Friday, May 31, 2013

IMD World Competitiveness Yearbook 2012: Now You Know!

The IMD Business School in Lausanne, Switzerland just released its yearbook on world competitiveness.  Understanding that I am very wary of list rankings (e.g. the USA Today List of Top Colleges), this one looks like it has some creds in the international economic sphere. 

I won't go into trying to mine this long document, but I noticed a section, 3.5.01, called "Attitudes and Values," which has results germane to points in yesterday's post.

"Attitudes towards globalization in your society are generally positive/negative," ranks Ireland at the top of 59 countries for being positive.  The country at the bottom?  France!

The British are always roundly criticized among the EU elite for being anti-Europe and anti-globalization of markets, yet Britain ranks middle of the pack.  Interesting.

Another survey question asks "The need for economic and social reforms is generally well understood/not well understood in your country."  At the top of the list for being well understood is Ireland, and again at the bottom, France.

Just coincidentally, this speaks to the point made yesterday that even a respected and insightful central banker like the Governor of the Banque de France is really swimming upstream as he speaks about the need to improve French competitiveness.

Thursday, May 30, 2013

A French Banker's Refreshing Report

Recent days have seen a variety of reports come across my screen; Governor Christian Noyer's letter presenting the 2012 Annual Report of the Banque de France was refreshing because it deviated in part from the droning, repetitive structure of reports from the IMF and even from our own beloved Federal Reserve System.

Some of the issues he discusses relate well to a popular post, "Plus ça change, plus c'est la même chose," from February.  Governor Noyer notes that by the end of 2013, the French economy is likely to have had two consecutive years of zero GDP growth, which is quite extraordinary.  Public debt is likely to end the year at levels not seen since WWII. 

Paul Krugman and his political followers have cobbled together a counter-intuitive narrative of low growth being about inadequate fiscal stimulus.  To this, Noyer says simply, "...this vision is incorrect."  He notes, as we did in our earlier post, that French competitiveness has been waning for some time.  For this and other reasons, France and much of Europe haven't benefited from economic globalization, despite having significant economic, human capital, and technological assets. Again, in our earlier post, the Alliance Bernstein analysts showed how much France lost ground to Germany because of its lack of competitiveness.

For the past ten years, he notes, France has had the highest levels of public spending in the world.  As the public debt soared, he contends that French households saw through this process to higher future taxation and cut their spending accordingly and quickly. 

France will have committed about 4% of GDP per year from 2010-2013 in order to stabilize the ration of debt to GDP at 90%.  Governor Noyer realizes that there has to be another set of policies which help release the growth genie from the lamp.  He focuses on the broad issues of regulation and unproductive social programs. 

He notes that France is the biggest spender on employment programs, but it has one of the Eurozone's highest unemployment rates, particularly among younger workers.  Money spent on expensive programs for professional retraining have had no results.  Welfare spending in total, he writes, accounts for 30% of GDP! 

In the administration of President Hollande, this is not something discussed over champagne in the Palace; the points Governor Noyer makes have to be said, and he says them in a style acceptable to the French elite.  To some extent, though, he dances around the problem, rhetorically. 

Nobody has put the problem in such stark and easily understandable terms as did CEO Maurice Taylor of Titan International when he responds to an inquiry about taking over a French tire plant in danger of closing.  "The French workforce gets paid high wages but only works three hours. They get one hour for breaks and lunch, talk for three and work for three. I told this to the French union workers to their faces.  They told me that's the French way."

I don't want to make it seem as if the U.S. unionized work force is superior.  When Hostess Brands slid into bankruptcy, one of the work rules on which the unions would not bend was this: bread trucks and cake trucks could not be consolidated.  Never mind that the customers didn't want two separate trucks tying up their parking lot and receiving for adjacent categories on the shelves.  Never mind that it was inefficient and duplicative.  Well, we know where that vision of a business took the company. 

The basic problem for Governor Noyer, as everywhere, is that he is a central banker: an intelligent and articulate one at that.  Politicians have to see some payback for themselves in challenging an ossified welfare state.  Don't hold your breath.

Tuesday, May 28, 2013

Jamie Dimon: Votes Have Consequences

The Wall Street Journal piece on the aftermath of J.P. Morgan's proxy victory makes the central point that we've made from the beginning, namely that the whole issue of better risk management, governance and allocation of time for CEO Dimon shouldn't turn into a personal referendum on Mr. Dimon. Of course, it did just that.

Now, come apocalyptic predictions from moguls who had Dimon's back.  This, for example from Marc Andreessen,

Mr. Andreessen, who runs venture-capital firm Andreessen-Horowitz, worries, perhaps overly so, that episodes like these give public capital markets a bad name. "My big concern is whether the public markets continue to function and whether it is still practicable to take companies public," he said.
Really?  The era of public equity ends with a disagreement over splitting the Chairman and CEO role?  I hardly think so.  Fraud, accounting misstatements, and secular mismanagement of shareholder assets over decades haven't killed the markets--yet, so this will be forgotten soon.

