Tuesday, December 31, 2013

Year-End Thinking About HP and the Tech Giants

The conference call is over.  The questions have been asked, and the voluminous slide sets are online with all the granular non-GAAP financials in place.  I know that it's a dull document, but there's nothing like sitting down with the 10-K and penciling through the document, looking at three years of results side-by-side. Before doing that, I like to read through the risk factors for any nuggets, and I like to read through the analysis of goodwill and intangibles discussion.  These tell me a lot about any concerns about the future that are not reflected in the historical results.

After some reconciliation to the past presentations and my notes , I came away with a more sober view of HP's challenges in 2014 than that which I held post the fourth quarter conference call.

CEO Meg Whitman was right from her earliest presentations, viz. this is definitely going to be a multi-year turnaround.  This company clearly was incredibly badly managed for a long time before her taking the reins, and unfortunately the Autonomy acquisition was not only insanely expensive, but it has cost valuable management time and somewhat circumscribed options.

The restructuring program's scale and management's focus on executing it on plan was really the only option, and its benefits can be seen in FY 2013 selling, general and administrative expense being $300 million lower than the FY 2011 level as reported. However, looking at the multi-year project, this is the 'easy' part, and I don't mean to be cavalier and it's all relative.

Even though the company's share price has had a nice one year run, the 10-K's three year stock price performance chart shows that it has clearly under performed the SandP 500 and the SandP 500 Information Technology Index by a wide margin.  So, there's still a long, long way to go.

Breaking up the company, which was the long standing refrain for a while, clearly would have resulted in nothing but a destructive fire sale, and that is clearer than ever when one looks at the seven reporting segments over the three year history.

Personal Systems has seen its operating margin decline from 6 percent in FY 2011 to 3 percent in FY 2013, but its revenue loss over the same period is over $7 billion.  Although the company has been chastised for being late to the tablet wars, if this segment can right itself there is tremendous opportunity.

One of the industry's leading low cost competitors, Acer has just seen the departure of three key senior executives, the head of global commercial business operations, its chief technology officer, and its GM of Chinese smartphone operations.  So, low cost production and decent form factor design alone aren't enough to succeed.  If HP can get the right leaders in place for Personal Systems, it could take advantage of its strong position in the corporate market as well as a stable position in the consumer market.

By contrast, the Printing business trimmed its year-over-year revenue decline to 1% in constant currency for FY 2013, while its operating margin of 16.3% is 130 basis points above the FY 2011 level.

Looking at the commercial segments, Enterprise Group and Enterprise Services the company has some tricky waters to navigate, and the risk section of the 10-K talks about about the commoditization of the x86 server products, while at the same time talking about a product transition to the Itanium platform that needs more software development by partners to support user requirements.

The Enterprise Group has seen its segment operating margin decline from 20% in FY 2011 to 15.3% in FY 2013, a 470 basis point decline, which is substantially larger than the margin rate declines in Personal Systems or Printing over the same periods.  I suspect that industry conditions and the product line transition may have negative revenue and margin implications for FY 2014.  The cautions in the risk section and the three year profile might suggest a year of treading water.

The Enterprise Services segment saw revenues decline 7% in constant currency in FY 2013, which was the biggest decline among the seven segments right behind Personal Systems.  Operating margins collapsed to 3% in FY 2013 from 7% in FY 2011.  This business needs some tough love.  Together, Enterprise Group and Enterprise Services comprise 46% of consolidated net revenue and about 45% of segment operating profit excluding Corporate.

While I have no doubt that HP will remain a critical vendor to large scale enterprises, the product line transitions, margin pressures and extended corporate buying cycles will probably put pressure on FY 2014 results.

The Software segment seems to bear the scars of the Autonomy acquisition, which I also noted in listening to the head of the business and comparing his tone from coming on board to his tone after the recent fourth quarter.  He sounds a bit worn out and frustrated.

Software revenue grew from $3,367 million in FY 2011 to $4,060 million in FY 2012 with some benefit from Autonomy, but it declined by 3% in constant currency to $3,913 million in FY 2013.  There has been a discussion about the inability of HP managers to replicate the sales cycles of pre-acquisition Autonomy.

The good news is that despite the revenue decline, segment operating margins in Software increased year-over-year to 22% in FY 13, an increase of about 200 basis points.  The bad news is that because Autonomy has been such an expensive debacle, HP probably needs to make more software acquisitions in the future in order to press its advantage as the herd of corporate IT suppliers gets thinned a bit, in the future.

Research and development expenditures have been flat for the three year period at just over $3 billion.Without knowing what kinds of projects comprise this spend, one wonders if buying innovation through acquisitions is cheaper than building innovation in-house.  No one ever asks this question on a conference call, and I've never read it addressed in an analyst report.

Finally, returning cash to shareholders is the tech industry shibboleth of the day for CEOs.  HP has spoken about a goal of returning fifty percent of  FCF to investors through buybacks and dividends.  I've never understood what is sacred about a number like 50%.  I know that Cisco hews to this self-imposed metric.

HP is running at about 30-38% of FCF, defined as CFO minus Cap Exp from the CF statements.  With the stock where it is, i.e. fairly valued, I would suggest stopping the buybacks and seeing if there are areas where it could be deployed internally to build more for the future.  What are HP Labs doing?

Acquisitions, according to the financial press, will require higher control premia.  Social media shouldn't be the metric for jumping to this conclusion.  Technology that will feed into the corporate and consumer computing environments needs market presence and distribution, which smaller companies cannot build without time and a lot of expense.  Acquisitions, especially for an entity like HP, are very risky for shareholders.

The Land of the Tech Giants

Cisco and Microsoft have advantages over HP in managing their respective corporate makeovers.  Both have fortress balance sheets and legacy business like routers and switches and Office software that can throw off cash even if their volumes and margin structures have to be ridden down over time.

HP's consolidated gross margin rate, even with a lot of blocking and tackling in sourcing and in asset management. has been flat over the three years at 23%. There is no cash cow hidden among the seven segments.

HP's balance sheet has been improved from its cratered complexion some time ago, but it isn't exactly pristine.

IBM has extremely strong market presence in multiple markets, financial capacity, and opportunities in super computing which are the bailiwick of very few players.

Making money on HP from here in 2014 won't be the easy money of 2013, but it should be an interesting evolution during the year.

Happy New Year!











Saturday, December 28, 2013

The Shadows Remain in Shadow Banking

"The basic point is that there has been, and remains, a strong public interest in providing a “safety net” –in particular, deposit insurance and the provision of liquidity in emergencies – for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds - taxpayer funds - protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions."
2010 Testimony of Paul Volcker to U.S. Senate Committee on Banking, Housing and Urban Affairs. 

Politicians of all stripes have rushed to have themselves photographed with the wise, grandfatherly oracle who is Paul Volcker.  But, what do we have after all the delay from 2010 until now?  We have a "rule" of over 1,000 pages which is full of contradictions and definitional lacunae.  A prime example would the prohibition against proprietary trading, or investment banks, who make much of their money from making markets, being enjoined from hedging 100 percent of their portfolios.  I didn't make it through much of the 1,000 pages, but after the champagne has been drunk will come the 2014 hangover when regulators wake up to the need for "tweaks."  Enough said here.

But, a seemingly unrelated story got my attention in regard to Paul Volcker's philosophical first principle that appears underlined in his testimony above.  It is the WSJ story about millions of tons of aluminum, copper, nickel and zinc which are hidden in "shadow warehouses." An owner of a shadow warehouse can, according to this story, have a stash of unreported material on one side of a fence from an LME regulated stash of the same material on the other side.  Material on the LME side goes into published statistics which drive market participant behavior and have impacts on prices.  

"It's a real concern for anyone in the industry that metal can be sucked away into a nonreporting location with no expectation or date as to when it's going to be available again," said Nick Madden, senior vice president and chief supply-chain officer with Atlanta-based Novelis Inc., an aluminum-products maker that is among the world's biggest buyers of the metal."

