Tuesday, December 31, 2013

Year-End Thinking About HP and the Tech Giants

The conference call is over.  The questions have been asked, and the voluminous slide sets are online with all the granular non-GAAP financials in place.  I know that it's a dull document, but there's nothing like sitting down with the 10-K and penciling through the document, looking at three years of results side-by-side. Before doing that, I like to read through the risk factors for any nuggets, and I like to read through the analysis of goodwill and intangibles discussion.  These tell me a lot about any concerns about the future that are not reflected in the historical results.

After some reconciliation to the past presentations and my notes , I came away with a more sober view of HP's challenges in 2014 than that which I held post the fourth quarter conference call.

CEO Meg Whitman was right from her earliest presentations, viz. this is definitely going to be a multi-year turnaround.  This company clearly was incredibly badly managed for a long time before her taking the reins, and unfortunately the Autonomy acquisition was not only insanely expensive, but it has cost valuable management time and somewhat circumscribed options.

The restructuring program's scale and management's focus on executing it on plan was really the only option, and its benefits can be seen in FY 2013 selling, general and administrative expense being $300 million lower than the FY 2011 level as reported. However, looking at the multi-year project, this is the 'easy' part, and I don't mean to be cavalier and it's all relative.

Even though the company's share price has had a nice one year run, the 10-K's three year stock price performance chart shows that it has clearly under performed the SandP 500 and the SandP 500 Information Technology Index by a wide margin.  So, there's still a long, long way to go.

Breaking up the company, which was the long standing refrain for a while, clearly would have resulted in nothing but a destructive fire sale, and that is clearer than ever when one looks at the seven reporting segments over the three year history.

Personal Systems has seen its operating margin decline from 6 percent in FY 2011 to 3 percent in FY 2013, but its revenue loss over the same period is over $7 billion.  Although the company has been chastised for being late to the tablet wars, if this segment can right itself there is tremendous opportunity.

One of the industry's leading low cost competitors, Acer has just seen the departure of three key senior executives, the head of global commercial business operations, its chief technology officer, and its GM of Chinese smartphone operations.  So, low cost production and decent form factor design alone aren't enough to succeed.  If HP can get the right leaders in place for Personal Systems, it could take advantage of its strong position in the corporate market as well as a stable position in the consumer market.

By contrast, the Printing business trimmed its year-over-year revenue decline to 1% in constant currency for FY 2013, while its operating margin of 16.3% is 130 basis points above the FY 2011 level.

Looking at the commercial segments, Enterprise Group and Enterprise Services the company has some tricky waters to navigate, and the risk section of the 10-K talks about about the commoditization of the x86 server products, while at the same time talking about a product transition to the Itanium platform that needs more software development by partners to support user requirements.

The Enterprise Group has seen its segment operating margin decline from 20% in FY 2011 to 15.3% in FY 2013, a 470 basis point decline, which is substantially larger than the margin rate declines in Personal Systems or Printing over the same periods.  I suspect that industry conditions and the product line transition may have negative revenue and margin implications for FY 2014.  The cautions in the risk section and the three year profile might suggest a year of treading water.

The Enterprise Services segment saw revenues decline 7% in constant currency in FY 2013, which was the biggest decline among the seven segments right behind Personal Systems.  Operating margins collapsed to 3% in FY 2013 from 7% in FY 2011.  This business needs some tough love.  Together, Enterprise Group and Enterprise Services comprise 46% of consolidated net revenue and about 45% of segment operating profit excluding Corporate.

While I have no doubt that HP will remain a critical vendor to large scale enterprises, the product line transitions, margin pressures and extended corporate buying cycles will probably put pressure on FY 2014 results.

The Software segment seems to bear the scars of the Autonomy acquisition, which I also noted in listening to the head of the business and comparing his tone from coming on board to his tone after the recent fourth quarter.  He sounds a bit worn out and frustrated.

Software revenue grew from $3,367 million in FY 2011 to $4,060 million in FY 2012 with some benefit from Autonomy, but it declined by 3% in constant currency to $3,913 million in FY 2013.  There has been a discussion about the inability of HP managers to replicate the sales cycles of pre-acquisition Autonomy.

The good news is that despite the revenue decline, segment operating margins in Software increased year-over-year to 22% in FY 13, an increase of about 200 basis points.  The bad news is that because Autonomy has been such an expensive debacle, HP probably needs to make more software acquisitions in the future in order to press its advantage as the herd of corporate IT suppliers gets thinned a bit, in the future.

Research and development expenditures have been flat for the three year period at just over $3 billion.Without knowing what kinds of projects comprise this spend, one wonders if buying innovation through acquisitions is cheaper than building innovation in-house.  No one ever asks this question on a conference call, and I've never read it addressed in an analyst report.

