Saturday, October 24, 2015

Thinking About HP Enterprise

As we come closer to the official splitting of HP into two companies, I've been listening again to the HP presentations, looking at some of the other big players and reviewing  my SWOT analysis of HP Enterprise.

In the three year turnaround of HP, CEO Meg Whitman characterizes FY 15 as being a year of "accelerating progress," in which the combined company invested in security, networking, and cloud activities and acquisitions, as well as on improving execution.

She noted that research and development as a percent of sales increased in each of the three turnaround years.  The company, she said, introduced new products and services, e.g. all flash memory, 3Par storage, HP OneView, software defined networking, a Gen 9 server, enterprise-wide implementation solution for Office 365, and HP Helion, i.e. the public cloud.

Post-split, HP Enterprise will have pro-forma revenue of about $50 billion, with operating margins of over 9% and operating income of about $5 billion.  Fifty percent of revenue will come from enterprise hardware, 37% from enterprise services, 7% from software, and 6% from financial services.

Notice the absence of any reference to Big Data, a major theme of several conference calls during the three year turnaround period.  IBM still talks about this theme, especially in its research publications, and in connection with Watson.  What happened? Autonomy.  The only way this acquisition made sense was as the analytical engine and product generator for a Big Data effort.  That investment has been vaporized, and whatever remaining products are in the market can't sustain a major presence in this theme. A definite weakness going forward.

We've written for more than three years about the weak, commodity service focus of Enterprise Services.  Despite the cost base restructuring, the fundamental weaknesses of this business compared to others like IBM and Accenture remain.

A $4 billion software business which has flat lined for several years is too small to be important to the needs of CIOs in the transition to the next generation data centers.  Another weakness that we've identified for years is still in the standalone company.

I would surmise that CEO Whitman, in her heart of hearts, sees the same landscape.  How else to justify a statement like more than 90% of the IT spend over the next several years will be what she calls "traditional IT."  This should be comforting to investors, presumably, because 50% of HPE revenue will come from traditional hardware boxes.  Also, traditional hardware sales have historically been accompanied by enterprise services contracts.  Actually, these statements, which may be correct, are reasons to be very much afraid if one were an HPE shareholder.

Traditional IT Spend Means Further Hardware Commoditization

A recent podcast on the Andreessen Horowitz website, entitled "Dell + EMC: Say Why?" gives some interesting views on how CIOs will behave over the next few years.  The first generation model of the data center is what they call the "Wall Street Data Center," made up of server racks from vendors like Cisco, HP, Dell, storage products from EMC, and Oracle software.  The next gen data center is represented by Facebook, Google, and Amazon.

In their deployments, server hardware has been truly commoditized, to the point that the best way for Facebook to achieve performance for its particular business needs is to produce its own customized server designs.  The software layer of the stack is the critical element in this type of data center.

Dell's recent merger with EMC positions it as a systems provider to some types of enterprises in helping them get the the next gen data center configuration.  Dell, which survived commoditization of its once core PC product, is better equipped to survive a commoditization of server hardware than is HP, so the panelists suggest.

What Kind of Cloud For Large Scale Enterprises?

The Andreessen Horowitz panelists agree that the future will largely be made of up of hybrid enterprise clouds, incorporating some legacy structures alongside newer, next gen designs.  Public clouds are a losing business, given the efficient, excess capacity of Amazon Web Services.  As we have written for some time, AWS, despite some recent big wins in the public sector, won't be the option of choice for the largest, multinational corporations in data intensive, higher risk industries like financial services, energy, and transportation/logistics.  

HP recently announced that it is shutting down its Helion public cloud business touted as an exiting new product introduction by CEO Meg Whitman just a few weeks before; HP is sending its customers to AWS.  This leaves HP pursuing the hybrid cloud structure, against stronger competition.

The panelists cite the fact that relatively few companies have the kind of technically savvy, global sales forces to succeed in selling and implementing a hybrid cloud computing offering to the biggest global companies.  They name IBM, Microsoft, and EMC as being the strongest sales forces, and HP are not mentioned.  So, Dell's interest in EMC beyond storage is in acquiring a world class sales force in order to help it become a systems provider and service partner for its customers.  

