Thursday, September 29, 2011

HP Hires Goldman: The Best Defense Is a Good Offense

HP's embattled board hired Goldman Sachs to assist it with anti-takeover defenses in wake of its unparalleled streak of value destroying activities. In a very limited sense, the board does have a duty to be prepared for the appearance of an activist investor, and so the move could be regarded as a good defense.  They have certainly hired the best to help them, but that's as far as it goes.

We wrote in our last post, "Without some fresh air in the board room, it's hard to see how HP becomes anything other than a value trap."  I really believe that the company won't be able to move forward and realize its potential without changing the way it does business both in the market and in the board room.  Putting a poison pill into place, for example, is a knee jerk, mindless alternative usually associated with companies whose fundamental options for creating value are limited.  A pill would also deter some high quality, traditional institutional investors, which are just the sort of investors the company needs now. 

The best defense can be a good offense.  In this case, the good offense would focus on fundamentals, such as definitively changing the company culture, changing the way an alternatively meddling and disengaged board works, rationalizing the company's strategy and portfolio, resetting the business model to focus on customers, raising the hurdles for returns and use of assets, and communicating in an entirely different way with stakeholders.  This is the only place where the company board and management should be focused, and not on trying to head off an activist investor.  HP is big enough that there are few activist investors who would be able to acquire a big enough stake and risk dead money while a turnaround takes place; it could happen, but it will take time, and in that time, the board and management should roll up their sleeves and focus on fixing the culture and the business model.

Hearkening back to my analyst days and thinking about Fluor's decision to put off buying HP computers for its global organization, I decided to talk to some tech repair people about what they thought of HP computers.  Several years ago, I noticed that a lot of tech savvy users carried HP laptops, in preference to Dell and IBM/Lenovo.  The latter manufacturers were classified as "junk," referring to everything from design, to component quality, to assembly and finishing.

Today, the situation seems to have reversed itself in my survey.  HP laptops and desktops were the ones marked "avoid," or "junk."  Meanwhile, Dell and Lenovo have become highly regarded for volume purchasers.  One repair tech was kind enough to take me on a tour of a desktop's guts that he had repaired.  It was a gaggle of cables, some of which were harnessed and some not.  He tried to harness a big clump of cables in the interest of allowing better air flow and accessibility for service.  Slots were poorly designed for boards and cards, which then resulted in poor fit and more heat.  The HP units look like someone built them in their garage.  Talk about fundamentals! 

If this business is to stay within the corporate portfolio, then it needs to be an industry leader, and not an object of ridicule.  This kind of turnaround requires hard work, as opposed to a press release about hiring Goldman Sachs.  Let's hope that HP gets down to business soon. 

Friday, September 23, 2011

HP Sum of Parts Valuation Is No Guide

Analysts who claim that a "sum of parts" valuation of HP at $37 per share justifies a "buy" are whistling in the wind, putting forward numbers without a reasonable basis.  Projections for sales, earnings and cash flow are all contingent on a capable management team, a motivated organization in tune with the strategic plan, and on a board that is itself of one mind and supportive of management and the plan.

As far as I can see, none of these things are in place at HP.  The new CEO comes from a consumer focused company into a technology company trying to refocus on the enterprise business, as different as night and day. She will be learning on the job. Who knows what the management team will look like after defections and reshuffling?  An organization that leaks information so consistently, thereby hurting their own share price is dysfunctional and clearly not motivated to focus on the business.

The sales teams are having their heads handed to them by customers demanding answers, and they have none because the former CEO was so absurdly out of touch. How can they maintain and grow their sales relationships? Sell the PC business: yes or no?  The new CEO has to study the issue, although she was a board member that supposedly signed off on that decision.  What if she comes to a different conclusion upon further reflection? The Autonomy deal can't be broken without major financial damage and loss of focus working on court actions.  How will that deal add value?

The same board is in place, with the same unhealthy dynamics and deeply flawed visions.  Board chair Lane's public flip flops on former CEO Apotheker don't give any comfort about temperament or judgment, and there's the continuing question about how much his position as Oracle's #2 is an asset to HP or a liability.  Oracle's poke in the eye to HP by hiring Mark Hurd was great PR grandstanding.

