Autodesk's John Walker explained HP and IBM in 1991

One reader of this column in particular has been urging me to abandon for a moment my obsession with IBM and look, instead, at his employer -- Hewlett Packard. HP, he tells me, suffers from all the same problems as IBM while lacking IBM’s depth and resources. And he’s correct: HP is a shadow of its former self and probably doomed if it continues to follow its current course. I’ve explained some of this before in an earlier column, and another, and another you might want to re-read. More of HP’s problems are covered in a very fine presentation you can read here. Were I to follow a familiar path at this point I’d be laying out a long list of HP mistakes. And while I may well do exactly that later in the week, right here and now I am inspired to do what they call in the movies "cutting to the chase", which in this case means pushing through bad tactics to find a good strategy. I want to lay out in a structural sense what’s really happening at both HP and IBM (and at a lot of other companies, too) so we can understand how to fix them, if indeed they can be fixed at all.

So I’ll turn to the works of Autodesk founder John Walker, specifically his Final Days of Autodesk memo, also called Information Letter 14, written in 1991. You can find this 30-page memo and a whole lot more at Walker’s web site. He has for most of this century lived in Switzerland where the server resides in a fortress today. We may even hear from Walker, himself, if word gets back that I’ve too brazenly stolen his ideas. Having never met the man, I’d like that.

What follows is an incredibly stripped-down version of Information Letter 14, nixing most of the Autodesk-specific bits and applying the underlying ideas to lumbering outfits like HP and IBM. I’m just one of many people to be inspired by this memo, by the way. It was the basis of Bill Gates’s The Coming Internet Tidal Wave memo from the mid-1990s that led to Microsoft reforming itself to take on Netscape.

When major shifts occur in user expectations, dominant hardware and software platforms, and channels of distribution, companies which fail to anticipate these changes and/or react to them once they are underway are supplanted by competitors with more foresight and willingness to act…

This of course describes both HP and IBM -- generally trying to use their corporate mass to lead from behind, which even they know doesn’t work.

Today (Autodesk, HP, IBM -- you name a successful company) is king of the mountain, but it is poised precariously, waiting to be pushed off by any company that seizes the opportunity and acts decisively. One of the largest unappreciated factors in Autodesk’s success has been the poor strategy and half-hearted, incompetent execution that characterized most of our competitors in the past. But betting the future of our company on this continuing for another decade is foolish, a needless prescription for disaster…

You cannot lead an industry by studying the actions of your competitors. To lead, you must understand the mission of your company and take the steps which, in time, will be studied by other, less successful companies seeking to emulate your success…

Autodesk is proud of its open door policy, and counts on it to bring the information before senior management that they need to set the course for the company. Such a policy can work only as long as people believe they are listened to, and that decisions are being made on grounds that make sense for the long-term health of the company. Rightly or wrongly, there is a widely-held belief which I’m articulating because I share it, that management isn’t hearing or doesn’t believe what deeply worries people throughout the company, and isn’t communicating to them the reasons for the course it is setting. This is how bad decisions are made…

NOBODY in the executive suites at either HP nor IBM is listening to the troops. No good ideas are welcome in either company at this point, which is stupid.

Now Walker takes us to the crux of the corporate problem faced by both HP and IBM, explaining it in terms of Wall Street’s obsession with profit margins.

Investors and analysts have learned to watch a company’s margins closely. Changes in margin are often among the earliest signs of changes in the fortunes of a company, for good or for ill. When sales, earnings, and margins are rising all together, it usually means the market for the company’s products is growing even faster than the company anticipated; the future seems bright. When margins begin to decline, however, it can indicate the company has let spending outpace sales. When competition begins to affect the company, or even when a company fears future competition, it may spend more on promotion, accelerate product development, and offer incentives to dealers and retail customers–all reflected in falling margins.

But high margins aren’t necessarily a good thing, particularly in the long term. One way to post high margins is by neglecting investment in the company’s future. Any profitable company can increase its earnings and margin in the short run by curtailing development of new products and improvements to existing products, by slashing marketing and promotional expenses, and by scaling back the infrastructure that supports further growth. Since there’s a pipeline anywhere from six months to several years between current spending and visible effects in the market, sales aren’t affected right away. So, with sales constant or rising slowly and expenses down, earnings and margin soar and everybody is happy.

For a while, anyway. Eventually momentum runs out and it’s obvious the company can’t sustain its growth without new products, adequate promotion, and all the other things that constitute investment in the future of the business. It’s at that point the company becomes vulnerable to competitors who took a longer view of the market.

