Thursday, July 31, 2014

Bank of America, Agency Problems and Selective Blindness in Our Judicial System

We wrote a widely read post about Bank of America's $40 billion mistake in acquiring Countrywide Financial back in 2012, which we link here for context.

The government's 2012 complaint in Federal Court (Southern District) makes interesting reading also for context to the current settlement debates.  According the Feds, Countrywide engaged in a scheme to defraud FNMA and FHLMC, and as a consequence the GSEs suffered more than a billion dollars in unreimbursed losses.

The story picks up, for some reason, in 2007 when Countrywide's originations had fallen from $490 billion in 2005, to $450 billion in 2006 to $408 billion in 2007.  A very superficial discussion of the monthly loan performance monitoring program required of the originators by the GSEs begs a very important question. Surely, delinquent or non-performing loans (here referred to as loans with 'defects') would have been evident from the 2005 vintage long before 2007.  There are mechanisms for dealing with these problems from the GSE perspective, including putting the loans back to the originators.  One would also think that reimbursement or compensation provisions would have been part of normal securitization agreements.  None of this is even mentioned in passing.

As we have said before, agency problems for Countrywide shareholders existed writ large because of the behavior of CEO Angelo Mozillo's outlandish behavior, which has been covered widely in the press. His compensation, bonuses and option grants were conditioned on the volume of originations, even if they were subprime 'stated income,' 'liar loans,' or 'NINJA loans.'

Mozillo, in turn, created compensation opportunities for Franklin Raines, who eventually relinquished $24.7 million of ill-gotten stock options gains from a reported six year earnings manipulation scheme, over which his gains would have surely been greater than $24.7 million. Mr. Raines never felt the heat and wrath of Federal prosecutors, rather his slap on the wrist came from another Federal oversight agency. Why wouldn't the full force of our justice system fall on two kingpins of this mess?  Justice for friends is different from justice for those deep pocketed corporations, who are giving up shareholders' money in the end.

In the government's complaint against Bank of America, there are a few selected quotes from the former CEO and from the current CEO which should arose the ire of BAC shareholders.

"We did extensive due diligence...It was the most extensive due diligence we (Bank of America) have ever done.  So we feel comfortable with the valuation.."  Former CEO Ken Lewis.

"....we will pay for all the things that Countrywide did."  Loose language from current CEO Brian Moynihan.
Fast forward to the recent imposition of fines by U.S. District Judge Jed Rakoff.  As one reads through the 19 page opinion, the judge's conception of gross versus net losses and his infantile examples seem to challenge the usual shibboleth that Federal court judges are more capable of understanding complex financial issues. Recent problems arising in the interpretation of potential sovereign defaults by Argentina raise similar issues.

The total value of 17,611 loans issued by the HSSL loan mechanism of Countrywide amounted to $2, 960,737,608.  But, 57% of these loans were, in the opinion of the government's 'expert' not in fact bad apples.  So the final penalty imposed was 43% of the maximum, or $1,267,491,770.  The wisdom of Solomon!

As Harry Truman said, "The buck stops here."  Well, what about the higher ups who sanctioned all ludicrous, uncontrolled financial malfeasance at their institutions?  According to Judge Rakoff, "....the fact that other, higher-level individuals arguably participated in the fraud but were, for whatever reason, not charged by the government..." doesn't rise to the level of this judge's scrutiny.

Instead, he lays liability at the foot of Rebecca Mairone, a Countrywide executive, who took the actions necessary to perpetuate the fraud described in the complaint.  Was she a lone, rogue agent?  Not hardly. Her crime seems to be having given "implausible testimony."  Judge Rakoff is given to pats on the back and slaps in his opinion. Attorneys on both sides are described as "excellent" (from Wayne's World?) and "superb."  Ms. Mairone apparently wasn't well coached by her excellent attorney to not give implausible testimony.  The jury in fact asked Judge Rakoff why the higher ups weren't being brought up on charges. They got the answer quoted above.

Finally, we are left with Bank of America, which recently reported results. Earnings were a bit better than expected, analysts claim because of expense controls, better than expected trading revenues, and lower provisioning, offset by much higher than expected legal expenses.  Revenues from the core banking businesses were, however, disappointing.  I wonder what will drive 2014 incentive compensation for the executive team?  Based on current expectations, BAC looks fully valued, but longer term its future growth, if it can ever put Countrywide issues behind it, still remains in question.

