“The Bear” on Business

I am confronted with a tricky business decision this week. Not major, just tricky. I won’t get into the specifics but the issue has made me reflect on one of the toughest maturing challenges I faced in my career.

I desire to fund a project. It isn’t a slam dunk that we should do it. More important to this blog topic, the project isn’t essential in the overall scheme of things. But I do believe we should do it. The project requires approval of my board. Though they were supportive after much discussion, I had to work pretty hard to convince some of them. 

For most of my career, I would view this as good enough to proceed. Today, I am deciding the opposite. My time and energy is better spent on areas where support is stronger. The hidden cost of proceeding forward is high. Why? If we go forward and things go incredibly well, it won’t matter. However, any other scenario would be more costly than it is worth.

For example if the outcome is poor, the perception will be that it was a bad decision from the get go. This is different from a bad outcome in a project that had widespread support–in which case problems would be dealt with more objectively and constructively. Even marginally positive results would be viewed unenthusiastically by the original skeptics. An added risk is that the proponent (in this case me) might be defensive in the future. Recalling that others were not fully behind it, the tendency will be to try to hard to prove them wrong. This often leads to destructive behavior. 

All and all, the risk/reward equation is out of balance. Five years ago, I would have intensified my effort and pushed ahead. This time, I will take a step back and conclude it is better off to not pursue.

Some investors believe that quality P&L management is a scarce resource in telecom.  When I first heard investors say this (which was around 2004), I felt insulted.  How can a broad brush generalization be made?  How can the quality of management in telecom be better or worse than other large industries?  I’ve come to concede there is some basis for this belief.

Think about it.  Up until the mid 1990s, telecom management gained their experience in the Bell System, MCI or Sprint. 

The Bell System was a great training ground for how to manage regulated monopolies in a slow changing environment.  Such skills are very different than those required in a fast changing and highly competitive environment.  In the early 1990’s, the more experienced and frankly most successful tended to stay within the Bell System, as it was a very secure environment.  For those being well taken care of by Ma Bell, jumping ship to the upstart competitors seemed awful risky.

Fortunately, in 1992, I was not viewed as an up-and-comer at Ameritech.  Times were kind-of tough and I was looking at a stagnant career path.  This led me to leave and join MFS.  I have reflected that if they were waiving a promotion and $10k raise in front of me, I probably would have been there for the next five years. 

MCI was certainly entrepreneurial and was known for marketing creativity.  Remember “friends and family”.  Talent emerged from MCI and plenty of these folks played a major role in competitive telecom.  This lasted until the mid 1990’s but by the late 1990s, MCI lost its ways and became bureaucratic.

Sprint developed its own very unique culture.  My perception is that less people emigrated from Sprint during the competitive telecom era.  Once they moved to Kansas City, they tended to stay there.

Competitive telecom was led by young and largely inexperienced individuals.  I certainly fit this profile as just about everyone I worked with.  Most of us were in the right place and the right time.  Technology and the regulatory/competitive landscape were changing so profoundly that more experienced outsiders were simply ineffective.  Under-qualified individuals found themselves responsible for spending large amounts of money and running large organizations. Had the young bucks of competitive telecom learned good habits, we would today have an ample supply of great talent.  But what they learned was the opposite.  They thrived in the boom environment.  Raise money.  Spend money.  Innovate.  Build.  Spin good stories.  Be loose with accounting.  Use bankruptcy or debt restructurings to survive.Better management skills were developed over the past few years.  I caution, however, that many companies were operating under constraints that were dictated to them.  They couldn’t raise more money.  They were forced to tie spending with the cash on hand.   As these external constraints get relaxed, will the managers–seasoned from lessons learned during the boom and bust–rise above their old habits?  I believe most will.

The Telecom industry has done a horrible job in developing organizational structures around P&Ls. It might not know it has this problem, but it does.

The “network” is the biggest cost of most telecom companies. The network consists of five major cost categories: construction, equipment, leased services from other telecom suppliers, day to day costs associated with operating the network, and developing IT systems to help design and operate the network. The super-majority of a telecom company’s capital budget and operating expenses fall in these five buckets.

