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Why tech companies should revisit their capital allocation strategies now
In this episode, members of the EY Strategy and Transactions team explore the pain points companies are experiencing around capital investments and what they need to do next.
We’ve seen the tech sector hit near-record highs as companies increase their value chain exposure and drive disruption and transformation across subsectors. On the surface, everything looks great, but are there hidden challenges that some of the recent successes may be obscuring? Our speakers explain why now is the time for tech companies to pause, reflect and strategize differently.
Capital allocations is a broad topic and EY teams recommend a focus on assessing, planning, reviewing and prioritizing the uses of financial resources across an organization. Some categories we explore are: debt repayment, dividends, capital investment, sales and marketing expenditures, share repurchases, acquisitions and R&D.
EY teams have developed a framework that consistently evaluates these investment decisions and monitors progress, enabling executives to prioritize the many choices and demands on their capital.
Join Barak and members of our EY Americas Strategy and Transactions team as they dive into the differences between these expenditures and the impact they can have on your bottom line.
Erika S. Maymon, Senior Manager, Ernst & Young LLP
Akhilesh Kulkarni, Senior Manager, Ernst & Young LLP
Key takeaways include:
We share key findings from the global capital allocation report based on a survey of chief financial officers to better understand how they think about their capital allocation strategy. Many CFOs felt that their strategy fell short and needed work to improve efficiencies and agility to respond to unexpected changes.
Lastly, our speakers focus on key considerations to make customized decisions leading to a well-defined governance process, continually entering new data to build agility and determining long- and short-term objectives.
For your convenience, full text transcript of this podcast is also available.
Christina R Winquist
Welcome to the EY Tech Connect podcast where we have candid conversations about the most pressing priorities facing tech, media & entertainment and telecommunication companies and provide strategic insights on the key issues that matter to them. As industry ecosystems evolve in new directions, we use these discussions to reflect on how companies can not only take advantage of new opportunities but also tackle emerging challenges.
Adrian Baschnonga
Hi, and welcome to EY Tech Connect, the podcast with candid conversations and strategic insights on the most pressing business issues facing tech, media and telecommunications companies. Learn how to build powerful industry ecosystems to navigate the future. I’m Adrian Baschnonga, Sector Analyst for Technology and Media here at EY.
Winquist
And I’m Christina Winquist. Hi, Adrian. I’m responsible for TMT Brand Marketing and Communications, and today we’re going to speak with a team that has spent years working with technology clients and recently published a thought leadership article titled, Why tech companies should revisit their capital allocation strategies now. So let’s get started.
Baschnonga
Fantastic. I’d like to introduce our stellar lineup of speakers today. We have Barak Ravid, EY Global TMT leader for Strategy and Transactions; Ryan Citro; Erika Maymon; and Akhilesh Kulkarni who are all part of the EY Strategy and Transactions teams on capital allocation, the pain points tech companies are experiencing and what needs to change. Let’s think a little bit about the industry backdrop. We’ve seen the tech sector hit near-record highs as tech companies increase their value chain exposure, drive disruption and transformation across sectors. So you’d forgive leading tech companies thinking actually their fundamentals are pretty strong. So why do they need to pause, reflect and strategize differently? Barak, over to you.
Barak Ravid
Thanks, Adrian, and thanks, Christina, and delighted to be joining you guys today. I think if you look at the sector overall as you mentioned, Adrian, things on the surface look great, right? We’ve got record earnings, we’ve got record growth, and the sector continues to deliver shareholder returns. And so on the surface everything looks great. However, when you start thinking about different growth companies and different constituents, you start to see a different picture.
So for example, the top quartile of companies in terms of over their last five years, they delivered 6X shareholder return, which is phenomenal. And it’s even more impressive when you think that they earned 110% of that, and by earned we mean they did it through revenue or margin expansion. It wasn’t through multiple expansion. When you look at the middle two quartiles, they delivered 3X growth. Again, really strong growth. However, this is where it starts to get interesting because they only “earned” 30% of that. So 70% of what they returned was through basically multiple expansion. So it’s kind of gifted as opposed to earned.
