Wednesday, January 30, 2013

Continuing Fog Around Coal


According to the International Energy Agency, as of March 2012 about 40 % of the world's electricity is generated by burning coal, and it is still the second fuel source globally behind oil. Coal is plentiful, relatively easy to mine and cheap to burn.  However, as we know from our own history in Pennsylvania and Appalachia, it also imposes very heavy long-term public health costs on  miners, plant operators, and on the general public.  This week's photos of the air quality in Beijing are a vivid reminder of what we have all known for generations. 

The first cry going out from the environmentalists is to make coal burning "cleaner." Significant academic research has been going on for decades trying to bring this dream to reality.  Unfortunately, an economically feasible solution is still in the labs. 

On coal gasification with pre-combustion carbon capture and storage, MIT's research is probably at the forefront. 

Similarly, pressurized coal combustion in an advanced oxy-fuel chamber has attractive properties for efficiency and greenhouse gas reduction, but the characterization of the process using computational fluid dynamics is still in its relative infancy.  

Finally, there is the dream of integrated carbon capture and storage. The demonstration project in Estevan, Saskatchewan is one of the largest of its kind. If environmentalists are agitated about fracking and the movement of underground gas near aquifers, they should predictably raise a hue and cry about deep well injections of gas.  Aside from these concerns, the real issue, as always, is the economics of these projects and their effects on electricity prices, which all consumers and businesses use.

China, if for no other reason than the health of its citizens, should be developing many such demonstration projects to burn its coal cleaner.  The same could be said for India, and India should also make a wholesale replacement of its urban diesel bus fleets, which choke the lungs of the Indian populace with soot and noxious gases. 

We really need to have a portfolio of energy sources with which to deal with the economic transitions among fuels and with a sensible path to reducing greenhouse gases.  Windmills and solar won't do the trick. Remember this favorite. "The Windmills of Your Mind?"  

Tuesday, January 29, 2013

Dell's Shotgun Wedding With Microsoft

According to the Wall Street Journal, a Dell leveraged buyout is at hand. Dell has been, along with HP, a quintessentially loyal partner and supporter of the Wintel monopoly over decades.  Microsoft has apparently learned from Warren Buffett and is offering a preferred security for its cash into the deal.  At the end of the day, Microsoft would like have a "captive OEM."  Since Michael Dell, like Bill Gates, is a founder of the company, it's not likely that control over Dell's future options would be given away.

Dell's manufacturing, sourcing, and supply chain management expertise are valuable assets for Microsoft's own push into devices.  As the world of suppliers continues to consolidate globally, Dell will eventually come back public and Microsoft will make money on its preferred.

I'd love to be a fly on the wall to hear what Michael Dell really thinks about Windows 8.  Hitching his company's wagon to this product, with no flexibility to hedge his bets, is not a good strategic decision.  Crafting the right deal for Dell will be a lot more than a matter of semantics.

Monday, January 28, 2013

The Best of Davos?

The Wall Street Journal had a blog entry called "Davos in Fifteen Minutes," or the Best of Davos.  If this was the "can't miss" material, it must have truly been a snooze fest.  But that ski slope powder, formidable!  I struggled to take away anything of value from the Best of Davos, but here it is.

Charles Dallara, who was leaving the Institute of International Finance after the meeting, joined the Swiss-based Partners Group, an asset manager.  After a tepid tribute to European central bankers, Dallara made a trenchant observation about where we are post all the financial card shuffling by Mario Draghi and others.  He said that the fundamental economic performance of Spain, Italy, Greece and Portugal continues to be unsatisfactory, despite all the press releases declaring victory.

He also laid blame squarely on the shoulders of the sovereign market investors, which include the national central banks, who have been "asleep at the wheel for years."  Since Europe has traditionally relied more on commercial banks for business lending (80 percent), commercial lending continues to be frozen in Europe.

Investors indeed have themselves to blame for drinking the European Kool Aid, but on the other hand, it was rational of them to take advantage of the "implicit subsidy" on sovereign debt provided by the previously unspoken, but inevitable ECB bailout.  Europe is still a ship taking on water, albeit a bit more slowly.

Robert Shiller of Yale and the Cowles Foundation gave a much more muted assessment of the housing market than is filling the front pages of our newspapers.  Professor Shiller is someone I've always enjoyed reading and listening to, including his economic class lectures at Yale. I want to know what he's thinking.

In the short-term, Shiller says the U.S. housing market is moving off the bottom and may be said to be improving.  Longer-term, as an asset class and as an economic driver, the outlook was--and he struggled for a word--"neutral."  The multi-family apartment market, he said, was more robust because of consumer demand and investor demand for their project paper.  The single family market, which reflects the American Dream of home ownership, had a more problematic and segmented outlook, reading between the lines and the look on his face.

Speaking about the stock market, he clearly wasn't enthused, but he noted that the valuations weren't overblown, especially given the paltry returns in fixed income.  Using the Cyclically Adjusted Price Earnings (CAPE) Ratio, he noted that it stands at 22.2x today.  The average for 2006-2013 was 21.7x, and the median was 21.5x.

Professor Shiller characterized the breathless headlines about the housing market being "off to the races," as so much fluff.

I think I'm going to go outside and enjoy some our fine Midwest powder, by shoveling it off my driveway!

Saturday, January 26, 2013

Microsoft's Q2 2013 Was a Mixed Bag

We've had a few recent posts about Microsoft, and we were certainly more positive about the initial launch of Surface RT, and a bit more cautious about Windows 8.  Listening to Microsoft's conference call was about as revealing as a White House press briefing.  Since they publish all their numbers laid out for the user  in Excel, the story is right there, including historical data.

The company wouldn't comment on how many Surface RT tablets were sold in the second quarter, but Credit Suisse analyst Phillip Winslow estimates the unit sales at 700,000 in the December quarter, which is nothing to sneeze at.  The company referred to the February 9, 2013 launch of Surface with Windows 8 Pro, which is supposed to have a broader retail channel launch than Surface RT that was available only through Microsoft pop-up stores.

The change towards selling devices will, over time, blend the gross margin rate down some, but ceteris paribus, it will be coming down from levels like 73.5% in the second quarter.  The CFO, who has also led some business units in his career, made repeated reference to "what we (Microsoft) learned in the quarter."

