Friday, January 31, 2014

WSJ"s Similar Take on Google Sale to Lenovo

Today's WSJ carries a story whose main line is that Google has made a good strategic move selling Moto Mobility.  It's implicit in our post yesterday, so there's no disagreement.  Where we differ is that overall, it's really not great for developed market consumers, particularly in the U.S., and it puts pressure on Samsung to go its own way with its Tizen mobile OS, which may be a good move but one which will slow their momentum even more and carries risk of confusing their customers.

The story says,
"The deal also helps Google bring more balance to the Android ecosystem. Today, Samsung dominates the Android world, selling more than six times as many phones as its nearest rival. A combined Lenovo and Motorola can help offset Samsung's strength, reducing the risk that the Android world is dominated by a single hardware maker."

Balancing the Android world is a nice euphemism.  The sights are set to take the wind out of Samsung's sails, which is not great for consumer choice.

Thursday, January 30, 2014

Competition in Mobile Phones: What Does Google's Sale of Moto Mobility Mean?

As I look at my trusty Samsung slider dumbphone by my side, I don't have an emotional stake in the smartphone market, but I have to say I don't think it looks good for consumer choice in U.S. markets.

Google buys Motorola Mobility for $12.5 billion, and it was widely understood that Moto's rich patent portfolio was a significant asset for building out Android as a mobile operating system alternative to iOS.
In the meantime, Google launched the Nexus line of smartphones, with its partner HTC,  to widespread consumer praise, and it sold out from Google's own website as soon as it was back in-stock.

This was clearly very encouraging to U.S. retail consumers who felt that they could get a clean version of the Android OS that they preferred to the versions licensed to vendors who put their own bloatware and undesired features on them.  Presumably, by getting a Google Nexus phone, a consumer would be assured first updates to Android, e.g. Cup Cake to Donut to Kit Kat.

The Nexus also featured unlocked phones at significantly lower prices to Apple and to most other comparable Android phones.  Finally, Motorola released the MOTO-X which, despite some snitty tech reviews, seems to be a raging favorite with the younger, Facebook crowd.  Everything is pointing towards a successful, robust alternative to Apple.  Windows Phone, if it ever gets there, would be a third alternative.

Now, without claiming to be an expert, it all looks a confusing, cloudy outlook both for U.S. consumers and for Google partners, like HTC and Samsung.  HTC seems like it has been hung out to dry by the announced sale of Motorola Mobility to Lenovo. Quite a few users I've seen like HTC phones, either unlocked or subsidized, on all the carriers.  It seems like their future as an alternative, innovative marketer of smartphones is in real jeopardy.

What about Samsung?  Although its phones are popular and highly regarded by business consumers, they also complain about the workings of Samsung's customizations to Android, which Samsung needs to make if they are to create a unique customer experience with the phone's customer interface.  If they customize further, it really creates problems for them.  They surely have the technical horsepower to innovate, but can they continue to do so?

What of Lenovo? Yes, they've done a nice job with the old IBM Think Pad line, but they did it by leaving a lot of the customer facing features the same, like the feel of that keyboard.  Can they really be a factor in the fickle U.S. smartphone market?  I don't know.

If Android loses share because the former Google partner base has been sprayed with pesticide, where do consumers go?  An overpriced Apple?

If Microsoft could ever pull it together with Nokia and speak to all the U.S. customer segments in smartphone, they could really have a tiger by the tail.  The jury is out on this one.

In the meantime, Google and Apple won't be suing each other, but they could both be suing's not a great day for U.S. smartphone consumers.

Wednesday, January 29, 2014

GM CEO Mary Barra: A Car Person Looks at Opel

GM CEO Mary Barra has a Herculean task on her hands turning around the flaccid and inward-facing culture at GM.  Her position on Opel sounds like the view of a person who likes and understands cars, which she does.  Apparently, she can throw a car around a test track with authority.  I can still see images of former GM CEO Roger Smith slow riding a Chevy Beretta around a track: you could feel the death of that car just watching it go down the track.

In 2009, we wrote about the relationship of GM's destruction of its own Saturn concept, and the sudden turn to Opel for new models.  One stupid strategic decision forced another set of sub-optimal decisions which hurt Opel in the longer term. Of course, the Federal government as owner once tried to force a divestiture of Opel. Note to self: the government should never own private businesses.

CEO Barra has to forge a new relationship with labor in Germany, and for this she needs some strong, accountable executive partners.  Next, there has to be a program of new model introductions that are not just reactive but innovative.  This seems to be where her interests lie, and she needs to prepare the dealer network to commit to her plans.

With all the talk about small SUVs and what the Brits call smaller "estates" it shouldn't be too hard to come out with products that consumers want to buy, and by that I don't mean electric vehicles.

Here's wishing her success.