Guess what kind of entities are involved in this unregulated, speculative activity?  "Until 2010, most warehouses were owned by logistics firms like Netherlands-based C. Steinweg Group. But as metal-financing trades became more popular, C. Steinweg was joined by units of Goldman Sachs Group Inc. and J.P. Morgan Chase & Co. as well as commodity traders Glencore Xstrata PLC of the U.K. and Switzerland and Trafigura Beheer BV of the Netherlands."  

Morgan and Goldman?  Here we go again.  

Friday, December 27, 2013

Compassion or Pragmatism: Khodorkovsky is Freed

The power of personal diplomacy should never be underestimated, as Hans-Dietrich Genscher's heroic work to free Mikhail Khodorkovsky shows. Ascribing motives to a person is most often a fool's game, and the theory that President Putin freed Khodorkovsky to curry favor for the Sochi Games seems ridiculous. Compassion? Putting an end to a story that has run its course? 

President Putin wasn't under any compulsion to enter into the discussions that eventually led to the release of interesting, complex, business savvy, and ruthless oligarch who is Mikhail Khodorkovsky.  He is certainly not a saint by any means.  It does seem that Herr Genscher's personal communications style engaged Russian President Putin in a long running conversation that resulted in Khodorkovsky's being freed.  

Elements of pragmatism and compassion were probably both part of the mix.  Germany and Russia have substantial long-term economic interests in what might be called the broader Europeanization of their relationship.  This is most probably why Chancellor Merkel lent her blessing to the Khodorkovsky conversation.  She is most certainly a pragmatist. 

One of the best and most incisive summaries of the whole Russian oligarchic system and economic reform is contained in a London Review of Books article by Keith Gessen. Let's hope that a real economic discussion of cooperation between Russia and Europe is a staple in the business news for 2014.




Thursday, December 26, 2013

Emerging Markets Aren't For Most Investors

Brokers have rebranded themselves as "wealth managers," and the lure of emerging markets has been part of their patter for individual investors for many years.  Emerging market mutual funds have sprouted at both new and established mutual fund companies.  Using Lipper data from the Wall Street Journal, the only wealth created recently has been for the brokers and the mutual fund companies themselves.

Over the past 3 years, 332 emerging market equity funds have generated an annualized total return of -1.54%.  Over this same period, the top five funds have generated total returns between 7-8% per annum, but they are all pan-African funds with minuscule asset bases from $6-$192 million.  

For the past 5 and 10 year periods, Lipper's emerging market equity fund universe generated annualized returns of 14.77% and 10.51%, respectively.  These historical numbers were, of course, the basis for generating sales, which were also helped by references to diversification and to overvaluation in U.S. markets.  

The problems with the naive emerging markets story are manifold.  Higher GDP growth rates aren't a guarantee of higher stock market performance on any consistent basis.  Some recent academic research suggests that if the higher GDP growth rates are consistent and sustained, they serve as a cap on the long term growth of current high growth public companies.  

Morgan Stanley emerging market fund research head Suchir Sharma has suggested that emerging markets have become a "mature asset class," and many of their stellar companies may be like shooting stars rather than homes for long-term money.  Don't forget, we're talking about equity vehicles available to individual investors and smaller institutions.  Morgan Stanley's largest emerging market fund (MGEMX), has had unremarkable performance for the time periods above, at the cost of a high expense ratio and a $5 million minimum.  

But, if GDP growth rates might be higher in some emerging markets and larger middle classes shift over to higher consumption, isn't there money to be made? There surely is, and the fact is being recognized by very wealthy private investors and by very large institutional investors.  Especially with the recent downturn in commodity prices and the visible failures of private empires built on the same, opportunities abound in private debt instruments and in real assets like production and processing plants and in the resources themselves.  

The problem?  The sponsoring organization for a superior fund must have informational, locational and institutional advantages that put its feet on the ground, with a history of actually doing business in a market. That doesn't describe the likes of  Morgan Stanley, Fidelity, or T. Rowe Price to give example of large fund families.  They rely on the same outdated, unreliable published economic and corporate statistics, freshened up with some quick visits to government officials in PR situations.  As Sam Zemurray said in his book, the only answer is to "go and see for yourself."  Few can do that and combine it with investment savvy. 

Carval Investors, a unit of global commodity production, marketing and trading giant Cargill, has some interesting offerings that have the advantages needed to be successful over the long-term in emerging markets. Their funds are open and suitable for larger, long-term investors who don't require liquidity.  For the rest of us, emerging markets will remain a crap shoot.  

Monday, December 16, 2013

Ukraine Gets A Gazprom Discount: At What Cost?

Ukraine may be offered a 'discount' of 25% off list prices from its sole supplier Russia's Gazprom and some additional loans up to $15 billion to extricate itself from the effects of a crippling drought and mismanagement that saw a dramatic reduction in Ukraine's grain harvests and exports. It's not clear how this 'discount' will be treated and repaid, in cash or in kind from future exports. Bloomberg suggests an announcement as early as tomorrow.

While the EU has properly said that it wouldn't negotiate on 'markdowns' to conditions for joining the European Union, it is also short-sighted not to realize what's at stake with Ukraine.  It was the "Russian breadbasket" in the halcyon days of Communism.  It could be a major exporter to the EU if development projects could be brought on stream, and Ukraine needs an energy import portfolio that contains more than one partner, which is today Russia.

It is unlikely that President Yanukovych can again turn his eyes to the formal EU entry process, as President Putin would be greatly distressed by any such move which would cause him to lose face.  The protesters, so far, have shown much more substance and courage than our own cartoonish "Occupy Wall Street" protesters.  But, economics more than politics will carry the day from here.

If the EU bureaucrats can muster up some creative alternatives to the full fledged, heavily administrative procedures for EU membership, there can be a real choice for the people of Ukraine to stand behind. The people in the street need some support from Brussels, Paris, Bonn, and Washington.

Saturday, December 14, 2013

Cisco's 2013 Financial Analyst Conference

Looking at the three key executive presentations at Cisco's Financial Analyst Conference, management made a case for why Cisco should emerge as the preferred IT provider for large global enterprises, even as their corporate customers face exponentially growing volumes of data, greater demands for analytics and decision making agility, and a rapidly evolving cloud-based computing environment. They make a pretty good case.

At the end of the CFO's presentation, however, it becomes clear that to get to this promised land, Cisco has to navigate a period of low or no growth in their core switching and router businesses, while they begin the most significant product line refresh in corporate history.  The 'core' Cisco business is projected to show revenue growth of 0-1% per annum over the next 3-5 years. This brought the projected revenue growth rate for the consolidated business over the next 3-5 years to 3-6%, which is down 1% from the top end of the prior projected range.  This is the point that wasn't taken well by analysts, who then felt that Cisco might not emerge as the preferred IT provider they aspire to be.

Some points that struck me in CEO John Chambers' slides:

