Thursday, July 30, 2009

NetFlix and Outmoded Corporate Organization

Some years back I networked into a group of people who were planning an IPO for a company with a software product that predicted consumer movie preferences, called MovieLens (now GroupLens) developed at the University of Minnesota. At that point, Amazon was getting off the ground primarily selling books with some music, and the group's idea was going to take the world by storm. Everybody was skeptical about Amazon's business model, but we know how that story developed.

I was struck by how the MovieLens techie people used business lingo but had no clue about a business model. Everybody was an Internet acolyte. It seemed ridiculous to build a big corporate scaffold around an interesting analytical functionality that had no value proposition for the consumer. I passed and there was no IPO, needless to say.

Now, I read the articles about the NetFlix Prize with interest. They have the same functionality in the back of the house. What are some of the ways a traditional corporation would address the issue of improving the predictive accuracy of consumer movie preferences by ten percent? First, hire a deluxe executive recruiter to lure an ultraluxe executive away from Sony Entertainment (they know movies, don't they?) and let them spend three to five years staffing up and spending lots of money before coming up with nothing and parachuting out. Second, hire McKinsey to spend a year and a couple of million to define the problem. Third, hire Andersen Consulting to take up residence and overrun the company with consultants like locusts, turning over every department before morphing the issue into a systems implementation. Sound familiar?

Instead, NexFlix's specification has produced collaboration and real team behavior, where international partnerships between established groups and unaffiliated specialists arose to put a winning group over the top. A traditional, isolated corporate model would not have struck these kinds of alliances. In fact, for so many years, even the simple notion of joint ventures between established corporations have not worked. The current form of the American corporation grew up after the Korean War, as they imitated the structures, language and hierarchy of the military organizations that had successfully prosecuted large scale, global military efforts. The world has changed dramatically, and whether it is hot and flat or not, we can learn something from the progress and perhaps the eventual demise of NetFlix. I think I'm going to start a subscription because I just like those folks!

Tuesday, July 28, 2009

Reflecting on The Recession

After reading today's Verizon's announcement that it was reducing its employee base by 8,000 workers, it made me start thinking about how Employment has fared in this recession compared to other downturns. Using monthly payroll data from the Labor Department, a Wall Street Journal chart showed that 19 months after the start of the 2007-2009 recession, there were 6.7 million fewer Americans working than in December 2007, a 4.7% decline versus 3.1% for the short, sharp recession of '81-'82.
According to Stanford economist Bob Hall, quoted in the WSJ, "In terms of employment, we've now passed 1982 and we're just about to cross the worst postwar recession, which was 1948."

So, the stock market moved up 23% or so in the second quarter. The positive earnings reports and "upside surprises" in the second quarter were driven by cost-cutting, one-time events, and absurdly low expectations. There was nothing to report in general on the top line. Valuations expanded from bargain basement levels to fair market levels, or "boring" levels to use Jeremy Grantham's phrase. How can it move up from here without quality earnings?

The movement in junk bond indices is hard to fathom, but these moves are usually precursors or coterminous with a movement in equity prices. High quality corporate bonds had a twelve month return of about 8%. Grantham's advice is "Go long quality and short junk." It seems reasonable given the lack of support from fundamentals going forward a quarter.

Meanwhile, the Federal largesse being handed out to Goldman, J.P. Morgan and other Most Favored Banks has yielded windfalls to their execs and shareholders, but it has done little to help the traditional banking sector. Robert Willmers, the CEO of M&T Bank puts it well in the Washington Post, "we must restore the balance of regulatory oversight between commercial banks and other parts of the financial services industry. We should do so not only to be fair to banks but because the nation's ailments won't be cured unless solutions are directed at the entire financial system, not just one-third of it. "

Monday, July 27, 2009

Spending Twice As Much On Healthcare

An oft-repeated refrain goes like this, "We Americans spend twice as much on healthcare as the Europeans, but we don't live any longer." Attending a lecture by Dr. Mehmet Oz, Professor of Cardiac Surgery at Columbia College of Physicians and Surgeons, gave me an "Aha!" moment on this issue. He opened up his lecture with the statement, "We spend twice as much on healthcare as the Europeans because we're twice as sick!"

Dr. Oz gets involved when cardiovascular disease has progressed to a critical stage. Starting at the beginning, Dr. David Kessler has documented the effects of the three demons--sugar, fat and salt--on our diets. Our kids are overweight and sedentary. Moving into adulthood, they may become obese. With obesity comes the beginning of cardiovascular disease, hypertension, high cholesterol and inflammation, diabetes, peripheral vascular disease, and stroke. Certain population groups have very high incidence of end stage renal disease which is expensive to treat, and difficult for the patient's quality of life.