Finally, returning cash to shareholders is the tech industry shibboleth of the day for CEOs.  HP has spoken about a goal of returning fifty percent of  FCF to investors through buybacks and dividends.  I've never understood what is sacred about a number like 50%.  I know that Cisco hews to this self-imposed metric.

HP is running at about 30-38% of FCF, defined as CFO minus Cap Exp from the CF statements.  With the stock where it is, i.e. fairly valued, I would suggest stopping the buybacks and seeing if there are areas where it could be deployed internally to build more for the future.  What are HP Labs doing?

Acquisitions, according to the financial press, will require higher control premia.  Social media shouldn't be the metric for jumping to this conclusion.  Technology that will feed into the corporate and consumer computing environments needs market presence and distribution, which smaller companies cannot build without time and a lot of expense.  Acquisitions, especially for an entity like HP, are very risky for shareholders.

The Land of the Tech Giants

Cisco and Microsoft have advantages over HP in managing their respective corporate makeovers.  Both have fortress balance sheets and legacy business like routers and switches and Office software that can throw off cash even if their volumes and margin structures have to be ridden down over time.

HP's consolidated gross margin rate, even with a lot of blocking and tackling in sourcing and in asset management. has been flat over the three years at 23%. There is no cash cow hidden among the seven segments.

HP's balance sheet has been improved from its cratered complexion some time ago, but it isn't exactly pristine.

IBM has extremely strong market presence in multiple markets, financial capacity, and opportunities in super computing which are the bailiwick of very few players.

Making money on HP from here in 2014 won't be the easy money of 2013, but it should be an interesting evolution during the year.

Happy New Year!











Saturday, December 28, 2013

The Shadows Remain in Shadow Banking

"The basic point is that there has been, and remains, a strong public interest in providing a “safety net” –in particular, deposit insurance and the provision of liquidity in emergencies – for commercial banks carrying out essential services. There is not, however, a similar rationale for public funds - taxpayer funds - protecting and supporting essentially proprietary and speculative activities. Hedge funds, private equity funds, and trading activities unrelated to customer needs and continuing banking relationships should stand on their own, without the subsidies implied by public support for depository institutions."
2010 Testimony of Paul Volcker to U.S. Senate Committee on Banking, Housing and Urban Affairs. 

Politicians of all stripes have rushed to have themselves photographed with the wise, grandfatherly oracle who is Paul Volcker.  But, what do we have after all the delay from 2010 until now?  We have a "rule" of over 1,000 pages which is full of contradictions and definitional lacunae.  A prime example would the prohibition against proprietary trading, or investment banks, who make much of their money from making markets, being enjoined from hedging 100 percent of their portfolios.  I didn't make it through much of the 1,000 pages, but after the champagne has been drunk will come the 2014 hangover when regulators wake up to the need for "tweaks."  Enough said here.

But, a seemingly unrelated story got my attention in regard to Paul Volcker's philosophical first principle that appears underlined in his testimony above.  It is the WSJ story about millions of tons of aluminum, copper, nickel and zinc which are hidden in "shadow warehouses." An owner of a shadow warehouse can, according to this story, have a stash of unreported material on one side of a fence from an LME regulated stash of the same material on the other side.  Material on the LME side goes into published statistics which drive market participant behavior and have impacts on prices.  

"It's a real concern for anyone in the industry that metal can be sucked away into a nonreporting location with no expectation or date as to when it's going to be available again," said Nick Madden, senior vice president and chief supply-chain officer with Atlanta-based Novelis Inc., an aluminum-products maker that is among the world's biggest buyers of the metal."

Guess what kind of entities are involved in this unregulated, speculative activity?  "Until 2010, most warehouses were owned by logistics firms like Netherlands-based C. Steinweg Group. But as metal-financing trades became more popular, C. Steinweg was joined by units of Goldman Sachs Group Inc. and J.P. Morgan Chase & Co. as well as commodity traders Glencore Xstrata PLC of the U.K. and Switzerland and Trafigura Beheer BV of the Netherlands."  

Morgan and Goldman?  Here we go again.  

Friday, December 27, 2013

Compassion or Pragmatism: Khodorkovsky is Freed

The power of personal diplomacy should never be underestimated, as Hans-Dietrich Genscher's heroic work to free Mikhail Khodorkovsky shows. Ascribing motives to a person is most often a fool's game, and the theory that President Putin freed Khodorkovsky to curry favor for the Sochi Games seems ridiculous. Compassion? Putting an end to a story that has run its course? 

