Sunday, July 31, 2011

Microsoft Should Keep Searching

We've been reflecting on Microsoft since 2009, a company which often seems like a statistical value, but which often disappoints. Divesting its Bing search engine effort would be the worst thing Microsoft could do, both strategically and from the point of view of transforming investor perception of the company. Hedge fund managers and industry analysts are rightly frustrated with the deployment of the company's assets and its habit of always playing catch-up to innovators like Google.

Any buyer of Bing would not pay full value for the franchise, and to sell it to Facebook would be doubly foolish. Microsoft is an investor in Facebook, and it now has an alliance with the perceived leader in social media. Facebook sees itself as allied with one of the founders of the tech revolution, and it probably sees a good cultural fit with the "new Microsoft" groups like Bing. Why throw this away for a piddling amount of cash, which Microsoft doesn't need?

Even Google, the imposing Transformer, has stumbled a few times. Google Health shut down with little fanfare or recrimination. The government says that EMR's are the key to taking costs out of health care (they're wrong), and Google couldn't come up with a consumer friendly option. Google + (what a lousy name!) is playing catch up to Facebook--not an enviable position.

So, for Microsoft, it's time to put the past behind, and like smart shareholders, look at the future. As Credit Suisse's Phillip Winslow put it, Microsoft's Q4 featured "monster bookings" of unearned revenue amounting to $17.1 billion! Revenue growth was strong in Servers and Tools (+11.9%), Business (+7.5%), and Entertainment and Devices (+28.8%).

So, let's look at Online Services, which includes Bing. Winslow writes that the June quarter had an operating loss of $728 million, or almost $3 billion at an annualized run rate. Online advertising revenue of growth of 19% was less than Credit Suisse's estimate, and revenue per search was down. Think about two years ago, when Microsoft has a 7.2% share in U.S. search, which it has now doubled to 14.4%, and including its powering of Yahoo! search, it has a 27% share of the U.S. search market. This is nothing to sneeze at!

I don't know how Microsoft allocates costs and charges among its divisions, but the operating losses to Online Services probably includes expenses of building massive data centers that power Azure, which is one of Microsoft's cloud computing offerings which will be critical for expanding Service and Tools and the Business Divisions. So, it seems unlikely that the $3 billion annualized run rate of losses in Online Services is the search engine effort itself.

A minor point, but not to me, is that I actually like Bing as a search engine. I was one of the early guinea pigs for MSN Network, taking an MSN email before they acquired Hotmail. I know how lame and poorly conceived their products can be. Bing is very, very different in look, feel and performance: it's a more than acceptable substitute, with certain advantages, like its response to travel inquiries. Remember that Peter Lynch once, perhaps apocryphally, bought Dunkin' Donuts for Fidelity Magellan because he liked the coffee!

The New York Times Sunday article on Bing gives me the feeling that Microsoft has created a different sub-culture in the Bing strategic business unit. Qi Lu, the President of Online Services, is quoted saying his mission is to "change the game," while recognizing that it will be "a long-term journey." Dr. Lu also characterizes most Microsoft project leaders as having a "renters mentality," whereas winning in search means having a "homeowners mentality," which I take to mean being emotionally invested in their business, liking their neighborhood and meaning to stay for a long time. Indeed, the Times reports that's the promise that CEO Steve Ballmer made to the group as he assembled them. I also like the comment because it came not from the usual cliche spouting, Stanford MBA type but from a Carnegie Mellon computer science PhD. I think Dr. Lu believes what he says.

Which reminds me, what about China? This is the place where every business needs to be to succeed, goes the market patter. Well, in its haste to "do no evil" while also taking over the world, Google appears to be have burned some bridges in China. Microsoft's research lab in Beijing produced a key Bing team leader in Dr. Harry Shum, and it appears that Microsoft has wide-open options in overseas markets, including China and others. Microsoft's "Mango" Windows Phone 7.5 supports 17 new languages, according to Tim Carmody. Windows Mobile was less than stellar, so let's hope that they've invested in getting Mango right.

As industry analysts write, the mobile computing/telephone platforms will be the convergent battleground for really expanding and personalizing online advertising and target marketing. We're very likely to have a duopoly in this market, and were Microsoft to exit Bing, the second player would NOT be Microsoft, and this would be a tremendous loss for its shareholders.