Thursday, January 23, 2014

Microsoft's Second Quarter 2014: Solid Revenue Growth Like Q1

We thought that Microsoft's fiscal 2014 first quarter was a very solid performance, demonstrating the strength and potential of its Commercial businesses.  Fiscal 2014's second quarter caught analyst estimates a bit flat-footed on both revenue and EPS.  Overall, though, the quarter's highlights and questions were really about the same as those in the first quarter.

Revenue of $24.52 billion grew 14% on a GAAP basis, and 11% on a non-GAAP basis.  Ex-currency, revenue grew 12% year-over-year on a non-GAAP basis.  Any way one looks at the quarter--and GAAP comparisons give a better view--it's a really strong performance in a revenue-challenged tech industry.

Gross margin of $16.24 billion was flat in dollars, year-over-year. The gross margin rate was a breathtaking 66.2%  Really, the pattern that may appear in the near-term future is solid revenue growth, but significantly less profit growth.  Looking at this quarter, it's as if Microsoft is investing its gross profits, which are robustly driven by the Commercial businesses, in its Devices and Consumer businesses where some product margins are non-existent.  And, this is probably the right way to tack this ship windward given where it wants to go.

Operating income of $7.97 billion grew 3%, and net income was $6.56 billion.  Diluted EPS of $0.78 was up only 3% on a GAAP basis, and declined 4% on a non-GAAP basis.  Cash returned to shareholders in the quarter was a record $4.3 billion for dividends and share repurchases.


Commercial revenue of $12.67 billion--52% of consolidated revenue--grew 10% on a GAAP basis. Of this, licensing revenue of $10.89 billion grew 7% while Cloud and Office 365 revenue of $1.78 billion rose 28%. The real stellar performances come from the same sources as in the first quarter, namely server revenues up 12% and SQL Server Premium revenues up 25%.  Investors would have to put this growth up against the recent news of Dell and Lenovo looking to grab IBM's profitless server business; they would have to sit up and take notice of these counter-industry trends in Microsoft's business. 

Gross margin in Commercial was $10.45 billion, or a gross margin rate of 83%, and the margin comprised 64% of Microsoft's corporate gross margin dollars.  

Microsoft said that software penetration into enterprises was stronger in the largest enterprises versus medium-sized and smaller businesses.  Business trends were better in developed markets versus emerging markets.  So, the signs seem to be pointing to confidence CIOs are showing in Microsoft's commercial product offerings, both on the computing and software sides.  

Devices and Consumer

Hardware revenue of $4.73 billion was up 68%, as the Xbox One and Xbox 360 got strong responses from customers. We had our doubts about this platform launch, but clearly we misjudged the extent to which the execution in this business improved for the retail channel's holiday season. Xbox One sold 3.9 million units during a five week period in 13 markets; Xbox 360 sold 3.5 million units in the holiday period. 

The Surface and Surface RT lines got rejuvenated, as the execution going into the holiday season must have been much better than last year.  Sales of almost $900 million were significantly above the $400 million level of the prior period.  However, hardware overall turned out to be a profitless venture, as the gross margin on revenue as $0.41 billion, down 48% year-over-year on a GAAP basis. 

As long as the Commercial business is humming along, and it should continue to do so, it gives the consumer businesses cover.  The  first steps are evident in this quarter: getting the right products and the right promotions out into the retail channel with marketing dollars behind them.  Profits can follow later, if Microsoft can manage the revenue line and report acceptable profits while continuing to return cash to shareholders. 

Licensing revenue of $5.38 billion was down 6% on a GAAP basis, while gross margin of $4.98 billion was down 3%.  The gross margin rate for this segment of Devices and Consumer is a nice offset for the hardware business.  But, it just feels as if the Device and Consumer businesses are stepchilds in Microsoft.  

CEO Succession

We've posted before about the implausibility of Bill Gates wanting to take back the CEO reins at Microsoft, and an interview with the New York Times discussed his thought processes at length. A problem now is timing.  If a big decision is made to bring in an outside, superstar CEO who isn't embraced immediately by the dysfunctional culture, then will the momentum in the Commercial business and the signs of Spring in the Devices and Consumer business come to an end?  

Phones: The Unspoken Word

In the entire presentation and even into the question period, only one analyst pushed the issue of what had happened with Windows Phone.  One could almost feel the presenters taking a deep breath.  The initial lineup of Nokia Windows smart phones, including an entry level Nokia Lumia 521, seemed to have been launched haphazardly with very poor marketing support.  Even though the higher priced phones got some decent reviews for things like their cameras, the Nokia name didn't resonate in the retail channels. 

Now, with the acquisition of Nokia's phone business about to close, the future of this business and the price paid for it would make a prospective shareholder nervous.  Is Nokia to Microsoft what Autonomy was to HP?  I hope not, but it's completely unclear how Surface tablets, and Nokia phablets will play together into a coherent consumer offering.  

One Windows user experience across all devices: it sounds like a logical and ambitious goal, but how long will it take to make it a reality, with revenue and profits?  

Wednesday, January 22, 2014

What's Wrong With PIMCO?

