Running Money, page 7
In 1785, Edmund Cartwright sought to fix this problem. His first issue was waiting for Arkwright’s patent on the Water Frame cotton-spinning machine to expire. Once it had expired, Cartwright figured correctly that cotton mills would be built by the dozens and spit out an abundance of thread and yarn. Cartwright thought for a moment about starting his own cotton mill, but his business instincts kicked in, and he moved up the value chain. He wanted to leverage the abundance of yarn, not help to create more. Instead of contributing to the falling price of yarn, he thought about what he could do with cheaper thread. Then he worked on the missing piece of the puzzle: a mechanical power loom.
Without even looking at a hand-operated loom, he built a fully mechanical one. It didn’t work, but that didn’t stop Cartwright from getting a patent in 1785 for his mechanical loom. He persisted in the shop, and eventually his loom fully emulated the hand and foot movements of weavers with hand-operated equipment.
Cartwright opened a weaving mill in 1787 in Doncaster, with workers simply feeding in or fixing broken thread. He tried to use a waterwheel to operate the mill, but it barely budged his machine. He quickly contacted Boulton and Watt and hooked up their steam engine. Cheap power helped create a new market that didn’t exist previously.
My sense is that Cartwright built his power looms assuming he could get enough power applied to them—which of course was a huge mistake. He didn’t worry about power until it was a problem and then lucked out that Boulton and Watt had already licked it. Boulton and Watt had brought down the cost of power, probably by a factor of 10, or about 5% per year. Lucky for him, and lucky for Boulton and Watt. Not much different from the first Lotus 1-2-3 spreadsheets operating at a crawl on the first IBM PCs, driving demand for faster and faster 286 and 386 microprocessors from Intel.
Cotton was hot. Operators of Spinning Frames and power looms were demanding more and more raw cotton from the New World. The hands that were missing were not weaving hands but hands to pick cotton. Unfortunately, Africans pressed into slavery met that demand, accelerating the Triangle Trade. Finished goods out of England were provided to slave traders on the coast of Africa. Slaves from what is now Ghana, among other locations, were transported to Jamaica to harvest sugar cane and to Georgia to pick cotton. This sugar and cotton and other raw materials were brought back to England to be turned into finished goods, and the triangle started all over again.
Seedless cotton was tough to find. It took one slave all day to remove sticky green seeds from one pound of cotton, a hidden but stubborn bottleneck to cheap clothing out of England.
A Yalie named Eli Whitney headed south, and in the winter of 1792, as every schoolkid now knows, Whitney invented the cotton gin. Gin, in case you were wondering (I was), is short for engine, good old Georgia talk.
Operating a hand crank, one person running Whitney’s cotton gin could clean 50 pounds of cotton a day instead of just the one pound by hand. Now that machines had broken the barriers all along the cloth value chain, the clothing business took off. And demand for steam engines took off with it.
In 1792, when the gin was invented, no more than 150,000 pounds of American cotton made its way to England; eight years later it was 17 million pounds. By 1850, 700 million pounds of cotton were exported to England. To put this in perspective, in 2003, 5.6 billion pounds of cotton were exported from the U.S. That’s a factor of 5,000 growth in the first 58 years. Then cotton grew by another factor of 8 over the next 153 years, or a puny compound annual growth rate of 0. ‘insert about 100 zeros’ 1%. Hmm, you’ve got to be early on these trends. That’s where the money is.
With steam-powered mills and looms and a steady flow of clean cotton, England now had the economic engine it needed. Import raw materials like cotton, run them through industrial machinery run by steam-powered engines and export finished goods like yarn and cloth and textiles. That was and still is the definition of an industrial economy.
The key is that finished goods can be sold at prices so much cheaper than handmade goods. Back then, it changed the way the world dressed, with less itchy clothes at that. Even Don Valentine would have called that a monster market.