This kind of strategic, communications and governance debacle at HP is usually reserved for micro cap companies or for companies that are quasi-public, i.e. controlled by a family, an entity, or by an uber CEO.  For a company of HP's size, this should generate years of business and law school case studies.

Value investors looking at HP won't get an extra reward for being early, because so many of the risks are unknown at this time.  Technicals and noise trading should dominate the stock in the near term, Time is the friend of a new, fundamental investor looking at this stock.

Saturday, September 17, 2011

AIG Enterprise Risk Management: Tougher Than It Sounds

             Photo credit: Philip Montgomery for the Wall Street Journal, Online Edition

AIG has a new "risk czar," Peter Hancock, an economist by training I'm happy to see, who heads up the Chartis unit charged with doing "enterprise risk management."  I have yet so to meet a public company director who can describe in concrete terms what this means for their company, and especially so for financial companies.

One of the operational problems generally, and especially for financial companies, is that risk is generated in silos.  An example of a large silo would be proprietary trading, and a sub-silo might be what's called Delta-1, where the latest rogue trader has surfaced at UBS.  Every profit center will have its own system of reporting, especially for the purposes of calculating bonuses and incentive compensation.  Lots of magic takes place when financials are rolled up for the purposes of external reporting.

Since risk is being generated in large numbers of relevant silos, how can a person at one desk look at a chart, report, or dashboard and monitor risk on an enterprise-wide basis?  I don't believe its possible for an investment bank, which is why we've had rogue traders since way in the early days of MBS trading in 1987.  Howard Rubin generated $377 million in losses which were not discovered until he left Merrill Lynch, and somebody found the unreported trade confirms in his locked desk drawer; he was banned from the industry for nine months and eventually joined Bear Stearns.  Joe Jett was another prominent "profit center" for Kidder Peabody who created some fictional profits of $350 million and paid himself a $9 million bonus before being discovered.  A Japanese trader for Royal Dutch Shell lost $1 billion in unauthorized commodity trading.  Nick Leeson was a recent example who lost $1 billion for Barings, and apparently Kweku Adoboli of UBS has hired Lesson's attorney to defend him in his court action. Sounds like a prudent move for the trader.

The point is that rogue traders are nothing new, and the ones in the news are really a subset of those who are out there and undiscovered, or who had big exposures that reversed themselves before they were found out.
Bonuses, like those that Joe Jett generated for himself, are done in the profit centers themselves and on a basis that is too fast for any effective risk management, except well after the fact.

Managers in the profit silos will complain to risk czars that rigorous systems of oversight and reporting will negatively impact their ability to recruit superstar trading talent.  Guess which side is going to win this argument?  Not somebody like the man in the picture above.

Now AIG is supposedly a simpler business than before, with the demise of their specialty financial businesses.  If this is true, and it has gone back to its traditional  insurance and reinsurance businesses, then it might be possible that a risk management system could be devised and operative.  I can't conceive of how this can be done for a traditional global investment bank.

Dodd-Frank does not give any degree of comfort. Banks will have to divest their prop trading desks, but the problem is that nobody can agree on what constitutes a prop trading desk.  Witness the confused discussion on whether or not Adoboli's Delta 1 desk constituted a prop trading operation, or one that worked on behalf of UBS clients!  The more things change, the more they remain the same.

Wednesday, September 14, 2011

Best Buy Gets Yellow Tagged

Best Buy shares have gone on a yellow tag sale, as their price has fallen 32% year-to-date.  There is some good news for shareholders, namely in the current maturity cycle for their stores and without any significant plans to expand retail footage, the stores are throwing off cash.  Sales growth, however, is another story.

I've followed this stock from its early days when it was forecast by Wall Street to expire under pressure from the now defunct Circuit City.  I made money for my customers several times during the stock's short cycles.  However, in recent years, it has me scratching my head.

I can't answer one basic question: "Why would I get in a car and drive into a Best Buy?"  Music, which was a great traffic draw and a source of impulse purchases, has come and gone because of the revolution in how music is sold and enjoyed.  The appliance section, despite all the corporate best intentions, still seems out of place in the store and uninviting.  Sears is still the top of mind destination store for the top brands and Kenmore.

