Tuesday, November 27, 2012

HP: The Elephant's Been In the Room All Along

August 2010:
"HP shares continue to look like a value play, but I suspect that there's a very large, cultural elephant in the room that could slow any transformation into a sustainable, growth story."
 September 2011:

"Here's what's reported in the NY Times about the final process leading up to the selection of Mr. Apotheker as the CEO:
"Before a final vote on Mr. Apotheker, H.P. search committee members again urged other directors to meet him. No one took them up. At least one director, Ms. Salhany, tried to slow the process, worrying aloud that “no one has ever met him. Are we sure?” But her concerns were brushed aside." Without making reference to a duty of care, this is a total abdication of any professional responsibility for a business decision that would be critical, given the recent history of CEO failures and their effect on business under performance.
Now, more shareholder value will be destroyed by paying the exiting CEO, which makes the company even more of a laughing stock.  More important is the fact that a successor will have to make sense of an acquisition for which HP is acknowledged to have grossly overpaid. Integrating Autonomy's corporate culture with the divided, rudderless and dysfunctional HP culture will be a Sisyphean task. The frustration and disappointment of customers, as for example Fluor's CIO saying that HP is "lost now," will haunt the new CEO also.  Without some fresh air in the board room, it's hard to see how HP becomes anything other than a "value trap."
September 2011:
"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. 
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."
August 2012:

"The board at IBM knew that the company was in trouble to the extent that it went to a total outsider as their new CEO, someone who understood the mechanics and language of efficiency and cost.  It's unclear whether the HP board really understands anything. At some point, some of the new investors like Dodge and Cox and GMO should get involved in planning for a significant refresh in the HP board for the next proxy season. 
 Aside from looking at metrics relative to HP history or industry comps, it's hard to make a bull case for HP.  This argument sometimes appears as, "It can't get much cheaper."  Investors who got in at $20-25 felt this way, and we disagreed in prior posts. Unless HP as an organization believes it is in trouble and acts that way, as Gerstner says, then it may be a short-term trade from depressed levels, or a value trap.  Time will tell, and it's very early in this story, with no clarity."

" The Autonomy question still needs to be answered.  Besides the CEO having a digital dashboard (another hackneyed IT phrase) for Autonomy, is this the platform to take HP into the Big Data future?  Any more writedowns?  Some industry types suggest that their sales penetration pre-acquisition was narrowly focused on areas of Internet security rather than on the broader analytics of Big Data.
 Meg Whitman also says for the Times, "I am the the first (HP) CEO in a long time who is from the Valley."  This statement sounds a bit delusional.  Having board members or the CEO from a geographical provenance wouldn't seem to be associated with value creation." 
October 15, 2012:
 "The board of directors that CEO Whitman needs to help her move the company forward is a different one from what is there today.  Now that the CEO has finished the fact-finding, channel checking and strategic reset, she should take on this task because it will be critical, in my opinion, for moving the company away from some of the flawed assumptions of the past which led to the acquisition of EDS and the absurd price paid for Autonomy."
November 1, 2012:
" We've heard good things about the internal bureaucracy busting, cultural changes being initiated by CEO Whitman.  This is akin to taking down a fifty foot oak with a tomahawk.  The new CEO needs lots of help from her executive team, middle management, and her board."
Can you identify the elephant?  Institutional shareholders shouldn't need an ISS report to think about what has to be done to light a fire under this company.  If they remain passive, then they are not acting to protect the best interests of their own fund shareholders.

It will also be interesting to see if the CEO and CFO can sign the fiscal 2012 Section 404 certification attesting to the existence and effectiveness of  financial controls over use of corporate assets and financial reporting.Can the auditors give their blessing again without identifying significant deficiencies?  Billions in value were destroyed while the controls were apparently in place and effective. If this fiction continues, then Sarbanes-Oxley is another example of regulatory form over substance.

Sunday, November 25, 2012

Former NY Governor Pataki Speaks on Smart Grid

The Wall Street Journal has a column penned by former New York Governor George Pataki, who says,

"Damage to substations, poles, transformers and power lines causes most power outages during storms. Even so, improvements to other parts of the grid can protect us against disasters. One improvement would be to expand the use of distributed power generation through fuel cells, microturbines, and the simultaneous "cogeneration" of both heat and power. 
Such distributed power sources have very small installation footprints—fitting even on the roof of a building—and can provide secure power regardless of other outages on the electrical grid. During and after Sandy, cogeneration allowed pockets of New York City (such as the large Co-op City neighborhood) never to lose electricity or heat. Crucially, favorable amortization schedules and tax treatment, along with operational cost savings, can make these power sources attractive investments for building owners and other investors. They can even generate revenue by selling excess electricity back into the marketplace during times of peak demand, a practice known as demand response. 
Finally, the way the Federal Emergency Management Agency works with electrical utilities after disasters needs reform. Under the current system, utilities receive federal emergency funding to replace damaged electrical components only if they replace them "in-kind" with the same technology. This means that all sorts of antiquated components are simply being replaced. This makes no sense. The federal government should promote modern technologies and best practices.
Officials at all levels of government should work to ensure that structures rebuilt after Sandy are more resilient and energy-efficient than their predecessors."           
As a popular, previous post noted, a smart grid should not become something that accommodates all kinds of inefficient energy inputs because of popular green ideology.  Such a grid would be prohibitively expensive and inefficient.  We have the knowledge in our universities and private research institutes to build a grid which is orders of magnitude more reliable, efficient and "green" than what we have.  Let's get going and build it.

Wednesday, November 21, 2012

Dumb and Dumber: HP and Autonomy Dueling PR

So much has been written about HP's fiasco in voluntarily, with open eyes agreeing to acquire Autonomy for more than $10 billion, which had no grounding in any reality.  Here are some concluding observations, ahead of getting ready for Thanksgiving.

