Tuesday, July 30, 2013

The Strange Situation of Met Life

The U.S. Financial Stability Council, yet another bureaucratic creature spawned by Dodd-Frank, recently moved Met Life to the final decision stage of being named a non-bank Systemically Important Financial Institution, or "SIFI."  Part of the booby prize for achieving this designation is a requirement to introduce something fuzzy called "contingent capital" into the firm's capital structure. G.E. Capital and AIG were just designated as non-bank SIFIs.

The Stern School's V-Lab ranks Met Life just behind Goldman Sachs in terms of its contribution to systemic risk from North American financial institutions.

I can't see any fundamental reasons Met Life should be put into the SIFI category.

Going back to the financial crisis that precipitated increased global financial regulation, it's interesting to look back at how the banking and insurance industries performed during the crisis.  According to an analysis of public company annual reports by Oliver Wyman, from 2007 until February 10, 2010, the cumulative global insurance industry credit losses totaled $271 billion, compared to $1,715 billion for the global banking sector.  Banking sector credit losses were over 6x those of the global insurance sector.

AIG alone accounted for 36% of the insurance sector's credit losses.  Yet, it wasn't anything in AIG's insurance businesses that precipitated the losses, but it was AIG's prop trading business and its outsized exposure to CDS.   Most insurance companies were able to absorb their losses on their balance sheets.

As a result of the crisis, the global insurance industry had to raise $170 billion of additional capital to shore up their capital structures, whereas the global banking industry had to raise $1,468 billion over the same period as above, a factor of 9x higher.  AIG accounted for 58% of the insurance sector's new capital raised, according to Oliver Wyman.

So, nothing in the experience of the great crisis suggests that the basic insurance company model would require heightened regulation or higher capital levels beyond Solvency II or Basel II's respective arcane requirements.

Met Life is the largest U.S. life insurer by assets, so it is a force to be reckoned with.  Met Life, according to Morningstar analyst Vincent Lui, chose to forgo TARP assistance, but it did take advantage of other Federal programs to strengthen its balance sheet post-crisis.

It raised $400 million from the Federal government for general corporate purposes, and it recapitalized with $2 billion in stock and more than $1 billion in debt.  The current debt/capital ratio is about 30%.

Under CEO Steve Kandarian, who joined Met Life at its Chief Investment Officer, the company has made a number of risk-reducing and potentially value-enhancing measures.  First, it gave up its bank charter, whose purpose had been to own a small deposit gathering function through which to cross-sell insurance and benefit programs.  Having sold this in 2013, Met Life was also freed from regulation by the Federal Reserve Bank.  Earlier, it had also sold its ownership in Stuyvesant Town, which removed the company from the risky and politically sensitive business of being a major landlord in New York city.

Getting to its core insurance business, the CEO has slowed the growth of Met Life's variable annuity business underwriting, and repriced the new business. In traditional products like universal life, it has also raised prices and reduced policy rates.  The variable annuity business might have been one reason to be concerned about the stability of Met Life, but this risk has been publicly recognized, the balance sheet strengthened, and the business growth tapered.

The company has made significant ventures into overseas markets.  In 2012, Met Life generated one third of its operating earnings from outside the U.S.  After its recent acquisition of ALICO from AIG, it operates in 45 countries, including Chile, India and Japan; before the ALICO acquisition foreign markets accounted for 17% of operating earnings.  Markets like Chile, the company says, are less price sensitive and customers are stickier than in developed markets where irrational pricing during underwriting cycles destroys profitability.  This move gives the company growth opportunities, margin expansion plays, and geographical diversification.

In the U.S. the company provides life insurance and other employee benefits to about 90% of the companies in the Fortune 500, according to Morningstar.  This business is also fairly sticky and not subject to underwriting cycles, as is traditional life sold to individual customers.

Over 80% of the investment portfolio are in fixed interest securities and mortgage loans.  The company operates in a highly regulated business overseen by state commissioners of insurance. Certainly if the Federal government were to decide to add Met Life to the systemically important list, it would add to policyholder costs and possibly restrict the availability of some products in some states.  When one looks at Met Life, the question is why does this company stand out among its peers for being riskier?

Of course, it is possible that the company becomes mismanaged under the current CEO, but given his initial moves as Chief Investment Officer and then as CEO, this would seem less than likely.  There is talk about raising the dividend and of buying back shares, which doesn't seem warranted where the stock is today.  This is a 140 year old company with a reputation for prudence, hopefully it reverts to its heritage.

Looking at this company through the lens of the British "twin peaks" regulatory model, the two questions would be (1) does the company's failure pose a substantial risk to the global financial system, and (2) would policy holders be protected in the event of a failure.  The answer to the first is "No," and the answer to the second is "Yes," because a supervisor in the event of an insurer failing is given much more latitude to protect policy holders from corporate assets or by sale to another solvent insurer.

Where have we lost the plot on financial regulation?  We are overrun with lawyers, both in our legislatures, government departments, and in private practice.  The British, by contrast, are probably overpopulated by people of an economic/philosophical bent.  One thing they have recognized about regulation is the benefit to keeping it simple.  The article by Andy Haldane, "The Dog and the Frisbee" makes the points well.