Most companies, the panelists rightly say, cannot wave a wand, spend billions, and risk their businesses on a straight implementation from a Wall Street data center model to a Facebook-type data center. Instead, they reckon that most CIOs will recognize that there is excess capacity in public clouds and huge price pressures on hardware vendors; the customers will exploit both to give them a multi-year, relatively lower cost glide path to the development of some Facebook-style new data center architectures alongside legacy public clouds.  

The winners in the private enterprise clouds they reckon will be, as we have suggested, Microsoft Azure and IBM.  

HP Enterprises path to generating earnings growth beyond year 1 of easy comparisons will be fraught with difficulty, and raising research and development expenditures significantly or making big acquisitions will both be greeted by consternation on the part of new shareholders. HPE may still suffer from the past sins of the combined HP entity, despite a workmanlike, three year turnaround. 

Tuesday, October 6, 2015

MSFT Lowers Expectations and Declares Victory

Microsoft's PR flaks must be encouraging the CEO to get in the news more, and he has been placed in two recent, high visibility stories.  In one, there is a rambling, philosophical interview about long-time insider, CEO Satya Nadella being, in fact, an "outsider" at Microsoft.  There seems to be little evidence so far that (a) this is true, or (b) that it would be making a difference to making this behemoth more nimble, responsive to consumers, and consistently innovative.

In 2014, we wrote,
"The Nokia acquisition could easily become this company's Waterloo.  Value creation at Microsoft won't happen with the Ballmer-created organizational rabbit warren, bloated cost structure, and dysfunctional culture that we've written about in our most widely read posts."
Well, Steve Ballmer has gone to play with new toys, including basketballs.  Microsoft wrote off 80% of the the value of the Nokia acquisition, according to the WSJ; this was inevitable, as we wrote when the Windows Phone forecast of 15% market share was first given.

Now, CEO Satya Nadella has pared back the plans for new Windows Phone launches to what looks like a very singular offering for corporate users.  So that leaves me, an early adopter, and a somewhat satisfied user of the first Nokia Cyan an orphan.  Typical Microsoft.

My first experience with Windows 10, which was okayed for my aging but perfectly functioning Windows 7 laptop, was tremendously dissatisfying. Windows 10 comes with bloated, self-serving products like Microsoft Edge, and it doesn't seem to work well with the free version of Outlook Live. My local copy of Outlook from Office 2013 froze up, crashed, and lost many of my contacts.

Of course, the Waterloo analogy is a bit overwrought, as this company can financially slough off this economic fiasco.  However, this company badly needs a cultural evangelists inside the company that can speak for the consumers, not the corporations.  Inside Apple, that person happened to be Steve Jobs at the top, and throughout the organization it was populated with people obsessed with the user experience and feedback.

Windows is really betting the farm on Windows 10, and Waterloo may be down the road apiece unless things really change.  I hope that the CEO gets a machete and hacks away at the culture inside Microsoft that could have allowed the Windows Phone to be relegated to a meaningless share of the mobile phone market.

Wednesday, September 23, 2015

More Process Doesn't Mean Better Governance

I've been a presenter at governance classes at the University of St. Thomas Law School and at various professional association fora.  Every once in a while, there is a somewhat smug comment from a presenter about the 'superior' European corporate governance model, which consists of a management board and a supervisory board.

Well, here come the recent revelations about Volkswagen.  I know a lot about Volkswagens, having been an owner of a Beetle and several Rabbits, including a German built Diesel that got 50+ mpg during the era of high U.S. gas prices.  When they weren't in the shop with inexplicable model year problems, e.g. electrical system problems, fuel line problems, and ignition system problems, they were a joy to drive, real German fun for less than a BMW or Porsche.

Well, here is a link to the governance process at Volkswagen Group. Layering on more internal auditors, creating more process, and complicating financial reporting and notes to the financial statements cannot lower the risk of this kind of corporate value-destroying behavior which may have been implemented deep in the bowels of an engineering organization, but which must have had management consent at various levels.

