Dell Reports "Weaker" Results: Right on Time

Just like clockwork in the continuing market manipulation which is the Dell buyout, the Wall Street Journal reports Dell is moving up its quarterly earnings report to this Thursday because, among other things,

"Dell now expects to report revenue of roughly $14 billion, and earnings of 20 cents a share, excluding some expenses, according to the person briefed on the financial results.The average of analyst estimates had called for Dell to post $13.5 billion in revenue, and earnings of 35 cents a share, excluding some items, according to FactSet Research Systems Inc"

So Dell's revenues are better than expected, while earnings are worse.  The apologists say that Dell had to clear excess inventory and sacrificed profits to do so.  Perhaps.  Or, as academics Xu, Qian and Li found in their research,

"In particular, a number of papers find substantial improvement in ROA following buyouts in which the target managers and other insiders participate (management buyouts, or MBOs), and the authors attribute the improvement to the strong incentives for value-creation created by MBOs.However, part of the improvement in ROA may be explained by how earnings are reported both before and after the MBOs, as it has been well established that this process is subject to managerial discretion. If managers of a publicly listed firm plan to take the firm private, they have an incentive to undertake activities to temporarily deflate earnings before launching an MBO. With lower earnings before the MBO, the firm can display greater improvement in operating performance after the MBO once the earnings-reducing activities are halted. Moreover, lower pre-MBO earnings canlead to lower stock prices, enabling the buyout team to acquire the target ‘on the cheap’ if outside investors do not fully understand the nature of these activities."

The Southeastern Asset/Icahn group have been asked by the board to structure their ideas as an offer to buy up Dell's public securities.  Meanwhile, the quality of this quarter's soon-to-be-reported earnings should be viewed with the appropriate skepticism 

It's Not All About Prince Jamie Dimon.

Americans reflexively poke fun at royalty, especially their finery, rituals and pretensions. They raise our democratic hackles, and folks like Britain's Prince Charles are easy targets on both sides of the Atlantic. Divine right and hereditary succession are anathema.

But, Americans too have our own royalty and their supporting elites.  Our royalty includes corporate CEOs, hedge fund managers, private equity moguls, political dynasties like the Clintons, and media icons like Barbara Walters, whose "retirement" is front page news in the New York Times.

So, the issue of separating the Chairman of the Board position from that of CEO at JP Morgan Chase has become a referendum on the Princely rule of CEO Jamie Dimon. Riding the wave up to the mortgage bubble of 2006-8, getting princely bailouts from the general taxpaying rabble, and now riding the next wave of rising stock prices due to unprecedented monetary easing, Mr. Dimon is wealthier than ever and politicians hang on his every word.

Except for one thing.  With a dismissive wave of his royal hand and using a British metaphor of "a tempest in a teapot,"  Mr. Dimon irritatingly put up with questions from the stock-owning rabble about there being too much risk in JPM's proprietary trading operations.  All of his own, hand selected, massively compensated traders, executive vice presidents and risk managers told him, "It's okay, we're good."

Well, it wasn't. We've looked at the London Whale report in great detail and said before that it was a colossal failure at the top, where the Prince makes his royal abode. Splitting the positions of board chair and CEO is not a guarantee of better risk management or lower volatility of the share price.  However, nobody can make a rational argument for why combining the roles is better for shareholders and for corporate governance.

The only argument for combining the positions: the Prince might abdicate and go off to do something else. Seriously, what would that be? The "picking up your jacks and going home" card has already been played, which is amazing for its chutzpah and pettiness.

Mr. Dimon's friends in Greenwich, perhaps akin to Henry Vth's "band of brothers," have announced to the world that "they got his back." So, a real issue of governance has descended, in the finest American tradition, into adolescent posturing for the media.

Jamie Dimon should be able to do a better job of running JP Morgan Chase, of selecting a better inner cabinet, and of holding them accountable and monitoring their results, if he were freed from the drudgery of running and managing a board and its committees.  Running the business is where he has a comparative advantage and a track record.  Put all his time there: it is the best thing for shareholders.