Wednesday, July 30, 2014

Christians and the Middle East: A Book Review

From the Holy Mountain: A Journey among the Christians of the Middle EastFrom the Holy Mountain: A Journey among the Christians of the Middle East by William Dalrymple
My rating: 5 of 5 stars

Dalrymple is a Trinity College man, and although the jacket characterizes him as a 'travel writer,' this book is much, much more.  Published in 1997, it should be a timeless classic. The author starts out to journey through the early Eastern Church's great poles of Alexandria, Constantinople, and Antioch. His road map is to follow the travels of John Moschos, author of The Spiritual Meadow, who journeyed through this world around 578 A.D.  If this sounds a bit arcane and dry, the book, story, writing, and sense of people and place are anything but; it is compelling reading, especially in light of the redrawing of maps in the Middle East that has been put into motion today.

From the genocides of 1895 and 1915 in eastern Turkey, Armenian and Suriani (Syrian) Christians have almost been eradicated from the history, culture and archaeology of this region. The author writes,
"From 200,000 in the last century, the size of the community fell to around 70,000 by 1920. By 1990 there were barely 4,000 Suriani left in the whole region;now there are around nine hundred, plus about a dozen monks and nuns spread over the five extant monasteries." One village with seventeen churches now has one inhabitant.

In Jerusalem, Palestinian Christians are despised by both Arabs for apostasy and by Jewish settlers for being cooperators with terrorists.  The Archbishop of Canterbury is quoted as saying the end result of Jewish policies to erase the Christian presence will turn Jerusalem into a "Christian theme park" for tourists and souvenir hunters.

The plight of Alexandria, home to the world's biggest library and a seat of learning in philosophy, languages and sciences, has a similar depiction.

Finally, in Egypt, the Coptic Christians (Coptic is related to a word that means 'Egyptian') have been persecuted and suffered a forced diaspora.

None of these very sad and melancholy developments are editorialized. Rather, it is absolutely remarkable how much hope springs from the stories, like the proverbial mustard seed.  This is the power of the author's grounding, openness to people, and genuine affection for the regions in which he travels.  The people who help him in his journey, from Muslim taxi drivers to nonagenarian monks living in total isolation, are all remarkable characters.  They give us hope, as does this book.

As another reviewer said, read this book and give copies to others.  It is a wonderful read on many levels.

View all my reviews

Monday, July 28, 2014

Purdue Brings A Politician's Face to Cost Cutting.

"It was the first of many steps (former Indiana Governor) Mr. Daniels has taken as he seeks to reorganize Purdue's sometimes-antiquated systems. A year and a half into his tenure, Mr. Daniels has frozen tuition (for the first time in 36 years), cut the cost of student food by 10% and introduced volume purchasing to take advantage of economies of scale." Wall Street Journal 

Since the biggest piece of a college's expenses are for salaries and benefits, it's laughable that making administrators purchase office supplies at Costco and cutting food costs will make any difference to the skyrocketing costs of college education.  Freezing tuition, other things equal, just means that the endowment gets eroded to make up the difference, or the college incurs more debt.  This would make perfect sense to a politician.  

Having a look at my own undergraduate alma mater, one sees a huge, bloated academic and professional infrastructure, some of it mandated by Federal law and much of it mandated by empire building Presidents who are in arms races to build shiny, new facilities and to outdo their predecessors with capital campaigns.  

Since university financial statements are as useful as municipal statements, with lots of funds lying around invisible to the outside eye, it is nigh impossible to subject universities to the same level of scrutiny to which corporations are accustomed.  I invite readers to try their hands at their own universities and share what they come up with. One reporter in California reports that City College of San Francisco spends 92% of its budget on salaries and benefits. 

We bemoan student debt loads without asking why these debt loads were incurred.  Although the reasons may be manifold--duplicative and unproductive departments which grant few degrees, bloated administrative staffs, deadwood tenured staff--the universities are not delivering value to the students for all their federal and state subsidies.  They are selling a subprime product at superprime prices. In most markets, like food, finance or healthcare, this would provoke outrage, but in education, it's all about the future and that's good enough. 