Cultural norms and the significantly lower degree of commoditization of food in Europe helps them avoid some of this progression, at least to our degree. Remember the wisdom of "The Mediterranean Diet?" We also tend to spend a lot of lifetime healthcare dollars at the end stages, and Europeans are more sanguine about end of life issues than we are. A distinguished German cardiologist said to me once, "Over here, it's okay for people to die. We don't pull out every high tech intervention for every patient." Cold, but a good point.

We have wonderful research, medical diagnostic and treatment tools, and the best doctors and institutions. We overuse many of these tools, and sometimes use them beyond their clinically indicated uses to little incremental patient value. We haven't asked some of the hard questions implicit in the German cardiolgists remarks; at least we haven't done it in public debate.

The transaltion of the spending comment to the increased lifespan comment is ripe for some quantitative treatment, and you can find a lucid treatment on the Becker-Posner blog.

Friday, July 17, 2009

Reflecting on India

Nandan Nilekani is the CEO of Infosys, and a highly visible leader in the global IT CEO pantheon. He recently wrote a 500+ page book called, "Imagining India: The Idea of a Renewed Nation." He was recently interviewed at the Wharton School Forum. He saw one of his functions as being a global ambassador for India, as he visited customers around the world and they asked him questions about the country. Eventually, he decided that he couldn't answer many of their pressing questions, such as "How can India have such shiny corporate campuses co-existing with miserable slums right on their doorstep?" So, he interviewed more than 125 leaders in different fields, thought long and hard, and came up with this book. I applaud what drove him to this effort. I hope to able to tackle reading the book, but some things he said in the interview struck me right away.

The critical problem for India, he says, is to expand access to resources and opportunities for a very young population. That young demographic gives India tremendous potential in the sense that a productive workforce of that size can support a large, older population and provide social stability. He duly notes that in the South (especially Kerala) and the West of India, the demographics show an aging population and stable or declining birth rates. In the North and Central parts of the country, the population is young and growth rates are high. Unfortunately, this is exactly where the rural-urban migration is taking place, and these are the people who are creating and populating the slums that his questioners are asking about. That rural-urban migration has to stabilize and eventually stop. Unfortunately, India has been wrestling unsuccessfully with this problem since Independence.

Nilekani rightly notes success in what he calls "infrastructure" by citing the example of the wireless communications infrastructure story in India. He cites more than 8 million cell phone users among the middle class population, of which he says more than ninety percent are prepaid phones. Good for the companies, and hopefully good for the users too. Speaking about the Indian elections, he notes that India is the only country in the world that relies on electronic voting machines, were 1.1 million electronic machines collect and tabulate the vote for an electorate of more than 700 million. These are certainly successes to be admired.

However, the most basic infrastructure like water, power and transportation remains a disgrace. "Seventeenth century" would be an appropriate epithet for these sectors. If you've ever driven behind a diesel public bus in any large Indian city, I don't have to say more.

If ordinary communities don't have water, power and sanitation, then agriculture can't flourish, people can't feed themselves and remain on the land, and they will migrate to the big cities. If urban households don't have the same amenities, then kids will face challenges in doing their homework and staying motivated because they're hungry and they don't have a comfortable environment to study. It affects everyone, and I see the same thing here in Minneapolis, tutoring inner city minority children in mathematics.

The issue isn't a lack of ability or a lack of desire. For many kids here, it's the fact that no one is home to make them breakfast before school or there is no food on the table for anyone. For others, it is a lack of a quiet space in an overcrowded, uncomfortable apartment that makes it impossible to concentrate. It's magnified in a country like India. For a small percentage of the population that can overcome the odds and get into an elite college, there's a pathway out, but the percentages don't work.

Nilekani is right; it is about access and opportunity. But, this presupposes the existence of basic infrastructure for stable families and communities. It presupposes a balance between industry and agriculture, where some people can remain tied to the land and live decent lives. India, unfortunately, is getting stumped on these issues, and its corporate elites have to find a way to take these issues on because it's the right thing to do, and it's in their own self-interest. Otherwise, over time, extremism and dissatisfaction will roil the political system and overturn the gains we've earned so far.

Citigroup's Second Quarter Earnings

Citigroup's second quarter earnings were interesting. In no systematic order, we noted a few key items. Citicorp's North American banking operations, the old John Reed core business, saw deposits grow by 12% year-over-year. Expenses are down 21% year-over-year. Tier I capital ratio improved to 12.7% at the end of the quarter. The interest margin was healthy but can go higher once the separation of the companies and asset sales are done.