Except, Mr. Dimon is reported to have called institutional shareholders moaning how much the proxy fight took out of him.  If this is true, it is symptomatic of the corporate royalty mentality and the sense of entitlement.  JPM is a global powerhouse and an effective company, but that doesn't mean that it does everything right or that it doesn't make egregious mistakes.  Mr. Dimon should have said something like this to his opposing shareholders, "Look we're on the same side; we both want results, success and superior returns.  Somehow, this all got off track.  If you'd be amenable, let's talk privately about your concerns when you feel they're not being addressed.  I've got lots of active shareholders, and they're all important.  The lines of communication, directly to me if you need, are always open. Anything else you need to tell me and my team?"

The Journal writes, "To paraphrase what the economist Paul Romer once said about crises: "A catharsis is a terrible thing to waste."  I think that a pithier version of this notion comes from Bill George, who writes in his book on leadership, "Never Waste a Good Crisis."

JPM Morgan's CEO and board should pay attention.

Saturday, May 25, 2013

PG's CEO Shuffle: Why Are Shareholders Giddy?

Several of our recently covered themes about corporate CEOs reverberate in the story about PG asking the much ballyhooed, former CEO A.G. Lafley to parachute in to save the company from shareholder discontent. 

First of all, it appears that PG has underperformed the Household Products sector in both the five and ten year horizons. Since mid-2012, it has trailed its peers, but the secular underperformance clearly reflects something beyond the performance of the current CEO. 

As we have written about before, the economic environment which is then reflected in stock market sentiment accounts for much of what is falsely attributed to "CEO performance."  Mr. Lafley clearly had a better environment for consumer sentiment, income and spending than did his hand chosen, personally mentored successor Mr. Bob McDonald. 

The famous stories about the revival of Tide detergent under Mr. Lafley are a great example of misleading attribution.  The sale of "concentrated" Tide for HE washing machines meant consumers would pay way too much more for marginally different performance.  It was clever, and it succeeded because of PGs control over shelf space and end caps, plus aggressive advertising and couponing.  When the economy turned south, consumers said,'Goodbye Tide' and 'Hello Arm and Hammer' generic low price detergent for their high efficiency machines.

As things turned south within the company, McDonald was coached on how to deal with investors by Mr. Lafley.  Unfortunately, sentiment inside the company got so bad that a former high ranking executive with the company "sent a 13-page letter to lead director Jim McNerney, Boeing Co.'s CEO, detailing a number of concerns about Mr. McDonald's leadership and calling on the board to split the CEO and chairman jobs. Dissent with Mr. McDonald's leadership was bubbling up through management's senior ranks, with some executives reaching out to board members asking for a change, people familiar with the matter said." (Wall Street Journal)

This kind of behavior by those current and former executives is not professional.  Note the comment to split the CEO and board Chair positions.  How did the board not have any idea about the sentiment among senior executives?  Wouldn't they be able to pick this up from meetings and social occasions with the executives during board sessions and retreats with management? 

So now Mr. Lafley is brought in to right the ship, which will probably right itself through some of the measures already in place, and to choose another successor. But since he recommended Mr. McDonald and coached him, why would a board hand the important task of CEO succession to Lafley? 

PG is famous for its bloated brand management structure which is mind numbing for bright new recruits and for middle managers alike.  After your Ivy League MBA, you can be the Deputy Assistant Brand Marketing Analyst for Dash detergent. Wow. If you can move around and luck into a hot brand and be seen through the layers, perhaps your career can advance after ten years.  Lafley didn't address the bloated corporate structure during his halcyon tenure, and his successor only made a weak start.

The board which has sat through secular underperformance, failed to insist on succession plans for the CEO, ignored corporate sclerosis, failed to stem the loss of future leaders, and could not take the pulse within its own organization. 

I don't understand why investors are so excited by today's developments. 

Friday, May 24, 2013

HP: Stairway to Heaven or Road to Irrelevance?

Opinions in the financial press seem to line up at both extremes today.  Thus, headlines say things like,
  • HP's strategy is not sustainable;
  • HP has a big slog ahead;
  • Time is not on HP's side;
  • HP needs growth;
  • HP is mortgaging its future;
  • The bullish case for HP;
  • HP is still a real value.
The risk-reward ratio for HP in the short run is pretty uninspiring, with the dividend to give some comfort until revenue growth and real, as opposed to non-GAAP, earnings growth appear.  Just as we noted for Best Buy, where we said vendors needed the company, we'd say that customers need HP.  If it didn't exist, a company like it would have to be invented.

Yes, it has some legacy businesses, but so did IBM and surely Dell does.  Cisco is slowly trying to reinvent itself, but it still derives the lion's share of its revenue from mundane products in the Internet plumbing. Lenovo and other PC makers?  Not hardly, not now.  Microsoft and Oracle?  Quasi-monopolists who are also using their enormous cash flows to reinvent themselves also. 