Don't Count on Putin Blinking On Ukraine

With the EU rumored to be moving to Tier 3 sanctions by Tuesday,the emerging view among Western commentators who form opinions by talking to each other, is that Russian President Putin may have gone too far and may "blink" and reverse his Ukrainian strategy.

While is it encouraging to see how the Ukraine seems to be rallying its military forces and crowd funding drones to better target Russian-led separatists, it is another thing to believe that President Putin will suddenly say "Hold on, let's reconsider here." 

In the long run, there is no doubt that the Russian experiment, tied by the ultimate "cult of personality" to one man, is doomed for economic and demographic reasons, as well as by the very oligarchs who were created by plundering national resources at the start.  It's another thing to think that it stops here.

A "on again, off again" strategy of maintaining a continuing, low level instability in Ukraine, whose economy was already a basket case, through a winter will probably erode what looks like a unified domestic political front now. Also, President Putin knows that once U.S. election cycles kick into full swing, domestic issues like border security, young refugees, and corporate malfeasance will take center stage over foreign affairs.

Putting in place a meaningful menu of sanctions coordinated among North America and Europe is something that must be completed.  That will serve as an effective counterweight to a strategy of simmering tensions in Ukraine until next Spring, when a new crisis can manifest itself.

As Dmitri Trenin suggests, were President Putin to back down now, he would face the prospect of appearing to break faith the right wing Russian nationalists, perhaps one of the few political constituencies he has solidly in his pocket.

Saturday, July 26, 2014

Amazon Web Services Won't Dominate Cloud Computing

Back in 2013, when the the hype about cloud computing and big data was gathering steam, we wrote,

"Unfortunately, none of this really makes it any clearer who is going to carry the day as far as supporting the migration of mega-cap, public multinational corporations to a public cloud computing infrastructure. Will one or more of these companies really want their entire IT infrastructure to reside with a bookseller and operator of global merchandise bazaars?"

Last week, the theory that Amazon Web Services would be the growth and earnings engine for the company was called into question. Data security, risk management, documentation and mitigation of breaches will weigh more heavily on CIOs, particularly in health care and financial services, than saving a few nominal bucks by outsourcing data storage and applications.

Amazon seems to be replacing Apple as the cult stock du jour.  It continues to rate Buy recommendations from major brokerage houses based on long-term dividend discount models that generate huge enterprise values in the indefinite future.  Amazon seems to have corporate ADD.  It touts a business, generates revenue and headlines, loses interest or focus, and then lavishes money on the next, new thing.  Typically, investors don't like this shell game, but Amazon moves on arrogant, uncommunicative and undeterred.

Basic outsourcing of IT services, renting servers and hosting applications, is indeed a commodity aspect of the cloud computing opportunity, and as such it should be the least interesting to investors.

Thursday, July 24, 2014

Microsoft Is Changing For the Better: Evidence From 2014 4Q

Before looking at the numbers for FY14 Q4, I think it's more important to cover the many tells that things are really changing at Microsoft, for the better.

The first signs appear in Mr. Nadella's memo to employees about the 18,000 employee workforce reduction. Having been responsible for a reduction myself (about 1% of MSFT's, but 15% of our workforce), and having been part of several Wall Street reductions myself, I can say that they are almost always done badly for the organization's survivors and inhumanely for the affected employees. So what about this announcement?

The first was a quick reprise of contextual messages.  The company is on the road to becoming a platform and productivity company, which employees had heard the previous week. Having a focus, however, isn't a be all and end all.  

Aligning the organization, changing its culture, and improving communications and decision making within the organization are key initiatives that will take time.  The organizational staff reduction, unfortunately, is part of that longer-term change.  Thus, the CEO makes it clear that this is not an effort to cost cut one's way to success, as has been done with blazing incompetence by the likes of  "Chainsaw" Al Dunlap, and Ed Lampert at Sears, to name two. Along with these reductions will come resource additions in other areas.  The key message to employees: your organization is committed to grow, not to shrink its way to success. 

Finally, there is a human element, expressed in the statement, "We will offer severance to all employees impacted by these changes, as well as job transition help in many locations, and everyone can expect to be treated with the respect they deserve for their contributions to this company."  This isn't a phrase that would normally be offered by HR or by the general counsel; it really seems like it is a sentiment coming from the CEO, and that's good for the effected employees and for the survivors as they go through the grieving process with their former colleagues. 

