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.