Meanwhile the board probably should change over time and change its committee charters.  Risk management, such as it is which isn't great, should report in some fashion to a board committee.  This committee should be free to go where it will, looking under the covers for Warren Buffet's "ticking time bombs."  Opinions vary on how this kind of change can be structured, but it's not rocket science.

The goal is to get better first, lowering risk incrementally and increasing oversight and transparency for the entire board.  Splitting the roles is just a first step, but hopefully the board is strong enough to stand up to the Prince and his court.

Southeastern Asset and Icahn Continue Activism With Dell

Coincidentally with the issue of a letter today from Icahn Enterprises and Southeastern Asset Management to Dell's board of directors, this post ties back well to the previous post about corporate governance.

Southeastern Asset became actively engaged with Dell's board and management on June 15, 2012, when co-founder Mason Hawkins, CFA discreetly proposed a leveraged recapitalization to unlock shareholder value.  Southeastern's idea morphed into the Dell/Silver Lake Partners all cash offer of $13.65!  To make matters worse, Southeastern and other existing shareholders were not given a way to participate in Michael Dell's deal.

Southeastern's first quarter letter to its shareholders has a very cogent description of their investment process and the transition from engagement to activism. They write,

" 'Activism' is not part of our normal process, nor is it our preferred avenue. ...Becoming active generally indicates that we made a mistake in assessing our (management) partners. ...When the company's underlying assets remain strong, the stock's undervaluation is compelling, and the primary 'fix' is to people, we will generally become active if we believe we have good odds of successfully improving our clients' outcome." 

All of this is entirely consistent with their first letter to Dell's board, which used material from Dell's own presentation to suggest a compelling valuation for the company's underutilized assets.

A chart shows that for 255 positions Southeastern has held since 1993, 90% of these positions required no 13D filings.  Of the 26 positions which required a filing, Southeastern became engaged and active. Without suggesting that their ownership was a sole causal factor, 20 of these positions resulted in higher stock prices for their clients, 2 were break-even, and 4 resulted in lower prices.  Clearly, Southeastern's principals are not corporate raiders, greenmailers, or investors who want to run their portfolio companies.  They want to close the gap between market value and intrinsic value, especially when management are felt to be not doing their jobs.

Southeastern Asset owns about 8.5% of Dell's shares, while Icahn Enterprises owns about 4.5%.  The opening salvo of the letter notes that the stock price is below Michael Dell's cash offer of $13.65.  It notes that the board has allowed management and private equity to buy Dell with the shareholders own money, using relatively little of their own equity.

Furthermore, the board poisoned the market for alternative bids by agreeing to an egregious $450 million break-up fee for Dell/Silver Lake; in the event that an alternative bid emerged and were deemed superior, the break-up fee would still be a ridiculous $180 million.

The letter says that the board accepted an analysis of Dell's value that focused solely on its mature business lines, like personal computers.  The $14 billion of recent acquisitions, including innovators like Compellent, was not factored into long-term revenue opportunities, according to Southeastern/Icahn.  The letter suggests significant value creation opportunities by selling into China, Brazil and India.  Unfortunately, this battle has already been lost.  Lenovo has China wrapped up, and it has significant inroads in Brazil also; India may not prove to be a very profitable market for a large U.S. based, public company.

No significant operating improvements were built into the Dell/Silver Lake model.  One of Carl Icahn's favorite tactics, changing the capital structure, was not factored into the $13.65 value.

The Southeastern/Icahn letter makes some interesting points about Dell's global supply chain, one of its foundational strengths.  The letter says that it can be substantially improved by removing bloated overhead, redundant costs, and by improving facilities utilization by consolidating call centers, assembly operations, and by bringing some of these closer to the U.S. Another very interesting point, which I think plagues the entire PC industry, is what the letter characterizes as "infinite customization."  It suggests an "80/20" model for revenue and profits from the mind-bending number of customized layouts offered to consumers; a stocking model could reduce the size and improve the utilization of Dell facilities as well as generating potential efficiencies in buying key components like CPUs, motherboards, drives, displays and graphic cards.

