Yesterday I began a series on the 2nd of my four management ethics principles. The second principle—without the sub-points–is:

2.   Be clear, open and honest in communications with investors.

Clear.

Open.

Honest.

Remember the Meatloaf song from the 1980s: “Two out of Three Ain’t Bad.”     Well, when it comes to my Management Ethics Principle #2, Two out of Three Ain’t Good Enough.

Being Clear and Open, but not Honest is obviously a major problem.

So is it a problem to be Clear and Honest, but not Open. This implies a lot of important parts of the story might be skipped over. It is very easy to be Honest and Clear if much of the most relevant information is simply not addressed. You can’t be held accountable for something you didn’t disclose. In the post Sarbanes-Oxley era, many public companies simply keep to a minimum the information they share with investors. In private companies, this is often the case as well. If investors ask for information, the management team will provide. Other information—including maybe the answers to questions the investors should have asked—is kept close to the vest. This puts a huge burden on investors to figure out what information needs to be extracted from the company.

What about Open and Honest, but not Clear? This often manifests itself when an executive uses complexity to make it hard for the audience to follow what is going on. Investors get frustrated, as it is hard for them to get their heads around what they are being told. The executive goes through the charade of that he or she is trying to be helpful, but complexity is a tool to keep investors in the dark about what is really going on. Time is usually an ally of this type of executive—as he or she knows time is a constraint of most investors. Those executives who are good at this strategy—where “good” equals “most dangerous”—leave their investors thinking how lucky they are to have an executive who understands such a complex business. At times, the result is that investors believe they are highly dependent on the executive. Perhaps they even believe that part of the company’s competitive advantages is that their executive is one of the only people who truly understands the business.

Don’t get me wrong—telecom is an extremely complex business—more so thaN most businesses. Though difficult, it is management’s job to find ways to communicate to their investors so that they can understand the business.  As a side note, I read books on theoretical physics–if an author can explain quantum teleportation in a way I can understand, a telecom executive can explain their business to an investor.

There you have it. Two out of Three Ain’t Good Enough. By the way, there have been a few storied situations—such as Enron and Worldcom—where honesty was at the core of the problem. However, it is the other two combinations that I suspect are more common and, perhaps, harder to detect.

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Two weeks ago, I spent a week revisiting the origins of BearonBusiness. Way back in October of 2007, I launched Bearonbusiness with posts that outlined my belief system when it comes to business. Two weeks ago, I focused on the first of the four principles. Over the next handful of days, I will spend time on the second principle.

For context, the first principle is:

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

The second principle is:

2. Be clear, open and honest in communications with investors.

a)  Whether the news is good, neutral, or bad, management is responsible for making it easy for investors to understand what is happening in the business.

b) Financial performance should be tracked and reported in a clear and unbiased way.

c) Management should understand and clearly articulate the risk profile inherent in the businesses decisions being made.

The events of the past two years are scary illustrations of how the principle is often pushed aside by management teams.

As I’ve mentioned often, Warren Buffet is my inspiration for both the content of the principles and for taking the time of sharing them with whomever cares to pay attention. He shares his wisdom via the Berkshire Hathaway annual reports and, specifically, via his Owner’s Manual.  The Omaha Oracle has been publishing this Owner’s Manual for many years. Read it. Print it out. Book mark it. I have found that reviewing it many times has helped my thinking about business get to a higher level.

Tomorrow I will begin to dissect Principle #2.

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iPhone price per unit has dropped 50% in three years. Its Price per iPhone GB has cliff-fallen 600% in the same period. It stock price is up 150%, despite the Great Recession of 1999. I thought price compression was bad. After all, that why the Chief Loan Officer concluded “Bandwidth is a bad business.”

Let’s look at the volume of iPhones sold in the past three years (normalizing for the remainder of 2009).

UnitGrowth

*Based on CY: 2009 Normalized doubling the sum of 1Q09 and 2Q09

Wow. It looks like the number of iPhones sold has skyrocketed 10-fold.

Recall that today’s iPhones are 32GB. When introduced in 2007, they were 4GB. Let’s plot the number of iPhone GB sold by Apple each year.

*Based on CY: 2009 Normalized doubling the sum of 1Q09 and 2Q09

*Based on CY: 2009 Normalized doubling the sum of 1Q09 and 2Q09

That is a 30-fold increase during these 3 years.

So, what do you think? Is it good that they sold 30-fold more GBs of iPhones, even though the price per GB of iPhone plummeted by 600%? The stock market thinks so, or Apple wouldn’t be up 150% during this period.

What does this say about the Chief Loan Officer’s conclusion that Bandwidth is a bad business due to price compression? This requires another blog series…perhaps next week…

Source: http://en.wikipedia.org/wiki/File:IPhone_sales_per_quarter.svg

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It turns out Steve Jobs is a bearonbusiness reader. He must have been following the series this week, because he IM’d me.