Microsoft has integrated Bing into platforms like Xbox Live, which once seemed moribund but which is increasingly popular among twenty-something gamers. All of this multi-platform embedding of Bing takes investment, and now is not the time to take the ill-advised strategy of writing off the efforts. Microsoft, would among other things, break faith with some of its powerful new innovators inside the company, thereby dooming it to be regarded as a dinosaur in the tech world.

Microsoft should look at this issue like Warren Buffett looks at Berskhire's portfolio. Buffett's job is to reallocate cash flows from businesses which don't need them (like See's Candies) to businesses with significant moats and potential for high returns. For once, this appears to be what Microsoft has begun to do with search, in effect diverting large free cash flows from Office to ventures like Bing. Keep it up, Microsoft: don't blink here, and don't be waylaid by short-term concerns.

Friday, July 29, 2011

USA Men's Soccer Changes Its Leadership

U.S. Coach Bob Bradley was probably unfairly dismissed as US Soccer's Men's coach, precipitated by the team's dismal showing against Mexico, and with three years to go until the next World Cup. Jurgen Klinsmann, a talismanic striker who proved himself in the top leagues in Germany, Italy and England has taken the job, after turning it down once before.

The reason for his first refusal was instructive. He wanted total control over all U.S. Soccer operations. In our corporate model of organization, President Sunil Gulati couldn't create a position like this. Is Klinsmann a control freak or a megalomaniac? Not at all. He understands the U.S. issues all too well.

Bob Bradley, like all the U.S. coaches before him, didn't have a wealth of players to choose from to form a team which can compete at the highest international levels, plain and simple. Relatively few of our players go abroad to star in England, Germany, Italy or Spain. The MLS has improved its level of competition significantly, but it has diluted the domestic talent by expansion and by the occasional binges of importing over-the-hill foreign players.

The U.S. team has always suffered from a dearth of out and out strikers, who are not glorified midfielders. Clint Dempsey has proven to be a top class striker in the English Premier League, but on the U.S. squad he suffers for a good partner and for good service from the wings. Landon Donovan is a fine player who has turned into a good team leader, but he cannot carry the team on the field. The U.S. defense is aging and inconsistent. The midfield is a revolving door.

Our youth and Olympic Development Program are not well coached, well directed, and have not been a great feeder either for the league or the US team. Most of the youth teams that I seen and coached against are glorified "kick and rush" sides with iron lungs and great physicality. Occasionally, you see teams that pass to feet, pass backwards, switch sides and maintain possession, but these are rare. Very, very rarely do you see lethal strikers who can make a shot out of nothing. In other countries and leagues, they are common. Why?

Klinsmann, in his own words, has said publicly that the U.S. has not found its soccer identity and it may take years to do so. He cited our university system as being completely disassociated from professional player development, which is different from many countries. Klinsmann, because of his German pedigree from Stuttgart and Bayern Munich, has immaculate technique and great vision and field sense. Can he help the U.S. define its style? Can he work with limited talent, without the control over any of his feeder systems? His coaching tenure at Bayern Munich ended in mutual frustration after one year. I hope he does well for our country, and I think that Bob Bradley did a very fine job and fielded a team that wore our colors well.


Japan Pulls Together: For Now

Japan has 19 of its nuclear reactors off-line on March 10th, according to the Wall Street Journal. Today that number has doubled, which I believe is higher than any observers initially estimated. Electricity to Tokyo is down 20%.

If anyone owns an international mutual fund with Japanese holdings, most of them have behaved as if the holdings were marked down to zero. Brokerage companies in Tokyo would not be able to do business without power, the thinking went. Instead, peak consumption in Tokyo is 23% below last year, according to the Journal, in a hotter summer. Japanese stocks are broadly back to their pre-crisis levels, according to the Journal story. All of this comes from the same kind of social pulling together that occurred in New York, post 9/11, and which is also characteristic of the Japanese social contract. If you've read this blog on these issues, it's no surprise.

