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.