The service experience, which has had its ups and downs, is on a down cycle.  In some stores, the only person who ever says anything to the customer is the security person at the door who says, "Goodbye."

Televisions have been commoditized and subject to everyday discounts and sales by players from Target and Costco to Office Depot and Kmart/Sears.  The Magnolia store-within-the store usually looks like tumbleweeds are going through it.  Computers are about as exciting as toasters.

Some retailer used to have an interesting tag line, "What do you want to do?"  Maybe that's the pitch for Best Buy.  Solve the customer's problem by packaging the best-in-class product and service options for, say a mid size flat screen TV with good sound that can double as a computer screen for my son's Xbox and streaming NetFlix.  Perhaps the store could even guarantee the "lowest price" on the bundle, which of course will never be put to the test.  Throw in some freebies from smaller vendor-partners looking for exposure.

The problem is two-fold: no compelling reason to go the store, and an unmemorable customer experience when you go.  Lots of stores are struggling with the first aspect, and Apple's retail stores have mastered the customer experience part.  Until these problems are worked out, the same-store sales decline, absent significant new technology introductions, will continue.

Monday, September 12, 2011

The ECB Built the Euro On A Shaky Foundation

I found an interesting ECB press release form 1999, in which  Tomasso Padoa-Schioppa, a Member of the Executive Board of the ECB talks about the founding and construction of the European currency.  The discussion is all from a central banker's perspective, and the "primary objective assigned by the Treaty.." is "price stability."  This is to be achieved by a coordinated lowering of interest rates and target growth rate of 4.5% for M3.

What's really curious about this release is the lack of any reference to the financial markets and their role in setting the value of the euro.  The oblique reference to fiscal harmonisation presages today's issue.

"The situation (stability of prices and interest rates), however, would change if the currently perceived risks of fiscal relaxation in Europe were to materialise. The European policy mix might then become unbalanced, and market developments could adversely affect long-term interest rates and the exchange rate. These risks should be considered carefully when assessing the stance of fiscal policies. Reducing deficit and debt levels must therefore remain the objective of European governments, in particular where the public debt is large. This is a pre-condition for a balanced policy mix, one that will keep interest rates low and make the euro a stable currency. You may say that this is the traditional central banker's argument. Yes, it is; but that does not mean that it is not valid."

There never was any incentive or regulatory mechanism for member countries to keep the fiscal policy mix stable.  It was hopelessly naive to have assumed otherwise.  Governments cannot cede sovereignty over fiscal policies to bureaucrats in Brussels, so it still is huis clos.

The market's taking a hatchet last Friday to the share prices of the supposedly stronger European banks was ominous.  Again, the rating agencies went from having their faces splashed with Canoe for their bravado in taking the U.S. credit rating down, to having their faces covered in egg, as they chase the ambulance on the euro.

As we said back in June, the Greeks hold the cards in the short-term in this crisis, which is why it took until September for things to come to a head.  Now that the markets have awakened from their stupor on the euro, there is no really attractive option on the European table which is politically palatable.  In the US markets, meanwhile, it is the spectre of the 2012 elections that is forcing at least some political posturing on our own budget deficit woes. 

Thursday, September 8, 2011

Fed Has No Magic For Unemployment

Chairman Bernanke's suggestion that the Federal Reserve System has tools available to address extraordinarily high unemployment rates goes against basic economics, whose mechanisms are described in the web sites of the Fed's own Regional Banks, such as the Dallas Fed to pick one of many.

It isn't a matter of dissent for Philadelphia Fed President Charles Plosser to say, "I am really doubtful that monetary policy is a tool that is going to help us very much."  It's basic economic theory.

An operation to effect a twist in the yield curve won't help employment, but it will help Wall Street trading desks, bond funds, and corporate treasurers, folks who don't need more candy.  Mortgage rates are already at 4%, and housing is still on life support because only the top tier borrowers get the published rates.

Monetary policy has already created extraordinary support for mergers and acquisitions, dividend increases and share buybacks.  Witness, for example, Ecolab's strategic entry into the water and energy businesses through the acquisition of Nalco.  Ecolab's $2 billion in corporate debt refinancing is being led by a strong syndicate of banks, and in addition Ecolab announced a $1 billion share repurchase program.  Liquidity and access to credit in investment grade corporate markets is not an issue for monetary policy.