On the quarterly conference call, there was a clear distinction between the styles, presentations, and nuances of the CEO and the CFO.  In fact, CFO Amy Hood sounded absolutely liberated from her former role of merely explicating and micro-parsing the financial numbers (deferred revenue forecasts, contracted versus billed revenue), and she added the CFO's restrained nuance to the always more enthusiastic and high level comments of a new CEO. Long term investors expect and like this differentiated,tag team approach. Together, it was a much more well stitched together set of messages than the previous environment, dominated by the overbearing Steve Ballmer.  
GAAP revenue for FY14 Q4 increased 18% year-over-year to $23,382 million, which included $1.99 billion of revenue from the inclusion of NDS for a partial quarter.  GAAP gross margin  of $15,787 million increased by 10%, and the GMR was a robust 67.5%, although this was down from an unusually higher rate in the prior year period.  

GAAP operating income of $6,482 million grew 7% over the prior-year period, and the margin was 27.7%, with all the moving parts. Nokia NDS contributed $(692) million to the quarter's operating income, of which $127 million was for integration and restructuring expense in the period. 

Diluted EPS of $0.55 per share declined 7% on a GAAP basis from $0.59 in the prior year period.  Dividends per share were $0.28 in FY14 Q4.  On a non-GAAP basis, which is interesting but not decisive to an investment thesis, diluted EPS of $0.66 increased 10% over the prior-year period. 

This Is A Software Company

While HP struggles to become more software-oriented, and while IBM divests a commodity server business to become more software oriented and relevant to corporate buyers, MSFT already is a software company with robust margins, despite appearing to become more of a hardware company through acquiring Nokia NDS.  

What's more important than this artificial hardware/software duality is the nature of the enterprises who will operate data centers, private, public, and hybrid clouds.  These are the customers who need to make significant investments, and they look to their trusted vendors to help them through their decision making process,  

Another thing about the new CEO is that it is clear that he can talk about customer requirements, hardware, software, data security, and computational issues with engineering, product development, and real life, customer-facing experience.  This kind of credibility will resonate with Microsoft sales forces and with the customers: this is a big deal and a big change from an MBA-type blathering on about "the cloud."  

This shows up, in our opinion, in the quarterly results where commercial cloud revenues increased by 147% year-over-year, driven by Azure, storage, computing services and the CRM online product.  The annualized revenue run rate for cloud revenues was cited as being $4.4 billion at the end of the quarter.

Microsoft Dynamics revenues were up 13%.  As a small enterprise, one of my companies adopted an early version of the former Great Plains/Dynamics software, and as a non-IT user, I found it uninviting and logically convoluted. However, for small and medium size businesses, facing the prospect of Oracle or SAP, is even more unpalatable. 

What About Commodity Hardware?

Server licensing revenue increased by 14% year-over-year.  Server product revenue increased by 16%. The Microsoft SQL Server product line had a major refresh with Server 14, and its revenues were up 19%.  

The corporate IT executives are under more and more pressure to deliver services of demonstrable performance and value from among the buzzwords, of clouds, big data, business intelligence, and BYOD. CEO Satya Nadella made the point when Microsoft, "operating some of the planet's most massive data centers," approaches customers with their Cloud OS platform, they build instant credibility.  He said that this platform represents one of the company's largest revenue opportunities, for as public cloud use increases the data center is where revenue growth will come from. 

Even, the much maligned Bing! search engine continues to garner share of U.S. searches, now north of 19% and revenue per search went up in the quarter.  This business is targeted to be stand alone profitable in 2016. 

Late To Tablets?

Microsoft Surface, for all of its being late to market, was built from the ground up on a totally different premise from most tablets, which as we've said are put to non-productive uses.  For business users, small, medium and large, productive work will involve working on documents, spreadsheets, and presentations. Surface has, and continues, to make its point that it is a viable laptop replacement with the virtues of a tablet. The CEO noted that a new form factor launch of Surface was tabled.  

The Surface Pro 3 is aimed at facilitating easy note taking, as with a pen, tying it in easily with One Note, which had been a forgotten application for a long time. 

Making and Office 365 accessible through apps for iOS was a small, but master stroke. Google Docs won't be the answer for most users, nor will Chromebooks for price/value.  The jury is still out on this venture, but Microsoft has planted a viable flag in the marketplace. 