One of the most difficult and important decisions the management of a company makes is choosing the level of investment in the future of the business. Spend too little, and you’re a hero in the short term but your company doesn’t last long. Spend too much, and the company and its stock falls from favor because it can’t match the earnings of comparable companies…

This is the pit into which HP and IBM have fallen. They want to maintain margins to keep Wall Street happy, but the easiest way to do that is by cutting costs. Eventually this will be visible in declining sales, which IBM has now experienced for three straight years. Yet with a combination of clever accounting and bad judgement even declining sales can be masked… for awhile.

Let’s turn now to what happens to the money that remains after all the bills and taxes have been paid. A small amount is paid back to the shareholders as dividends, but the overwhelming percentage goes into the corporate treasury -- the bank account -- the money bin. When a company runs the kind of margins Autodesk does for all the years we have, that adds up to a tidy sum: in Autodesk’s case (in 1991) more than $140 million. When thinking about the future of the company, what can and can’t be done with that cash is vital to understand.

At the simplest level, the money belongs to the company and management can do anything it wishes within the law: give some back to the stockholders as a special dividend…, buy other companies…, buy real estate or other capital goods for the company…, or just invest the money, collect the income, and add it to earnings…

But here’s the essential point. When you spend a dollar, whether to hire a programmer, buy a truck, run an ad, or take over Chrysler, it it doesn’t matter whether it came from the bank account or from current sales… Regardless of how prudent you’ve been piling up money over the years, the moment you spend any of it in your business, it’s just as if you increased your day to day operating budget. That means rising expenses without an increase in sales, and that translates into… falling margins.

About the only thing you can do with the money that doesn’t cause margins to fall, other than giving it back in dividends, is investing it in other companies. When you make an investment, that’s carried on the books as capital. As long as you don’t have to write the investment off, it doesn’t affect your operating results…

The accounting for money in the bank, then, can create a situation where pressing company needs remain unmet because the expenditures required would cause margins to fall, yet at the same time, the company is actively investing its cash hoard outside the company, in other businesses, because those investments do not show up as current operating expenses. Thus, the accumulated earnings of a company, the ultimate result of its success, can benefit any venture except the one that made the money in the first place…

This explains why IBM is always buying little companies then squeezing them, often to death, for profits. Buying these companies is an investment and therefore not a charge against earnings. But having bought the companies, spending any more money on them is not an investment and hurts earnings. IBM could develop the same products internally but that would appear to cost money. So instead they try to buy new products then deliberately starve to death the companies that created them. In accounting terms this makes perfect sense. To rational humans it is insane. Welcome to IBM.

Management strives, quarter by quarter, to meet the sales and earnings expectations of the Wall Street analysts and to avoid erosion in the margin which would be seen (rightly) as an early warning, presaging problems in the company. In the absence of other priorities this is foremost, as the consequences of a stumble can be dire…

But management has a more serious responsibility to the shareholders; to provide for the future of the company and its products. Focusing exclusively on this quarter’s or this year’s margins to the extent that industry averages dictate departmental budgets for our company is confusing the scoreboard with the game…

I attended a meeting in early 1989, where I heard a discussion of how, over the coming year, it would be necessary for Autodesk to reduce its sales and marketing budget to lower and lower levels. Walking in from the outside, I found this more than a little puzzling. After all, weren’t we in the midst of a still-unbroken series of sales and earnings records? Wasn’t this year expected to be the best ever? Weren’t we finally achieving substantial sales of AutoCAD to the large companies and government?

True, but there was this little matter of accounting, you see. From time immemorial, most copies of AutoCAD had been sold by dealers. To simplify the numbers, assume the retail price of AutoCAD is $1000, the dealer pays $500 for it, and all sales by dealers are at the full list price. So, for every copy of AutoCAD that ends up in a customer’s hands, Autodesk gets $500 and the dealer gets $500. Autodesk reports the $500 as Sales, deducts expenses, pays taxes, and ends up with earnings, say $125, corresponding to a margin of 25 percent.

But suppose, instead, we sell the copy of AutoCAD to a Fortune 500 account -- Spacely Sprockets, perhaps? In that case, the numbers look like this (again simplified for clarity). Autodesk ships the copy of AutoCAD directly to the customer and invoices Spacely Sprockets for the full list price, $1000. However, the sale was not made directly by Autodesk; the order was taken by one of our major account representatives, the equivalent of dealers for large accounts. When we get the check, we pay a commission to this representative. Assume the commission is $500.

Regardless of who bought the copy of AutoCAD, the financial result, the fabled "bottom line", is the same. There’s one fewer copy of AutoCAD on our shelf, and one more installed on a customer’s premises. Autodesk receives $500, and our dealer or representative gets $500. But oh what a difference it makes in the accounting! In the first case, where Autodesk sold the copy of AutoCAD to the dealer, that was the whole transaction; whatever happened to the copy of AutoCAD after the dealer paid for it has no effect on Autodesk’s books. Autodesk sells, dealer pays, end of story. But in the second case, when Autodesk sells to Spacely Sprockets, that appears on Autodesk’s ledger as a sale of AutoCAD for $1000. The instant the $1000 shows up, however, we immediately cut a check for the commission, $500, and mail it to the representative, leaving the same $500 we’d get from the dealer. Same difference, right?