While this is encouraging, some of the ongoing debate is not as uplifting. Like Germany, there is a growing sentiment in Japan to completely and immediately wean itself from nuclear power. The blame for much of this sentiment can be laid at the doorstep of the industry itself, because of its poor communications, stakeholder relations, and too cozy association with business lobby groups. That can be fixed, but will it?

In the short run, Japan is said to be firing up decommissioned coal and natural gas capacity. Japans is already the largest importer of thermal coal, which is the worst fuel from a greenhouse gas emissions standpoint. Japan is also a very large importer of LNG, and this fuel is environmentally preferable to coal. Both of these measures are short term, however.

Completely shutting down the nuclear sector, and increasing renewables, particularly solar, will have significant costs. Hopefully, these issues will be more reasonably and rationally debated in Japan, as opposed to our "get out the machetes" politics. This is where the Japanese political leadership will be challenged, now that the people of Tokyo have done their part individually and collectively to meet the challenge of reduced power supplies.

LNG is relatively cheap now, and the yen is relatively strong, so perhaps there is a way to increase imports and stockpiles of LNG in preference to coal. Both GE and Siemens have dual fuel, high efficiency power plant turbines with modular designs which might have decent economics when compared to the hybrid alternative of shutting down nuclear and substituting thermal coal. Chinese solar panels are in plentiful supply, if analyst reports are correct.

Shigeru Ban has advised Japan to start rebuilding housing quickly,with cost and energy-efficient structures that respect the landscape. On the energy front, our advice would be similar: a little bit of thought about long-term implications, but pull together and fix the problems with solutions that work economically and environmentally.

Thursday, July 28, 2011

Debt Fixes and Recession: Not The Problem

A New York Times blog has taken the blatantly political position that debt limit or spending reduction "fixes" could be what tips the economy back into a recession. Think of the economy as a house in which the two elderly residents have been slowly asphyxiated by a gas leak. As they lie moribund on their living room floor, a tornado comes and destroys their house crushing the poor couple. They become casualties of the tornado, as reporters on the scene show. Got that? Does that make sense?

The demise of the American consumer sector was a long-time coming, and a confluence of forces were at work. The same Times blog reported that the 2008 Census data showed median household income actually fell in the decade to 2008. This is a fundamental, secular problem, working slowly and insidiously like a poisonous gas. With interest rates low and the housing bubble growing into the Goodyear blimp, consumers filled the gap with both secured and unsecured credit. The latter, as we all know, is especially toxic when it is supercharged with absurd fees of all kinds that bear no relation to the issuer's cost of funds and a normal profit margin.

The tornado raging through town was of course the 2008 global financial system meltdown, which destroyed consumer's residential equity, and subsequently turned a decade of stock returns into a big zero. This had a catastrophic effect on consumer balance sheets. Another unfavorable secular trend built into this period was the rise of the Chinese mercantile machine, into which U.S. corporations were only too happy to feed domestic jobs, which further hampered the real hourly earnings of workers who who were able to maintain their jobs.

The chart below, which comes from the Minneapolis Federal Reserve Bank's research presents an "autopsy" on the American consumer household:

U.S household debt
Both the debt-to-assets ratio AND the debt-to-income ratios are still near their all time highs more than two years into a recovery! The current recovery is the weakest by far in terms of consumer financial measures. The current recovery is shown by the two tiny drops in the debt and income ratios. Typical recoveries are characterized by very sharp rebounds off the lows, driven by strong real fundamentals like rebounds in housing, autos, consumer goods or new orders. This one takes us into dark territory.

It was laughable when the stock market run began to see commentators trumpeting "consumers have repaired their balance sheets!" We also know from corporate earnings reports, conference calls, and the financial press that companies are still generally loathe to expand employment, and even a small bounce in temporary workers has flattened out.

Monetary policy has been out of bullets for a while. QE-V won't cut the mustard for this problem. Of course there have been repeated FedSpeak comments about "fiscal stimulus," while also talking about the need to tame deficits in order to placate the investor gods who brought us into this mess through the shadow banking system.

Fiscal stimulus--short of a New, New Deal--would have a marginal impact on the deep, and broad-based pain felt by millions of households, and embedded in the above graph. Both parties need to stop posturing and worrying about their own 2012 reelection issues: show some leadership, please!