I believe that one thing they learned is the conversion of the user base, particularly corporate users, to Windows 8 is going to take more time and more support dollars than planned. Many large corporate users haven't really finished their implementations of Windows 7 yet.  In certain industries, like healthcare, IT managers are focused on compliance with HIPAA and on determining how many actual network attachment points they currently have on their system.  Dollars for a Windows 8 implementation are not a sensible use of funds for corporate executives in an uncertain 2013.

The core Windows business in the quarter had sales increase 24 percent to $5,881 million, with operating income increasing 14 percent to $3,296 million; adjusting for revenue deferrals, the revenue gain was 11%. So, even though consumers may have been confused between Windows 8 RT and the full Windows 8, it wasn't a bad quarter.

Servers and Tools revenues increased 9 percent y-o-y to $5,186 million with operating income increasing 9 percent to $2,121 million.

Microsoft Business Division saw revenues decline by 9 percent to $5,691 million,  but adjusting for deferred revenue the decline was 3 percent. Operating income declined to $3,565 million from $4,188 million in the prior year period.  Healthy indicators in this business include a higher mix of multi-year licensing cited by the CFO and a 12 percent increase in revenue from the Microsoft Dynamics ERP.  Operating margins in this business, though down y-o-y, are robust.

Online Service and the Entertainment Services Division remain works in progress.  The Bing search engine increased its market share in the quarter by 120 basis points y-o-y, and online advertising increased, while display ad revenue declined.  Revenue per search increased.  Windows phone revenue increased by $546 million.

Cash flow from operations was $4,780 million and capital expenditures were $930 million--substantially above the prior year.  Free cash flow from operations was $3,850 million. Of this, $1,658 million went to share repurchases and $1,933 million to dividends.

There wasn't one question on the conference call about the proposed participation in the Dell LBO.  It certainly makes sense that Microsoft support one of its biggest, loyal partners in rolling out Windows 8.  It also makes sense as Microsoft accesses Dell's manufacturing and supply chain management capabilities for chips, boards and component assemblies. Microsoft enjoys a low effective tax rate, and some observers have suggested that participation in a Dell LBO could be done in way that would allow Microsoft to access overseas cash without paying taxes on repatriated balances.  That would be an additional financial engineering benefit, but let's see.

The bulls on the stock suggest a significant opportunity for operating margin expansion in the coming quarters and years, starting with the next quarter due to a surge from Windows 8 on the consumer side.  The problem, as we have written about before, is the unanswered question, "Is this a value stock or a value trap?"

Traditional value-oriented mutual fund investors like Tweedy Browne dipped their toes in the stock in the 2008 down draft, but they subsequently sold out of it.  The relative valuation metrics always look cheap, as they do now.  Aside from index investors, and small positions held by Vanguard Wellington, this stock is not at all widely owned by growth or value investors.

Were the company to significantly raise its dividend to get its yield into line with value stock yields,  and cut back on its share repurchases, this would help.  It will need continuing investment in its online and entertainment businesses, as well as to support its consumer device businesses.  Share repurchases don't earn the management any kudos with the stock flat over five years.

The other question is the management.  Managing distinct enterprise-oriented businesses with hardware, software and services and consumer businesses that will depend on access to content, new product launches and hardware is exceedingly difficult under the current organization.  Who is in charge of these distinct efforts?  The Street is clearly not enamored of CEO Ballmer.  It might be time to launch Windows 8, declare victory, restructure the company, and allow CEO Ballmer to retire on a win.

I don't think there is any chance that will happen given the cultural legacy of Microsoft. If Microsoft is going to drive the financial strength of the balance sheet engine to deliver significant value, then the corporate organization and leadership needs a major refresh.  Hopefully, it won't be another five years of the share price going sideways.

Tuesday, January 22, 2013

Megabanks and Our Failing Banking System

Readers of this blog have seen many references to the work of President Richard Fisher and his research staff at the Dallas Fed.  The New York Times columnist Gretchen Morgenson cited a recent speech by Fisher, which reiterates themes expressed in the Dallas Fed's 2011 Annual Report.

Our last post on J.P. Morgan Chase concluded, based on the contents of JPM's own internal report, that the organization had become too risky to the financial system, and too complex to manage.

The work of the Dallas Fed comes at the megabank issue from the truly fundamental level: what are they doing with their privileged position in our financial system, to really help the economy?  The megabanks, according to the Dallas Fed research, are impeding both the transmission of monetary policy and the traditional path to additional lending and recovery.

Our banking industry post-crisis is more concentrated than ever, as shown by this chart from the Dallas Fed.

So, 0.2% of U.S. banks hold 69% of the industry assets.  This isn't good for systemic risk management, enterprise risk management, or for job creation and economic recovery.

The next point about this kind of system is that the resolution process for the 5,500 community banks can be completed in a weekend, and we've seen that happen in my home state, Minnesota.  The resolution process for banks with moderate asset size may take weeks or months, but we have a lot of experience with these too.  There is no workable resolution process for megabanks, and so they are guaranteed perpetual life support by the U.S. Federal Reserve Bank and the U.S. Treasury.  Their shareholders and creditors know this too.  There can be no "creative destruction" for JPM.

This "implicit subsidy" is extremely valuable to the managements, shareholders and creditors of the megabanks.  As a result,

"unsecured depositors and creditors offer their funds at a lower cost to TBTF banks than to mid-sized and regional banks that face the risk of failure. This TBTF subsidy is quite large and has risen following the financial crisis. Recent estimates by the Bank for International Settlements, for example, suggest that the implicit government guarantee provides the largest U.S. BHCs with an average credit rating uplift of more than two notches, thereby lowering average funding costs a full percentage point relative to their smaller competitors.[8] Our aforementioned friend from the Bank of England, Andrew Haldane, estimates the current implicit TBTF global subsidy to be roughly $300 billion per year for the 29 global institutions identified by the Financial Stability Board (2011) as “systemically important.”[9] To put that $300 billion estimated annual subsidy in perspective, all the U.S. BHCs summed together reported 2011 earnings of $108 billion.
The rating uplift, the significantly lower cost of funding, and the ability to leverage back office expenses on a huge asset base puts the other 99.2% of U.S. banks at a huge disadvantage in offering competitive products and services to their customers.   Paradoxically, the megabanks get this free ride despite the fact that they are inherently more complex to manage and to regulate.  They also pose the systemic risk.

Dodd-Frank, as we have said until we're blue in the face, adds nothing but complexity to what the British call "macroprudential regulation."  Here are some interesting charts, again from the fuller Dallas Fed study.