Their credit card business and their mortgage business, both now sequestered into Holdings, look like delinquencies are still increasing and charge-offs are ahead. Consistent with this view, provisions of $9.9 billion for Holdings were consistent with a similar level in 4Q 2008. These trends are visible in the slide presentation to accompany the call and shouldn't be a surprise going forward. Sub-par performance from the credit card master trusts impacted Citigroup in the quarter. It's hard to see how this plays out and over what time horizon.

The other piece of good news is that Richard Parsons seems to be quietly improving relationships with all the multiple regulatory bodies overseeing Citi, and it no longer seems as if anyone is looking to take Citi as a scalp for being a reluctant ward of the state.

The one thing that is now a serious issue, in our mind, is the culture inside the organization, which has never been anything but awful even in the growth years. There is so much turnover and changes in reporting relationships, it's hard to see why anyone would be enthusiastic about helping the organization through the current crisis given the disconnect between risk and reward for all but the super-elite management. The troops need a mission, a message, and a strongbox full of lucre if the company succeeds that will be shared throughout the organization.

Thursday, July 16, 2009

All Atwitter About Goldman

So Goldman Sachs earnings declined 10% but beat Wall Street's lowered expectations, so the market is euphoric. It doesn't make sense. What drove their earnings is something akin to a confluence of one-time events, namely the timing of government-mandated equity issues and the fact that given the absence of competing underwriters like Bear and Lehman, among others, Goldman took a bigger share of a lucrative fee business. Investors now want to equate the health of "the banks" with the health of the Goldman and Morgan duopoly. The banking sector proper still has massive issues that are being swept under the rug using the whisk broom of press releases.

Stephen Roach was for many years the readable, insightful economist for Morgan Stanley. He sums the issue up for me.

"The financial crisis is not over,” Stephen Roach, chairman at Morgan Stanley Asia said on CNBC. “The (International Monetary Fund) is telling us that by the end of this crisis $4 trillion worth of bad assets will be written down. Thus far financial institutions have written off, at most, half of that. So there's plenty more to come.”

Ted O'Glove's phrase, the "quality of earnings" is germane to the Goldman report. Big numbers, but low quality because of the "one time" issues. As for missing Wall Street expectations, that's easy to explain. What's left of the Street's banking analysts are so shell shocked and afraid of being whipsawed that it's safer for them to take estimates down through the basement and then be "surprised" but cautious going forward. The owners of the stock are happy with the "upside surprise" too.

Wednesday, July 15, 2009

The Supremes

I find it really disheartening to see the level of attention we lavish on these rituals for elevating someone to the Supreme Court. Judge Sotomayor seems like a nice person, but is she the best candidate we can come up with nationwide? Now, we all understand that she is going to be confirmed. Yet we have to go through this mind-numbing ritual. And, in grand political style, the candidate has to skate delicately away from some of her nonsensical and injudicious remarks. The Congressional staffers helping her out have all the stock phrases: "I was quoted out of context;" "That was then, this is now;" "I'm a different person now;" "I would be a Supreme for all the people." Pick one and rework--we're done.

I've written before about my meeting with Chancellor William Chandler III of the Delaware Chancery Court some time back. Sitting at a table of lawyers, the questions came rapid fire for the Chancellor. He had several qualities I admired. The first is that his pace did not rise to match the rapid breathing, high heart rate of his questioners. He sat back, Zen-like and listened intently. He also thought about his response before he spoke. On television, the producer would have been crying about "dead air."

When he responded, at first, it didn't seem as if he were answering the question. However, if you listened carefully, it was exactly what he was doing, and the response was not, "I think, I think..." He gave a short, very precise response to what the salient point was, or should have been. It was very impressive.

The good news is that since most public companies are still Delaware corporations, that bench will still have lots of influence on corporate law and governance. The Harvard Law School governance blog carried a nice piece about the work that the Chancery court is doing.

If only the Supremes would aspire to be these qualities.

