Friday, June 13, 2014

HP's Business Risks

The "Risk Factors" section of a company's 10-Q is almost always a cover the waterfront, throw in the kitchen sink list that, once drafted at the behest of corporate counsel, is too rarely refreshed.  According to the securities regulations, however, it must bear some relationship to reality.  In that spirit, we looked at this section in the company's most recent quarterly for Q2 2014.

If we are unsuccessful at addressing our business challenges, our business and results of operations may be adversely affected and our ability to invest in and grow our business could be limited.
Three broad categories are discussed:

  • Dynamic and accelerating market trends, but especially "the market shift to cloud-related infrastructure, software, and services, and the growth in software-as-a-service business models. After all, the CEO has said that this is the single most significant business development she has seen in her career. 
  • Major competitors, e.g. IBM and Cisco, are expanding offerings of integrated products and solutions.
  • Business specific competitors are targeting specific areas of HP's portfolio and going after new markets.
  • Emerging competitors are introducing new technologies and new business models
  • The final set of challenges "relates to business model and go-to-market execution."
The reference to business models is interesting: what does it mean?  It surely cannot refer to Software-as-a-Service, as this has been bandied about for a decade or more.  It also appears in relation to outside competition, and in the final bullet point as an internal challenge.  I believe that this could refer to the antiquated sales model in a large organization like HP, where sales forces are organized by consumer versus enterprise, by product, by customer size, geography, public versus private enterprise, and by product versus services.  Sales force effectiveness is often referred to in CEO code as "execution," which we have often heard from the CEO of IBM and the CEO of HP recently.  

Competitive pressures could harm our revenue, gross margin and prospects.
 "We have a large portfolio of businesses and must allocate resources across all of those businesses while competing with companies that have much smaller portfolios or specialize in one or more of these product lines. As a result, we may invest less in certain areas of our businesses than our competitors do, and these competitors may have greater financial, technical and marketing resources available to them than our businesses that compete against them. Industry consolidation also may affect competition by creating larger, more homogeneous and potentially stronger competitors in the markets"

This seemingly boilerplate paragraph addresses some of our repeated concerns.  HP's CFO has repeatedly made reference to decisions about share repurchases and other investment decisions being "returns based." HP's portfolio has some businesses that are being obsoleted by technological developments or changing customer requirements, e.g. UNIX based servers, developer reluctance to write new software for Itanium products, or lower demand for hardware being switched to cloud-based configurations. There is little reason to invest in these businesses from a returns standpoint.  The market will prune these parts of the HP portfolio.

There are other parts of the portfolio that HP should probably prune itself, like portions of Enterprise Services. 

HP has invested $1.4 billion through the first six months of fiscal 2014 for share repurchases.  There is no reason to make the suggestion that HP is at a disadvantage compared to competitors because it has to invest across a broader portfolio.  If "more homogeneous" competitors are potentially stronger, then surely HP can become more homogeneous, if the numbers and the customers will support this.  This shouldn't be a risk, nor should it be an excuse.  

Research and development expenditure of $873 million in 2Q 2014 increased 7.1 % year-over-year. Should it increase faster?  A big acquisition at this point, beyond the financial and integration risks, seems like it is unlikely to be successful because if the target had an entrepreneurial culture, it would have a difficult time maintaining that spirit in a behemoth that is in a continuing human capital restructuring that has just been extended.  

The post about 2Q 2014 is our jumping off point for this post, so have a look back. HP's evolution from this point forward has to move beyond quarterly guidance and forecasts.  The company is on a stable footing, and the financial risk has been sharply diminished, at great credit to the management.  However, from here it really has to be about a much more focused and clear picture of the future portfolio and investment requirements going forward.  

Wednesday, June 11, 2014

The Uber Tech Bubble

We know from the soporific testimony of former Federal Reserve Chair Alan Greenspan that even the wisest economic oracles and policy wonks can't identify a financial bubble until it has burst.  (This theme is explored in Bill Fleckenstein's "Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve," 2008.)