These are the deadweight economic losses from regulations like Dodd Frank, which are blunt instruments that weigh most heavily on those organizations for which existing regulatory and resolution mechanisms are both adequate and proven.

Finally, businesses need loans most urgently when times are tough.

This chart shows that the community banks, and the moderately sized banks are the ones which have maintained or expanded their business lending through and after the financial crisis.  Ultimately, this is why our nation needs a banking system, for maturity transformation and intermediation.  We don't need banks for proprietary trading.

Also, anyone who deals with one of the big twelve banks knows a few things about their business models:

  • Over a long period of time, most of their income has become fee income as opposed to net interest income from traditional lending.
  • Fees on traditional small checking and deposits have climbed into the stratosphere when measured against the risks and cost of funds.  
  • Seniors, students, new entrants to the work force, and new immigrants can't get a low cost, plain vanilla banking product without arbitrary limits and high fees.  Credit unions can't compete with limited locations and few ATM's.  
  • Megabanks are inexorably milking their former best customers with higher fees in the hope that they leave. The megabanks want to get into upmarket services like asset management accounts combining brokerage and banking with significant minimums.
  • The investment banks in these holding companies can take as much risk as they like to show attractive returns on equity.  
  • Traditional commercial and industrial loans are not attractive products for megabanks to offer, and their best customers, awash in liquidity themselves, have already floated large issues of fixed-rate term paper at historically low spreads for investment grade. 
Fisher's paper ends with the following quote,
"To us, the remedy is obvious: end TBTF now. End TBTF by reintroducing market forces instead of complex rules, and in so doing, level the playing field for all banking institutions."
Have a read through these materials linked above which are clear, well researched, and fundamentally sound.

Note: all charts and graphs above are from the hyperlinked Dallas Fed publications.

Saturday, January 19, 2013

J.P. Morgan "London Whale" Report: A Whale of a Tale

The 129 page internal report by J.P. Morgan on "2012 Chief Investment Office Losses" is alternately a dry and a comic unintentional indictment of the company, its management, and the academic concept of risk management for a modern investment bank.

The most widely read post on this blog is from September 2011, on the subject of AIG, financial risk management, and rogue traders.  Reading the current report absolutely convinces me about the merits of the arguments I made in the 2011 post. Further, it is also clear that the TBTF ("Too Big To Fail") argument is off the point.

Institutions like J.P. Morgan are TCTM ("Too Complex to Manage") The talk about the "London Whale" does nothing more than anthropomorphize the huge, systemic risk posed by institutions like J.P. Morgan Chase.  The 2012 CIO losses cannot legitimately be attributed solely to the behavior of one trader, or even to a group of traders.

To have outsiders look at the Synthetic Credit Portfolio ("SCP") would have been prohibitively expensive and time-consuming.  It would have also shed no more light than does the current report.  The internal report is poorly written, alternatively simplistic and opaque, and completely exonerates the cast of incompetents, charlatans and cynics that populated the CIO.  Any reader who understands Wall Street will understand where the issues lie after reading the report, although the reader may not understand the fine details of the SCP's portfolio implosion.

The whole premise of the SCP is unconvincing.  It was supposed to be a vehicle for deploying excess deposits in the system to inoculate J.P. Morgan's core credit portfolio from unanticipated changes in interest rates, inflation rates, and economic growth. SCP's overall strategy, trading tactics, and management truly describe a proprietary trading vehicle, a distinct profit center.  It was certainly not managed as a hedging vehicle.

Here's the arc of the story in numbers and events:

  • At month-end January 2011, cumulative mark-to-market (M2M) losses on the SCP portfolio were $100 million;
  • At month-end February, M2M losses are $169 million;
  • At month-end March 2011, M2M losses are calculated at $718 million.  
  • On April 5, 2011, CEO Jamie Dimon, the CFO and CRO are told the SCP's risk was "balanced," the market for credit index swaps"dislocated" and the M2M losses "temporary."  One trader, without any defensible basis, says that the losses would "mean revert."
  • On the basis of these dubious assurances, CEO Dimon utters the infamous quote on a 4/13/2011 conference call describing investor concerns about the SCP portfolio as "a tempest in a teapot." CFO Braustein says that he is "very comfortable" with the portfolio's position and risk profile. 
  • All during the month of April, losses in the SCP continue to mount.  Non-CIO personnel, primarily from the Investment Bank, take over management of the portfolio.  Taking a more rigorous and defensible look at the portfolio risk, they analyze correlations between the instruments and estimate risks across a range of different scenarios.  Their basic conclusion: SCP's risk was much higher than than was reported to senior management ahead of the April quarterly conference call.  Markets had become illiquid because other savvy investors like Boaz Weinstein had come to understand months before, the extent of SCP's predicament. So, the comments given to management about credit index swap markets being dislocated was disingenuous.  A noose had been slipped on JPM and tightening for months. 
  • By May 2011, M2M losses were more than $2 billion!  
  • Around this time, CEO Dimon says that the SCP investment strategy was "flawed, complex, poorly reviewed, poorly executed, and poorly monitored." 
  • JPM's external auditors, PwC had reviewed the portfolio marks in conjunction with the report of the first quarter's financials and found no issue with them.  Their subsequent May 2011 investigation found that the portfolio markets lacked "integrity."   Whereas PwC had expressed confidence in the process and outputs of the M2M, they now opined that the marks no longer represented "good faith estimates of fair market value," according to the report. 
  • By 6/30/2011, cumulative M2M losses on the SCP stood at $5.8 billion.  
  • on 7/13/2011, JPM restated the first quarter's net income based on the inadequate M2M marks, reducing it by $459 million.
Going back to December 2011, J.P. Morgan Chase had begun thinking about Basel III's capital requirements.  Management's directive was to reduce risk weighted assets ("RWA") both in the Investment Bank and in the CIO.  According to the internal report, the CIO was known to be a large consumer of total RWA.  

At this time, the SCP was generally short credit.  The directives to SCP management were to reduce the overall size of the portfolio, and to make it more "credit neutral", in order to reflect bank strategists' more optimistic views about the economy.  When the CIO traders tried to reduce significant short high yield positions, they found the market illiquid.  The traders then came back to management and said that the directive would be too costly.  

