Wednesday, December 31, 2014

US Postal Service Reform: A Dead Letter in 2014

Throughout 2014, we read warnings about yet another crisis at the US Postal Service.  Aspects of Congressional regulation regarding prefunding of employee healthcare do have the effect of showing paper losses, and the postal union suggests that removing the prefunding requirement by itself would put the USPS in a healthy condition.

Unfortunately, this isn't the case. Meanwhile, as Congressional bills like Carper(D)/Coburn(R) languish without coming to the floor for a vote, it is clear to anyone who uses the Post Office that delivery times from Minneapolis to New York, for example, which used to be 2-3 days for First Class mail are now 5-7 days, while rates have gone up.

There are too many small post offices, too little self service, and the delivery fleet itself is outdated and antiquated.

The Postmaster-General admitted that its commercial bulk rates were not competitive enough to win share from online retailers like Amazon.  The USPS recently cut rates for holiday shipping by large shippers, and it did take share from FedEx and UPS, much to their chagrin.

Delivering groceries with the current expensive workforce, work rules, and antiquated fleet seems ridiculous. Handling returns for online retailers should help fixed cost coverage and make some money.

However, without dramatically reforming employee heath and welfare benefits, this is all the usual posturing with no real reform.  Carper/Coburn makes noises about bringing these programs in line with other Federal agencies and about enrolling some beneficiaries in Medicare, but why should this be done solely for USPS, when Congress itself and the Federal government are all on gold-plated plans?

The bill also suggests that these proposed reforms are all subject to bargaining.  Goodbye to any meaningful reform.  Look for continued decline in the speed and quality of service ordinary consumers enjoy, and look also for more glum faces and surly workers at the post office.

Monday, December 15, 2014

Telecoms Start Racing to the Bottom

We wrote a while back about Masayoshi Son's potential impact on US retail cellular phone users, particularly because he wants to become number one in his markets.

Predictably, his first efforts at taking over T-Mobile met federal regulatory veto.

T-Mobile has forced some innovation on the industry by making it easier for consumers to get phone upgrades and by doing away with contracts. Their subscriber growth turned around.

Meanwhile, however, spectrum auctions are indicating that others perhaps have a better economic model and can pay more for spectrum that ATT, Verizon, T-Mobile, and Sprint.

So, the major carriers have put forward their "race to the bottom" business model of promising to cut monthly bills in half while offering unlimited data and phone service.  Clearly, this is not sustainable, as we have noted for years.  With spectrum prices rising, the cost of building out different network or adding other services is becoming prohibitive.

So, the WSJ notes,
"What difference does a month make? In telecom, the answer is about $45 billion.
That’s how much market value Verizon Communications Inc., AT&T Inc., Sprint Corp. and T-Mobile US Inc. have lost collectively since mid-November amid a fast-moving reassessment of the industry’s value by investors. The lost value is greater than the current market capitalization of Sprint and T-Mobile combined, and it reflects concern that cellphone service will be costlier to deliver and less lucrative to sell."
The carriers also got dinged on behalf of consumers by the Feds because although they promised "unlimited text and data" to all customers, heavier users faced slower download speeds, of course a form of rationing and making the whales pay for their consumption. If the fines levied are paid, then they either have to adopt some kind of utility pricing which is transparent, or face growing losses because their business models don't create value. 

Thursday, December 11, 2014

Economic Winter in Ukraine:Western Allies Distracted and Silent

Politicians are the same the world over.  Dealing with real issues in a principled and economically rational way just leads to attacks from noisy, vested minority interests, or 'activists.'  Their self-interest lies only in their narrow agendas: the pols get instant support and the majority either doesn't know or doesn't care.  What could be better or safer?

So, Europe is worried about climate goals and ECB pronouncements, while in the U.S. we are also worried about climate pacts and yet another government funding impasse. Russian President Putin continues turning the screws in Ukraine, maintaining his currency with his nationalist supporters.

With signs of a better business climate in the U.S., a favorable Ukrainian exchange rate, an idled Ukrainian export capacity in sectors like agriculture and heavy machinery, and an avowed desire to open European markets to exports, this should be a time of optimism for Ukraine.

Instead, we still have the self-proclaimed Donetsk People's Republic in place.  Gas has flowed to Ukraine, the first shipments since June, but these have been prepaid, further draining currency reserves which must be dangerously low.

As an exportable machinery manufacturer in Ukraine tells the Journal: why worry about exporting machinery when I don't know how to find a customs official?

Germany, which seems to have become even more inward looking than the U.S., should be taking the lead, but after reported talks with President Putin weeks ago, Chancellor Merkel is probably off to holiday parties.

Ukraine deserves better from the U.S. and the European Union.

Wednesday, December 10, 2014

HP in Barcelona Discover 2014

If like me you weren't able to attend the HP techfest in Barcelona, you can watch most of the speaker presentations on video.

As we said back in 2012, IT buyers needed a provider like HP that could deliver them solutions for their systems issues--legacy systems, burgeoning data, mobile applications, and higher hurdles for system security and compliance to name a few.  CEO Meg Whitman's accomplishments include convincing them that HP was such a partner.  Barcelona drives the same messages given consistently throughout 2014 with updates on new products and services, along with customer participation. 

A staple menu item in all the presentations is "Big Data," a term which clearly causes audiences to either cringe, yawn or glaze their eyes over.  

Software EVP Robert Youngjohns gave an interesting presentation on the New IT, forged from the fires of Big Data.  HP's approach, he says, distinguishes among three distinct types of Big Data:
  • Business data, coming from traditional sources like the corporate ERP, CRM, BI, and HR systems, for example).
  • Machine data (examples were log files and sensor data, i,e, the Internet of Things)
  • Human data (Email, video, photos)
The first category, which seems to be where the corporate data engine room hits the financials, is growing slowly.  It is the other two categories, particularly the third where the growth is explosive. He went on to say that the HP big data platform distinguishes among each big data category and tailors the offering accordingly.

His presentation brings up my concerns about the vacuity of the term Big Data.  Businesses are still growing, in broad terms, at GDP-like rates, or at the upper end, single digit multiples of the same. Machine and human data are exploding at ridiculous rates.

He quotes another fluff statistic: more photos are being produced each day than in the first 100 years since the invention of the photographic process.  Surely, the obvious conclusion is that the value of machine and human data are fractions of traditional business data, from data about exploration wells to customer purchasing patterns. 

If the value were commensurate, IBM, Exxon and other Big Data producers capable of deploying new systems would be seeing explosive growth in revenue or profit.  However, nothing like this is visible. Bellwether companies like Cisco sometimes see revenue shrinking. 

Youngjohns gives a personal example that raises the same issue.  He is a tech geek at home too.  His home wireless network is very complex. He has the controls for his climate system managed by sensors and a panel.  He has imaging, music, television and other activities on wireless subsystems. He decided to find out why NetFlix was operating very slowly, and so created a reporting system of activity logs which, he said, soon generated a terabyte of data!  

Now, I couldn't hear anyone laughing in the audience, but they should have been. The architecture of this network is clearly faulty, at least the infrastructure and maybe more. Leaving this aside, big data in this case was bad data, and unproductive for its expected benefit, namely to make NetFlix run faster.  The hardware and software costs per unit of data are so low, which merely masks the unproductive nature of the activity. 

Moving on to another presentation on Data Centers and the Cloud, the same issues came up in a different way.  Data centers, we are told, have to provide services for all kinds of devices, like fitbits, videos, and sensors, again the Internet of Things. These apparently create large data streams. 

However, much of this are personal data, surely. Why should a commercial infrastructure expand to support this data demand?  One of the speakers really struggled to come up with examples of supported devices that didn't sound as ridiculous as Fitbits, but he couldn't.  The demands being put on data centers from personal uses like Instagram, SnapChat, Facebook and other social media stem from the BYOD policy that has become the standard in corporate America: it is a policy that requires more resources and which ultimately reduces employee productivity.  

He did cite an example of instrumenting the corporate vehicle fleet, where a large volume of operational data (speeds, routes, mileage, fuel consumption) would create large data center demands. This doesn't sound earth shattering, but just a move up from what's being done currently by operators like UPS.

The Haven platform brings together ArcSight, Autonomy and Vertica for data analytics, while also providing a broader platform and tools for asset and security management. Sounds like things are being put into place for HP.