We may be soon hearing about large corporate downsizing from companies like Bank of America and Yahoo, if the latter were merged with another competitor.  None of these decisions will be affected by a manipulation of the yield curve by the Fed.  More small bank failures add a steady stream to the unemployment pool.

Unemployment in traditional economic terminology is frictional, cyclical or structural.  Following the global meltdown and the weak recovery, we have the worst of all labor market worlds.  Structural changes have been underway for many years due to China's mercantilist policies and our ceding ground on both light and intermediate manufacturing.  Cyclical forces will come into play once again if the economy falters in the fourth quarter. Finally, there is no appetite for corporations to add workers, especially with tepid sales growth and little pricing power.

A highway infrastructure program will certainly help unionized trades, which is probably a good Fall election time strategy, but it won't help the tens of thousands of people, from several generations, that are on line at job fairs, seeking employment in corporate America.

EU and Euro Are Still Not Out of the Woods

Germany's high court ruling saves face for Chancellor Merkl, but it isn't a resounding endorsement either.  It's unclear to an English speaking reader what the basis was for rejecting the constitutionality of the German government committing taxpayer funds to sovereign bailouts.  However, it does require that the Chancellor seek approval from the parliamentary budget committee before taking on future obligations, as opposed to the current practice of notice after the fact.

Again, there is an element of pragmatism in the high court's directive to go to the budget committee as opposed to the full parliament, which would have meant gridlock and political grandstanding.  In reflecting this pragmatism, the German courts seem vastly more enlightened than our own.

What happens from here?  The pressure will continue to mount.  Finland's demand for its own dedicated collateral in exchange for participating in the current bailout commitment is still on the table, unresolved.  If the Finns back down, they face political issues at home, while if they are accommodated, the flood gates open and the deal falls apart.  The weaker players are currently being subsidized by the ECB's buying of their bonds, supposedly to keep credit spreads narrower than they otherwise would be.

What awaits them down the road?  Greater austerity and fiscal oversight from the EU.   For Italy, this seems like an unacceptable bargain for the shrewd Italian P.M. Berlusconi, whose balanced budget bill requiring a constitutional amendment is on the table today.

There is simply no significant sentiment behind fiscal harmonization in the EU, and any leader from a peripheral country who dared to back the concept would probably be ousted in a snap election.  Failing fiscal harmonization, the ultimate owner of systemic risk in the Eurozone would be Germany.  Do they want to be in that position?  I think not.  Stay tuned.

Wednesday, September 7, 2011

Banks Need To Get Smaller

Watching Bank of America's management take continuing headers on banana peels, I thought it a good time to pull back and think again about governance issues and the banks.  I still can't get away from the fact that the banking sector needs to de-concentrate and get more competitive.

Ironically, as we are rightly bemoaning the anti-competitive aspects of ATT's merger with T-Mobile, we seem to have accepted a more anti-competitive and systemically dangerous concentration of assets among the remaining mega-banks.

I'm going to walk through an interesting survey paper by Mehran, Morrison, and Shapiro of the New York Federal Reserve Bank, Staff Research Report 502, "Corporate Governance and Banks:What Have We Learned From the Financial Crisis?"  I think it more instructive than wallowing in the reality show that seems to be the financial news.

The governance of public banks is more complicated than for non-financial companies because of (1) the multiplicity of stakeholders, and (2) the complexity of their business portfolios, which include traditional banking, investment banking, and proprietary trading.

Bank stakeholders include depositors, debt holders, shareholders, and the government, both as the provider of deposit insurance and as the holder of systemic risk in the event of bank failure. Even though bank capital structures are about 90% debt, as opposed to 40% on average for non-financial corporations, shareholders with their thin layer of equity are given primacy in strategic, business and governance issues.

The authors look as debt as a financing decision for non-financial corporations, whereas they say it is a "factor of production" for modern banks.  Deposit insurance, despite attempts at improving the system, is still essentially a fixed price insurance, and not risk-based in pricing.  I don't believe that any part of the current bogus financial reform has changed this feature, which would put any traditional insurer, but not the Federal government, out of business.