Now, the CIO traders came up with an alternative strategy to accomplish the corporate directives, namely to go long investment grade corporates.  One of the key findings of the report was that the SCP traders designed a "flawed strategy."  Chief Investment Officer Ina Drew was cited for failing to vet, understand, and manage the SCP investment strategy and its implementation.  In addition, the CIO's risk management functions and finance functions were found to be "ineffective."  That is a very bland word for pervasive incompetence and laughable processes and controls.

An appendix to the internal report describes the VaR model used by the CIO.  Post-crisis, everyone knows the limitations of these models.  At the time, the particular models used inside the CIO had been designed to fit Basel I, but they were not in line with the requirements of Basel II and II.5.  The corporate executive management were already looking ahead to being Basel III compliant.

Apparently, there was a large dichotomy between the risk management functions inside the Investment Bank and those inside the CIO.  The CIO's VaR models, for example, gave very limited treatment to asset correlation risks, even though the traders knew when they did their monthly M2M that correlations were increasing thereby raising the riskiness of the portfolio.  

In August of 2011, the CIO hired an outside expert, a British "mathematician," referred to in the report as the "modeler."  Apparently, this secret agent lingo is to protect the identity of this person so as to not jeopardize potential prosecution in Britain.  The modeler apparently sold his engagement by saying that a "better model" would both deal more effectively with asset correlation and simultaneously reduce RWA.  This is intuitively implausible, given what the traders were finding in their daily operations, but it was what everyone wanted to hear. 

The modeler built his model in an Excel workbook, requiring manual entry of daily data.  Meanwhile, because the CIO was top-heavy and understaffed with high-powered analysts, data entry for daily fair market valuations was done by a junior trader.  In mid-March 2011, according to the report, this junior trader was directed by his manager to choose an outmoded, simplistic formula for FMV which lowered the reported losses for the period.  Remember from earlier in the post that losses went from $169 million in February to $718 million in March.  

Meanwhile, traders inside the CIO approached their managers and CIO executives about their compensation being at risk for the growing chorus of monthly bad news!  They were assured that this was not going to an issue, and that the issue would be treated fairly.  Incredibly, the internal report absurdly asserts, with no evidence, that compensation issues did not affect trading behavior inside the CIO.  Some things never change on Wall Street. They never will, Dodd-Frank and any other Rube Goldberg regulations notwithstanding.  Paul Volcker, where art thou?

The modeler's output was implemented, even though it was widely understood that the model had limited back testing.  Executive management believed that on the day of implementation, that the model's data input would be automatic.  It wasn't.  There were two specific areas of remediation, related to the valuation of illiquid tranches, which were supposed to be fixed before implementation.  They weren't.  On April 10th, a data input error failed to record a $400 million daily fair market value loss in the portfolio, until the error was later uncovered.  What a comedy of errors in the most powerful investment bank in the world.

The J.P. Morgan Chase board of directors rightly concluded that the CEO should be able to rely on the competence and ethics of his direct reports.  However, it also said that "...he (Dimon) could have better tested his reliance on what he was told."  The board had no choice but to take the approach of "the buck stops here" with CEO compensation, and it did. This did show that the board was not brain dead, but little else changed inside the organization, as other key actors exited stage right in a genteel way.  Ina Drew's past incentive compensation was subject to some clawback, but again, the CIO organization was untouched by any real consequences.

This was the case despite the report's concluding that (1) CIO managers failed to escalate their concerns to executive management, corporate officers and even to the board of directors; (2) traders had hidden the full extent of their losses, and (3) the CIO report to the CEO and his senior executives ahead of the first quarter 2011 conference call was "inadequate."  

As of January 19, 2013, here's how the Huffington Post described CEO Dimon's conference call with analysts:
"On calls with reporters and analysts Wednesday, he (Dimon) was his usual swashbuckling self, intensely proud of the bank he runs and sometimes impatient with critical questions.He said the portfolio where the troubled bets were made is "very close to being a non-issue" as far as trading losses are concerned. .../When analyst Guy Moszkowski asked about the "exotic investment strategies" of the Chief Investment Office, where the loss occurred, he shot back, "It has got not a damned thing to do with exotic investment strategies – zero, nada, nothing. OK?"
Unfortunately, Mr. Dimon probably scored the debating point against Mr. Moszkowski.  The investment strategies at the SCP were not at all "exotic."  To mash up Mr. Dimon's words with the findings of the report, the investment strategies were hare-brained, incompetently designed for the wrong purposes, not vetted by CIO management, implemented with Tinker Toy tools, left in the hands of unsupervised individuals, and reported to the CEO through folks whose economic interests clashed with their duty of candor.  All the same cultural issues remain. But, perhaps we are closer to future trading losses being a non-issue.

Looking for a bridge to buy?  

Tuesday, January 15, 2013

Facebook May Do a Face Plant

My social-media driven teenager finally got me on to Facebook, with quite a bit of reluctance on my part.  Facebook really does have some virtues.  For my cousins all around the world, it's a great way to see and read about what's going on in their lives.  Prior to Facebook, I would have had to glean everyone's emails and hope that individual connections could be made and sustained.

Instead, the ease of putting up photos and links encourages sharing. The other person can choose the frequency and form of the updates.  Photos are the best.  It's nice: I like it.

The Facebook interface, however, is very kludgy.  The search function for a person is terrible.  Adding a search by school or past relationship produces nothing.  The search doesn't seem to take into account what's already known about me on my page.  When I mention this to my teenager or any other high school age user, they all agree, "It's not very good." They put up with it.

But, Facebook did a splashy IPO.  What are they doing with the proceeds?  Surely, sweeping aside the look and improving the performance of their basic service must be a high priority.  I do notice ads everywhere.  This is generic stock-in-trade for any social media or consumer site. What else?

One of my cousins, an IT tech guru in the U.K., has reached out to me on Google+. I am trying to tell him to leave me alone.  You mean that I have to learn the mechanics of another site?  As I extolled the virtues of Facebook and its enduring value for connecting, he replied dryly, "You're assuming that they're going to be relevant and that they'll always be around."  But, they just did a massive IPO!

In today's New York Times, the writers ask tech pundits WSFD ("What Should Facebook Do?"). Here's what one pundit says,
“If Facebook would decide to become serious about search, it would be in a position to give Google a run for its money,” said Karsten Weide, an analyst with IDC, a financial research company."
I can't believe that the analyst is serious.   Google's search learns from every user's every interaction. They recognized long ago that search would always be at the core of what they do.  Microsoft, with its technology genes and deep pockets, has made a belated, somewhat successful run at search with Bing!.  Their shareholders were skeptical about the entry into search.  In their case, I believe Microsoft had no choice but to stake out territory.