  • CIOs are taking longer to make big commitments to new computing architectures from Cisco and other providers. This is similar to comments made by HP CEO Meg Whitman, and it jibes with IBM CEO Virginia Rommety's frustration with her sales force's inability to 'execute' or close sales on the usual schedules; 
  • Despite this nervousness and macroeconomic headwinds, Cisco has had 5 consecutive quarters of 8-10% growth in revenue from U.S. Enterprise customers.  For the recent 2013 fiscal year, U.S. revenues of $24.6 billion increased by 8.9% over the prior year. U.S. Commercial customer revenues over the same trailing five quarters increased 5-11%.  
  • Current growth areas are cloud computing, mobile, and video, as everyone agrees.  
  • Cisco's research and development budget and acquisitions will be directed to future growth areas in IT services, security, and collaboration.  
  • The key takeaway for me is the CEO's assertion that core routing and switching capabilities will be the foundation for the IT and business processes transformations that will create large, new addressable markets. Most analysts disagree with this assertion.  
Rob Lloyd, President of Development and Sales, made these points, among others:
  • For me these slides make a very important distinction about the different kinds of 'clouds' that will exist in the emerging computing environment, viz. public, or commodity, clouds like those provided by Amazon and others; private clouds, and virtual private clouds, both of which will feature highly developed security environments to protect corporate data.  Lloyd says that CIO decisions will be based on business agility (from the cloud provider and from the responsiveness of the environment), total cost of ownership, data sovereignty and trust and control. The latter two points are, in my opinion, going to be critical for a CIO and a board which will have to look at the risks associated with a move to the cloud. 
  • He has some interesting industry statistics on the components of data center spending:
    • Hardware accounts for more than thirty percent of data center infrastructure spending, despite its increasing commoditization;
    • People expenses account for 29 percent of the spend;
    • Software comprises 22 percent of data center costs;
    • Energy and facilities absorb 12 percent;
    • Disaster recovery (7 percent), Networking (10 percent), Storage (7 percent), Servers (11 percent), and Overhead (2 percent) make up the balance. 
  • Cisco's largest total addressable growth opportunities in 2017 will be in Saas (collaboration, security, and network operations), enabling cloud providers, and building private corporate clouds.  
The financial press suggested that Cisco might become the target of activist investors because of the stock's relative under performance relative to the 88% increase in HP, for example.  I'd find this company to be an unusual target for a few reasons. 
  • As we've said before, despite all the challenges in macro environment, pressures on pricing and reluctance of CIOs to make big commitments, and Cisco's continuing appetite for acquisitions, the company has a fortress balance sheet;
  • Cash from operations of $12.9 billion in fiscal year 2014 increased by 12% over the prior year, and free cash flow was $11.7 billion.
  • The company returned $6.1 billion to shareholders in fiscal year 2013 or 52 percent of its free cash flow, and it wisely changed the mix down to make the share buybacks a lower proportion than in the prior year.  
  • The proposal to divest the set top business picked up during the acquisition of Scientific-Atlanta has been floated, and it might improve profitability, if critics are right, but it's small potatoes in the scheme of things. In addition, the CEOs slides provides a justification for keeping the product line.  
  • If the stock gets below $18, it will be selling at about 9x adjusted fiscal 2014 EPS, which is about the level that HP hit before investor interest started to rise. What new value enhancing ideas would an 'activist' shareholder propose?  
  • The stock has a dividend yield in excess of 3%.  Assuming that the bottom doesn't fall out from under this company, an investor would get paid to wait for some revenue growth.
On the gross margin side, the product gross margin rate did dip below sixty percent in the last fiscal year, declining 1 percentage point to 59.1 percent.  Services margins held in at 65.7 percent, bringing the consolidated gross margin rate to 60.6 percent, a sixty basis point decline from the prior year.  

While pricing and an unfavorable product mix due to the product line changeovers took 360 basis points off the gross margin rate year-over-year, this was entirely offset by productivity gains of 3.7 percent.  In fact, the net erosion in the gross margin rate came from higher amortization of intangibles and an inventory adjustment from the acquisition of NDS.  Fundamentally, the company seems to be managing its manufacturing and procurement operations very well, and it is investing some of its cost-saving from staff reductions into getting design and production efficiencies.  

Analysts said that it wasn't an 'exciting' FAC from Cisco.  Maybe not, but this stock could have some legs in 2014: let's see.  I know that I have some tech head readers from the industry. Send me your thoughts.  

Thursday, December 12, 2013

A Quiet Crisis in Ukraine.

Recent developments in Ukraine have been reported as a situation where Ukrainian President Yanukovych is portrayed as 'negotiating' trade, aid and loan packages between the European Union and the Soviet Union for the benefit of his country. In truth, he doesn't have the power to negotiate anything with either side, and his status as a political lame duck makes his own political value to Russia precarious.

The Wharton School published a note from Sophia Opatska,CEO of the Lviv Business School in which she cites reports that the President has misappropriated more than $6.5 billion in recent official assistance flows for the benefit of his own family.  He has already treated himself as a satellite Russian oligarch, and the EU really had no choice but to say that it wouldn't negotiate terms of an EU entry with the Ukrainian President.

The Ukrainian people have a natural affinity for the more open economic systems of the European Union, but the bureaucratic requirements for a full entry are not just too costly, and they are really unwanted by the now badly beholden President Yanukovych.  The EU should find a way to trade more with Ukraine without the full rigmarole of official membership.

Further 'aid' from Russia will be too onerous and expensive, and any proceeds will do nothing for the people because of the corrupt nature of the government.  As Opatska writes in her note, "When it comes to corruption, the country ranks 144 out of 177 countries, tying with Nigeria, Iran and the Central African Republic."

While protests in the Ukraine have been ongoing since mid-November, they are attracting very little attention in the West because of the focus on the Middle East.  As important as we thought the Tienanmen Square protests in China were, what is going on in Ukraine is worthy of  equal attention, especially for Europeans who could see a potential economic good neighbor withered underfoot by Russia and a proxy government of Ukraine.   

Senators Ryan and Murray Show Some Courage

For all our mantras about gridlock, unprecedented partisanship, and 'divided government,' what Senator Ryan (R) and Senator Murray (D) have done is truly praiseworthy and encouraging.

Above all, beyond who gets what or if their long-term deficit reduction is meaningful, here's what's significant about what they did:

  • Both parties are increasingly held hostage or influenced by their extreme wings.  Yet a senator from the relatively fiscally conservative state of Wisconsin can open a dialogue with a colleague from the relatively liberal state of Washington, outside of the aegis or approval of their party leaders.  They were able to talk, recognize their constraints, and come up with a proposal that hewed to their own ideas while not rejecting outright the platforms of their party leaders. 
  • They shared the stage, although I wish that Senator Murray had really added more of her own voice from the podium.
  • Their actions proved that gridlock and all the other epithets describing our woes are cover for the extreme views of a very small entrenched leadership of both parties.  If they are able to quash the efforts of their own colleagues, American voters may eventually wake up to where the problem lies.
The real problem is the unthinking American electorate.  Everyone gets their data from television news, NPR or Fox on the far wings.  Very, very few read original documents or think for themselves.  We don't have enough time or energy, and basically we don't want to be introduced to anything that might contradict our deeply held views. Our current political elite on both sides of the aisle understands this and panders to it: how else could they have survived so many election cycles?  

Total domination of the opposition--uncompromising and unforgiving victory for their self-interest-- is what the electorate wants. Compromise is for wimps and losers. Well, what Senators Murray and Ryan have done is to show, even in a small way, that another path is possible.  Here's hoping something develops from this, and that more such alliances are forged. 

Oil and Gas Forecasts Again.

"We are not dealing with an era of scarcity, we are dealing with a situation of abundance," Ken Cohen, Exxon's vice president of public and government affairs, said in an interview. "We need to rethink the regulatory scheme and the statutory scheme on the books."  Wall Street Journal
 
 "The sheer abundance of oil and gas in the U.S. poses challenges for Exxon. Booming production has overwhelmed U.S. demand, pushing domestic prices lower and eroding profit margins for energy producers."

So, given that natural gas and other hydrocarbon supplies in North America have pressed gas prices down below their energy-equivalent prices to oil, simple economics says that we should export them.  Europeans should welcome this development, as it would ease pressures on them coming from Russian desires to use energy supplies as an economic hammer on Western Europe in the future.

But, we don't want to allow exports because "some fear" that U.S. consumers will pay higher prices for their utilities.  But, despite low prices, utility customers are already paying higher prices than a year ago.  Just check your gas and electric bills.  Look for things called "resource adjustments" or "interim rate adjustments." What we pay here has as much to do with utilities regulation for returns as it does with global energy prices.


Monday, December 9, 2013

A United States of North America?

The trouble with long-term economic forecasts is that they are inevitably wrong, both on direction and often on degree.  The recent past weighs too heavily on our horizons, and we can't imagine these recent trends ever stalling or reversing.  I don't speak about this only through observation, but from my own experience at the controls of forecasting models that spewed out some laughable results.