The argument boils down to $12 cash plus an equity stub with a potential value of $2-$5 per share in the near-term being better than $13.65 cash with no participation in future growth.  A $5.2 billion term loan facility would be in place to make the cash payout in the event the business ran into short-term cash generating problems.

If the Dell board were not to consider the alternative offer and deem it "superior," then the Southeastern/Icahn team would also put forward an alternative slate of directors.

Again, the Dell board's passivity and acquiescence to founder Michael Dell's talking down the company and buying a low valuation may still carry the day. Southeastern/Icahn has fired their last bullet, and credit to them for all their work which could benefit all shareholders.

An interesting academic paper germane to management machinations ahead of a management-led buyout shows how manipulative this whole process can be, especially when shareholders are passive. Southeastern Asset has done a great job in calling attention to Michael Dell grabbing the company he mismanaged in his second stint as CEO, with shareholders' money.  Aren't public markets wonderful?

Vanguard's Thinking on Corporate Governance

As both one of the largest sponsors of active and index mutual funds, Vanguard represents significant voting power for corporate proposals on management compensation and election of directors.

Glenn Booraem, Controller of the Vanguard Funds, recently posted a note on the Vanguard site, in which he writes,

"However, by its nature, voting reduces often complex issues to a binary choice—between FOR and AGAINST a particular proposal—making the proxy vote a rather blunt instrument. This is where the second—and perhaps more important—component of our governance program takes over; engagement with directors and management of the companies in which we invest provides for a level of nuance and precision that voting, in and of itself, lacks. So while voting is visible, it tells only part of the story.

We believe that engagement is where the action is. We have found through hundreds of direct discussions every year that we are frequently able to accomplish as much—or more—through dialogue as we are through voting. Importantly, through engagement, we are able to put issues on the table for discussion that aren't on the proxy ballot."

The governance industry, which now generates careers, robust fees and conflicts of interest, loves using blunt instruments, such as voting as a litmus test for shareholder engagement.  On the other hand, corporate managements often put out proposals without any regard for how they would play with their shareholders.

The truth is that institutional shareholders for many decades have been lazy, inattentive owners.  Their measure was to focus on price changes relative to an index; unanticipated, dismal performance would wake them from their slumber.  Proxy votes, as I experienced from several sides of the capital markets, were left to attorneys to check the boxes FOR, unless otherwise instructed.

An ongoing, deeper constructive engagement with corporate managements should yield better use of corporate assets which should lead to better performance with fewer surprises, which is what investors really want.  

Is IBM Losing It's Way?

In the late Sixties, our family moved up to Westchester County, and the influence of a growing IBM was spreading all over the county from Armonk to Yorktown Heights and many other locations.  The corporate motto, implemented by Thomas Watson, was "THINK."  Aside from Bell Labs, IBM was the top industrial research laboratory in the country.

Its history of innovation came from hiring the brightest people and applying their efforts in a well-funded, disciplined approach to technological innovation and problem solving.  Fast forward several decades, of course, and IBM ran aground; it was blindsided by technological changes, a bloated cost structure, and management hubris.

When Lew Gerstner was recruited as CEO in 1993, the outlook was dire.

"Gerstner happily quotes the doom-laden predictions about IBM’s future that were prevalent when he took over as CEO in 1993, a year the company posted an $8 billion loss, and IBM shares that had sold for $43 in 1987 could be had for $12. IBM’s "prospects for survival are very bleak," wrote the authors of the book Computer Wars."

The strategy put into place under Lew Gerstner was essentially extended by his recently retired successor Sam Palmisano.  CEO Virginia Rometty is now at the helm of this icon of American business, and she comes from a very successful career in sales at IBM.