So, to beat the drums about legacy businesses for HP alone, one would have to be wearing blinders.  IBM can't be the IT company for all shapes and sizes of commercial and governmental organizations.

Another interesting comment CEO Whitman tossed off in her response to a question went something like, "Dell trashed its quarter to move x86 servers."  Yes, it did.  In the end, besides clearing inventory, it does nothing for the company as it moves to privatization.  After it goes private, how will Dell spend money on research and development, new classes of servers, and the things that all companies need to prosper in the watershed changes to a new definition of IT? The new owners will be focused on one thing only, cash for distribution and debt repayment.   Dell may be the company on its way to irrelevance. 

The Moonshot server line has been referred to by CEO Whitman in the last two or three quarterly calls.  It's evident now why.  She talks about the generational transformation in information technology underway as being the biggest in her career.  The Moonshot server program is one pretty significant step for HP in addressing this change for and with customers. 

So much has been written about data centers, but they too are in the midst of a major transformation, because of the different devices on the network endpoints and because of the rivers of different kinds of data being processed, stored and analyzed.  An HP-funded white paper describes the new Moonshot 1500 platform as blade servers "on steroids."  It is described as the first software defined server to run Internet scale applications.  Clearly, this is the direction the company needs to go, and the project was green lighted in 2010. 

The charter for the group was "to break out of HP's mainstream enterprise value propositions."  This formulation is very encouraging, and clearly it was not a skunk works.  The platform is now out in the market place.  This probably reflects decisions by the new CEO to accelerate this project at the expense of others, and it seems like exactly where the company needs to go.

What are some of the risks?  The company's board is still not worthy of an industry leader.  The discussion with former board Chair Ray Lane, who rejected the advice of Dodge and Cox to step down, was embarrassing for the company; Mr. Lane was magnanimous enough to give up the Chair and deign to remain on the board.  Remember, he is from the "Valley."  Tone deafness has a high incidence rate in Silicon Valley.

Time isn't working against the company. Expectations are rock bottom, and valuations are appropriate.  Rebuilding the balance sheet, improving cash flows, paying down debt and changing capital allocation will give the company plenty of capacity to weather competition and the IT cycle.

Share buybacks should soon have seen their day, provided the board doesn't push management to put another big program out there.  If another program is announced, please go slow and leave it fallow.  Reinvestment in initiatives like Moonshot and in core businesses are paramount.  Research and development needs to drive differentiation of products and services.  That's where the high returns are, not in chasing the share price for the benefit of short-term shareholders.  

The mediocre board could also harm the company again in selecting and valuing acquisitions.  Their massive incompetence speaks for itself.  In this regard, a revival of the Autonomy flap could divert management time, but hopefully it goes away quietly, another legacy of board mismanagement.

I have a suggestion for the new board Chair, if the company can persuade him to accept: Mr. Bill George, the former CEO of Medtronic. I've followed his work at Medtronic, read his writings, spoken with and heard him speak, many times.  He has the stature, experience, business acumen, and moral leadership qualities to help the CEO and management navigate their way to real value creation.  I can't think of a better choice.

Thursday, May 23, 2013

My Biggest Takeaway from the HP Call

Instead of jumping to pushing the pencil through the HP Second Quarter 2013 earnings release, I listened to the conference call, while flipping through the release.  The most notable things I heard had nothing to do with the actual numbers.

In the aftershock of the Apotheker departure and Meg Whitman's coming on board, I wondered on this blog about the strength of the CFO and her ability to turn the CEO and the board away from some of their profligate ways.  On the early calls, which featured the "I'm Meg Whitman.  I've run this playbook before at eBay.  No worries."   I felt the CFO was passive and speculated about her possibly not having a lot of support from a board with a poor performance record.

What I heard on this call was qualitatively different, and that's encouraging. 

To set up the context, revenues in the second quarter were $27.6 billion, down 10%, y/y.  The biggest decline was in Personal Systems, whose revenues declined 20%; non-GAAP operating profits of $239 million dropped by $277 million from the prior-year period, and the non-GAAP operating margin fell 220 basis points to 3.2%. Notebook revenue and units both declined by 24%.  Because of the early release of industry shipment numbers, all of this was discounted, although it is still disconcerting. 

Printing revenue of $6.1 billion declined only 1%.  Non-GAAP operating profit of $958 million increased by $150 million y/y, and the margin rate increased by 260 basis points to 15.8%.  Thus, the Personal Systems Group with $13.7 billion in revenue managed to keeps its non-GAAP operating margin above the prior year by 30 basis points, despite a 12% decline in revenue.  Not bad. 

For those commentators who said that HP should get out of hardware entirely and become a software company, the quarter gave some pause.  Software revenue of $941 million declined by 3% y/y, on a double digit decline in new license revenue, but non-GAAP operating margin was a healthy 19.8%, 140 basis points better than the prior year.  The CEO's comments were a bit tepid when talking about this segment, and the word "execution" was used. 