  • Autonomy founder Dr. Mike Lynch is a quant and a promoter. As the Wall Street Journal Deal Blog noted, Silicon Valley's iconic deal maker Frank Quattrone shopped Autonomy to Oracle's Larry Ellison and former HP CEO Mark Hurd.  Lynch's protestations to the contrary are laughable and not worthy of someone whose academic discipline revolves around accuracy and precision. Oracle laughed at a $6 billion valuation. Slowing growth and the evolving market cachet on "big data" made the timing right to pitch a sale.
  • Ten out of the current eleven member HP board, including the current CEO Meg Whitman, hired CEO Leo Apotheker, who was clearly unsuited to be the CEO of a mature public company in need of a turnaround.  This same board acquiesced, or perhaps even advocated, the acquisition of Autonomy for the outrageous price paid.  While Apotheker was discharged, there has been no other senior executive management or board accountability for this, and other, value-destroying acquisitions. 
  • CEO Whitman's laying accountability at the feet of an HP strategy officer is unseemly and shows no respect for the intelligence of the stakeholders.  Whatever PR flak suggested this cop out should be fired. Saying that the solution is to now have a different strategy officer report to the CFO makes the board and executive team seem like idiots.  A reporting line in an org chart caused a loss of of $8.8 billion in value?  I don't think so.
  • What about the CFO?  A strategy officer is looking at the merits of entering into high powered analytics through acquisition.  The officer might be looking at product synergies and opportunities for cross-selling. Examining the financials of a target company, looking at its controls and financial reporting practices, seeing how its results would translate into HP, thinking about integration of financial reporting, and making projections about synergies and potential dilution are within the CFO's bailiwick and nowhere else.  Deloitte and KPMG would per force have had to report their findings to the CFO and to the Audit Committee Chair.  The whole strategy officer taking a fall discussion is a red herring.
  • As Jim Chanos and others have done, looking at the 2010 Annual Report for Autonomy raises a lot of questions.  However, looking at the financial statements alone is not sufficient; they have to be read with the notes to the statements, as a whole.  The notes are poorly written and uninformative.  Under these circumstances, the two accounting firms should have been able to uncover the accounting deficiencies now claimed as deceptions before the purchase. The Audit Committee Chair should have demanded nothing less.  Revenue recognition is widely recognized by any finance MBA as a major issue for software and technology companies with multi-element product sales and licensing. 
  • The culture and executive compensation practice at Autonomy should have been another warning sign, quite apart from the financials.  
  • At the HP Analyst Day, an HP executive made some carefully worded, but telling comments about Autonomy.  He said that their processes were not reproducible or scalable.  One of his goals was to bring discipline and process to all their functions, including product development.  These were clearly warning signs of things to come. How were product development issues not spotted in a due diligence process?  
  • Having HP's top lawyer issue a press release about clawing back value for shareholders is not comforting.  Recently, a small cap technology company I'm familiar with did a relatively small investigation into an issue at a foreign subsidiary; it generated $2 million in non-recurring expense in a quarter.  I can't imagine what this investigation is going to cost.  It will also now figure in non-GAAP earnings.  It is going to be an expensive, distracting and potentially embarrassing fight with no net benefits. 
  • As we posted recently, the entire board should voluntarily request not to be renominated for election.  The future board should not be filled with homogeneous Valley pals and insiders. It would be appropriate, in my opinion, for CEO Whitman to voluntarily forgo current year incentive compensation  for her role as a director in hiring Apotheker and in acquiring Autonomy.  In previous interviews, she has said she didn't come back to HP for the job or money, but for the challenge.  Giving back incentive compensation would acknowledge that the CEO wasn't up to the acquisition challenge as a director and that nobody is above being held accountable.  The effect on HP's corporate culture would be breathtaking. 
  • Good things are happening inside the company.  It is time to play the hand the company has now for all its worth and to move on.

To move into Thanksgiving with some more uplifting reading, here's a link to Japanese views on gratitude, as specifically integrated into Morita Therapy

Tuesday, November 20, 2012

Turnarounds and Turkeys: BBY and HP

The Macy's Thanksgiving Day parade is two days away.Wall Street got an early start trotting out some turkeys with today's earnings announcements: HP and Best Buy led the way, for different reasons.

Best Buy closed down 13 % for the day, but it is up a couple of cents in aftermarket trading.  The fundamentals weren't good, but the reaction of the stock seemed more a continuing plebiscite on the turnaround plan and arbitrageurs playing an offer from Dick Schulze, than it was an evaluation of the results themselves.  

The company's CFO Jim Meuhlbauer, who we were told has been at his post for ten years, allowed a very confusing discussion to ensue about gross margin dollars versus gross margin rates.  He made a remark, and analysts asked questions about what he said; then merchant Mike Vitelli seemingly contradicted what the CFO said.  Finally, the CFO noted that everyone agreed.  Since the 160 basis point compression in the gross margin rate was clearly the concern for analysts modeling the forward rate, this discussion should have been short, sharp and precise.  Instead, I'm sure that it confused analysts.  

The issue came back in a different way in the Q&A when Mr. Muehlbauer was asked to give some thoughts about the biggest drivers between what the analyst said was the 130-150 basis point gross margin rate compression over the past two years. The CFO said that the entire margin compression was due to sales mix, which really makes no sense.  

U.S. same store sales declined by 4%, which was affected by the smaller number of stores in the base due to closings.  Online sales of $431 million in the quarter grew by 10%.  Domestic selling, general and administrative expense grew by 15% y-o-y, but adjusted for the sales force training expenses related to the new product launches and for the absence of Best Buy Mobile profit-sharing payments, they were flat.  Not a great performance by any means, but not the end of the world either.