Warren Buffett's Berkshire Hathaway recently added a cool $10 billion to his stake in IBM.  When this was announced in January, I started reading up on IBM, and it seemed very much in the wheelhouse of the megacap public stocks Berkshire owns, and has owned for a very long time.

Leading up to the release of first quarter 2013 earnings, I trudged and slogged my way through the slides and audio files of IBM's Analyst Day.  There is a lot of material, with some interesting industry material and quite a bit of corporate puffery.  The meeting was held at the company's Innovation Center in Almaden, California. Almaden is the home of many innovations which are at the heart of modern computing and databases; IBM and Almaden lead U.S. industry in the number of technology patents issued in recent years. This is a high powered laboratory, staffed with the same caliber of scientists that Thomas Watson said were key to the long-run success of the company.

CEO Rometty's introductory presentation was so amped up and hyperkinetic, I could barely finish listening.  There was far too much information, presented too fast, with the CEO interrupting her own bullet point lists to move into asides, each with their own bullet point lists.  I couldn't figure out if we ever did complete the five key corporate strategies or not.

There was an off-key remark early which I will paraphrase, "I know that you all (analysts, I presume) are looking at all this very expensive real estate and saying, "Why?"  I know, and believe me, we think about this every day, but let's move on."  I realized that the CEO, who clearly has command of her business, was nervous.  But, seriously, would any serious institutional owner be wondering about this issue as a key to the buy, sell or hold decisions?  I doubt it.  It's such as short-term issue, not worthy of an industry leader.

The theme of short-termism continued in the overall tenor of IBM's first quarter 2013 earnings release, which the Street characterized as IBM's first "miss" in eight years.  Morningstar analyst Grady Burkett wrote,

"IBM first-quarter results came in well below our expectations, as the firm's hardware and software results disappointed. Overall revenue declined 5% year-over-year to $23.4 billion, while free cash flow declined to $1.7 billion, versus $1.9 billion generated in last year's first quarter. We expect to adjust our 2013 forecast to reflect this quarter's weakness."

On the short-term side, the CEO made extensive references to failures in the sales organization to bring in orders from large customers planned for the quarter.  As a result of this unsatisfactory performance, the sales leader was reassigned.  This kind of commentary and action seems more appropriate for an emerging technology company than for a $100 billion+ revenue company.  Again, I found this unseemly for a company which Warren Buffett has found worthy of substantial new investment.

If I try to distill the key points from the Analyst Day, here's what I took away. IBM stands at the intersection of software, hardware and services.  It operates in businesses which have cycles of innovation and commoditization.  Examples of the latter range from the x86 and other commodity server lines to some database and analytic consulting.

IBM's consistent strategic goal is to "move to higher value."  This is done by acquisition, divestitures, and remixing research and development budgets.  The CEO noted that IBM had divested $15 billion in low-margin revenue over the past ten years.  It would have been nice to have the comparable number for acquisitions as a benchmark.

Acquisitions are for the purpose of getting the company quickly into a new space or to expand its capabilities.  The target company must have intellectual property which is scalable, which seems like one of the problems with HP's acquisition of Autonomy.  It should also help IBM to expand its geographic reach among is 170 countries today.

CEO Rometty said that the company is placing a significant investment bet on Africa, and particularly in sub-Saharan Africa.  This, in contrast to the short-termism referenced above, seems to be a very long-term prospect.  It seemed like something an NGO would like to hear, but it's hard to envision how the ROI works for this kind of investment.

Software already provides about forty percent of operating earnings today, and some analysts see this crossing over fifty percent by 2015.  Understanding this business would seem to be key for estimating the company's future margins.  Standard and Poors rates the company's outlook "stable" and its prospects "low risk," but it also wrote,

“IBM’s good market position and broad product and revenue base provide cash flow and ratings stability,” she said. “Highly competitive industry conditions, a moderately acquisitive growth strategy, and significant share repurchases currently constrain the potential for a higher rating.”