Monday, July 29, 2013

Dell's Special Committee Backed Into A Corner: The Company is the Loser

CEO Michael Dell and his reluctant partners at Silver Lake have come with a "dime," that is they have upped their price for Dell to $13.75 a share.  Their only condition: the Special Committee of the board has to change the election rules so that the decision would turn on a majority of the unaffiliated common shares voting in person or by proxy; the non-voting shares would no longer be automatically considered as voting against the proposed transaction.

On the face of it, an impartial observer without any history or context, might say that this is reasonable.  Dell/Silver Lake's letter characterizes the previous schema for counting votes as not being "rational."  This is overreaching.  Let's go back to get some context.

Dell has been mismanaged during Michael Dell's second apparition as CEO.  All the current challenges of the PC business have been evident for many years, although the trends have certainly accelerated.  According to Bloomberg, Dell spent $12.9 billion for 18 acquisitions from 2009 to 2012, and then spent $5 billion in 2012.  These were to transform the company into a higher end server, storage, and SaaS company.  Remember that the shareholders' cash was spent under the glare of being a public company.  There was no shareholder revolt, but so far the value of these acquisitions has not materialized.  The board during all of Mr. Dell's tenure never held the management team accountable for mismanaging operations and the firm's financial resources.  

Once the CEO came forward with Silver Lake Partners, the board had to be very careful about not appearing as patsies for Michael Dell coming in to rescue the shareholders from the fruits of his own mismanagement at a bargain price.  They went so far as to survive shareholder actions in Delaware court, where the Chancellor described the Special Committee's "go shop" process as being transparent, value seeking, at arm's length from the CEO, and otherwise exemplary of the duty to maximize value.  Part of the process were the election rules, which Michael Dell and Silver Lake had agreed to before the current kerfuffle began.  Apparently, the rules were palatable then, but not now. 

Probably, the Dell/Silver Lake team were convinced that tired, frustrated, long suffering shareholders would be happy to get some cash back, take their losses in a frothy market and move on.  PC results continued to move south as industry shipments declined 11% in the most recent quarter. So, either the team were expert game theorists or they were hugely overconfident.  

On the other side, Carl Icahn's mercurial, press release-driven behavior did nothing to give shareholders an apples-to-apples value to compare to $13.65 a share from Dell/Silver Lake.  It seems like the Special Committee did its best to engage the Icahn/Southeastern group to come up with a firm, fully financed offer, but this didn't happen.

Stopping the election in mid-process makes a joke out of corporate governance.  This kind of tactic is more proper to banana republic-style elections, but it is inexcusable for an NYSE company.  Perhaps, the Special Committee feared that the $13.65 offer would be rejected without a firm alternative in place.  Stopping the process would give a last chance to either get Dell/Silver Lake to raise their offer OR for Icahn et al. to come up with a definitive offer.

In actual fact, Silver Lake Partners would walk away with the most money under the latter scenario of a superior offer from others.  Rationally (and I use that term loosely), Silver Lake probably would rather get their expenses paid, take a pour boire and walk away for better risk-adjusted investment opportunities.  

So, in the end where is the biggest loser?  Dell Inc.--the company management, its employees, supply chain partners, developers and stakeholders here and abroad.   Value has been consistently destroyed by a process that has been allowed to run amok.

In the end, the Special Committee which received Chancellor Stine's kudos for running such a great "go shop" process, may prove to have been an unwitting, or half-witted, patsy for a CEO's simple mismanagement and extraordinary chutzpah.  

Monday, July 22, 2013

Ed Yardeni Sheds Light on the Labor Markets

We recently wrote about the Fed going radio silent on the employment part of the dual mandate.

"In fact, the labor market has been said to hold the key to downshifting on QE3 or ending it.  If that is so, why not stop all the patter about monetary policy communications and put the cards on the table.  The June FOMC forecast suggests that the unemployment rate won't hit the top end of the central tendency target range until 2015.  
We need a more content-driven discussion of labor markets by the Fed as opposed to political apologists.  Americans beyond Wall Street trading desks would surely like to know what our sharpest economic minds think about our working futures. "
The Wall Street Journal pointed to Ed Yardeni's blog entry on this very subject.  
"In his prepared testimony, Bernanke said that “if a substantial part of the reductions in measured unemployment were judged to reflect cyclical declines in labor force participation rather than gains in employment, the Committee would be unlikely to view a decline in unemployment to 6-1/2 percent as a sufficient reason to raise its target for the federal funds rate.” 

"Wow, that’s an important statement! It’s not hard to see that all of the drop in the unemployment rate so far can be attributed to the decline in the participation rate. I constructed three hypothetical time series showing the total number of unemployed workers by subtracting actual employment from the civilian working-age population multiplied by labor force participation rates of 63%, 65%, and 67%. This analysis shows that nearly all of the 3.6 million drop in unemployment from the peak at 15.4 million during October 2009 through June of this year can be explained by the drop in the participation rate from 65.0% to 63.5%. The same can be said for the drop in the unemployment rate from its most recent cyclical peak. Currently at 7.6%, it would be at 9.7% if the participation rate were 65%. "
So, do you think that all the monetary policy sleight of hand has been good medicine for the labor market?  

NY Fed Symposium on Distressed Residential Real Estate

It looks like the NY Fed held a high level symposium on the distressed real estate and real estate owned markets, and they have made available the papers and discussions of the meeting in a handy compendium.  I have to put this on my reading stand, because surely determining the size of the backlog and its composition is the key to the market normalizing itself.