The international business, which has always been undermanaged, saw same-store sales decline by 5.2%, with European sales increasing, while Canadian and Chinese sales declined. Gross margins in the international business declined by 280 basis points, which clearly needs some explaining.  Selling, general and administrative expense in the overseas portfolio increased by 7%.  Now that Best Buy has a CEO with some  international credentials, this portfolio needs to be rationalized and optimized.  The Chinese market needs to be re-examined.

The company significantly lowered its guidance for the range of FY 2013 FCF to $850 million-$1.05 billion, down from a recently announced range of $1.25- $1.5 billion.  The explanation was lower projected profit levels and higher inventories.  The lower projected profits gets back to the same store sales, the overseas business, the gross profit margin rates, and mix of sales.

An analyst who asked a question about the wisdom of maintaining a $225 million annual dividend, seemed to surprise the CEO, which means he was poorly prepped.  The CFO added no light.  The board hasn't decided was the CEO's answer: not very clear or comforting.  If there were a choice between improving ROIC through higher volume, better margins or asset management, then that is a superior use of cash than dividends in a higher tax environment for investors.  Give investors some guide into how the board and management think about the issue.

The adjusted ROIC was 10.1% versus 10.6%, which not bad, given the weakness in the same store sales, both domestic and foreign.

I was very surprised that no analyst chose to ask for an update on the buyout plans of Dick Schulze's group. It could have easily been asked in a way which simply requested an update of prior public announcements.  The entire group was silent about the elephant in the room.

Bottom line, the results weren't good, but the new CEO has been in place a grand total of eleven weeks.  He has expressed a lot more clarity that the previous CEO did in his entire tenure.  Unfortunately, it was not a well prepared conference call, and the Q&A went off track.

The King Turkey award for the day goes to HP which reported Q4 2012 results that were right down the middle of their guidance, and in some important ways like FCF even better than expectations.  Adjusted EPS for the quarter was $1.16 verus $1.17 in the prior-year period, on the same basis.

The company's revenues were $30 billion in the quarter, down 4% y-o-y in constant currency.  Adjusted gross margins increased were 24.2% up 90 bp y-o-y, despite expected weak results in personal computers, offset by strong revenue and margin growth in software and an unexpected increase in printing margins. Operating cash flow in the quarter of $4.5 billion was 69% ahead of the prior year period, and and FCF was $3.5 billion in the quarter.  What is not to like about this quarter?

Answer: another massive writedown of $8.5 billion for impairment of goodwill and purchased intangible assets from the acquisition of Autonomy.  Some $5 billion of this amount relates to alleged fraudulent accounting at Autonomy prior to the acquisition; the fraudulent practices relate to revenue recognition and to the allocation of costs to expenses versus product costs that made product sales margins look like software transactions.  The fraud allegations have been referred to the SEC and to the UK Serious Fraud Office.

(Before I go on, I want to give a shout out to Jim Chanos, who often writes and speaks at Columbia's Graham and Dodd Institute: you had it pegged perfectly, Jim.)

To his credit, Barclay's analyst Ben Reitzes, with the first question on the call, asked CEO Whitman how she evaluated her own responsibility as a director of HP during the hiring of former CEO Apotheker and for the approval of his proposed acquisition of Autonomy.  Her answer was less than courageous.  All the directors feel really bad!  However, those responsible have been discharged: Apotheker and a VP of strategy.  What a limp fish of an answer.

About a month ago, we wrote about CEO Whitman's need to focus on internal issues and to change over the board of this company.   CEO Whitman should politely suggest to those long-standing directors, all of whom were there for the botched transaction not to stand for renomination by the Nominating Committee.  This company cannot move forward with these same directors in place.  It would be courageous for CEO Whitman to pass on a significant portion of her 2012 incentive pay for her part in the botched acquisition.

There was a period of time when HP insiders talked with pride about being from "the (Silicon) Valley."  All of the directors should be ashamed of themselves.  To say that they relied on audited statements alone is a failure of duty to the corporation and its shareholders.  Forget about suing Deloitte or KPMG: that is a distraction and a waste of money and time.

The "rocket scientist" founder of Autonomy, Mike Lynch, now appears to also be a very savvy promoter.  Another name from the "Valley," Frank Quattrone of Qatalyst Partners seems to have been involved in introducing Lynch to Oracle, ostensibly to talk big data, but really to shop the company. As this ploy was failing, HP was being driven, even against the first instinct of its board, to not only acquire Autonomy, but to pay a fool's price for merchandise passed over by Oracle.Oracle had also hired Mark Hurd.  It's an embarrassing story with a horrible ending for shareholders' equity.

The new CEO is making her impact felt among the rank-and-file and the producers at HP: this is a great thing, which reverses the Mark Hurd era's style and culture. She's definitely on the right track, and people are listening. If she holds herself and her board accountable, the troops will really be galvanized into believing that there really is a new day dawning. With the support of a new, talented and committed board, which also shows its belief in owning shares personally, this may still prove to be a value-creating turnaround.

Even with all the corporate mismanagement around us, we can all find much to be thankful for.  Happy Thanksgiving!

Sunday, November 18, 2012

Star Trib Story on Best Buy

Ahead of Tuesday's earnings for Best Buy, the Minneapolis Star-Tribune ran a lengthy piece on Best Buy, with reporter Thomas Lee heading up a team of reporters.  Overall, it's a useful placement for the Schulze-led private equity group looking at making a bid for Best Buy.

Investors who saw Dell's quarter, presumably shouldn't be surprised by Best Buy's being hit by the same lackluster reaction to the Windows 8 release and consumer reticence towards upgrading to ultrabooks, netbooks, or new laptops. Unless Best Buy sales declines open up a gash in the hull, it would seem as if the stock might churn, but shouldn't react too much by the end of the day. Bad news should be baked in.

Overall, the story is pretty well balanced, which is unusual for newspapers these days, which have a clear axe to grind.  It does refer to some of the same internal issues that we suggest are at the heart of Best Buy's losing its way as a market leader.