Years after the global financial management elite are just wiping the soap off their faces from the detonation of the Uber Bubble of 2006, comes what surely seems like deja vu: the $18 billion implied valuation of Uber, the car service.

What is amazing, besides the valuation, are the leaders of the financing round: Fidelity, Wellington Management, and Black Rock. Fidelity once had a value focus, but one could argue that with the growth of Contrafund that it is a growth shop.  Wellington Management was certainly for decades a poster child for Graham and Dodd valuation optics.  I guess that this deal was too good to turn down.

The writers at the Wall Street Journal are trying to sound cautious about this story, but they then bend over backwards to suggest that the valuation might be conservative!  "Some say...." as the saying goes.

The company is already cutting prices by 20% in some markets, perhaps addressing the obvious concerns about the effects of competition.  It is also pitching the story as being one of creating markets, not providing taxis-on-demand.  Part of the pitch made Uber sound like a C.H. Robinson/Expeditors International model for transportation services.

A 20% take of gross proceeds seems pretty outlandish, and somehow the cost of taxi medallions in New York City isn't responding to the alleged inroads of Uber.  Perhaps that is an inefficient market, but it does seem odd.

A stat was quoted about drivers grossing $90,000 or more per year.  That would imply more than $112,000 in annual fares, or $56 per hour average.  Allowing for cruising and dead-heading from airports, that suggests the fares are pretty high.

But who know?  This could be the next big thing, like "Ask Jeeves."  Or, it could be the next Amazon. Why couldn't Amazon launch a service like this?  Never mind.

Vergara vs. California Shines a Light

L.A. County Superior Court Judge Rolf Treu's decision in Vergara v. California makes for compelling, if sometimes tragicomic reading for anyone interested in the public education leviathan that consumes such vast resources with soaring costs, poor results and no accountability.

Beginning with 1954's Brown v. Board of Education Judge Treu notes its conclusion that inherently unequal facilities denied those students the equal protection required under the 14th Amendment.  Education, then stated as the most important service produced by the public sector, was to be made "available to all on equal terms."

This suit focused on challenging three statues, "permanent employment," "dismissal," and "LIFO."  When these are actually read in print and examined in basic terms, as Judge Treu does, they defy the notion of being being enshrined into state law by a legislature claiming to represent the best interests of students in public education.

"Grossly ineffective teachers" are found to have a disproportionate impact on schools serving predominantly low-income and minority students.  A study by Harvard economist Raj Chetty is quoted where he concludes that a year with a grossly ineffective teacher costs $1.4 million in lost lifetime income per classroom.

Another study, put forward by representatives of the educational establishment, cites evidence that only about 1-3% of the total teacher population are in the class of grossly ineffective.  This amounts to 2,750-8,250 teachers in total.

According to the Wall Street Journal,
"L.A. spent $3.5 million between 2000 and 2010 to fire seven teachers for poor performance. Yet only four of the seven were ultimately dismissed. Two received large settlement payouts, and one was retained. Chief of Human Resources Vivian Ekchian testified that the district employs 350 grossly ineffective teachers it hasn't even sought to dismiss."
The 0.001 percent of grossly ineffective teachers dismissed is a tiny fraction of the 1 percent dismissal rate of state workers in general and a multiple of the 8 percent rate in the private sector

School principals, under this regime, are not even in control of their own labor force, although they might be accountable for the student performance in their own schools. Even parents who clearly know from direct experience or from the parent network who the incompetent teachers are, cannot move their students from one classroom to another by request.  Management of the the labor force that is the biggest factor in the production of the services that determine lifetime earnings is locked by statute into the control of teachers unions. Ever hear the slogan, "The customer is king?" Not in education.