The CEO's core investment principles were also interesting:
  • Invest in the core platform and productivity businesses, e.g. cloud and device operating systems.
  • Consolidate overlapping development efforts, which is a corollary of the reductions and reinvestment in fewer management layers and fewer competing groups.
  • Run all businesses on a clear, simple model of business and productivity metrics.  This will be interesting and if it takes, it will mean that the culture will have changed dramatically.
There is a lot to like in the way FY 2014 closed under CEO Satya Nadella. 

Monday, July 21, 2014

The Market Continues to Ride the Wind

A healthy market, according to the fundamental and technical watchers of yore, climbed a "wall of worry." Right now, our equity markets continue to ignore both poor macroeconomic and corporate developments in ways that resemble the already forgotten 2006 period.

Looking at our own economy, what are some of the facts we've discounted?

  • According to Fed presidents, the labor markets remain weak, unhealthy, in flux or whatever euphemism is acceptable to the Yellen regime;
  • The housing "recovery" has stalled, weakened, sputtered.
  • The Fed won't tie monetary policy to rules, but some Fed Presidents feel that rates may rise sooner rather than later. 
  • Our larger, more concentrated banking sector is shelling out billions in shareholder equity to the government without admitting any crime they've committed.  Meanwhile, their fundamental businesses, with some lending growth, are lackluster.
  • Trading revenue continues to flounder for the investment banks.
  • Top line revenue continues to be hard to come by, and earnings gains continue to be of low quality, especially in the tech sector, where retirement plan commitments are excluded from "normal" earnings.
Let's move to Europe, where strategists have said the better values were from the fourth quarter of 2013.
  • From daily press releases, Chancellor Angela Merkel has gone missing, to be seen only at the World Cup in shades suddenly becoming a fan of the Champions.  
  • Is anyone still in the Elysee Palace?  
  • Britain put on a dismal performance at the World Cup, but the semi-comatose Roy Hodgson declared satisfaction with his efforts. The British economy seems to be like a Morris Minor with vapor lock.  
  • The Russian wolf is reconstructing his empire a bit at a time, alternatively threatening and blaming vast Western conspiracies.  Merkel and Hollande have gone from hectoring the EU periphery to becoming like pet poodles to the Russian wolf. 
  • No one knows what's going on in the EU banking sector, and Banco Espirito Santo wasn't on anyone's top ten list of troubled banks, but they are shown to have no clothes. 
  • What will a cold winter do to Russian gas prices coming through Europe?  
In the rest of the world, there's a mixed bag at best.
  • China's hoarding of raw materials seems to be an expensive and inefficient use of their assets.  Growth rates continue to be strangely high and no one seems worried.
  • India's elections were won on an anti-corruption platform, but what's really needed now is a pedal to the metal for infrastructure construction to match the pace of construction (much not completed) growth, apartment and condo development, and new corporate parks.  This will be impossible due to the corrupt program of rural subsidies to buy votes.  Economic policy for the past five years under the former Congress regime was an unmitigated disaster.
  • Brazil hosted a World Cup, spent $11 billion or so, and gave up their veneer of artistic and technical supremacy in the beautiful game.  The corporate environment is rife with inefficiency and corruption, the state enterprises leading the way.  Interested in issues of inequality?  Take a walk in a favela---with armed guards and an armored car, though.  
  • The Middle East has finally begun to be redrawn.  No one knows how it will settle out, and what the costs will be, especially for the U.S. and Israel.  Normally, this should cause some alarm. Not for these heady markets. 

Thursday, July 17, 2014

GE Puts Appliances On the Block

General Electric's CEO has long stated that one of his goals was to refocus the company away from financial services and more towards manufacturing value-added products for specialized industries. The next phase of that strategy was to change the mix towards industrial and away from consumer businesses.

Having followed the appliance business as a research analyst, I always felt it was a matter of time before the appliance business was pruned from the portfolio, and now the announcement has been made.

Just having returned from India, we noted that economic liberalization of decades ago has allowed appliances to permeate middle class households to an eye-popping degree.  The labels we saw in homes were Electrolux, Samsung, and LG, all of which should be interested in GE's business.