Europe would soon supplant the United States as a global economic power given that its unified markets were almost as large as that of the United States. Well, maybe that needs to be revised.  Japan will dominate global economics because we taught them all about manufacturing quality, and because their single minded management and skilled labor force would take them to world domination.  When they bought Rockefeller Center, that surely had to symbolize the end of our economic hegemony.  This globally consensus forecast has to take the prize for forecasts we'd like to disavow.

China will corner the market on manufacturing, as it moves upstream to capture high tech industries.  Its currency will supplant the U.S. dollar as the preferred global vehicle for trade.  Its double digit GDP growth into the foreseeable future will allow it to capture global stocks and capacity for materials from energy to rare earth minerals.  This forecast is already being nuanced away, and it will have some more trimming of the sails in the future.

In all forecasts of this ilk, U.S. is the inevitable loser. The reasons are all over the map, reflecting our vapid body politic: self-loathing, nostalgia, multiculturalism, right wing conspiracies, profligate spending, under investment by the government, the Tea Party and so on ad infinitum.

A recent, tongue-in-cheek story in the Wall Street Journal talked about a merger of the U.S. and Canada.
There's a kernel of an idea here, but I'd make it even bigger.  I'd propose a United States of North America. I recognize that the name itself would need marketing and political negotiations, but I would include a continuous market that would include the U.S., Canada and Mexico.

Having written about the problems with the European Union, of course this sounds outlandish, and it is.  The biggest barriers are the political and economic rent-seekers whose interests would be gored by a change in the status quo.  However, this is exactly the phenomenon of a genuinely different future vision being weighed down by the baggage of recent history.

The case for Canada's participation in such a venture is obvious.  A country with a population of 35 million people is one-tenth or less the size of the U.S. population.

Figure 36 Population of the Canadian provinces and territories in 2006 and 2031
Most of Canada's population is concentrated in two provinces in close proximity to the United States in a belt from Quebec to Windsor.  Statistics Canada's presentation of future population scenarios shows the continued concentration of the population in southern Canada, with some growth in the Canadian agricultural centers of Western Canada.

Canada is our biggest trading partner, by far.  Census numbers show year-to-date through October the value of trade with Canada amounting to $209 billion.  Mexico, on a year-to-date basis, is third at $164 billion, just behind China at $167 billion.

The opportunities for almost unimaginable social and economic gains from really freer economic markets are right in front of our eyes.  This whole economic region could be energy independent several times over, but that's the low hanging fruit.  Canada has land and mineral resources that are underpopulated and underdeveloped respectively.  Mexico has finally begun to state, at least for the press, that its bloated, ineffective public oil monopoly PEMEX needs technical help to develop its energy resources.  Socially, its government needs to get a handle on its myriad social and political issues.

Capital abounds in all three countries, looking for investment in a regime of stable markets and a well developed legal system.  The Canadian banking system is much smaller than ours, but more conservative and looking for expansion opportunities in U.S. markets.

Beyond tongue-in-cheek, there's a real opportunity in what looks like a "1% scenario."  Instead of talking about a solar future, some of our think tanks ought to be turning their attention to a United States of North America.  ¿quĂ© peinsa usted?


Friday, December 6, 2013

Shell Won't Build Louisiana GTL Plant: Energy Prices and Misguided Policies Conspire

Source: Mark Perry, Carpe Diem blog.




We've known for some time that oil and gas markets have been out-of-whack on an energy equivalent basis, as the above slide from Mark Perry's blog shows.  Now, the fear going forward is that a glut of U.S. crude supplies and growing demand for natural gas in various forms will make the chart turn sharply upward.  Aren't global commodity markets fun?

How does this relate to Louisiana?  Shell announced that it had abandoned plans for construction of a massive GTL ("gas to liquids") plant in Louisiana, south of Baton Rouge. The part that is hard to fathom is the report in the press that the costs of the plant had reached  over $20 billion from $12.5 billion projected in September 2013.  There were some suggestions that it was due to a shortage of skilled labor and materials. If it were indeed due to rising material prices for say, steel, that isn't apparent in government statistics.  If it were due to a shortage of skilled labor, which could be possible, it would be cheaper to bring people over from Shell's collapsing Nigerian operations or from declining North Sea operations and buy them homes in Louisiana.  Or, it could be higher anticipated regulatory costs.  However, one looks at it, this kind of increase is a bit hard to believe.  

Shell began a long term research and development project in 1970 when it began tinkering with the Fischer-Tropsch process for producing liquids from gas.  Fast forward through decades, and Shell opened the first commercial GTL plant in Bintulu, Malaysia, with a nominal output of 12,500 bpd in 1993.  The company learned by doing the risks associated with the process, According to the company, air pollution from forest fires caused an explosion in Bintulu's air separation plant which led to an explosion that shutdown the operation until it resumed again in 2000 at 14,700 bpd.  By now, of course, Shell had thirty years of experience with the complexities of producing liquids--diesel and aviation fuel, advanced lubricants--and commercial byproducts like naptha and paraffin, as well as recoverable sulphur which could be pelletized for input into fertilizers and other products. Bintulu has been the laboratory for the extraordinary Pearl project in Qatar.

Pearl came online in 2006 at ten times the capacity of Bintulu.  Its first commercial shipment was in June 2011, and the plant was scheduled to be at peak production by the end of year 2012.  In almost every way, design, construction, efficiency, process management, and partnership with the Qatari partners, this operation is remarkable.  The plant is tied into offshore gas fields operating in forty meters of water and delivering 1.6 billion cubic feet of wellhead gas into the plant.  Pearl provides 8% of Shell's worldwide gas output, according the company's documents. The plant is self-sufficient with its water use, and virtually everything that is recoverable is sold.  This was the kind of plant slated for Louisiana, and what a shame that it won't be built in the foreseeable future.

Shell has to integrate $10 billion in acquisitions, which were to be funded partly by asset sales which have been slower than planned. 2013, according to the company, will be a peak year for net investments, and it is expected that asset sales will step up in 2014-2015.  The company says that its preferred options for the future lay in deep water Brazil and in Canada with heavy oil.  The latter seems hard to believe as well. 

Critics say that the company has put itself into this bind by overspending in Alaska with little to show.  At the same time, Nigerian output losses and the planned sale of assets are weighed heavily on third quarter 2013 and will continue. 

Our energy policy has blocked pipelines and also blocked the shipment of our shale oil production by rail for environmental reasons.  Meanwhile, after fining BP billions for coating ducks and sea life with oil --which was mitigated pretty conventionally washing the animals with soap--comes the news that wind farms get a pass from actually killing the American eagle, and endangered species.  Mamma mia. 

GM Still Can't Manage Its Brands

We first wrote about Opel in 2009, when it was slated to be sold to parts behemoth Magna International. Opel's platforms, called Delta and Epsilon, found their way into some nice looking and riding cars in the U.S., including those badged as Saturns and Buicks, including the LaCrosse.

Then, after its successful IPO, the company decided to make the Chevrolet brand the American face of GM in Europe.  Huh?  Here in the U.S., it's an iconic brand which has made a nice recovery from a near death experience in the seventies and eighties when it put out unacceptably inferior cars. In Europe the brand would be met with a shrug of the shoulders.  Again, with irony, the Chevy Cruze platform here in the U.S. was an Opel platform.  Not a bad car either.

But, the financial management folks at GM have decided to pull the plug on the Chevy brand in Europe after its 1.6% market share post- introduction.  Of course, it's the only decision to make, because establishing the brand in the crowded and finicky European market would take too long and cost too many dollars.

Meanwhile, the Cruze and other Chevy platforms in the U.S. will now move to cheaper platforms from Daewoo in South Korea, except that rising wages there are complicating the pricing. Are you keeping this all straight?

What about the customers?  Won't they notice the difference between something produced by Opel technology and something from Daewoo?  What about the dealers?  Some in Germany, committed themselves to exclusively selling Chevrolets, in order to differentiate themselves from other dealers selling Opels.

This is another company that still can't get out of its own way.  The IPO may have gone well, and the balance sheet may be stronger, but the company still can't manage its dealers, brands or customers.  They all deserve better.