Tuesday, July 26, 2011

Debt Crisis: I'll Huff and I'll Puff

I hate to bring this up, but the minute-by-minute, mind numbing countdown to the debt ceiling expiration date reminds me of the Y2K commentary, printed in respected sources like the Wall Street Journal, telling of nuclear power plants melting down and planes falling from the sky as their internal calendars couldn't deal with the new millennium. As I recall, absolutely none of that folderol came to pass.

Let's say rating agencies downgrade after multiple warnings. Wouldn't the warnings, like those of the wolf, already be incorporated into prices? If the world were to suddenly divest itself of Treasuries, where would the funds go? There aren't enough German bonds, Swiss francs, or instruments-du-jour to go around. Letting the debt ceiling expire is not equivalent to the real possibility of any Treasury holders not being paid. Traders will make money. The average investor will get whip-sawed by her broker.

Tom Simons of Jefferies notes that the most recent 2 year Treasury Note auction was "well bid," and that "in a perverse sense, Treasuries have become a form of insurance against their own downgrade." Have a cup of tea?

Monday, July 25, 2011

Copa America: Teamwork Prevails Again

Uruguay beat Peru 3-0 in the Copa America final at the Monumental in Buenos Aires. This was to be the South American Championship when Argentina's soccer team, playing as the host nation, would beat arch-rival Brazil in a final, powered by two-time World Player of the Year, Lionel Messi.

Alas, this perfectly crafted media script was torpedoed by realities that have some parallels in the business world. Messi is a wonderful player, and he thrives in a Barcelona culture and system in which he grew up as a youth academy player. At Barcelona, he is surrounded by players who have all bought into the system--make yourself available to receive a pass, receive the pass, pass to the feet of a player in space, repeat--and execute flawlessly. With Xavi and Iniesta, he has two of the finest midfielders in the world who are always looking to give a killer pass that will spring Messi into space. Messi has freedom to roam, and his job is to finish when he gets the ball in or around the box.

Unfortunately, take a wonderful player and put him in a team of All-Stars, which is what a national team is, and it's not clear at all that he can perform. Would Steve Jobs make a difference turning around Yahoo? Probably not. He wouldn't have the assets around him and the culture that everyone has bought into that would help him succeed in the particular environment of Yahoo. Mr. Jobs too might not be interested in adapting himself to something so different as Yahoo would be compared to Apple.

So it is for the teams of Argentina and Brazil. Brazil looked positively awful in the Copa. A team of aging stars coupled with immature, but talented youngsters who don't understand how different the world tournament environment is and who react by showing off useless tricks. What's the reaction of the national football bodies in Argentina and Brazil to the poor showing? Hint: change the CEO. The Argentina coach is said to be on his way out, the second in a very short period of time. Brazil's coach will probably change soon, but not until some further defeats.

Changing the coaches and bringing in a new management team can't address the fact that (1) the best players make so much money playing for their clubs that playing for their countries doesn't carry the honor that it did for players like Maradona and Dunga, both of whom captained World Cup winners and managed their country's teams. The second reason is that typically players don't play the same positions for their country as they do for their clubs. So, they play out of position in a system that they generally don't understand, and everyone player has a slightly different personal agenda than that of the team.

How many management teams have you seen that would fit this same list of problems? It is interesting, and very instructive for someone who is a coach. A coach who can solve this problem would have to command respect, be a teacher and a supreme motivator. Often in short supply.

Kudos to Uruguay and their wonderful attacking tandem of Diego Forlan and Luis Suarez, now of Liverpool. They continued their great World Cup partnership, and backed by a solid midfield and the traditional, steely Uruguayan defense, it was a difficult assignment for Peru.

Friday, July 22, 2011

Ecolab Grabs For The Brass Ring

Ecolab's management seems as if it may have timed the financial markets well in order to make a very strategic acquisition of Nalco Holding Co. ECL has always carried a premium P/E and EV/EBITDA compared to its peers because, as Credit Suisse points out, it has high returns on invested capital and relative earnings stability. With its equity valuation high and corporate cost of debt low, ECL can handle paying $3.8 billion in stock, $2.7 billion of net debt, and $1.6 billion in low returning cash, for a total consideration of $8.1 billion.