Google is now taking a run at Facebook with a social media product that seems to be preferred by tech industry folks like my cousin. Google, as is their wont, is trying to quietly shove Google+ down the throats of anyone using search, Gmail, or Google Docs.  Taking a run at Google on search is a recipe for wasting hundreds of millions  Google has an insider, one of its most visible and quoted executives at Yahoo!.  No one knows yet if the model for Yahoo! will work.

Facebook taking on Goggle in search this late in the game, without any sign of refreshing and rejuvenating its core offering would give me heartburn if I were a shareholder. How long would it be before Facebook succeeded?  What are the metrics of success? What are the costs and the expected revenues?  Somewhere out there, it seems to me there is a distinct possibility that Facebook does a full face plant.

Sunday, January 13, 2013

Continuing Illusions About Afghanistan

The recent White House meetings with Afghan Prime Minister Karzai generated photo ops and a joint statement, but the road from here through the end of 2014 should be filled with lots of twists and turns.

Some of President Obama's key points:

  • By year-end 2014, Afghans will have full responsibility for their own security;
  • The war will come to a "responsible end;"
  • al-Qaeda can never again use Afghanistan as a launch pad for attacks against the U.S.
  • Our troops will continue "to fight along side Afghan troops, as needed;
  • More than 2,000 U.S. soldiers have lost their lives in the war;
  • Our remaining troop presence after 2014 will be involved in training, advising and assisting Afghan security forces.
We really don't appear to have any clear and credible vision of how our interests are going to be served by the laundry list of soft commitments we have made to the lame duck Karzai government.  For future economic commitments, the U.S. has promised to align 80 percent of the funds to Afghan priorities and to channel at least 50 percent of the funds through Afghan budgets. Since the system of taxation and government revenue collection in the country is already massively corrupt, it doesn't bode well for a future in which more funds are available for redirection into the hands of corrupt officials at all levels.

Although both Presidents agreed with the concept of a Taliban representative office in Qatar, the Taliban has not yet agreed to the concept of dealing directly with the government of Afghanistan. 

India and Pakistan's recent news bulletins about the killing of soldiers and agents at Kashmiri check points is the beginning of positioning the two nations for exerting their influence at the multinational talks on the future of Afghanistan.  The U.S. position on what it expects from both India and Pakistan in relation to the future of Afghanistan is murkier than ever.

The workhorse diplomatic effort have been carried out during the past four years primarily by Secretary of State Clinton, but her role is already diminishing because of health issues.  Secretary of Defense Panetta has occasionally spoken up to defend the U.S. against President Karzai's outrageous accusations, but given the diminished future role of the military, it's not clear how strong his voice will be. The Obama foreign policy apparatus, apart from Secretary Clinton's personal efforts, has not been effective.  

It is really in nobody's interest for there to be an Afghan civil war as the U.S. draw down nears. Ann Marlowe has a non-consensus perspective,
"What will happen after we leave Afghanistan? A lot less than we think. More like entropy, or a regression to the mean, than like a civil war. A slow drift to regionalism, with the increasing irrelevance of the Karzai kleptocracy we have empowered. On the plus side, IED attacks and other terrorist violence will decrease dramatically. So will corruption; without US backing, corrupt officials will be removed by local consensus or the time-tested remedy of assassination. Afghans are natural capitalists and they will continue to create businesses and try to improve the lot of their families."
Let's hope she is right.

As we are committed to direct future economic aid to Afghan priorities, it is well to remember that education of young women is still not a widely accepted goal, except through the network of village elders.  The Taliban's position is not something consonant with our values.  The good news is that work is being done through well-regarded, private groups like the Central Asia Institute.

Greg Mortenson and star students at the Sitara School.

The continuation of private social and humanitarian aid, under the umbrella of a strong, economically rational and principled foreign policy, will be the best medicine for the citizens of Afghanistan

Thursday, January 10, 2013

SVU Deal Good for Present: Future Outlook TBD.

Supervalu today announced the end product of the long-running review of strategic alternatives for the company.  SVU will sell 877 retail stores for $100 million cash and the assumption of $3.2 billion in associated debt to an affiliate of Cerberus Capital Management.  The store banners include Albertsons, Jewel-Osco, Shaw's, Star Market and Osco/Sav-On in-store pharmacies.  The acquired Albertsons stores are heavily concentrated in Southern California, along with another cluster in the Mountain and Pacific Northwest states.  This acquisition was a disaster from the get-go, and it was never going to get better under Supervalu's ownership.  Ironically, Cerberus will now add  some 400 Albertsons stores from Supervalu to the 162 that it owns from a prior transaction: Albertsons is born again!

The entry into Chicago through the acquisition of Jewel-Osco also was never worth the price paid, and competition from Dominick's, along with Supervalu's weakened position, meant continuing investment in margin without a real return.  So, some analysts might argue that the price paid by Cerberus on a pro-forma per store basis doesn't look rich, but Supervalu's equity value would be burdened interminably by owning these assets.  Getting rid of them, along with some $1.2 billion in liabilities of a multi-employer pension plan, is a good deal for long-suffering shareholders.

The second part of the deal takes the form of a tender offer by Cerberus and a very interesting set of four astute real estate partners, including KIMCO and Schottenstein Real Estate Group. The consortium, called Symphony Investors, will tender for up to 30% of the outstanding shares of SVU at a price of $4.00 per share, a significant premium to its thirty-day average trading value.  This also is a valuable option for shareholders who desire liquidity after the unfulfilled promises of recent years.  The floor for Symphony's acquisition through the tender is 19.9% of the shares (a tax issue), and Supervalu would make up the difference by issuing new shares so that Symphony's post-tender holdings amount to 30% in the ongoing company.

This too is good for continuing shareholders, as it aligns the interests of Cerberus/Symphony and Supervalu management.  Five members of the existing board will resign, and five directors will stay on.  Cerberus/Symphony will immediately add two directors, one of whom is Robert Miller, President and CEO of Albertsons LLC who will take over as non-executive Chairman of the Board.  Four more directors will expand the board to eleven members.  Sam Duncan, a very experienced retail operator, will take over as President and CEO of Supervalu and join the board, along with another Cerberus nominee.  Finally, a search is on for two independent directors. From the executive management and governance standpoints, these changes bring much more industry operating expertise, real estate expertise, and financial acumen to the board.  This too is a good thing.

