Tuesday, December 15, 2009

Exxon Deal Looking Greener Today

After a day of reflection, the post-game analysis of the ExxonMobil-XTO Energy deal is turning more to our positive viewpoint, so much so that the New York Times' green energy blog is laudatory about the increasing mix of natural gas in the portfolio. It does make sense.

ExxonMobil is a company that uses return on average capital employed (ROCE) as a key metric for the effectiveness of their business model. Their five year average ROCE is an impressive 30.7%, while the return in their most recently reported fiscal year was 34.2%. Looking through their extensive and useful disclosures, what they call "upstream activities" comprise their basic oil and gas operations. For all the complaints about difficulties of dealing with foreign governments and state-owned oil companies, ExxonMobil's ROCE in non-US petroleum operations is significantly above the corporate average. It's interesting to note that with the acquisition of additional natural gas resources through XTO, and a recovery in natural gas prices as inventories are worked off and economies recover, the ROCE in the worldwide gas operations looks to have substantial upside, which should really benefit shareholders and add value.

A December presentation at the Morgan Stanley Energy Conference also reiterates some of the rationale for the large acquisition. Talking about ExxonMobil's natural gas operations, a slide notes (1) gas is one of the fastest growing energy sources from the present until 2030; (2) unconventional gas resources will be key to supplying the markets in the future, and (3) technologies for efficient exploitation of the unconventional resources will be key.

Again, for some of the rightful criticism of the company in the past, its historical returns on capital have been very strong, and this deal has the potential to enhance them significantly in the medium and longer-terms, which is where governance theories say managements should be focused.

Monday, December 14, 2009

Paul Samuelson

Today's papers marked the death of Professor Paul Samuelson, a real, trail-blazing economist. His Foundations of Economic Analysis, which I read for my introductory graduate school course in microeconomic theory, really turned my head around, as it was a masterful application of rigorous mathematics to economic markets and behavior. The book, which is much more influential and better done than his textbook, won a Wells Prize for Harvard dissertations in 1941. In one of my introductory operations research courses, I later ran across his writing again in Dorfman, Samuelson and Solow, "Linear Programming and Economic Analysis, affectionately known as DOSSO, that took some dry theoretical concepts and applied them to real-life problems. Again, Professor Samuelson fired my imagination. I mourn the passing of a real intellectual giant who advanced knowledge that benefited many disciplines.

Exxon Strikes A Good Deal

The Wall Street Journal, as it must, put out a quick piece about ExxonMobil overpaying for XTO Energy. Their analysis was confused and off-the-mark. It sounds like a good, opportunistic strategic deal that should be in the interest of ExxonMobil shareholders and perhaps also for those concerned about the global environment.

The paper contends that ExxonMobil's deal values XTO's natural gas resources at $17.50 per barrel-of-oil equivalent (BOE) versus the implied value of $14.90 shown in XTO's disclosures. This dubious premium is 17.4%, less than the 25% premium implied in the total deal value. However, it's the wrong number to look at in the first place. The report talks about "proven reserves," which are those that have been demonstrated to exist and to be recoverable with conventional technology at current prices. This is the most conservative measure of XTO's asset base, but it should only be a fraction of the resource base.

The press release itself talks about the energy assets of XTO Energy including"...shale gas, tight gas, coal bed methane and shale oil." These resources are unconventional resources, as opposed to reserves. ExxonMobil's alternative to the acquisition would be to create a worldwide unit to explore for and acquire these resources, and then to develop the extraction technology. That would take time and lots of expense. Why build this capability when natural gas prices are at cyclical lows, and XTO has proven technical and organizational capabilities, which is the other real asset that ExxonMobil is buying?

ExxonMobil, as well as the other global majors, have really not over invested in their fundamental businesses in recent years, as they have focused on using free cash flows to buy back shares and increase dividends. In one transaction, the company has tipped the balance towards investing in a cleaner-burning, hydrocarbon fuel that will, along with oil, still account for the lion's share of global production and consumption into the medium-term future. What better transaction than this from a fundamental viewpoint?

The December ExxonMobil Energy Outlook for 2030 indicates the average annual growth rate in worldwide demand for natural gas to be 1.8% per year, which is much faster than the demand for petroleum. So, in this transaction, the company has significantly enhanced its reserve and resource positions in the fuel that the world economy will demand. It all makes perfect strategic and economic sense. Given the culture in the global oil patch, it's unlikely that this transaction materialized out of the air, and I would venture to guess that it's good for both organizations. Looks like a good deal to me.

Tuesday, December 8, 2009

News From Newport Beach

My investor antennae went up after reading that PIMCO's Bill Gross, my investment writer/analyst of choice and global bond guru, had started up an equities research effort, built around a "deep value" approach. To that end, the firm made several key hires, including Neel Kashkari formerly of Goldman, Sachs and a key figure in creating and implementing Fed and Treasury programs for AIG, Bear and Lehman.

Bill was a long-time, perceptive critic of GE's empire-building using the cheap currency available to GE Capital. This took place during go-go markets, when GE was the darling of every conglomerate and industrial analyst on the Street. So now, PIMCO wants to look at public equities with a value approach. That makes me sit up and take notice; it should be a development worth watching.

PIMCO's early strategy for the New Normal was to "shake hands with the government," i.e. own lots of GSE and Government-guaranteed mortgage paper, plus buying high quality corporates and staying high up the capital structure. This approach has proved a winner in spades, and it may continue to outperform, with some adjustments.

