Friday, November 22, 2013

Bubbles Morph Over Cycles: Web 2.0 Becomes Social Media

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

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

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

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

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

Best Buy Can Have A Dominant Role in Electronics

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

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

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

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

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

Wednesday, November 20, 2013

Best Buy's Encouraging Third Quarter

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

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

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

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

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

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

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

In our post of November 16, 2012, we wrote,
"They are shown to have one of the largest customer loyalty data bases in the industry, but it isn't an effective program, especially for inducing activity among inactive customers.  Office Depot, for example, has a better program that requires no customer effort to update and use. This can be easily fixed. 
Best Buy's website looked like something from the 1970s, and the navigation and functionality were primitive.  It looks a lot better since Mr. Joly has come on board, and it can do much, much better.  Despite this, the company drew 1 billion online visitors and generated $2.3 billion in sales from the online channel. 
For all the talk about "low hanging" fruit, some of the fruit, like the operations at Best Buy Canada, is lying on the ground. The cultural and organizational issues, which are much more subtle, can yield a lot, but they will take time."
We've talked about Best Buy's having lost touch with their customers over the years.  Much of what we found the most encouraging about the CEO's introductory remarks didn't have a lot of numbers attached, but it was clear why he was talking explicitly about these issues.  The company now sees customers interacting with the company in very personalized ways.  For example, like most customers, we do extensive price and product research online before visiting a Best Buy or before visiting Best Buy online. The customer might order online, come into the store to purchase, or purchase online but come into the store for merchandise pickup.  These might be different customers shopping in different ways, or it might be the same customer shopping in different ways for specific types of merchandise.

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

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

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

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

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

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

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

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

Monday, November 18, 2013

Increased Regulation: The Biggest Risk for Middle Market Companies

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Saturday, November 16, 2013

Germany Steps Up to Work With Ireland

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

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

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

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

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

Thursday, November 14, 2013

More Thoughts on Cisco and the New IT

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

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

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

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

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

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

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

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

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


Wednesday, November 13, 2013

Cisco: The Fourth Horseman Reports First Quarter 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, November 11, 2013

QE A Feast for Wall Street

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

What Kind of A Recovery Is This?

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

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

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

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

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

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

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

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

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

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

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

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

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

Monday, November 4, 2013

Showrooming and Best Buy: Wall Street Consensus Discredited

Almost a year ago, looking at the beleaguered Best Buy shares, we wrote,
"The fundamental issues at Best Buy have nothing to do with "showrooming," but everything to do with the company's own internal issues.  Back in the time when I rated the stock a 'Buy' the internal organization and culture were strengths, while during this long down cycle, the opposite has been true."
Renew Blue was a valuable start to a turnaround process that is still in its early innings.  The Wall Street Journal reports today, "Recent results suggest that last year's fears over showrooming were overblown"  My basic principle for reading the financial press has a three-fold test: a trend being written about has either (1) long ago gone out to sea and is of historical interest only, or (2) it is a manifestation of the herd instinct and is of limited substance, or (3) it is entirely self-serving for some interest group, in which case the investor has to 'follow the money.'  Reading the financial press for a glimpse into the future is not time well spent.

All this being said, Best Buy's meteoric share price rise is way ahead of any reasonable projection of earnings growth, unless it is getting an unwarranted multiple expansion.  Technology choices for consumers, especially when looking at manufacturer's websites or undifferentiated websites like Amazon, are overwhelming and confusing.  Price may be important when the consumer has settled on a specific product.  

Let's say a consumer is looking for a new laptop.  Windows or Mac?  If Windows, then go to Windows 7 and skip the new OS. or go to Windows 8.1 now, but with touchscreen or not?  If Windows 8.1 touchscreen, then convertible or not?  Windows 365 or Windows single, permanent license? What about a Chromebook to avoid the issues of OS and Office?  But, more expensive WinTel laptops offer better performance and screens than Chromebooks for viewing movies.  What to do?  It makes my head spin. 

Like George Zimmer or Joe Namath, I "guarantee" that the average consumer can use help to make the best decision for their own, misunderstood needs.  This is where a store-based retailer could add value to the consumer's tech choice nightmare.  Is that retailer Best Buy?  That result isn't in yet.