President Putin wasn't under any compulsion to enter into the discussions that eventually led to the release of interesting, complex, business savvy, and ruthless oligarch who is Mikhail Khodorkovsky.  He is certainly not a saint by any means.  It does seem that Herr Genscher's personal communications style engaged Russian President Putin in a long running conversation that resulted in Khodorkovsky's being freed.  

Elements of pragmatism and compassion were probably both part of the mix.  Germany and Russia have substantial long-term economic interests in what might be called the broader Europeanization of their relationship.  This is most probably why Chancellor Merkel lent her blessing to the Khodorkovsky conversation.  She is most certainly a pragmatist. 

One of the best and most incisive summaries of the whole Russian oligarchic system and economic reform is contained in a London Review of Books article by Keith Gessen. Let's hope that a real economic discussion of cooperation between Russia and Europe is a staple in the business news for 2014.




Thursday, December 26, 2013

Emerging Markets Aren't For Most Investors

Brokers have rebranded themselves as "wealth managers," and the lure of emerging markets has been part of their patter for individual investors for many years.  Emerging market mutual funds have sprouted at both new and established mutual fund companies.  Using Lipper data from the Wall Street Journal, the only wealth created recently has been for the brokers and the mutual fund companies themselves.

Over the past 3 years, 332 emerging market equity funds have generated an annualized total return of -1.54%.  Over this same period, the top five funds have generated total returns between 7-8% per annum, but they are all pan-African funds with minuscule asset bases from $6-$192 million.  

For the past 5 and 10 year periods, Lipper's emerging market equity fund universe generated annualized returns of 14.77% and 10.51%, respectively.  These historical numbers were, of course, the basis for generating sales, which were also helped by references to diversification and to overvaluation in U.S. markets.  

The problems with the naive emerging markets story are manifold.  Higher GDP growth rates aren't a guarantee of higher stock market performance on any consistent basis.  Some recent academic research suggests that if the higher GDP growth rates are consistent and sustained, they serve as a cap on the long term growth of current high growth public companies.  

Morgan Stanley emerging market fund research head Suchir Sharma has suggested that emerging markets have become a "mature asset class," and many of their stellar companies may be like shooting stars rather than homes for long-term money.  Don't forget, we're talking about equity vehicles available to individual investors and smaller institutions.  Morgan Stanley's largest emerging market fund (MGEMX), has had unremarkable performance for the time periods above, at the cost of a high expense ratio and a $5 million minimum.  

But, if GDP growth rates might be higher in some emerging markets and larger middle classes shift over to higher consumption, isn't there money to be made? There surely is, and the fact is being recognized by very wealthy private investors and by very large institutional investors.  Especially with the recent downturn in commodity prices and the visible failures of private empires built on the same, opportunities abound in private debt instruments and in real assets like production and processing plants and in the resources themselves.  

The problem?  The sponsoring organization for a superior fund must have informational, locational and institutional advantages that put its feet on the ground, with a history of actually doing business in a market. That doesn't describe the likes of  Morgan Stanley, Fidelity, or T. Rowe Price to give example of large fund families.  They rely on the same outdated, unreliable published economic and corporate statistics, freshened up with some quick visits to government officials in PR situations.  As Sam Zemurray said in his book, the only answer is to "go and see for yourself."  Few can do that and combine it with investment savvy. 

Carval Investors, a unit of global commodity production, marketing and trading giant Cargill, has some interesting offerings that have the advantages needed to be successful over the long-term in emerging markets. Their funds are open and suitable for larger, long-term investors who don't require liquidity.  For the rest of us, emerging markets will remain a crap shoot.  

Monday, December 16, 2013

Ukraine Gets A Gazprom Discount: At What Cost?

Ukraine may be offered a 'discount' of 25% off list prices from its sole supplier Russia's Gazprom and some additional loans up to $15 billion to extricate itself from the effects of a crippling drought and mismanagement that saw a dramatic reduction in Ukraine's grain harvests and exports. It's not clear how this 'discount' will be treated and repaid, in cash or in kind from future exports. Bloomberg suggests an announcement as early as tomorrow.

While the EU has properly said that it wouldn't negotiate on 'markdowns' to conditions for joining the European Union, it is also short-sighted not to realize what's at stake with Ukraine.  It was the "Russian breadbasket" in the halcyon days of Communism.  It could be a major exporter to the EU if development projects could be brought on stream, and Ukraine needs an energy import portfolio that contains more than one partner, which is today Russia.

It is unlikely that President Yanukovych can again turn his eyes to the formal EU entry process, as President Putin would be greatly distressed by any such move which would cause him to lose face.  The protesters, so far, have shown much more substance and courage than our own cartoonish "Occupy Wall Street" protesters.  But, economics more than politics will carry the day from here.

