Thursday, October 31, 2013

Treasury Report on Germany's Trade Surplus Is Incomprehensible

The big headlines about the U.S. Treasury, and hence the Obama administration, criticizing Germany's export-led trade policy seemed outlandish.  So, as I always do, I try to get to the source and see for myself.  The source is the innocuously titled report. "Semiannual Report on International Economic and Exchange Rate Policies." 

Most of the facts recitation, charts and discussion are unsurprising because they've already been discussed ad nauseam in lots of print and discussion sources.  The stage is set by this factual recitation.  The euro area current account was close to balance in 2009-2011, and it increased to a surplus of  2.3% of GDP in the first half of 2013.

The report also notes, "On a real effective basis, the euro appreciated by 2.7 percent in the first
half of 2013 and by a further 0.6 percent in the third quarter of 2013."  Keep this in mind.The report continues,
  "The euro area economy expanded by 1.2 percent, on a seasonally adjusted, annualized basis (saar), in the second quarter of 2013, marking the first expansion of economic activity in the euro area in seven quarters. Expansion was supported by domestic demand growth in Germany - though growth in Germany still continues to rely on positive net exports, which continues to delay the euro area’s external adjustment process – and on domestic demand in France."
This is an incomprehensible logical leap, so let's back up to the facts that may, or may not support this. The German current account surplus in the first half of 2013 was a bit more than 7% of GDP.  The Netherlands ran a current account surplus during the same period in excess of 10% of GDP.  So, if Germany were somehow able to run a domestic demand constraining, export-led policy in the face of a rising euro, then what were the Netherlands doing?  The answer is that the contention is economic humbug.  

Later in the report we read,"Germany’s current account surplus, meanwhile, rose above 7 percent of GDP in the first half of 2013, with net exports still accounting for a significant portion (one-third) of total growth in the second quarter, suggesting that rebalancing is not yet occurring domestically."  Wait.  This means two-thirds of the total growth in the second quarter was accounted for by sectors other than net exports.  How can the Treasury's political conclusion laying the burden for the eurozone's adjustment process at the feet of German trade performance be justified?  

The performance came despite the fact that the currency movement was unfavorable.  I would call it good performance.  On the other hand, the report doesn't offer the detailed trade statistics among countries or regions to delve into the problem further, but the growth of the Chinese economy and the push for 'infrastructure investment' alluded to in the report was probably a source of Germany's strength in net exports.  

In fact, the discussion about China seems to raise more questions about their continuing management of their economy, despite the strong nominal increase in the renminbi during the period.  China continues to build foreign reserves and there is no sense of their economy rebalancing  towards domestic consumption.  China, however, gets a free pass in the reports discussion of international adjustments.  

The German reaction to the political nature of the Treasury's report was strong, as reported in the Wall Street Journal.   "The German export growth story is mainly in emerging markets like China, the implicit criticism that Germany should export less and consume more—there I have my doubts because [European] periphery economies don't have products Germans would consume,' Mr. Brzeski said."

Wednesday, October 30, 2013

The Sears Way: Kill the Lands End Brand, Then Spin It Off to the Public.

My family and I were early customers of Lands End.  Did they sell the same kinds of polo shirts, trousers, and oxford dress shirts as many other retailers?  Yes.  But, the company's value proposition and culture were totally different, and once we were sold on this, our family could reliably buy our wardrobe staples through their catalogs. They even pioneered certain categories like duffel bags and winter wear, offering high quality at just above discount prices.  Their stuff lasted forever.

Two of their staples for men were the basic men's polo shirt and khaki trousers.  Quality of the basic fabrics was high, and they always had nice details like collars that lay flat and buttons that didn't break. Founder Gary Comer began his business career in advertising copy writing, and I confess that the catalogs themselves were fun to read.  They continuously reinforced in story the company's corporate messages:

  • We provide wardrobe basics of the highest, department store quality, or better, at discount store prices, and we deliver to your door.
  • Lands End spends a lot of time with our suppliers and designers to make the basics better.  We pay attention to detail, e.g. rolled collar dress shirts as opposed to fused collars. 
  • If you're not satisfied, ship it back to us on our dime, no questions asked. And, this was actually true.
  • You can always talk to us on the phone, and we're farm folks in Wisconsin who love to talk to our customers.
The customer service folks were women working out of their homes to earn a little extra money, and they knew the catalogs, loved the company, and really enjoyed helping customers with sizing and color questions. All of the above is a concrete example of a company's value proposition written into a corporate culture, which people were proud to advertise themselves.  This was the Lands End brand.

Now, it is been totally debased, and we've written about this before.  The clothes are awful.  If possible, they are a step below the early, trashy Target private label line Merona, and even worse than Penney's Stafford private label line.  Perhaps a step below Wal-Mart would be the appropriate comparison.  The customer service folks are gone, and they're generic call center people who probably handle dozens of catalogers. 

I would never need to call about returns, because no one in their right mind would buy this merchandise in a Sears store.  They are laid out like dump tables in an Odd Lots store. 

So, when the spin out story is put together, it will be an empty shell.  The folks who now provide the comparable quality merchandise are L.L. Bean or Eddie Bauer, but they are significantly more expensive. Lands End could never recapture their niche from these two, and other, competitors, of which there are many niche catalogers, like Duluth Trading.

So, today's story is about Sears trying to "unlock value" from Lands End.  Good retailing companies are about a sustainable value proposition, execution and a strong culture.  Sears has sucked all of these out of the company that Gary Comer founded.  Hedge fund managers can't operate companies, so beware of one who is selling one he operates.

Tuesday, October 29, 2013

Consumers Will Soon Face Choice, Technology and Budget Fatigue

Desktop computing was going to die, as consumers and business users moved to laptops, notebooks and ultrabooks.  Soon after this, the world was going mobile, and computing was converging on the phone. Then, limitations of screen size, carrier spectrum, and battery life moved tech companies towards tablets.

A recent forecast by Cisco Systems projects that by the end of 2013, the number of cellphones, tablets, laptops and other wireless devices (such as those connected to smart sensors) using global spectrum will exceed 7 billion devices, about equal to the world's population.  This, in our opinion, is one of the elephants in the room. Now, let's move on to Apple before we return to our main theme.

According to the technology research team at Credit Suisse, Apple shipped 33.8 million iPhones in their recently reported FY13 4th quarter, up 26% yr/yr. By fiscal year 2015, CS projects that the iPhone will account for 55% of sales and about 62% of its profits.  The company now has $91 billion  in net cash. Is there a problem?

A minor one is Carl Icahn's absolutely loony idea to drain the cash to buy back shares, take on debt and create "shareholder value."  Wall Street Journal "High Definition" columnist Farhad Manjoo puts it very aptly,
"Mr. Icahn doesn't seem to realize that Apple, like all tech companies, is ephemeral. It is a giant perched atop an ever-shifting mountain of silicon, a behemoth whose success is as tenuous as it is fantastic. To the extent that Apple can guarantee any future for itself, its salvation is in its cash. It needs to spend its money on its future."
This is spot on, but the problem is "How will consumers use technology in the future?"  Apple is increasingly positioning itself in the high end, meaning smartphones with ASPs of $400 or more, according to CS.  This will protect profits, but will also cede market share to Samsung, HTC, and other Android manufacturers. It is however a conventional strategic direction.

But, Apple is number one in tablet computing, with a 40% market share, according to CS.  Its tweaking of the prices points for the most popular iPad Mini should expand its market share, when taken together with its its new iOS which promises the same user experience across Apple phones and over iMac notebooks and laptops.  Apple quotes a statistic that says with 39% market share of tablets, 81% of web traffic from all tablet Web traffic comes from iPads.