Nalco's business is in three segments: Water Services, Paper Services, and Energy Services. All of these businesses are really problem solving solutions for the customers, which involve chemicals, products like filters and the like, and a high touch level of service to solve a unique, often site-specific problem. Water Services are said to be a $6.4 billion global opportunity, of which Nalco says it has a 20% share. Likewise, Energy Services are said to be a $5.6 billion global opportunity, of which Nalco says it has a 30% share. Paper Services are a $6.7 billion global opportunity, of which Nalco has an 11% share. The jewels for ECL are clearly Water and Energy.

Nalco has historically aimed at a corporate target of 5% real growth. In some years, this has been north of 7%, while in other recent years it has been 2%. Although the equity analysts talk about lack of predictability, a GDP-like real growth rate in what was once a commodity business isn't bad, provided that the acquirer can realize revenue synergies, access new customers, and take significant costs out of the combined operations.

Naclo management gave itself a target of $75 million in annual cost savings from streamlining its operations. Nalco recently embarked on a hub-and-spoke operation for its water treatment offices in the Midwest in order to squeeze smaller, local and regional competitors. This build out can probably be stopped or reversed to fit into Ecolab's structure, depending on the most efficient way to serve the new customers. Nalco also looked to enhance its sales people's offerings by partnering with companies like U.S. Filter and Johnson Diversey. These partnerships can either be scaled up, or rationalized with Ecolab's partnerships. Buying power is now substantially enhanced. ECL management is looking for $150 million in synergies, of which $30 million are said to be gained in 2012. If Nalco's targets of $75 million were real, then the $30 million should be a slam dunk.

These businesses are ALL about the sales force, the product offering, and the service culture. Whether this acquisition works or not, the rubber will meet the road in how well Ecolab's management teases out the best in both organization and about how quickly it can squeeze the obvious inefficiencies out of Nalco's sprawling organization. Both companies are global companies too, so there may be even more synergies in combining the best of the organizations in developed and emerging global markets. Like Exxon's entry into the gas markets by acquisition, this one looks like it has a lot of potential to add value for Ecolab shareholders, notwithstanding some short-term downgrades to analyst opinions.

Thursday, July 21, 2011

June Index of Leading Indicators

The June Index of Leading Economic Indicators was up 0.4% compared to the consensus estimate of up 0.2%. What drove the increase was not reassuring, namely the steep yield curve and the M2 spike at the end of June. However, the magnitude of the boost from M2 is troubling to me. An increase of $76.9 billion for the week ended June 27th, and an increase of $88.6 billion for the week ended July 4th. According to the Money Market Economics group at Jefferies, these are the third and second biggest increases on record. The biggest increase was the $176.3 billion mainlined into the system on the collapse of Lehman Brothers in September 2008. We are well into one of the weakest recoveries on record now, so traditionally monetary stimuli would have been switched off long ago.

Some commentators noted that some of the fundamental indicators were affected by weather and other issues. This is clutching at straws. Absent the push from both M2 and yield curve slope, the index would have declined.

It is very hard to see what drives economic growth of 3-3.5% in the back half of 2011. Whatever growth does occur would not seem to be strong enough to move the employment numbers. A real danger of stagnation at low levels of growth exists. It also appears that inflation pressures from the real side of the economy are minimal at the present time.

The market is up today, though, as it searches for particles of light with a Greek "resolution," whatever that means.

Monday, July 18, 2011

Sawa Leads The Nadeshiko: Omedetou!

Homare Sawa wears a number 10 on her jersey (she is second from the left in this BBC picture). Her influence on the Japanese team reminds me of Michel Platini, when he skippered the great French sides in international competition. He controlled the ball and held it in tight traffic, then looked to find the right team mate with a perfect pass, and he inspired his team, even when the "ball was not rolling" for France, as he would say.

The U.S. tactics in the first half were spot on: four at the back with two holding midfielders all pressed a high line, squeezing the Japanese midfield and denying possession and time on the ball. The American wide players were free to press forward wide on the flanks and cross into the box against a shorter Japanese defence. It worked superbly, and the U.S. should have been up at least 3-0 in the first half except for the stellar goalkeeping by Kaihori and some poor finishing by the U.S.