If the EU bureaucrats can muster up some creative alternatives to the full fledged, heavily administrative procedures for EU membership, there can be a real choice for the people of Ukraine to stand behind. The people in the street need some support from Brussels, Paris, Bonn, and Washington.

Saturday, December 14, 2013

Cisco's 2013 Financial Analyst Conference

Looking at the three key executive presentations at Cisco's Financial Analyst Conference, management made a case for why Cisco should emerge as the preferred IT provider for large global enterprises, even as their corporate customers face exponentially growing volumes of data, greater demands for analytics and decision making agility, and a rapidly evolving cloud-based computing environment. They make a pretty good case.

At the end of the CFO's presentation, however, it becomes clear that to get to this promised land, Cisco has to navigate a period of low or no growth in their core switching and router businesses, while they begin the most significant product line refresh in corporate history.  The 'core' Cisco business is projected to show revenue growth of 0-1% per annum over the next 3-5 years. This brought the projected revenue growth rate for the consolidated business over the next 3-5 years to 3-6%, which is down 1% from the top end of the prior projected range.  This is the point that wasn't taken well by analysts, who then felt that Cisco might not emerge as the preferred IT provider they aspire to be.

Some points that struck me in CEO John Chambers' slides:

  • CIOs are taking longer to make big commitments to new computing architectures from Cisco and other providers. This is similar to comments made by HP CEO Meg Whitman, and it jibes with IBM CEO Virginia Rommety's frustration with her sales force's inability to 'execute' or close sales on the usual schedules; 
  • Despite this nervousness and macroeconomic headwinds, Cisco has had 5 consecutive quarters of 8-10% growth in revenue from U.S. Enterprise customers.  For the recent 2013 fiscal year, U.S. revenues of $24.6 billion increased by 8.9% over the prior year. U.S. Commercial customer revenues over the same trailing five quarters increased 5-11%.  
  • Current growth areas are cloud computing, mobile, and video, as everyone agrees.  
  • Cisco's research and development budget and acquisitions will be directed to future growth areas in IT services, security, and collaboration.  
  • The key takeaway for me is the CEO's assertion that core routing and switching capabilities will be the foundation for the IT and business processes transformations that will create large, new addressable markets. Most analysts disagree with this assertion.  
Rob Lloyd, President of Development and Sales, made these points, among others:
  • For me these slides make a very important distinction about the different kinds of 'clouds' that will exist in the emerging computing environment, viz. public, or commodity, clouds like those provided by Amazon and others; private clouds, and virtual private clouds, both of which will feature highly developed security environments to protect corporate data.  Lloyd says that CIO decisions will be based on business agility (from the cloud provider and from the responsiveness of the environment), total cost of ownership, data sovereignty and trust and control. The latter two points are, in my opinion, going to be critical for a CIO and a board which will have to look at the risks associated with a move to the cloud. 
  • He has some interesting industry statistics on the components of data center spending:
    • Hardware accounts for more than thirty percent of data center infrastructure spending, despite its increasing commoditization;
    • People expenses account for 29 percent of the spend;
    • Software comprises 22 percent of data center costs;
    • Energy and facilities absorb 12 percent;
    • Disaster recovery (7 percent), Networking (10 percent), Storage (7 percent), Servers (11 percent), and Overhead (2 percent) make up the balance. 
  • Cisco's largest total addressable growth opportunities in 2017 will be in Saas (collaboration, security, and network operations), enabling cloud providers, and building private corporate clouds.  
The financial press suggested that Cisco might become the target of activist investors because of the stock's relative under performance relative to the 88% increase in HP, for example.  I'd find this company to be an unusual target for a few reasons. 
  • As we've said before, despite all the challenges in macro environment, pressures on pricing and reluctance of CIOs to make big commitments, and Cisco's continuing appetite for acquisitions, the company has a fortress balance sheet;
  • Cash from operations of $12.9 billion in fiscal year 2014 increased by 12% over the prior year, and free cash flow was $11.7 billion.
  • The company returned $6.1 billion to shareholders in fiscal year 2013 or 52 percent of its free cash flow, and it wisely changed the mix down to make the share buybacks a lower proportion than in the prior year.  
  • The proposal to divest the set top business picked up during the acquisition of Scientific-Atlanta has been floated, and it might improve profitability, if critics are right, but it's small potatoes in the scheme of things. In addition, the CEOs slides provides a justification for keeping the product line.  
  • If the stock gets below $18, it will be selling at about 9x adjusted fiscal 2014 EPS, which is about the level that HP hit before investor interest started to rise. What new value enhancing ideas would an 'activist' shareholder propose?  
  • The stock has a dividend yield in excess of 3%.  Assuming that the bottom doesn't fall out from under this company, an investor would get paid to wait for some revenue growth.
On the gross margin side, the product gross margin rate did dip below sixty percent in the last fiscal year, declining 1 percentage point to 59.1 percent.  Services margins held in at 65.7 percent, bringing the consolidated gross margin rate to 60.6 percent, a sixty basis point decline from the prior year.  