Sunday, July 21, 2013

Why HP Has An Edge on Microsoft in Consumer Markets

HP is a hardware company trying to reinvent itself into a software and cloud computing company, which will include some high end servers/storage appliances.  Microsoft has a business with high end servers and business software, but with a consumer business which is stumbling out of the gate.

Is there a difference between the two?  HP's long experience with home and small business printers is a differentiator.  HP translated a dominating market share in high volume, business laser printers into a cash cow franchise, based on supplies, for the consumer market.  It learned about models for different retail channels and constantly tinkered with the printer itself to make it lighter, cheaper and almost disposable.

On the laptop side, it translated a leading position with the business enterprise into a leading position with the home user, despite the presence of Dell.

HP has also entered the tablet market alongside Dell and other Android OS manufacturers.  It hasn't had a real winner yet, but its Slate has earned some passable reviews compared to the Nexus 7, and it has responded to the market by cutting prices to clear inventories, hopefully in preparation for a new model. Like many of its laptops, their tablet is private-labeled by Asus.

Since HP uses Android for the OS, it isn't saddled with Microsoft's problem of loading Windows 8 onto the Surface, which is where Microsoft shot itself in the foot.  Knowing that developing a separate OS for tablets was out of the question, they opted instead to handicap their tablet and confuse customers with Windows 8 and Windows 8 RT.  The Windows cash cow became an albatross in the tablet market.

What Microsoft does next after the Surface write-down, with the new Hardware organization in place, will be telling.  As the Stones put it musically, I've got "No Expectations."

Microsoft's Blown Quarter: Reflecting on the Aftermath

Now it's easier to understand why CEO Steve Ballmer looked dyspepsic announcing Microsoft's latest reorganization: he knew that a guano-tinged quarter was coming down the pike. In the post about the reorganization, we noted that "this company is its own worst enemy."  

The company took a $900 million inventory write-down for its Surface RT units, parts and accessories.  Beyond the obvious financial impact, it's hard to see the way forward coming into the Christmas selling season. Those hardy souls who opted for Surface won't come back, and their friends with Apple or Android tablets have their decisions re-affirmed. 

Even though we believe that Microsoft engineers and partners did a nice job of designing a form factor for Surface with decent durability and features, it was not ready for the burden of Windows 8.  Worse, users of tablets don't use them to deploy Office applications and do their work-related projects on the tablet.

Apple got it 100 percent spot on: tablets are used to browse the web, check emails, read e-books, take videos and photos,watch videos and television, and update their social media sites.  It may have sounded like a rational step for consumers to do their Powerpoint on Surface, but it's not what they wanted.  Microsoft executives don't understand their retail customers at all, whether for tablets or for gaming.

Whereas Office 365 might make some sense for very large corporations, it's not because of the savings of subscription versus licensing, but for the potential to economize on IT resources to make sure applications are always up, desktop users are being supported, application security, and upgrades. For the retail consumer, at the prices being announced, a subscription seems like anathema. 

Where Bing has made real progress (Credit Suisse reports its 18% market share is up 230 basis points year-over-year), Online Services is still a peanut in the corporate structure. 

Entertainment and Devices continues to lose money, despite the strong brand equity of Xbox among gamers. The company alienated younger gamers with the announcement of the requirement to be online to play and for the ban on reselling the consumer's own games.  Windows Phone seems too little and too late given that the consumer mobile market itself is hitting a wall, just as the number of makes, models, and plans has grown too expensive and too confusing.  For your first smartphone, who would take a flyer on a Nokia Windows phone? This division lost $110 million, down from last year, but its future seems uncertain. 

The Business Division is the other strong performer, and somehow, it seems to keep growing and performing well, despite competition from other large players. It's almost as if there are two Microsofts: the dumb consumer folks and the smarter business division folks.  Or, maybe it's the executives who direct the smart engineers to do stupid things in the consumer businesses.

Jeff Ubben of ValueAct Capital is apparently now a shareholder of Microsoft.  Mr. Ubben knows the company well from his Fidelity Value Fund days.  A press release said that independent directors have already had a conversation with him.  As we wrote in our last post, 
"A better question for the board is this one: should Microsoft continue to exist in its current corporate form, given how badly it has consistently missed industry waves like the Web, tablets and mobile devices?  Can any executive lead such a bipolar organization effectively?  Now that there is one corporate CFO, you better believe that the investment bankers are asking themselves this same question and will be coming up with some ideas."
Apart from these short-term pressures, it's clear to me that Microsoft cannot deliver value with the culture that produced the venture portfolio strategy, acquisitions in online advertising, Windows 8, Windows Phone, the debacle with Surface, and a reorganization that fails to address any of the cultural issues.  This is rearranging deck chairs again. Steve Jobs cracked Apple's engineering culture by sheer force of personality and will. No one person can perform this job within Microsoft.  It really needs to be shaken up beyond org charts.

Friday, July 19, 2013

Bank of America: Good Fundamentals But Not Yet Ready for Prime Time?