Tuesday, July 14, 2009

Walking on the Economic Moonscape

GM is emerging out of bankruptcy, but it's hard to believe that such a short visit to "the box" will have changed much about the organization. A real learning organization is able to look at its past mistakes and figure out how things went off track. Creating the Saturn division was a bold move, but starving it for investment at a key juncture in its life was a critical mistake. Then, with the division starved for product and the dealers crying "Foul!" it rebadged a number of its new models with the Opel platform. For me, the interesting thing is how good these cars like the Vue and the Aura look. They are also good value in the US market, probably on a par with Hyundai.
But, giving a brand a last-ditch makeover with no sustained marketing or dealer support is not a real solution. It's like putting lipstick on a critical patient and saying, "There, get better!"
As the sale of Adam Opel GmbH nears closing, GM plans to retain a 35% stake, which is a good thing, as Opel was the source of the rebadged Saturns and clearly can make, design and produce good cars. Meanwhile, talking about brands, I walked by a Chevy and a GMC truck parked side-by-side in a parking lot and couldn't tell the difference. What does GMC stand for? Time to keep walking the moonscape.

The market is searching for direction, as Goldman Sachs reports gonzo earnings when the the financial sector, witness CIT, is still taking hits. So, the whole bailout candy store operation has achieved what? MFN's like Goldman, now under the bank holding company umbrella, are purring like a Cheshire cat that swallowed the canary. Bank of America will now owe fees for an agreement it apparently didn't sign, and for which it shouldn't be held responsible. Bank earnings up because margins will be up, fee income stays steady or rises, but troubled assets are still in the root cellar and lending remains sluggish.

I've been trained to look for inflationary shoots in the levels of unprecedented monetary expansion and fiscal stimulus that we've seen. However, if labor is the biggest expense for most corporations, it seems as if the unprecedented levels of job loss may mean an on-going slack in the labor market, even if the recovery gains traction in 2010 or later. Maybe the inflation concern is something to be rethought. It seems more and more likely that few corporations will regain the kind of pricing power that they enjoyed during the last two expansions. Something to think about on Bastille Day.

Thursday, July 2, 2009

What's Up With Oil? July Hiatus

When the equity market tries to convince itself that the second quarter gain of 15% in the S&P 500 is real, it occasionally frets about oil prices. We recently heard a presentation by John Hess, the CEO of Hess Corporation, at Harvard's Belfer Center. Here are some things we took away.

Oil represents 35% of the global energy supply today. Separately, Ian Bremmer of McKinsey notes that the world's 13 largest oil companies, measured by reserves, are controlled by governments. They are : Aramco (Saudi Arabia), Gazprom (Russia), CNPC (China), NIOC (Iran), PDVSA (Venezuela), Petrobras (Brazil), and Petrona (Malaysia). Hess, as the CEO of a multinational producer himself, makes the point that the future energy policy of the world's major producers will become their foreign policy. To put this into perspective, multinational corporations today produce only 10% of the world's oil and gas and hold only 3% of the world's reserves. U.S. policy makers need to keep this in mind in the future. No amount of political wind about wind will take away the global dependence on hydrocarbons, particularly oil and gas, for the intermediate term future.

From 1986-1996, oil was $15-20 per barrel. Demand growth led prices upward from there. 86 million barrels per day (mbd) is the current worldwide demand. The recession has shaved about 2 mbd off that total, but in the near future, demand will outstrip supply, and prices should start moving up once more. Hess said that we are nearing a crisis in productive capacity, and not a crisis in reserves, or oil in the ground.

He cites a total reserve number of 2-3 trillion barrels of oil worldwide. The problem is that existing fields are being depleted by about 6% per year, and continuing production from these mature fields will require increasing pressures for extraction, which is more expensive. Hess says that we need to add 5 mbd to replace the depletion from producing fields and to provide for demand growth. However, industry exploration hasn't replaced reserves at this level since 1984.
The top 6 multinationals, including companies like Exxon and Conoco, produce about 11 mbd, or about 13% of world demand, and their depletion is about 6% per year. OPEC's swing capacity is about 3 mbd, a little bit more than the current recession-driven decline in demand. Aramco is producing at about 8 mbd today, but OPEC is reinvesting only about 10% of its proceeds in exploration and development to maintain production and provide for future growth. The rest is being fed into their domestic economies for current consumption and diversification through sovereign investment funds.

The industry cycle is five years from prospecting to the drilling of exploration wells. Hess says the average is another five years to the drilling of production wells. So we need a ten year lead time to offset depletion and provide for growth. He characterizes the industry's $400 billion per year exploration budget as inadequate.