When the review of strategic alternatives for Supervalu began quite a while back, the avowed goals were the following:

  1. Improve the current operating profile of the company;
  2. Position the company for future growth;
  3. Create shareholder value.
Progress on the first objective has been de minimus , for all the rhetoric.  Excising the 877 bleeding stores, along with the new management and directors, should allow more rapid, meaningful progress to made on improving the operations.  The company's position, with lower ongoing capital expenditures,  better debt and working capital structures, and a more focused retail, is better.  The creation of shareholder value in the future is the big question.  The answer isn't clear, yet, but the odds are better now than before.  

Current CEO Wayne Sales said it best, in response to a question about whether the company had been significantly deleveraged.  To paraphrase, he said, "I wouldn't say that it has been deleveraged; it has been derisked."  That is a fair and accurate statement.  

What remains of Supervalu retail?  Their independent retailers, which they unfortunately referred to as their "legacy business," comprise 1,950 stores, which are 47% of the remaining $17 billion in retail sales.  The Sav-A-Lot business has 1,300 stores, representing 25% of retail sales.  The remaining retail stores(28% of sales) are what used to be the core of the original retail business, banners like Cub Foods (39 stores), Farm Fresh (42 stores), Shop 'N Save (103 stores) and Hornbacher's (191 stores).  Cub, like some of these others, is a mixture of corporate and licensee stores. 
What doesn't compute going forward is the size and composition of the distribution centers that support the approximately 2,000 remaining retail stores.  According to the Supervalu 2012 Fact Book, the retail support operations comprise 20.6 million square feet.  Something has to give here, and some of the distribution centers assets may need to be sold, but the good news is that there some of the sharpest retail real estate operators now have a stake in the company and will be represented on its board.  

The biggest item, in my mind, is the much-ballyhooed expansion of Save-A-Lot.  Save-A-Lot, unlike traditional food retail, is not an operations play; it is a real estate play.  Finding the small store in the right second or third tier center with the right demographics makes the format's economics work. We may have passed the bottom in the commercial real estate cycle, but there should be opportunities to roll the format is the real estate can be assembled.  The logistics and support, on the other hand, require very small distribution centers, nothing like the mammoth Supervalu facility in Hopkins, MN, for example. 

With a few thousand items, mostly private label, in a limited assortment store, the operations are relatively simple.  The real estate is the key.  It may now be that Supervalu is finally positioned to execute on the roll-out of Save-A-Lot.  The answer to this question won't be evident in a quarter or two, and looking at the most recent quarter, there are still problems in executing at Save-A-Lot.  

Quarter Three Results

Sales were $7.9 billion in the fiscal third quarter, and GAAP EPS was $0.08 per share. Netting out one-time gains and losses of $0.05, non-GAAP operating EPS was $0.03, significantly below a poorly estimated consensus of $0.07. Identical store-sales ("IDs") declined by 4.5%, which was an acceleration from -4.3% in the prior quarter.  Customer counts were lackluster, items in the basket declined, and average retails per item were also down.  Overall, the consolidated gross margin declined 70 basis points: not a good thing. Wholesale sales were flat.  

General and administrative expenses were a whopping 19.5% of sales compared to 19.3% in the prior year period.   Operating income margin declined from 2.4% in the prior year period to 1.8% in the current third fiscal quarter.  Public shareholders aren't going to see value added from this kind of margin on declining identical store sales. 

Worst of all, results at Save-A-Lot deteriorated as the operating margin in this format declined dramatically from 6.1% in the prior year period to 3.9% in the current fiscal third quarter.  Corporate operated stores did worse than licensee stores. (A small item in one of the press releases notes that founder Bill Moran's company is an investor in the restructured Supervalu---that's a good thing among this dismal news).  Save-A-Lot has large concentrations of stores in Ohio (remember that Schottenstein Realty Group's home base is Columbus, OH) and Florida.  Florida's higher than national average unemployment rate put pressure on food retailers in that state, the CFO said.  

The assortment in Save-A-Lot has become stale.  Comments were made about introducing 200 or so new items into the assortment which were more relevant to the more strapped shoppers.  Hopefully, with new management and an active board, this process too will move much faster.  

The company, even from when I followed it long ago as a retail analyst, had major IT problems. A relatively new executive has taken over this portfolio.  If she is able to cut through the mangrove swamp of systems and bring the staff up to the industry standard, then better buying, better working capital utilization and better, fresher assortments for the independent customers will become achievable.  Can this be done?  Maybe, but we won't know in two or three quarters.  

The company has suspended guidance, but it will need to reinstate it if it wishes to get fresh interest in the stock.  Their whole investor relations effort needs to be turned upside down.  I followed Kroger through its hair-raising  leveraged recapitalization, where it survived triple couponing, a recession, Wal-Mart and Sam's Club,declining food price inflation and Albertsons.  It can be done, and hopefully Supervalu has started down the road.  

Monday, January 7, 2013

Issues With HP's Financial Reporting..Again?

In our first impressions of the H-P 10-K, we noted our surprise that company management and their external auditors did not find material weaknesses or significant deficiencies in the  internal controls over asset protection and financial reporting, given both the processes and results of the Autonomy acquisition, among other issues.

Subsequently, a Wall Street Journal reporter raised an issue about a large-scale receivables sale program that might be distorting the company's reported cash flow from operations.  This issue is interesting, but it may be that the arcane accounting regulations allow wiggle room and ambiguity in the presentation.  The bottom line is that H-P should be tripping over itself to be unimpeachable in its presentation, especially given its most recent credit rating downgrade.

We wouldn't be surprised if the credit rating agencies had their analysts on the phone with HP to dig into this issue, since if it were material, then the rating agencies could have egg on their faces.

Now, a well known accounting blog has taken issue with HP's tax footnote 14.  If the author, a professor of accounting and a former Big 8 auditor, is correct, this issue seems to go beyond presentation and interpretation. The author ends his post with this quote, "And of course, there remains E&Y’s obligation to question the adequacy of the Company’s internal controls over financial reporting."  We couldn't agree more.