Then when you look at the bottom quartile, they delivered 2X returns. Again, not too bad, but they earned almost none of that because almost all of that was multiple expansion. When you think about that, you think, well, if I’m in the middle quartiles or in the bottom quartile — but let’s maybe focus on the middle quartile — if I’m sitting in the C-suite, how long do I want to keep betting on multiple expansions continuing to rise? At what point do I need to start acting much more rapidly and driving (inaudible) growth? See that the market rewards grow, and there’s only so much share buyback and dividends that I can kind of return to my shareholders and still expect to be a growth company. So it’s becoming more and more of a pressing issue, and companies really need to think hard about how they navigate much more (inaudible).
Baschnonga
Really interesting, Barak. Yes, I love the sense of the hidden challenge there that some of the recent successes may be obscuring some of these latent challenges.
Winquist
Absolutely. Really interesting. Ryan and Akhilesh, you both authored this paper based on your years of experience working with tech companies. What is capital allocation, and why is it important for them?
Ryan Citro
Thanks, Christina. Yes, I think it’s really important to define it. It’s a very broad topic here. So when we talk about capital allocation, what we mean is really the assessment, planning, review and prioritization of the uses of financial resources across an organization. I’ll give you some examples of some categories that we look at: debt repayment, dividends, capital investment, sales and marketing expenditures, share repurchases, acquisitions and R&D. Those are all really kind of different uses of capital, and what we really find is that it’s really imperative to develop a framework that consistently evaluates these investment decisions and really monitors the progress on a basis that really allows executives to prioritize the many decisions and demands they have on their capital.
Akhilesh Kulkarni
That’s a great point, Ryan. Often, we see that the funding decisions are made in silos. Different teams use different criteria, different parameters to make those investment decisions and, because of that companies can’t really compare projects across different uses. For example, if I’m an executive and I want to figure out whether I should use the funds to add new customers or whether I should use funds to add a new cool feature to my product, how do I compare that? How do I make sure that my capital is being utilized in the most efficient manner?
And if you can’t compare, then you can’t ensure that it’s efficiently used, but also if you can’t compare very quickly, you cannot redeploy the capital when the market situation changes. So, this not only hurts your efficiency, this also hurts your agility.
Citro
Yes, I’m glad, Akhilesh, you mentioned the agility component because it’s something that we’ve seen really pronounced through the course of the pandemic that we’re living through right now. In our recent survey of CFOs, we found that 56% indicated that capital allocation strategy had to be really completely rethought during the pandemic. So there were a bunch of issues related to supply chain, customer loss, employee turnover that were really unimaginable scenarios pre-pandemic. Because their processes were not really agile, they had to really redefine them to really account for these differences in their process.
Erika S. Maymon
Yes, that’s right, Ryan, and I’m glad you brought up the pandemic, because what we saw during the early days of COVID-19 was that it really highlighted the importance of clearly defining an organization’s capital allocation strategy and ensuring that decision-making process was well-structured, transparent, measurable and consistent for the key stakeholders across the organization. The other thing I want to emphasize is that capital strategy does not stop with up-front planning. It actually extends to the execution phase of investment because one of the most important components is the performance monitoring throughout the investment cycle, and it’s really that feedback loop that’s continuously informing decisions and building that agility and accountability into your capital planning process.
Baschnonga
Erika, yes, really interesting, and thank you to Ryan and Akhilesh. Now Ryan, you mentioned the Global Capital Allocation Strategy report based on a survey of CFOs. Could you perhaps talk us through a few of the key findings from the study?
Kulkarni
Yes, sure. I’d be happy to. So, as we all know, the pandemic had tremendous impact on the businesses, right? Systems, their processes were stress-tested like never before. Like mentioned, there were unimaginable scenarios before the pandemic that sort of became everyday reality for most of us. Basically, this situation provided a very unique opportunity to understand how CFOs felt about their capital allocation strategy. Did they feel that their strategy worked for them, helped their organization to be more efficient and agile in these highly uncertain times? Or did they feel that their strategy didn’t work? If it didn’t work, what were the pain points? What didn’t work for them? What specifically didn’t work for them? And then what do the CFOs plan to do about it?