Sawa's response was that of a leader: she rolled up her sleeves and took command, by doing what was necessary. She dropped deep into her defensive half and tackled several U.S. players on the bye-line, preventing them from turning the corner on a beleaguered defense. If the U.S. kept up the pressure in the midfield and continued to attack and finish in the second half, the game would have been killed off.

Instead, the U.S. chose to sit back, allowed space in the midfield, almost inviting Japan forward, hoping to hit them on the counter attack. This drained all the energy from the U.S. team, which lost its sense of urgency. Sawa now returned to the area around the center circle and started spraying passes forward. As I tell my 5' daughter, height doesn't matter when the ball's played to feet and does the work. Sawa was unlucky not to get an assist, but she did score the tying goal and won the Golden Boot for the tournament, somewhat unusual for a midfielder.

Meanwhile, the U.S. defense became inept in front of Hope Solo, failing to deal with balls early and making clumsy challenges while also clearing balls across the face of goal. This is a major No-No. and it led to a goal. The Japanese players were all smiles after their pre-penalties huddle with their coach. I would like to know what he said to them. The smiles meant they were relaxed, and their kicks showed it. The U.S. team's Carli Lloyd's jaw was tense and her mind was telling her to rip a hole in the back of the net: instead, she skied it into the stands. My daughter is one of her club's penalty takers, and she knew the outcome before the run up. None of this is cosmic or indicative of a higher power at work. It's the subtle shifting of dynamics in a game involving twenty-two players on a huge field. In soccer the players on the field make the choices and the mistakes, not somebody wearing a Motorola headset and holding a clipboard. That's why it's a great game--it belongs to the players, not to upper management.

The U.S. team should be proud of their play, and they were deserving finalists who played with verve and tenacity. They will learn and get better. The Nadeshiko, however, are a real team of individuals with commitment to a common cause. Homare Sawa is not a star in American terms, but a real leader and a great player. And, she got the job done.

Sunday, July 10, 2011

South China Sea: A UN Framework Foresaw Issues

China has taken dead aim on territorial claims in the South China Sea, which run into often conflicting claims by the Phillipines, Malaysia, Vietnam, and Brunei. The Third United Nations Convention on the Law of the Sea established workable concepts for territorial seas, exclusive economic zones, and a framework for waters under international jurisdiction, including special arrangements for straits which were key for international commerce. The U.S. Coast Guard, Merchant Marine and Navy were all on board with the treaty.

Unfortunately, the foolish Republican, neo-isolationists and a handful of American multinationals, many of which are out of business now, got together and decided that the LOS treaty was not something the U.S. needed or should accept. Predictably, in the South China Sea, territorial claims to outlying islands define the outer boundary from which territorial seas and EEZ's are defined. Without a global framework agreed to by all the major powers, China has seized on the notion of signing individual side deals with the smaller ASEAN players. This is not in the interests of these players nor those of the international community, but it's difficult to see how this gets resolved now in a rational, economic way.

What's at stake here? Potentially rich resources of natural gas, for one. Although the inferred resources need quite a bit of proving out, gas resources are said to rival those of Qatar. Other potential subsea mineral deposits have also been identified in the South China Sea. Secretary of State Clinton can try the Kissinger shuttle diplomacy tack here, but we have no leverage at all. China has already taken the position that any compromise on their claims to outlying islands, which they say date back to 1947, represents an attack on their sovereignty.

Not signing the LOS treaty didn't seem like a big deal a few decades ago, but it was truly an impotant opportunity lost, and we'll eventually find out what some of the costs are in the South China Sea and in other areas.

Thursday, July 7, 2011

Corporate Governance: Nothing New

McKinsey's Quarterly Survey of Corporate Governance shows interesting comparisons with the same poll taken in 2008, before the collapse of Lehman Brothers. The results should be disappointing for shareholders concerned about board effectiveness.

44% of the respondents say that their boards simply review and approve the strategies proposed by management. 58% of the board members responding said that their knowledge of the company's current strategy was lacking. Roughly the same percent said that their knowledge of the value creation process, company risks and industry dynamics were also lacking.

Have the boards been spending more time on issues? Afraid not. The amount of time spent on strategic issues was about 23% of board time in 20111 versus 24% in 2008. The amount of time spent on talent issues was also roughly unchanged in 2011 versus 2008, at 10% vs. 11% of board time spent on the company.