Of course, now it is going to split into two pieces. Stay tuned. 

Checking in on Intermediate-Term Bond Funds

Year-to-date, according to Alliance Bernstein, U.S. stocks are up 14%, compared to a gain of 4.2% for bonds.  From the local market peak on 9/18 to the trough on 10/15, bonds showed their shock absorbing qualities as they declined by only (-1.4%) versus equities at (-7.4%).

It's unclear what fund managers at intermediate-term bond funds are thinking, as the most recent published disclosures are from 9/30, but much has been made of higher cash levels at many funds. Morningstar data shows overall bond fund cash at over 8% of assets, which is alternatively attributed to bond sales, cash inflows, or raising cash for expected redemptions as equity markets continue to rise.

We lean towards the importance of the last factor, especially in light of the growing uncertainty about when and how the Fed plans to raise interest rates.

If bond funds behaved like equity funds, there's no doubt that they would be taking some money off the table because their winners have had long runs and the relative rewards going forward look less inviting.

Investment Grade Corporates issued by financial institutions had a total return of 2.5% in 2006, 11% in 2012, and 8% in 2013, according to Dodge and Cox portfolio managers whose allocations to IGCs is twice as high as their benchmark index.

If there were to be a flight away from bond funds to equity mutual funds ( a sure sign of a market top looking at retail funds), portfolio managers would be challenged because bond markets are relatively thin and inefficient, something we have noted before.

Financial regulation post-crisis has made the dealer market more risky and less profitable.

The favorite financial company issuers in the IGC sector include: Bank of America, JP Morgan Chase, Goldman Sachs, Morgan Stanley and Wells Fargo.  Bank of America, according to Bloomberg data from April 2014, had 1,295 bonds outstanding, but only 53 of these were liquid enough to included in the Barclays US Corporate Index, a popular benchmark.  But, these 53 issues, 4% of total bonds issued, amount for 46% of the dollar amount of Bank of America's debt outstanding. These bonds are over-owned because of their inclusion in the index, and because of their liquidity; investors who chose from the other 1,242 Bank of America issues will be in real trouble if there is a market traffic jam in a bond exodus.

According to BlackRock, market reform in bonds is long overdue, and aside from proposed regulation on mutual fund bond sales our regulators have not seen the improvement in bond markets themselves as something worthy of their serious interest.

Thursday, November 20, 2014

IT Buyers Face More Regulatory Risks For Business Interruptions

In yesterday's post about Cisco, we stated our belief that IT buyers, whatever their justifiable complaints against their traditional suppliers, need them as real partners going forward because of the increasing risks IT leaders face if their systems suffer business interruptions.

In today's Journal, the case of Royal Bank of Scotland made the business pages as RBS paid a fine of $88 million for an IT failure that kept customers from accessing or transacting from their accounts reportedly for weeks.

British regulators opined that there wasn't a underinvestment in IT systems which led to the failure, but rather an absence of adequate software testing systems which led to the outage.  Heaven only knows how regulators who were asleep during the global financial meltdown suddenly have become expert in software implementation and testing.  This is, however, the world in which IT buyers, particularly in financial services, are going to function from now on.

To save pennies on a project, bring in newer,smaller unproven partners, or to piece together hardware, software and services on an a la carte basis would be a risky way to do business and it wouldn't be good for an IT exec's career.

The Four Horsemen of Tech will continue to have an advantage going forward in the new world of IT, if they can change their go to market strategies and become more customer-centric: they don't have any other options.

Wednesday, November 19, 2014

Cisco's 1Q FY15: Looking Forward and Back.

Looking Back at Our Cisco Posts

"Cisco's 4th Quarter: A Tiger Changes Stripes," 8/16/2012
  • Credit Suisse worried about 250-300 bp erosion in the gross margin rate going forward! (the time frame is not specified)
"Cisco: The Fourth Horseman Reports First Quarter 2014," 11/13/2013
  • For the period 7/2008-2013, Cisco's shares return an average rate of 7.4% per annum, trailing both the Standard and Poors broad index (16.5%) and the Tech Index at 18%.
  • $12.1 billion in revenue increases 1% y/o/y.
  • It will take 4-5 years to transition the company away from a heavy reliance on its traditional core of switching and routing.  
  • From 2008-2013 the gross margin rate declined 800 basis points.
  • Long-term growth rates of 5-7% expected from a reconfigured Cisco. 
  • If this were combined with operating leverage on a leaner company and better supply chain efficiencies, long-run value creation would be significant.
"Cisco's 2013 Financial Analysts Conference," 12/14/2013
  • Core business growth might average 0-1% per annum over the next 3-5 years!
  • Hardware still accounts for about 30% of data center spend.
  • Servers account for 29%.
  • Software accounts for 22% of the data center spend.
  • "stock could have legs in 2014."
"Cisco's Fiscal Second Quarter 2014: Nothing New From the First," 2/13/2014.
  • "When...(a stock is) priced like a 'going out of business' sale that's the time to take a look at the risk/reward ratio." 
"Cisco's Third Quarter and Cloud Computing," 5/18/2014.
  • Customers apply 75% of their skilled labor to the management of their applications, software layers and infrastructure.  Over time, this ratio must fall to about 25% in order for them to meet the new demands on IT departments.
  • This is the opportunity for vendors like CSCO, HPQ, MSFT, and IBM.
"Cisco's 4Q: FY'14: Low Quality of Earnings Concerns," 8/14/2014
  • Concerns on the analyst call about the effects of software defined networks (SDNs).
  • Switches are 30% of the quarter's revenues
  • Acquisitions mentioned: Tail-f Systems; ThreatGRID; Assemblage, for mobile collaboration.
  • Expect the share price to be range bound between $20-25 for the balance of the year.

Coming into 1Q FY15

  • Facebook's announcement about its new data center architecture was seen as a negative for Cisco's earnings announcement and for sentiment on the stock's prospects: 
"Our previous data center networks were built using clusters. A cluster is a large unit of deployment, involving hundreds of server cabinets with top of rack (TOR) switches aggregated on a set of large, high-radix cluster switches. More than three years ago, we developed a reliable layer3 “four-post” architecture, offering 3+1 cluster switch redundancy and 10x the capacity of our previous cluster designs. But as effective as it was in our early data center builds, the cluster-focused architecture has its limitations.
First, the size of a cluster is limited by the port density of the cluster switch. To build the biggest clusters we needed the biggest networking devices, and those devices are available only from a limited set of vendors. Additionally, the need for so many ports in a box is orthogonal to the desire to provide the highest bandwidth infrastructure possible. Evolutionary transitions to the next interface speed do not come at the same XXL densities quickly. Operationally, the bigger bleeding-edge boxes are not better for us either. They have proprietary internal architectures that require extensive platform-specific hardware and software knowledge to operate and troubleshoot." [I love the unconventional use of the mathematical term 'orthogonal' in the press release]
The bears on all the Four Horsemen of Tech, especially CSCO and HPQ, would say that the mega-users are rebuilding their next-Gen data centers with their own designs, which include more software defined network architectures. (remember the concerns on the prior 4Q FY 14 call)

The 1Q FY 15 Results

  • Revenue of $12.2 billion increases 1.3% over the prior-year period.
  • The gross margin rate of 63.3% is the highest level in three years. (Remember Credit Suisse's projections from 2012)
  • The operating margin rate is 29.2%
  • Switching and routing are 47% of consolidated revenues versus earlier projections of two-thirds. (some of this might be bleeding off into new categories, but it shouldn't be that significant)
  • New product introductions are cited, including ASA with FirePOWER, an industry-first threat focused firewall.  Perhaps the latter feature came from the ThreatGRID acquisition mentioned a quarter earlier.
  • The stock price which began the year at $21.98 is at $26.59 intra-day as of this writing.  The stock indeed had legs in 2014!

What's Ahead?

  • The world won't belong to Huawei.
  • Even thought IT purchasers are taking longer to make their big purchase decisions, very few of them are going to design their own data center configurations.  Mix and matching will have its limits, as IT officers rise higher up in the executive chain with more visibility and accountability for performance and for mistakes. 
  • The succession plan for CEO John Chambers is being signaled as evolving.  The revenue growth under Mr. Chambers has been nothing short of astonishing, although some of it was riding a tech wave for sure.  
  • The next alignment of the executive team, the culture, and the ability to tell their story better will tell all about the stock's price appreciation potential.  Some board refresh would be appropriate.  
  • So far, Cisco has been doing exactly what it said in 2012, which itself is unusual for mega-cap companies.  