The timing and tenor of Mohamed El-Erian's resignation as CEO and Co-Chief Investment Officer of Allianz's Pimco are certainly a bit strange.

One newspaper article somehow correlates this event with the massive $41 billion outflow of funds from Pimco's Total Return Fund in 2013. Unfortunately, there are only two things wrong with this assertion. The outflow had nothing to do with the management of the fund.  Rather, it had everything to do with the ending of a twelve year bull market in bonds sometime in mid-2012 according to some observers; since most investors react late to market inflection points, it took the relentless beating of the drums about rising interest rates from the Fed's unconventional monetary policies for the stampede to be at full power during 2013. Second, this fund, along with several others which follow the same strategy, e.g. Harbor Bond, are all run by Co-Chief Investment Officer Bill Gross.

Much as Mr. El-Erian has been the public face of Pimco on broader global economic issues, Mr. Gross has been the face of Pimco to Wall Street and the markets.  Where there was overlap, the key firm messages, such as the "New Normal," and "Shake hands with Uncle Sam" were put forward by both executives.

One wonders where the drive to get Pimco into equities came from.  Perhaps it was from Pimco's owner, Allianz.  That would make sense, as every market observer knew that the bull market for bonds would end, and the long-term market for global equities was one in which Allianz should be represented.  Logically, it could have been done through leveraging the research, market reach, and brand recognition of Pimco.

The move into equities was clumsy, slow and seemed to lack any overarching themes.  Why another equity mutual fund sponsor?  Why is your approach going to be better than hundreds of others? Can Pimco attract and retain equity research and portfolio management talent?

The hiring of Neel Kashkari, former banker and right hand man for Tim Geithner's bank bailout operations, was clearly a marquee hire.  There were lots of press releases and a fund or two were launched, but none of it made any sense. The funds were overpriced, and their styles were opaque, somewhat black box with a promise of research.  The availability of the funds through supermarkets wasn't clear. The funds clearly lacked any track record, which complicated their marketing. This whole, poorly conceived adventure was a total failure.  Mr. Kashkari is now running for Governor of California.  Who was the architect? I don't think that it was Mr. El-Erian, but he probably had responsibility for its implementation.

I have devotedly read Bill Gross' investment letters for about the same number of decades I've read those of Warren Buffett.  I've also seen him in action a few times at meetings, and I feel I have some understanding of his personality as far as markets go.  I just don't see his hand in the equity venture.

Mr. El-Erian is much more a "big picture" Davos-style thinker, and his recent appointment to a Presidential panel on big picture issues suggests that having two high-powered spokespeople for a bond house is probably overkill.  Mr. Gross, in contrast to Mr. El-Erian is a hands on, savvy, highly respected investor with a deep understanding of bond markets, equity markets and their interaction with global economics.

It was Bill Gross, the ultimate bond market investor, who long ago saw the folly and the house of cards which was behind the equity performance of General Electric, viz. its reliance on GE Capital for its earnings. As I read all the Pollyannaish equity research on GE's stock, I learned a lot from the perspective of Bill Gross, who was a lone bearish voice on the equity at the time.  Mr. El-Erian's own equity management record at Pimco was mediocre with a small amount of capital.

On the other hand, the same questions that are aimed at Warren Buffett could be aimed at Bill Gross?  What about executive succession?  The funds are too big to be run by one person forever.  I don't think that Mr. Gross even has his Charlie Munger.

So, I would say the questions for the future are:

  1. Will Pimco remain a bond house forever?  What if anything was learned from the first debacle?
  2. What about management succession for Mr. Gross?

Morgan Stanley on Emerging Markets

We have posted before about the fact there many fewer diamonds than paste among emerging market mutual funds touted to individual investors.

Today, Ruchir Sharma of Morgan Stanley Investment Management, whom we cited in the above post, has revisited the whole lure of emerging markets in the Wall Street Journal. What he says in this piece effectively outdates some of the material in his book.

Mr. Sharma writes,
"Commodity prices rose 160% in the 1970s, and the number of nations that were rapidly catching up to the West rose to 28, compared with the average of 22 in the typical decade. In the 1980s and 1990s, when commodity prices stagnated, the number of rapidly converging nations fell to just 11. Commodity prices then doubled in the 2000s, another golden age for convergence, with 37 nations catching up at a rapid pace.
But commodity-driven economies such as Russia and Brazil tend to stop catching up as soon as commodity prices spiral downward. According to the World Bank, of the 101 middle-income economies in 1960, only 13 had become and still remained high-income by 2008: Equatorial Guinea, Greece, Hong Kong, Singapore, Ireland, Israel, Japan, Mauritius, Portugal, Spain, Puerto Rico, South Korea and Taiwan. Of those 13, only Equatorial Guinea is a commodity-dominated economy.
Last decade's mass convergence was a freak event that caught the world's imagination." 
The things that will ultimately limit the progress of all countries, especially the continuing rapid advance of emerging markets will be social and political factors, like a viable social contract, property laws, an ability to forge a democratic model that fits various social customs, social responsibility and accountability for business moguls, and a commitment to regulation, ethics and transparency in capital markets. Even where countries show gains in these areas for a while, they are difficult to entrench into a national consciousness because of the long histories of corrupt governments and business in many emerging economies.  
Emerging market investment opportunities are always present, but how accessible will they be through public markets?  Time will tell. 