In order to make things better, board members felt that more time should be devoted to board work, and that a better mix of skills and knowledge should be brought into the board rooms. They also called for "better people dynamics that enable tough, constructive boardroom discussions." Instead of focusing on long winded, uninformative C,D&A and prattling on about sustainability, investors need their boards to work on the fundamental activities which comprise the fiduciary duties of boards.

Wednesday, July 6, 2011

Unconventional Gas: Getting Out of Balance Fast

There's no doubt that natural gas is a much better fuel for electricity generation than coal, particularly if we are serious about safety, land and water use issues and about greenhouse gas emissions. Lately, though, the whole discussion has become a rush to unleash drilling in the U.S. for unconventional gas. In the course of the policy discussion, for which our legislators are severely over matched as usual, a number of half truths have been uttered by the industry.

First of all, let's define what we mean by the term, unconventional natural gas resources. We mean tight gas sands, coal bed methane, and gas shales. Methane hydrates are a scientific research curiosity at this point and are not in our use of the term.

It is universally accepted from a geological point of view that unconventional natural gas resources occur in a much more complex and challenging environment than do conventional gas resources.

It is true that North American producers have had roughly five decades of experience producing natural gas from shale. However, this production has generally been at relatively low levels, and it has occured in shallow, fractured shale formations. The experience is not indicative or instructive of what will be encountered in the high volume production of shale gas from deep, low permeability formations like Barnett, Marcellus, Haynesville and the Horn River. The technology to drill is there, but the industry's experience in these kinds of formations is relatively limited.

There has been legitimate concern about the presence of methane near drinking water supplies which are within the northeastern formations. Industry experts, perhaps rightly, conclude that there is no direct association with deep drilling for shale gas. However, it is curious that there are no other obvious explanations for the source of the methane either. We've had a similar occurrence here in Minnesota, in terms of finding methane contamination, and it has been attributed to unauthorized chemical dumping by a manufacturer decades ago. The case for explaining this occurrence is not clear either.

Broadly speaking, according to IEA projections, the US and Canada would be relatively self-sufficient in natural gas in 2035, on the assumption that shale will grow to account for one-third of North American production by then. Natural gas imports will fall from about 10% of supply now to 6% in 2035. Oddly enough, total greenhouse gas emissions from our energy portfolio increase slightly over the forecast period, because the strong growth in unconventional gas production comes at the expense of coal (good) and nuclear (not so good).

The worldwide oil and gas industry knows all about producing hydrocarbons in all kinds of deep water and hostile environments, but that experience has been forged over fifty years or more. On the knowledge curve, for unconventional gas from deep shale formations, the industry has a lot to learn yet. It shouldn't put drinking water supplies and public health at risk by claiming otherwise. Universities, research institutes, the industry, and government agencies need to work together to birth this new energy source in a responsible manner.

On a side note, the sudden, capricious decisions by the governments of Germany and France to scuttle their nuclear industries mean that by 2035 they will be much more dependent on gas imports probably from Russia by pipeline and from Qatar by LNG. This may create balance-of-trade issues as well as heighten security concerns in the future.

Tuesday, July 5, 2011

Rare Earths in Pacific Ocean : Don't Get Too Excited

As much as US companies and policy makers are concerned about Chinese export controls on rare earth elements, a WSJ story about Japanese identification of deep-sea muds containing rare earth elements in the Pacific Ocean is not something to get excited about.

Early in my professional career, I headed up a team at the United Nations which helped fund, coordinate and aggregate international research on the geology and economics of subsea minerals, including managanese nodules, subsea massive sulphides (SMS), and subsea muds. A member of my team now heads up the International Seabed Authority as its Secretary-General. This was a heady, exciting time as worldwide science and engineering teams from many countries opened up a new frontier for potential mineral resources.

Unfortunately, international politics, economics, and price declines of key minerals from terrestrial sources all led to the promise of these subsea resources being postponed. The potential is a lot closer now, but we still don't have a real production operation to use as a data point. The Japanese subsea muds are scientifically interesting, but of little import beyond that for the foreseeable future.