Wednesday, December 4, 2013

The Poverty of Behavioral Economics

With the awards of the recent Nobel Prizes in Economics to Eugene Fama, Lars Peter Hansen and Robert Shiller, the whole discussion about market efficiency and behavioral economics surfaced anew in the press.  Professor Fama's efficient market theories are said to be discredited, according to the financial press.  The evidence?  The last financial crisis and its aftermath.  Never mind that the supposed evidence is weakly related, if at all, to the theory.

Professor Shiller, on the other hand, is suddenly lionized as a foil to Professor Fama for being a 'behavioral economist.'  Having viewed Shiller's "Financial Economics" class that he teaches at Yale online, I'm very puzzled, as most of that course is a nice exposition of modern portfolio theory, of which Fama is a father along with several others.

In the investments class I taught to upper level finance MBAs at the University of St. Thomas, there was a small discussion from Shiller about how markets can deviate from efficient equilibria due to something he describes as "noise trading."  Since this was a counterargument to the mainline theory from an economist of quality and stature, I dutifully taught it in our discussions.

The problem?  It sounds good, and it intuitively matches our ex-post experience of market runs and crashes.  However, there's no good model for how fundamental traders and noise traders behave, and therefore there is no model to test and no data.  It's an interesting idea, but empty.  It's a metaphor, but little else.

Recently, I received two different kinds of material from Chicago Booth School of Business.  One was an informative and thoughtful piece by Professor John Cochrane, one of my favorite researchers, on why Gene Fama was awarded the Nobel Prize. If you'd like to understand the theory apart from its facile characterization in the press, have a read, linked above.

By contrast, I also received a link to a video in which three 'behavioral' researchers from different disciplines at Chicago Booth expound findings from their latest research.  The research results seemed either blindingly obvious, somewhat puzzling, or downright counterexperiential.  These are all very smart people, but the discussion betrays the real poverty of behavioral economics.

Going into their relatively small experiments, there is no theoretical model from which they can measure their actual results compared to the expected results from their theories.  They find some correlation or trend, give it a name, and say that the result is "quite surprising."  Why?  What exactly did you expect?  I was really interested to know about the relative effectiveness of intrinsic versus extrinsic rewards in the performance of marathoners. I don't know anything interesting, thought provoking or useful after this discussion.

Tuesday, December 3, 2013

More Sunshine on Cloud Computing

The New York Times and other media are back touting cloud computing.  Cloud computing players will come in all weight classes, but the NYT names the heavyweights as Amazon, IBM, and Google.  Curiously missing  from the roster is HP.

Unfortunately, none of this really makes it any clearer who is going to carry the day as far as supporting the migration of mega-cap, public multinational corporations to a public cloud computing infrastructure. Will one or more of these companies really want their entire IT infrastructure to reside with a bookseller and operator of global merchandise bazaars?  Will a CIO really want to give over her IT infrastructure to Google? This is a company not known for transparency about its own operations or about its actual privacy policies.

All the talk in these articles is about unused, read 'cheap,' computing capacity, or the ability to get the power of a supercomputer by linking hundreds or thousands of servers together.  All of this is very loose talk.

Connecting servers together to do relatively mundane tasks is, or has to become, a commodity function.  Moving an entire corporate IT infrastructure to a public cloud, and for the CEO, CFO, CIO or others to sign off on the existence and effectiveness of a system of internal controls for this kind of setup, is a really risky venture, philosophically, financially and from the litigation standpoints.

Microsoft has reported good uptake of its Azure offerings.  Google claims to have $1 billion in revenues from cloud computing, although with Googleyness, it's not at all clear how this number is derived. HP, on one of its recent conference calls also cited $1 billion of cloud revenue, although the CEO quickly put in the caveat that not all of this number was 'incremental.'  At least she was honest.

Microsoft is also taking out full page ads for large corporate adoptions of  Office 365, and this is part of Microsoft's cloud numbers.  This certainly makes sense for these types of users, and the economics are hopefully superior to the licensing model, as they should be.

If Amazon is indeed selling at 150 times forward earnings, then its domination of cloud computing has already been discounted into its price.

Ask your favorite corporate CIO what he or she thinks about all this.  I'd bet you will hear a litany of buzzwords, and see a rather glazed look in their eyes. If you press for details and numbers, little of value will be forthcoming.

Check the list of risk factors in the 10-K too to see if something is really getting off the ground. Ask what the CFO thinks: most of them are worried about bigger business issues. This story is just beginning, and the real winners may be a different set from that of the New York Times.

Friday, November 22, 2013

Bubbles Morph Over Cycles: Web 2.0 Becomes Social Media

In the last Internet Bubble, Mary Meeker was the consensus "Queen of the Bubble," according to CNN. The linked article really portrays the wholly delusional aspect of equity markets and valuations during the last bubble.

"As the Internet exploded, Meeker became bolder about relying on nonfinancial metrics such as "eyeballs" and "page views." Here she is, for instance, in a July 1998 report on Yahoo (entitled "Yahoo, Yippee, Cowabunga ..."): "Forty million unique sets of eyeballs and growing in time should be worth nicely more than Yahoo's current market value of $10 billion." Four months later, when she revisited the company, which had just reported its third quarter, she wrote that there were "five key financial highlights." First on her list--even before revenues or operating margins--was the fact that Yahoo's page views had risen 25%."

Here we are in this market cycle, where the Web 2.0 bubble has reappeared in a different flavor, the Social Media bubble.  

"Snapchat is not even 3 years old. It's run by a couple of twenty somethings with no prior business experience. And it has never made a cent.
Yet investors are fighting for the opportunity to throw hundreds of millions at the mobile messaging service that is all the rage with teens.
The tiny Venice Beach start-up just turned down a $3-billion all-cash offer from Facebook Inc. And then, according to the Silicon Valley rumor mill, it rejected an offer from Google Inc., this one for $4 billion.
That's a big pot of cash for a smartphone app that could vanish almost as quickly as the messages people send on it. .../
Among the better-known Silicon Valley companies with monster truck-sized valuations are mobile payments start-up Square Inc. at $3.25 billion, online storage start-up Dropbox Inc. at $4 billion, private transportation service Uber Technologies Inc. at $3.5 billion and home rental service Airbnb Inc. at $2.5 billion."
How are things different between these two tulip manias?  One major environmental factor is the long-running, artificially induced low rate environment, with the promise of such rates in place for near eternity. Investors are feeling more confident, which I suppose means that the entrepreneurs heading these start ups feel like they might as well grab the candy being handed out by Mr. Market, and the investment bankers who have had a few salad years are only too happy to oblige.

There is nothing new on Wall Street.  Wall Street loves recycling, especially of ideas.  



Best Buy Can Have A Dominant Role in Electronics

The almost universal assumption is that consumer electronics are a commoditized products that can be sold anywhere, from drugstores to specialty superstores.  Therefore, it follows, says the universal consensus, that players like Walmart and Amazon should dominate consumer electronics sales, because of their purchasing power, scale efficiencies, and convenience.  Products that fit this paradigm perfectly include VCR-DVD players, MP3 players, and even smaller flat screen displays.

Apple of course has pioneered its own approach.  It develops tightly integrated electronics with a proprietary operating system packaged with stylish, uniquely identifiable design.  They have carefully nurtured a worldwide consumer brand.  Their products are manufactured through a small, tightly controlled network of suppliers, protected by a large patent portfolio.  Their margins are enormous, and although their market share for smartphones may have peaked, their profits and profit margins continue to be nonpareil in the industry.

Smartphones are likely to become ubiquitous, but at least at the upper end, they may not become commodities along the historical lines of the VCR. VCR components were all the same--read/write heads, laser readers, rollers, generic circuit boards, power supplies, and a metal cabinet--and there was nothing around which to build a distinct brand.  Westinghouse units sold in a drugstore were equal to JVC units sold in a specialty store, and prices eventually collapsed. Smartphones offer the same of opportunities for design, innovation and technical integration that can make brands, like Samsung, stand out from Google/Nexus, for example.