Thursday, January 3, 2013

Climate Change and Politicized Science

Global warming seems so Nineties.  Climate change is currently the preferred term in the lingua franca of left wing politics, education, and pop science.  It was originally proposed as one of the key pillars of the Obama Administration's foreign policy in the first term, and it is on the list of unfinished business for the President's second term.

Even the local weatherman, whose main job is to give a consensus five day forecast, feels the need to rail against "climate change skeptics" and talk about melting polar ice.  Thanks for the intellectual stimulation. It is good, once in a while, to remind one's self what a good, measured and circumspect approach to science has to say about climate cycles.  Professor Judith Curry, Chair of the Department of Earth and Atmospheric Sciences at the Georgia Institute of Technology, is a scientist whose writings I've come to enjoy.

Starting from the beginning, she notes the large number of degrees of freedom in a complex natural system that encompasses immense atmospheric and oceanic systems.  These in turn, are driven by a number of complex sub-systems with innumerable inter-linkages.   Finally, these systems are non-linear and regularly feature large scale perturbations. It sounds simple, but look how different it is to situations in which traditional mathematical models do well.

Modelers like to characterize systems with an economy of sub-systems, and these in turn are preferably characterized by limited numbers of well defined linkages.  Even if the system is thought to be non-linear, it's nice to use linear approximations.  It's also nice to have the system converge quickly to a new equilibrium after a small perturbation.  Whether it's a model of an ocean fishery or a model of central bank monetary intervention, modelers don't like to begin with the complexity of natural systems because of the need for circumspection about any theoretical results.

High priests of climate change have no doubts, qualms, or reservations.  Thus for example, the American Meteorological Society, of which Dr. Curry is a former member of the Executive Council, writes,

  •  "Warming of the climate system now is unequivocal, according to many different kinds of evidence.  
  • Climate is always changing. However, many of the observed changes noted above are beyond what can be explained by the natural variability of the climate. It is clear from extensive scientific evidence that the dominant cause of the rapid change in climate of the past half century is human-induced increases in the amount of atmospheric greenhouse gases, including carbon dioxide (CO2), chlorofluorocarbons, methane, and nitrous oxide.
I have always been fortunate to have had really good teachers of physics, chemistry, mathematics, geology, and oceanography during my academic and professional careers; none of them ever spoke or wrote like the AMS above.  They always respected the limitations of what they knew or had measured; they were always cognizant of their own ignorance of important matters, which were always the subject of further research.

But, as the AMS categorically states on behalf of its large membership, "case closed" for anthropogenic climate change. 

How we got to where we are today can be explained in large part by the "framing" of the issue. The UN Framework Convention for Climate Change framed the issue in terms of dangerous climate change which supposedly could be directly mitigated by stabilizing carbon dioxide levels at arbitrary levels.  The allocation of the global mitigation burden would be done through an intensely non-scientific, arbitrary political procedure.  

Scientists in these kinds of settings become tools of the politicians and NGO policy wonks, and they also become slaves to their own personal ambitions for prestigious awards, research grants, endowed chairs, and for joining the well-paid international speaker's circuit on all things green.  

I am getting to know the work of Dr. Curry and many of her colleagues, but I have always been impressed by a 2009 document from the Geological Science Committee of the Polish Academy of Sciences on the Threat of Global Warming.  It struck the right tone for my ears, not dissimilar to that of Dr. Curry. (The translation from Polish has some English malapropisms, but a reader can suspect where they occur and substitute a better word.) Here are some excerpts,
  • Geologic  research proves irrefutably that the permanent change is the fundamental characteristic of the Earth's climate as throughout its entire history, and the changes occur in cycles of varied length - from several thousand to just a few years. 
  • Not all reasons for climate change or their phenomena are fully known yet.
  • Although in the history of the Earth, a considerably warmer climate than today had dominated, there had been repeated occurrences when the Earth experienced massive global cooling which always resulted in vast ice sheets that sometimes even reached the subtropics.
  • Over the past 400 thousand years - even without human intervention - the level of CO2 in the air, based on the Antarctic ice cores, has already been similar 4 times, and even higher than the current value. At the end of the last ice age, within a time of a few hundred years, the average annual temperature changed over the globe several times; in total, it has gone up by almost     10 °C in the northern hemisphere, therefore the changes mentioned above were incomparably more dramatic than the changes reported today.
  • Detailed monitoring of climate parameters has been carried out for slightly over 200 years; it only covers parts of the continents, which constitute only 28% of the world. Some of the older measuring stations established - as a result of progressive urbanization, in the peripheries of the cities, are now within them. This factor, among other things, is the reason for the rise of the measured values of temperature. The research of the vast areas of the oceans has only been launched 40 years ago. Measurements taken for this kind of short periods of time can not be considered as a firm basis for creating fully reliable models of thermal changes on the surface of the Earth, and their accuracy is difficult to verify. That is why far reaching restraint needs to be kept regarding blaming, or even giving the biggest credit to man for the increased level of emissions of greenhouse gases, for such a theory has not been proven.
  • There is no doubt that a certain part of the rise of the level of greenhouse gases, specifically CO2, is associated with human activity therefore, steps should be taken to reduce the amount on the basis of the principles of sustainable development, a cease (sic.) of extensive deforestation, particularly in tropical regions. 
China certainly lags behind the developed economies and behind many emerging nations in the magnitude of air pollution from burning coal and from inefficient transportation systems.  Mitigating their large incremental role in total CO2 emissions is not high on their list of national policy objectives. India's black soot-spewing diesel trucks and public buses have created London fogs for many decades in cities like Calcutta; huge public health issues have been created for women, children and the elderly from ingesting black carbon soot into lungs and nasal passages.  India too doesn't see nationwide fleet replacement as a viable economic alternative for mitigating climate change.  Brazil has cleared wide swaths of the Amazon rain forest, which removes natural balancing mechanisms for higher fossil fuel use in growing cities.  Russia's air, water and soil problems are well known, but President Obama is not going to lecture President Putin on the need to buy into climate change. 

So, we use climate change as another political litmus test for our own political righteousness, which is defined by politicians from Al Gore to Mike Bloomberg.  Scientists should remove themselves from this game and refuse to accede to demands of politicians for slogans ("glacial melt," "acid oceans," "rising sea levels") and certainty based on pseudo-science.  

Equities: Not Enough To Go Around?