Operating cash flow in the quarter was $3.6 billion, and free cash flow was $2.9 billion with the full year's free cash flow projection being upgraded to $7.5 billion. The cash cycle improved to 21 days, an improvement of 7 days. Net debt declined, and there is ample capacity to deal with debt maturities coming due.  $797 million was applied to share repurchases to offset dilution, in the words of the CEO, and $283 million was returned to shareholders as dividends.  Quite an impressive performance.

In response to a question from the Barclay's analyst, the CFO said that there had been increased educational efforts within the company about the importance of cash flow from operations.  This effort was not solely directed to upper management.  Rather, she noted that the message, "every individual can make a difference" had been promulgated throughout the organization.  This is a very big deal for me, having gone through the same process myself.  It can really engender changes in behavior from sales executives to administrative staff. 

In response to a question about walking away from unprofitable RFPs, the CEO was rambling on, getting herself into a cul-de-sac when the CFO interrupted and added a financial number which shed light on the analyst's question.  I never heard her interject herself that confidently before.  Again, this was a big deal for me.  If I were in that analyst's shoes, I would note, "It's the Meg and Cathy team now."

The question was asked about the improvement in cash flow from operations having a timing aspect to it; here the discussion became too arcane.  Some of the W/C improvements had to be timing, but these flips happen in any business.  The point is the full-year projection of CFO, which is quite healthy.

The CEO made a good point in response to the knee-jerk analyst question about accelerating the pace of share buybacks.  The stock here is clearly ahead of itself: it isn't a no brain buy from here up.  CEO Whitman said that capital allocation would be on a return basis, including reinvesting in the businesses and perhaps some tuck-in acquisitions.  Bravo.  That makes sense.  Her focus has to be on long-term, sustainable value creation. 

Especially since the CEO suggested that revenue growth in 2014 would be a "challenge," it is critical for the CFO to maintain a grip on the cash flows, with the goal of priming the balance sheet and reducing net debt in order to upgrade the credit rating.  HP is off to a good start.

Wednesday, May 22, 2013

Dimon Unchained: Vive Le Roi Soleil!

Since the financial press headlines have trivialized the whole issue of splitting the roles of CEO and board Chair at J.P. Morgan Chase, I felt that I should jump on that bandwagon with a similar headline.  A newspaper with a financial and economic flavor like the Wall Street Journal trumpets, "Dimon Undaunted." 

We learn from the Journal, " shareholders value returns on their investment more than they do making political statements." I'm not sure how what the vote means, but this interpretation of the results, were it valid, casts shareholders as a trend following, lazy lot who can't distinguish among, risk, reward and luck. 

Twelve months-to date, according to Charles Schwab, Financials are up 41.7%.  159 Capital Markets companies are up 59.8%.  Even 59 boring Insurance companies rose 39.5% over the twelve months. 

Schwab classifies JPM in "Diversified Financial Services,"  and this sub-sector of Financials rose 81.7% over the twelve months-to date.  The leaders are, of course, Bank of America (up 93%) and Citigroup (up 92%) with J.P. Morgan Chase rising 56% over the same period.  Bank of America and Citigroup are not without their significant issues, including, for example, the Countrywide overhang, the inevitable cultural clash with the Thundering Herd, and a "bad bank" in Citi Holdings. 

The Standard and Poor's 500 over the same period is up less than 30%.  So, the famous dart throwing monkey, aiming at a Financials board would have most almost certainly outperformed the equity money managers' benchmark. 

Even though the broad sector called "Financials" did exceptionally well, much of the success was owed to something totally outside of management control, namely the unprecedented monetary policy of the Bernanke Fed.  Beyond that, the dynamics within commercial banks were different from those within, say, the reinsurers.  The latter benefited from something of a traditional underwriting cycle, when losses were attenuating, salespeople stopped chasing bad business, and premiums rose. 

The levels of risk among the sub-sectors and companies within the sub-sectors were all distinct, even while the sector's performance was uniformly superior.  Institutional investors and sell-side analysts should be sensitive to the different amounts of risk taken by the various companies to generate the earnings which account for some of the superior stock performance. 

Unfortunately, investors suddenly only seemed to care when things like the London Whale report came to light.  That report showed an organization like most Wall Street houses in every market cycle: traders acting on their own, maximizing the size of their books without worrying about the sign on the balance, and overseen by executives who were clueless and powerless to reign them in.  Everyone managed information upward, to the point where a CEO described legitimate concerns about systemic risk building up in the book as a "tempest in a teapot." 

Politicians are indeed ambulance chasers in our system.  But, there would be no ambulances to chase if boards and CEOs did their respective jobs, which are distinct and different. The board is responsible for the strategy, direction, and long-term risk management to ensure that the business lives forever; it appoints an executive management to create a business model that implements and sustains the growth of profits, which are either reinvested or distributed to shareholders in order to give them their required return.

These are two distinct, but inter-related missions.  The CEO and Chair of the board are intuitively not the same person.  No economic benefit can be attributed to this configuration; no governance benefit derives either. It is an "ego thing," i.e. the CEO expects it.