Here are a few relevant quotes,
"But former and current executives described a chaotic, adrift culture. The company encouraged employees to experiment but without real follow-through."
"They said all the right things, but there was no action."
There was clearly no accountability for mistakes, particularly at the executive management level and down to senior management.

In addition, Best Buy fell prey to the siren song of the big consulting firms, with almost all the leaders coming up with expensive, misguided projects directed away from the core issues.  The most astonishingly ill conceived decision was to outsource IT, the LAD artery of a transaction driven company, to Anderson Consulting.  That is now on track to being internalized, which is not without risk.  I can clearly see the consulting company slides that advocated this misguided step.

The Napster acquisition is not mentioned in the article.  After apparently passing on discussions with Richard Branson of Virgin about developing an Internet music service, Best Buy bought Napster for $122 million and essentially wrote it off for some stake in Rhapsody.  Probably another consulting company slide set drove this lunacy.

Best Buy's board and management would be foolish not to work with Dick Schulze, the entrepreneur-founder and largest shareholder, to turn this company around.  The "Renew Blue" presentation seems to provide a good road map focused on fundamentals that might be a good start for working together.

Turning the company upside down with a leveraged buyout might be a quick, tax-efficient tonic for fatigued portfolio managers and arbs, but it might not be the best thing for long-run value creation.

Friday, November 16, 2012

"Renew Blue" Is A Good Start for Best Buy

When I followed Best Buy as a sell-side analyst in the early nineties, it wasn't even "chopped liver" on Wall Street.  Specialty retailing analysts who followed electronics unanimously preferred Circuit City, the foie gras of electronics retailers. Between Circuit City's taking the higher end, tech savvy consumer and Wal-Mart's capturing the low-end, the only future for Best Buy was bankruptcy. Even Radio Shack got more respect for high sales per square foot and its gross margins.

This is a perfect scenario for a value investor, like myself.  When the Street hates a stock, it's easier and more fun to conduct in-depth research. Those of you who've read this blog over the years know how much I learned from Ben Graham's approach, and from his accomplished disciples like Max Heine, Bill Ruane, Warren Buffet, Charlie Munger, Chris Browne, John Spears and others.

In the spring of 1994, I put a 'Buy' recommendation on the stock, and by mid-July it was at a three month low and had fallen 11 percent in one day on fears of slowing growth. The shares got caught up in negative market sentiment about high multiple stocks, and there were fears about Circuit City's aggressive entry into the Twin Cities market with their new superstore format.  Needless to say, the shares did exceptionally well from that point, as did a number of large institutional investors in Boston who came on board in front of rapidly improving fundamentals. 

This is just for context and not to ressurect history.  I've never lost touch with this story.  I can honestly say that for the past decade, Best Buy has made about every fundamental market, operating, strategic and cultural mistake that a maket leader can make. 

Technology product cycles and frothy equity markets can often mask weakening fundamentals.  Just as sentiment worked against them before, analysts are now negative: 2 hold 'Buy' ratings, with 19 'Hold' ratings, and 2 'Underweight' or 'Sell.' 

The fundamental issues at Best Buy have nothing to do with "showrooming," but everything to do with the company's own internal issues.  Back in the time when I rated the stock a 'Buy' the internal organization and culture were strengths, while during this long down cycle, the opposite has been true. 

So, CEO Hubert Joly's investor presentation "Renew Blue" is most definitely on the right track.  What's surprising to me is that Best Buy is still in a relatively strong market position despite shooting itself in the foot in ways which are handled gingerly in the slides. I believe that I can also see the imprint of the new CFO on the presentation.

Best Buy's core market is $228 billion for fiscal 2012, and it has been growing at a three year CAGR of 3.2%.  This is certainly a nice market to be in, and just as in 1994 it is still fragmented.

48% of Best Buy's market is served by retailers with market shares of 4% or less. 

According to Best Buy's research, it still has the number 1 market share at 16%, followed by Wal-Mart at 15%, followed by Apple, Sears, Target, and Amazon with a 4% market share. 

Best Buy has lost connection with its customers, which is the biggest knock against management.  Their big market characterization of their customers a few years ago, which probably cost millions was foolish. Their current survey shows that they have even managed to lose their "low price" identity, which is quite a feat.

They are shown to have one of the largest customer loyalty data bases in the industry, but it isn't an effective program, especially for inducing activity among inactive customers.  Office Depot, for example, has a better program that requires no customer effort to update and use. This can be easily fixed.

Best Buy's website looked like something from the 1970s, and the navigation and functionality were primitive.  It looks a lot better since Mr. Joly has come on board, and it can do much, much better.  Despite this, the company drew 1 billion online visitors and generated $2.3 billion in sales from the online channel.

For all the talk about "low hanging" fruit, some of the fruit, like the operations at Best Buy Canada, is lying on the ground. The cultural and organizational issues, which are much more subtle, can yield a lot, but they will take time.

Appliances are still a square peg in a round hole.  The good news is that nobody in the
"big box" format does a very good job, with the exception of Sears which is a historical artifact ready to be picked off by a better merchandiser.

The presentation about ROIC in the stores is very interesting.  It parallels issues faced by Home Depot in the recent past.  When they fixed this issue, the stock took off in a period of peer and market outperformance.

The Geek Squad is their best acquisition, but still underleveraged.  Experiments like Simplicity need to be multiplied and rolled out when ready.

Some analysts suggest vendors might not have an interest in Best Buy surviving.  Just like 1994, I can't understand what these folks are thinking.  Vendors need Best Buy.  Best Buy hasn't treated the vendors like partners and it hasn't demanded, or merited, the best from them.  This can be fixed.

The whole managment tier under the top management has to be redone, both the cast and the script.  This will be critical to translating this presentation into sustained performance in earnings and in shareholder returns.  Now that the overture has played, I'm anxious to see Act I. 