Now, the Wall Street Journal speculates that the potential losses due to regulatory and judicial exposures in America and the EU could wipe out the firm's equity.  But, the truth of the matter is that strategic and executive mismanagement are also culprits, as they have been for years at America's own hapless General Motors.

The Jetta, is a car I often coveted.  I didn't see the value in its higher prices over the basic equivalent Rabbit/Golf platforms. However, the Jetta was just beginning to get traction over the far more bland Accords and Camrys.  Management made a decision to make the cars feel more like these cars by---wait for it--taking away the driveability of the car.  These seial changes, described in WSJ articles, are just as much to blame as this recent fiasco about engine management software designed to cheat EPA tests in the destruction of value.

Political forces, particularly in the sunsetting Obama administration will fillet out the coffers of Volkswagen for the benefit of client constituencies and for the benefit of the U.S. Treasury.

A CEO resignation isn't enough to fix this problem, and meanwhile VW can kiss its ambitions in the U.S. market auf wiedersehen for years.

Friday, September 4, 2015

A Shrinking U.S. Equity Market?

$173 trillion in investable assets in all forms of retirement funds.  Thousands of mutual funds in the U.S., more worldwide, looking for equity investments, as advisers continue to trumpet the need to own high equity allocations in order to participate in global economic growth, particularly outside of the developed markets.

Of course, developed economies, particularly the U.S., will continue to grow too, despite current doom and gloom.

Right now, governance lawyers trumpet the need for shareholder activism by all institutional investors.

Investors want mature companies to retire their outstanding share bases in order to artificially pump up share prices, never mind the longer term growth prospects for the ongoing company.

Private equity sponsors are awash in dollars, and everyone is seeking higher returns after years of central bank-enabled lower rates around the world.  They look to take out mature firms which they judge to be under performing.

What happens when you look into the stew pot after throwing in all these ingredients?  It may be "Honey, I Shrunk The Investable Equity Market!"  There may not be enough listed, liquid, institutional quality U.S. equities to satisfy the appetites for them!

It's something we've long suspected could happen, and now a National Bureau of Economic Research Working Paper 21181 (May 2015) by Dodge, Karolyi, and Stulz says that we may arrived in such an undesirable situation already.  A copy of the paper just landed on my desk, but interested readers with AEA or other professional memberships can access a copy through NBER.

The abstract has the punchline, and since this is publicly available, I reproduce it:
"The U.S. had 14% fewer exchange-listed firms in 2012 than in 1975. Relative to other countries, the U.S. now has abnormally few listed firms given its level of development and the quality of its institutions. We call this the “U.S. listing gap” and investigate possible explanations for it. We rule out industry changes, changes in listing requirements, and the reforms of the early 2000s as explanations for the gap. We show that the probability that a firm is listed has fallen since the listing peak in 1996 for all firm size categories though more so for smaller firms. From 1997 to the end of our sample period in 2012, the new list rate is low and the delist rate is high compared to U.S. history and to other countries. High delists account for roughly 46% of the listing gap and low new lists for 54%. The high delist rate is explained by an unusually high rate of acquisitions of publicly-listed firms compared to previous U.S. history and to other countries."
If their analysis is correct, the real situation may be worse than it seems. Delists account for 46% of the listing gap, according to the authors. But, the delisting gap should be higher than it is.  There are so many microcap companies that trade below $5, and more below $10 a share that really have no business continuing to be public.  I've long felt that boards should work to perhaps consolidate some of these companies, to create a portfolio of products and revenue that might be attractive to institutional investors.  Institutionally, this isn't possible because companies don't want to throw in the towel and merge with another weak sister.  Most large mutual funds are not permitted to invest in companies like these anyway, since they are extremely illiquid and not followed by Wall Street.

Furthermore, what's coming down the pike in terms of future IPOs?  Let's look at Google, for example.  Everyone is making money on the shares which almost singlehandedly, along with Amazon and other uber-caps, are driving the indexes.  So, no one complains.