Spectrum rationing through different price plans will eventually rear its head again.  As we've said before, most tablet users we've seen are taking, uploading and emailing photos, downloading and viewing videos of television, sports and movies, and doing routine web based queries for restaurants and amusements, along with reading email, online publications.  None of this seems to be productivity-related work for an employer's enterprise, the area where Microsoft dominates with its Office franchise.

Microsoft continues to plug away at its phone franchise through Nokia. It's financial impact on the company is and will be de minimus in the near term. Their efforts with Surface and Windows 8.1 has a similar aim to Apple, though.  That is, a Windows 8 user should have a similar user interface experience from desktop, to mobile, to laptop/tablet.  Microsoft is trying hard to converge the laptop and tablet into one. Its price points are probably still off, and Microsoft's relationships with developer communities in mobile are evolving very slowly.

Google, meanwhile, is showing that it can create relatively lower priced products in smartphone and tablets, with the Nexus lines.  These, in our opinion, are controlled experiments rather than an effort to seize significant market share.  Android is too fragmented and fractured an operating system to migrate across the traditional computing platforms. However, Google may be looking at essentially leapfrogging the shorter term moves of Apple and Microsoft.  I can't recall the name of the presenter who said that Android is a perfect system for computing without a traditional user interface; he showed the example of a mirror at home.  The user, using hand gestures, could access broadcasts or find information on something as mundane and ubiquitous as a mirror, so no dedicated, battery draining display.

Apple does have some choices to make to ensure its future growth, remembering that it is an extraordinarily profitable company with an 8% effective tax rate or so. Microsoft has made some decisions for now, but its fate is far from clear, given its institutional and leadership uncertainties.

Consumers, on the other hand, will wake up one day and realize that they have too many devices and are paying too much, even with hidden subsidies, for news and entertainment.  For U.S. companies, the worldwide middle class in developing countries will be effectively closed off to them because of their relentless focus on protecting their developed market franchises.

Technology companies have always been ephemeral, as Mr. Manjoo observes, and it remains to be seen which ones can successfully navigate the consumer technology future.

Monday, October 28, 2013

One American's Personal Encounter With Syria

The Bread of Angels: A Memoir of Love and FaithThe Bread of Angels: A Memoir of Love and Faith by Stephanie Saldana
My rating: 5 of 5 stars

In August of 2012, the Wall Street Journal featured a column by Stephanie Saldana on the kidnapping and execution of Jesuit priest and Abbot Paolo Dall'Oglio by rebel forces. At the end of the poignant column, the credit said that Stephanie Saldana was the author of "The Bread of Angels," and I knew that I had to read it.  It paints an intimate portrait of a young woman of Mexican-American heritage from San Antonio, Texas, who decides to spend a year in Damascus.  It could be described by readers as a travelogue, a story of broken romance, or yet another story of a spiritual quest.  I has elements of all of these.  For me, in light of our possibly deciding to attack Syria, it had a different impact.  It showed how little we know about places with rich histories, like Syria.  Even the author, who had studied Arabic in university and knew about Middle East history, she was unprepared for what she found.

The people in her story are richly drawn, and they all welcome her, and her 'landlord' adopts her as a granddaughter and invites her for coffee two or three times a day.  Syrians too know very little about Americans, and Stephanie certainly opens their eyes too. Understanding among countries will never be advanced by politicians no matter how high minded or well educated.  International amity and cooperation is built on the thousands of little interactions among real people, like Stephanie and her grandfather, called the Baron. This would be a great selection for a book club, and I'm going to offer it to my wife as an idea.  It's a timely, but timeless read.  Highly recommended.

View all my reviews

Sunday, October 27, 2013

Costs of the Greek Exit From the Euro

"Huge, Massive, Crippling." Words like these are bandied about by European politicians when talking about the costs of a Greek exit from the euro.  But, we would like to know, in the words of Monty Python, "How big is it?"

A 2012 study which is still quoted today, comes from a private forecasting group, Prognos AG, commissioned by the Shaping Sustainable Economies Programme of the Bertelsmann Group. The summary is contained in Policy Brief No. 2012/06, "Economic impact of Southern European member states exiting the eurozone."

Unfortunately, it looks like a model of comparative statics underlies the conclusions of this study.  It really doesn't come to any measurable conclusions for the basic question.  Instead, just like the run up to our great bailout of the US financial system, it just cries wolf.

The basic conclusion?  "...Greece defaulting on its sovereign debt and leaving the European Monetary Union would in and of itself have a relatively minor effect on the world economy..."  The reissued Greek currency "would be devalued relative to all other currencies, and the scope of this devaluation remains every bit as uncertain as the extent of a (debt) haircut."  Wow.  This is deep stuff.  Even the remark about being devalued relative to all other currencies seems a bit flippant. What if an exit were accompanied by real economic reforms and a commitment to minimally enforce statutory tax collections?  I would surmise that the the devaluation compared to Italy, Portugal, and Spain, for example, could be less than the devaluation compared to Germany, for example.  So, from this study, we really know nothing new.

The totally speculative conclusion is that a Greek exit, "..could..undermine investor confidence in the Portuguese, Spanish and Italian capital markets and thus provoke not only a sovereign debt default in those states as well, but also a severe worldwide recession."

Look an exit from the euro is something that is not even legally contemplated, and there's no doubt that it would be extremely messy with lots of unforeseen, unintended consequences.  Hedge funds and profiteers of all stripes would make out like bandits.

However, the current house of cards has enormous costs associated with it as well, and any comparison to a Greek exit has to be based on better economic models and netted against the costs of the current inefficient, dysfunctional regime.  The ECB's failure to do its own job by quickly forcing European banks to mark down their holdings of European sovereign debt to some remotely realistic economic value is a disgrace.

A thoughtful Greek exit (and they certainly have lots of smart, internationally known economists) would be aimed at real economic reform, a healthy tax system including collection and enforcement, budgetary and pension reform, and an independent monetary policy for a currency whose initial devaluation would put into place adjustment mechanisms that would eventually allow sustainable growth.  In any case, Greek elected officials would once again be in charge of their affairs.  Can it be done?  Maybe.  Maybe not.

However, the current six year European economic hoax continuing into the indefinite future doesn't serve the interests of the peripheral members of the EU.

Thursday, October 24, 2013

Microsoft Reports Solid First Qtr 2014: Does 'One Microsoft' Make Sense?

Introducing the quarterly results, Microsoft CFO Amy Hood's talking points script must have had the word, "execution" written in large, bold type.  We would hear over and over about how well the company had executed against its goals in the quarter, given the macro headwinds in tech, the move to "One Microsoft," and the higher "cadence" of the company, as demonstrated by the release of Windows 8.1 less than a year after the initial version.

The highlight on execution was probably deliberate, and it was done to differentiate Microsoft's performance from that of HP and IBM, where both CEOs lamented their teams' lack of execution.  The real story in the quarter was the performance of the Commercial segments, formerly referred to as the Enterprise segment.

Following the most recent Analyst Day, we wrote,
"The Enterprise businesses are attractive and Microsoft may ultimately be a stronger competitor than Oracle and other established players on the software and services sides, but that is still an open question.
One of the most interesting slides from Kevin Turner's presentation is one depicting revenue from three large scale corporate customers, pre and post-cloud computing services.  It shows Office 365 and Azure customers, and the year-over-year revenue gains are on the order of 20% or better.  Again, the problem is that the sales efforts and compensation models for these businesses are quite different from the consumer businesses.  Let the Microsoft Enterprise stand alone and do its thing while creating value unencumbered by the legacy of a consumer-unfriendly culture endemic to Microsoft."  
 Total Commercial Licensing and Other Business increased 10% yr/yr, from $10.19 billion to $11.2 billion in the current year's quarter.  Commercial Licensing revenue increased 7% yr/yr to $9.59 billion. The more transactional annuity business increased by 8%, which also helped by allowing more revenue recognition in the current quarter; the company said that contract renewals had also been strong. Other Commercial Licensing Business increased 28% yr/yr to $1.6 billion, as Microsoft's cloud conversions and new business gained traction.  The company said that two-thirds of new Microsoft Dynamics ERP customers chose a cloud configuration for the software deployment.