I suppose this is no different from the way the world was changed by electricity at the turn of the last century or by radio in the 1920s or television in the 1950s, or maybe automobiles or washing machines or refrigeration or air conditioning. Industry supplied the product more and more cheaply, and an entire consumer economy was built around these cheap, revolutionary products.
Heck, entire economies evolved to supply this stuff—Japan with consumer electronics and then cars, Taiwan or China with all sorts of manufacturing and assembly. These are all gussied-up remakes of the Industrial Revolution movie—like King Kong, or Hong Kong.
Industrialization was not some master plan to remove workers from their century-old tasks. Instead it was a complete reengineering of life based on the ability to provide daily staples at much lower costs. Getting everyone together in one steam engine–driven manufactory produced higher-quality and lower-cost textiles than anything that could be done at home by old spinsters.
As long as England could keep prices for their cloth going down, they would both create new markets and keep competition away. Growth created by and protected by its own declining price elasticity. Hmm. This is something I want to invest in.
Rocker v. Pittman Prizefight
SAN FRANCISCO, CALIFORNIA—FEBRUARY 1997
“Any questions for Bob or me?” asked Richard Hanlon, the investor relations guy from America Online.
“Was MTV really your idea?” someone from the back corner of the room asked.
“In fact, I was CEO,” answered Bob Pittman. I started to chuckle. I had already met several others who claimed to have founded MTV. My thought was interrupted when the guy sitting next to me let out a sigh so loud everybody in the room looked over.
Fresh from a gig fixing the Six Flags theme park and then milking Century 21 real estate brokers, wonder boy Robert Pittman had been hired by Steve Case to be the public face of America Online. This was one of his first appearances.
Pittman had just given a presentation in the Grand Ballroom at the Robertson Stephens Technology Conference. We were now sitting in a breakout session in a small room with a conference table for 20 and probably another 20 seats scattered around the room. The press was not allowed in, only investors, so all questions were fair game.
“How’s flat-rate pricing going?” a woman across the table asked. Microsoft’s new Microsoft Network charged $20 per month, and AOL had recently responded by going from per hour pricing to $20 per month flat rate.
“Pretty good.” (The guy next to me let out a snort.) “Sure, there are some busy signals, but it is a sign that our customers really like the service.”
“You’re kidding, right?” I heard from my right. I looked down at the guy’s nametag. It read “Dave Rocker, Rocker Partners.” Ah, the famous short. This guy lived to find companies in trouble. His hedge fund would sniff out corporate malfeasance, short the stock and then yell at the top of their lungs for everyone to come look at these scumbags that were ruining this company. Then he sat back, hoping the stock would crater and make him millions. At least, that’s the concept. Rocker’s problem was that there had been a bull market since 1983 and not much had gone down. It was a tough market to be a short in.
“Look, busy signals are localized. I live in New York, and when I get a busy signal when I call to check my e-mail, I just look up a number in Denver or LA and call that one—I get right through,” Pittman calmly explained.
“But doesn’t that defeat the purpose of local dial-up?”
“It’s just a short-term thing. Anyone else?”
“Is there any magazine that doesn’t come with an AOL CD sewn in? I’ve got a growing collection of drink coasters at home.” This one came from the analyst from Robertson.
“The hit rate on these marketing programs continues to exceed expectations,” Pittman answered.
“So we can expect to see a large expense this quarter for these marketing programs,” Rocker asked.
“Like all subscription services, we write off customer acquisition costs over the expected life of the subscriber.”
“Which is?”
“I’m not sure. But it’s in years.”
“But your customers don’t stay for years,” Rocker screamed.
“They might.” Pittman started scanning the room for someone else to ask a question. But the rest of us were having too much fun watching Rocker grill Pittman, so no one volunteered.
“As far as I can tell, you guys are bleeding cash. You throw money at CDs and haven’t bothered to upgrade your network, which is why you have busy signals. If you accounted for the marketing like you’re supposed to, you’d be reporting losses,” Rocker said.