The ten year records for alternative investments have been lackluster, and many college endowments are stuck in illiquid investments with portfolio imbalances. According to Kaplan and Schoar (Journal of Finance, Volume LX (4)), the average private equity fund's return net of fees were roughly equal to the return of the S&P 500 for the period 1980-1997. The Venture Capital Index returns for the one and three year periods ending June 30,2009 were -17.1% and 1.3%, respectively. Considering the risks, lackluster is a kind word.

As the world economy recovers, the reward profile for equities should improve, with larger being better (risk adjusted) than smaller, and OUS being better than US. Stay tuned for news from Newport Beach.

Monday, December 7, 2009

New Century Financial In The News

The SEC is finally bringing a case against the founder, CFO and Controller of New Century Financial, once one of the nation's largest originators of sub-prime mortgages. The case against the three officers involves fraud for, among other things, reporting to investors in 2006 that the loan portfolio was healthy and outperforming its peers, even when there was substantial internal data to the contrary. New Century filed for bankruptcy protection in 2007, and it once had a market value of more than $1 billion.

It is amazing that it has taken the SEC this long to bring an action in this high profile case. To be fair, part of the problem is that SEC core functions suffered under the dreadfully inept watch of the former Chair under a Republican administration. To do its job, the SEC needs leadership, a mandate, and resources, of which it had very little under the prior administration.

A special master for the bankruptcy court, Michael J. Missal, wrote a scathing 581 page report, which I have to admit that I read, excoriating the external auditor's complete breakdown in internal supervision and QC. It also faulted the auditor's failure to heed the signals of a coming meltdown that were evident from their own working papers. The firm vehemently denied the accusations, and their huffing and puffing rang hollow.

It is certainly good that some company officers will be held accountable for this fraud, but the light should also be shone on the board and its ineffectiveness, along with the passivity and inattention of the auditors. It's a real life, educational case for audit committees of financial services companies.

Countrywide Financial is another egregious case that had a direct impact on the current mortgage crisis, but it was acquired by Bank of America, and it may be old news given the euphoria about BofA paying back TARP funds.

Sunday, December 6, 2009

Reform Runs Out of Gas

Last week I attended a presentation by Bob Pozen, author of "Too Big to Save." Bob is Chair of MFS Investment Management, former Chair of Fidelity Management & Research, and lecturer at the Harvard Business School. Bob is an attorney by profession and Robert Shiller, the Yale economist, is his co-author of the book. I came with a lot of optimism, but left with a sense, at least from the slides, that reform of the financial markets has now been, as the Brits say, "crocked." That is to say, the plate has been thrown down on the floor and broken into shards of crockery. Reform now means a lot of incremental procedural changes that altogether don't add up to much.

Pozen says that there is too much focus on bank lending to business as being the key to economic expansion. He notes that bank lending was about 26% of total credit creation in 2006. Much more important, he says, is the task of reinvigorating the securitization market. He says that current volume, if I heard it correctly, is about $20 billion annually versus $1.2 trillion in 2006.
One reason that the market imploded, among many, was the fact that issuers were not required to hold a retained interest in the securitizations, and I would presume that establishing this as a norm would be one of the enhancements discussed in the book.

I felt that he glossed over the role of S&P, Moody's and Fitch in the whole debacle. The capabilities, business models, and governance of these institutions have not changed. Pozen's answer is to have these and other credit rating agencies, submit bids to an SEC master who would pick the best one for each issue. This seems like a procedural step that leaves all the significant issues behind the failure of the agencies untouched. It's another "check the box" procedure, a la Sarbanes-Oxley.

He rightly points out the popularly misunderstood nature of the extent of financial institutional bailouts. Out of about 650 financial companies that have been recapitalized, there are 290 small banks. Many of the companies don't hold deposits, but received TARP money anyway. The program was rolled out without any limits or rationale. That was, and is, reflective of management incompetence on the part of the Government. Remarkably, he notes that the Government got 15% warrant coverage on its deals whereas Warren Buffett demanded and received 100% warrant coverage for his Goldman deal! Don't want to ruffle any CEO feathers, especially with the taxpayers' money.

Repealing Glass-Steagall was clearly a humongous mistake. Pozen says reinstating a separation of commercial and investment banking is not desirable. It may not be, but his argument escaped me. He says that underwriting securities is not the problem. That may be true, but principal trading of all manner of convoluted instruments surely is the problem, and it takes place on the same trading desks. There was an obligatory comment about financial innovation, but who needs the kind of "innovation" that got us here? Finally, he rightly points out that if other nations don't follow, then US banks would be at a disadvantage. But, wouldn't the UK and the other G's want to coordinate this kind of policy?

On the subject of executive compensation, he noted the failure of the whole system for regulating the banks that took TARP money. We've always pointed out that this was a blunt instrument, and that focusing on the back-end compensation without getting at the philosophical issues about economic rents and short-termism in corporate objectives would be a futile exercise. He noted that Wells Fargo responded to the guidelines by stripping down the options-related compensation of its terrific CEO, whom I have always admired for his focus and consistency. Unfortunately, his base salary went from $900,000 to $5.6 million, and his restricted stock grants more than made up for any "loss" of option-related potential gains. Pozen said that this is not the kind of "reform" that was intended, but that it was a rational and predictable response to the foolish rules-based structure.

Pozen mentions that there is no data to support the notion that procedural-based SOX led to better stock price performance or less malfeasance or bad governance. Again, our systems are based on rules and bright lines, and Europeans tend to favor principle-based systems. Ultimately, it's the people in charge of Governments and the corporations, along with an informed citizenry that make a system fair and reasonably efficient.

I'm sure that there's lots of good ideas in the book and some good analysis of the historical origins of the crisis from Robert Shiller. After all this time, though, I would have expected more penetrating ideas for reform.