Since shareholders can't exercise their rights in Google because of the multiple share classes, they are not owners in the traditional sense.  Activism here has no meaning. The new tech companies have little need for massive capital investments, aside from those arising from pie-in-the-sky projects like driverless cars.  As such they should be poster children for returning cash to shareholders, but au contraire, they have little appetite for doing so.

None of this is lost on the investors and managements of Uber, Alibaba, and all the other supergiant companies that have to eventually become IPOs.  Investors can't continually raise the arbitrary valuations of these companies, and continue to pour in cash when it is becoming apparent that cash balances alone won't capture the growth they require for their current valuations.  Witness Uber and its battle with its Chinese nemesis.  So, if the next wave of IPOs is dominated by these kinds of companies, large cap funds of every stripe--tech sector, growth, new era---will all wind up owning the same companies while charging wildly different fees.

Meanwhile, retirees will need income but the pool of dividend paying companies is shrinking, with mergers being one reason.  They are also buying back their shares.

I get a headache thinking about this, but it is a real problem beyond the current fast food menu in financial journalism.  Keep an eye on this one, and I am doing some work on this for other reasons.

It is Labor Day weekend in the U.S.  Enjoy some time with your family and friends. Equity markets will open next week as usual.

Thursday, August 13, 2015

Berkshire Hathaway's Issues Aren't Its Numbers

Berkshire Hathaway's net income for its fiscal 2nd quarter 2015 declined 37% over the prior year period, which generated some market consternation.  However, in a holding company of this size and breadth, driven by insurance businesses, volatility is a fact of life, as the Chairman himself has often said in his letters.

The big question about this company can be framed in terms of corporate succession, and that is certainly where the press reports traditionally have gone.  The genius of the company so far lies in its structure as a holding company and on distinctive features of its operating model.

"There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by our corporate headquarters in the day-to-day business activities of the operating businesses."

One of the companies I followed as a research analyst was RPM, International, the old Republic Powdered Metals.  Founded by entrepreneur Frank C. Sullivan, the company grew rapidly under his son, Tom Sullivan.  The two corporate leaders were Tom Sullivan and CFO Jim Karman, much like Warren Buffett and Charlie Munger.  The paragraph above describing Berkshire applies very well to the RPM I covered. RPM's long-term superior returns and sustained dividend growth have proven out its model, and its market cap today is north of $6 billion, driven by acquisitions, just like Berkshire.

A really key difference highlights the uniqueness of Berkshire's model, which is something I've written about for some time: it is the breadth and spread of the business portfolio.  RPM's portfolio is all in specialty chemicals and coatings worldwide.

Berkshire's portfolio encompasses a huge insurance business, spread over personal lines, commercial lines, and reinsurance.  Beyond that, it owns a leading railroad, a significant manufacturing company portfolio, and significant energy utility business.

In the case of both companies, acquisition of portfolio companies has taken place over a long period of time, with the important factor being the operational acumen and character of the target company founders or executives.  All an investor has to do is to read Berkshire's Chairman's Letters over time to see the repeated reference to portfolio company leadership when calling out outstanding results. Judging character and letting the operators run the companies are common features of both company models.

Going back to the Berkshire 10 Q, we read, "Berkshire's senior corporate management team participates in and is ultimately responsible for significant capital allocation decisions, investment activities, and the selection of the chief executive to head each of the operating companies."

It is the husbanding of corporate cash flows from the operating companies, together with the insurance float and holding company financial capacity by Warren Buffett and Charlie Munger and the reallocation of the pool among the different operating companies, investments, and acquisitions that lies at the heart of Berkshire's long-term success.

The operating company executives do their jobs in stellar fashion, and they are in good businesses to start with.  They are extremely well compensated, and they are allowed to act like entrepreneurs, though they are managers.

With this context, let's go back to the question of corporate succession.  Mr. Buffet's son, Howard Buffett as non-executive Chair.  He has written an interesting book, "Forty Chances."  Beyond that, it's frankly hard to see how this succession would give an investor confidence in the future, to be dispassionate about it, as an analyst would have to be.