“We endorse current analyst expectations of a slight profit for the current quarter” is all Pittman could say.
“But those are your own numbers. You fed them the numbers, and now you’re endorsing their expectations?”
“Analysts do their own independent work.” I watched the analyst from Robertson look down and saw the blood rush from his face.
“Aren’t you losing more subscribers than you are gaining?” Rocker went on.
“Our churn is within acceptable limits,” Pittman replied.
“What does that even mean? C’mon. You guys are getting all sorts of cancellations, but I can’t seem to find them in your filings. What are you doing, just waiting for a quarter with big sign-ups so you can bury the cancels?”
“Our accountants sign off on our reporting.” Pittman was starting to sweat, and had an I-don’t-need-this-shit look on his face. “Anyone else?”
“Yes. Is it true Tom Hanks is going to be the new voice for ‘You’ve got mail’?” This came from behind me.
“Well, not exactly. He is slated to star in a movie of that name, with Meg Ryan. It will be out next year from Warner Brothers. We might have made it ourselves, but who wants to own a movie company?”
“How are you going to pay for upgrading your network?” Rocker was back.
“Excuse me?”
“When I look at your balance sheet, your cash is draining fast. And you probably have to spend a hundred mill upgrading your system to get rid of those busy signals or all those subs are going to jump to MSN.”
“We think we have adequate facilities to finance—”
“No you don’t. Your stock is sinking like the Titanic, and your credit lines look like they have already been tapped. Unless you pull a rabbit out of a hat, you can’t afford to put much into your network. And my engineering friends tell me you have to revamp the whole damn thing to a packet-based architecture or you won’t ever be able to handle more subscribers than you have now, no matter how many CDs pile up in people’s homes.”
Rocker was right. The stock was sinking fast. The fairy-tale story of amazing growth had hit an iceberg.
“We’ll get there. I have the utmost confidence,” Pittman said.
“Is that enough?” Rocker said.
“Well, I’d like to thank everyone for contributing to the breakout session,” Richard Hanlon concluded as everyone laughed and filed out of the room.
Nick Moore found me as I was running to another meeting.
“I heard the America Offline meeting was pretty brutal. The stock is getting touched up,” Nick said.
“Round one to Rocker,” I said.
“Those guys are pretty crafty. Their accounting is better fiction than Hemingway, but they always seem to pull it off. I’m not sure what it will be this time, what rabbit they’ll pull from a hat, but I’m not shorting it. Rocker is going to get killed.”
“What makes you so sure?” I asked.
“AOL has more levers to pull than Rocker does. As long as they are growing, they can cook the books and hide the losses for years.”
“You think it’s one of these exponential markets?”
“What do you mean?” Nick asked.
“I don’t know. I’ve been playing around with these second derivative markets—things that grow exponentially.”
“Don’t hurt yourself.”
“No one thinks in second derivatives—you know, the growth of growth, breakout stuff. Like, well, like people have a hard time thinking in four dimensions.”
“You mean the Age of Aquarius?”
“That’s the Fifth Dimension.”
“Oh. Well, let the sunshine in. Surrey down to a stoned soul picnic, man,” Nick said as he walked off.
“Never mind.”
The way I heard the story years later from a friend who worked in AOL’s business development group is that Pittman went out on the prowl for cash. He was close to signing a sponsorship deal with MCI or Sprint for maybe $5 million over a couple of years, which would have been a good start. Then into his office walked Daniel Borislow, the CEO of Telesave, a small and, many would say, fleabag long distance company. Borislow dropped a check for $100 million onto Pittman’s desk in exchange for access to AOL’s eight million customers.
Now put yourself in Pittman’s shoes. You just got the crap beat out of you by Rocker, your stock is cratering, your balance sheet is bone dry and, like manna from heaven, $100 million is handed to you. At that point, you would have done a deal with Tony Soprano for 100 large. And a deal he did, in effect relaunching AOL as a media company, selling access to their customers. A grand master plan by Pittman? I doubt it. I think he has Dave Rocker to thank for forcing his hand.