Much of the company's total return to shareholders have come from dividends and share repurchases.  While this has been well executed financial engineering, the company needs to better articulate how the business model works in the current commoditization cycle in which the new CEO has taken over the portfolio.

Europe Needs Some New Saviors

"Looking at the original photo ops with former French President Sarkozy and Chancellor Merkel, it was evident to us from the start that the fundamental interests of France and Germany could never align.  Now, with a new French President with his own limitations and political agenda, the situation is worse than before.  At least former President Sarkozy and Chancellor Merkel had a cordial relationship; President Hollande, despite his having been trained at the Ėcole nationale d'administration, seems determined to establish a prickly relationship with Chancellor Merkel."    (October 2012)

 Today's Wall Street Journal correctly focuses on the dynamic that we pointed out last Fall.  They write,

"Mr. Hollande's success or failure to reach consensus with Ms. Merkel—without alienating his leftist majority in Parliament—is likely to have profound repercussions on the euro zone's future. There are widening concerns that France, Europe's second-largest economy behind Germany, risks becoming the next problem child."

The European press tried valiantly to make a savior out of ECB President Mario Draghi.

"The turning point factor in the Spanish sovereign debt crisis has always been nailed as the July 26, 2012 policy statement by Draghi that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” What Mario again didn’t say was that his bank’s liquidity dropped by a staggering €72 billion in just four hours of that very same day.  Amazingly, the next day Spanish bond yields fell sharply to 6.9% – and in response to that, the Madrid stock market forged ahead by 4%".

Again, last Fall we wrote that Draghi had no solutions for the Euro.  Today, it's clear that whatever it takes will not be enough.

Unfortunately, politicians are sending their hitman economists out to turn the issue into a policy referendum between continued austerity and pseudo-Keynesian government stimulus.  Continued austerity alone, with sky high Greek and Spanish unemployment rates, would impose continued suffering and crush national psyches without lasting benefit.  Stimulus would benefit the chosen favored groups and achieve nothing.  Fundamental labor market reform and reform of work rules needs to happen if things are ever to get better.  Many European banks are pigs with lipstick on.  A broom needs to sweep through the sovereign debt and banking system. 

Europe badly needs someone with inspiring and credible, Churchillian rhetoric to talk about sacrifices that have to be made, by financial fat cats and by fat cat labor unions. Mario and Francois are soap opera actors who aren't up to the task. 

CIA Delivers Bags of Cash to Karzai

In a 2011 post we wrote,

"In President Karzai, the West is funding a presidency which is thought by the population and by international observers to not be legitimate.  It is also deeply corrupt."

A year ago, we wrote,

 Here is an excerpt from a current story from Radio Free Europe/Radio Liberty:
"The Taliban and criminal gangs, old and new warlords, and tribal leaders rule vast parts of the country. The authority of the government, many of whose ministers are considered corrupt, barely extends beyond its offices in Kabul. In order to survive, the Karzai government has to ignore or accommodate all those forces working to undermine it, from the Taliban to the warlords. "

Now, suddenly, our lapdog press reports that the CIA has been delivering bags or backpacks of cash monthly to President Karzai,

 "The C.I.A. payments open a window to an element of the war that has often gone unnoticed: the agency’s use of cash to clandestinely buy the loyalty of Afghans. The agency paid powerful warlords to fight against the Taliban during the 2001 invasion. /...
But the cash deliveries to Mr. Karzai’s office are of a different magnitude with a far wider impact, helping the palace finance the vast patronage networks that Mr. Karzai has used to build his power base. The payments appear to run directly counter to American efforts to clean up endemic corruption and encourage the Afghan government to be more responsive to the needs of its constituents." 

We stand by what we wrote in March,

"The only currency that will work with Mr. Karzai is money, not more of our money, but less of his accessible from his numbered bank accounts or other hidden assets.  Relationships are fine, but this one is dysfunctional and manipulative; we are on the wrong end of the manipulation.  The sooner this gets put on the right footing, the safer our troops, personnel and allies will be as we withdraw."