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A Strong Balance Sheet is the Best Defense
Buy the rumor, sell the news
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Milton Friedman’s 1970 speech, about inflation
In 1970, the economist Milton Friedman (no relation) gave a presentation in London to the Institute of Economic Affairs titled “The Counter-Revolution in Monetary Theory”. In the short essay that he read, he uttered one of my favorite quotes, “inflation is always and everywhere a monetary phenomenon.” The full quote, on page 11 of the preceding link, reads:
It follows from the propositions I have so far stated that inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. However, there are many different possible reasons for monetary growth, including gold discoveries, financing of government spending, and financing of private spending.
(Emphasis in original.)
My adaptation, about balance sheets
I’ve adapted his saying: Business constraints are always and everywhere a balance sheet phenomenon. When a company chooses to do something, you can often look to the balance sheet to see why.
The COVID angle
When BioNTech partnered with Pfizer to manufacture and distribute its covid vaccine, it did so in part due to balance sheet issues: its balance sheet was too small to finance the manufacture and distribution of billions of doses, but Pfizer’s was not. Thus, faced with the constraint of its small balance sheet, BioNTech partners with a company with a much larger balance sheet. In fact, you can read between the lines of their initial press release, and infer that BioNTech is availing itself of Pfizer’s much larger resources:
During the clinical development stage, BioNTech and its partners will provide clinical supply of the vaccine from its GMP-certified mRNA manufacturing facilities in Europe. BioNTech and Pfizer will work together to scale-up manufacturing capacity at risk to provide worldwide supply in response to the pandemic. BioNTech and Pfizer will also work jointly to commercialize the vaccine worldwide…upon regulatory approval….
Under the terms of the agreement, Pfizer will pay BioNTech $185 million in upfront payments, including a cash payment of $72 million and an equity investment of $113 million. BioNTech is eligible receive future milestone payments of up to $563 million for a potential cost consideration of $748 million. Pfizer and BioNTech will share development costs equally. Initially, Pfizer will fund 100 percent of the development costs, and BioNTech will repay Pfizer its 50 percent share of these costs during the commercialization of the vaccine.
In other words, Pfizer is essentially funding the development of the vaccine, and 50% of its cost will be repaid by BioNTech once the vaccine starts to be sold. Stated more plainly, BioNTech doesn’t have a large enough balance sheet to finance development of the vaccine (or to pay back a loan for its development). However, when the vaccine starts to sell, BioNTech expects to have more cash on its balance sheet with which to pay back a portion of the loan.
You can see Pfizer’s quarterly balance sheets here. For the quarter ended June 30th, 2020, Pfizer held $177 billion in assets on its balance sheet, of which approximately $46 billion was current assets. (Current assets include cash and assets easily converted to cash.) That $748 million expense that Pfizer incurred to develop the vaccine amounted to about 1.6% of its current assets.
Nascent companies don’t have strong balance sheets
We see the importance of strong balance sheets elsewhere in business. It is often said that regulations favor the incumbent. Scott Kupor, partner at VC firm Andreessen Horowitz noted this in a recent tweet:
This is worth unpacking a bit, because it gets to the heart of why strong balance sheets are so important. Regulations are expensive to comply with, and every additional regulations foisted onto companies increases companies’ operating costs by some amount. The stronger a company’s balance sheet, the more easily the company can amortize those regulatory costs over a large asset base. That’s just a fancy way of saying: if a company has a lot of assets, it can more easily finance increased expenses associated with new regulations. Since incumbents generally have strong balance sheets while nascent companies do not, and since Kupor is in the business of investing in nascent companies, he cares a lot about expenses foisted onto new companies.
The importance of balance sheets is seen in unexpected places
Once you understand the importance of strong balance sheets you start to see it expressed everywhere. The recent news that Amazon Web Services kicked the controversial app Parler off its services is a function, in part of Amazon’s strong balance sheet. Amazon can afford to finance the blowback associated with removing a popular, yet very controversial, app from its services. Sure, Amazon will lose some customers and incur some bad press among those sympathetic either to the app’s users or to free speech principles. But, Amazon has a very large balance sheet (larger even than Pfizer’s) and can use that balance sheet to (1) wage its own public relations campaign in response to criticisms leveled at it; (2) litigate the inevitable lawsuits that arise from its action; and (3) parry with regulators and legislators looking to score points. Smaller companies with weaker balance sheets probably can’t finance that blowback, and would be more averse to attracting the negative publicity attendant with eliminating a controversial customer.
Fundamentally, strong balance sheets provide companies with flexibility, optionality, insurance, and maneuverability. Companies with strong balance sheets are able to exploit opportunities, spend cash to deal with the negative consequences of corporate decisions, forge partnerships with other companies, etc. In other words, business constraints are always and everywhere a balance sheet phenomenon.