In most telecom companies, the head of IT, the CTO, and the head of network are three of the most powerful positions. They report to the CEO/COO. The executives have sprawling organizations and huge budgets. Their personality types tend to be authoritarian—not surprisingly since they have so much to do.

Who are the P&L owners? Typically, telecom companies organize their “P&Ls” around geography, product line or perhaps customer channel. Nextlink/XO was known for organizing around geography. Level 3 circa 2003 was organized around product line. Over the past year, Level 3 tried channels.

Executives might tell the P&L owner that they are accountable for their “businesses”. But what does this mean in practice? The cost centers control most of the company’s resources. This, in and of itself, isn’t necessarily a problem. It becomes a problem when (a) the cost center does not associate costs with P&Ls in a meaningful manner and (b) the cost centers resist the P&L manager making decisions which affects the cost center’s cost. P&L financial reports rarely get beyond questions around why costs are allocated the way they are.

“Our costs are too high,” conclude the P&L manager. The retort from the cost center: “We are much more efficient than our competitors. The problem must be one of the following: we aren’t selling enough, our prices are too low or the cost allocation methodology is misleading.”

How would anyone know?

Now the P&L manager wants to do something different. Change a product. Improve cost structure. Introduce a creative partner relationship. Look out! The cost is staggering. More resources are needed. And the work must be prioritized across everything else the other P&L managers want to get done. By the time requirements are approved and the work is slotted, the business opportunity has passed. The work is done anyway since it has now made it way into everyone’s objectives.

Sound familiar?

So that gets us back to the Telecom P&L. The P&L manager does not get meaningful P&L financial reports. The reports, if they exist at all, almost certainly exclude capital. Most expenses are allocated using somewhat arbitrary and ambiguous methodologies. The organization as a whole views the P&L financials as an interesting but most inconsequential activity.

Do you doubt this? Reflect on whether the CEO/COO of the company pays attention to the bottom line financials of their P&Ls. By bottom line, I mean down to the cash flow level. Do they hold their P&L managers accountable for how much profit and cash flow they deliver to the company? If not, P&L is simply a glorified product management or sales management position.

Are there two bigger words in business jargon than empowerment and accountability? Perhaps, but both are certainly in the top 10.

So is P&L.

The past two journal entries were on the topic of organizing Zayo Group into three distinct businesses. A business relationship certainly exists between the three units; Zayo Managed Services and Onvoy Voice buy transport services from Zayo Bandwidth. I described the reason for three distinct businesses as being (a) focus and (b) financial transparency. Two other benefits are worth discussing.

Accountability, specifically around P&L, will be vastly improved. We will have three groups maintaining their own financials all the way to down to the balance sheet and cash flow level. This might sound fairly basic, but for reasons I will explain in the next blog entry, this is a big deal in the telecom industry.

My guess is that people at all levels of our organization will experience something they haven’t had in a long time in their career, if ever. They will feel empowered. They will be energized. They will feel invigorated.

On a daily basis, employees will see an increasingly direct relationship between what they are doing and how it is impacting our bottom line. Capital decisions will center more on how expenditures will really impact cash flows—and less around how to dress up a business plan to convince corporate to approve. Expenses will be scrutinized—are they really essential for us to win business and provide great service to our customers? Winning and retaining business will feel more important than ever—with a more direct relationship between revenue and cost, every dollar of revenue will matter a ton more.

Though feelings of discomfort are inevitable, I believe most people will respond well to more clearly defined financial accountability. I guess we will see.

In the prior blog entry, I shared thoughts on why we are dividing Zayo into three discreet businesses. The rest of this entry is a letter I sent to Zayo employees explaining the rationale. Note: this email was sent to employees within 10 days of the Zayo/Onvoy closing.

I know there is a fair amount of confusion of the three business unit structure. In the telecom world, people are simply uncomfortable with having separate businesses. Conventional wisdom is that it is more efficient to have one finance department, one NOC, one marketing organization. It seems nearly every functional person will insist that their group needs to look across the entire company.

Berkshire Hathaway is the most successful public company of all time. It is why Warren Buffett is the world’s 2nd richest man. They own multiple businesses. How many people work in corporate? Answer: a dozen.

“Yes but Berkshire is a holding company. They own businesses of all different types. That is why they are separate,” you might be thinking. “Zayo is different. We are one business.”