While pricing and an unfavorable product mix due to the product line changeovers took 360 basis points off the gross margin rate year-over-year, this was entirely offset by productivity gains of 3.7 percent.  In fact, the net erosion in the gross margin rate came from higher amortization of intangibles and an inventory adjustment from the acquisition of NDS.  Fundamentally, the company seems to be managing its manufacturing and procurement operations very well, and it is investing some of its cost-saving from staff reductions into getting design and production efficiencies.  

Analysts said that it wasn't an 'exciting' FAC from Cisco.  Maybe not, but this stock could have some legs in 2014: let's see.  I know that I have some tech head readers from the industry. Send me your thoughts.  

Thursday, December 12, 2013

A Quiet Crisis in Ukraine.

Recent developments in Ukraine have been reported as a situation where Ukrainian President Yanukovych is portrayed as 'negotiating' trade, aid and loan packages between the European Union and the Soviet Union for the benefit of his country. In truth, he doesn't have the power to negotiate anything with either side, and his status as a political lame duck makes his own political value to Russia precarious.

The Wharton School published a note from Sophia Opatska,CEO of the Lviv Business School in which she cites reports that the President has misappropriated more than $6.5 billion in recent official assistance flows for the benefit of his own family.  He has already treated himself as a satellite Russian oligarch, and the EU really had no choice but to say that it wouldn't negotiate terms of an EU entry with the Ukrainian President.

The Ukrainian people have a natural affinity for the more open economic systems of the European Union, but the bureaucratic requirements for a full entry are not just too costly, and they are really unwanted by the now badly beholden President Yanukovych.  The EU should find a way to trade more with Ukraine without the full rigmarole of official membership.

Further 'aid' from Russia will be too onerous and expensive, and any proceeds will do nothing for the people because of the corrupt nature of the government.  As Opatska writes in her note, "When it comes to corruption, the country ranks 144 out of 177 countries, tying with Nigeria, Iran and the Central African Republic."

While protests in the Ukraine have been ongoing since mid-November, they are attracting very little attention in the West because of the focus on the Middle East.  As important as we thought the Tienanmen Square protests in China were, what is going on in Ukraine is worthy of  equal attention, especially for Europeans who could see a potential economic good neighbor withered underfoot by Russia and a proxy government of Ukraine.   

Senators Ryan and Murray Show Some Courage

For all our mantras about gridlock, unprecedented partisanship, and 'divided government,' what Senator Ryan (R) and Senator Murray (D) have done is truly praiseworthy and encouraging.

Above all, beyond who gets what or if their long-term deficit reduction is meaningful, here's what's significant about what they did:

  • Both parties are increasingly held hostage or influenced by their extreme wings.  Yet a senator from the relatively fiscally conservative state of Wisconsin can open a dialogue with a colleague from the relatively liberal state of Washington, outside of the aegis or approval of their party leaders.  They were able to talk, recognize their constraints, and come up with a proposal that hewed to their own ideas while not rejecting outright the platforms of their party leaders. 
  • They shared the stage, although I wish that Senator Murray had really added more of her own voice from the podium.
  • Their actions proved that gridlock and all the other epithets describing our woes are cover for the extreme views of a very small entrenched leadership of both parties.  If they are able to quash the efforts of their own colleagues, American voters may eventually wake up to where the problem lies.
The real problem is the unthinking American electorate.  Everyone gets their data from television news, NPR or Fox on the far wings.  Very, very few read original documents or think for themselves.  We don't have enough time or energy, and basically we don't want to be introduced to anything that might contradict our deeply held views. Our current political elite on both sides of the aisle understands this and panders to it: how else could they have survived so many election cycles?  

Total domination of the opposition--uncompromising and unforgiving victory for their self-interest-- is what the electorate wants. Compromise is for wimps and losers. Well, what Senators Murray and Ryan have done is to show, even in a small way, that another path is possible.  Here's hoping something develops from this, and that more such alliances are forged. 

Oil and Gas Forecasts Again.