Domestically, GE has lost its way, and this will put a bit of a cap on the price as there will be some cleanup to be done by any buyer.  It is ceding entry level products, and trade-up brands to the Korean manufacturers. Even its experiment at the high end with Profile has lost ground.  With global markets so ebullient, this would seem like the opportune time to divest this business.

Wednesday, July 16, 2014

Marketing Indian Textiles

More than sixty years ago, the Government of India began a noble experiment to promote Indian textiles, specifically those handcrafted textiles produced by small scale producers throughout the country.  Given the quality, unique designs, colors and dyes, the global markets seemed ripe for the introduction of products that would introduce Indian artistry and craftsmanship to consumers in developed countries through tourist sales.

The vehicle was a Government enterprise called the Central Cottage Industries Emporium, with showrooms in centers like Delhi, Mumbai, Kolkata, Chennai, and Bangalore. Having first visited the Delhi showroom with my family in the Sixties, we always took home unique items for women friends of the family, who were always excited by the unique look and feel of the apparel; wearing them on a regular basis in a Western lifestyle was, however, always a different matter, I noticed.

Coming back to that same showroom during our most recent trip to India a few weeks ago, I was appalled by what I saw.  The fixtures looked like the same particle board shelves from the Seventies, with chips and dents visible everywhere.  Displays were full of merchandise, stacked in neat piles which were good for inventory but not for pulling out and piquing customer engagement.  The floor staff, who have no incentives, were as disinterested and sullen as ever.  Light fixtures were ancient, but they now featured compact fluorescent bulbs providing awful lighting with large areas of shadows. Forget 2014, this was an experience worse than 1960.

Design is supplied largely by the suppliers themselves, who really have no idea about modern tastes and preferences among customers in the developed world, or even of affluent customers in India or in the rest of the developing world.  It is as if time had stood still, and so have the inventory turns.

My teenage daughter, looking for gifts for her friends, and my wife struggled to find merchandise that would be worn, as opposed to admired.

I thought about a proposal to privatize this business, with a revenue sharing arrangement with the government. I could already see the easy ways to rip apart the space and create an inviting store.  My cousin's daughter Shalini James had created a successful retailing operation in several of the largest international malls in Cochin.  Her expertise, along with others in our family, could be the backbone of a new model for Cottage Industries Emporium. I was excited thinking about what could be done.

However, we had already been shopping in some very attractive outlets of a fifty-year old retailer Fabindia, founded by an American in New Delhi, and now run by his son. My family, including my son and nephew, were excited to be shopping here.  I didn't realize how big their volume was, and how many stores they had throughout the country.  Their original mission was the same as that of the Cottage Industries Emporium.

Some of the big differences in the model?  First and foremost, Fabindia have their own international design staff who are connected to fashion centers in the U.S., Paris, Milan and the rest of the world.  The design input went to the artisans, who obviously weren't in a position to afford this kind of expense.  No problem: that barrier was eliminated.  Concepts of sustainability and fair compensation to artisans are corporate values.  Supply chain management is an established corporate function: no one can accept merchandise sitting on shelves as they do in Cottage Industries. The brand and values are being extended into home, including furniture recently, food and personal care items.

Another conversation ensued with a cousin who is a corporate marketing executive.  He said that Cottage Industries were already a zombie enterprise, whose largest volumes were sold to overseas visitors from foreign government delegations who were force fed into their outlets with limited time.  Other than that, he said, there was almost nothing left.  Yet, like all government enterprises, it will not be shuttered to improve the government's use of assets, but it will soldier on to oblivion, to the detriment of artisans and employees.

Indian textile exports are around $40.2 billion, about 5.2% of global textile exports. Last year, India assumed second place globally behind China.  While government may have primed the pump decades ago, it's time to abandon being a fabric retailer.

Tuesday, July 15, 2014

Back From India

My family and I returned from a long overdue trip to India to reconnect my children, my spouse, and myself with my family, who are all over India.  Our hubs were in Delhi, Trivandrum/Cochi/Ponkunnom in Kerala, and Bangalore.  My family are in government, private business, public business, and are operators of estates in various commodities.  The degree of change and contradiction in the Indian story are, respectively, staggering and puzzling.  I'll post over time, as I try and digest what I've observed.  There are personal pics for my friends on Facebook.

Meanwhile, the news here seems totally non-surprising, just as expected.  Missing phones, email and papers for three weeks wasn't critical after all.