Wednesday, January 15, 2014

Jamie Dimon Comment on Share Buybacks

Looking back at my notes on JP Morgan's earnings call, I forgot to recount a somewhat offhanded comment the CEOmad  to a multi-part question from an analyst.  The analyst recounted  how much stock the company had bought back year-to-date, and  he asked whether or not the company would complete the current authorization in a big chunk.  It was an incredibly stupid question, but it elicited an interesting response.

CEO Dimon said something like this paraphrase, "When the stock was in the thirties, it was a once in a lifetime value.  We don't buy back shares just for the sake of doing it.....with the stock where it is now....(trails off)"

This is spoken like a CEO who understands the difference between price and value.  The big technology companies historically like buying shares like automatons.  I give the CEO kudos for saying something his mega-cap CEO peers should understand better.

JP Morgan Looks Like It's Positioned Well

Let's think back to the beginning of Bob Paulson's plan to save the global banking sector from itself, when the nine CEOs were invited to sign the famous one page deal injecting $250 billion of taxpayer money into their banks. On top of that, Wells absorbed Wachovia, JP Morgan absorbed WAMU, and Bank of America absorbed Merrill Lynch.  WWE-style chest thumping and outrage was shown by most of the participants, except by JP Morgan CEO Jamie Dimon, according to the newspaper. He apparently did the cost of capital calculation in his head and saw the Feds as a cheap source of funds.

Fast forward and we've concluded with the Feds now raiding the JP Morgan treasury for some $30 billion in fines for originating and selling bad mortgages to the GSEs and for not blowing the whistle on the Madoff Ponzi scheme.

So the fourth quarter of 2013 capped a pretty miserable year compared to 2012, but the fourth quarter showed all the signs of the bank being well positioned for an improving U.S. and global economy and for the concomitant steepening of the yield curve.

On a managed basis, 2013 corporate revenue of $99.8 billion was flat with 2012 revenue.  Reported, diluted EPS of $1.30 was down compared to $1.39 in the prior year, on the same basis.  However, excluding extraordinary items, 2013 diluted EPS was $1.40.  During this long waiting period for the economy to show a lasting rebound, banks like Morgan and Wells have been pulling out all the stops to generate some semblance of earnings stability.  JP Morgan has taken allowances into income in prior quarters, to the consternation of some analysts, but based on some of the underlying trends in credit cards, business loans, mortgages and deposits, the turn may be coming.

JP Morgan's efforts to position the bank for an economic rebound look like they've put the bank in a strong position,

JP Morgan's Consumer and Community Banking business now serves 43% of U.S. households, and its increased penetration has most certainly been helped by the acquisition and build-out of the old Washington Mutual branches.  What seemed like poison at the time may turn out to be honey for the shareholders. The base of 5,600 or so branches will not be expanded in the near-term as much as it will be reshaped and optimized for better productivity.

The CaCB business grew deposits in the fourth quarter of 2013 to $461 billion compared to $426 billion in the prior-year period, a solid 8% increase.  Allowances for loan losses, non-performing assets, and the net charge-off rates are all down year-over-year in the quarter, and its looks like the charge-off rates are near historic lows.

Fourth quarter 2013 provision for credit losses was $72 million, compared to $1.1 billion in the fourth quarter of 2012, a decline of 93%; the full year provision for Consumer and Community Banking declined similarly to $335 million compared to $3.8 billion in 2012.

The Mortgage Banking business, to no one's surprise, fell out of bed.  Full year 2013 net revenue of $10 billion was down 28% from 2012 revenue of $14 billion.  Provisions for credit losses benefited 2013 pre-tax income by $2.7 billion compared to a benefit of $0.5 billion in 2012. Non-interest expense declined 17% for the full year, driven by the large headcount reductions. Net income of $3.1 billion declined only 8% in 2013, year-over-year.

Mortgage production revenue was down 78% in the fourth quarter, and 54% for 2013, yielding $2.7 billion in production revenue.  According to a slide in a recent analyst presentation deck, the current mortgage underwriting standards look pretty strict, with average FICO scores of around 750+.

The credit card, merchant services and auto businesses had good solid quarters, and delinquencies on the card portfolio have been on a ski slope downward and the portfolio has been cleaned up.

A slide talking about earnings sensitivity to a rising rate environment back in June 2013 modeled earnings gains of $2.1 billion and $3.8 billion, respectively, from a 100 basis point and 200 basis point parallel shift in the yield curve.

The investment bank made gains in various underwriting segments, and the compensation levels ended the year so as to give opportunity should the global IPO and acquisitions cycles continue to heat up.