"We are not dealing with an era of scarcity, we are dealing with a situation of abundance," Ken Cohen, Exxon's vice president of public and government affairs, said in an interview. "We need to rethink the regulatory scheme and the statutory scheme on the books."  Wall Street Journal
 
 "The sheer abundance of oil and gas in the U.S. poses challenges for Exxon. Booming production has overwhelmed U.S. demand, pushing domestic prices lower and eroding profit margins for energy producers."

So, given that natural gas and other hydrocarbon supplies in North America have pressed gas prices down below their energy-equivalent prices to oil, simple economics says that we should export them.  Europeans should welcome this development, as it would ease pressures on them coming from Russian desires to use energy supplies as an economic hammer on Western Europe in the future.

But, we don't want to allow exports because "some fear" that U.S. consumers will pay higher prices for their utilities.  But, despite low prices, utility customers are already paying higher prices than a year ago.  Just check your gas and electric bills.  Look for things called "resource adjustments" or "interim rate adjustments." What we pay here has as much to do with utilities regulation for returns as it does with global energy prices.


Monday, December 9, 2013

A United States of North America?

The trouble with long-term economic forecasts is that they are inevitably wrong, both on direction and often on degree.  The recent past weighs too heavily on our horizons, and we can't imagine these recent trends ever stalling or reversing.  I don't speak about this only through observation, but from my own experience at the controls of forecasting models that spewed out some laughable results.

Europe would soon supplant the United States as a global economic power given that its unified markets were almost as large as that of the United States. Well, maybe that needs to be revised.  Japan will dominate global economics because we taught them all about manufacturing quality, and because their single minded management and skilled labor force would take them to world domination.  When they bought Rockefeller Center, that surely had to symbolize the end of our economic hegemony.  This globally consensus forecast has to take the prize for forecasts we'd like to disavow.

China will corner the market on manufacturing, as it moves upstream to capture high tech industries.  Its currency will supplant the U.S. dollar as the preferred global vehicle for trade.  Its double digit GDP growth into the foreseeable future will allow it to capture global stocks and capacity for materials from energy to rare earth minerals.  This forecast is already being nuanced away, and it will have some more trimming of the sails in the future.

In all forecasts of this ilk, U.S. is the inevitable loser. The reasons are all over the map, reflecting our vapid body politic: self-loathing, nostalgia, multiculturalism, right wing conspiracies, profligate spending, under investment by the government, the Tea Party and so on ad infinitum.

A recent, tongue-in-cheek story in the Wall Street Journal talked about a merger of the U.S. and Canada.
There's a kernel of an idea here, but I'd make it even bigger.  I'd propose a United States of North America. I recognize that the name itself would need marketing and political negotiations, but I would include a continuous market that would include the U.S., Canada and Mexico.

Having written about the problems with the European Union, of course this sounds outlandish, and it is.  The biggest barriers are the political and economic rent-seekers whose interests would be gored by a change in the status quo.  However, this is exactly the phenomenon of a genuinely different future vision being weighed down by the baggage of recent history.

The case for Canada's participation in such a venture is obvious.  A country with a population of 35 million people is one-tenth or less the size of the U.S. population.

Figure 36 Population of the Canadian provinces and territories in 2006 and 2031
Most of Canada's population is concentrated in two provinces in close proximity to the United States in a belt from Quebec to Windsor.  Statistics Canada's presentation of future population scenarios shows the continued concentration of the population in southern Canada, with some growth in the Canadian agricultural centers of Western Canada.

Canada is our biggest trading partner, by far.  Census numbers show year-to-date through October the value of trade with Canada amounting to $209 billion.  Mexico, on a year-to-date basis, is third at $164 billion, just behind China at $167 billion.

The opportunities for almost unimaginable social and economic gains from really freer economic markets are right in front of our eyes.  This whole economic region could be energy independent several times over, but that's the low hanging fruit.  Canada has land and mineral resources that are underpopulated and underdeveloped respectively.  Mexico has finally begun to state, at least for the press, that its bloated, ineffective public oil monopoly PEMEX needs technical help to develop its energy resources.  Socially, its government needs to get a handle on its myriad social and political issues.

Capital abounds in all three countries, looking for investment in a regime of stable markets and a well developed legal system.  The Canadian banking system is much smaller than ours, but more conservative and looking for expansion opportunities in U.S. markets.

Beyond tongue-in-cheek, there's a real opportunity in what looks like a "1% scenario."  Instead of talking about a solar future, some of our think tanks ought to be turning their attention to a United States of North America.  ¿quĂ© peinsa usted?


Friday, December 6, 2013

Shell Won't Build Louisiana GTL Plant: Energy Prices and Misguided Policies Conspire

Source: Mark Perry, Carpe Diem blog.




