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How does a high-growth tech company grow sustainably? That, in essence, was the question before Twitter co-founders Biz Stone and Evan Williams at last week's D7: All Things Digital Conference. Their answer: Create value.
Or so we hear …
I wasn't at the conference -- how about an invite for your friendly neighborhood Fool next year, guys? -- so I'm cribbing from a video interview the two men gave to News.com's Ina Fried following their onstage remarks. Stone summed up Twitter's often-frustrating patience in revealing its business model to the world:
In order to create a company that has this enduring value, that is going to be here five, 10, 15, 20 years from now, you have to focus on delivering value first and profit second, especially considering we are only two years old.
Now, forget that Stone said that about Twitter, and apply his remarks to your favorite tech stock idea. Wouldn't you be thrilled if that company's CEO talked so openly about sustainability during its next earnings conference call? Wouldn't you want him or her discussing ways to create value? After all, this is how we profit as investors: Value begets returns.
Now reverse the equation. Think about the consequences of failing to follow Stone's thesis for Twitter, and you'll come to understand the landmines that too many tech firms step on early in their development. Here are three of the most common pitfalls to beware:
1. Too much expansion
One of the most loathsome phrases in tech investing -- but not all investing -- is "acquire scale." In older industries such as goods manufacturing, leaders traditionally believed that acquiring more factories, competitors, Twinkies, etc. would drive down the per-unit cost of what they produced to the point of maximum profitability. Early on, this worked extremely well for automakers such as Ford (NYSE: F ) and General Motors. Today? Not so much.
In tech, overexpansion is especially dangerous, because acquisitions are more often about intellectual property and customer lists than actual capital equipment. But even techies sometimes blow it in the back room. Witness Cisco's (Nasdaq: CSCO ) $2.5 billion inventory meltdown earlier this decade, after a wave of acquisitions.
2. Too little openness
Twitter thrives today for the same reason that Microsoft (Nasdaq: MSFT ) thrived with Windows and Apple (Nasdaq: AAPL ) thrives with iTunes: developers. Each service invites coders to play, explore, and -- here comes that phrase again -- create value. Every one of these services is a platform, and platforms make money.
Contrast that with Novell (Nasdaq: NOVL ) . At one time, NetWare was a pervasive operating system for Windows networks. But developers never really loved it. They didn't play with or extend it. Instead, system administrators were certified to maintain it.
3. Prizing profits over innovation
Twitter takes a beating for failing to emphasize profits right now. I understand why. Investors love to talk about profits and free cash flows, and they're right to do so -- most of the time. Unfortunately, cash originates from value. Without it, you have neither cash, nor a business. Bravo to Stone and Williams for seeking a model that maximizes value. Too many 2-year-old start-ups chase profit at value's expense.
This bad habit isn't limited to big firms. Think about the differences between Yahoo! (Nasdaq: YHOO ) and Google (Nasdaq: GOOG ) . Yahoo! is plenty profitable and gushes cash to this day -- more than $700 million worth over the last 12 months. But does it create value anymore? Do Yahoo!'s services still combine to deliver something worthwhile to users as easily as Google's Voice Search and Maps do? I doubt it.
Here's hoping that Yahoo!'s new CEO, Carol Bartz, an expert value creator during her years at Autodesk, changes that.
Value creation is a blend of art and science. Getting it right takes time, a truth that Twitter seems to understand. It's not alone in that wisdom: Few firms have ever delivered on the value equation as well as Apple has in recent years. Investors have enjoyed the ride.
So if you want to invest in tech, think first about value -- where it comes from, what drives it, and what might destroy it -- when evaluating the tech stocks you own or wish to buy. Returns will follow.
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