Bill Murray in "What About Bob?" plays a hyper-neurotic, emotionally stuck man who can't get out of bed in the morning.  In this clip, he achieves a breakthrough and goes "sailing." But, his version of sailing is not ours: he is lashed to the mast high above the water.  I hope this lightens up the end of a heavy earnings week.  There is a loose analogy to Bank of America's position after the second quarter. (An aside: Richard Dreyfuss as Bob's hyper-anal shrink resembles which current Fed Chairman?)

It was an eye opening quarter in a lot of ways:

  • $1.1 trillion in deposits, up 4%;
  • Net income of $4 billion;
  • Non-interest expense down $1 billion from the prior quarter;
  • Net credit loss rates at 0.94%, the lowest since the second quarter of 2006.
The problem?  BAC is hamstrung by two distinct legacies.  The first is of its own corporate actions: the acquisition of Countrywide Financial and its consequences which resonate throughout the consumer business.  The second is the overhang related to the Federal bailout, impending regulations and restrictions on dividend policy.  

The company increased its consumer and commercial banking sales force (financial solutions advisers, mortgage loan officers and small business bankers) by 21% year-over-year in order to extract more relationships, products and revenue from the huge deposit base.  However, the company has to judiciously balance this against the ongoing costs of dealing with the thousands of mortgages which had to be restructured due to errors in applying fees and foreclosures by the mortgage servicers. The former Countrywide mortgages and loans (PCI--"purchased credit impaired") are reported separately and are still a drag.  

The net charge off rate for consumer and business loans was 0.94%, but if the PCI loan portfolio were included the reported rate increases very modestly to 0.97%, because of the fact that most of the principal is insured, even though interest in not accruing on the loans.  If the PCI write-offs are included then the NCO rate goes to 1.07%.  

Overall fee income was down in the quarter compared to the prior-year period.  Having to deal with the Countrywide legacy has resulted in BAC ceding mortgage market leadership to Wells Fargo, in terms of originating new home mortgages and refinancings.  

Overall, for Consumer and Business Banking, the return on average allocated capital (a non-GAAP measure) was 18.6% in the second quarter, down from 19.5% in the first quarter.  Average loans in the second quarter were flat to the first quarter and down $10 billion from the prior-year period. 

So, things are improving in terms of banking relationships and credit quality, but the company can't go full speed ahead to capitalize on its opportunities because of the legacy of bad loans, especially those associated with the Countrywide acquisition.  

Global Wealth and Investment Management (GWIM) comprises Merrill Lynch, U.S. Trust and other operations.  In the second quarter of 2013, this business recorded $4.5 billion in net revenue with non-interest expense a surprisingly high 72% of net revenue. The pre-tax margin for this business was a record high of 28 %.  GWIM's return on average allocated capital was 30.6% , ahead of the prior quarter's 29.4% and compared to a return of 18.6% for the capital-intensive core banking business.

The problem with GWIM and core banking, as we have written about before, is one of cultures.  They are totally different, and I don't believe that any company has been able to make them work together to effectively cross-sell and work together on accounts.  GWIM responds instantaneously to rising equity and bond markets, as they did in the second quarter.  Right now, GWIM fits into BAC, but let's see if the marriage has legs, or if, at some point, Merrill Lynch's leaders cry to be on their own.  

Global banking and investment banking had nice quarters, and Bank of America's global banking franchise, like that of Citi, is something of real value.  

Capital ratios for all the current and soon-to-be standards are improving and close to where they need to be.

Tangible book value at the end of the quarter was $13.32, and most analysts argue for an appropriate P/TBV multiple of less than one, around 0.95 in the case of Credit Suisse.  On their projected 2014 TBV of $15.12, the stock appears fully valued after the strong second quarter.  It has had a glorious run from the low, though.  One day it may really be sailing!  

Dell's "Time Out" Call in Shareholder Election

I confess that in all my years in the securities business, Dell's suspension of the shareholder vote was a first for me.  At this point, no matter which side wins the pro-forma battle, everybody loses the war to generate EVA from Dell without saddling the horse with unnecessary burdens.

Michael Dell's argument that he cannot take the measures he needs to take to restructure the company he created in its current version, through acquisition is disingenuous.  Of course it can be done.  Those who don't believe or who don't have patience will sell to those who have longer time horizons and who like turnarounds.  Supply and demand, plus speculators at the margin will set the stock price.

Expectations can be set as low as management likes: look at Hewlett Packard after Meg Whitman became CEO and took expectations into the basement. The stock plummeted to $12.  Once there was a modicum of credibility in the new strategic plan, some weak shareholders were flushed out and replaced.  The stock has doubled, even before real earnings improvement has become visible. So, please Mr. Dell, what on earth are you talking about?  HP is quite a good proxy for Dell: a maker of PCs and servers trying to become a cloud computing, software and services company.  

We've said before that shareholders as a class, including institutional shareholders, are apathetic about real economic management of their investments.  Now, the financial press speculates that some funds which were first inclined to vote "No" to the Dell/Silver Lake buyout are now ready to vote "Yes."

The alliance between Southeastern Asset and Carl Icahn's fund has been an alliance of convenience between a one time corporate raider turned "shareholder activist" and a traditional Graham-Dodd investment management company.  Because there is no more dialogue with Mr. Dell, their deal may not be the best alternative for the company either.

The real winner may be Silver Lake, which gets all its expenses reimbursed in the worst case, and which could get a large breakup fee for doing nothing except distracting a public company from its duty to create value for its shareholders now.