Thursday, November 15, 2012

Google's High Speed Internet Comes to KC

In a recent post about Google and the wireless industry, we wrote,
"A friend in the IT business told me that Google has a broadband experiment in Kansas City where they are offering customers the fastest broadband and online storage for a fraction of what the cable companies charge. Go for it, Larry and Sergey!"
In today's Wall Street Journal Online, the journal reports,
"This week, Google began installing fiber-optic cable to homes in Kansas City, Kan., as part of a high-speed Internet and video service that competes with incumbents such as Time Warner Cable Inc. and Dish.

Google hopes to expand the service around the country, according to people familiar with its plans.  /....
Many of Google's moves to directly oversee the way people access the Web are driven by a belief: that faster Internet download speeds at home and on mobile devices mean people can use more Google services such as Internet search, Gmail and YouTube video, translating into more revenue for the company."

Attempts to break cable's monopoly in both video content and high-speed Internet have been relatively minor incursions that are primarily rent sharing among the industry.  Let's hope that this seedling venture grows into something that gives the consumer a high quality product at a significantly lower price.

Wednesday, November 14, 2012

Politics Will Determine the Fate of the Euro

It has always been clear to me the European Monetary Union (EMU) and the single currency were poorly designed as both a political system and as a common currency area. Roland Vaubel, of the University of Mannheim, is a distinguished economist who has followed the euro from birth, and his podcast tells the story eloquently.

For example, I never really understood what would have motivated Germany to be interested in a common currency, given its strong economy, currency and its clear understanding of the weaknesses in the euro's design.  It goes back to the Franco-German relationship, which has always been one of mutual suspicion and grudging acceptance, at best. 

German Chancellor Helmut Kohl was extremely interested in common European Union foreign and defense policies, and he felt strongly that a European defense policy had to have a nuclear component.  France, of course, was especially loath to give Germany access to a common nuclear capability. Kohl was willing to talk about a common currency in exchange for his larger interest in a common EU foreign policy and defense structure. So began the bargaining.

When the Berlin Wall fell in the autumn of 1989, the former Federal Republic of Germany had reunification thrust upon it.  President G.H.W. Bush was an early supporter of unification.  France and the United Kingdom were publicly cool and privately opposed.  According to Professor Vaubel, French President Mitterand got his euro in exchange for lending his support to German reunification. 

There is a well established body of economic research, begun by Professors Peter Kenen, Charles Kindleberger and Robert Mundell, on the "optimum currency area."  The original eleven members of the economic and monetary union (EMU) in no way fit the criteria for an optimum currency area.  Everybody knew this from the outset, but rules were put into place which were consistent with such an area. These rules were flouted openly to admit the weaker members.  These flaws have come become manifest in the secular budget deficits, inefficient labor market productivity, and high public debt to GDP ratios.

The original charade with eleven members has been expanded, in violation of the system's own rules, to seventeen members.

Before the formation of the euro, French monetary policy had to react to and align with German monetary policy, something which rankled French political sensibility. 

The German government hoped, according to Professor Vaubel, to maintain control over the euro by having veto power over the European Central Bank board's decisions, and the earliest supervisory board was stocked with supporters of a "hard currency."

The Maastricht Treaty of 1991, at the behest of France, specified that a European monetary union would be established by 1999.  This and some other subtle changes were apparently not appreciated by German negotiators until it was too late.

The Stability and Fiscal Pact of 1996 represented another German attempt to put some discipline into the dismal fiscal performance of euro currency zone members by establishing limits for the ratio of sovereign debt to GDP of euro zone members.  The three percent limit was quickly violated by most of the members.

The EMU attempted to emulate the U.S. Federal Reserve by establishing a 2 percent inflation target for union members.  This target has not been consistently achieved, and now inflation is running at three percent with economies heading into recessions. 

Germany is the largest shareholder of the European Stability Mechanism, which has 80 billion euros in contributed capital and 620 billion euros in callable capital.  Exposures to large losses from this facility will be political poison for the current German government, which faces Federal elections in September 2013. 

According to Professor Vaubel, two-thirds of the German electorate have consistently opposed bailouts for Greece and other weak euro periphery members.  So, no matter how badly the Chancellor is painted in the European press, it seems unlikely that any decisive breaks from her basic position will be translated into real, additional financial commitments before the 2013 election. 

Friday, November 9, 2012

Banks and Rating Agencies Behave Badly in Australia

Floyd Norris in today's New York Times Business section, tells the story of an Australian federal judge who ruled that investors in a CPDO (Constant Proportion Debt Obligation)  can sue Standard and Poors for assigning a AAA rating to a structured finance vehicle which seemed inherently unsuitable for any qualified institutional buyer.

This is from issuer ABN AMRO's draft marketing materials cited in the Australian court's judgment:
What is the CPDO?

  • A CPDO is a fixed income instrument with cashflows that have a high and rated likelihood of payment
  • A CPDO aims to pay the stated coupons by taking leveraged exposure to a notional portfolio of credit indices. It comprises of exposure to a Credit Index Portfolio and a cash deposit
  • The Credit Index Portfolio aims to generate sufficient returns to enable the coupon payments to be made
  • The Target Portfolio Size of the Credit Index Portfolio is set such that the present value of the expected income from the Credit Index Portfolio is linked to the difference between the present value of the coupons and principal due under the Note and Note NAV
  • Once the current Note NAV equals the present value of the payments due under the Note, the Credit Index Portfolio will be unwound and no further credit exposure taken ...

The Floating Rate Notes were issued in the amount of Aus $45 million.  The notes are not backed by ABN AMRO or any other institution. ABN AMRO sold the Notes to its client, an Australian workers' compensation fund.

According to the issuer,
"The CPDO is suitable for investors who:
– Seek to take high grade exposure in a form that has not had value eroded by movements in correlation as has occurred in the CDO market
Require high rating of principal and coupon payments, but without the necessity of principal protection
– Wish to diversify their current structured credit portfolio
– Require liquidity for structured products."