Thursday, November 13, 2014

Is Twitter For the Birds?

I recently read Biz Stone's book, "Things a Little Bird Told Me: Confessions of a Creative Mind." As a rule, I avoid business books because of their short half-lives, and in other cases their blustery tones from self-absorbed authors.  This book is relatively short, easy to read, and Stone co-founded Twitter whose market capitalization is $26 billion today.  Stone's personal story is interesting and different from that of the traditional, elitist Silicon Valley entrepreneur.  There are some interesting observations about start-up dynamics, personalities, and product development. I enjoyed the read, and wanted to catch up on Twitter today.

Among my network, there are lots of people who like Twitter for a variety of reasons.  I signed up without a smart phone, found it a bit hard to understand, and I am a member of the inactive users metric category.  Any way you cut it, Twitters valuations are off the charts, and today's junk credit rating from Standard and Poor's isn't encouraging.

In Biz Stone's book, he points out that Twitter's early user base helped define the platform's best features, like the hashtags and retweeting.  At the same time, he notes that the company's developer platform, today called "Fabric," was badly constructed and led to so many system crashes that users went to a site ""

Twitter had created something different, and its 140 character limit, which people loved or hated, turned out to be a real asset.  Users looked beyond the system issues and really became emotionally engaged with the company itself. Twitter goes public, and today it is close to where it started and the sentiment is decidedly negative.

I invested some time listening to a couple of presentations from their recent Analyst Day webcast.

The Public Company

Looking at the board of the company, two of the three (or four) co-founders remain on the board of directors, Evan Williams and Jack Dorsey.  So, in a sense, there should be continuity with the values and commitment to customer engagement which Stone writes about in his book.  

The board of directors seems okay for now.  There are two directors with venture capital and financial experience.  

It seems clear from the capital expenditures for the past two years that the company had been underinvested for some time, which is somewhat consistent with the crashes and continuous fire fighting recounted in the book.  Stock compensation expense is off the charts, but it's also clear that Twitter has built out a real management team befitting a valuable tech company, with the kind of experience it needs to go forward and innovate around its platform.  

The CEO and CFO presentations reflect the CEO's career at Anderson Consulting and they are cogent and pretty self-explanatory.  

The most interesting presentation for me was that of Adam Bain, President of Global Revenue and Partnerships. Given his prior corporate experience, he understands first-hand how advertisers work, think and buy media; he is a board member of the Ad Council.  If monetization is one of his main charters, this is the kind of profile he needs.

Having served as an officer of an NYSE direct marketer and with my analyst bent, I fully understand the importance of metrics.  This is where the bears are feeding on the Twitter story.  But, I also know from being a NASDAQ med device CFO that analysts can fixate on metrics that are important to them but that are not required for profit growth and success.

Some of My Bullet Point Notes

  • Twitter has to become easier to use, for the novice user and for the discouraged, inactive user.
    • Biz Stone noted this from his days at the company.
    • Company acknowledged this under objectives "Strengthening the Core," and "Reducing Barriers to Use."
  • Twitter connects users to their world and to the world, which are different.  The first is served by their current chronological stream of updates, while the latter will be served by tailored or curated products like "While You Were Away" under development. 
  • Their approach to rolling out new products will be to do lots of testing before launch. This was spoken like a real, engineering driven company under some strict development protocols. This can be good and bad; I've experienced the bad, and I suspect Twitter has also.
    • The last observation is based on executive comments about Engineering and Product teams being on the same page, with everyone having visibility into the timelines and to who is accountable.  This can be a real nasty problem, and it sounds like they've taken care of it going forward.  This can be a big deal.
  • An analyst put forward his own metric on minutes spent on Facebook per user log-in versus minutes spent on Twitter; his score card was 40 minutes per user for Facebook and 3 minutes per user for Twitter.  
    • There was a good response about looking at frequency, velocity and distance between visits at Twitter.
    • The best response was "No advertiser buys on the basis of time spent on the site," which is paraphrasing Adam Bain, I think, since the speaker didn't identify himself. 'nuff said.
  • Twitter commissioned interesting neuropsychological research from a British firm
    • Twitter's emotional engagement with its sample users was 75% higher than the baseline sample population for similar brand and social network companies. This difference was the highest in the firm's experience.  Similarly, Twitter users' sense of relevance to their feeds were 51% higher than the baseline norm. Both of these translate into higher level memory retention, or "top of mind" which means more likely action.
    • All of this is very consistent with the stories in Biz Stone's book.  (Look for the story about the tweet "Did you get the pizzas?" )
  • Twitter has 672 million tweets sent out during the World Cup, the most watched sporting event in the world. I think that seems low, since the Cup usually has 900 million+ viewers: they can do better.
    • But, when Luis Suarez of Uruguay bit Italy's Giorgio Chiellini, Twitter users got so emotionally engaged, it triggered a wave of targeted advertising by some of the biggest global advertisers for brands like Adidas, Snickers, McDonald's, and Cinnamon Toast Crunch.  
    • It reinforced the immediacy of Twitter with both its users and the big advertisers who covet the ability to make multiple, direct connections to customers.
  • 70% of their users are outside of the U.S., and the platform will be designed to work even in "low connectivity" environments which means for the emerging and frontier markets. 
  • Analysts worried about their ability to get "free content" from big partners like the NFL.
    • An executive gave a very cogent explanation why a rational mega-player who looked at their ROI would not immediately turn to a strategy of making Twiiter pay for highlights.
  • Great example of a campaign for HP's "bendable laptop."
  • Strong executive endorsements from T-Mobile, Pepsi and General Electric.
    • Quite a spread of industries and customer types.
There's no hurry on this stock and although it appears priced for perfection, it may finally be on its way to becoming a company that creates shareholder value. 

Tuesday, November 11, 2014

Catching Up With the Financial Press: Nothing Has Changed

U.S. equity markets have had five consecutive record closes. Governments in the U.S. and Europe continue to view financial sector public companies as ATM machines, with a steady stream of announcements of higher reserves for legal settlements.  Everybody's happy.  Where are we now compared to the dark days of 2006-2007?

  • Our banking system is more concentrated than ever, with the top 4 banks controlling 47% of domestic banking assets.  Weighed down by an unending stream of regulatory and capital constraints, their business models need revision. 
  • Despite all the research on the role of Fannie Mae and its central role in the subprime mortgage debacle, no meaningful diminution of its role has occurred through legislation or regulation. According to Goldman Sachs in "The Mortgage Analyst," May 2014: "Mortgages implicitly or explicitly guaranteed by the government are 90% of all loans originated, compared to two-thirds before the crisis." To cap it off, a new executive has called for Fannie to once again increase home ownership by loosening credit standards!
  • QE has been a windfall to some market participants but a policy bust.  Even career Fed watchers can't make sense of pronouncements about the path of interest rates.  We have long said there is no fundamental economic case for raising rates. Minneapolis Fed President Kocherlakota let the cat of the bag first when the noted that the Fed couldn't right size its balance sheet for decades.  
  • Europe's Fed-lite and QE-lite have been even worse failures, and their banking system still hasn't done its penance.  What's worse, economic fundamentals remain weak, with capital spending reflecting the negative sentiment of business executives.  
  • The marriage of IFRS and GAAP was called off when bride and groom refused to show and the minister went home.  More than a decade worth of meetings, workshops, presentations, interim proposals, and investors have more verbiage and less clarity in disclosures than ever.  
  • The IMF, of all players, has opined that a risk heat map for some markets like high yield, leveraged loans, and even corporate bonds show levels comparable to the 2006-2007 peaks!
I'm going to cut the list off at this point, but you get the picture, dear reader.  Words over action, form over substance, special interest politics above all, that's 'market reform' American style. 