We've known for some time that oil and gas markets have been out-of-whack on an energy equivalent basis, as the above slide from Mark Perry's blog shows.  Now, the fear going forward is that a glut of U.S. crude supplies and growing demand for natural gas in various forms will make the chart turn sharply upward.  Aren't global commodity markets fun?

How does this relate to Louisiana?  Shell announced that it had abandoned plans for construction of a massive GTL ("gas to liquids") plant in Louisiana, south of Baton Rouge. The part that is hard to fathom is the report in the press that the costs of the plant had reached  over $20 billion from $12.5 billion projected in September 2013.  There were some suggestions that it was due to a shortage of skilled labor and materials. If it were indeed due to rising material prices for say, steel, that isn't apparent in government statistics.  If it were due to a shortage of skilled labor, which could be possible, it would be cheaper to bring people over from Shell's collapsing Nigerian operations or from declining North Sea operations and buy them homes in Louisiana.  Or, it could be higher anticipated regulatory costs.  However, one looks at it, this kind of increase is a bit hard to believe.  

Shell began a long term research and development project in 1970 when it began tinkering with the Fischer-Tropsch process for producing liquids from gas.  Fast forward through decades, and Shell opened the first commercial GTL plant in Bintulu, Malaysia, with a nominal output of 12,500 bpd in 1993.  The company learned by doing the risks associated with the process, According to the company, air pollution from forest fires caused an explosion in Bintulu's air separation plant which led to an explosion that shutdown the operation until it resumed again in 2000 at 14,700 bpd.  By now, of course, Shell had thirty years of experience with the complexities of producing liquids--diesel and aviation fuel, advanced lubricants--and commercial byproducts like naptha and paraffin, as well as recoverable sulphur which could be pelletized for input into fertilizers and other products. Bintulu has been the laboratory for the extraordinary Pearl project in Qatar.

Pearl came online in 2006 at ten times the capacity of Bintulu.  Its first commercial shipment was in June 2011, and the plant was scheduled to be at peak production by the end of year 2012.  In almost every way, design, construction, efficiency, process management, and partnership with the Qatari partners, this operation is remarkable.  The plant is tied into offshore gas fields operating in forty meters of water and delivering 1.6 billion cubic feet of wellhead gas into the plant.  Pearl provides 8% of Shell's worldwide gas output, according the company's documents. The plant is self-sufficient with its water use, and virtually everything that is recoverable is sold.  This was the kind of plant slated for Louisiana, and what a shame that it won't be built in the foreseeable future.

Shell has to integrate $10 billion in acquisitions, which were to be funded partly by asset sales which have been slower than planned. 2013, according to the company, will be a peak year for net investments, and it is expected that asset sales will step up in 2014-2015.  The company says that its preferred options for the future lay in deep water Brazil and in Canada with heavy oil.  The latter seems hard to believe as well. 

Critics say that the company has put itself into this bind by overspending in Alaska with little to show.  At the same time, Nigerian output losses and the planned sale of assets are weighed heavily on third quarter 2013 and will continue. 

Our energy policy has blocked pipelines and also blocked the shipment of our shale oil production by rail for environmental reasons.  Meanwhile, after fining BP billions for coating ducks and sea life with oil --which was mitigated pretty conventionally washing the animals with soap--comes the news that wind farms get a pass from actually killing the American eagle, and endangered species.  Mamma mia. 

GM Still Can't Manage Its Brands

We first wrote about Opel in 2009, when it was slated to be sold to parts behemoth Magna International. Opel's platforms, called Delta and Epsilon, found their way into some nice looking and riding cars in the U.S., including those badged as Saturns and Buicks, including the LaCrosse.

Then, after its successful IPO, the company decided to make the Chevrolet brand the American face of GM in Europe.  Huh?  Here in the U.S., it's an iconic brand which has made a nice recovery from a near death experience in the seventies and eighties when it put out unacceptably inferior cars. In Europe the brand would be met with a shrug of the shoulders.  Again, with irony, the Chevy Cruze platform here in the U.S. was an Opel platform.  Not a bad car either.

But, the financial management folks at GM have decided to pull the plug on the Chevy brand in Europe after its 1.6% market share post- introduction.  Of course, it's the only decision to make, because establishing the brand in the crowded and finicky European market would take too long and cost too many dollars.

Meanwhile, the Cruze and other Chevy platforms in the U.S. will now move to cheaper platforms from Daewoo in South Korea, except that rising wages there are complicating the pricing. Are you keeping this all straight?

What about the customers?  Won't they notice the difference between something produced by Opel technology and something from Daewoo?  What about the dealers?  Some in Germany, committed themselves to exclusively selling Chevrolets, in order to differentiate themselves from other dealers selling Opels.