Overall, this segment's performance was clearly head and shoulders above that of the comparable commercial businesses of HP and IBM.  Given that the company has a new segment financial reporting format, the company provided both a new and old presentation to help during the transition.  In what was formerly called "Servers and Tools," revenue increased by 11% to $5.052 billion, while operating income increased by 17% to $2.026 billion.  SQL Server revenue grew by double digits, while SQL Server Premium revenue grew by more than 30%. So the problems HP and others faced with the erosion of commodity x86 server sales and margins did not hit Microsoft in the quarter.

Under the new presentation, which shows Gross Profit contribution by business segment, I took the Commercial Business gross profit as a percent of Microsoft's consolidated gross profit less the 'corporate' gross profit, and one sees that the commercial businesses accounted for 67% of the gross profit dollars in the quarter compared to 62% of the gross profit dollars in the prior year period.The rest of the corporate gross profit comes from Devices and Consumer Licensing. For me, the commercial business performance was the high water mark for performance in the quarter.

The problems in the personal computer markets did affect Microsoft, but not as badly as would have been expected.  Windows OEM revenues fell 7% yr/yr, but that compares to a 15% yr/yr decline in the fourth quarter of FY13.

Bing;s Search advertising revenues increased 47% yr/yr, and the Bing! search engine had an 18% U.S. market share in the quarter.  Search volumes and revenues per search both increased in the quarter, due to better algorithms and advertising.

The model upgrades for Surface generated $401 million in sales, with the 32 MB Surface RT being the popular model. Inventories are in place for the selling season, but the levels are not as aggressive as with the introduction.

A lot is expected from the Xbox product launches, but I have some doubts about the heavy duty gamers caring that much about a somewhat incremental hardware upgrade.  The gamers care about the games, and Microsoft is not in that business.  The future of Surface, Windows 8.1, Windows Phone, and Xbox are all TBD.  It sounds like the company is trying to improve its own lackluster performance, but it remains to be proven, beyond one Christmas season.

The company returned $3.8 billion in cash to shareholders in the quarter, with a 22% increase in the dividend.  This is certainly nothing to sneeze at.  However, looking at where profits are generated in the consolidated company, it still isn't clear at all that there should be "One Microsoft."

Finally, I would question if there exists one person who could make a believable claim to have the skill sets and the inside credibility to lead this company on a multi-year path to sustained organizational optimization and shareholder value creation.  More on this later.

No United States of Europe

"A European Union running fiscal policy for its member states out of Brussels was never in the cards--that could not have been a noble experiment. " (Out of the Box blog, January 2012)

Today, the Wall Street Journal puts our headline more delicately, "Plans for Political Union in Europe Unravel."  What a surprise!  

The story further notes, "Germany is leading the resistance," which was the inevitable outcome because, as we've long held, the interests of France and Germany diverge fundamentally as they concern the euro, the improbable economic union, and the unimaginable political union.  

We've also written about the need for the EU to increase the competitiveness of all its members, which covers the gamut of issues from barriers to labor mobility, budgets, agricultural subsidies and many other member practices that hamper the effectiveness of the common market.  So, an adviser to Chancellor Merkel put these issues on the table when the WSJ reported,

"He (Herr Meyer-Landrut) proposed that EU leaders attending the meeting agree on a set of indicators, such as rising labor costs, that would signal when a country's economy is veering off course. He also said national governments should sign binding promises on economic overhauls that EU leaders would monitor."

The proposal, which is eminently on point, found no takers, and it generated a French rejoinder about needing to focus on "social cohesion."  The fissure is evident again, as well as the fact that Italy and the periphery have no interest in having their national policies subject to EU monitoring.  

If this is the case for a rather straightforward economic rationalization that would benefit the euro, how on earth could a political union ever be on the table?  It isn't and it won't be under any conceivable circumstances.

Since the EU built the Brussels bureaucracy ahead of the creation of a meaningful currency and economic union, the talks and meetings will continue for the indefinite future.  Otherwise, the bureaucrats would be out of jobs and there would be lots of vacant buildings and apartments in Brussels. 

The euro will continue to limp along as a currency until the next shock again threatens the stability of the failed experiment.  The ECB will raise its head again, and we'll have the same rounds of discussions.  The system really does not serve the economic interests of citizens of the entire European union. 

Wednesday, October 23, 2013

What Is Men's Wearhouse Up To?

I covered the retailing industry when Men's Wearhouse did its IPO. Iconic founder George Zimmer was the commercial pitchman, featuring a deep, raspy voice, lots of sincerity and the tag line, "You'll like the way you look. I guarantee it."  Whenever I went to New York to visit family I would stop by the east side midtown store, and it never failed to have good traffic.  The younger guys usually needed a suit and accessories for big job interviews, the first day on a new job, or for a wedding or a graduation.  As it is for most men, time spent in a store is anathema and we are looking for help.

Men's Wearhouse advertised and delivered a high customer service model alongside promotional pricing and nice average tickets.  The service reputation was rightly played up in their ads, which George Zimmer consistently did for decades. 

So, now Jos. A. Bank. a heavily promotional retailer with bare bones service makes an unsolicited bid for Men's Wearhouse.  It's rejected with the usual patter about unsolicited bid, predatory price, not recognizing the value inherent in the company, distracting the company from the value-adding strategies of the current board, and so on.  Meanwhile, the price is eventually raised and a deal is done.

Now, a tactic from the eighties reappears.  We've always said: "There's nothing new on Wall Street," or put another way, "Wall Street is Green: we always believe in recycling old ideas."  Men's Wearhouse wants to make a deal to presumably pock mark its balance sheet, making it more difficult for Jos. A. Bank to buy the company.  Men's Wearhouse announces that they are in talks to buy Allen-Edmonds, a Port Washington, WI maker of fine, hand crafted men's shoes with a long history.  Prices are premium, and the shoes are made in the U.S., and the company turned itself around under the ownership of PE investors Goldner Hawn. Allen-Edmonds has started making inroads into China's insatiable markets for high end goods, and it has also started a line of specialty accessories and apparel.  

If a man bought a Ralph Lauren Polo suit, Allen-Edmonds shoes wouldn't be out of place.  But, how could the brand be sustained under ownership by Men's Wearhouse?  The price point is totally off, and the core signature styles are probably for an older customer demographic than the one responsible for their growth.  If it were bought at a price satisfactory to Goldner Hawn, the only way to make it work would be to essentially destroy the brand by taking all the production and material sourcing offshore while making the shoes totally machine-made.  Goodbye value.  

I'm a bit surprised that there hasn't been a quote from an Allen-Edmonds spokesperson pooh-poohing a deal.  The home for A-E is with a high end, global marketer of goods with a story.  

Maybe this is just a bit of corporate pique on the part of MW.  Brands can be built slowly and impaired quickly.  Customers who get confused about what their favorite retailer is doing leave quietly and never come back.  I'm scratching my head on this one.

Friday, October 18, 2013

IBM CEO's Email: Lots More in Common With HP

When we compared the quarterly results of HP and IBM exactly one year ago, we noted,
"The reports of both companies show how difficult it is to consistently generate above GDP revenue growth, ex-currency, in this tepid recovery, now almost three years old, from the financial crisis."
In their most recent earnings call, HP CEO Meg Whitman noted the importance of having a team with the right people, in the right place and with the right attitude.  Yesterday, IBM CEO Virginia Rometty announced a reconstitution of the growth markets team at IBM, tasking sales leader Bruno DiLeo  " reassemble the team that used to run the growth markets unit, and he will take over responsibility for running the group. Under Mr. Di Leo, IBM's growth markets unit saw a strong run, often generating double-digit revenue growth. The unit was established under Di Leo in 2008 and he ran it until early 2012." 