Pimco's Bill Gross has talked provocatively about the death of the "cult of equities." He sagely makes a case for the nominal,expected rate of return from a balanced portfolio being in the range of 3%.  Bond strategists would be hard pressed to argue that future nominal returns from bonds could come anywhere close to the returns from the past decade.  Stocks, in Bill Gross' view, could reasonably be expected to deliver about a 4% nominal return per annum in the future.

Now, for pension funds and individual investors to achieve adequate rates of return for their current or future retirement needs, the virtues of equities are universally trumpeted.  This is very reasonable. My question is: what will the future supply of investment grade equities look like, and will they match up with the traditional requirements of institutional investors?  I'm not sure that they will, which is a problem.

Traditional exchanges like NYSE Euronext are facing an uncertain future, especially from the profitability standpoint and more so from relevance.  Fewer and fewer companies have been floating equity and listing their shares on traditional exchanges.  The following statistics are from Bloomberg as reported by MarketWatch. In 2002, the London Stock Exchange had 1,531 listed companies.  At year-end 2012, only 936 were listed on LSE.

$112 billion in capital was raised through initial public offerings in 2012, the lowest level since 2008.  Asian IPOs were 50 percent of their 2011 level.  European issuance was one-third of the 2011 level.  U.S. new issue volume was relatively flat to 2011, but only because of the massive, but disappointing Facebook IPO.

One year does not a trend make.  Definitely something to always bear in mind.  These numbers are cyclical. Yes, but coming after an accelerating equity market towards the close of 2012, and reduced worries about the euro collapse, Grexit, and the U.S. fiscal cliff, one would expect bankers to be queuing up offerings for the first part of 2013.  That may be the case, but let's see.

Where are the new issues going to come from?  Probably from emerging markets, which are the future as the broker newsletters say.

The whole notion of public companies which are of interest to large, institutional investors is not something that is in the psychic wheelhouse of entrepreneurs in Asia, India, Brazil or Russia.  Investment-grade public companies need to report about their quarterly financial results, risk management, corporate governance, internal controls, political contributions, sustainability, climate change, conflict minerals, executive compensation, related party transactions and so on.  Very few of these processes, procedures and values are naturally occurring in the psyches of powerful entrepreneurial families or oligarchs.  In fact, why bother learning them?

Equity risk premia have been falling, as have price-earnings ratios for seasoned companies and valuations for initial public offerings. Given some of the well known scandals among larger capitalization companies, such as Satyam and Sino Forest, institutional investors' appetite for risk has been diminished.  The number of names in which mutual funds can take a 2-3% stake while still sleeping at night is diminishing, which means the portfolio of many emerging market funds are looking strikingly similar.

Meanwhile, on the established company front worldwide, the capitalization leaders will be generating much of their expected return from dividends, buybacks and capital structure management. Will today's mega-caps be replaced by social media companies?  The evidence today is not compelling to make the argument.

The cult of equity may very well be dying, as Bill Gross says.  If some of the older horses are putting themselves out to pasture, there may not be enough attractive young mustangs at the auction to attract middle aged portfolio managers who need reliable financials, dividends, predictability, liquidity, strong boards and managements that are stewards of shareholder resources.

Wednesday, January 2, 2013

2012 Tepid Recovery and Strong Equities

The U.S. recovery continues to be tepid. At the same time, risks have intensified, including from the worsening of the euro area crisis as well as the uncertainty over domestic fiscal plans, says the IMF in its latest assessment of the world’s largest economy.

Yet, among equity mutual funds, certain categories had stellar returns, and even the more prosaic categories produced very solid returns.  According to Morningstar data, Global Real Estate funds were the top performing category with a scorching 31.8% gain, as of 12/31.12.  Despite political ineptitude, corruption in the sale of spectrum and food inflation, Indian Equity Funds returned 29.6% for 2012, the second leading category among global equity mutual funds in the Morningstar universe. Not surprisingly, Financial Sector Funds were the third leading category, fueled by relentless central bank monetary easing; financials returned 24.8% in 2012.

In the Large Cap Value fund sector, the leading mutual fund was the justifiably much maligned Fairholme fund. It rebounded on a modified, concentrated portfolio to return 35.8%, which is the number 2 top-performing equity mutual fund among all funds in the Morningstar universe.  Its fees are still too high for a large cap fund with such a large asset base. It's not clear what analytical infrastructure is generating ideas and returns, other than Bruce Berkowitz.  The fund returned to the well with a big stake in  Bank of America, an idea he bought at the bottom in 1992, and it proved rewarding again.  

Dodge and Cox Stock Fund, buoyed by holdings in consumer discretionary stocks, financials and telecom delivered 22% returns for the year.  Even as the fund made an ill-timed investment in Hewlett Packard, the well defined investment process, diversification, composition, low turnover and low expenses worked together to deliver better results than the average 15% return for all U.S. equity mutual funds.  

Midcap Value Funds returned 16.6% as a category, and the Legg Mason Capital Management Opportunity Trust returned an astonishing 41.1% for 2012, which makes it the best performing fund among all U.S. equity mutual funds.  What does this one year return demonstrate?  Very little.  Just as Apple is a cult stock, this fund was a cult fund for more than a decade.  Morningstar's analyst Bridget Hughes writes.  
 "With the added flexibility comes risk. Although the fund has had periods of spectacular performance, the lows have been devastating to performance and give rise to the question of the strategy's efficacy, even over the longer term."
Overall, equity investors seemed to take money out of equity funds, continued to pile into bond funds, and within equity funds moved to passive management versus active management.  Among the active managers, there is still a lot of "closet indexing," which makes some of the ridiculous management fees even more repugnant to whipsawed investors.

The mantra should be the same for individual investors buying equity mutual funds:

  1.  Don't chase yesterday's performance.
  2. Don't get enamored of a cult portfolio manager.
  3. Buy from a fund sponsor with a track record, a proven strategy, an investment process, and sufficient analytical support the portfolio managers. 
  4.  Higher fees are unjustified and don't buy superior performance. Never ever pay a front-end sales load. 
  5. Your fund management team should eat their own cooking. 
  6. Read the fund literature that comes your way.  It goes into the circular file for most investors, whereas consumers spend more time reading the instruction manuals for their smart televisions and game consoles. 
  7. Understand, as best you can, how the fund is taking risk and how it adds value.  (3,5 and 6) will help you get there. 
Equities as an investment class face some long-term challenges in the coming years, but more about that later.  Happy New Year to our readers!  Keep those cards and letters coming.