Let's start by saying that ABN AMRO should not have marketed this product to its customer in any case. The prospectus should have had much more meaningful and transparent risk disclosures.  Standard and Poors didn't seem to have any reasonable basis for rating these securities AAA.  Even though in the court document, there is a convoluted battle among experts on what an AAA rating means (better than AA relatively) or doesn't mean (the highest absolute rating or lowest risk), there is a pretty telling statement in the prospectus which says,
"The probability of receiving the rated coupons and principal at maturity is benchmarked to the default probability of an S&P bond with the same rating and tenor."
On this definition, and given all of the email exchanges and witness testimony, a rating of AAA seems beyond reason.

However, it also seems clear that the client probably violated their own statutory investment policy guidelines for selecting and evaluating this investment.  So Floyd Norris' comment below is equally unreasonable:
"But the buyers of C.P.D.O.’s did not understand what they were doing. It appears that those investors, including an agency that managed investments for Australian local governments, and some of those governments themselves, did not bother to go into details."
The investment process laid out in the judgment has steps and particular measures which should disallow investing inappropriately, i.e. without understanding the investment's suitability and risk profile. To suggest that they "did not go into details" is a failure in their duty of loyalty.  Investors should not be protected by the government for being lazy, or for failing to exercise due care and diligence in accordance with their own published, statutory guidelines.

We've written about the failure of the rating agencies during the 2004-2006 runup to our own credit crisis.  Nothing was done to hold them accountable.  The investment banks have moved on to sunnier earnings and increasing management compensation after drinking at the public trough.

The investors should be compensated if the investments were (1) not suitable for their clients, (2) marketed with incomplete, misleading or false claims about their risk-return profiles, and (3) the expected performance of the Notes under reasonable scenarios did not warrant a AAA rating, according to SandP's own internal standards.

Institutional investors should not, however, receive government help to generate recoveries for their own greed, laziness or stupidity.

Wednesday, November 7, 2012

Smart Grids and Utilities of the Future

Since we've written before about investing in our electric power distribution and transmission infrastructure as a potentially superior choice for government stimulus funds, we try to keep up with industry discussions by advisory firms such as KPMG's Global Energy Institute. A recent webcast talked about a number of issues relating to the Electric Utility of the Future.  

Investment is certainly needed simply to maintain reliability, as one speaker noted: approximately one-third of the national grid's equipment is at or beyond its economic life.  About $12 billion per year is required to maintain the grid for anticipated future demand.  Significant upgrades to new technologies for better performance, efficiency or other goals would require additional investment beyond this maintenance capital spending level.  

The electric utility of today is a heavily regulated enterprise, and the utility of tomorrow, in my opinion, won't be much different, especially in light of the twin-headed hydra of government mandates and regulation.  

Energy Secretary Steven Chu took up his position with a strong technical and academic background, and he has ridden his hobby horse of renewable energy hard.  Electric utilities were given mandates, often by their states in response to federal guidelines, to generate a minimum percentages of their electricity generation from a renewable portfolio, primarily wind and solar.  Xcel Energy, our local utility, is mandated to produce 30% of its energy for Minnesota customers from renewable sources by 2020.  

The utility of the future would be one in which distributed power would be a significant part of the mix of power on the grid. For example, the KPMG speakers noted, there was a federal goal of having 1 million plug-in electric vehicles (PEV) in operation by 2015.  Clearly, we're going to miss this goal by a mile. The current estimates are for between 200,000-700,000 PEV nationwide, with the upper end almost certainly unattainable.

A national fleet of PEV were regarded, in the federal government's grand vision, as distributed users of electrical power for recharging, and as "load balancing" factors. Trying to imagine how the load balancing would work is laughable: Two pm on a hot summer's day in Fresno.  The power company is approaching peak load.  Gmail messages are sent via smart phone to all local Nissan Leaf owners to drive to a recharging station and to all plug into the grid, to have their batteries drained to shave the peak load.  Seriously!

The electric utilities themselves note that were PEV to achieve a 10% penetration into the nation's auto fleet, concentrated episodes of recharging could affect local substations, leading to larger system shutdowns. 

A more significant example of distributed power are the large corporate data centers of companies like Google and ATT.  The companies reap benefits, in that they do not pay transportation and distribution charges like other customers, for power that they use or supply to the grid.  

However, utilities are caught in this conundrum.  Investing in a smart grid, in which there is distributed power, means significant dollars for the additional, improved infrastructure. Sales to a Google data center, for example, will mean lower revenue for the utility than would the same amount of power sold to traditional retail or corporate customers.  

Lower revenue, because of their enormous high fixed costs, is Code Red for the utility of today, and it will continue to be so for the utility of tomorrow.  

Xcel Energy has filed with the PUCO for a $285 million rate increase, about 11 percent, for 2013, which will amount to $9 per month, on average, per customer. This is in an environment of slow growth, job loss, and declining customer usage of electricity.  Here's what Xcel has to say about the effects of lower customer usage,
"Finally, Xcel is asking ratepayers for $75 million, or about 26 percent of the increase, to account for lower electricity usage. The utility has projected that customer usage will be 4 percent less in 2013 than this year..."

Customers react to their economic circumstances by reducing their usage, but paradoxically, they have to pay more because of the nature of the regulated utility.  

Xcel is also using about twenty percent of the proposed rate increase to" pay for upgrades to its electrical grid, including both high-voltage transmission and lower voltage distribution lines typically found in cities.
Some of that money will be used to pay for the high-voltage CapX2020 transmission lines approved by Minnesota and Wisconsin regulators."

The utility of the future will be subject to the same efficiency and equity issues as the utility of today:

  • The requirement to comply with arbitrary and costly mandates about portfolio mix in its power generation;
  • Investments to make their grids compliant with new power sources and demands;
  • The inability to maintain debt service and cash flow without significant counter-cyclical rate increases;
  • The need to make smaller retail customers pay increases which are substantially above economic or income growth rates at a time in which their reduced demand is the rational economic response.
None of this sounds very smart. 