“Hey Dan. How’s the Bandwidth Infrastructure business treating you?”

“It seems to be doing well financially.” I decided not to share the Chief Loan Officer’s conclusion that was: “Bandwidth is a bad business.” It’s embarrassing, afterall.

“Hey. What’s with the blog posts on iPhone being a Bad Business?” Jobs texted back. I was hoping he wouldn’t bring that up.

I babbled on the keyboard. “You know, with the way the price of iPhone GB is compressing…”

Steve Jobs cut me off with his quick-fingered response. “Have you followed our stock price?”

“Not recently,” I responded, “I don’t see what that has to do with anything.”

“Well, at the end of 2006, it was $80/share. Today it is $200/share. And, in case you had your head buried in sand, it was the iPhone which drove this 150% gain.” Before I typed back, he added, “This run-up was achieved despite the Great Recession of 2009.”

“Yeah, but you are providing a GB of iPhone for $10 today, compared to $65 two years ago. Do your shareholders know that?”, I challenged but sounded unsure to even myself.

“Hey, I gotta run. One more thing before I sign-off. That new Fiber-to-the-Tower technology you are deploying is exciting. The bandwidth price-point that you are giving to at&t is helping them get ready for the 64GB iPhone.”

I hope he is not telling our Chief Loan Officer friend about our lower price point…

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The Chief Loan Officer of a big bank decision was final. Despite his team’s recommendation to loan money to Zayo Group, his answer was: “Nope! Bandwidth is a bad business.” I babbled in response. We expanded our debt facility but not with that bank’s money. Had I have followed his lead, maybe he would have loaned us the money. All I needed to say was: “I agree. So is the iPhone business.”

Yesterday, I backed up my point with hard data. In the three years since the iPhone was launched, the Average Price per Unit dropped a stunning 50%. Can you say Apple Meltdown?

Not wanting to panic those bearonbusiness readers who own AAPL, I left out the most stomach-regurgitating part. Apple stockholder, brace yourself.

It turns out iPhones are getting more robust. When introduced, they were only 4GB. Today, they are 32GB. Can you believe this? Apple must produce more GB, for which they get less money. Let’s see what this looks like when the Average Price per GB of iPhones is plotted.

AveragepriceperGB

Are you gasping? Do I need to call 9-1-1? Yes, in 2007 Apple was going-to-town selling a GB of iPhone for a earth-stomping price of $65. By 2009, they were giving a precious GBs of iPhone away for $10. That’s a 600% decline in only three years.

Short AAPL; and when you do, share your gains with me.

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The Chief Loan Officer of a big bank had to sanction his team’s recommendation to loan money to Zayo Group. “Nope,” he determined after but one question. His question: “What about Price Compression?”. My city-state-of-Babylon response was to babble. My answer was straight from the opening scene of the 1999 horror film “The Looming Telecom Meltdown”. Except in the movie, the Chief Loan Officer loaned the money anyway.

His final comment was “Bandwidth is a bad business.“ My answer should have been: “I agree. So is the iPhone business. You want some data to prove this?”

Below is a chart of iPhone Average Price per Unit.

AveragePriceperUnit

“Holy crap”, I can hear you gasp. Price per unit has plummeted by half in just three years.

This is the good news part of the bad story. Are you ready for the bad news? Tomorrow…

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I’m in the Bandwidth Infrastructure business. Lot’s of smart people think this is a bad business. I think it is a damn good one. Is it or isn’t it?

It turns out this question is not so easy to answer. A few months back, a new potential debt sponsor was interested in joining Zayo’s syndicate. A team of eight of the bank’s employees did a bunch of work and concluded they were in. Only one step remained—the chief loan officer had to sanction. In days past, this was a rubber stamp stage. Rarely would a Chief Loan Officer reject a deal that made it through the entire process—and had unanimous support.

These days are not like days past. And, though telecom meltdown was years ago, the memories of those who lost billions are still top-of-mind.

We got through the presentation and the chief loan officer had but one question. “What about Price Compression?”

I went into my best impersonation of the ancient city-state of Babylon… and babbled. “Silicon Economics,” I explained. “How do you think the Internet would grow by 60% a year if the price per unit of bandwidth doesn’t drop?” I opined. “Price compression is the fuel that drives mobile data growth,” I pleaded.

The loan officer looked around the room, smirking. He reached for his folder and stood up. “That’s what I mean. Bandwidth is a bad business. Thanks for coming and good luck.”

Stunned, I sat there in silence. In hindsight, I should have said: “I agree. So is the iPhone business.”

[to be continued…]

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Recall, Principle #1 is:

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

Yesterday, I listed several ways that executives could game the system. I opined that the vast majority of recent executive pay debacles involved one or more of the outlined situations. I want to close the discussion of the Management Ethics #1 series by making three points.