My answer: GEICO. B-H Reinsurance. General RE. National Indemnity Primary. U.S. Liability. Medical Protective. Homestate Companies and Cypress. Applied Underwriters. Central States. Kansas Bankers Surety. Lloyds of London.

What do these businesses have in common? One, they are all insurance companies. Two, they are run completely separate from each other, each with their own leader, each with their own accounting system, each with their own bank account, and each with their own IT systems. Three, they are all owned by Berkshire Hathaway.

Neutral Tandem just went public this month. The company, which was formed only a few years ago, provides wholesale voice services. Their revenue is about $70M. Their enterprise value is about $700M. Onvoy Voice has about $35M of revenue. To say I’d be pleased with a $350M valuation would be as understated as saying I’d be pleasantly surprised if, tomorrow morning, when I weigh myself like I do most mornings, the scale says 190 lbs.

Neutral Tandem doesn’t own any fiber; they buy bandwidth. They don’t provide managed services to enterprises; they focus on voice services to carrier customers. They have their own NOC; their own bank account and accounting systems, and their own customers. They have a clear business strategy.

What Neutral Tandem doesn’t have is a parent company that stands in the way of their ability to execute. They also don’t have to stand in line to get IT work done because the needs of other groups are a high priority. They will create value, or not, for their owners based on factors in their control.

Will Onvoy Voice have an advantage over Neutral Tandem because Onvoy gets to share a NOC, share a billing system and share a legal staff? I think not.

Substitute Cbeyond/Zayo Managed Services for Neutral Tandem/Onvoy Voice, the same points hold.

Zayo Bandwidth was the genesis of Zayo Group. Zayo Bandwidth’s path to value creation is to stay narrowly focused on being a bandwidth factory. Their implementation task is hard enough on its own; I do not want them bogged down by needing to coordinate systems, processes and corporate resources with two other business units. Over the past few months, I have seen several pure bandwidth businesses that are doing quite well—Hudson Valley Datanet, Fibertech, and Citynet’s Wholesale Unit in particular stand out. If Zayo Bandwidth does as well as these three, I will be thrilled. (Perhaps not as thrilled as if I saw 190 lbs on my scale, but pretty darn close.)

So there it is. That is why we are separating into three businesses. It is for this reason and no other: I want each of the three businesses to have a true leader, a clear strategy and the autonomy to execute their plan. I want each to be fairly judged on its financial results. I don’t want any of the businesses to be encumbered by being part of the same ownership group.

Zayo Group is $125M in revenue.  Since its launch in early 2007,  Zayo has acquired five companies.  The first three were  companies that offer high capacity bandwidth over their fiber networks–not surprisingly since “bandwidth factory” was the focus of our investment thesis.  The fourth, Onvoy, also offered bandwidth over its fiber but also focused on two other lines of business–wholesale voice and managed services.  The fifth company, Voicepipe, offered similar services as Onvoy’s managed services.

We are faced with a challenge.  Bandwidth was our original mission–and a key to our investment thesis is to maintain a myopic focus on being a supplier of big bandwidth.  With the addition of lines of business that have very different profiles than bandwidth, how do we stay focused while also exploiting the new opportunities?

In telecom, the knee-jerk organizational structure is to centralize and functionalize.  All engineering and technology reports to CTO.   A vast IT organization develops a systems architecture to meet all needs.  One do-everything provisioning system is conceived.  One NOC “efficiently” oversees the entirety of the network.  A large and silo’ed finance organization tries to make sense of it all.   

For telecom companies that have multiple lines of business, the drive to centralize and functionalize is, in my mind, fundamentally what makes everyone’s job exponentially more difficult.  Not only does this make day-to-day execution hard, but it causes them to lose complete sight over the economic drivers of both bandwidth and the many other very different things that they do.  Financials become increasingly unpredictable.  It is difficult to tell what activities/investments are creating value and which are destroying value.   Decision-making becomes excruciatingly slow.  Companies become internally focused.  Customers get frustrated with long service delivery cycles and poor information flow.

