Analysis: Is U.S. tech self-destructing?

By MARTIN HUTCHINSON, UPI Business and Economics Editor  |  Nov. 14, 2003 at 5:46 PM
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WASHINGTON, Nov. 14 (UPI) -- "Is high-tech offshore outsourcing a threat to innovation and economic prosperity?" asked a New America Foundation forum on Thursday. Rather the question should have been: Given outsourcing, the relative cost structures, and its current modus operandi, is the U.S. tech sector headed for long term decay?

Make no mistake about it, there is nothing magical about tech that makes it intrinsically a U.S. based industry. Consumer electronics, for example, pioneered by RCA and Zenith in the 1950s, is now dominated by Japanese and South Korean producers. If other countries develop a tech capability that outstrips America's, in terms of innovation or cost, they will get the business.

Outsourcing research and development, or high level software, or complex engineering, or middle management integration between different elements in the "value chain" of tech products has very different implications from outsourcing low level manufacturing operations. Whereas the workers in say an assembly plant in Malaysia are unlikely to develop the capability to compete with the plant's U.S. owner, Indian software engineers and researchers, with education very nearly as good as that in the U.S., and with experience at a responsible level in a U.S. company, will quickly acquire the capability to compete with the U.S. The largest semiconductor manufacturer in the world, in terms of volume, is no longer Intel but Taiwan Semiconductor; there can potentially be many more such stories in the future.

Of course, many factors are required for business success beyond entrepreneurial ability. Professor Michael Porter has identified the tendency of regions to form a "pole" of excellence in a particular activity, whose residents will dominate that activity worldwide, providing the majority of the activity's innovation and new business, as well as a high proportion of its overall revenues and employment. Naturally, in the tech sector, this factor has tended so far to favor the United States. However, as higher-level functions are outsourced overseas, "poles" of capability are gradually built up in overseas locations. Once such "poles" have been established, new competitors in the industry are as likely to arise in the new "pole" as in the original one. Two excellent examples of such "poles," both of which have arisen in the last decade are Taiwan in semiconductor manufacturing and Bangalore in software. In both cases, there are plenty of opportunities for new competitors in those locations, and little competitive advantage for U.S. companies against such competitors.

The real advantage that overseas competitors may have against their U.S. counterparts in the tech sector, however, is the cost of top management. In the United States, this can run into the billions, even the billions per person. John Chambers, for example, not the founder of Cisco but a professional manager brought into the company in the early 1990s, cashed in $38 million worth of stock options Friday, but this still left him with options worth $363 million at today's prices, all of which he has received since 2001. In total Cisco's stock option plan has issued 321 million shares, with a total value of $7 billion -- considerably more money than the total earnings of the company since its formation. Except for social security tax, of course, none of this money has been reflected in Cisco's income statement, only in its balance sheet, where the company is buying back shares at a frantic rate -- more than $7.8 billion of scarce cash has been spent on share buybacks since 2001, in years of a tech downturn.

Cisco, paying out 100 percent of its profits to executives through share options, is exceptional (though there are companies such as eBay that pay more.) However, many tech companies pay out 30-50 percent of their profits, when the math is done properly. At this level, top management remuneration is not just significant, it may be the largest single element in the company's costs, an element that is almost wholly out of control while that management remains in the U.S., with remuneration standards as they have been since 1995.

In other countries, needless to say, such largesse is unnecessary. The Indian software company Infosys, for example, paid its executive directors 60.7 million rupees (approximately $1.5 million) in 2003 -- between the two of them. Admittedly, they got stock options as well -- to a value of approximately $700,000 between them in the same year. By Indian standards, of course, this may be princely remuneration, but American top executives of a company of Infosys' stature ($1 billion in sales and $250 million profit after tax) would not be satisfied with ten times the amount, and might call in compensation consultants to see if they could boost their income even if they were paid 100 times the amount.

Taiwan Semiconductor, located in a richer country than India, pays somewhat better than Infosys, in terms of salary and bonus -- its remuneration to Directors in 2002 totaled 133.9 million Taiwan dollars ($3.8 million.) The company's stock option plan issued options on 19.7 million shares in 2002, 0.1 percent of the total shares outstanding with a total fair value (at 2002's rather depressed share price) of 34.9 million Taiwan dollars ($1 million), around 0.25 percent of the company's Net Income. This was spread between the entire management team.

Of course, because of the sector's energetic lobbying, investors are not directly informed of the true cost of stock option grants. Indeed, they currently appear to take no account of them when valuing companies (else, why was eBay, a loss-making company when stock option grants are taken into account, valued at $35.1 billion Friday?)

While U.S. investors allow their interests to be diluted ad infinitum in this way, the cost of capital for U.S. tech companies is exceptionally low, even negative, and hence the companies can flourish. However, can it be doubted that at some stage in the future, whether or not the Financial Accounting Standards Board forces proper valuation of stock option grants, the U.S. investor community itself will finally take their cost seriously, and factor into its earnings calculations the true remuneration of the top management of tech companies in the United States?

At that point, the U.S. tech sector will be in trouble, as the true unattractiveness of further investment therein will become apparent. Labor cost differentials can be overcome, by outsourcing, even if the labor is highly skilled, such as top engineering or research and development. But if you outsource top management, you are sending the entire nexus of the company overseas. At that point, if its top management is outsourced overseas, the tech business may thrive worldwide, but it will no longer have a significant U.S.-based component, beyond a few salesmen.

The short-sighted greed of U.S. tech management, and the foolishness of a regulatory system that has allowed them to hide the true costs of their overpayment, will bear true responsibility for this development.

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