Tuesday, November 4, 2014

Michael Dell Has Pulled The Wool Over Shareholders--Again

Photo: Damon Winters/New York Times

The New York Times article today is a nice puff piece about Michael Dell's "disdain" for Wall Street and all its "circus clowns," of which there are certainly many, to be sure.  Mr. Dell will try to persuade people that his company is "about far more than the personal computers and computer servers it had been known for, with products intended for things as varied as cloud computing networks of global enterprises and handy personal devices"

What's unusual about all of this?  Mr. Dell's comment that "It is a transformation....he actually started about six years ago, spending $18 billion on 40 acquisitions..."  So, let's get this straight, there was the public disclosure about declining margins on PCs and a gloom and doom future.  Meanwhile, there was an undisclosed, private story built around the acquisitions as a platform for generating significant shareholder value.  This transformation would take time and investment.  Yet, the only thing communicated publicly was gloom and doom and feigned frustration with a faceless "Wall Street."  

Had a coherent plan for long-term value creation been laid out, with numbers, metrics and market opportunities, the shareholder base would have turned over from those playing a short-term rebound in PC volumes and pricing to those long-term shareholders, like Southeastern Asset Management, who did sense that there was more value in the portfolio than the short-term financials demonstrated.

Southeastern would itself have brought other like-minded investors with it.  Carl Icahn would have huffed and puffed, but with long-term shareholders firmly aligned with the founder, board and a few analysts, he would have gone away.  

The fact that Southeastern made the proposal for existing shareholders to retain a stub interest in Dell post-buyout is the clearest indication that they had tumbled on to the value inherent in those acquisitions and in a transformation led by a motivated CEO.  Silver Lake Partners understood the game that was afoot.

Mr. Dell's complaint in the article about a board of directors impeding speed in deal-making and alliances seems hollow and self-serving.  A board approved $18 billion spent on 40 acquisitions, didn't they?  And, it sounds like they didn't really ask too many questions about the stealth six year plan.  If they had, they might not have agreed to the buyout transaction as it was done.

Of course, another benefit of being public is the ability to use stock options to build out the kind of deep team needed to pull this transformation off. In a private company carrying a lot of debt and with a sponsor looking for special dividends and conserving cash, compensation arrangements are more arcane and probably won't extend down into the organization.  

This story continues to be a very cynical one where long-suffering and newer, long-term equity investors weren't treated well.  If the company were to come public in the future, Mr. Dell will use those same Wall Street "circus clowns" he sneers at to tell the public that the new Dell IPO stock is a "Strong Buy."  

Dick Kovacevich On TARP and the Financial Crisis

Dick Kovacevich, the retired Chairman and CEO of Wells Fargo & Company is one of the best chief executives of the hundreds I have met during my career in the capital markets, though I never covered banks.  I heard him tell the story of Norwest Bank for many years, and it was always the same message about the importance of the retail 'stores' and improving the number of relationships per customer. My savvy banking analyst colleague at Roulston and Company held him in the highest regard also, and he didn't hand out plaudits easily. Mr.Kovacevich's  pitch was a model of clarity, simplicity, and focused on a few core metrics. The ROA, with a modest degree of leverage and a portfolio of businesses including asset management, led to a superior ROE: it was beautiful and simple.

When he took on the famous "merger of equals" that was Norwest and Wells Fargo, Kovacevich really stepped on the hornets' nest, but he handled it with brass knuckles in a velvet glove.  Having seen him during a few pickup basketball games, he was unassuming and never drew attention to himself. As a board member at Fingerhut, I know that he was always prepared, engaged and focused on getting the company to do the right thing for all stakeholders; when he couldn't meet his own high standards any more, he left the board. It isn't any coincidence that WFC has been one of Berkshire Hathaway's core equity holdings for many years.  His piece in the current Cato Journal caught my attention, and whenever Dick Kovacevich talks about banking and financial services, it's compulsory listening for me.

In 2009, in the din of drums beating for more special Treasury/Fed/government rescue plans, we stood along side a relatively small minority writing about letting the capitalist mechanism of bank failure under existing mechanisms do its job, as it had done before.  This post, it turns out, is being re-read often today.

CEO Kovacevich was in Washington, D.C. for the 2006 Treasury TARP meeting.  He writes,
"I believed at that time, and I still believe today that forcing all banks to take TARP funds, even if they didn't want of need the funds, was one of the worst economic decisions in the history of the United States."

The Sins of the Few, Not of the Many

At some point, all banking crises have at their root, a crisis of confidence. TARP destroyed confidence in the banking system because the public concluded that all the TARP banks had to be in trouble, otherwise why would they have taken the government's money?   Kovacevich writes that "...isolated liquidity issues turned into a tsunami impacting all banks and industries."

Fewer than twenty financial institutions precipitated the crisis, in his opinion. Dick Kovacevich writes that "The housing crisis got as big as it did...only because of the existence of quasi-public/private entities such as Fannie and Freddie."

Meanwhile, of the twenty institutions he references, half were investment banks and half were commercial banks, roughly. Citi was a commercial bank acting more like an investment bank. Why, he asks, punish 6,000 commercial banks for the sins of a relative few?

Bear, Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and others had liquidity crises. Their funding model where trillions in balance sheet assets were funded by short-term liabilities was toxic, just waiting for the music to stop when short-term funds couldn't be rolled over any more.

Abuse of the Term "Systemically Important."

After more than forty years in the banking business, Kovacevich writes,
"In my opinion, there was not any systemic reason to not let banks fail over this time."
Bear, Stearns which was half the size of Lehman Brothers should have been allowed to fail. Had this happened, he writes that Lehman's assets would have been sold as the BS workout would have provided market guideposts for bidders to price Lehman's assets. Under the secrecy of TARP, there was no transparency, and hence no confidence and hence the Treasury could talk about the lack of  bidders for all of Lehman, which is a red herring and disingenuous.

Regulatory Failure and Incompetence

One quarter after being forced to take TARP funds, Wells Fargo reported record earnings, the highest in the firm's 160 year history.  In less than one year, the TARP funds were paid back, along with $2.5 billion in bank interest cost of funds borrowed, and warrants required as part of the shotgun package for the unused and unwanted funds, were exercised in-the-money. 

When WFC stepped in to rescue Wachovia in the fall of 2008, it took about one week for WFC's auditors and examiners to conclude that expected losses and required litigation reserves would exceed existing reserves by more than $60 billion!  

How, the author writes, could have ongoing examinations by the Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have failed to turn up this deficiency earlier?  

SEC oversight over the Financial Accounting Standards Board failed when it allowed FASB to impose mark-to-market requirements when markets had become frozen (i.e. failed) and unable to generate economically rational prices. All the market participants understood the market failure, but their opposition was cast politically as an aversion to regulation and financial discipline.  

The Fed's proprietary risk models overrode those used for the banks' own stress tests, and yet these models weren't shared with the member banks for comparison and testing.  The helter skelter regulatory regime required major banks to put forward profit and capital forecasts for the May-November 2009 in early 2009.  

The Fed's secret, proprietary risk models concluded that WFC's revenues would be 30% lower than WFC's own internal forecasts!  This kind of discrepancy should have set off alarm bells at the Fed, and making the models available for examination would have been the truly 'scientific' thing to do when confronted by an anomalous result like this.  Regulatory chutzpah, arrogance and incompetence fuelled by populist, anti-bank sentiments and by their highly paid outside consultants, ran high. 

Actual results for the forecast period were 2% above WFC's internal forecasts.

The Office of Thrift Supervision failed in its routine examination and regulation of Washington Mutual, Countrywide, IndyMac Bank, New Century, First Franklin, Option One, Fremont Financial and other sub-prime originators.  We have written about WAMU, Countrywide, IndyMac, and New Century in multiple posts.  Various reports by Special Masters/Examiners and others have made the egregious abuses available for anyone to see.

Things were dire at the massively mismanaged OTS, yet nobody was banned from their industry or prosecuted on the regulatory side. OTS was folded into the OCC: the regulatory apparatus wasn't held accountable or downsized, it just got swept under a rug with a new name.

A Simple Idea To Make Banks Stronger

Mr. Kovacevich notes that the total long-term debt of the bank and its bank holding company plus equity and reserves are broadly about 30% of assets, which should be more than sufficient to withstand even a black swan scenario. 

Debt holders, he rightly observes, contribute more capital and can impose more financial discipline than equity holders through either a bridge bank or through the bankruptcy mechanism.  If one felt that this cushion might not be adequate, the author says that an additional 5-10% holdback on uninsured deposits could be imposed; this proposal has been offered by many academic researchers on the banking system, such as Chicago Booth School of Business or the Columbia Business School. 