At Zayo, we cannot afford to get bogged down.  Our solution is to separate into three businesses.  Not channels.  No product groups.  Not lines of businesses.  Not even business units.  We are organizing ourselves as three completely separate businesses. 

What does this mean in practical terms?   My answer might sound over-simplified (and perhaps even silly), but I am convinced it is the key.  The answer: each entity will maintain its own accounting systems.  I mean this is a very literal sense.   They will keep their own books.   They will have their own bank account.  They will be judged with how well they manage their financials up to and including the balance sheet and cash flow statement. 

Most telecom people have trouble with this.  “How inefficient,” they reckon.  “What about all the economies of scale you’d sacrifice by having one NOC, one provisioning system, one head of engineering, etc.”   Or, they object: ”But everything is about how fixed costs are allocated.  Therefore, it is just arbitrary how you divide costs between units.” 

In the subequent blog entry, I will post an excerpt from an email I sent to Zayo employees last week explaining what we are doing and why they should be confident.  Hint: Berkshire Hathaway.

I was on LVLT Yahoo message board and typed in Zayo.  As CEO of Zayo Group (www.zayo.com), I was humored by what I saw.

“Is everyone on crack? Zayo???  Let’s see we have a telecom industry of $300 billion in revenue a year and Zayo with $225 million in dumb money and $89 million in debt is going to do what to whom? Zayo has bought a mish-mash of things that make no strategic sense at all. Zayo will come clean with their investors by June of 2008 — they can spend money, but can’t generate a return. They have bought 4 pigs so far … running out of cash.  Here is Zayo - no one at Zayo has a history or experience of growing a business. They have a history of strip and flip.”

Entertaining.

In the prior blog, I shared why I believe focusing on exit strategies can be very harmful to a company and its investors.  Charlie Munger and Warren Buffett take this many steps further.  They simply say that they are unlikely to sell any business.

Point 11 of Warren Buffett’s Owner Manual is:  You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations.

Munger and Buffett have earned the right to take this position.  They earned it because they have demonstrated year over year that Berkshire Hathaway is an environment in which businesses are run well.  They create value for their shareholders.  In most cases, a company is likely to perform worse if extracted from Berkshire.

What about a strategic buyer?  Generally speaking, Buffett’s companies are either so big (making strategic synergies less relevant) or so unique (resulting in the likelihood a strategic buyer would screw up the franchise). 

Also, Berkshire has created its own franchise about being a great long-term home for a business.  A person who sells their business to Berkshire need not fret about a subsequent and disruptive sale.  They need not worry about a strategic buyer messing up what is special about the company.

Berkshire is very unique in this regard.  Let me repeat.  They have earned the right to take this approach based on nearly 50 years of outstanding execution to be adamant about the philosophy. 

“What’s the exit strategy?”  Page 4 in the Venture Capital handbook.  Page 6 in Private Equity Investing for Dummies. 

I dare you to answer “Not only don’t I know, but I don’t particularly care either.”  Don’t expect to get funded.

Which, come to think of it, leaves me a bit concerned.  I wonder if my investors are reading this blog.  This entry could be a bit of a problem if they are. 

Warren Buffett says: “If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.” 

The Bear pipes in: “Getting Bailed out is No Exit Strategy.”

Mark Cuban chuckles: “Getting bailed out worked pretty darn well for me.”  Cuban, the eccentric and free-wheeling owner of the Dallas Mavericks, sold his Broadcast.com start-up to Yahoo in 1999 for $5.7B.    http://www.internetnews.com/bus-news/article.php/90621  Wall Street responded positively to the deal.  Though Yahoo has done well over the years, this particular acquisition was something that they certainly regret.  Cuban, who lives the life of a king, must laugh himself to sleep every night while pondering his good fortune.

I sold ICG to Level 3 in 2006.  I did it because our investment group and executive team crafted a turn-around plan that suggested these properties would be worth more if they were part of a larger entity.  I did it because our investors needed a big win (marked by a liquidity event) and because certain members of my executive team desperately wanted to put cash in the bank.  I did it because recent meltdown memories (including just prior to us at ICG)  included companies that began to show signs of turn-arounds (often through bankruptcy or debt restructurings) only to be faced with yet another crisis.  In the back of my mind, I feared we might fall into the same trap.