In passing, I would say that reconstituting a sales team from a few years ago isn't automatically a winning strategy. Five years ago, they may have been the right players in the right place; some of being in the right place at the right time is just LUCK.  They may have been average players entering the business at the inflection of the down cycle, riding the upswing. If they have the right attitude, it has to be that the wind is now in their faces, but they know that they can prevail. Let's hope the move bears fruit. 

Mr. DiLeo's name was mentioned by the IBM CFO in his responses to a question in this week's earnings conference call.  He previewed the culture of performance remarks today when he noted IBM's substantially reduced quarterly incentive payments.  So, really despite the brave face the CFO put on at the beginning of yesterday's conference call, he had to know that it really was a disappointing quarter, with poor execution.

Going back to the 2015 Road Map slides, we see that from the 2010 baseline, the company projects top line revenue growth of about 5%, made up of 2% growth in the core company, excluding divestitures; about 1% from shifting to smaller, but faster growing businesses; and, 2% revenue growth contribution from acquisitions. Now, two years from the End of the Road, revenue growth looks really problematical.  

Bouncing to HP CEO Meg Whitman's continued reference to "GDP like" growth rates, we see that theme in the IBM Road Map projections.  The IBM core businesses are projected to grow at about 3%, composed of 2% organic and a 1% benefit from mix.  Maybe this is the face of our mature technology companies for a while.  Can it be true?

Looking at the at least $20 non-GAAP EPS in $2015, the revenue growth shortfall over the past six quarters compromises both the revenue contribution, but it has a greater effect on the enterprise productivity and on the margin mix contribution.  The contribution from share repurchases in the most recent quarter was a higher contribution than the assumed average from 2010-2015.  That can reverse, to be sure, but the "execution." a.k.a. revenue growth has to turn around. 

The Road Map assumes, on average, 11% a year in constant currency growth contribution from IBM's "growth markets," which means non-North America and developed Europe.  It won't be easy.

Looking back at the whole market this week, it raises a point that appears at the head of this blog post. Technicians used to say that a healthy market "climbs a wall of worry." This far into our so-called, economic recovery, organic revenue growth has been lacking across the board for seasoned, large public companies, no matter what the sector. 

  • IBM third quarter revenue of $23.7 billion is down 2% in constant currency;
  • Industrial bellwether G.E.'s revenue of $35.7 billion down 1.5%.
  • Goldman Sachs reports revenue of $6.7 billion, down 20% yr/yr;
  • Wells Fargo revenues decline 3.5%, yr/yr;
  • JP Morgan Chase revenues decline 8.1% yr/yr;
There has been some good news as from Google and eBay, but the latter sports a high relative multiple.  The market seems to be trading as a bet on Washington histrionics, but investors' companies seem to be reporting challenging environments across their markets.  European stocks have been touted by lots of money managers and have been bought extensively, despite issues shoved under the rug at the big banks and top line challenges at the larger European non-financial companies.  I don't know what it all means, but it certainly doesn't feel like an environment for hitting new highs, but there it is. 

Thursday, October 17, 2013

IBM's 3rd Quarter Report: Issues Outweigh the Financial Engineering

Reading up on IBM's recent history, I was genuinely surprised to see the lack of significant revenue growth since 2008; I know we've had a tech cycle on top of a recession,but still this is Big Blue.  This company likes financial engineering, befitting a company founded by engineers.  According to Forbes, Warren Buffett owns about 6% of IBM, comprising about 19% of the Berkshire equity portfolio.

Mr. Buffett likes company management, its levered return on equity, and the large return of cash to shareholders through buybacks and dividends. The relatively flattish share price alongside the continuing buybacks allows Berkshire to wind up owning a proportionately larger share of the company over time. In many ways, this is the dream profile for the ultimate value investor.

Going into the call, it struck me that HP, Microsoft, IBM and Cisco, despite the varied regard in which the companies and management are held by investors,  all share the same problems.  They have all built very large, profitable businesses selling hardware, associated middleware, application software, consulting and enterprise management services to large corporate customers.  Now, everyone agrees that what buyers purchase and how they pay for it, will be rapidly changing.  So, the common challenge is to turn these aircraft carriers around on the high seas.  As their legacy businesses decline, they have to manage a transition to an environment that won't require or favor aircraft carrier organizations in the future.  They're all in the same boat, which I guess I didn't realize.

The third quarter 2013 conference call was led by a very fast talking, matter-of-fact CFO who dutifully read the results, which he characterized as representing solid accomplishments.  There were some, but overall this quarterly report, taken in the context of no revenue growth from 2008-2012, should have been a major disappointment to management.  The financial engineering that permeated the GAAP results, on top of of significant non-GAAP adjustments, made for a very low "quality of earnings."

Consolidated revenues of $23.7 billion in the third quarter, declined 2 percent yr/yr on a constant currency ("c.c.") basis.  59% of revenues came from Global Technology Services ($9.5 bn) and Global Business Services ($4.6 bn).  These businesses were the bright spots in the quarter, which we'll see later.  The Systems and Technology group revenues of $3.2 bn declined 16 percent yr/yr, in c.c. More on this later too.

GAAP gross profit was $11, 380 million, but with $102 million in adjustments for acquisitions and $154 million in adjustments for pension plan investment assumptions, transition expenses, and plan terminations, non-GAAP adjusted operating gross profit was $11, 636 million, or a very healthy gross margin rate of 49.1 percent. The rate increased one hundred basis points, yr/yr, due to margin expansion in the services businesses (against easy comparisons) and to a better mix of software sales, due a 2 percent c.c. increase in software and to the double digit decline in hardware sales.

GAAP total operating expenses were $6,567 million in the quarter, but after adjusting for acquisitions and pension expenses, they were reduced to $6,352 million, on a non-GAAP basis.  GAAP pre-tax income of $4,812 million, after acquisition adjustments of $214 million and pension expense adjustments of $257 million, translated to $5,284 million of non-GAAP, pre-tax income.

The GAAP tax rate for the quarter was a financially engineered 16 percent, down 860 basis points over the prior year quarter.  Wow!

Diluted EPS for the third quarter of 2013 were $3.68, on a GAAP basis, compared to $3.33 in the prior-year quarter, on the same basis, an increase of 10.5 percent.  This was characterized as a solid performance, but it was really financial engineering.

The company's supplementary slides had a good reconciliation bridge from last year's third quarter diluted EPS to the 2013 year level: $3.33  was reduced by ($0.14) due to the lack of revenue growth, while margin expansion in the services businesses contributed $0.33 per share yr/yr.  The effect of share repurchases in the quarter added $0.16 per share on a yr/yr basis.  All this yields the current year's $3.68 per share. Note that the tax rate effect wasn't explicitly called out.

54 percent of the yr/yr improvement came from the margin expansion and 5% sales expansion in Global Business Services, while 46% of the yr/yr improvement came from the effect of share repurchases.  One could characterize this as a 'balanced scorecard' between operations and financial balance sheet management, but given the history of recent years and quarters, I don't think this is justified.

Anticipating the forthcoming questions about execution, the CFO mentioned the culture of performance and accountability in IBM; he noted that quarterly incentive payments declined by $177 million (if I heard this right) year-over-year to affirm the comment.  Of course, it's not clear what this means: quarterly bonuses or reduced sales force commissions which would automatically follow from lower sales, or both.  He didn't put the comment out clearly or with much conviction.

Regionally, sales in the Americas were $10.3 billion, flat on a c.c. yr/yr.  So, Big Blue or no, the IT spending cycle is stuck in neutral for all the players.  EMEA sales of $7.3 billion were down 2 percent in c.c.  Asia-Pacific sales of $5.5 billion declined 4 percent on a c.c. basis.  Together these regions account for 97% of consolidated revenue.  The BRICs amount for the remaining 3 percent. so for all the commercials about a globally smarter planet, virtually all of IBM's sales really occur in traditional markets, not a bad thing but different from the commercials.