Next, assume that Berkshire's most successful, adept and widely respected executive in his industry (insurance), Ajit Jain were to be named as Berkshire CEO.  The press talks about him as the leading candidate, whatever that means. Would this be a comforting move for investors?  I would say, "Not necessarily."

First of all, who would succeed Mr. Jain as leader of an insurance empire that contributed $2.3 billion of net earnings over the six months of fiscal 2015 to-date?  Who would have similar insights into the entire panoply of global insurance lines that Mr. Jain possesses?  Without knowing that, it would be foolish to just jump for joy at Mr. Jain's ascension.  Shareholders know nothing about the holding company leadership at the next level in order to make an informed assessment.

Secondly, Mr. Jain's interest in stepping out of an industry he knows like the back of his hand, into a portfolio which goes from box chocolates to railroads and reallocating capital among them might not be very strong.  He probably realizes that this would not be his forte, nor would it be "fun."

CEOs of operating businesses tend to be specialists, which to some extent underlies their success. They know, grew up in, or have a passion for railroads, bending metal, or pricing risk.  I don't know a comparable figure to Warren Buffett or Charlie Munger among all the hundreds of companies I have covered, researched or visited with in my travels.

So, the question really boils down to whether or not the Berkshire Hathaway model and its historical success are inextricably bound up with the business philosophies, characters, and acquired networks of the two current leaders.

Take the next idea bandied about, namely that one of the two new investment executives named to run the liquid investment portfolios were named to lead the company.  Frankly, investors should probably head for the exits.  Their limited experience is in traditional asset management, no matter how sharp they are or how well they are doing with inherited portfolios.

Think about the long-serving operating executives of the holding company subsidiaries.  With a change, would they feel as comfortable and secure with the structure to which they have committed their energies? I don't know, but I suspect that they would have questions and might lose focus for a time.

I suspect the reason why Mr. Buffett has been so coy about the "succession" issue is that he himself knows that (1) too little attention has been paid to it because of the complexity of steering a company this size and growing it through massive acquisition since 2013. And, (2), there is no simple answer in naming two leaders.

Tuesday, August 11, 2015

Google's Alphabet: Seizing the Day

Our mid-July post on Google focused directly on corporate structure, focus and returns to shareholders, especially dividends to return excess cash.  It looks like Google's founders have learned their lessons quickly with a dramatic announcement of a reportedly Berkshire Hathaway-like holding company structure and a division among their core businesses and their longer-lived, investment businesses which will be run by their founders.  Here is the quote that piqued my interest from Larry Page's letter,

"We've long believed that over time that companies tend to get comfortable doing the same thing, just making incremental changes. But in the technology industry, where revolutionary ideas drive the next big growth areas, you need to be a bit uncomfortable to stay relevant.
          Our company is operating well today, but me can make it cleaner and more  transparent"

Talking about the Four Horsemen of tech--Cisco, HP, IBM and Microsoft--we feel that it isn't at all guaranteed that all of these players will stay relevant to their customers just by shuffling the asset deck among separate companies, or by just selling businesses.

Concerning IBM, it has been reported that Berkshire Hathaway has continued to buy IBM shares, thereby somehow comforting retail investors that holding on is a good thing.  Tech darlings can become irrelevant: remember Digital Equipment, the darling of Harvard Business School professors for their innovation and culture?  Remember Wang Labs?  Remember Cray Research? (not the current company)  It can happen.

It can happen to Microsoft too.  Larry Page hits the nail on the head. You need to stay relevant, and incremental changes, like reorganizations or shuffling executive portfolios, won't do it.  Big company boards and executives like stability and comfort: being uncomfortable is a cultural shift, which IBM, Cisco, HP and Microsoft all need, some worse than others, but all basically the same.

To be fair, though the BRK analogy has some flaws.  Berkshire Hathaway works for, among several reasons, the capital reallocation process from subsidiary income dividended up to the holding company level, where Warren Buffet, checked by Charlie Munger, makes the critical decisions.  I suspect these decisions will continue to be made by founders Page and Brin, with a bias towards the long-tailed investments.  More clarity is needed here.