This is another company that still can't get out of its own way.  The IPO may have gone well, and the balance sheet may be stronger, but the company still can't manage its dealers, brands or customers.  They all deserve better.

Wednesday, December 4, 2013

The Poverty of Behavioral Economics

With the awards of the recent Nobel Prizes in Economics to Eugene Fama, Lars Peter Hansen and Robert Shiller, the whole discussion about market efficiency and behavioral economics surfaced anew in the press.  Professor Fama's efficient market theories are said to be discredited, according to the financial press.  The evidence?  The last financial crisis and its aftermath.  Never mind that the supposed evidence is weakly related, if at all, to the theory.

Professor Shiller, on the other hand, is suddenly lionized as a foil to Professor Fama for being a 'behavioral economist.'  Having viewed Shiller's "Financial Economics" class that he teaches at Yale online, I'm very puzzled, as most of that course is a nice exposition of modern portfolio theory, of which Fama is a father along with several others.

In the investments class I taught to upper level finance MBAs at the University of St. Thomas, there was a small discussion from Shiller about how markets can deviate from efficient equilibria due to something he describes as "noise trading."  Since this was a counterargument to the mainline theory from an economist of quality and stature, I dutifully taught it in our discussions.

The problem?  It sounds good, and it intuitively matches our ex-post experience of market runs and crashes.  However, there's no good model for how fundamental traders and noise traders behave, and therefore there is no model to test and no data.  It's an interesting idea, but empty.  It's a metaphor, but little else.

Recently, I received two different kinds of material from Chicago Booth School of Business.  One was an informative and thoughtful piece by Professor John Cochrane, one of my favorite researchers, on why Gene Fama was awarded the Nobel Prize. If you'd like to understand the theory apart from its facile characterization in the press, have a read, linked above.

By contrast, I also received a link to a video in which three 'behavioral' researchers from different disciplines at Chicago Booth expound findings from their latest research.  The research results seemed either blindingly obvious, somewhat puzzling, or downright counterexperiential.  These are all very smart people, but the discussion betrays the real poverty of behavioral economics.

Going into their relatively small experiments, there is no theoretical model from which they can measure their actual results compared to the expected results from their theories.  They find some correlation or trend, give it a name, and say that the result is "quite surprising."  Why?  What exactly did you expect?  I was really interested to know about the relative effectiveness of intrinsic versus extrinsic rewards in the performance of marathoners. I don't know anything interesting, thought provoking or useful after this discussion.

Tuesday, December 3, 2013

More Sunshine on Cloud Computing

The New York Times and other media are back touting cloud computing.  Cloud computing players will come in all weight classes, but the NYT names the heavyweights as Amazon, IBM, and Google.  Curiously missing  from the roster is HP.

Unfortunately, none of this really makes it any clearer who is going to carry the day as far as supporting the migration of mega-cap, public multinational corporations to a public cloud computing infrastructure. Will one or more of these companies really want their entire IT infrastructure to reside with a bookseller and operator of global merchandise bazaars?  Will a CIO really want to give over her IT infrastructure to Google? This is a company not known for transparency about its own operations or about its actual privacy policies.

All the talk in these articles is about unused, read 'cheap,' computing capacity, or the ability to get the power of a supercomputer by linking hundreds or thousands of servers together.  All of this is very loose talk.

Connecting servers together to do relatively mundane tasks is, or has to become, a commodity function.  Moving an entire corporate IT infrastructure to a public cloud, and for the CEO, CFO, CIO or others to sign off on the existence and effectiveness of a system of internal controls for this kind of setup, is a really risky venture, philosophically, financially and from the litigation standpoints.

Microsoft has reported good uptake of its Azure offerings.  Google claims to have $1 billion in revenues from cloud computing, although with Googleyness, it's not at all clear how this number is derived. HP, on one of its recent conference calls also cited $1 billion of cloud revenue, although the CEO quickly put in the caveat that not all of this number was 'incremental.'  At least she was honest.

Microsoft is also taking out full page ads for large corporate adoptions of  Office 365, and this is part of Microsoft's cloud numbers.  This certainly makes sense for these types of users, and the economics are hopefully superior to the licensing model, as they should be.

If Amazon is indeed selling at 150 times forward earnings, then its domination of cloud computing has already been discounted into its price.

Ask your favorite corporate CIO what he or she thinks about all this.  I'd bet you will hear a litany of buzzwords, and see a rather glazed look in their eyes. If you press for details and numbers, little of value will be forthcoming.

Check the list of risk factors in the 10-K too to see if something is really getting off the ground. Ask what the CFO thinks: most of them are worried about bigger business issues. This story is just beginning, and the real winners may be a different set from that of the New York Times.