In public education, the customer, whether parent or student, is a mushroom or a pawn.  The interests of this group of students who brought the suit, with the assistance of Dr. David Welch's organization "Students Matter," are congruent with those minority parents who support school choice through vouchers, and with those minority students attending parochial schools who are not supported by the public purse.  Perhaps one day, all of these interests will come together as they should through real school choice, which is the only way to real educational reform.

Monday, June 9, 2014

NY Fed's Bill Dudley on Business Investment

Here's an excerpt from a recent speech by New York Fed President William Dudley:
"Business fixed investment and housing are two key areas where activity has been disappointing.  They need to kick in more forcefully for the economy to grow at an above trend rate for a sustained period.
With respect to capital spending, the recent trajectory has been very soft relative to the apparent strong underlying fundamentals.  Corporate cash flows have been strong, profit margins are high, balance sheets are healthy and financing generally appears readily available at low interest rates.  Moreover, the absolute level of capital outlays is low so that the capital stock is expanding only slowly.  Despite these positive fundamentals, real business spending on equipment and software has risen only 3.2 percent over the past four quarters and contracted in the first quarter.   This is a bit of a puzzle to me.  But, I expect it to be resolved by a pickup in capital spending.  Recent trends in durable goods orders and conversations I have had with businesses in my district suggest that such a pickup may finally be occurring."
 Since the earliest days of QE and the long march of this unconventional monetary policy, we have never wavered about two issues, (1) the efficacy of an unknown policy mechanism that transmits this policy to the real economy, and (2) the problem of unwinding the balance sheet, about which fears were expressed by the President of the Minneapolis Fed, who has since recanted and who now sees the light. 

Here too, the NY Fed  President's remarks are instructive:
"Turning first to economic activity, the trajectory of economic growth continues to disappoint.  Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy."

Tuesday, June 3, 2014

Productivity Growth and Corporate Underinvestment

Share buybacks have entered the realm of the new corporate orthodoxy.  Much as we have liked, and ourselves implemented, buybacks, they are now being used somewhat mindlessly, especially by mature technology companies, like Cisco and H-P.

When a corporate CFO says that "We see no better investment than our own shares," that statement shouldn't be allowed to pass without some clarification.  Likewise when the target of returning fifty percent of quarterly free cash flow to shareholders in the form of dividends and share repurchases is adopted, a question should be raised about how the math works on this kind of capital utilization.

These statements co-exist with the statements that cloud computing, for example, is the most disruptive technological change since Silicon Valley became a brand.  If this is true, and earnings are under pressure from short-term and long-term trends, then wouldn't it be better to invest in corporate internal projects to position the company for the new future?

Likewise, acquisitions when public market valuations are at local historical highs wouldn't seem to be obvious choices for use of cash.

Where may some of the fallout from these trends be seen?  Productivity, which is measured in many different ways, e.g. output per hour worked, total factor productivity, and capital per worker.  The macroeconomic analysis of productivity has always been a relatively weak area of economic research, but the various time series put out by our BLS do have the advantage of going back a long way.

Looking at one series, real output per hour worked for non-financial corporations, something noteworthy can be seen. The series is indexed to 2009=100, to coincide with the business cycle recovery. The linked chart shows the index at 107.1 in January of 2012, and stuck at 107.7 as of October 2013.

On a broader front, U.S. GDP growth fell to 1.9 percent in 2013, while hours worked rose by 1.1 percent, according to the Conference Board. So output per hour grew by 0.8 percent, and output per hour in manufacturing actually fell.

None of these trends bode well for labor incomes.  Companies like Exxon which are increasing their exploration and capital budgets are largely doing it outside of the U.S. as environmental regulations and energy policy politics make it rational for them to look for opportunities elsewhere.  Tech companies with huge cash hoards held abroad, which are then leveraged for share buybacks and dividends don't serve the long-term interests of shareholders.

Surely, there must be some politicians somewhere who could team up with corporate executives to create a framework for better capital allocation and investment in our businesses rather than in financial engineering. Continuing down this pathway may feed equity markets, but it won't fuel the economic future for the next generation of our labor force.