The one truly eye-watering item was the prevalence and magnitude of the legal expenses all over the financial statements.  The "Other Expense" category for 2013 showed expense of $19,761 million compared to $14,032 million in 2012.  Of these amounts, legal expenses comprised $11 billion (56%) in 2013 and $5 billion (36%) in 2012.

Legal expenses are also buried in some of the mortgage production operation results.  I couldn't follow the CFO's rapid fire presentation about reserves for litigation, but it sounded like large amounts. Because she is a British physics major by training, she has real command of numbers and of the Basel and mark-to-market modelling issues.  The speed of her delivery made me think of the classic Fed Ex commercials.

Monday, January 13, 2014

Revenue Growth: A Challenge for Banks

This is a big earnings reporting week for the Big Banks, starting tomorrow. The folks at Credit Suisse are relatively positive on the big banks, although their overriding comment for the sector is that revenue growth will be very challenging.

Even more ironically, their favorite idea based on earnings exposure to emerging markets and relative valuation is Citigroup. Now remember that former CEO Vikram Pandit was drummed out of his position because his strategy was not engendering a turnaround fast enough.  Never mind that possibly apart from Bank of America, no other global mega-bank had been as badly managed for decades.  It appears from reading the CS analysts their bullish case on Citi is based on developments that really had been the core of Mr. Pandit's presentation from the beginning.

It should be an interesting week for financial stocks.

Sunday, January 12, 2014

Martoma Gets Left Holding The Bag

Matthew Martoma, as capital market players go, seems like a decidedly uninteresting and unsympathetic character.  In the early days of his notoriety as part of S.A.C. Capital Advisors, LP ("SAC"), his job was to get an information advantage in the market place that would help his boss make profitable decisions about their pharmaceutical/health care holdings.

Mr. Martoma, who back then sounded like a junior analyst, went to one of the many "expert networks," where individual experts in various specialized areas make themselves available primarily to hedge fund types who are looking for non-public information.  These experts receive, in the typical case, hourly consulting fees, for which the network takes a nice chunk for doing little. One of the doctors he found was Dr. Sid Gilman of the University of Michigan, who was a principal investigator on a large-scale clinical study on a compound of interest to one of SAC's portfolio holdings.  

So, this physician made himself available on an expert network, and the network advertised his presence and area of expertise.  According to the press, Gilman and Martoma had many conversations, and Dr. Gilman was always forthcoming with more information, because the calls and consulting fees continued to mount.  Dr. Gilman violated all of the normal codes of conduct of the University of Michigan, where he was employed, as well as his code of conduct as a clinical investigator.  He normally would have suffered sanctions from his employer, from the study's sponsor, from the FDA, and the SEC.  So far, it looks like he has turned into a stoolie on Mr. Martoma, and he has received a free pass from the Feds.  It doesn't seem as if the University of Michigan or the trial sponsors have taken any action against him.

Over time, as Mr. Cohen has paid a large fine, out of the pockets of his investors, and taken a plea while restructuring his business as a family office.  He has played the system, and the Feds didn't have the desire nor the gumption to go the full fifteen rounds with him.  Dr. Gilman has also played the system, although he should be facing multiple professional and regulatory consequences.  

Meanwhile, Mr. Martoma is suddenly, routinely described as a "hedge fund manager," or a "portfolio manager."  He was nothing of the kind, given what he spent his time doing and the nature of his conversations with the only manager who really mattered, Mr. Cohen.  It seems too late for him to roll on Mr. Cohen.

Mr. Cohen has spun a narrative that Mr. Martoma was a "one trick pony," and he suggested that he was discharged because he didn't provide consistent value to the operation.  Never mind that he received a $9.3 million bonus for his sweating our inside information from Dr. Gilman on Wyeth and Elan studies. 

There's no way that Mr. Martoma can exonerate himself or come out a winner, because someone has to be sacrificed, as this six year pursuit of SAC is now stale and can't provide incremental career boosts for the lead prosecutors.  You can't sweat blood out of a stone, and the SAC story is now just that. 

Even if Mr. Martoma were able to supply details of his conversations, the physicians are immune from prosecution and now contend that were lured or tricked into making public information they shouldn't have revealed.  Mr. Cohen can use the famous "I have no recollection of any such conversation."  

Mr.Martoma seems like a wan, confused, isolated character without any friends in high places.  The press are out to add unsavory, and irrelevant details, like his changing his name and now, his doctoring a Harvard Law transcript. Is that relevant to the alleged insider information trades? "In the halls of justice, the only justice is in the halls."  

Friday, January 10, 2014

JP Morgan: Size Alone Is Far From The Problem.

The financial crisis happened, and the response of our journalism machine, politicians, regulatory bureaucrats, academics, and corporate apparatus is put out mountains of reports, testimony, articles and propaganda about what happened.  Nobody reads this material, so the operative narrative is written when the dust has settled and memories have become cloudy. 