At the same time, I was convinced that we were selling way below value.  Hindsight is 20/20 of course, but I know now how right this conviction was.  We sold ICG for $170M, resulting in a total exit of over $225M on our $8.7M investment. 

Level 3 got a bargain for ICG.  Our revenue was $80M and growing at 15%+ a year.  Our EBITDA was $25M and was growing at 20% annually.  Our free cash flow was $1M/month and growing.  Our franchise was a vast and unique network in Colorado (and to a lesser extent Ohio)–replacement value was well north of $150M.   Today, the business would have been generating $35M of EBITDA and have been valued over $350M.  It pained me to let it go at the time.  I pains me even more now.

This experience led me to better appreciate Warren Buffett’s frame of mind.  I will chat more about this in a subsequent entry.  For now, I want to emphasize why I think over-focusing on exit strategies is harmful.

Too often, in my mind, companies tailor their strategy to “how would buyer such-as-such value my business?”  Or they look at others (including investors) and get enamored with eyeballs, seats, page views, clicks, lines, route miles, pops, or other potentially meaningless measures of value.  My belief is that way too many executive teams (and investors!) unknowingly get confused between building a solid business with chasing the latest get-rich-quick trend. 

Focusing on exiting promotes short-sighted behavior.   It moves focus away from fundamental long-term decision making.   It often tugs a company the wrong direction.  It is why I now explicitly discourage dwelling on exit strategies. 

I focus on the following:  Do we have a solid franchise?  If not, what one are we trying to create?  If so, how do we make it stronger?  How will this translate into predictable and abundant free cash flows?  Let’s do all these things extremely well.  Let’s not get all worried about how a strategic buyer or Wall Street analyst will value our company based on today’s metric-du-jour. 

Do me a favor.  Don’t mention this to my investors.  They cannot help themselves: exit strategy is in their DNA. 

Believe it or not, I actually did some research for this post. Not a lot. I typed into Google “Sprint, Worldcom, Vesting, CEO”. On the top of the list was:  Sprint Sham Merger.  It was exactly what I was looking for.

The headline from this link: “Sprint Executives Accused of Perpetuating Sham Merger for Personal Gain… Secret Change to Stock Option Plan Allows 5 Top Sprint Executives To Obtain $600 Million in Early-Vesting Options”.   What a perfect illustration of what I was talking about in my previous blog post.

It turns out that Sprint’s stock option agreement had a term that allowed for accelerated vesting if shareholders voted “yes” to approve a merger.  The merger need not happen for vesting to accelerate–only an approval by shareholders was necessary.  As it turned out, after the positive shareholder vote, the Worldcom proposed merger unwound.  It was never consummated.  Nonetheless, Sprint executives received a windfall due to the triggering of the vesting acceleration. 

Wow.  I know not whether individuals were legally liable.  Regardless, it certainly doesn’t seem right. So who is at fault?

I don’t know the details but I suspect what I what I am about to write is pretty darn accurate.  Executives and the board were guilty of some combination of poor ethics and unacceptable incompetence.  It might be one or the other or, most likely, a lot of both. 

First, no acceptable excuse can be given for allowing this language in the first place.  The company’s general counsel (who presumably was an officer) shouldn’t have allowed it.  The CEO should have been aware of it and, if so, should not have approved it.  It should have been a non-starter for the board’s compensation committee.

Second, the CEO and board, if they absolutely believed this was necessary and appropriate, should have been obnoxiously blunt to the shareholders that, by voting yes, they would trigger an enormous shift of value from the company to management whether or not the merger occurred.  This fact should have been made crystal clear to shareholders at the time the company sought approval.  It should have been raised above nearly all other disclosures.  The communication should have painted the scenario such that no shareholder who voted “yes” could have claimed to be the slightest bit surprised of what eventually transpired. 

I guess if it was fully and completely disclosed, the blame must be partially shouldered by shareholders–at least those who voted yes.  Personally, I would still question both management and the board for even bringing this to the shareholders.  It is doubtful such a proposal would have been made.  My guess is a high disclosure standard would have resulted in the board/executives simply not putting this structure in place.

Principle #1 of “Ethics according to the Bear” was written with this Sprint incident (and many, many others) in mind.