Nautilus Minerals (TSE:NUS) has developed an SMS site in the Bismarck Sea, within the territorial waters of Papua New Guinea. The deposit is called Solwara I, and it received its final environmental clearance from the PNG government on December 29, 2009. Indicated reserves in Solwara I are 870 kilotonnes, and inferred reserves are 1,300 kilotonnes. Mineralisation of the deposit comprises a matrix of Cu-Zn-Ag-Au as target minerals.

The company had been pursuing a secondary stock offering in Canada to raise funds for the project, but the offering, even with the Canadian investor appetite for smaller mineral companies, was recently withdrawn. The company does have other alternatives, including further investment from strong strategic partners.

The work done on this project has been exemplary, and to have passed the stringent environmental regulatory framework of PNG is a testament to the corporate collaborative culture, something which U.S. extractive industries lack. Capital expenditures for the system from subsea mining to delivery of dewetted ore to the dock is estimated at about $400 million, with operating costs at $64 per tonne. The subsea collection system has been designed by an industry leading company, and a subsidiary of GE's Oil and Gas segment will operate the subsea lift pumping system.

If there is a project to watch to see the birth of a subsea mining industry, this is the one I'm watching. However, markets and economics still prevail, and the public markets apparently still don't quite have the risk appetite to fund this kind of project at attractive valuations for NUS. Stay tuned.

Old Tech and New Tech : Wrong Question.

Today's WSJ continues the quest to reconcile the ridiculous valuations of recent IPO's like LinkedIn with the current valuations of tech behemoths like Apple, HP, Microsoft, Google and IBM. It's the wrong optic, turned on the wrong set of questions.

These two segments of the market have nothing to do with each other, and broadly speaking, the players who populate these markets are operating under different charters. As we've written about before, every kind of investor wants to get in on the circus of a hot IPO. Flipping is the name of the game, encouraged by the underwriters fanning the flames. Once the IPOs are out in the market place, the game changes and a different mix of players emerges, including those awaiting a small pop from analyst initiation reports, presumably at "Strong Buy."

Investors playing in the seasoned tech equities, as we've written about, are the traditional institutional investors, which now include both growth and value investors. However, the newspaper articles quoting pundits opining about "growth" have it wrong also. It's all about returns, and about risk.

Apple, which has doubled its share price in each of the past five years inevitably had to take a pause and even pull back, in relative terms. It had become a cult stock, and everybody knew about iTouch, iTunes, iPad, iMac and about the slew of competitors who could only play catch up. Questions about Apple's leadership succession have to weigh on the stock. If indeed Apple=Steve Jobs, then it's time to head for the exits. Since no other story has been forthcoming, why not take the money and run, i.e. sell the stock and buy something cheaper?

We know that corporate disclosures for post retirement benefit plans have long included projected returns for equities of 8 percent or better. We know that the decade ended 2009 had stock returns of zero for the broad indexes. Now, everyone is rightly saying how can we continue to project equity returns of 8 percent? So, for the sake of argument, let's say that the projected return on equities for the next ten years is 5 percent, without getting into all kinds of complexities like emerging markets for the moment.

Microsoft has a forward dividend yield of about 2.5 %. This means that to get a return of 5%, an investor would have to get only 2.5% from price appreciation, arising from either higher earnings, higher valuation ratios or some combination. Let's say that US GNP grows at 1-2% per year for the next ten years. MSFT should be able to grow earnings, even at the same valuation, at a GNP growth rate or better. Unless, something like a 100 year storm were to hit--like losing 100 percent of its Office franchise or losing its SQL server business. Even in ten years, how likely is this? This is a risk question. I don't know the answer, to be sure, but I also don't know anyone who does, and that includes bloggers, tech gurus and talking heads. So, even if earnings don't come through, and the dividend were to increase modestly, an investor would have a positive return with seemingly little downside risk.

This is the kind of reasoning that underlies the Tweedy Browne comment that Microsoft is "statistically cheap." Of course, they also refer to the fact that the returns on MSFT's consolidated businesses are still enormously high, even with the current P/E of 9. So, the question is not "growth or no growth," but "market or better return" with "below market risk."
This is the value investor's lens, and it's always been a good one, and it is now especially in these frothy times.