Shareholder primacy has led to executive compensation schemes that are heavily weighted to short-term rewards, which encourage imprudent risk-taking.  They note that from 1996-2007, 29% of the options issued to the top five executives of banks surveyed vested in one year.  According to the authors, "Since 2006, CEO's in the banking sector have had the highest pay of all the executives in the economy."  This is turning anything like traditional economics on its ear.  It makes no rational sense.  The final ignominy: none of this higher incentive has led to better share price performance.

The authors diligently search for better compensation metrics.  They suggest that a metric for CEO's should be related the CDS for their corporation, but this seems subject to too many random elements, and it has not been shown to be a market price with high informational content.  A better idea would be to have a higher percentage of the CEO deferred compensation at risk for bank failures or rescues.  The operational problem would be when the CEO's lawyers and the corporate lawyers draft up what constitutes a failure or a rescue, accounting for every contingency.  Maybe more research would be useful.

Risk management, they find, is typically separated by product line or by organizational lines.  Boards are not able to give an acceptable band of risk taking for the corporation as a whole.  Compensation for key management is all about attracting and retaining, the marketplace never talks about risk management in compensation or in management objectives.

The authors think that regulatory capital can be a substitute governance tool, but I wouldn't be optimistic about it being a sufficient one.  They point out that much of the new capital raised by banks has been through hybrid instruments like preferred stock. This is before Warren Buffett's "trick or treat" with Bank of America.  Rather than raising common equity, because of  low stock prices resulting from their own mismanagement, managements continue to pay dividends and give away free equity kickers to preferred holders.  The authors note that this has overturned the primacy of debt holders despite their being 90% of the capitalization.

The much ballyhooed Volcker Rule has been substantially watered down in both Dodd-Frank and in the Consumer Protection Act of July 2010, which means that the banks will continue to remain systemically important and susceptible to requiring bailouts in the future.  It's not a pretty picture for governance making the sector better, or for learning from our mistakes.

Sunday, September 4, 2011

Taxing High Frequency Trading

A "click tax" on high frequency trading would be a very good idea, if for no other reason than being a controlled experiment.  The Wall Street Journal has a convoluted story about the idea, where it gives space to the conflicted, self-interested apologists for HFT, who are laughable in their special pleading.

The market for large capitalization stocks is very efficient.  If you follow the activities of the Yale University endowment, you can read this opinion in their annual reports on the fund, so I don't think this is a controversial position.  Small capitalization stocks would seem to have less market efficiency, which accounts for the approach of Dimensional Fund Advisors and many other funds who argue for persistent excess returns from small cap investing.

Even here, the question is "How inefficient?"  Also, what's the gain to society versus the cost of narrowing the efficiency, and by how much?  As Lord Adair Turner has pointed out in his writings on lessons from the global meltdown, the whole notion of equilibrium models and mechanistically efficient markets was adopted as a cult religion by market participants, regulators, the Fed, politicians and journalists.  Concepts like VaR and credit default spreads proved to be inadequate and misleading running up to the crisis and beyond.  Efficiency as as a be all and end all is also cultish.

An owner of an HFT firm is quoted in the journal as saying that a transactions tax of 0.01% on high frequency trading would wipe out the business.  There we have it: that's all the value that's being added.  It's not worth it.  The Journal then suggests that HFT is part of the constellation that has made it easier for individuals to trade stocks.  Huh?  How so? It's a ridiculous notion. 

HFT significantly adds to volatility, and volatility is what scares investors and encourages them to "buy high and sell low."  Individual investors are now being told by their brokers that trades are justified by movements in VIX, itself a flawed, circular indicator of market health. 

Let's try the experiment.  Implement the tax.  If the industry goes away, let's see what happens.  Will markets freeze up?  Will spreads widen like the Grand Canyon?  I'll bet that nobody will notice except for the folks pocketing lots of money for an activity that doesn't help investors or our capital markets. 

Friday, September 2, 2011

Sunset for U.S. Solar Industry?