The good questions from analysts centered on the same issues that we noted at the beginning of this post. If I can paraphrase Toni Sacconaghi of Sanford Bernstein, he said something like the following. " I want to step back a bit from the current quarter. IBM has reported negative revenue growth for the past six or seven quarters.  Without the tax rate benefit in the current quarter, this quarter would have been considered a 'miss.' What has changed at IBM, and should we think about IBM in a different way going forward?  Is this a company that reports no growth on the topline and reports less than double digit earnings growth on the bottom line?"  Questions from Goldman Sachs, Stiefel Nicholas, and Barclays were basically around the same point, namely "What does the company model look like in the future? "

For the much heralded "Road Map," the question was how to get from here, about $16 in EPS to $20 in two years.

The CFO's responses, sad to say, generally evaded the core question.  I think that he himself was thinking aloud through the questions, which is amazing, since they are the critical issues that he must have briefed about beforehand.

There was a reflection about IBM's China business that was said to be about 5 percent of IBM's revenue, which is a bit inconsistent with the geographic presentation of sales, but it could be rounding. Of this, forty percent was in hardware which declined precipitously due to the country's slowing of outside procurement as it develops a new five year plan, slated for completion in November 2013.  The CFO opined that once the new plan was published, business should return to normal in the first quarter of 2014.  Talk about rose colored glasses!  Chinese global enterprises like Lenovo, Huawei and others are integral parts of the economic plan since, in some cases the government itself is a large stakeholder.  Their designs, like IBM's are global, and to think that a US company will be able to continue with business as usual under a different Chinese economic worldview may be ill conceived.

An analyst noted that achieving the Road Map's $20 EPS would require 12 percent yr/yr earnings growth in 2014 and 2015.  What is required for this kind of acceleration?  The CFO said that Systems and Technology would have to stabilize its level of profitability compared to 2013.  To achieve this minimalist goal, he said, that the STG would have to successfully introduce new products that are planned for launch. Services should minimally require low single digit growth, although it wasn't clear what these businesses would look like ex-planned divestitures. The cloud businesses, just like HP, will have to grow at double digit rates, but not all of this will be incremental, but it should be more profitable. If I were building a model with what little I know, I would have to do a lot of hand waving to get my desired end product of $20 in earnings.

Somewhere in the end of the question period, the CFO's position changed and he said that the quarter had been challenging or disappointing, I don't recall his exact language.  Finally, this was an honest reaction. Judging from the stock trading down six percent right after the call, others agreed.

With a consolidated debt/capitalization of 64 percent, and a non-financial debt/capitalization of 39%, IBM has a strong balance sheet.  It did not make an egregiously bad large acquisition like HP did with Autonomy. It should be able to plug in several smaller, tuck-in acquisitions to help its cloud efforts.  The four horsemen will be trampling each other in the field to overpay for innovative, niche companies.  Given their lackluster revenue growth and their changing markets, they probably have little choice.

The question of "execution" is referred to often in HP CEO Meg Whitman's remarks.  Clearly, this has been a sore point too for IBM, but their stock of goodwill with the Street has insulated them from more strident choruses.  Their multiple, highly compensated sales forces and distribution channels probably need to be rationalized too over time.  Unfortunately for shareholder most of this will be under the covers.  If the customer is changing, and their budgets and desired ways of using technology are changing, then it follows that corporate go-to-market organizations will have to change with them.

Tuesday, October 15, 2013

Feds Continue To Pick the Pockets of JPM Shareholders

Going back to JP Morgan's own internal report on the "London Whale," everything is there for an interested party to see. The need to fix the way JPM goes about its businesses was lost in a referendum on CEO Jamie Dimon keeping his Chairman of the Board position. Now as the Feds grab another $11 billion from the shareholders, it is once again open season on a celebrity bank CEO.  This is ridiculous and more befitting a reality television show than talking about the management of one of our largest banks.

Let's try to put some things in context.
Over the past five years, eyeballing raw charts from Schwab, JP Morgan's stock is up about 30%, which looks slightly better than Wells Fargo's rise of about 23%.  The big losers are Bank of America (-40%) and Citigroup (-70%).  Here's what Andew Ross Sorkin wrote in the print edition of the New York Times,
"When I called Dennis Kelleher, president of Better Markets, a nonprofit Wall Street watchdog (he was playing golf when I reached him), he put it this way: "By any objective measure, Jamie Dimon should be fired. The compliance failures are egregious and systemic."   
What objective measures are those?  Everyone of the big four banks are digging out from under the mortgage mess, and if WFC is now considered a darling of the sector, JPM's performance has been on a par or better.  This is a ridiculous suggestion, and shareholders see it differently.
However, the age old question about having a global investment bank together with a global commercial bank and a global asset manager is an appropriate question to ask.  Not necessarily because of "systemic risk," since nobody can really define what this means, but because the cultures of these businesses are distinctly different and they are operationally impossible to manage effectively together.  [on the issue of not being able to define systemic risk, see NBER  working paper 185 (2012) from Nobel Laureate economist Lars Peter Hansen].   The London Whale report makes it clear that layers of executives and multiple complex regulatory schemes cannot inoculate shareholders from outsize trading losses.  It's happened in the past, from the beginning of mortgage backed asset trading, and it will happen again in some market.

What's to be done?  Split up commercial banking and investment banking, at a minimum.  However, the Volcker Rule is eons from implementation, so this is tilting at windmills.  It is interesting to note that Warren Buffett likes commercial banking and asset management, and he owns both these businesses through his investment in Wells Fargo.  He also likes global investment banking because of his investment in Goldman Sachs.  He could have bought a financial supermarket through Citigroup, Bank of America, or JP Morgan Chase, but he didn't.  Instead, he bought what he regarded as best in breed for each business in the public market.  JP Morgan's board should think about this, after all there's always something to be learned from Mr. Buffett's investment behavior.

For JP Morgan shareholders, they should think about a few things:

  • Strengthening the board and making it more than a rubber stamp.  Bring some people in to help in the real areas of weakness, like risk management. Comments about the board's failure to monitor their own systems of internal control and to align compensations structures with governance are right on the money.  What's in place for a company of this size and complexity has been shown to be woefully inadequate. 
  • Think about the continuing legal settlements and the implications for future liability.  $11 billion for acquired mortgages in a shotgun acquisition at the behest of the Feds themselves?  How could the board have signed off on this?   Bank of America CEO Brian Moynihan seems to have a better handle on managing this issue than does JP Morgan; have a board member give him a call and compare notes. 
  • Look at the whole mortgage business itself.  The originate-to-distribute model and the structure of MBS deals needs to be reset.  Wells Fargo seems to be tuning down its mortgage engine.  The servicers effectively hung their clients out to dry and have escaped unfazed.  Does the board understand how this business operates?  
  • Assign a team from the CFO's office to help the board manage the legal bills.  An $8 billion quarterly bill?  I used a blended bill rate of $1,000 an hour, assumed minimal sleep for all, and the number of people involved in a quarter is nonsensical.  Next time, admit nothing, put up no resistance, and offer to pay $8 billion on the spot; you're $3 billion to the better and the Feds are better off, since their costs are largely fixed. 
  • Pick a lead director to interact with the CEO on a weekly basis.  This is to make sure that he has someone to talk to besides his self-interested lieutenants, who clearly let him down during the trading crisis.
  • Think about a different corporate structure, portfolio and business model for JPM.  Value is being destroyed on a large scale with the current model. 