Sundar Pichai has earned his spurs in the core businesses, through managing and growing several very large ventures, and it's great that Google's founders have moved rapidly to put the company jewels in safe hands.  He will need some help dealing with Wall Street and adding other duties to his operating portfolio, but this kind of transition is done very slowly at most NYSE-size companies. Here it was done with a quick strike, but there's nothing wrong with that.

Shareholders have reasons to have expectations biased to the upside. Their co-CEOs have been listening and reflecting, as engineers often do, but they have acted at a stroke, which engineers are often wont to do.


Tuesday, August 4, 2015

Andreessen Horowitz and The End of Windows

I read a very interesting post by Ben Evans, a partner at Andreessen Horowitz, titled "Microsoft, capitulation, and the end of Windows Everywhere."

In many ways, what he says about Microsoft is right in alignment with our writing over the past few years.  In some other ways, namely about the future of computing, I am not sure that extrapolating the present gives the picture about the future winners.  It almost never does.

Mr. Evans introduces his article by saying that it's very difficult for large companies--like Cisco, HP, IBM and Microsoft--to throw in the towel on a business.  His identification of internal corporate processes driven by strategy teams and abetted by high price, outside consultants as outlawing giving up is hilarious, and true. I've sat through many of the "hundred-page decks" myself, arguing that tacking while staying the course was the best.

Back in 2013, we wrote,
  • Establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.(This means that the legacy though currently very profitable will inhibit real innovation.  Microsoft needs to let go of Windows and its legacy)
Ben Evans puts it succinctly, "Windows is not a point of leverage for Microsoft in mobile."  

He also debunks the strategy put forward by Microsoft CEO Satya Nadella which emphasized courting the developer community to build apps for Windows 10, which will appear across all computing form factors, from tablets to phones and desktops.  Again, Mr. Evans writes, "Uber doesn't have a desktop Windows app, and neither does Instacart, Pinterest, or Instagram.  The apps and services that consumers care about are either smartphone-only or address the desktop using the web, with only partial exceptions for the enterprise." 

He unfortunately confirms my suspicion that my value-driven move to Windows Phone on Nokia devices will leave me abandoned in the desert, as Microsoft often does to its loyal customers. Windows 10 will mean nothing to me on this device, as I have the look and feel, and the great apps like Here Maps already.  

We are in rabid agreement that "Microsoft has missed mobile," but I am not sure that I agree with Ben's  conclusion that all computing will be done on phones.  

The most current, relatively disinterested data on smartphone usage comes from Pew Research, and I direct my readers to their surveys and conclusions.  But, let's go back to another strand from the IT Guru Business, namely "Big Data," and Smart Cities and Smart Corporations.  We know that the back end of these houses are going to need massive computing power, mainly driven by cloud-style models with consulting and analytical support.  

On the front end, where are the analysts, directors, and VPs going to do all their data analysis, scenario testing, and supporting work for presentations?  Certainly, none of this can or will be done on a phone, unless people start carrying around 30" flat screens!  If this phenomenon is real, as all the tech CEOs have said, since they are reporting their multi-billion dollar revenue run rates on every conference call, then surely this significant transformation of enterprise research, analysis, business forecasting, risk management, and financial forecasting won't by supported by the growth in the number of smartphones.

Suddenly, a device like Microsoft Surface looks like a godsend, or Apple's Macbook Airs.  

Pew's research shows that, especially for younger users, whether students or entry level employees, smartphones are used to relieve boredom, to text, send photos, find friends who are in the neighborhood and other non-GDP enhancing uses.  

Is the smartphone the future of "computing?"  Who knows?  But, it surely depends on what's meant by "computing," The venture backed companies developing apps are doing it in office spaces, on big displays, backed by computing power supplied by Amazon Web Services and others.  They may use their phones to order pizza at the desk, but the future of computing is surely more complicated and nuanced than that.