Right now, we appear to be heading in a different direction.  Think about a $129 smoke detector for the "connected home."  This would replace a $12 unit available at a drugstore, hardware store, discount retailer, or a retailer like Home Depot.  Who on earth would make this trade?  Never mind that the initial setup is complicated and that a newspaper reporter couldn't hook up with her home wireless network.  She took out her $12 unit and tossed it out!  Nest is establishing a brand; after all, their founders came from Apple.  A smoke detector was the ultimate commodity, but it could become something else.

The more complicated the palette of consumer choice becomes for electronics--and it is inevitable that it will--the more the opportunity opens for brick and mortar retailers like Best Buy to dominate significant segments of the consumer electronics markets, broadly defined.


Wednesday, November 20, 2013

Best Buy's Encouraging Third Quarter

Best Buy's stock trading at $43.58 crashed down to a low of $38.58 before rebounding today.  The price at the higher level was more inflated than the Hindenburg, and I'm sure that most technicians say that a pullback was both warranted and healthy for the longer-term.

Again, it's very funny to see the analyst at Credit Suisse who couldn't like the stock at $12 reiterating a Buy, with the undocumented suggestion of $5.00 per share in earnings power.  The only things missing are when, why and how?

Management's presentation wasn't as polished as in the past.  I know that the executive team are trying their best to give analysts what they want, in what they perceive as their own language. Management always does best when it speaks in their own natural language, expressing who they are and how they think.

The somewhat arbitrary logic of the points presented by the CEO, and the rapid fire basis point differentials between the next quarter and the present quarter for key ratios was hard to follow on the call.  For the CFO to then state that the company was not giving guidance may have been technically correct, but it was also confusing.  Analysts should then make their own revenue projections, plug them in, and then check their margin percentages to make sure the changes fit those given, I guess.  Over time, I hope that they come back to the simpler, clearer, more measured approach that characterized Hubert Joly's first presentation that really calmed the roiling seas when he took over as CEO.

Third quarter fiscal 2014 revenues of $9.4 billion declined 0.2% y/y, due to the effect of store closings in the interim period from the prior year quarter, and softness in international sales, particularly Canada and China. Non-GAAP EPS of $0.18 versus $0.04 was better than expected. Domestic revenues of $7.8 billion increased by 2.3% y/y, which was good news, driven by a domestic same-store sales increase of 1.7%.  So, the streak of declining same-store sales has been broken ahead of the holidays, which seemed like a litmus test for shareholders to believe in the story beyond cost cutting.

Domestic online sales increased 15% over the prior-year period.  So much for show rooming and Amazon. The CFO mentioned the strength of domestic pre-orders for new video game systems and software.  Most of this revenue will be recorded in the fourth quarter of fiscal 2014.  Were these orders recorded as revenue in the current quarter, domestic online sales would have increased over 20%.  New product introductions have always been critical for specialty retailers like Best Buy.

The Renew Blue cost savings programs appear to be on track faster than expectations and faster than those of other mega-cap companies I've followed over the years.  This speaks to the acuity of the current team, and it raises the question of what on earth was going on before they arrived?

In our post of November 16, 2012, we wrote,
"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."
We've talked about Best Buy's having lost touch with their customers over the years.  Much of what we found the most encouraging about the CEO's introductory remarks didn't have a lot of numbers attached, but it was clear why he was talking explicitly about these issues.  The company now sees customers interacting with the company in very personalized ways.  For example, like most customers, we do extensive price and product research online before visiting a Best Buy or before visiting Best Buy online. The customer might order online, come into the store to purchase, or purchase online but come into the store for merchandise pickup.  These might be different customers shopping in different ways, or it might be the same customer shopping in different ways for specific types of merchandise.

 But, it's not all about price all the time, and Best Buy gets this.  So, in this quarter and in coming quarters, some of the savings from Renew Blue are being reinvested in Best Buy's website.  This is a no brainer, and the new CFO has done this kind of major rebuilding of the engine and the body before at Williams Sonoma.

The CEO noted their expenditures on improving site navigation, taxonomy and the results for natural language queries.  Best Buy's site was in the Stone Age when CEO Joly came on.  It's improved, but it has a long way to go. Yet the improvements made already have generated 15% y/y sales increases.

They have combined killing their previously lame customer rewards program and replacing it with a new one, attached to a new private label credit card program from Citi. The company now offers product category guides online, and allows customer reviews to populate the online guides.  In the quarter, the CEO said that the number of customer product reviews posted online went up fourfold. This is slowly catching up to the industry's best practices, but with Best Buy's size and product diversity, making the website a place where customers want to spend time and give input is a big deal for reconnecting with customers.

Best Buy Canada has wound down 15 stores, and Canada has a poor mix of sales and a strongly promotional sales environment in the prior quarter, which contributed to a sixty basis point decline in the gross margin rate.

More than 400 large format stores will soon be equipped to ship to customers from the store.  Two of the corporate distribution centers are being optimized for online order fulfillment.  Amazon is the platinum standard for online fulfillment, but the good news is that there is nothing proprietary about the building blocks of this capability.

The CEO made a couple of references to welcoming show rooming, as the Best Buy stores are great showrooms, and some of them could in effect become fulfillment centers from the same real estate. This is another big deal.

The CFO noted another orchard of low hanging fruit, namely the merchandise from customer returns.  She said, "As we've discussed, customer returns replacements and damages represent approximately 10% of our revenue and over $400 million a year in losses." (Thomson Reuters transcript) 

If the turnaround was in the second or third inning in the last quarter, it is in the top of the third or fourth at this stage.  What's been unveiled so far looks and sounds very encouraging. 



Monday, November 18, 2013

Increased Regulation: The Biggest Risk for Middle Market Companies

The 2013 BDO Board Survey is published by the Corporate Governance Practice of BDO USA, LLP.  It surveys directors of middle market public companies with revenues of $250-$750 million about corporate governance issues.

In August 2013, the Public Company Accounting Oversight Board ("PCAOB")  issued a proposal to improve financial disclosure.  The proposal would require external auditors to furnish additional material in their audit report, such as the length of tenure with the client, and a discussion of critical audit matters that gave "the auditor the most difficulty in forming its audit opinion."

"Yet, less than one-third (27%) of public company board members believe the PCAOB's proposed changes will actually improve the usefulness of the report.Conversely, almost half (45%) of the directors say the changes will not improve the auditor's report..."

In a masterpiece of accountant's understatement, Lee Graul, a partner in the Corporate Governance Practice says, "Clearly, corporate board members aren't sold on the usefulness of the PCAOB's proposal..."
Nevertheless, many millions are spent employing the staff of the PCAOB and its infrastructure, including time wasted in congressional review, by corporate and accounting advocacy groups pro and con. This is yet another example of a proposal made by accountants and lawyers to make careers for accountants and lawyers, which imposes costs on shareholders of the companies and provides no benefits for the users of the financial statements by lowering risk or increasing value.

The SEC and the flock of other securities regulators and 'shareholder advocacy" groups have trumpeted the value of the SEC rule which allows public companies to disclose material information through postings on social media.  Are you ready?  "... none (of the directors surveyed) indicate that their companies have 
utilized this new channel to do so and only 11 percent anticipate utilizing social media for material disclosures in the future."  

"More than two-thirds (69%) of public company board members cite regulatory/compliance overload as the greatest risk facing their businesses."



Cutting Military Pay: Don't Play Politics With The Troops

"You can't expect this country to maintain a strong military if we aren't maintaining some kind of common-sense budgeting," Leon Panetta, the former Defense secretary in the Wall Street Journal

Of course, this is a complete red herring, as Secretary Panetta is a career politician operating in an arena where common sense is completely absent.  Government budgeting has nothing to do with budgeting or common sense.

"We have the analytic tools that potentially we didn't have before." General Martin Dempsey, Chairman of the Joint Chiefs of Staff, also in the WSJ. 

What tools are those?  Countless commissions of the armed services, think tanks and legislatures have identified the problems over decades.  