The Journal closes its article with this quote, "  We also hope he (Mr. Dimon) won't let the recent unpleasantness deter him from calling out Washington's blunders." 

We hope that he stops standing on a soap box, pronouncing on cosmic issues.  Instead, here's hoping that Mr. Dimon improves his board substantially, treats them less like mushrooms and a nuisance, and digs into hiring and overseeing a higher quality cadre of executives who are not afraid to tell him when the risk meter is flashing red. 

A final point we've made many times before.  Rakesh Khurana of the Harvard Business School wrote in 2006,
"Because the CEO market is not, in fact, operating like others, the presumption that it will produce efficient outcomes is unwarranted. The problem is not just one of excess pay. Flaws in the pay-setting arrangements for corporate leaders have produced arrangements that dilute or even distort incentives.."

A forthcoming book by Michael Dorff of Southwestern Law School comes at the same issues with a slightly less economic lens, but he makes similar points to those Professor Khurana and I have raised:
  • “If oil goes to $150 a barrel, is the CEO of Chevron a genius?” he asks. “When oil then falls from $150 to $100, does that make the CEO of Chevron an idiot?”
  • "How about when a CEO borrows billions — because the Federal Reserve is flooding the world with cheap dollars — and uses those funds for stock repurchase plans, or to pay higher dividends? Is that why CEOs are supposedly worth the millions that their shareholders end up paying them?"
  • “There are always outliers,” he concedes. “There are very salient examples, like Steve Jobs or Warren Buffett. You’d say those guys certainly matter, but, on average, CEOs don’t matter.”
Perhaps that's an oversimplification.  Vive Le Roi! 

Tuesday, May 14, 2013

Dell Reports "Weaker" Results: Right on Time

Just like clockwork in the continuing market manipulation which is the Dell buyout, the Wall Street Journal reports Dell is moving up its quarterly earnings report to this Thursday because, among other things,

"Dell now expects to report revenue of roughly $14 billion, and earnings of 20 cents a share, excluding some expenses, according to the person briefed on the financial results.The average of analyst estimates had called for Dell to post $13.5 billion in revenue, and earnings of 35 cents a share, excluding some items, according to FactSet Research Systems Inc"
So Dell's revenues are better than expected, while earnings are worse.  The apologists say that Dell had to clear excess inventory and sacrificed profits to do so.  Perhaps.  Or, as academics Xu, Qian and Li found in their research,

"In particular, a number of papers find substantial improvement in ROA following buyouts in which the target managers and other insiders participate (management buyouts, or MBOs), and the authors attribute the improvement to the strong incentives for value-creation created by MBOs.However, part of the improvement in ROA may be explained by how earnings are reported both before and after the MBOs, as it has been well established that this process is subject to managerial discretion. If managers of a publicly listed firm plan to take the firm private, they have an incentive to undertake activities to temporarily deflate earnings before launching an MBO. With lower earnings before the MBO, the firm can display greater improvement in operating performance after the MBO once the earnings-reducing activities are halted. Moreover, lower pre-MBO earnings canlead to lower stock prices, enabling the buyout team to acquire the target ‘on the cheap’ if outside investors do not fully understand the nature of these activities."
The Southeastern Asset/Icahn group have been asked by the board to structure their ideas as an offer to buy up Dell's public securities.  Meanwhile, the quality of this quarter's soon-to-be-reported earnings should be viewed with the appropriate skepticism 

It's Not All About Prince Jamie Dimon.

Americans reflexively poke fun at royalty, especially their finery, rituals and pretensions. They raise our democratic hackles, and folks like Britain's Prince Charles are easy targets on both sides of the Atlantic. Divine right and hereditary succession are anathema.

But, Americans too have our own royalty and their supporting elites.  Our royalty includes corporate CEOs, hedge fund managers, private equity moguls, political dynasties like the Clintons, and media icons like Barbara Walters, whose "retirement" is front page news in the New York Times.

So, the issue of separating the Chairman of the Board position from that of CEO at JP Morgan Chase has become a referendum on the Princely rule of CEO Jamie Dimon. Riding the wave up to the mortgage bubble of 2006-8, getting princely bailouts from the general taxpaying rabble, and now riding the next wave of rising stock prices due to unprecedented monetary easing, Mr. Dimon is wealthier than ever and politicians hang on his every word.

Except for one thing.  With a dismissive wave of his royal hand and using a British metaphor of "a tempest in a teapot,"  Mr. Dimon irritatingly put up with questions from the stock-owning rabble about there being too much risk in JPM's proprietary trading operations.  All of his own, hand selected, massively compensated traders, executive vice presidents and risk managers told him, "It's okay, we're good."

Well, it wasn't. We've looked at the London Whale report in great detail and said before that it was a colossal failure at the top, where the Prince makes his royal abode. Splitting the positions of board chair and CEO is not a guarantee of better risk management or lower volatility of the share price.  However, nobody can make a rational argument for why combining the roles is better for shareholders and for corporate governance.