Thursday, July 18, 2013

The Fed Should Stop Talking to Wall Street Traders

The Fed has the famous "dual mandate."
"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."
Every time the markets swoon, all of the attention is focused on how, when, or if QE3 will be tapered, unwound, or continue into the indefinite future.

The important question is , "What's wrong with the labor markets?"  The Wall Street Journal recently pointed out,

"The latest unemployment report was as underwhelming as the Household Survey. The biggest gains in June came from leisure and hospitality industries, including hotels and fast-food restaurants. Of the 195,000 new payroll jobs, 75,000 were in restaurants and bars, where the average weekly paycheck is about $351, less than half the average for all other private industries. Not to mention that these positions offer fewer hours, especially in the restaurant world, which has averaged 26.1 hours per week versus 34.5 hours for all private employers.s
What's going on? The fundamentals surely reflect the feebleness of the macroeconomic recovery that began roughly four years ago, as seen in an average gross domestic product growth rate annualized over the past 15 quarters at a miserable 2%. That's the weakest GDP growth since World War II. Over a similar period in previous recessions, growth averaged 4.1%. During the fourth quarter of 2012 and the first quarter of 2013, the GDP growth rate dropped below 2%. This anemic growth is all we have to show for the greatest fiscal and monetary stimuli in 75 years, with fiscal deficits of over 10% of GDP for four consecutive years. The misery is not going to end soon."
The Fed Chairman has made passing references to the labor market and to the Fed's work.  Why not publish the Fed's research as addenda to his testimony?  Surely, their best economists have looked at the labor market and its true underlying health, as opposed to the headline numbers.  This is where the nothing has been done, because monetary policy's power is very limited, as opposed to asset markets where it can create bubbles at will.  
In fact, the labor market has been said to hold the key to downshifting on QE3 or ending it.  If that is so, why not stop all the patter about monetary policy communications and put the cards on the table.  The June FOMC forecast suggests that the unemployment rate won't hit the top end of the central tendency target range until 2015.  
We need a more content-driven discussion of labor markets by the Fed as opposed to political apologists.  Americans beyond Wall Street trading desks would surely like to know what our sharpest economic minds think about our working futures. 

Monday, July 15, 2013

HP Adds Directors Who Can Help Management

HP announced the addition of three new directors to the board: Robert Bennett, former CEO of Liberty Media; Ray Ozzie, of Lotus Notes fame and former Chief Software Architect for Microsoft; James Skinner, Chairman of the Board of Walgreen and former CEO of McDonald's.

These seem like upgrades from the traditional list of Silicon Valley types.  Ray Ozzie brings an entrepreneurial mindset, first hand experience with technological innovation and experience with how a large company views software development.  His imagination still seems fertile, and he's seen the good and bad in corporate development. Walgreen was always one of the best run companies I followed as an analyst; during that time, the CEO was the board chair and favored the traditional pedigree of a pharmacist who came up through the ranks, e.g. Cork Walgreen and Dan Jorndt. For James Skinner to take that role suggests a great deal of faith in his abilities, and his operational experience with one of the globally iconic consumer brands should help HP in its consumer businesses.

A good step forward.

Sunday, July 14, 2013

Microsoft Reorganization Falls Flat

Microsoft at its worst is an arrogant, tone deaf company feasting off its OS monopoly and the ubiquity of Office in corporate settings.  In recent times, however, even I thought they were being maligned too much by analysts, who thought that they had no reason to be in the search business.  They've made some good progress coming out of nowhere.  I really do want to feel better about this company.

Instead, the recent announcement about another corporate reorganization made me feel that this company is its own worst enemy.  A company's lack of market place vitality almost never gets solved by a reorganization of an existing portfolio.  Here is my first clue that this announcement spells trouble:
                                                                                            credit: Getty Images
This is the CEO who wrote the 2,700 word memo communicating the reasons why Microsoft was going to re-energize itself and its customers with a reorganization that would unleash "One Microsoft."  One small problem: this man looks incredibly tired, bored, and devoid of any energy and enthusiasm for the message he is delivering.  This is not a man who is going to take names; he badly wants to take a nap. He doesn't believe in what he is preaching: a Chinese menu of platitudes and buzz words.

By contrast, my wife and I went to a movie at the independent Uptown theater in Minneapolis last weekend. With the trailers, there was a b&w, silent animated commercial that moved with incredible pacing.  It drew the viewer in, even though it might not have been evident to all what the trailer was about.  It was an Apple ad in the style of the "Designed in California" campaign.  I own no Apple products, but I loved the trailer.  Contrast this with the image to Mr. Ballmer's right: static, cliched, tired. This must have been a product of the pre-reorganization marketing department.

To demonstrate that most of the press couldn't make anything much out of this announcement, check this headline from the Wall Street Journal, "Steve Ballmer Solidifies His Grip on Microsoft."  He has no need to do this, having been CEO for thirteen years, being a "friend of Bill," and having done major reorganizations before.  Surely, this motive has to be a red herring.

credit: www.bonkersworld.net

This chart on Microsoft probably captures the real issue the best: it's a cultural issue, spawned by years of allowing a sprawling, mismanaged organization with misaligned incentives to corrode any incentive to take risks, innovate, think for the long term, and work together beyond one's SBU.