Iraq's production is 2 mbd versus 5mbd before the onset of the Iraqi conflicts. However, Iraq's reserve potential is said to be #2 behind that of Saudi Arabia. The problem is going to be an economic and political one. There will clearly be a resource-based nationalism that seeks to control the development of the oil resources by a state-owned company, and yet they cannot achieve that goal without the technology and resources of the multinationals. How can these companies, some of which are public, assess not only the political risks of force majeure but the relatively new security risks to the lives of their international personnel on the ground? They can do this by placing exceptionally low bids for their licenses. However, this will not be acceptable to the national oil company. Again, the outlook for prices is not good.

Investment in equipment has lagged. Rig rates have gone from $100,000/day to $500,000/day because of the shortage.

It was interesting to hear Hess, speaking at Harvard, say that the worldwide shortage of geologists, geophysicists, drilling and reservoir engineers is one of the biggest constraints that the industry, and his company, faces today. Fewer finance MBA's and more P.E.'s!

Worldwide, he said, the transportation sector accounts for about 50% of oil demand, primarily through automotive, commercial, and jet fuels. He cites the 20% total efficiency of the current gasoline auto engine as something that should be addressed post-haste. He favors putting out a challenge CAFE level of 35 mpg by 2020. We know one major auto company, currently in bankruptcy, that would be gonzo under that regime.

China's oil demand is about 7 mbd, or a little less than 10% of world demand, and non-OPEC demand is growing at 1 mbd currently, and could accelerate if worldwide growth resumes.

It was a sobering, but realistic scenario, and one that computes. No amount of talk about ethanol, wind, residential solar, or fuel from algae will address the near-term and intermediate term futures without demand reduction/efficiency strategies and strategies to increase the development of reserves.

Before going on a July hiatus, we wanted to give our loyal readers some food for thought. Talk to me and let me know your thoughts, even off line. Happy Fourth of July!

The New Normal

Pimco's Bill Gross has posted his July Outlook and it's compulsive reading for us. An investment thought leader who manages to viscerally tie the image of an overweight baseball umpire (John McSherry) collapsing from a heart attack to the outlook for the consumer economy has quite a refreshing view of the world.

Pimco's view of the "new normal" means lower growth, lower profit margins, and lower returns for asset classes driven by the delevering of the shadow banking system and its satellites, as well as a re-regulating of the global economy. The gloomy news, and we hope they're wrong, is that these conditions will "persist for a generation at a minimum."

Economists who look through the lens of the "permanent income" hypothesis of Milton Friedman notice that consumers have lost about $15 trillion in wealth since 2007. The loss has been in relatively illiquid forms of wealth like homes right through to liquid forms like stocks and bonds. The theory says that with a significant downward shift in their permanent income, which is related to wealth, consumption plans will also ratchet down, and not just for a month or two.

A friend of mine who is very active in the rail car market made me choke over my pancakes at breakfast the other day with this telling statistic. We all know about rail car loadings and their utility as a current indicator of economic performance. What I didn't know is that about 500,000 rail cars are currently parked in sidings or sheds. My friend said that this represents about one-third of the total rolling stock of rail cars. Now these cars carry things like coal, lumber, roofing and building materials, auto parts, grain, high fructose corn syrup, and industrial chemicals. He said that one-third of the fleet being idled is a percentage never seen before in other recessions. The outlook of some of the lessors was that they may not be redeploying some of these cars for "a couple of years!" This, to me, is a sentiment indicator and an outlook for the future. Never mind what this may portend for some of the leasing companies in the shorter run.

Pimco's investment thesis-- and I recognize that they are a bond house--is that investors should stay high up the capital structure, and prefer secure income from bonds and dividend-paying securities to riskier assets, like growth stocks.

Wednesday, July 1, 2009

Earnings Quality or the Lack Thereof

KPMG recently announced the results of a study of 1,064 public companies (minimum revenues $500 million, minimum capitalization $500 million, and minimum assets of $300 million) looking at the magnitude of goodwill impairment for the period from January 2006 until December 31, 2008. Most of the surveyed companies did their SFAS 142 required impairment testing in the fourth calendar quarter.

The surveyed companies had $87 billion in impairments in 2006, $143 billion in 2007, and $340 billion in 2008. Banks were the hardest hit, accounting for 23% of the total goodwill impairment reported by the surveyed group of companies. Within industries, 30%+ of the companies surveyed in semiconductor manufacturing, technology, and media sectors reported impairments during the survey period.

The median banking industry impairment was $411 million in 2008 versus $49 million in 2007. The materials industry's reported impairment was $394 million in 2008 versus $30 million in 2007.

So, if we are looking at the quality of earnings and balance sheet health coming into second quarter reporting season, we would suspect that earning quality will have declined. The asset side of the balance sheets of financial companies will still be of dubious quality at best.