These kind of grandstanding comments give cover to focus on relatively small pieces of the puzzle, because the biggest barriers to efficiency, real cost controls and a better military are the political and military elites themselves.

Where does it begin?  According to Professor Andrew Bacevich, Professor of History at Boston University the problems lie at home with our own policies and failed assumptions.  Professor Bacevich retired from active duty in the Army with the rank of colonel. 

Our all volunteer army concept is at the root of our problems that have building for decades, as Bacevich writes in the compelling, "Breach of Trust."  Most observers know that we have too many military bases here at home and worldwide.  Domestic base closures have been identified and recommended, but Congressional leaders always fight to keep their own state's facilities free from right sizing.  Congress members and Presidential staff all agree that development of duplicative weapons systems and aircraft must be stopped, until it comes to closing down research and manufacturing in their home states. The big dollars are here in these issues, and if action is taken here, then headcount reductions follow and compensation would be significantly reduced, but through lower staffing levels and not by pay rates alone. The latter are blunt instruments.

Over time, our military were called on to invade and control Iraq in a traditional style, tank, artillery, aircraft and ground troop invasion, and this was carried out in exemplary fashion.  Then, we asked our military to become 'nation builders,' and we overstayed our welcome. In Afghanistan, our troops were put into absolutely untenable positions with no clear military objectives.  This situation is vividly described in Jake Tapper's "The Outpost." Trained soldiers and their commanders were asked to fight an enemy who couldn't be differentiated from the tribal leaders whose support they were supposed be garnering by winning hearts and minds.  Tours of duty were too long, and farces like "the surge" made us all at home feel safe and sound that things were going well. 

We wind up fighting as a foreign invader against trained foreign jihadists and guerrilla fighters from Chechnya and Pakistan tribal territories while engaging in nation building.  These are tasks that are impossible to carry out simultaneously by troops without the proper military intelligence and support. It's not a matter of pay.  

Further, the illusion of fighting wars with contractors makes no sense, budgetary or otherwise.  So, as the defense budget continues to shrink as a total share of Federal spending, we are staring at an abyss in the future. Having National Guard regiments serve in ways that were never in their traditional terms of reference does nothing to strengthen this service, but it does demoralize troops who have to serve multiple tours abroad. 

Demands on our capability to project our power and to defend our citizens and way of life will grow greater and more complex.  We can do this in an intelligent way, but cutting military pay as a first step is an insult to those who serve and it is shameful posturing by the legislative and military elites who know very well where the big dollar savings lie.  







Saturday, November 16, 2013

Germany Steps Up to Work With Ireland

We've talked about the idea of Germany working within the EU, not as the lender of last resort, but as an experienced strategic lender, investor and partner.  Now it appears that Germany is doing just this with Ireland, to the benefit of both parties.  In Ireland's case, they get access to credit without all the intrusive and unnecessary political regulatory baggage associated with EU, ECB, and other facilities.  

"Mr. Kenny said that his government will "work more closely" with German ChancellorAngela Merkel to sustain Ireland's recovery, saying that Germany's development bank KFW had been asked to help provide credit to Ireland's enterprises."  Source: MarketWatch. 

Ireland is not out of the woods by any means, but their ability to stick with their programs and come to an exit from their bailout has been hailed as exemplary, even by the IMF!  

The Irish government did have the ability to exit the bailout with a standby international and EU credit facility, but they again made reference to the additional terms which were not consistent with the Irish government's view of economic sovereignty.  

This announcement was, to our ears, the one tiny, but potentially path breaking news in a long period of EU crisis. 

Thursday, November 14, 2013

More Thoughts on Cisco and the New IT

We've been thinking about 'big data' in many posts, and it is now one of the common buzzwords on the lips of most tech CEOs, institutional investors, and analysts. This phrase, along with many others, such as 'software defined networks,' 'virtualization,' 'SaaS,' and 'the cloud,' mean that IT is undergoing a fundamental shift in the way that customers interact with technology, corporations use data, and buyers evaluate and pay for IT equipment and services.

So, is this sea change the reason that the Four Horsemen of Tech--IBM, Microsoft, HP, and Cisco--are struggling with top line revenue growth and earnings?  Is this why their shares sport historically low absolute and relative multiples?  It could be, but it seems as if there's something wrong with the market's view, as there was during the Internet bubble and during the Y2K crisis-that-wasn't.

Companies in other, more prosaic industries deal with the slow death of their cash flow rich businesses, and the better companies adapt or reinvent their portfolios.  Think about the check printing business for financial printers like Deluxe, Merrill Corporation and John Harland.  Who writes checks?  I use my iPhone and so on, yada yada.  Well, Deluxe has done quite well by branching out into search engine optimization, brand identity, and e-marketing, while still maintaining a check business that is providing cash for an array of financial services.  The Four Horsemen should be able to navigate their industry change, but some are playing a stronger hand than others, but this fact alone won't determine who will take the pot at the end.  That's why stock picking is an art.

Today, in the aftermath of Cisco's sell-off for poor guidance, I read one analyst who essentially said that Cisco was finished because of their dependence on selling high margin gear for an evolving system of software defined networks. The analyst is being myopic just as the banking analysts were who said checks are going away. Cisco management admitted on their call that they realized three years ago that they had to prepare for a major product line shift in their core business, and it is underway in the most recent quarter.  They may take a while to get it right, but having a huge market place presence and a fortress balance sheet is a strong hand for Cisco to hold.

Looking at Cisco's board, I noticed that Dick Kovacevich, the retired CEO of Wells Fargo is a director. Dick made an extremely challenging "merger of equals" work through regulatory, economic, operational, cultural and management challenges.  Wells Fargo was, and is, a bank that had consistently made large investments in technology.  Having the perspective of a financial services buyer on the board is extremely valuable; plus, I know from seeing him operate on the board of one my employers that he is a man of integrity with a strong sense of duty and loyalty to his shareholder constituency.  There are other strong directors who know tech from a different angle, like Marc Benioff and Arun Sarin who provided innovative software and hardware to customers.

Thinking about the "big data" opportunity, it isn't clear that any of the Four is building an insurmountable lead, because the nature of the opportunity, like every market, will have layers and segments which will require different business models and capabilities.  On the high end, for users like the U.S. government and its agencies, and for big university research systems, IBM and Cray Research have established positions and they compete with NEC, Hitachi, and other competitors.  Companies like HP and Dell who want to pursue this opportunity will come into it by building inexpensive high performance computing machines from commodity parts, thus analysts say undercutting margins for products like IBM's Watson and Cray's XC30-Cascade.  I doubt that the buyers will look at their decisions in this simplistic way, but we'll have to wait, see and learn.

HP went and bet the farm on buying an analytic engine through Autonomy.  This may or may not be enough, but they recklessly overpaid. Cisco, meanwhile, is really making a big run at network security and this opportunity can probably be more financially rewarding, faster than the big data opportunity.

Finally, IT buyers are not like Wal-Mart buying shampoo.  The CIO reports to someone who can put her out of a job for a catastrophic failure or a loss of confidential personal or financial data that invites regulatory bodies in for fines and civil lawsuits.  CIOs like meeting their peers and talking about they have recently implemented the 'next big thing.' I have lived through millions being wasted on business intelligence software, digital dashboards for real-time analytics, and data centers with robotic arms to swap data cartridges for IBM and Hitachi mainframes.  None of those CIOs pinched pennies.

Here is an example from a real life customer which is implementing a very large scale super computer project in Japan.  The Railway Technical Research Institute is dealing with a train system that is the transportation backbone for the country, where an unanticipated seismic event affecting bullet trains with several hundred passengers would be catastrophic.  In this case, a provider who could provide experience and a tightly integrated system capable of handling thousands of processors and a tested analytical engine got the bid.  The market for high performance computing and big data will definitely have segments in which many players can participate.



 




Wednesday, November 13, 2013

Cisco: The Fourth Horseman Reports First Quarter 2014

In Cisco's current 10-K, we note that for the period 7/2008-7/2013, an indexed investment returned an average annual return of 7.4%, trailing both the Standard and Poors Technology Index (up 18% p.a.) and the Standard and Poors Index (up 16.5%) by a wide margin.