Posed all these questions to more than a thousand CFOs globally across industries, and the responses basically tell us that a majority of the CFOs felt that their capital allocation strategy fell short of the target and needed to be completely (inaudible). We also found that a significant number of participants didn’t really have that much confidence in their capital allocation process being agile and efficient, basically helping them achieve their organization’s objective and then optimal growth.
Maymon
Yes. Absolutely, Akhilesh, and I think I observed the same thing in the study. What’s interesting is that these same trends held true when we double-clicked on the responses from the tech CFOs. We were actually surprised to learn that tech CFOs have even less confidence than their non-tech counterparts that their capital allocation strategies are agile and efficient. For example, according to the survey, only 46% of tech executives polled felt their capital allocation strategy was agile enough to respond to unexpected changes compared to 55% of non-tech sector respondents. Similarly, while 60% of non-tech sector respondents said that their capital allocation strategies were efficient, that number fell to 54% for technology executives. So, there’s definitely something to explore there. I mean that’s pretty compelling don’t you think?
Kulkarni
Yes, that’s right, Erika. I must say that these responses were very surprising to all of us, especially given the amazing run that tech stocks had during the recent years. This all ties back to what Barak was talking at the beginning that while things are running well, things are good for tech sector, it’s not the same for everyone, and then it seems that our survey basically corroborates that there is a growing realization among the executives about deficiencies.
Winquist
OK, great. Really interesting. Thank you, guys. What are some of the common capital allocation decisions tech companies need to make? Are there different decisions for software vs. hardware vs. asset-intensive companies? What are your thoughts?
Citro
Yes. Certainly every capital allocation process needs to be really tailored to the nature of the organization and the different investments that they’re looking to make and their strategy, and so I think it’s a great question because we see performance metrics on, say, R&D investment for software companies vs. capital expenditures that are kind of the predominant investment for asset-intensive companies can be really treated differently from an accounting standpoint and also from the standpoint of just looking at the differences in the risk profiles of those different asset categories and investment categories. Really in determining these trade-offs between these different asset classes, it’s really important to evaluate the investments on performance indicators that can really accurately capture these differences.
I can give you an example. I have a client that has a software business as well as a hardware business, and they’ve used historical metrics of like return on invested capital to really capture the returns and compare investments across the different businesses. What we found is that you get some differences in answers between what they perceive are investments that are successful vs. ultimately what the data is telling them based on differences in risk profiles associated with the investments as well as differences in accounting treatment. For instance, R&D is a period expense that is a one-time expense. When you’re looking at returns on that relative to capex that ultimately gets capitalized, you can really get some differences that’s purely related to accounting.
So, what we’ve done is to help companies to look more holistically at some of those different considerations and ensure that their performance metrics really capture those differences. So in this particular instance, we had them also evaluate their investments on net present value, and that really allowed them to discretely model in the differences in accounting treatment or the differences in risk profile associated with each. That really allowed them to be a little bit more agile to understand the types of investments they should be making on a go-forward basis.
Baschnonga
That’s great, Ryan, and really interesting to hear the differences and the nuances there when we think about metrics specifically. But what about some of the other trends in uses of capital that you’re seeing across the industry?
Maymon
Adrian, I’ll add that we continue to see share buybacks as a significant component of capital allocation strategy for tech companies, and our survey tells us that the CFO rationale for the share buybacks is strongly aligned with a goal of meeting shareholder and analyst expectations. Right? No surprise there. But this response was nearly three times more common than a desire to deploy that excess cash on investment opportunities with acceptable returns. This tells us that while shareholder and analyst expectations can drive short-term returns, it can come at the opportunity cost of foregoing longer-term investments with returns that could be very attractive to the company. That’s certainly something that tech companies need to consider.
Winquist
Wow, that’s great. Thanks so much. Akhilesh, how do transactions factor into the overall capital allocation framework?