The best picture of what happened inside of JP Morgan Chase is provided by their own report on the London Whale trading fiasco. After reading the report in conjunction with mountains of other publications, and having worked inside the bowels of several money center banks, I concluded,

"Institutions like J.P. Morgan are TCTM ("Too Complex to Manage") The talk about the "London Whale" does nothing more than anthropomorphize the huge, systemic risk posed by institutions like J.P. Morgan Chase.  The 2012 CIO losses cannot legitimately be attributed solely to the behavior of one trader, or even to a group of traders."

Today, a spokesperson from the CFA Institute is quoted as saying in the New York Times
 “With respect to the big banks, it is not so much a culture problem but a complexity problem,” said Kurt N. Schacht, a managing director at the CFA Institute, an organization that promotes ethics and standards at financial firms. “We think these firms are so large that they are always going to be plagued by rogue operators.”
It's nice to be out ahead of the consensus narrative on complexity versus size, but really to take billions from the shareholders of J.P. Morgan Chase makes little sense from the point of view of simple justice.  

The Madoff fraud was out in the open for anyone to see who was doing their jobs, and this means the SEC in particular. The best due diligence is often very straightforward, and after the fact seems simple, but it's not.  Harry Markopolos did his job when he tried to replicate Madoff's published trading strategies in a real market.  There were others on trading desks who had never heard of Madoff, despite the huge trading volume he would have created if his strategies had been real.  These traders were always under the regulatory umbrellas of FINRA and the SEC, and it would have been easy to interview them and ask them about the Madoff funds.  Harry did the math, and he reported it to the SEC. It went nowhere. The SEC, and its highest officers, should pay the billions to Madoff investors because the evidence was put right in front of their noses and they ignored it 

Besides turf wars between the Boston and New York offices of the SEC (a hallmark of government regulatory and prosecutorial operations), Markopolos "describes poor investigative ability at the SEC." In the newly minted, redacted press narrative, J.P. Morgan Chase pays the bill because they can and because they have little choice.  The people who failed to do their jobs have new leaders, more notoriety and bigger budgets.  Go figure. 

Thursday, January 9, 2014

IBM CEO: All Is Not Well With Watson

Well, the big announcement came from IBM, and it wasn't at all surprising.  It also leaves questions unanswered.  The NYT headline reads, "IBM Is Betting That Watson Can Earn Its Keep."

The Watson Business group will have three relevant features that speak to the weakness of the initial concept. 

  • Locating it in the East Village far from Armonk speaks to the need to develop a different kind of culture from Big Blue. It is also allows the company to draw from a wider base outside of New York City, since it is easier to get to the Village than it is to Armonk. Princeton and the little tech belt in New Jersey come to mind.
  • Experts in industries will be part of the development team. This would presumably address problems the Watson project has had with clients, including WellPoint. 
  • The group will have a small venture fund, which clearly says that the basic computing platform needs innovation around its analytical core which can't be done quickly through IBM. 
Henry Morris of IDC says what we've been saying for some time,“Big Data by itself isn't value, it has to deliver recommendations about what to do,"  It can't do that until IBM works directly with its customers to help them understand the dynamics of their own businesses in a way that's helpful to the computer's modes of operation.

Yesterday's comments from WellPoint's Vice President about the IBM Watson experience are a bit puzzling. She said, "...Watson initially took too long to "learn" WellPoint's policies. The task was then to check against treatments for beneficiaries to see if they complied with the policies.  This is not at all a super computing task. IBM's inability to essentially design Google-type searches around the problem seems hard to believe.

The problem, as we said yesterday, is not all about hardware or software--though the latter is a real issue--but it's about being able to work together with the customer and to really understand their needs, as opposed to fobbing off an order for some iron, software and support, which is the traditional IT package. 

On the next conference call, look for analysts to seek revised and specific goals for the Watson Business Group like revenue, net effects on expenses, and earnings contribution to the Road Map.  Get working on those slides now!

Finally, the comparison of the current CEO's early tenure with that of former CEO Sam Palmisano leaves out the luck factor and timing of market and IT cycles.  This is a different time and a different environment, and there needs to be more work done on IBM's sales and customer service paradigms than was evident during headier times.  

Wednesday, January 8, 2014

IBM: Watson Needs A New Sales Mentality and Model

We believe that super computing is an opportunity for a limited number of global players in the future. Super computing is one of the areas where a tangible connection can be made to the whole ephemeral concept of Big Data.

Particle physics research, running large scale climate simulations, and weather forecasting are examples of a few areas where customers are deploying super computer configurations and buying new iron. These are long cycle, episodic big ticket sales. This is not what IBM is used to doing.

Personalized medicine and supporting patient diagnoses with simulations and statistical analyses have a long way to go, and it's not clear that this will generate the kind of quick fix revenue growth that investors like.