Dodd Frank Doesn't Make Our Banking System Better or Safer

25,000 pages of new law have not been translated into workable regulation even after more than four years after passage. Regulators have completed only about 52% of the 398 proposed new rules under Dodd Frank, according to the law firm of Davis, Polk. 

More than 100 highly trained and paid regulators office at, or work full time on the specific accounts of the largest banks on a routine basis.  

Fannie and Freddie are still around, not being wound down.  They have once again received the charter, just before the election cycles, to turn on the spigots and make home ownership accessible to all.  Have we learned anything?  No, but that's not the point in politics. 

I'll be posting on a fascinating book by Charles Calomiris (Columbia Business School) and Stephen Haber (Hoover Institution at Stanford University), "Fragile by Design."  It is a must read for any students of money, banking, financial economics and regulation.  

Thursday, October 23, 2014

A Wow! Quarter for Microsoft

Listening to the rebroadcast of the earnings call without visuals, one could sense CEO Satya Nadella verbally punching the air expressing his pleasure about Q1 2015's results demonstrating real changes at Microsoft in terms of execution, innovation, and putting the customer at the heart of what Microsoft does.  The customer is now regarded as a partner, not just as an ATM.

Look at what is happening to the competition. HP has chosen to split itself apart, which is probably the right action at the right time, but it will distract their customer-facing activities as the go-to-market operations change in size and charters.  IBM finally needs to go CEO Rometty's woodshed and reinvent its market proposition beyond the Smarter Planet commercials.  Cisco sits on its balance sheet and continues to blather on about the "Internet of Things."

Things don't buy hardware and software: people do.  Corporate buyers clearly want more from their go-to providers.

MSFT reported Q1 2015 revenue of $23,201 million, up 25% over the prior-year period, or up 11% excluding the $2.6 billion in Nokia Phone revenue (9.3 million Lumia smart phone units) included in the fiscal 2015 number.  Gross margin dollars increased 11% despite the inclusion of lower margin phone revenue and an unfavorable mix to low end equipment in that business.

Research and Development expenditures of $3,065 million increased 11% over the prior-year period. In addition to returning cash to shareholders, the company sends a message that it will continue to invest in innovation on behalf of the customer's future needs.

$1,140 million of integration and restructuring expense was recorded in the quarter, amounting to $0.11 per diluted share. GAAP diluted EPS of $0.54 in Q1 2015 compared to $0.62 in the prior-year period.  DPS of $0.31 increased by 11% year-over-year.

Apart from OEM Windows licensing revenue declining by 2% and Consumer revenue decreasing by 5% as the transition to Office 365 continues, all the businesses performed well, certainly compared to the competition.

Computing and Gaming Hardware revenue of $2,453 million grew by 74% year-over-year, and the gross margin rate increased by over five percentage points. $908 million of Surface 3 revenue in the quarter continued to demonstrate the potential for a device that can do real work, while having the look and feel of a tablet.

Devices and Consumer Other revenue of $1,809 million increased 16% year-over-year.  Search advertising revenue increased by 23% and Bing's share of U.S. search increased 140 basis points to 19.4%.  7 million Office 365 subscribers increased 25% sequentially over the prior quarter.

Finally, the Commercial Business revenue of $12,280 million increased a solid 10% over the prior-year period. Server product revenue grew 11%, and revenue increased across the range of servers from SQL to the newer, data center-oriented specialty servers.

Other Commercial Revenue of $2,407 million increased 50% over the prior-year period, driven by Commercial Cloud revenue growing 128%. The CEO noted in his remarks that 80% of the Fortune 500 use Microsoft's cloud infrastructure and services, while at the same time it was noted that the Azure pay-by-usage computing model is enjoying significant penetration into start-ups.  With Amazon's recent record losses, one would suspect that its commodity cloud services might be looked at askance as that company comes under pressure for its suspect business model.

Free cash flow in the three months ended September 30, 2014 was $7.1 billion, and $2,307 million in dividends were paid and $2,888 million in common shares were repurchased.

Finally, two new board members were joined the Microsoft board, both of whom add professional profiles and board experience that should serve the new CEO and the management team well.  Charles Scharf is the CEO of Visa, and he held senior executive positions at Bank One Corp., JP Morgan Chase, and Salomon Smith Barney.  Financial services companies with their massive volumes of transactions and their growing need for robust data security should be prime customers for Microsoft's commercial data center and cloud offerings.  Teri List-Stoll is the CEO of Kraft, Inc., and her twenty year career at Procter and Gamble should give her insight into the management and development of brand equity for consumer products; her service on the Danaher board is also useful because Danaher's culture ( which centers on the customer, measures efficiency and performance, and looks to optimize the portfolio is consonant with CEO Nadella's aspirations for the future Microsoft.

Overall, this quarter, especially in the current tech environment, demonstrates exceptional focus and performance across Microsoft, both in its business execution and its governance.  

Tuesday, October 21, 2014

IBM Folds the Road Map Hand

As far back as 2012,  we questioned the utility of the 2015 Road Map and its construction. Back in 2013, after CEO Virginia Rometty's overly enthusiastic presentation at Innovation Day, we felt that IBM may have been losing its way.  With the announcement of 3Q 2014 EPS, the Road Map has finally been abandoned. Better late than never.

The CEO's coming on to the investor conference call breaks with an IBM tradition: what a lousy tradition that was!  Abandoning the Road Map, though it came late, perhaps finally symbolizes CEO Rometty's uncoupling from the heritage of her predecessor, under whose leadership the company failed to act on a clearly emerging change in the demands customers would make on their key vendors for IT hardware, software, and services.

Shares outstanding have been reduced by a staggering fifty percent since they beginning of the mega-programs. We have written about these before, so need to go over the ground. Hopefully, it will become less of a focus.

We have always talked about the need for the Tech's Four Horsemen to reinvest in their core businesses, if indeed they want to stay relevant to their customers.  The good news is that IBM, in the CFO's prepared remarks, made specific reference to some sizeable initiatives:
"In the first quarter, you’ll remember that we announced a number of initiatives that
support the shift to our strategic areas of data, cloud, and systems of engagement.
These included the launch of Bluemix, which is our cloud platform-as-a service for
the enterprise, it included a $1.2 billion investment to globally expand SoftLayer
cloud hubs
, and it included a $1 billion investment to bring Watson’s cognitive
capabilities to the enterprise
. In the second quarter, we made progress to
implement these initiatives, including in June, Bluemix became generally available,
we opened new SoftLayer data centers, we started to ship POWER8, and expanded
the OpenPOWER consortium, and we completed substantially all of the divestiture
of our customer care business.
More recently, we announced additional actions to continue our shift to higher
value. You saw last week that we are investing $3 billion over the next 5 years in
research and early stage development to create the next generation of chip
. Those will fuel the systems required for cloud, big data and
cognitive systems.And just a couple of days ago IBM and Apple announced a strategic global partnership to provide a new level of business value from mobility, for enterprise
SoftLayer was a big deal acquisition, and making these investments confirms the commitment to add value to it, not just to book revenue.

The next thing the CEO needs to do quickly is to act on something she noted in 2012, the irrelevance and misalignment of the go-to-market model of the old sales force.  Customers are crying out for a change: make it easier to deal with you and to figure out where our ROI lies!

Tuesday, October 14, 2014

T-Mobile Still Rudderless

T-Mobile's meringue-like offer from a French billionaire evaporated, since it was all spidery sugar and so substance.

The company's network is still woeful compared to its competitors, and it has dead spots in major metros and is often more challenged in buildings than its competitors.  Despite disingenuous promises from its CEO, it's only strategy now amounts to giving away data and grabbing more unprofitable subscribers.

Meanwhile, Deutsche Telekom's ownership of an established carrier in a major market has added no value, and their continuing, failing efforts to divest their stake also drives down TM's value.

Wireless needs to be priced like any other utility: giving away more and more goodies to no-profit customers will do nothing to provide funds for building out the network.  TM seems to be stuck in the worst place now, despite all the CEO preening for the cameras.

Friday, October 10, 2014

The Strange Tale of UBS

UBS, as a global bank, has enjoyed a cachet among its high net worth customers in the wealth management and asset management businesses, while U.S. investors have never warmed to its name as a core holding in their institutional portfolios.