Tuesday, November 6, 2012

Klaus Adam Sees It Our Way on Greece

Professor Klaus Adam  writes,

"This unfortunate outcome must be blamed on the inability of the Greek political elites to deliver the structural economic changes that are needed. Salary cuts and tax increases alone simply cannot re-establish the competitiveness of the economy. And if true economic reform cannot be delivered, then a euro- area exit remains the only other available option. This is a sad and unavoidable conclusion, and it follows from the simple fact that Greece cannot go on borrowing forever."

"A Greek debt default and a simultaneous euro area exit would achieve all of these goals, virtually overnight. Obviously, the adjustment would be rough and turmoil would probably prevail for a number of months, but the adjustment would take place."

We've written about this possibility since 2011, when the markets were oblivious to anything but rosy scenarios for the euro experiment.  However, given years of the dithering by European leaders and their enablers like the ECB and the IMF, a Greek exit alone won't end the issues within the EU.  It may resolve the pain for the Greek population and perhaps allow some real reforms under the leadership of its own politicians.  The broader issues within the EU and the fissures between France and Germany will only intensify.

Monday, November 5, 2012

Martin Feldstein's Thoughts on the Euro

I've been a reader of Martin Feldstein's research since my graduate student days, when I recall a paper about an optimal two-part tariff, among others.  Over the years, he has produced lots of clear-headed thinking on economic policy as well.

In a recent Guardian blog, he talks about the economic benefits of a 20-25% devaluation of the euro on the competitiveness and trade balances of zombie and near-zombie states.

We've talked for more than two years about the structural incongruities among the EU members which always threatened the stability of a currency union, and Feldstein recognizes this too when he writes,
"Moreover, even under this optimistic scenario, the problem of the current account deficits of Italy, Spain, and the other peripheral countries will remain. Differences among the eurozone countries in growth rates of productivity and wages will continue to cause disparities in international competitiveness, resulting in trade and current account imbalances. Germany now has a current account surplus of about $215bn (£176bn) a year, while the rest of the eurozone is running a current-account deficit of about $140bn."
Feldstein notes that the euro should have devalued significantly already, thereby precipitating a sort of normalized adjustment process.  However, the ECB unlimited guarantee to buy Spanish and Italian debt has perpetuated the crisis by keeping the euro high to support markets.

Occasionally, the idea of Germany leaving the euro is put forward.  These writers argue that legally and administratively, it wouldn't be that difficult, since only contracts inside Germany would have to be redenominated into the German currency.  Everything else would remain in euros, although they would take a  
haircut according to where the devalued euro settled.  This is an intriguing idea, but it might not work either.

Who would be the "paymaster" of the smaller euro currency union?  France?  They would hardly want to accept this position, and they couldn't really handle it either. Italy?  Those who favor Germany leaving the euro suggest that the smaller euro currency area would be more likely to move to fiscal union.  I hardly think so.  The same issues remain, and the two biggest economies in the union would have their bluff called about giving up economic sovereignty over their budgets.  Interesting thoughts, but they hardly seem politically or economically feasible either.

Friday, November 2, 2012

NYC Marathon: Bloomberg Comes to His Senses

Mike Bloomberg is an extremely intelligent man, with a wry sense of humor and a natural ease around people. I got a chance to sit next to him some years ago at a Johns Hopkins alumni event. He created a multi-billion dollar global business, and he has run my home town for three terms as Mayor. New York City is innately ungovernable, but he has quietly manged this Herculean task without, say, the relentless self-promotion of Ed Koch. Bloomberg's  name is iconic in global finance: if anyone says, "Check the Bloomberg," nobody has to ask, "What do you mean?"  I give him a lot of credit, and I have the greatest respect and admiration for him.

My wife, kids and I returned to New York in October 2001 to visit the WTC site, family and friends, and to pay respects to my fellow Seido black belt, Captain Patrick Brown, who died with his colleagues from Ladder 3 in the north Tower. It was an unforgettable visit for all of us.

Fast forward to November, and to the third game of the World Series.My family and I were all at our television as President George W. Bush threw out the first ball.

This video has lots of priceless moments.  Among them is Derek Jeter's interaction with the President of the United States, where he tells the President (1) don't think about tossing a fake pitch from the front of the mound because they will boo you; and (2) after he persuaded the President to take the mound, he says "Don't bounce it because they will boo you.We're New Yorkers."  What happens afterwards, and the whole event was so right, so genuine, so human and it brought tears to all of our family watching.  A person on the video who says "I didn't vote for Bush" admits that he too was lifted by this sincerely motivated, very American gesture.

I have to contrast this with the unbelievably crass, emotionally tone deaf proposal to run the 2012 New York Marathon on schedule.  Mayor Bloomberg, who seems increasingly jaded by his thankless job, has given himself over more and more to bad advice from his consiglieres. The New York Times recently lionized Mary Wittenberg, the CEO of New York Road Runners.  Wittenberg is portrayed in the New York Times,
"Mary Wittenberg, chief executive of the New York Road Runners, had attempted to recast the marathon as a "Race to Recovery" highlighted by a fundraising drive to support relief efforts. Already those efforts have raised $1.1 million from the Rudin family, a longtime sponsor of the marathon, a $1 million commitment from the Road Runners, $500,000 from ING, the event's title sponsor, and what will likely be hundreds of thousands more from runners who have been asked to donate $26.20 to recovery efforts."
 Let's set the scene.  Hundreds of thousands of healthy runners, moving through the five boroughs for their own pleasure, supported by race staff providing them with water, energy drinks and medical attention. Police and fire fighters monitoring roads and bridges still scarred by wind, water and dirt.  Fans cheering them on. The roads littered by paper cups and Gatorade containers. Medals and speeches at the end. Would President Obama show up at the finish line to support the "Race to Recovery" as the "Recovery President?"  Would Mayor Bloomberg be there for the obligatory photo op to reaffirm their mutual affirmation of global climate change as the biggest problem we've all endured?