One of our most widely read posts talks about the IBM Road Map and some of its assertions, which might not be consistent.  The problem is, as it is for most of the Tech Giants, revenue growth.  We noted,
 "The Road Map assumes, on average, 11% a year in constant currency growth contribution from IBM's "growth markets," which means non-North America and developed Europe.  It won't be easy."
 Markets outside North America and developed Europe surely won't be driven by super computing sales. And, furthermore they will likely vary too much quarter-to-quarter to move the consolidated revenue number on a consistent basis.

So, back to super computing. Much of the hype surrounding Watson comes from IBM's own PR that attempts to differentiate itself from other super computing players by talking about "machine-based learning." That is, the machine starts working on a complex business or process and quickly learns where it can produce better results and adjusts itself.  Some of the thought behind this is futuristic, but much of it comes by analogy from Deep Blue/Watson's work on chess and Jeopardy! where this process worked well.

The big difference?  In both these cases, the rule books were rather small and rigidly defined.  They were fixed and would not be improved.  Even though chess has lots of combinations from a move, the whole computational matrix had boundaries defined by the board, numbers of pieces, and rules limiting the kinds of moves a piece could make.

A machine learning a business today is hype.  Today's WSJ article essentially has the customers saying so.
"For example, Watson's basic learning process requires IBM engineers to master the technicalities of a customer's business—and translate those requirements into usable software. The process has been arduous."
The first problem is that most customers don't understand their businesses well enough to document the processes in flow charts or decision trees.  Heuristics are in place that work currently, but many of these reside in people or groups.  All of this has to be documented, processed and checked by the IBM engineers and then written into software.  Only then can the machines try their hand at simulating, modeling and back testing the results.  This process, as opposed to the hyped "machine learning" is time and people intensive.

The sales process for this kind of deployment is not the kind that tech salesmen like, viz. find an upgrade area and make the sale on specs, provide financing, and book it just like you've done for years.  Aftermarket support can be done by relatively lower cost resources doing traditional IT fixes.

The kind of post-installation support, including business consulting as opposed to IT consulting, required at a large medical institution is going to totally different from what IBM is used to providing.
"So far, just a handful of customers are using Watson in their daily business. With the supercomputer's help, health insurer WellPoint Inc. determines if doctors' requested treatments meet company guidelines and a patient's insurance policy. Elizabeth Bigham, a WellPoint vice president, said Watson initially took too long to "learn" WellPoint's policies."
So, the IBM CEO felt confident, based on the enthusiasm of her senior sales exec that Watson would have the fastest path to $1 billion of revenue of any venture in the company's history.  IBM really needs to do a lot less of the tiresome "Smarter Planet" brand building, and a lot more rethinking of its sales processes, organizational structure and sales execution before the path to journey's end on the "Road Map" becomes clear to investors.

Monday, January 6, 2014

QE: We Don't Know How It Works

We've never been a fan of the new Fed monetary policy, and here's an excerpt from a 2012 post on the subject:
"First things first.  No QE3.  No Operation Twist and Shout. No more monetary "Shock and Awe."  Lowering rates further or keeping them low indefinitely will NOT raise the "animal spirits" of entrepreneurs and megacap corporate CEOs.  Why?  If there's no reasonable prospect for increased final demand in the foreseeable future, businesses will sit on their cash because the capacity increasing projects still won't be worthwhile even if rates decline by a further 30 bp.  They will instead pursue mega mergers and short-term measures to raise their share prices. Larry Summers makes this point in more colorful language than I can conjure up.
Fiscal policy should be aimed at nudging, cajoling, and jawboning industry to build more pipelines to move North America's increasing energy resources to where consumers need products, building LNG terminals for export, building more refineries, switching coal plants to gas, and building out the power grid and telecom infrastructure, to name a few.  We have to get rid of the budget-busting social initiatives currently in place in order to accommodate a change in the expenditure mix.
Investing in what we need to become productive in the future would be a desirable by-product of this persistent low-rate environment.  Its blind perpetuation would be a continuing transfer of wealth to financiers and speculators."
 Well, it seems that even the architects of quantitative easing don't really know how or why it works.  New York Fed President William Dudley, himself an alumnus of Goldman Sachs, should certainly be among the most qualified to understand the effects of QE on investors and on market behavior.  Instead, we read in the Wall Street Journal that,

  • Mr. Dudley and Fed Chairman Bernanke see "clear benefits" from QE
  • Mr. Dudley acknowledged that a lot is still unknown about how the bond buying works
  • "we don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”
One would have thought this statement would have generated some market consternation, but with the continuing euphoria the markets remain strong.  

Unwinding the Fed balance sheet, or removing $2 trillion in deadwood from commercial bank assets at the Fed, will not be simple.  The proposed reverse repo mechanism is fraught with risk and unintended consequences.  I hope to return to this in a future post.

Fed President's Plosser's consistent concerns about the Fed balance sheet have characterized him as a 'hawk,' whatever that is, but now his concerns have been echoed, in different language by a 'dove.'