Today's New York Times has a disjointed piece on UBS which does nothing to make the investment case for the 'new' UBS, and it shows the continuing disjunction between traditional banking businesses and investment banking.

We learn that in 2011, the current CEO Sergio Ermotti embarked on a strategy to reduce risk-weighted assets that was mandated by Basel regs.  A foundation for accomplishing this was to cut costs, exit capital intensive businesses, and to focus the portfolio on businesses like wealth management and asset management, alongside a smaller, more focused investment bank.

In 2012, we learn that the CEO recruited Andrea Orcel, a long-time Bank of America executive, to head up its investment banking operation.  Here is Morningstar's take on the recent history of the investment bank's contribution to consolidated UBS financial results:
" Investment banking is a risky activity that can cause very large losses. Between 2007 and 2009, UBS lost nearly CHF 30 billion and required a government bailout as a result of its investment banking losses. In addition, losses in investment banking indirectly affect the private bank. UBS was among the banks hardest hit by asset write-downs, which has damaged its reputation as a competent asset manager, and the 2011 rogue trader scandal set back its recovery. UBS suffered nearly CHF 400 billion of net asset outflows as a result of its damaged reputation. UBS' move away from the riskiest investment banking activities, especially those with long tail risks, should help to reduce the risk of further damage."
Naturally, the investment banking business had the normal global, economic cycle rebound in worldwide fee revenue, and it led to Mr. Orcel becoming the highest paid corporate executive in the bank, despite the fact that apart from some some timing and cost-cutting he hadn't done anything very extraordinary. We've written about cultural problems when global investment banks are put together with more traditional banking activities, like client wealth management services.  Shareholders haven't done well, even recently.

Morningstar notes that for the fiscal 2014 second quarter,
 "Return on equity was disappointing at 6.4%, and excluding the litigation provisions doesn’t help much--we estimate that pro forma return on equity was 8.1%, well below UBS’s 12% cost of equity."
So, no EVA inside this combined operation.

We learn that an activist shareholder with 1% of the equity, wants to have two securities, one for the investment bank and the other for the wealth management and asset management businesses; the shareholder could then decide which business they really wanted to own and sell the less desirable one.

The CFO responded,  “We have zero intention of changing our strategy,” said Tom Naratil, UBS’s chief financial officer. Of course not.  The current deal is unbelievably cushy for the entrenched management and board, and it's unlikely that given the regulatory scrutiny on the combined entity along with the history of prior management turnover, another change would be countenanced by shareholders.  The company's presentations assert that financial results would be stronger in a rising rate environment that could come by mid-2015, if Fed watchers are right.

So, investors have a Wealth Management business with extremely attractive returns, According to Morningstar, returns on attributed equity in the Wealth Management business are regularly in the 40% range, and even during the heart of the crisis they were in the mid-teens!  This is a business to own. Investment Management is also a fine business with excellent margins and sticky customers.

Investment banks should be run as partnerships, as they were in the good old, white spats days.  This would, of course, shrink their global reach and risk-based prop trading, but for the public shareholder these aren't attractive businesses to own because of their high fixed costs, volatility, and capacity for major surprises, not to mention a heightened regulatory scrutiny.

Morningstar's Stewardship rating for UBS went from Poor to Standard.  I guess that's progress.

Tuesday, October 7, 2014

Our Futility Against ISIS

ISIS continues to be in the news, and Americans will soon tire of hearing the drumbeats when it becomes evident that progress one day is offset by the entity growing new tentacles and stinging the civilian populations in new ways.

Since our military intelligence and foreign policy machinery are equally ignorant about all parts of the world, perhaps we should be talking with the French, after all they held the Syrian and Lebanese mandates for quite a while.  What do they think about our publicity-seeking efforts to bomb ISIS into submission?  I suspect that it's not very much. 

Some newspaper reporters rightly raise the point that without having President Assad stop his brutalization of his own population and determining desirable options for his transition, a blind campaign of bombing from on high will produce neither change nor retreat by ISIS. 

The other obvious question is who is funding ISIS beyond its own internal cash generation from kidnapping for ransom and selling stolen oil in Turkey?  

NBC News has mentioned wealthy nationals from Qatar.  Ironically, Qatari desires to form an Islamic State in a region combining Syria and Lebanon plays a role in a novel by the French author Gerard de Villiers, "Madmen of Benghazi," linked above.  This novel has been around for a while.  

Maybe we should be paying an official visit to Qatar and and request that they do start enforcing their own laws against funding political regime change against their own Arab neighbors.  

Sunday, October 5, 2014

HP Comes Full Circle

The whisper wire says that "Hewlett-Packard Plans to Break In Two." The stock has done well off its lows, and shareholders have been returned significant free cash flows through dividends and share buybacks, while corporate bondholders have also been satisfied with their holdings, despite some concerns about bondholder unfriendly payments from free cash flow.

So, we have gone all around the mulberry bush. In the first half of 2012, bearish analysts were calling for the sale of the company in parts, which they claimed would be worth more than the consolidated corporate equity's value at the time. This made no sense. Fortunately, neither the board nor management bit on the fire sale scenario.

The bullish analysts believed in the single powerful vendor selling the full line of hardware, software and services for the enterprise and for the consumer.  It wasn't obvious to us that sophisticated buyers would build their IT infrastructures on this "one stop shop" model, either.

It made more sense to us to focus on the financial stabilization, improvement of core metrics, and pruning the portfolios of marginal businesses, and focusing on faster innovation, even as the CEO touted HP Labs.

In the first quarter of FY13, we wondered if the realignment of some sector reporting pointed to future divestitures. But during the same conference call, we also noted that,
"The CEO clearly rejected any conversation on the call about breaking the company into pieces or divesting large businesses like Personal Systems and Printing."
In between these points, there were also regular allusions to the need for significant acquisitions, despite the colossal failure of the Autonomy acquisition.

So, today, coming full circle, HP has leaked the news that it will split itself into two companies: a PC/Printer business and an enterprise company, with the PC/Printer business being dividended to shareholders through a tax-free distribution.  Well, it isn't technically a divestiture. And, this way, the management of the PC/Printer business can continue to improve its business using the large free cash flows from printers and supplies, while eventually selling itself at a much higher price than would have been the case in 2012.

What is surprising is that the SEC/IRS would have agreed that the two businesses had been operating separately and distinctly from each other before the transaction.  The company itself said that HP was calling on global IT companies with one voice and one product portfolio.

Who gets the debt? Are bond covenants conveniently renegotiated?  What is the most important factor in the success of this deal going forward.?  The inter-company agreement must be thousands of pages long.  The settlement of the power struggle in the terms of the agreement will give important clues as to which company gained at the expense of the other.

The Journal's reports of customer comments like these are a sad commentary,

  • “What I really noticed is that they had not evolved their products, and they were not necessarily involving their customers, who wanted to help them.” Senior Data Architect, Coach, Inc.
  • HP has been slow to embrace the cloud, and it lacks certain capabilities of rivals.
  • "slow to react to market forces"
Selling the company for parts wasn't the right strategy.  Improving the company has paid off.  This latest announcement says that continuing the current operational plan would be a long slow grind. It will be interesting to hear management talk about how the two companies will work together, post the spin off. 

Friday, October 3, 2014

Berkshire's Model Moves to Cars

As the market moved way past emotional fatigue with the Pimco story, Warren Buffett is beaming about his acquisition of the $8 billion van Tuyl auto dealership empire.

Certainly, generational transfers of ownership are an attractive timing feature of getting into the business, but it has to be an attractive business and one of the best in breed.

What's attractive about auto dealerships?  Americans, and indeed much of the world, have automobile ownership built into our genes, and it has spread down into more multivehicle households than anyone would have predicted years ago.  It is a consolidating business, with GM having too many dealerships, yet their vehicles will need to be sold.

The service portion of auto dealerships is far south of sub-optimal, and waiting for innovation.  Perhaps Berkshire can spark real growth in this business, which is where most dealers make their money. Even this business can become more attractive for consumers to go to their dealerships as opposed to their neighborhood shops if the dealers would stop gouging.

Finally, the financial services aspect of dealerships is dominated by the manufacturers captives, but with Berkshire as a large auto insurer through GEICO, there are many paths to rolling out more products through relationships at the dealer floor and at the insurance office.  This is probably where some of the immediate magic will come from.