The only argument for combining the positions: the Prince might abdicate and go off to do something else. Seriously, what would that be? The "picking up your jacks and going home" card has already been played, which is amazing for its chutzpah and pettiness.

Mr. Dimon's friends in Greenwich, perhaps akin to Henry Vth's "band of brothers," have announced to the world that "they got his back." So, a real issue of governance has descended, in the finest American tradition, into adolescent posturing for the media.

Jamie Dimon should be able to do a better job of running JP Morgan Chase, of selecting a better inner cabinet, and of holding them accountable and monitoring their results, if he were freed from the drudgery of running and managing a board and its committees.  Running the business is where he has a comparative advantage and a track record.  Put all his time there: it is the best thing for shareholders.

Meanwhile the board probably should change over time and change its committee charters.  Risk management, such as it is which isn't great, should report in some fashion to a board committee.  This committee should be free to go where it will, looking under the covers for Warren Buffet's "ticking time bombs."  Opinions vary on how this kind of change can be structured, but it's not rocket science.

The goal is to get better first, lowering risk incrementally and increasing oversight and transparency for the entire board.  Splitting the roles is just a first step, but hopefully the board is strong enough to stand up to the Prince and his court.

Friday, May 10, 2013

Southeastern Asset and Icahn Continue Activism With Dell

Coincidentally with the issue of a letter today from Icahn Enterprises and Southeastern Asset Management to Dell's board of directors, this post ties back well to the previous post about corporate governance.

Southeastern Asset became actively engaged with Dell's board and management on June 15, 2012, when co-founder Mason Hawkins, CFA discreetly proposed a leveraged recapitalization to unlock shareholder value.  Southeastern's idea morphed into the Dell/Silver Lake Partners all cash offer of $13.65!  To make matters worse, Southeastern and other existing shareholders were not given a way to participate in Michael Dell's deal.

Southeastern's first quarter letter to its shareholders has a very cogent description of their investment process and the transition from engagement to activism. They write,
" 'Activism' is not part of our normal process, nor is it our preferred avenue. ...Becoming active generally indicates that we made a mistake in assessing our (management) partners. ...When the company's underlying assets remain strong, the stock's undervaluation is compelling, and the primary 'fix' is to people, we will generally become active if we believe we have good odds of successfully improving our clients' outcome." 
All of this is entirely consistent with their first letter to Dell's board, which used material from Dell's own presentation to suggest a compelling valuation for the company's underutilized assets.

A chart shows that for 255 positions Southeastern has held since 1993, 90% of these positions required no 13D filings.  Of the 26 positions which required a filing, Southeastern became engaged and active. Without suggesting that their ownership was a sole causal factor, 20 of these positions resulted in higher stock prices for their clients, 2 were break-even, and 4 resulted in lower prices.  Clearly, Southeastern's principals are not corporate raiders, greenmailers, or investors who want to run their portfolio companies.  They want to close the gap between market value and intrinsic value, especially when management are felt to be not doing their jobs.

Southeastern Asset owns about 8.5% of Dell's shares, while Icahn Enterprises owns about 4.5%.  The opening salvo of the letter notes that the stock price is below Michael Dell's cash offer of $13.65.  It notes that the board has allowed management and private equity to buy Dell with the shareholders own money, using relatively little of their own equity.

Furthermore, the board poisoned the market for alternative bids by agreeing to an egregious $450 million break-up fee for Dell/Silver Lake; in the event that an alternative bid emerged and were deemed superior, the break-up fee would still be a ridiculous $180 million.

The letter says that the board accepted an analysis of Dell's value that focused solely on its mature business lines, like personal computers.  The $14 billion of recent acquisitions, including innovators like Compellent, was not factored into long-term revenue opportunities, according to Southeastern/Icahn.  The letter suggests significant value creation opportunities by selling into China, Brazil and India.  Unfortunately, this battle has already been lost.  Lenovo has China wrapped up, and it has significant inroads in Brazil also; India may not prove to be a very profitable market for a large U.S. based, public company.

No significant operating improvements were built into the Dell/Silver Lake model.  One of Carl Icahn's favorite tactics, changing the capital structure, was not factored into the $13.65 value.

The Southeastern/Icahn letter makes some interesting points about Dell's global supply chain, one of its foundational strengths.  The letter says that it can be substantially improved by removing bloated overhead, redundant costs, and by improving facilities utilization by consolidating call centers, assembly operations, and by bringing some of these closer to the U.S. Another very interesting point, which I think plagues the entire PC industry, is what the letter characterizes as "infinite customization."  It suggests an "80/20" model for revenue and profits from the mind-bending number of customized layouts offered to consumers; a stocking model could reduce the size and improve the utilization of Dell facilities as well as generating potential efficiencies in buying key components like CPUs, motherboards, drives, displays and graphic cards.