Friday, October 11, 2013

HP Analyst Day 2013: Sober Optimism

HP's 2013 Analyst Day 2013 disappointed the worst skeptics, including those who boldly called for the stock to move to the mid-teens. Hopefully, that analyst's research director is asking some tough questions about the analyst methodology and model.  It was a solid presentation that raised as many questions as it answered. The management team's presentations were well drilled, and everyone hewed to the CEO's key themes.

First, the CEO quoted a statistic about the amount of information that mankind created since the primordial ooze until 2000, which I frankly don't remember; today, that amount of raw data is produced in one year. This theme was echoed by other executives, including by George Khadifa who heads HP's Software businesses. The context here would be that corporations need to store, protect, analyze and extract value from data mountains that are running on IT infrastructures patched together from the sixties through the eighties.

Within this lies the second theme, namely that IT is being reinvented in its mission, strategic importance, and in the way customers use it, pay for it, and in the way they select partners.  Again, the "new IT" theme was consistently echoed by all the executive presenters.  This all seems eminently plausible.

Meg Whitman's Presentation

In this five year turnaround, the first year was spent diagnosing the patient and building the foundation for the turnaround. After that, her focus was on fixing and rebuilding the company, especially the executive team. She characterized a good team as having the "right people in the right places with the right attitudes."  That's an interesting triad, but it doesn't mention the right incentives, which are especially important in a large, sprawling organization like HP.  The good news is that the CEO said that the current group of executives are a team, for the first time, and it is made up of the right players.  That is no mean accomplishment and would seem to bode well for the future.

Meg Whitman said that FCF of $7 billion through nine months of FY13 and net debt reduction of $8 billion both exceeded the guidance ranges provided at the Analyst Day one year ago.  The management team had done all they could to achieve the corporate financial goals, and to exceed some; she was happy with the performance, but she was now looking forward into the back half of the turnaround.

The CEO repeatedly talked about sales forces and their interactions with their customers.  She has formed her opinions from, among other things, personally meeting with 1,000 major customers of HP,  Overall the sales teams lacked focus, metrics, and the technology infrastructure to sell effectively to their corporate customers and partners.  Increasing the quality of HP's interactions with its customers was overall the number one goal for everyone in the corporate leadership down through the next level of executive client-facing management.

She told a story about being with a top tier corporate IT buyer who said that she told her HP leader about some IT problems for which she was seeking a solution.  The HP account leader said that she would go back to corporate and get some ideas.  Before HP responded, the customer told the CEO that she had already received emails from two competitors asking to set up meetings with their senior technical people to talk about solutions.  It was a small story, but it seemed to speak volumes about the inertia and bureaucracy within HP.

Execution, particularly in sales, both growing within accounts, and quickening new product introductions will be critical to fulfilling the shareholder value part of the turnaround.

The other big, recurring theme echoed by all the executives was that HP's future was going to built around four areas: Cloud, Security, Big Data, and Mobility.  She felt that by offering devices, infrastructure, software and services HP was one of the very few players that could provide the new IT buyer with the whole spectrum of products, tools and services to help their businesses.

The CEO reviewed the major businesses. Enterprise Services, a $17.5 billion business (based on nine months, YTD), accounts for 21% of the YTD revenues but only 5% of the non-GAAP operating income. Whitman cited the inconsistent leadership, strategy, lack of EDS integration, and inadequate internal systems as the biggest reasons for its historically poor performance.  This business needs some portfolio pruning, in my opinion, but the CEO said that there would be no major restructurings in fiscal 2014.  The segment's non-GAAP operating margin was said to be at the high end of the outlook given at last year's meeting, but that doesn't change the fact that this is an albatross that needs to take flight.  It clearly has the CEO's attention.

Whitman cited a pretty extensive list of new leadership within Enterprise Services, including executive promoted from within and new hires from Bain, Accenture, Microsoft, and Elastic Intelligence/BMC.  The leadership group has pretty easy comps to have a strong 2014, let's hope that they get there.

Turning to the Enterprise Group, the CEO noted this is the group that this groups focus is to exploit the industry trend and customer need to build and support a converged infrastructure driven by servers which are increasing dramatically in power, with smaller profiles and lower power consumption.  The Enterprise Group comes to the customer with products like the Moonshot server line, 3PAR storage solutions, networking, security, and data center management tools. Instead of selling a grab bag of discrete products, HP has reset their offerings into a platform called HAVEn for analytics.  The two different capabilities are provided by Vertica for structured data and by Autonomy for unstructured data.  For the nine months of the current fiscal year, Enterprise Group revenues are about $20 billion, with non-GAAP operating income of $2.8 billion.  Enterprise Services, at some point after the ship is righted and the portfolio pruned, should probably be integrated into the Enterprise Group.

Talking about the competitive landscape, Whitman noted the growing population of single technology startups, along with the well known established players.  Partners like Microsoft and Intel are now competitors both on devices, servers and services.  Although she "likes" the assets at HP, she again mentioned the word "execution," which she said will determine HP's degree of success in monetizing those assets. She again reiterated the point that revenue opportunities were being missed at existing large accounts and with partners.  Some of the customer feedback she received is that HP isn't attentive to the customer's thinking and slow to respond.

The response has been to arm the sales organizations with better tools, including Salesforce and Workday. Company-wide, everyone has a Top 40 pairing of opportunities by country, a Top 30 desired innovations for 2014, and a Top 15 growth markets in IT.  All prospecting and market development work, whatever the business segment, will work of the same playbook, and these are expected to have the most financial impact on the CFOs goals.

George Khadifa's presentation on Software was a lot more sober and a little less energetic than the one he did upon joining last year.  It is about a $4 billion on an annual basis this fiscal year. IT operations management is about 39% of the Software segment, applications delivery management about 22%, Autonomy about 23%, Security about 15%, while Vertica is about 1%. 51% of their business is built around software that supports and maintains IT infrastructure: it is recurring revenue. He characterized HP as a large SaaS player, noting that their business is larger than those of Workday and Splunk.

It sounds as if he is quite excited by Vertica, but it is tiny.  It seems that Khadifa has his arms around Autonomy, in terms of getting them to focus their sales and product development efforts around fitting into the HAVEn platform instead of selling the next personal innovation of an engineer.  Khadifa talked more like a corporate insider this time, and he seemed a bit weary from all the infighting and pruning he probably has to do to get this business as a real growth engine, given its relatively small size.  I assume that Khadifa continues to report to the CEO as was announced at last year's Analyst Day.

I continue to believe that Meg Whitman needs more support around her if she isn't going to burn out on this turnaround.  With the repeated reference to execution and the mediocre performance of sales teams, that's too much micro work to land on the CEO's desk, especially if she continues to interact with customers, partners, investors and the board.  A stronger board could provide some counsel and support here, notwithstanding the two new members who are good for the long-term direction.

Overall, she describes HP as growing at GDP rates.  Assuming little inflation, that could be 2-3%.  Lest you think that's pessimistic, she also made repeated references to a balancing act of managing declining or stagnant business lines while feeding and investing in in the future growth drivers.  That is very difficult for the managers of these empires to carry out, unless they think like a CFO or CEO.  So again, if this lands on the CEO's desk, this balancing act of portfolio unwinding and growing is not easy at this scale, espcecially with the business segments being more inter-connected than discrete.  

The research and development budget will be about $3 billion next year.  There will be lots of back office upgrading of systems to manage the diverse portfolio, and these kinds of expenditures were cut off during the Hurd tenure.

Getting back to the GDP-like growth concept for the HP top line, the CEO said that this should be consistent with a 7-9% operating margin and an ROIC of 15-25%.  With limited information and not a lot of effort, it's hard to see how one gets there with the current portfolio.

According to the slides from the CFO's presentation, Printing and the Enterprise Group together comprised  45% of the YTD revenue of $83.2 billion, and 77% of the non-GAAP operating profits.  Enterprise Services and Personal Systems together, account for 49% of revenue and a paltry 14% of operating profit. Software is very profitable but only about 3% of revenue.