The emergence of a U.S. solar energy industry with leading edge technology seemed like a no brainer, especially given the Obama Administration's policy of favoring wind, solar and biofuels with taxpayer largess.  Recent developments reported by the New York Times are not encouraging, "In addition to Solyndra, Evergreen Solar of Massachusetts and SpectraWatt of New York also filed for bankruptcy in August. BP Solar shut down its factory in Frederick, Maryland, last spring. Those bankruptcies and closings represent almost a fifth of the solar panel manufacturing capacity in the United States, according to GTM Research"

Let's try to follow the economic chain on the solar industry.  Oil prices remain relatively high, especially compared to levels that would allow renewables to take a growing share of our energy portfolio--should be a + for solar.  U.S. companies seem to have developed collection technologies that increase efficiency compared to older panels--should be a + for solar.  The federal and state and local governments have been generous with subsidies for renewables--should be a + for solar.  Yet, the solar industry in the U.S. and even in Germany has been retrenching.  Why?

The NYT article also points out the rapid growth of Chinese solar companies, buoyed by cheap state loans and rock bottom labor costs.  Since China still produces electricity predominantly through coal, and since solar has an infinitesimal share in Chinese energy consumption, it seems clear that the growth in Chinese production is aimed at export markets and therefore the loans violate WTO agreements. This seems like a fairly unproductive use of Chinese government loan capital, as there is no significant demand for solar panel installations in the U.S., except for vanity residential projects by hedge fund billionaires or for corporate sustainability advertising by Google on a data center in the Mojave. 

The residential construction market is moribund, and will stay that way for a while as the issue of foreclosures is worked through the system.  Who would rationally put a solar panel into a remodel?  In this market, many traditional home improvement projects, like basements with pool tables and wet bars, are nor paying back.  New construction isn't focused on solar panels as an amenity either. 

The basic calculation is payback, and the payback isn't viable today.  Our city looked at a solar installation on a community center as a demonstration project, and even with some favorable state government cost-sharing, it was a non-starter.

Perhaps the biggest issue is that it's all off the grid anyway.  Again, if the administration is looking for a "moon shot" type of infrastructure project, it should be to rebuild the U.S. energy transmission grid which would benefit  both consumers and businesses.  Then, if Bono were to build his new recording studio in Joshua Tree Monument, he could just plug the solar panels right into the grid and sell his excess electricity to the utility! 

There's nothing wrong with pursuing improvements in solar panels, as it's a logical focus for science and engineering programs, but we should recognize that this source, along with wind and renewables, will continue to be marginal contributors to our total energy portfolio for some time, unless we are willing to accept both significant changes in life styles and higher costs. 

Thursday, September 1, 2011

Maybe the ECB Will Sue Goldman?

Today's WSJ reports on a Goldman strategist's report to hedge fund clients that takes a "head for the hills" view of European banks. The report, according to the WSJ, opines that "as much as $1 trillion may be needed to shore up European banks." This report is not a product of GS's Research department, which is interesting. It also is explicitly tied to trading desk revenues as it offers hedge fund clients a way to implement the specific strategies outlined in the report by calling GS trading. Bearish euro bets are part of that strategy, clearly.

The article doesn't give a link to the actual report, so bear that in mind when reading this post, as I always like to review a primary source myself. GS's assessment of the US economy and recovery is very main stream, and I wouldn't guess that it's too different from that of the economic analysis group.

Apparently, there is a bank-by-bank analysis of capital adequacy of the European banks. I can' imagine that ECB officials will be happy to hear about the recommendations in this report. Hopefully, they won't issue a press release threatening legal action!

As we head into the fourth quarter, and after reading lots of analyst work on banks and currencies, it seems like we are entering another risky period, with eerie similarities to the earlier crisis. What's more, Dodd Frank will provide no protection or improvement in crisis readiness, because nobody knows how to implement its laundry list of mandates.

Brad Sabel and other partners at Shearman & Sterling have done some insightful analysis on these issues. The Volcker Rule, which is a key part of derisking the global situation, is light years from implementation at this point. Similar to the earlier global crisis, we may be in a situation where stress tests and ECB pronouncements show major European banks to have adequate capital, but we won't know who the weak sister is until some external event forces the curtain back.