Despite the under performance, Cisco's balance sheet is impressive.  For the fiscal year ended 7-2013, free cash flow was $11.7 billion, for the fiscal year ended 7-2012 FCF was $10.4 billion, and for the fiscal year ended 7-2011 FCF was $8.9 billion.

Despite its long history of acquisitions, which have become fewer in number and larger, Cisco has a tangible book value of about $6.24 even after stripping out goodwill and intangible assets.  The company recently closed on the $2.7 billion acquisition of Sourcefire, a leading innovator in the cyber security field.  In one of their slide presentations about the acquisition, Cisco talks about the importance of compatible corporate cultures when considering a target.  This acquisition is very consistent with CEO John Chambers' remarks on the FY14 1Qtr conference call where he said the number one concern of Cisco's top 95 global IT CIOs was IT security.

While acknowledging the maturity and scale of the current Cisco, the company returned $3.3 billion in dividends to shareholders in the fiscal year ended 7-2013, more than double the $1.5 billion returned to shareholders through dividends in the fiscal year ended 7-2012.

So, a company with a fortress balance sheet and high returns has dramatically under performed its peers and the broad market. Let's look at the recently announced FY 14: 1Q.

Revenue of $12.1 billion increased 2% yr/yr.  $9.4 billion revenue came from selling products, and $2.7 billion came from services.  Subsequent line items are non-GAAP numbers. Cisco's consolidated gross margin is an extraordinary 63%, and that rate increased by 30 basis points over the prior-year period.  Product gross margin was 62% and increased 50 basis points, while services generated a 67% gross margin, which also increased 30 basis points over the prior-year period.

Operating expenses were 33.7% of revenue, down 110 basis points yr/yr reflecting the significant worldwide reduction-in-force throughout the enterprise.  Operating income was an extraordinary 29.3% of revenue, up 140 basis points over the prior-year period.  Net income of $2.9 billion reflected a margin of 23.7% and income grew 12% yr/yr on a non-GAAP basis.  Diluted EPS of $0.53 increased 10% yr/yr.

During the quarter, the company repurchased 84 million common shares at an average price of $23.65 and returned $2 billion to shareholders.  The company also paid dividends of $914 million.

As of the fiscal year ending 7-2013, the company had 75,049 employees.  26,416 worked in research and development. 25,938 employees worked in sales and marketing, a number which clearly reflects the importance of consultative selling in the corporate culture. 7,546 employees worldwide were in administrative positions.  Research and development expenditures were about $6 billion in the last full fiscal year.

Analyst questions and concerns after the management presentations centered on the forward guidance for the next quarter.  One analyst said that he was "floored by the guidance."  Management suggested that revenues for the current quarter might be down as much as 11% sequentially.  While this seemed like a discontinuous change, the explanations were fairly clear.

The first quarter ended with a shortfall in bookings versus sales forecasts in the last two or three weeks of the quarter, and the backlog going into the second quarter was correspondingly low. Combined, these two factors comprise somewhat more than a $1 billion shortfall in the current quarter.

Their core set top box market will decline by about 4-5% in the next two quarters, as a technology transition continues to take place.  Emerging markets, including China, are and will continue to be very challenging. Each of Cisco's top ten emerging market countries missed their sales forecasts for the first quarter. The top five markets had yr/yr sales declines of 18-30%.

The CEO noted that Cisco had relied too much on core switching and routing product sales for many years, without being ahead of technical and engineering developments that would require new platforms for the high end customers.  He said that it took 4-5 years to fix this oversight, and it is done or their two core product segments.  Routing and switching are in the midst of major product line transitions.

The worry is that consolidated gross margins will decline, and they most likely will.  On a GAAP basis, consolidated gross margins have declined about 800 basis points from 2008-2013,  the period of the stock price under performance.

In the meantime, the company's work force has been right sized to work with significant margin pressure, if it comes. The substantial dividend increase and the commitment to share buybacks would suggest a company that should generate substantial free cash flows.  In fact, the company just announced an additional share repurchase authority of $15 billion.

Cisco's goal is to become the number one provider to its top global corporate customers.  It has the sales organization and culture and the balance sheet to make this happen.  Their acquisitions and new product platform launches seem to be in the right direction for their customers.  Their guidance for long-term revenue growth is 5-7%, which is above the "GDP rates" suggested by HP.  If this happens alongside some operating leverage, then the stock would appear to be undervalued, given its capability of producing prodigious cash flows.  

Monday, November 11, 2013

QE A Feast for Wall Street

"Unless you're Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.
As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again "bubble-like." Meanwhile, the country remains overly dependent on Wall Street to drive economic growth."

What Kind of A Recovery Is This?

I've spent some time thinking through a typically informative presentation by my former colleague, Dr. Ward McCarthy and his partner Tom Simons, CFA of Jefferies, Inc, "U.S. Economy and Inflation: Economic Recovery in the Era of Conflicting Monetary and Fiscal Policy."

I want to pick out some points the authors make and then express a different set of questions and concerns.


  • "The U.S. economy entered the 5th consecutive year of growth in Q3 of 2013."
The authors note that the recovery and expansion phases of the current business cycle "have been slow to date."  Not only is this true, but the nature of the recovery and expansion has been singular among recent cycles in that it hasn't featured an early-cycle housing recovery.  Instead, it has featured a "late-cycle housing recovery," which along with a recent pickup in CAPEX spending are both "important for the continuation of the economic expansion."

The consumer sector has usually been one of the engines of recovery in prior business cycles, but not in this one.  How could it be otherwise?  The authors note,

  • "The unemployment rate has declined from 10% in October 2010 to as low as 7.2%, but remains high by historical standards."
  • "Real Personal Consumption Expenditures has been remarkably steady and sluggish for an extended period." 
What of the miraculous, unconventional monetary policy of the Bernanke Fed?  It appears to be the only thing propping up the stock market, because even the faintest whisper of a taper sends the market into atrial fibrillation. The authors note, "Consumer spending behavior provides evidence that the Fed's QE has not had a widespread impact on the consumer sector outside of housing activity."  

On a broad macroeconomic front, productivity growth in the U.S. economy has been one of the biggest contributors to economic growth and wealth creation for decades.  But, a secular shift in the composition of output may not bode well for this in the future. The authors put the problem in simple terms, "It takes 85% of the U.S. labor force to generate a monthly trade sector surplus of less than $20 bn."  

So, ironically in this recovery, "The decline in goods-producing activities has been fundamental to the sizable monthly trade deficits in goods that have been a drag on the economy and growth."  

In secular terms, this could change, were higher value-added manufacturing to be "right shored" to the U.S. The biggest barrier to this happening is our own fiscal, political and regulatory irresponsibility.  

During this recovery, the Federal government has run annual deficits of over one trillion dollars.  While an observer could point to a short-term decline in the ratio of the deficit to GDP ratio, the total stock of Federal debt stands at an astounding $16.7 trillion, according to the St. Louis Fed.  

The Congressional Budget Office forecasts of tax revenue, spending and deficits are inherently untrustworthy. The authors note that the most recent CBO forecast has discretionary spending "rising for the remaining 8 years in the forecast horizon" beyond FY14.  

This is before yesterday's announcement that Medicare spending shall treat mental health expenditures equally to medical expenditures. The impacts of the 39 million or so additional consumers coming into the plans before this expansion have been dramatically understated, but out politicians are looking no further than the 2014 election campaigns. 

Finally, our banking system is holding excess reserves of over $1.9 trillion, and the Fed's balance sheet may not normalize until 2019 or beyond.  Meanwhile, studies from the New York Fed show that unwinding the Fed's balance sheet will remove the patent medicine of Fed remittances to the Treasury which have been widely hailed as demonstrating the 'success' of the bailout and unconventional monetary policy.  We'll look at these issues in some later posts.

So we have a five year old recovery that is built on pretty sandy soils.