Not if you’re an accountant! In the first case, Autodesk made a sale for $500 and ended up, after expenses and taxes, with $125, and therefore is operating with a 25 percent margin (125/500). In the Spacely sale, however, the books show we sold the product for $1000, yet wound up only with the same $125. So now our margins are a mere 12.5 percent (125/1000). And if we only kept $125 out of the $1000 sale, why that must mean our expenses were 1000-125=875 dollars! Of that $875, $375 represent the same expenses as in the dealer sale, and the extra $500 is the representative’s commission which, under the rules of accounting, goes under "Cost of sales".

Or, in other words, (the money) comes out of Autodesk’s marketing and sales budget.

That’s why the marketing budget had to be cut. To the very extent the major account program succeeded, it would bankrupt the department that was promoting it. If we were wildly successful in selling AutoCAD into the big companies, Autodesk would make more sales, earn more profits, then be forced to cancel marketing program after marketing program as the price of success! All because the rules of accounting would otherwise show falling margins or a rising percentage of revenue spent on "cost of sales".

The purpose of this discussion is not to complain about the rules of accounting. You have to keep score somehow… Instead, what disturbed me so much about this incident was the way management seemed to be taking their marching orders from the accounting rules rather than the real world. Budgets were actually being prepared on the assumption that marketing and sales efforts would have to be curtailed to offset the increased "cost of sales" from the major account sales anticipated over the year. Think about it: here we were planning for what was anticipated to be and eventually became the best year in Autodesk’s history, and yet were forced to cut our marketing and sales as a direct consequence of its very success. Carried to the absurd, if the major account program astounded us and began to dwarf dealer sales, we would have to lay off the entire marketing and sales department to meet the budget!

This is another reason why HP and IBM have taken to ruthlessly cutting expenses, which is to say people. These aren’t huge one-time layoffs to lay the groundwork for true corporate re-orgs, they are exactly as John Walker feared: labor reductions driven purely by accounting rules. For the people of HP and IBM they are death by a thousand cuts.

The only way to use retained earnings without directly increasing expenses is by investing it… Unfortunately, unless the goals and priorities of Autodesk’s current Business Development effort have been seriously miscommunicated, it seems to me embarked on a quixotic search for something which in all probability does not exist: "The Next AutoCAD…’" In other words, we’re betting the future growth of our company on our ability to consistently identify products which sell for more than any other widely-distributed software and will be sold exclusively by a distribution channel which has demonstrated itself incapable of selling anything other than AutoCAD.

What’s wrong with this picture?

When you adopt unrealistic selection criteria, you find unattractive alternatives. The desiderata that Autodesk is seeking in the products on which the company’s future will be bet would have excluded every single successful product introduced since 1982 by Microsoft, Lotus, Ashton-Tate, Word Perfect, and Borland. What are the odds Autodesk will find not one, but several products that these companies have missed?

You can always find an investment that meets your criteria, but if your criteria are out of whack with reality, you might as well blow your money at the track where at least you get to smell the horses…

"The next AutoCAD" here could just as easily mean the next IBM 360, the next DB2, the next LaserJet printer, except those kind of opportunities don’t come along very often and as companies get bigger and bigger their successes are supposed to get bigger, too, which usually isn’t even possible, leading to the very corporate decline we are seeing in both companies. "The next AutoCAD" could mean Ginni Rometty’s favorites -- cloud, analytics, mobile, social, and security, except with IBM a lesser player in every one of those new markets, what are the chances of being successful with all of them? Zero. With one of them and a Manhattan Project (or IBM 360) effort? Pretty good, but not one of these segments by itself can be a $100 billion business.

Whether it’s Meg Whitman or Ginni Rometty, the problems these executives face are the same and are almost equally impossible. Neither woman can pull a Steve Jobs turnaround because Steve’s task was easier, his company was already on its knees and vastly smaller than either HP or IBM. So stop comparing these behemoths to Apple circa 1997. A better comparison would be to Dell.

By taking his company private Michael Dell changed the game, eliminated completely Wall Street pressure and influence, and dramatically increased his chances of saving his company. Why haven’t Meg and Ginni thought of doing the same? Why aren’t they? There’s plenty of hedge fund money to enable the privatization of both companies. But the hedge funds would immediately fire the current CEOs, which is probably why this doesn’t happen.

Ginni Rometty and Meg Whitman appear to be more interested in keeping their jobs than in saving their companies.