The CFO noted that the reduction in force announced over a year ago was stated as being from 29,000 employees plus or minus 15%; the final RIF will be at the upper end of the range.  To date, 22,000 employees have left the company, worldwide.  2014 earnings will get an incremental $1.1 billion of benefit compared to fiscal 2013.

FCF for 2014 is projected at $6-6.5 billion, down from the nine-month pace of the current fiscal year.Earnings per share were projected in the $3.55-$3.75 range.

So the the stock appears to be selling at 6-7x its forward, adjusted EPS level, which is certainly distressed.  The company could just continue to do what it said, and it could show significant gains from multiple expansion alone.  A distressed P/E for tech companies at similar turning points would have been 10-11x.

The consensus which seems to have been a great guide for contrary action on this stock, is Neutral or Hold. I do wonder about the continuing focus on returning 50% or better of the FCF to shareholders through dividends and buy backs. Now that it's clear HP is not a distressed investment, why continue to act as if it's in liquidation?  If there are investments to be made in 64% of the revenue that can be fed by businesses that generate 36% of the operating profit and are stagnant, why not invest what's needed to get out of the gate faster?  Make the shareholder cash return a true residual.  Invest in your growth, unless you really don't have clear projects or you don't believe in them.  It may be splitting hairs, but I think not.

Whether one believes it or not, it is easier to understand what this company is doing and where it's trying to go than it is for that giant ball of yarn in Redmond.  Congrats to HP for trying to be transparent without being blustery or self-congratulatory, like people in blue shirts at Microsoft.

Thursday, October 10, 2013

The IMF Pulls the Rug from Under the Greek Government

I thought that it would take longer than a day after yesterday's post for the IMF to show its fecklessness as a global economic institution, but here it is from the Wall Street Journal

The Greek government, based on a projection from those clueless prognosticators at the IMF, will only hit a 2014 primary budget surplus of 1.1% of GDP compared to the 1.5% contained in the terms of the first bailout.  40 basis points projected difference and the Greek government and people will be thrown to the wolves and not receive a next round of funds from the troika, which in turn will freeze any other creditors from acting also.  Meanwhile "negotiations" with the troika over how to solve this problem will begin in the next few weeks.  

The Greek government has done more than any the French or U.S. governments have ever done: the Greeks have actually cut wages and spending and decreased the primary deficit in the here and now, not at some future time.  Addressing the collapse in tax revenue collections and longer term issues of economic and administrative reform haven't gone as well as could be hoped, but surely none of the core EU countries can point to the Greeks and say, "Let's show you how we slashed our central government budget and reformed our economies in two years."  

The Greeks are being very circumspect in their statements, but their frustration is very clear in the short quotes reported in the Journal. 

“The Greek government does not comment on reports from international organizations like the International Monetary Fund,” it said, adding that it refrained from commenting “even when this organization (the IMF) accepted [it made] wrong assumptions and wrong estimates in the drafting of the first Economic Policy Program for our country.”  Let's remember that the Managing Director of the IMF admitted they "had no clue" that economic fundamentals in Greece would deteriorate so quickly after the first bailout.

Yet, the Greek government committed itself to the austerity program and suggests that it might consider more measures, even with likelihood that the IMF's 2014 forecasts for the EU will prove to be too optimistic.  

What this set of announcements does is to raise the specter of another Franco-German confrontation about solutions to the Greek debt crisis, casting the Germans again as the bad actors for not agreeing to have their taxpayers contribute to the "solution." Here we go again. 

Wednesday, October 9, 2013

Revisiting the Euro and the Grexit

Less than a year ago, we expressed our doubts about the scenarios for Greek austerity.   We said, "It's hard to see a scenario continuing where the Greek government keeps wearing sackcloth and ashes, begging for more relief.  They can never achieve the 4.5% GDP target even in 2016.  What is the point of this two year long multinational charade?"

Now we know that the Directors at the International Monetary Fund, when they implemented the Greek bailout in May 2010 knew that it was a charade, based on minutes of meetings viewed by the New York Times.  According to the Times, one-third of the forty voting Directors worried about the "immense risks" of the bailout, and the consensus was that it would not be feasible without demanding concessions from the creditors.  This demand was never put on the table.  Why?

French banks, like BNP and SocGen, and German banks like DB and Commerzbank were among the largest private creditors to Greece and didn't want to take the balance sheet hits at a time when capital adequacy and the need for bigger equity cushions might be demanded of the banks.

So, Dominique Strauss-Kahn opined, according to the Times, that there was "no doubt" that the Greek bailout would succeed.  He was not available for comment. Christine Lagarde, the IMF's Managing Director since 2011, had her eyes on that prize and needed to have a public success, even if was doomed to fail. When asked about the failure today she notes, "We had no clue that the overall economic situation was going to deteriorate as fast as it did."  It's nice to admit that you were clueless, but it's also hard to believe.

The Greek GDP has contracted by 20% since 2007, according to the Economist.  The austerity programs took the primary budget deficit (w/o interest payments) from 10.5% of GDP in 2009 to 1% of GDP in 2012. The revival of the economy can't come from the consumer sector, as the Greek unemployment rate of 27.2% is the highest in Europe.  Exports can't make up the difference, nor can increased direct private investment because of an antiquated Greek legal system that doesn't offer adequate protections.  The Greek bureaucratic logjams in the ports has been relieved, but it's still not on a par with those of the core countries.

As reported in the Wall Street Journal, Citigroup's economic forecasts for Greece are disheartening, and on another planet from those of the IMF, the ECB and the EC.  Citigroup sees the Greek GDP contracting by 11.8% in 2014.  They may be directionally correct, but let's hope that they are being too pessimistic.  There will be political blood in the streets under this scenario.

What are some of the reality bytes from all this?

  • The European monetary system still has fundamental design and execution flaws that make it unstable in most environments;
  • It offers peripheral members few real benefits except access to easy credit; 
  • Unless the peripheral countries undertake real economic reforms, the austerity medicine may make the patient better, if it hasn't killed him first;
  • French, European and Italian banks need to take their medicine and acknowledge the diminished economic values of sovereign debt on their balance sheets;
  • The continuing struggle for EU power between France and Germany is very analogous to the struggle between our two sides in Congress.  Despite all the nice rhetoric and the ECB posturing, their divergent interests still limit the effectiveness of the monetary union. 

Tuesday, October 8, 2013

Checking In With Tech's Four Horsemen: HP

Let's recap in broad strokes how we got were we are.  Meg Whitman takes over as CEO, gets a brief honeymoon.  She eventually produces not only a clear, new strategic plan and resets expectations for a multiyear horizon.  From the fourth quarter of 2012 until recently, the stock goes on a tear from $12ish to $27ish, before pulling back testing the $20 support level.

The initial guidance strategy, depending on your viewpoint, was to take investor expectations to the sub-basement.  Another way of looking at it would be to say that management told it "like it was."  A multi-year turnaround.  Lots of industry and macro headwinds.  Lack of innovation and commitment to deliver new products.  Sales organization problems.  Executives in the wrong spots on the roster.  And so on, and so on.

The promised staff reductions came quickly, and the ramp up of this program caught some skeptical analysts by surprise.  Along with some one-time factors, good tax planning, and cash flow management, debt was paid down faster than expected and the share repurchases continued.  What was not to like about this?

We believe that the dysfunctional culture within HP and the organizational discouragement precipitated by the reigns of the imperial and imperious Mark Hurd and the clueless Leo Apotheker have gained traction and buy-in within the rank-and-file.  The new board members, given their stature and experience would certainly not have come on ship if they didn't fully vet the longevity and outcome of the turnaround.

So, here we are, but where is that?  The consensus view of analysts for the Analyst Day outlook revisions are that the company, which has already cautioned about no 2014 revenue growth, will revise this outlook down sharply, for both the revenue and earnings lines.  In other words, "No Expectations."