The argument boils down to $12 cash plus an equity stub with a potential value of $2-$5 per share in the near-term being better than $13.65 cash with no participation in future growth.  A $5.2 billion term loan facility would be in place to make the cash payout in the event the business ran into short-term cash generating problems.

If the Dell board were not to consider the alternative offer and deem it "superior," then the Southeastern/Icahn team would also put forward an alternative slate of directors.

Again, the Dell board's passivity and acquiescence to founder Michael Dell's talking down the company and buying a low valuation may still carry the day. Southeastern/Icahn has fired their last bullet, and credit to them for all their work which could benefit all shareholders.

An interesting academic paper germane to management machinations ahead of a management-led buyout shows how manipulative this whole process can be, especially when shareholders are passive. Southeastern Asset has done a great job in calling attention to Michael Dell grabbing the company he mismanaged in his second stint as CEO, with shareholders' money.  Aren't public markets wonderful?

Vanguard's Thinking on Corporate Governance

As both one of the largest sponsors of active and index mutual funds, Vanguard represents significant voting power for corporate proposals on management compensation and election of directors.

Glenn Booraem, Controller of the Vanguard Funds, recently posted a note on the Vanguard site, in which he writes,
"However, by its nature, voting reduces often complex issues to a binary choice—between FOR and AGAINST a particular proposal—making the proxy vote a rather blunt instrument. This is where the second—and perhaps more important—component of our governance program takes over; engagement with directors and management of the companies in which we invest provides for a level of nuance and precision that voting, in and of itself, lacks. So while voting is visible, it tells only part of the story.
We believe that engagement is where the action is. We have found through hundreds of direct discussions every year that we are frequently able to accomplish as much—or more—through dialogue as we are through voting. Importantly, through engagement, we are able to put issues on the table for discussion that aren't on the proxy ballot."
The governance industry, which now generates careers, robust fees and conflicts of interest, loves using blunt instruments, such as voting as a litmus test for shareholder engagement.  On the other hand, corporate managements often put out proposals without any regard for how they would play with their shareholders.

The truth is that institutional shareholders for many decades have been lazy, inattentive owners.  Their measure was to focus on price changes relative to an index; unanticipated, dismal performance would wake them from their slumber.  Proxy votes, as I experienced from several sides of the capital markets, were left to attorneys to check the boxes FOR, unless otherwise instructed.

An ongoing, deeper constructive engagement with corporate managements should yield better use of corporate assets which should lead to better performance with fewer surprises, which is what investors really want.

Sunday, May 5, 2013

Is IBM Losing It's Way?

In the late Sixties, our family moved up to Westchester County, and the influence of a growing IBM was spreading all over the county from Armonk to Yorktown Heights and many other locations.  The corporate motto, implemented by Thomas Watson, was "THINK."  Aside from Bell Labs, IBM was the top industrial research laboratory in the country.

Its history of innovation came from hiring the brightest people and applying their efforts in a well-funded, disciplined approach to technological innovation and problem solving.  Fast forward several decades, of course, and IBM ran aground; it was blindsided by technological changes, a bloated cost structure, and management hubris.

When Lew Gerstner was recruited as CEO in 1993, the outlook was dire.
"Gerstner happily quotes the doom-laden predictions about IBM’s future that were prevalent when he took over as CEO in 1993, a year the company posted an $8 billion loss, and IBM shares that had sold for $43 in 1987 could be had for $12. IBM’s "prospects for survival are very bleak," wrote the authors of the book Computer Wars."
The strategy put into place under Lew Gerstner was essentially extended by his recently retired successor Sam Palmisano.  CEO Virginia Rometty is now at the helm of this icon of American business, and she comes from a very successful career in sales at IBM.

Warren Buffett's Berkshire Hathaway recently added a cool $10 billion to his stake in IBM.  When this was announced in January, I started reading up on IBM, and it seemed very much in the wheelhouse of the megacap public stocks Berkshire owns, and has owned for a very long time.

Leading up to the release of first quarter 2013 earnings, I trudged and slogged my way through the slides and audio files of IBM's Analyst Day.  There is a lot of material, with some interesting industry material and quite a bit of corporate puffery.  The meeting was held at the company's Innovation Center in Almaden, California. Almaden is the home of many innovations which are at the heart of modern computing and databases; IBM and Almaden lead U.S. industry in the number of technology patents issued in recent years. This is a high powered laboratory, staffed with the same caliber of scientists that Thomas Watson said were key to the long-run success of the company.

CEO Rometty's introductory presentation was so amped up and hyperkinetic, I could barely finish listening.  There was far too much information, presented too fast, with the CEO interrupting her own bullet point lists to move into asides, each with their own bullet point lists.  I couldn't figure out if we ever did complete the five key corporate strategies or not.

There was an off-key remark early which I will paraphrase, "I know that you all (analysts, I presume) are looking at all this very expensive real estate and saying, "Why?"  I know, and believe me, we think about this every day, but let's move on."  I realized that the CEO, who clearly has command of her business, was nervous.  But, seriously, would any serious institutional owner be wondering about this issue as a key to the buy, sell or hold decisions?  I doubt it.  It's such as short-term issue, not worthy of an industry leader.