First, let’s return to the Mike Hampton series. Like professional athletes, executives should get paid all they are entitled to. It is not government’s business to restrict this, any more than it is government’s charter to not allow Tiger Woods to have made $1B dollars so far in his career. Moreover, it is not the government’s business to “help” investors do a better job of managing executive pay. That is, the market needs to sort out how to do a better job of determining executive pay packages so as to not repeat the recent debacles. [This statement isn’t true in the extreme—as the government must play certain roles—but it should be a guiding principle. I don’t want to expound on this now but perhaps will later.]

Second, I am a director of three companies and am a member of certain compensation committees. Like the other directors, I am limited in the amount of time I can spend in these duties. As such, I know first-hand that there is a strong dependency on management when it comes to structuring and understanding executive compensation packages. The director’s role is not easy to perform. Hiring objective and qualified experts is often prohibitively expensive. Thus, the dependency on conflicted executives remains a very-real aspect of the executive compensation process.

Third is the answer to logical questions. Why does my Management Ethics principle #1 include both 1a and 1b? Why not make them two separate principles, as they both are extremely important? It is because they are so inter-related. A management team is more likely to satisfy their responsibilities under 1 b if it fully embraces that (a) their shareholders as long term business partners and (b) the enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

By the way, the extreme importance of executive compensation—and the inherent conflicts of interest—are why it is covered as part of the FIRST management ethics principle.

Zayo and Envysion employees: I’d like all of our folks to read this bearonbusiness series. Please encourage your co-workers to follow these posts.

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Yesterday, I discussed part 1b of the first of my management ethics. Management Ethics #1 is:

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

It is management’s responsibility to ensure executive compensation and perks:

• are clearly understood

• are approved by its investors

Both aspects to this must be satisfied. Unlike a professional athlete, a CEO/executive team has more of an opportunity to game the compensation dynamic. The fact that this opportunity exists does not entitle managers to exploit it.

How does management game the system? Here is how:

• Allowing employment contract language to be unnecessarily complex, thereby making it difficult for investor representatives (e.g., compensation committee) to evaluate

• Providing summaries that, although perhaps accurate, are incomplete or misleading

• Providing supporting analysis that fails to identify relevant scenarios—like when an executive makes millions while the company is crumbling

• Failing to identify flaws in the plan—for example, if the plan encourages management to pursue inappropriately risky investments which conflict with the overall Management Ethics #1 principle

• Manipulating accounting results to benefit management compensation without the intended benefit to the owners

• Using professional services experts—such as human resource or financial analyst consultants—who are inappropriately influenced by management

• Having the investors’ representatives (e.g., comp committee members) having inappropriately cozy relationships with management

I will not blame only management for all the recent debacles on executive pay. Certainly, investors/directors shoulder some of the responsibility. However, the vast majority of debacles involved one or more of the situations above.

More tomorrow…

Zayo and Envysion employees: I’d like all of our folks to read this bearonbusiness series. Please encourage your co-workers to follow these posts.

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Yesterday, I shared color on the 1a part of the first of my management ethics. Today, I will provide some color on 1b. Management Ethics #1 is:

1. Treat shareholders as long term business partners; and view management as managing partners.

a. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company.

b. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.

I wrote a long series on salaries in baseball. I know I haven’t completed the series—and I will return to it at some point. However, this post provides a clue on my beliefs.

A major league baseball players’ job is to do whatever it takes—within the rules of the game—to help his team win. Managements’ job is to do whatever it takes—while abiding by the law AND appropriate ethics—to maximize value for its stakeholders.

However, our society is not socialistic. Core to our capitalistic system is that employees are entitled to get paid what they are worth. Baseball players want to help their team win—but at contract time, they want to get as lucrative a contract as possible. Good management wants to maximize return for their shareholders—but they too want to get paid as much as possible. Here is the difference.

Professional sports athletes do not have an opportunity to game the system. That is, their contacts are the result of intense negotiations with management. Whether the contract works out well (e.g., Peyton Manning) or poorly (e.g., Mike Hampton), management cannot blame the player for manipulating the circumstances. It is a balanced and transparent negotiation. The team’s “front office” will take the blame if, in hindsight, the contract was ill-advised. Team manager and/or general manager might get fired.

When it comes to executive pay packages, the dynamic could be different. A CEO/executive team has more of an opportunity to game the situation. The point of Management Ethics 1(b) is to clearly state management’s responsibility to not game the system. Instead, it is management’s responsibility to ensure executive compensation and perks are:

• clearly understood

• approved by its investors

Both aspects to this must be satisfied. More on this tomorrow.

Zayo and Envysion employees: I’d like all of our folks to read this bearonbusiness series. Please encourage your co-workers to follow these posts.

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