Stealing from the future

There are plenty of examples where companies and government units borrow from their future in different ways. There are very different issues for the two actors, so we’ll split this into two posts: this one on companies and another future post on government.

The traditional way that companies approach capital needs is to borrow money, raise equity, or get cash from operations. That’s pretty much all there is in terms of sources of capital. What good CFOs do is try to match up the timing of cash flows in and out between source of the capital and the use of the capital.

Matching Revenue and Expenses

The simplest example of this is a company that borrows money to buy a piece of equipment that will last 10 years. Ideally, the company will find a loan that allows it to pay back the principal at a rate that is closer to 10 years than 1. The in-between model would be to have the repayment on the loan at least closely match the expected cash flows from the products the machine produces. That way, even if all the cash from the machine is used to pay back the loan in five years, at that point the company owns the machine and the cash flow it produces stays with the company for other purposes. However, the key is to avoid being upside-down on this structuring.

A good example of getting it wrong is using short-term funds to purchase a long-term investment. Getting a one-year mortgage for real estate is a straightforward example. The problem is that the need to pay for the investment will arise much sooner than the investment produces a return, which means that additional capital must be used.

American Airlines taken for a ride

We recently found two examples of companies making operational decisions that put them at risk for financial stress. In the first example, American Airlines has at different times, sold a lifetime pass for unlimited first class air travel, in some cases with a companion option, also sold for a single upfront payment.

Now, to the company at day 0, this looks great! Money in, and all the expense out in the future. (If your bonus is pegged to that quarter’s revenue number, you were sitting pretty.) But this story describes how AA felt about the program after they managed to think about it in a backwards way. In any case, they grew to despise the program and the customers who had paid them.

What happened? A few things:

1. They took in short-term revenue against long-term expenses. I’m going to guess that AA exerted about zero fiscal discipline in the way of setting aside those funds to offset future expenses. Most companies do not operate like insurance companies, who have obligations to set aside reserves in amounts set by law or regulation. Whether insurance companies, who also have short-term income and long-term expenses, would screw up in the same way is a question that history would probably answer in the affirmative. A similar argument is often made about executive compensation, particularly where compensation is paid on the basis of interim paper profits and final outcomes are not used to adjust comp, such as on Wall Street.
2. They probably underestimated the amount that some people would travel. First-year economics (unless you’re in Washington and discussing universal free health care) tells everyone that reducing the price of a good or service increases its consumption. So their expenses were probably higher than they anticipated. That’s what leaders get paid for, though: to assess and manage risk.
3. They also, according to the article, made the same fallacy as record and movie companies fighting piracy: that every flight would have otherwise been a paid ticket. It’s clear to anyone thinking about this that people flying every weekend to London probably wouldn’t be paying full price to travel that much in the absence of the all-you-can-eat pass. But once the AA folks got the itch to salvage the “lost revenue,” the customers were doomed. The article tells the rest.

AT&T gets wrong number

A similar analysis, but with some different particulars, applies to AT&T’s unlimited iPhone data plans. This interview quotes the CEO as saying it was a big mistake – they didn’t plan for as much usage as they saw.

But then there’s his funny statement complaining about building infrastructure to service paying customers. This is the part that I want to focus on, because it’s what I think is at the heart of these stealing from the future problems.

AT&T implies that they were looking for valuable customers: bigger payments from customers who didn’t use more services and who could be serviced at low marginal cost. In less delicate language, they were looking for a free lunch. They want money and don’t want to provide services. Sure, good plan, but who’s gonna feel sorry for them? No one.

(Another example just popped into my head: someone I worked for chose to remodel/expand his home from the proceeds of a home equity loan, using the rationale that the house paid for the work itself and that it was free money because of the increase in value. )

Planning ahead

Where do these examples leave us? First, pay attention to the only thing that matters: free cash flow. Each of these companies got into trouble because they were focused on front-end money in and failed, apparently miserably, on what the back-end money out was going to be. Software companies and others selling subscription or long-term contracts that fooled with revenue recognition issues (before changes made recognition more sensible) exploited the disconnect in timing between the appearance of money in and the outlay of that same money down the road. It’s this time dimension of the problem that leads to our name for the problem: stealing from your future.

On a personal basis, the best financial advice I can think of is to simply not go into long-term debt for short-term expenses. The only debt you should try to allow is a mortgage on a house or other long-term investment such as education. No, as many others have written, your car is not an investment. (If you’re buying a James Dean-era Porsche, then you are the exception.)

Next time around, we’ll talk about how this same principle, and the sloppy math allowed by crappy financial statement standards, has led us to the huge municipal debt problem from pensions, health care, and other unfunded obligations. Note in advance: I am not talking about the decision to offer pensions or other benefits. Instead, I’m talking about keeping track and being honest about the numbers. Then we can all plan ahead, unlike AA or AT&T.