The theme of short-termism continued in the overall tenor of IBM's first quarter 2013 earnings release, which the Street characterized as IBM's first "miss" in eight years.  Morningstar analyst Grady Burkett wrote,
"IBM first-quarter results came in well below our expectations, as the firm's hardware and software results disappointed. Overall revenue declined 5% year-over-year to $23.4 billion, while free cash flow declined to $1.7 billion, versus $1.9 billion generated in last year's first quarter. We expect to adjust our 2013 forecast to reflect this quarter's weakness."
On the short-term side, the CEO made extensive references to failures in the sales organization to bring in orders from large customers planned for the quarter.  As a result of this unsatisfactory performance, the sales leader was reassigned.  This kind of commentary and action seems more appropriate for an emerging technology company than for a $100 billion+ revenue company.  Again, I found this unseemly for a company which Warren Buffett has found worthy of substantial new investment.

If I try to distill the key points from the Analyst Day, here's what I took away. IBM stands at the intersection of software, hardware and services.  It operates in businesses which have cycles of innovation and commoditization.  Examples of the latter range from the x86 and other commodity server lines to some database and analytic consulting.

IBM's consistent strategic goal is to "move to higher value."  This is done by acquisition, divestitures, and remixing research and development budgets.  The CEO noted that IBM had divested $15 billion in low-margin revenue over the past ten years.  It would have been nice to have the comparable number for acquisitions as a benchmark.

Acquisitions are for the purpose of getting the company quickly into a new space or to expand its capabilities.  The target company must have intellectual property which is scalable, which seems like one of the problems with HP's acquisition of Autonomy.  It should also help IBM to expand its geographic reach among is 170 countries today.

CEO Rometty said that the company is placing a significant investment bet on Africa, and particularly in sub-Saharan Africa.  This, in contrast to the short-termism referenced above, seems to be a very long-term prospect.  It seemed like something an NGO would like to hear, but it's hard to envision how the ROI works for this kind of investment.

Software already provides about forty percent of operating earnings today, and some analysts see this crossing over fifty percent by 2015.  Understanding this business would seem to be key for estimating the company's future margins.  Standard and Poors rates the company's outlook "stable" and its prospects "low risk," but it also wrote,
“IBM’s good market position and broad product and revenue base provide cash flow and ratings stability,” she said. “Highly competitive industry conditions, a moderately acquisitive growth strategy, and significant share repurchases currently constrain the potential for a higher rating.”
Much of the company's total return to shareholders have come from dividends and share repurchases.  While this has been well executed financial engineering, the company needs to better articulate how the business model works in the current commoditization cycle in which the new CEO has taken over the portfolio.

Thursday, May 2, 2013

Europe Needs Some New Saviors

"Looking at the original photo ops with former French President Sarkozy and Chancellor Merkel, it was evident to us from the start that the fundamental interests of France and Germany could never align.  Now, with a new French President with his own limitations and political agenda, the situation is worse than before.  At least former President Sarkozy and Chancellor Merkel had a cordial relationship; President Hollande, despite his having been trained at the Ėcole nationale d'administration, seems determined to establish a prickly relationship with Chancellor Merkel."    (October 2012)
 Today's Wall Street Journal correctly focuses on the dynamic that we pointed out last Fall.  They write,
"Mr. Hollande's success or failure to reach consensus with Ms. Merkel—without alienating his leftist majority in Parliament—is likely to have profound repercussions on the euro zone's future. There are widening concerns that France, Europe's second-largest economy behind Germany, risks becoming the next problem child."
The European press tried valiantly to make a savior out of ECB President Mario Draghi.

"The turning point factor in the Spanish sovereign debt crisis has always been nailed as the July 26, 2012 policy statement by Draghi that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” What Mario again didn’t say was that his bank’s liquidity dropped by a staggering €72 billion in just four hours of that very same day.  Amazingly, the next day Spanish bond yields fell sharply to 6.9% – and in response to that, the Madrid stock market forged ahead by 4%".

Again, last Fall we wrote that Draghi had no solutions for the Euro.  Today, it's clear that whatever it takes will not be enough.

Unfortunately, politicians are sending their hitman economists out to turn the issue into a policy referendum between continued austerity and pseudo-Keynesian government stimulus.  Continued austerity alone, with sky high Greek and Spanish unemployment rates, would impose continued suffering and crush national psyches without lasting benefit.  Stimulus would benefit the chosen favored groups and achieve nothing.  Fundamental labor market reform and reform of work rules needs to happen if things are ever to get better.  Many European banks are pigs with lipstick on.  A broom needs to sweep through the sovereign debt and banking system. 

Europe badly needs someone with inspiring and credible, Churchillian rhetoric to talk about sacrifices that have to be made, by financial fat cats and by fat cat labor unions. Mario and Francois are soap opera actors who aren't up to the task.