In an act that defies belief, Borislow and Telesave decided to write the $100 million off over 40 years as a marketing expense. The fact that 40 years is 30 years longer than AOL has been in business or 20 years longer than the PC has been around, or even a few years longer than microprocessors have been around didn’t seem to bother anyone. Rocker’s short got squeezed by two lemons.
On the announcement of the AOL-Telesave deal, both stocks jumped and went on a three-year wild ride—while Dave Rocker twisted in the wind.
I could care less about AOL—a service for teenage girls. But it was clear they were going to spend billions on building out their network, and I wanted to find every piece of intellectual property needed to upgrade it.
That’s what Fred and I cared about—the underlying technology that becomes part of the infrastructure of a new trend. If the trend is big enough, it doesn’t matter who actually wins—AOL or Microsoft or Verizon or IBM. If we could just find some protected piece of IP, some design, some code, something that everyone has to buy in size, we’d have a ten-bagger on our hands. I was naive. I didn’t realize how big an if that really was.
Sinking Like a Red Brick
LOS GATOS, CALIFORNIA—SPRING 1997
“Thanks for taking the time to meet with us.” We trucked our way down to Los Gatos, on the fringes of Silicon Valley, to meet with Red Brick Systems. We owned some shares. Their stock was flying, going up a point or two a day, and we needed to figure out if we should be buying more. We wanted to meet the CEO, but we were met by the CFO. He was wearing the techie uniform: a denim shirt and khakis. I had on a tan shirt and jeans; the anti-uniform, I suppose.
“Not a problem. Let’s go to my office.” Fred and I followed the CFO through a maze of cubicles until we got to what looked like an executive section of real offices with windows along the edge of the building. “Here we are, c’mon in.” The CFO proceeded to close the door behind us. I thought I saw Fred cringe.
“Sorry our CEO can’t meet with you. I’ve got my fingers on the pulse around here, and I’ve got our head of sales stopping by in a little bit.”
He proceeded to walk us through their prospects. Red Brick sells data-mining software that can find patterns in customers’ databases. This means that a retailer can sift through their database of sales and note that lemonade sells well on sunny days, and, gee, maybe they should stock up and put it at the front of the store when it’s sunny.
We got the standard PowerPoint presentation, which looked exactly like the one they used on their IPO road show, with maybe just the financial numbers updated. Pretty dull. Khakis walked us through a bunch of case studies—customers would put in Red Brick and save three times the price of the software within a year. Fred asked a few questions about follow-on sales and how long it takes Red Brick to roll up their financials. I thought it was pretty neat technology but that its results were just common sense, not startling. Still, it was selling like hotcakes.
The head of sales came in.
“What is the sales cycle like? How long does it take to close a deal?” Fred asked.
“Oh, I can close them pretty quickly.”
“But is there the usual pipeline and sales funnel and all that?”
“Yeah, of course, but when I find someone who is interested, I can come to terms pretty quickly and get the deal done,” the sales guy said as he glanced over to the CFO, who nodded slightly. “So, I—uh, I mean the company—can make its quarters.” He sounded like that hedge fund guy who talked about making his month.
We learned more than we ever wanted to know about data warehousing, data marts and online analytical processing, said our goodbyes and scrambled out to my car.
“Well, it’s interesting, but I guess I still don’t get why anyone actually buys this stuff. It all seems so obvious,” I said.
“Do you have your phone?” Fred asked.
“Yeah, sure. Why?”
“Call someone, anyone, and get rid of all our Red Brick shares.”
“Really?”
“This thing is going to blow up.”
I made a few calls, and the first trader I reached got the order.
“I’m happy to dump this thing, but what did you see?”
“The first sign was that the CFO closed his door.”