Sure enough, one Gartner analyst puts his finger on an example of this dysfunctional culture,
"It was just ludicrous to see the divisions between Windows Phone and Windows 8 last year," said David Cearley, an analyst at Gartner Inc. IT -0.08% That was a glaring miss." 
Some writers talked about CEO succession.  A better question for the board is this one: should Microsoft continue to exist in its current corporate form, given how badly it has consistently missed industry waves like the Web, tablets and mobile devices?  Can any executive lead such a bipolar organization effectively?  Now that there is one corporate CFO, you better believe that the investment bankers are asking themselves this same question and will be coming up with some ideas.

Microsoft will now have an executive in charge of partnerships and business development.  These are both functions which Microsoft performs very, very poorly.  Anyone can stick a logo on their website saying they are a Microsoft partner at some level: what it means in terms of value to the partner and commitment from Microsoft are a mystery.

Back to the issues of warring internal fiefdoms, Julie Roberts-Green has been given the entire hardware portfolio for Microsoft, an opportunity that could be a blind alley or chimney to the summit. She's got a lot of work to do.  Here's a comment she made to Wired Magazine,
"when ex-Wired editor Michael Copeland asked Larson-Green about replacing Ballmer at our business conference this past May, she was uncharacteristically blunt. “I wouldn't rule it out, but I’m not in a hurry,” Larson Green said. Give me a year and ask me again.”
Wow.  So this reorganization has really got executives who are speaking with "One Microsoft" voice.

I have listened to quite a few large scale reorganization announcements from companies I followed as an analyst.  In the short-term, the only guaranteed yield was executive turnover, followed by middle management malaise.  I can't think of one which, by itself, was a catalyst to the kinds of things Mr. Ballmer talks about in the papers.

It will be interesting to see if the executive compensation philosophy and structures reflect the goals of this reorganization by putting the executives' skin in the game to work together on one strategy (whatever that is) to deliver value.  Look at the next proxy and stay tuned.

Saturday, July 13, 2013

Dell Stumbles Towards the Finish Line

Southeastern Asset Management deserves kudos for trying to work with Michael Dell and his board to realize value for all shareholders.  They may rue the day that Carl Icahn got involved, ultimately failing to give a clear, apples-to-apples comparison for shareholders to make next week.

Let's get down to the fundamental issues in this deal.  Institutional shareholders as a group don't want to manage the company nor do they want to be hands at the throat activists: they are apathetic as a class, especially when the stock price is going up.

When Dell was a badly mismanaged as it has been for years, with the exception of Southeastern and a few other institutions, the majority of large shareholders sold or hung on without becoming more engaged with the company.

Yes, there are information asymmetries between external shareholders and management. Yes, boards can obfuscate, delay or stonewall uppity shareholders trying to shake up poor or lazy managements. But, the fact that shareholders as a group allowed themselves to be reactive to the Dell/Silver Lake offer rather than being proactive earlier is their own fault.

Securities regulations can't make managements better, and they can't make shareholders pay more attention.  Market forces are supposed to achieve these ends, though they often do not.

So, solely in respect to the Dell Special Committee's handling of the Dell/Silver Lake offer and its "go shop process," Chancellor Strine of the Delaware Board of Chancery,

"...seemed skeptical of plaintiffs' claims that the deal, which is set to go before a shareholder vote July 18, includes protections that would hobble a competing bidder. Rather, he said, the company's board took steps to encourage a higher offer, and suggested the plaintiffs have an uphill battle ahead of them.

“Not only was there a post-signing market check … but there was, in fact, an active look at other potential private equity sponsors,” the chancellor said in a court conference Wednesday. “I do not see any plausible, conceivable basis in which to conclude that it is a colorable possibility that you (plaintiffs) could deem the choices made by this board to be unreasonable with all the different safeguards."

This is pretty emphatic language dismissing Icahn's claims that the process since his involvement was flawed.  A last second improvement to his offer by offering a warrant adds complexity to the comparison, not transparency.  The explicit financing for the deal seems to change depending on which press release a shareholder reads.  And, it turns out that Mr. Icahn missed a meeting with the Special Committee that he himself had requested.  

Shareholders left it late. Courts don't see a conspiracy in the process.  None of the shareholder advisory firms saw an opportunity to gain by staking out a position supporting the Southeastern/Icahn transaction. The Icahn offer is still a "mystery meat" without a bottom line dollar price, financing in place. The company announced another dreadful quarter for the PC business, reinforcing their crying the blues. It looks like it's all over for rebels. 

What is still inexcusable is management's effective standstill during the runup and to the closure of this transaction.  Effectively, it is being paid to do nothing, and it has not taken steps to restructure the business, deal or not.  It has been a mismanaged company for years. 

The sooner this sham ends, perhaps the sooner Dell can get on track to becoming a viable company producing superior returns for its owners.  

Wednesday, July 10, 2013

ECB and the EU Make a Power Grab

The last post about the Greek bailout revisited our constant theme about the love affair Europeans have with technocratic and bureaucratic elites.
"Together with the IMF and the European Commission, a troika of bureaucrats now wields the power to micromanage the taxation and expenditure policies of member states."
 Now, the European Commission is pushing to be the sole resolution authority for winding down national banks, especially those with transnational operations; the European Central Bank is already set to become the sole supervisory authority for banks beginning in 2014.

