid Cerberus Capital Management back. And due to mismanagement of Remmington and the high debt payments required due to Cerberus Capital Management, Remmington eventually declared bankruptcy.

Some interesting questions arise from this story.

1. What was the value add to the Cerberus Capital Management purchase of Remmington?
2. How was Cerberus Capital Management allowed to pay itself back the money it used to purchase Remmington by making Remmington take out a bond?

Counterfeit Capitalism

The rise of companies that specialize in raising money over running a business is a term by Matt Stoller called counterfeit capitalism. 

Generally speaking, Softbank’s model is to manipulate private capital markets as a way of drowning out competitors with cash. For instance, there were several ‘rounds’ of WeWork investment where Softbank was buying more shares at higher valuations. WeWork ostensibly became more valuable because Son said it was more valuable, and bought shares for higher prices. And since there was no public market for these shares, the pricing of the shares was totally arbitrary. WeWork then used this cash to underprice competitors in the co-working space market, hoping to be able to profit later once it had a strong market position in real estate subletting or ancillary businesses. (emphasis added)

This is of course Amazon’s model, which underpriced competitors in retail and eventually came to control the whole market. And Amazon has spawned a host of imitators, including WeWork. It has also reshaped venture investing. The goal of Son, and increasingly most large financiers in private equity and venture capital, is to find big markets and then dump capital into one player in such a market who can underprice until he becomes the dominant remaining actor. In this manner, financiers can help kill all competition,(emphasis added) with the idea of profiting later on via the surviving monopoly.

What predatory pricing does is to enable competition purely based on access to capital. This model has spread. Bird, the scooter company, is not making money. Uber and Lyft are similarly and systemically unprofitable. This model is catastrophic not just for individual companies, but for their competitors who have to *make* money. I’ve written about this problem before. Amazon has created a much less competitive and brittle retail sector. Netflix’s money-losing business is ruining Hollywood.

Endless money-losing is a variant of counterfeiting, and counterfeiting has dangerous economic consequences. The subprime fiasco was one example. Another example was the Worldcom fraud in the late 1990s, which forced the rest of the U.S. telecom sector to over-invest into broadband. Competitors have to copy their fraudulent competitors.(emphasis added) It’s a variant of Gresham’s Law, which says that “bad money drives out good.” If you can counterfeit something for cheap, the counterfeit will eventually take over the entire market and drive out the real commodity.(emphasis added)

As euphoria in capital markets takes hold, predatory pricing scheme come to entirely wastes capital on money losing enterprises, and eventually these companies become Soviet-style generators of white elephants and self-dealing. The men and women who run them have to be charlatans, because they are storytellers justifying losses.(emphasis added) Powerful men like Dimon are sucked in, consultants start explaining to old-line economy companies how they too can become like WeWork, and eventually more and more of the economy just adopts counterfeit capitalism.

This story of the financialization of companies is greatly underreported and is causing massive damage to the economy and workers.

References

https://www.amazon.com/Snake-Oil-Frackings-Promise-Imperils-ebook/

https://mattstoller.substack.com/p/wework-and-counterfeit-capitalism

https://www.nytimes.com/interactive/2019/05/01/magazine/remington-guns-jobs-huntsville.html