Targets have been lowered, and some analysts have projected a price decline to the mid-teens, post the revised outlook.

In the meantime, the company seems to have introduced both Windows and Android tablet lines aimed at the corporate accounts.  So, their stated intention of being the best, platform-agnostic supplier of hardware, software and services to global corporate accounts seems well underway.  That's pretty encouraging.

As we've said before, there is still some significant portfolio optimization to be done, e.g. on corporate technology services.  Lowering expectations would give good cover to announce this now, but I'm not sure that it's on the radar at the moment.  Not a big deal.

Given that Dell has shot itself in the thigh with its acrimonious deal that couldn't have given its customers or employees much comfort, HP's visibility with corporate accounts should continue to increase.  That's good.

So, we definitely go into Analyst Day, with "No Expectations," which is okay, and we return to the Stones for a closing serenade,

Bill May Return to Microsoft, or Not.

With all the hot news stories--like the budget deal and the Middle East--cooling into sludge, it's the moment for the New York Times to opine about the "widespread fascination" about the future role of Microsoft Chairman Bill Gates.  The story tries desperately to titillate the reader about Mr. Gates' increased presence at product introduction meetings.

On the other end of the spectrum, I have to applaud two institutional shareholders who, according to the New York Times, approached the company to have it consider having Mr. Gates relinquish his Chairman's position because it would inhibit a new CEO from adopting radical changes from the existing strategies that have cemented the company's role as a tech follower, and a mediocre one at that.

I don't believe that either of the above two events will come to pass.  Mr. Gates is having too much fun with his philanthropic projects in education and global health to return to the drudgery of extracting this company from the mud and getting its culture jump-started again.  As a co-founder and large owner, he wouldn't countenance losing face by relinquishing the Chairman's role without some future bridge-building to a CEO whom he respects and who has produced some results.  Too early for this.

The CEO of Ford makes the current short list of successors to Steve Ballmer.  Sell the stock on the announcement of Mulally's appointment as Microsoft CEO.  Watch the exodus begin on the servers and tools sides of the business.  Damage control all around, because it makes no sense.  Nothing else looks new, except that people like former Motorola Mobility CEO Sanjay Jha don't appear on today's list.

On the Microsoft Surface side, it's interesting to hear some different views about the Surface RT.  About a year ago, writing about the launch, we made a couple of key points:

  1. "The question now becomes, can they act like a consumer products company and tell their story to the customer?
  2. "The cost of making every buyer happy is a better investment that buying back shares.  That cost is just another form of advertising and brand rehabilitation."  Can they commit to making buyers happy?
Unfortunately, the answer to both these questions has been "No."  We know that the company took a write-down, forget that.  Some British IT users call Microsoft's marketing of the Surface RT "absolutely shocking," which in American English would translate into a profane phrase.  Why?

We've written before that most people still use their iPads as photo albums, video cameras, and places to find maps or restaurant reviews.  They are not productivity tools, and far from it.  The British buyers don't care about the shortage of "rubbish apps that you download and never use again."  Rather, they do like being able to use Office for document work and to connect easily to printers.  This indeed is productivity.  So Microsoft produced something better, but they didn't communicate to users what they had produced and why it was better.  

Now, they're going to cut prices and release Windows 8.1. Okay, but what about those people who took the risk first and got hosed?  Bill Gates should send everyone of them a computerized, hand written note saying, "You took a bet on us, and we let you down.  We've learned and I promise you that it won't be at your expense.  Come to a Microsoft Store, let us swap you out to a new machine, transfer your data to Sky Drive, and we'll give you a coupon for the price difference that you can use at the app store. Bill"  Let the accountants get busy. No one will care, except for consumers who would be shocked by a show of customer care, strength and confidence. It won't happen, but it should. 

Monday, October 7, 2013

Warren Buffett Follows Up With Michael Dell

Dear Michael,
I wanted to follow up on my last letter about your cramming down the SilverDell deal on your shareholders.
Listen, I know that you're very busy, and now that you're in bed with the private equity types you will truly see what "hell on earth" really means.  You'll long for the days with your fawning analysts and compliant public shareholders. Good luck with that project.

I wanted to follow up on the Goldman deal that I made, as I'm sure that you don't keep up with our picayune business.  To reiterate, I threw Goldman an expensive life line during the crisis, and this was to people who really understand what "expensive" means.  If I've learned one thing, it's that markets retrace from overshooting both ways.  You just have to be there with dry powder, make your deal and be patient.

Anyway, not to lecture.  Berkshire invested its $5 billion into the preferred shares and picked up $1.5 billion in dividends before Goldman redeemed the paper, paying us an additional $500 million.  Since the stock was about $160, well above the warrant strike price of $115, they came to Berkshire to offer us a deal for fewer shares without splashing out the cash.  The accounting treatment will be sweet, and the tax treatment even better, not to mention all the cash that's already rolled in.

Berkshire now owns 3% of the premier global investment bank, and I know that if they ever get their shorts in a knot again, the Feds will bail us all out again.  For all my railing about executive pay and CEOs paying more taxes, Lloyd Blankfein ,who like you knows how to pay himself well, works for me!  How sweet this capitalism is.  My shareholders love Charlie and I, while Llloyd's love him, and it's a love fest with Wall Street.

Which gets me back to Dell. Are your assets, namely your people, walking out the door as all the bureaucratic machines grind through getting your deal approved?  Was this mess really the best thing for your company? If you ever come back to the market to sell a public deal, wait three to five years so they won't remember who you are.  Wall Street is fickle and forgetful.

Unfortunately, I don't see Berkshire being interested in anything you're doing.  It's a pity.  But, you see I a make 8,000 meter mountains of money investing in things like banks, railroads, insurance, machine tool makers, candy and ketchup makers.  It's not as highfalutin as your tech world, but more profitable and more fun!

I'll look for you in the pages of Barron's, Michael.

My best,

Warren Buffett

Checking In With Tech's Four Horsemen: Microsoft

As the whole CEO succession debacle continues to unfold at Microsoft, I continue to be amazed at their inability to deal with longstanding, loyal, zero resource demanding customers like myself in a way that makes me feel good about our relationship.

I somehow got signed on for a trial subscription to Office 365.  I want to cancel and to find out how this subscription was initiated.  Emails, after a lengthy delay, generated a support incident link; clicking on the link in my Chrome browser generated nothing by a little X in the center of the white screen.  Lots of attempts to figure out how to change Chrome's settings to display the Microsoft page failed.  "Aha," I said to myself, "of course, the geniuses at Redmond want to thumb their noses at Google and at me to make me use Explorer as my browser."

Reluctantly, I open the resource hogging, hacker inviting, slow as molasses IE, and it too cannot display the message from Microsoft support!  More emails to Microsoft, using the address header eventually send instructions about going to "Internet Options," and authorizing Microsoft support twice as a trusted site, one on the support site, and a separate authorization for the secured support page.  Ridiculous, right?  This is their own browser and their own communication!  After doing this a few time, Explorer still can't display whatever it is Microsoft is trying to tell me.

A couple of times, the site displays, flashes suddenly and then displays an error about frames not being able to be displayed.  All of this because I want to cancel a subscription that I didn't intentionally order, if I ordered it at all.  The last thing in the world I want to be doing is to be figuring out browser settings on my time.

After no communication to resolve my issue.  I actually got a customer satisfaction survey about their support, without ever having resolved anything.  It is the first time in my life I ever filled out a survey with every answer being the most unsatisfactory level possible.  "How would you like to hear from us?"  Smoke signals would suffice.  A post card?  Weeks have gone by and nothing from the company that Steve Ballmer has led into the brave new world of technology.

It is going to be a great supplier of technology hardware, software and entertainment to the masses.  I don't think so because they have no idea what this involves.