Increasing scale will only give Berkshire's new auto CEO more leverage to build a better model of the auto dealership.  No matter how hard the business is, or how bad the economic times, dealers make a profit.

All of these features suggest that this new frontier for Berkshire is a promising one.  I still don't get the newspapers, though.

Tuesday, September 30, 2014

Pimco Executives Hit the Phones

The Wall Street Journal says that executives at Pimco are hitting the phones trying to staunch the outflow of more than $10 billion from the Total Return fund. The CEO is even talking to brokers himself!

Maybe this is the kind of "all hands on deck" connect with the customers tactic that wasn't implemented when more than $65 billion left the fund before.  Perhaps this is why BG got very upset with the marketing executive and the CEO himself?

Seems like a reasonable hypothesis, doesn't it?

Monday, September 29, 2014

Missing the Mark on Medical Device Marketing

The Wall Street Journal headline says "Medical Devices Lack Safety Evidence" according to a study, not from an academic medical center or high powered clinical research group, but from yet another policy think tank.  It is very disappointing, and it isn't up to their usual journalistic standard.

Safety and risk profiles are reflected in the Class ranking of medical devices: Class I (bandages and surgical gloves, for example), Class II (e.g. infusion pumps and surgical drapes) and Class III(e.g. heart valves, stents, and orthopedic shoulder replacements).

The story reports the following:
"Most devices can get FDA clearance simply by showing that they are roughly equivalent to another product, called a predicate device, that is already on the market. The theory is that if the older device has proved safe and effective, the new one should be also."
"Most devices?"  Yes, a new surgical drape or a guide catheter won't require a full fledged IDE study; that would make no sense, there would be no reason to ever change an old technology, even if materials improved or manufacturing methods allowed miniaturization.  "Roughly equivalent" is the term of a bad journalist.  The FDA guidance says,
 "If FDA agrees the new device is substantially equivalent to a legally marketed device for which premarket approval is not required, the manufacturer may market it immediately."
Were the rule otherwise, the accidental company that came first to market would argue that everybody else required a full fledged IDE study for their improvement or enhancement.  Patients and innovation would suffer for no reason.

Class III medical devices rarely fall under the 510(k) labeling, because of their risk category.  The nature of the clinical study may be different.  All of this falls under the review of FDA staffers, aided by medical consultants, and in the case of companies pushed down the IDE path, a long, expensive, arduous and risky clinical trial path.

The 510(k) substantially equivalent pathway can involve bench data, lab studies, computer simulations, animal studies, or some combination of all.  Reviewers often add more questions and require additional data after the study process has begun.  Having been through it a few times, it is a bit arcane, and having "the public" read a bench study about laminar flows for a company's device adds nothing to the quality, cost or safety of patient care.

Post-market surveillance of cleared devices is definitely one area that needs to be improved, with more burden placed both on the device developer and the medical institutions that use them.  The premarket approval process itself could be made a bit more consistent.

And, a really significant problem is turnover and under staffing at the FDA itself, which I can say from experience, is widely acknowledged but not successfully addressed.

Saturday, September 27, 2014

A Final Word on Bill Gross

Well, it is too bad, but as always happens in the world of Wall Street finance, it is all about personalities.  Wait, that describes politics too, but that's another discussion. Some final thoughts.
  • As a fixed income investor, a CFA charter holder, Bill Gross has proved his mettle more than any investor as his industry. His industry awards are testament to this, as any unbiased observer would have to admit.  
  • The statement in the press release outlining his departure from Pimco was petty and small minded.  Objectively, without the personal investment management and asset attracting talents of Mr. Gross, there would have been no blockbuster, mega-sale to Allianz, which made his allies and detractors very rich.  This should have been acknowledged, and this shows that the CEO doesn't have a generous spirit, no matter what the simple business decision taken. 
  • The culture at Pimco involved, according to the press, lots of shouting and berating of subordinates, colleagues and superiors.  Except for the superiors part, anyone who has worked on Wall Street knows that this is part and parcel of the everybody culture. Were Hunter S. Thompson still alive, he might have written "Fear and Loathing on Wall Street." 
  • For Bill's part, it's not a good idea to yell at your CEO or your board members: definitely a lack of EI, likely under duress. Inexcusable, unproductive, not worthy of him as a person or as an executive.  
  • It is hard to understand the outflows from Total Return given its long-term track record, and it should have been a matter of the institutional sales and marketing teams getting behind this to prevent it. Corporate buyers of investment management services are very sticky, even in the face of bad long term performance.  The pension consultants needed hand holding to head off the outflows.  The stories of yelling at these functions seems understandable.  Was there accountability here?
  • I didn't know that the equity funds launch was Mr. Gross' idea, according to the press. This is unsubstantiated and hard to believe, a side issue nevertheless, as he wasn't responsible for managing their ineptitude.  Again, the marketing of these funds was terrible.
  • It will be interesting to see what happens to the management of Harbor Bond Fund.
  • If all of this inner turmoil was going on for so long, then the board and CEO were not up to their tasks, which was to bring back unity and stability in the locker room.  They failed.
  • Working for Jeff Gundlach, who himself left his employer in a huff without anywhere near Bill Gross' track record, was a non-starter.
  • Janus may be a non-starter, unless Bill Gross does better with his yoga and re-centers himself. He and I had a short correspondence way back when about yoga and meditation.  I think he disconnected the asanas from the spiritual development piece.  They are inseparable. 
  • It's all unfortunate, but in the end, nobody is indispensable.
  • Pimco should lose assets, as whoever takes over Total Return or a clone, can't really claim the historical performance record of Bill Gross, according to how I read the II performance reporting standards.  Instead (s)he will have to articulate their own investment strategy and improve transparency, which was always frustrating when reading the Total Return fund's reporting.
Sayonara, Mr. Gross.  Less time in headstands and more perhaps in seiza. Investors start checking your quality bond fund alternatives.  The universe isn't as big as it should be.  

Friday, September 26, 2014

Bill Gross Leaves Pimco

Back in January we posted our answers to the question of "What's Wrong with Pimco?"  One of the issues was succession for Bill Gross, and that was answered today as the author at the top of our fixed income reading list for the past several decades is leaving to go to Janus.

Again, it has little to do with fund outflows and all to do with organizational issues at PIMCO and perhaps a heavier hand being exerted by its German owners.

We wrote about Pimco's astonishingly inept roll-out of equity mutual funds, and the wave finally hit their bellwether product the Total Return Fund and its high profile manager.

Janus was a hugely mismanaged organization for decades, but perhaps it is living up to the name of the Roman god of new beginnings with the hiring of Mr. Gross.  Love your essays, Bill!  Keep 'em coming.

Revisiting Marissa Mayer

Calls by some shareholders to receive most of the money from Yahoo’s sale of a stake in Alibaba could limit the options for Marissa Mayer, chief executive.

Jason Alden/Bloomberg via Getty Images and the New York Times.  

I thought Yahoo's appointment of Marissa Mayer as CEO a few years back was a great move for the company and would bring a sharp, decisive, enthusiastic leader to the company and perhaps to other corporate boards.  The first thing I notice from this New York Times photo and story is that the gleam has gone from her eyes when compared to her taking the reins at Yahoo.  There is clearly a look of weariness, perhaps even resignation.

The articulation of a clear direction for the Yahoo turnaround, milestones and a fast pace of change have all been missing.  One analyst says that Yahoo needs to be "rewired."  But everybody knew this years ago, and it seems incredible that so little has seemingly been accomplished.

I also guessed that her having been in the Google inner sanctum would have been a source for inspiration, guidance, and even partnership in some areas.  Yahoo seems like the armadillo walking slowly down the center line on a Western highway while the semis roar by.  

The acquisition game from here is riskier than a few years ago. For Yahoo to move its needle, a big acquisition is required, but those will have a variety of suitors, all of whom are stronger financially and organizationally than Yahoo. The limited track record so far hasn't been good.

As the Yahoo CFO points out, shareholders don't need to whine incessantly because $1.3 billion has been spent on acquisitions in the past two years, versus returning $6 billion to shareholders.  Ms. Mayer shouldn't obsess about a fifty-fifty split in free cash flows, but she needs to start articulating her playbook in greater detail.