Talk about moral hazard and conflicts of interest: French and Italian banks are among the largest of the banks with significant balance sheet and systemic risk issues, although Germany has a couple on the potential list also.

How can authorities in Germany give up control over winding down their banks?  Now, national sovereignty issues will again come to the fore.  This debate will play on through the fall elections and should create more division and uncertainty.

Tuesday, July 9, 2013

Looking Back at the Greek Bailout

I just finished reading Neil Irwin's book, "The Alchemists," who are Mervyn King, Ben Bernanke and Jean-Claude Trichet, portrayed by the author as the Three Musketeers saving the world from financial cataclysm.

The chapter on Greece made me go back and think about the chronology of events to the latest news today, namely that the EU has to make continuing contributions to a Greek bailout, which has currently consumed 248 billion euros, according to the WSJ. The recounting of events for this crisis makes good reading.

Greece didn't fit the profile of a good member country to adopt the euro.  Its economy was relatively small, had low levels of per capita income, and a business environment rife with corruption, institutional cronyism, and an ineffective public sector. Greece joined the eurozone through a clever bit of financial deception.

In 2001, Goldman Sachs arranged a series of currency swaps for the Greek government, which according to the EU's rules at the time, allowed the country to report a much lower level of public debt on the books, which in turn allowed Greece to meet the debt/GDP criteria for admission.  Eight years later, this tactic was no longer approved by the EU rules.  MIT Ph.D. Mario Draghi was at the time the Vice Chair of Goldman Sachs International.  Greece's entry into the eurozone was tainted from the very beginning, and the EU had to know this, although Draghi now disavows any knowledge of this particular transaction.

Irwin tells the story of George Papacontstantinou (Ph.D., LSE), the Greek finance minister of the Panhellenic Socialist Movement party, who was working on a 2009 budget which had assumed a deficit equal to 6% of GDP.  As voters were going to the polls October 4, 2009, the deficit was moving toward 8-10% of GDP, because the government was spending well above the budget and deliberately going slow on collecting tax revenue.  As Dylan wrote, "You don't need a weatherman to know which way the wind blows."

On October 7, 2009, Papaconstantinou got a call from George Provopoulos, the Governor of the Bank of Greece, who was the only one who really understood the financial position of the Greek government.  Provopoulos said the the Greek government budget deficit was running up the debt/GDP ratio in excess of 12.5%, or more than double the level projected a few weeks before.

The actual debt/GDP ratio for 2009 came in at 15.7%, the highest ratio in the world at the time, according to the author.  As for the Greek government, Irwin says, "...the Greeks were cooking the books," but sovereign debt investors continued to be complacent.

Fast forward to today.  The member nations of the eurozone, having been described by economists as too heterogeneous at the inception, have broken down into a fluid core and a periphery.  Even within the core, the German economy continues to stand apart.

Eurozone members, through the increasingly intrusive bureaucracy in Brussels, have already accepted a high degree of micromanagement over their national commercial enterprises.  During the Greek crisis and its aftermath, the ECB violated its own founding treaty, Maastricht, in order to directly purchase sovereign debt; the treaty expressly forbade using ECB facilities to fund deficits. Of course, like politicians everywhere, both sides parsed whether the letter or the spirit of the treaty were broken.

No matter, because when Mario Draghi spoke the comforting words that he would do everything within his mandate to save the euro, financial markets were buoyed, he had become the head of the most powerful institution in Europe.  Together with the IMF and the European Commission, a troika of bureaucrats now wields the power to micromanage the taxation and expenditure policies of member states.

The European Commission is now responsible for putting out its own questionable forecasts for the economies of its member states.  Writing about the outlook for Greece, the winter forecast suggests that domestic final demand will finish its sixth year of percentage decline from the prior year.  The report somehow suggests that Greek exports will grow as a result of its increasing competitiveness due to labor market reforms and improved work rules.  This defies all logic, as very little has actually been done to date, and Greek exports to other EU countries have been relatively unchanged over the years of the crisis.

If you thought that we had left the situation of lurching from crisis to crisis, the Journal reports,
"And Greece, the euro zone and the IMF have yet to complete a deal that calls for public-sector payroll cuts affecting 12,500 state workers and other measures before Monday's Brussels meeting, officials in Athens said Sunday."
The Greek unemployment rate was 25.7% in 2012, and according to the EU forecast it should end 2013 at 27%.  According to the Greek economic statistics, there has been some progress in indicators like compensation expense per unit of output.  The troika chiefs and the heads of state in the eurozone need to start being honest with other and with the markets, because the current state of affairs is certainly not indicative of any benefits to a full-fledged political union.

As Jacques Rueff, an advisor to Charles de Gaulle, is reported to have said,
"L'Europe se fera par la monnaie, ou ne se fera pas."  
Right now, the common currency continues on shaky ground. 

Thursday, July 4, 2013

The Morning After in Tahrir Square

Former President Morsi's regime had become inherently unstable: something had to give, and it did. He had no plans or ability to address the critical fuel shortages which hit all Egyptians every day, whether they voted for Morsi or not.

Robert Springborg, writing in Forbes in 2012, notes the uneasy marriage of convenience between the Muslim Brotherhood and Egyptian rulers which he says dates back to King Faruq.  Morsi's barely credible 51% popular majority was mistakenly interpreted as license to set himself up as the next dictator.