Kulkarni
Tech companies choose between organic and inorganic growth all the time. They may be looking for ways to increase their customer base or to add to their product portfolio or simply acquire talent, and they can do it both using organic and inorganic ways, but tech companies need to routinely evaluate their internal initiatives against external targets and decide what makes most sense for them.
If they pursue inorganic growth, they may pay a higher valuation multiple up front but then face a lower execution risk and a quicker time to market. On the other hand, if they opt for organic growth, they may need much lower capital up front, but then the company takes on a higher execution risk and longer time to market. So the company should have a way to basically consistently evaluate these decisions against each other using both qualitative and quantitative considerations. That’s a big part of capital allocation.
Baschnonga
Pretty interesting, Akhilesh, some of these trade-offs that need to be top of mind when you’re thinking organic vs. inorganic. Erika, if I could turn to you, I know you’ve been working with tech companies to design and implement their capital allocation processes. What do you think high-performing tech companies need to consider when they’re thinking about their capital allocation decisions? What are the key steps they need to take?
Maymon
Sure, Adrian. Well, first of all I think, as with most business processes, capital allocation needs to be customized to the organization. However, I can share a few guiding principles. Number one, you want a rigorous, well-defined process that includes governance. You’ll need to consider who the relevant stakeholders are. What are the KPIs? What are the business drivers? Is it subscription bookings, licenses, earned revenue? You also want to take a look at the long- and short-term objectives of the organization as well as things like risk appetite and return requirements.
Number two, capital allocation needs to be agile. This means that you need a live tool where you can continuously enter new data and adjust assumptions. That’s how you really stay responsive to the market and any changing economic conditions. I mean we saw how important that was during the pandemic, and it’s the agility of the process that’s truly going to enable that dynamic decision support and that critical element of course correction.
Third, finally, I think it’s really important that your data is aligned to your business drivers and KPIs, and that is going to help allow for that ongoing tracking and performance monitoring. What we often find with tech companies in particular is that they tend to face some gaps in between the data that they can access and synthesize and the meaningful KPIs that they want to be able to track. That just may be a function of tech companies being in that perpetual state of fast growth and evolution. So, we work with them to help close those gaps, but ultimately you want to have a balanced scorecard that is providing insightful and on-demand visibility into the impact of the investment decisions you’re making, because it’s that transparency that’s going to give you the confidence that your capital allocation process is working. Ryan, is there anything you’d add to that list?
Citro
I think that’s a great summary. I mean the only other thing I would say just to tie it all together is that ultimately the process needs to be applied in a consistent fashion throughout the organization because at the end of the day it’s the consistency that ensures the process remains sustainable and objective so that you’re effectively interpreting the data to make decisions across the organization.
Baschnonga
That’s great to hear, Ryan, and thank you, Erika. Good to hear more about these principles and understand the importance of structure, agility and consistency with effective data management at the heart of it all. Now as we wrap up, it would be great if I could ask each of you for a final call to action. So Akhilesh, maybe starting with you.
Kulkarni
Yes, I’ll go first. I would say fix the roof when the sun is shining. Tech companies, based on our survey, recognize that their capital allocation process can be improved, and they should start thinking about these improvements now when things are going well for them.
Baschnonga
Super. Ryan, perhaps you.
Citro
Sure. I’d say it’s all really about first step being self-evaluation, understanding the current state of your organization and the areas for process improvements that will help to ensure that your process is agile.
Baschnonga
Super. And Erika, how about you?
Maymon
Yes, I definitely agree with the points that Ryan and Akhilesh made, and I would also add get informed about some of the leading practices in your industry. That’s going to help you adopt a process that’s going to work best for your company.
Baschnonga
Fantastic.
Winquist
Great, and I understand we can access the article at ey.com/techcapitalallocation. So go and check it out everybody.
Thank you, guys so much for your time and for joining us at EY Tech Connect. For more information on thought-leading perspectives, visit ey.com/TMT, and you can also follow us on Twitter at EY_TMT, and don’t forget to subscribe. Thanks so much.