I wonder if her management team has the right roster with the right incentives. I would guess not, otherwise you would read more about them in the press.  I don't want to look up their board members, because they clearly haven't been doing their jobs if the CEO looks wan and beleaguered by shareholders after the stock has bounced off the bottom due to the Alibaba stake. 

Here's hoping for some positive changes and good news. 

Monday, September 22, 2014

Fed Policy Risks

Back in 2011 we were pretty lonely writing about the future risks of the unprecedented monetary accommodation that became today's monetary policy. We noted this comment from Minneapolis Fed President Kocherlakota,
"In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before."
He was right and he was early: it made perfect sense to me, but this view was quietly squelched with assurances that the Great Unwind would have several tools in its armamentarium.  Hold this thought as we summarize the Fed's policy risks from Dr. Ward McCarthy of Jefferies.

Ward says that the Fed's recent parsing language meant to say that it is "in no rush to raise rates."  We have long said that there is no fundamental economic case for raising rates.

To the point above, McCarthy says "unwinding this extraordinary accommodation carries...risks that policy makers had not previously had to consider."

He says that if the Fed waits too long to raise rates in response to rising inflation, the markets would overreact and a subsequent move would be roiling to bond markets.  This risk, in my opinion, is one of the lower ones.  There are many data points for inflationary changes, both real and in expectations. At present, there is almost no sign of economy-wide pressure from commodities, wages, or capacity constraints, which are the traditional harbingers.

If the Fed were to remove its accommodation too early, and the economy were to again enter a recession, it would very few options.  Negative rates, Dr. McCarthy says, are not politically or institutionally feasible in the U.S.

The Fed has now defined the federal funds rate as the key policy rate.  Dr. McCarthy agrees with us in saying that the reverse repo facility tool is not the best solution resetting the floor for interest rates. He notes that Fannie, Freddie and the Federal Home Loan banks are not eligible to collect interest on their reserves at the Fed.  Given their continuing enormous influence in the housing market, this makes the RRP program of limited reach, not to mention risky to the system, as others have written.

The IPO market's backlog will comfortably start coming to market given the benign outlook from the Fed.

The Chinese Government as Partner for Alibaba.

In yesterday's post, we made the point the smartest thing Alibaba CEO Jack Ma did was to cut the Government of China in as a partner, but we also cited the risk of their exercising a Godfather-like call on shareholder assets at a time in the future.

Today's Wall Street Journal, coincidentally, picks up that very same point and expands it.

Watch for that unanimous panel of Buy/Strong Buy reports from Wall Street.  Look for significantly under valued assets like the payment system and the opportunities of building their own fulfillment system in China.  Expect the same investor behavior as in the halcyon days of Mary Meeker and the earlier dot com frenzy.

Sunday, September 21, 2014

Looking at Alibaba 38% Higher

Alibaba's IPO predictably blew the doors off, up 38% after the first day close with market makers doing their best to rein things in from super heating. Aside from the scale, which is inevitable from the passage of time with markets, it was all pretty much according to the Wall Street script.

Of course, things should go swimmingly for a time, otherwise lynch mobs would be seeking the bankers with malice in their hearts.  But, a quick look at Alibaba's press says that the story has legs in the medium term.

The Wall Street Journal curiously takes the position that "this time it's different." Shareholders needn't worry.
"But shareholders can choose whether to live under these limitations (structure, governance, no voting power for the common....). They understand the convoluted workaround was dictated by Chinese law, which restricts foreign ownership. And, let's face it, when investors begin to worry about the actual rights specified in a share agreement, it usually means something has already gone seriously wrong.
True comfort for shareholders comes not from legal boilerplate, but from incentives. Alibaba founder Jack Ma could take the $22 billion raised Friday and stiff his foreign partners. That's a risk. But his self-interest is otherwise. He wants a strong stock as a currency for acquisitions. He wants stock options to motivate his increasingly global management team. He wants easy liquidity for himself and other insiders.
Of course, a lot can go wrong with a company, and Mr. Ma told a road show audience last week that his most important task was government relations back home. That's another risk. But Chinese officials have incentives too."
Common shareholders claims on their company are residual.  They don't have the covenants, protections, clear judicial means to exercise their claims, and even claims on specific assets, as some other investors do.  Something clearly has gone wrong in this structure, for the common equity investors, but they don't care because everybody knows the short term outlook should be a lay up.

I wonder if the Journal remembers the agency problem.  Incentives existed for the managements of AIG, IndyMac Bank, Bank of America, Countrywide Financial, Metris, Green Tree Financial and so on endlessly, and that's just for financial services.   The boards did not represent shareholder interests and rein in their managements.  I would bet that few shareholders of Alibaba could name one of their corporate board apart from Mr. Ma.

"A strong currency for acquisitions."  The management of every public company wants the same thing.  It's no magic elixir.  Remember HP? Remember Compaq and other failed acquisitions before their currency became seriously devalued?

The smart but inevitable move that Mr. Jack Ma made was to cut the Chinese government in on his deal. The selected list of Chinese officials was not created by accident.  It is why Mr. Ma spends so much time on government relations back home.

The payment network may be an undervalued jewel.  The money market mutual fund may revolutionize investing in China.  Unless the Chinese government decides at some point that this capitalism thing needs to have its model adjusted. Years from now?  Probably, but at some point inevitably.

At some point when Mr. Ma is the wealthiest man ever in recorded history, will the siren song of marginally more money still attract him?  What if he decides to invest money, perhaps with the encouragement of the Chinese government, on Chinese tourism to Mars?  What if  his vision and attention wanders to personal causes?

Governance often becomes boilerplate because that makes careers for politicians and their cronies, but it is really about meaningful, properly defined rights and obligations, the right people and the right processes to manage a company in which shareholders get a strong say.

Prediction: 100% of the analyst reports will be Buy or Strong Buy.  There are no new tricks on Wall Street: only the names, dates and scale changes.

Thursday, September 18, 2014

Alibaba: Open Sesame To the Uber Humongous IPO

In a recent post about emerging markets as an asset class for foreign equity investors, we wrote about some things they should look for in selecting their markets and their issuers:
"In order to translate these into growth in corporate earnings and portfolio returns, investors need: political stability, strong respect for property rights, effective dispute resolution, a predictable regulatory and tax regime, a positive foreign investment climate, efficient markets, strong corporate governance, reliable corporate auditing and financial reporting, ethical managements, transparent corporate structures, and economies balanced between exports and internal consumption. Divining the strengths and weaknesses of an EM in these areas can only be done by active management, with experience in the markets, boots on the ground and a disciplined investment process." 

Despite the fact that the Alibaba IPO will be a record breaker in all investment banker metrics, it seems to lack these basic, critical features and it seems ripe for momentum investors and flippers, aka hedge funds.

A June 2014 staff report of the U.S.-China Economic Security Review Commission goes into the issues clearly and raises the potential legal, investment and governance issues for U.S. investors.  The Chinese government itself makes it a public policy to keep foreign equity investors in disadvantaged positions in their companies.  Yet, Chinese Internet companies have pursued foreign listings with a structure called Variable Interest Entities, which the report says may in fact be illegal under Chinese law.

Templeton's Mark Mobius points out the two-tier equity structure that clearly entrenches management and gives it and the preferred class effective control over corporate assets.  Disputes, he notes, must be settled in Chinese courts, despite the overseas listings.  Good luck with that venue for the poor common equity investor.

The reporter interviewing Mr. Mobius notes that Hong Kong regulators passed on allowing Alibaba to list on their exchange, in part because of the opaque corporate structure.  Asked why U.S. regulators allowed the listing on NYSE, he quietly notes several points, which I may paraphrase a bit:

  • U.S. markets have never reformed, post-crisis.
  • U.S. regulators serve their customers, namely the broker-dealers and their investment bankers.
  • Out equity markets are driven by short-term investors who will flip the shares.
Ironically, some part of Templeton may get a few shares and flip them too.  If they are passing out free candy, why not take it?  But, the comments are sobering coming from one of the oldest companies in the emerging foreign equity investment business. 

Professor Anant Sundaram of Tuck Business School has made comments on the deal from the governance standpoint that worth reading, published in Barron's and the New York Times. 

When Ali Baba opened the door, it was to a wonderful land.  It will remain so until the door closes and investors long to return to the other side.