In November 2012, he unilaterally gave the President's office broader powers while simultaneously declaring that Egypt's judicial branch could not challenge his decisions.  The U.S. and our European allies accepted these moves passively, which was another diplomatic faux pas. Because of our intoxication with the word "election," that meant President Morsi needed to be given some room.  

He also saw Egypt as returning to its former glory days as a leader in the Arab world, 
"Khalil el-Anani, an Egyptian expert on Islamist groups, called the move "Morsi's endorsement of jihad in Syria" and warned it was "a strategic mistake that will create a new Afghanistan in the Middle East. ..."He is pushing Egypt into a sectarian war in which we have no interest."

The best thing that could be done for the economy?  Charge someone--perhaps an economic council chaired by the military and populated by representatives of major political groups, private sector representatives and Egyptian technocrats--with getting Egyptian consumers supplied with fuel on a reliable, transparent and sustainable basis.  If that could be done, and it should, then the long-suffering populace might be able to better stomach another round of parliamentary and Presidential elections.  

Tuesday, July 2, 2013

Our Absurd Treatment of Bangladesh

Bangladesh became a center for apparel manufacturing after other locations like India and China became higher cost.  Once countries like Canada dropped their 18 percent duty on clothing made in Bangladesh, its industry exploded.  However, its production is focused on lower-value basic items like t-shirts and underwear.

Over time, the goal of a Bangladeshi apparel industry would be to move to higher value fashion items for better manufacturers and retailers.  In order to do that, they have to continue to expand their output, while improving their quality and capabilities.  Manufacturers have to continually lower their costs for the inevitable concessions that will be demanded by their volume customers, like Walmart.

So, the local entrepreneurs inevitably look for every way they can to cut costs while boosting production.  The building collapse which killed over 1,110 people came in a building that was rented by one of Bangladesh's largest producers.  The owner of the building has been brought up on charges that he built his buildings on ground that couldn't support the structure, and that he used substandard rebars and concrete.

The bigger problem is that the entire system of building project review, permitting, and inspection is bankrupt and doesn't work.  As well meaning as some of the manufacturers are about signing a pact to be responsible for the safety of facilities owned and run by others, this is neither a viable solution nor one which will appeal to their shareholders.

The appropriate internal regulatory mechanism is vendor certification, which all garment companies have to some degree.  So, before deciding to produce in Bangladesh, the company should have looked at the whole gamut of issues from plant safety through worker treatment and occupational health and safety.  Never mind that companies now report on sustainability issues, which should also touch on the sustainability and riskiness of supply chains.

However, in our short-term corporate mindset of looking for a boost in today's share price, the companies can't care and don't care.  They can't because if their t-shirts cost $1.00 more than their competitor's they will lose share; they don't care because a higher share price means a higher bonus.

So, while Bangladesh is called on the carpet by President Obama, China is given a free ride on safety issue in many industries.  Who bears the brunt of our ham-handed arrogance?  The young women who, despite working in extremely difficult conditions, are often the only support of their families and who provide a way out of poverty in their country.

Of the European companies, H&M had been working with its suppliers on issues like working conditions and plant safety as a normal course of their doing business.  For this kind of effort to pay off, both supplier country and retailer have to make longer-term commitments to each other.  Facilitating and funding some parts of this effort would be an appropriate role for multilateral agencies and for governments like the United States.

A Withering Arab Spring in Egypt

Like the ending of the Prague Spring, Egypt's Arab Spring is withering away with President Morsi unable to rally any support from his own cabinet members, the Egyptian judiciary, and even some factions of the Muslim Brotherhood which brought him into power.  The BBC reports that some of the street protesters have even set fire to the Brotherhood headquarters in Cairo.

To understand the role of the military in Egypt, we've never heard a more coherent description than in Professor Richard Bulliett's 2011 talk sponsored here in Minnesota,
"Once the neo-Mamluks come into power, their goal is to tap deep roots, through appropriating assets, government monopolies, and widespread nepotism. A kleptocracy is their modus operandiThat is how, for example, the Egyptian military controls most of the prime residential and leisure real estate in Egypt. Once the neo-Mamluks are established, their ideology is very flexible. They are relatively indifferent about secularism, Islamism, socialism, capitalism, or fascism, as long as nothing affects their finances and life styles. While both U.S. political parties may long for an nineteenth century ideal of a secular democracies in the Middle East, this is not even in the political calculus of the neo-Mamluks."
Unlike say the Pakistani military, the Egyptian military doesn't have a fervent desire to run a government, so a "military coup" would be an undesirable last resort.  But for the Egyptian military to have given an almost unattainable 48 hour ultimatum means that they see real danger to their assets and lifestyles.

Again, Professor Bulliett called the current situation right back in 2011,
"Free and fair" elections will not occur, but rather "credible" elections in which Bulliet says that the Muslim Brotherhood may even achieve a plurality. However, they too understand the rules. Don't go overboard with any reforms that bring the eyes of the world on Egypt, take the counsel of the generals and protect their privileges.
President Morsi's pan-Arab ambitions may have not been on the agendas of Egypt's generals.  In addition to dealing with the real economic and social needs of his populace, Morsi will have to placate the generals and give up some of his chest-puffing pan-Arab rhetoric to make the generals more comfortable as they vacation at their villas.