Meanwhile, thousands of New Yorkers are just tonight having their power turned on--including my sister--and the hotels are gouging New Yorkers for $500+ per night because of the demand by displaced residents, tourists and friends.  What about the New Yorkers who live in Breezy Point who still have to look at this?

           Julia Xanthos/New York Daily News

Should the displaced residents take time out to cheer for the marathoners after their homes have been destroyed?  You get the idea. There was nothing genuine about the idea to run the race: it smacks of emotional ignorance, arrogance, or of a cynical calculation.  Thank goodness someone read the Tweets, blogs and social media to take the public's temperature.

Our family had a chance this year to go back to the former World Trade Center area, where I found an old friend.

U.S. Equities: An Expensive, Clean Dirty Shirt?

I'm paraphrasing Bill Gross' comment about U.S. Treasuries and expanding it to the U.S. equity markets.

Cliff Asness of AQR Capital Management put out a third quarter bulletin to investors in which he talked about the Cyclically Adjusted Price-Earnings ratio ("CAPE") of Robert Shiller.  Depending on how you look at the long-term picture of CAPE, the equity markets are relatively cheap, or not.

The bullish case would say that the CAPE at 9/30/2012 was 22.5 times the average of ten year trailing real earnings.  This is one-half the level of 1999-2000, at the peak of the market bubble.  So, we should feel 'the pump' as the weightlifters would say.

When I first looked at his chart, it's clear to see the bullish conclusion, but then the other side is also evident. Asness notes that the CAPE time series has spent 80% of its time below the current level of 22.5.  So, he concludes, based on some additional partitioning of the long period, that someone expecting a 10% nominal equity return (about 8% real) is betting on exceptional returns compared to history.

This gets us back to Bill Gross' metaphor. Emerging markets, for all the bullish broker comments, aren't attracting the big money, such as Norges Bank Investment Management. There has been a flight to liquidity, size and decent dividend yields, which largely spells U.S. equity markets.

However, we've seen in repeated corporate reports a blizzard of financially engineered quarters, with simultaneous challenges expressed about future revenue prospects.  Next year, comparing to these strong quarters might be problematical.  Shouldn't the market move downward?

The typical buy and hold investor, who isn't foolish enough to think that he can trade against the market with their broker's option software, should find his prospective returns being truly circumscribed.  Thanks, Uncle Ben, for nothing!

Thursday, November 1, 2012

AdWords Made Little Sense for Business Owner

As I continue my mental struggle to understand the "brand new day" model of advertising alchemy represented by Google, here comes a cautionary tale from the New York Times about Paul Downs, owner of Paul Downs Cabinetry outside of Philadelphia.  He managed his own AdWords campaign, and from what I can tell, he was looking at all the right metrics and seems completely in tune with Google's new world.

To get to the bottom line of this story, Paul Downs Cabinetry makes high-end conference tables for corporate customers. His AdWords budget had been yielding good results until the Spring of this year, when his mix of inquiries shifted to a lower-margin modular conference table, while orders for the corporate units fell out of bed.  Mr. Downs seems to be a very number savvy business owner, and he couldn't figure out the issue.

As he checked with search engine optimization firms, they too couldn't seem to offer him any real economics for hiring them, and they seemed bereft of any meaningful suggestions, other than increasing his ad budget.

It turned out that Google's algorithms are driven by click rates, which wasn't a surprise to him.  The problem was that the education market was clicking a lot to look at his lower-end modular tables, but these didn't turn into click-through corporate inquiries or sales.  The algorithm switched his ad dollars to those times of day when the click rates were the highest, namely when education staffers were browsing and clicking.  By the time of day when his corporate prospects started browsing, his ads had stopped running, since they were directed to high click rate times of day.

His dollars were in the wrong place, despite the black box wizardry of the algorithms.  It turned out there was a fix by restructuring his program into several smaller programs.  I had a few observations.  Why should a savvy small business owner have to supply this much intellectual capital into a program whose whole basis is that it is smarter and learns?

It seems like the AdWords algorithms themselves should been able to see this difference between clicks that turned into click-throughs and those that didn't.

Those SEO consultants are an entire industry created by the Google's model.  The ones in Paul's story seem about as shady as penny stock brokers!

HP Printing Announcement and New Intra-Day Low

HP hit an intra-day low of $13.80 on Wednesday, but it did announce a new range of multi-function printers for government and commercial users.  Meg Whitman's comment about their not having refreshed their multi-function printer offering for seven years appeared in the press release, but it was the same comment that Dave Donatelli made during the analyst day discussions, so it was not new information.

The new multi-function printers incorporate features like direct document management to the cloud and tagging of documents using Autonomy's IDOL system, which was also demoed during analyst day.  Adding functionality from Autonomy is certainly encouraging.

Looking on the consumer side, however, their multi-function offering looks like it should all be on close-out.  The machines have been around forever, and they seem to have very large footprints and profiles for a small, home office or small business. There are too many models, and the pricing is confusing.

What's at the root of not refreshing the MF printer lines for seven years?  It's the "cash cow" seduction.  Everything HP did, including the pricing of consumables, was to generate the bulk of operating earnings and large cash flows, taking advantage of the brand name in large government and business accounts.While executive management in the printing business probably exceeded incentive comp thresholds, it wasn't a good strategy for the business to sustain itself.

We've heard good things about the internal bureaucracy busting, cultural changes being initiated by CEO Whitman.  This is akin to taking down a fifty foot oak with a tomahawk.  The new CEO needs lots of help from her executive team, middle management, and her board.  Let's hope it continues.