Saturday, January 4, 2014

Separating Symptoms From Disease at Microsoft

The WSJ has a piece on the fact that Microsoft after four months hasn't chosen a successor to CEO Steve Ballmer.  Yes, this is a comparatively long period as corporate searches go, and yes the issues they point out real, if not obvious.  Both co-founder Bill Gates and his hand picked, ineffectively long serving CEO Ballmer are still on the board, which creates problems for a successor who wants to clean sweep the company.  The bizarre presence of Value Act investors on the board means that they are suggesting one of several possible value enhancing strategies which are out of step with incrementalism.

All of these are symptoms of the real underlying problem: Microsoft's current corporate structure is inefficient and ungovernable, if the goals are to use capital efficiently, create incentives for employees, maximize its market opportunities and to create substantial shareholder value.  Looking to one messianic leader to exert magic with the current structure, culture, board and legacy of mediocrity has to have proven extremely difficult. The good news is that in this case, taking time is much better than being rash.

Microsoft needs a major reboot with new leaders, incentives, structures and board.  Technology buyers, especially on the corporate side, have to be hoping that their needs will be addressed by an energized and industry-leading player.  If the board does its job well, perhaps that will be a new Microsoft.

Friday, January 3, 2014

Huawei and Balkanization of IT

The Wall Street Journal reports on the continuing circus at the National Security Agency, where it continues its investigations into the security of IT products.  This is the same issue that we wrote about in 2012, except at that time the discussions were more open in the form of testimony before a Senate committee on Capitol Hill.

Today, Huawei, which is one of several vendors allegedly under investigation by the NSA, calls for avoiding the "balakanization" of IT products by political or national geographies.  Well, it seems that back in 2012, Huawei wasn't forthcoming enough for the standards of the Senate investigators.  Give the customers what they want if the market is important to you.

Of the companies mentioned, Cisco seems to have the most appropriate response in an accessible blog format.  To some extent, they are citing chapter and verse from their own internal controls over IT, and a customer can read the appropriate documents without having to search or call the company.  That itself is a comfort when something like the Der Spiegel article hits.

According to the Journal, HP is waiting for information and documents from Der Spiegel.  That isn't the best public response.

Thursday, January 2, 2014

The Chrysler UAW Bailout

The auto industry bailouts during the financial crisis completely overturned our traditional legal statutes governing how creditors are treated during bankruptcies. With today's announcement that Fiat is buying out the 41.5% of Chrysler which it does not already own, these issues are as evident as ever.

A 2012 Backgrounder from the Heritage Foundation gives good information and references which are very consistent with the most recent October 2013 report from the SIGTARP Inspector General.

Chrysler has been mismanaged for many decades, and it has had several turnarounds.  None of them ever really addressed their operational and product development mismanagement, or their labor costs which were among the highest in the American automobile market.  Pre-bankruptcy labor costs at Chrysler were $76 per hour in May 2012, higher than both GM and Ford at the time and significantly higher than costs at Honda, Toyota and Nissan.

Pre-bankruptcy, Chrysler has $6.9 billion of senior secured liabilities and $2.9 billion of junior secured liabilities, according to the figures in the report.  $5 billion was owed to unsecured trade creditors.  Chrysler owed $8 billion to the VEBA (Voluntary Employee Beneficiary Association) formed in 2007 to assume the liabilities of the employee retirement plans.

Bankruptcy allows the corporation to restructure its contracts, subject to two heretofore inviolable principles. Secured creditors stand first in line for recoveries, including the ability to seize encumbered assets if necessary.  Unsecured creditors are considered the great unwashed, and they are traditionally wiped out or in unusual circumstances get pennies on the dollar as recoveries.

Because of Chrysler's long, troubled financial history its bonds were secured debt, which wasn't typically the case.  Senior secured creditors of Chrysler who were owed $6.9 billion recovered $2 billion, or $0.29 on the dollar.  The junior secured creditors somehow recovered $0.0 on $2 billion owed.

In this kind of structure,  which is very unusual, the unsecured creditors, including the UAW/VEBA, should have expected nothing except to be wiped out. Instead, the Obama administration converted the $8 billion into a 41.5% stake in the reorganized Chrysler, along with a 9% note.  The total 2012 PV of the Chrysler bailout, which only benefited the UAW and its membership, was estimated at $9.2 billion in the report cited.

Labor agreements and labor costs are traditionally renounced and reset in bankruptcy agreements.  While labor costs were adjusted to close the nominal gap to Honda/Toyota/Nissan to around $56 per hour, Chrysler workers will still earn substantially more than the average U.S. manufacturing sector worker, with no ties to productivity or work rule flexibility.

The exercise of Federal control and intervention in financial markets and in matters like executive compensation of corporations in which it has bought a stake at gunpoint will surely be regarded as a weakening of our economic system whose virtues we trumpet so loudly.  The government's facilitating of rent seeking by its favored political constituencies, like auto unions, is also an unprecedented manipulation of the bankruptcy process in which the role of the judges and administrative apparatus have also been marginalized. "If there's money up for grabs, I might as well be the one grabbing," a client once told me. He was a greenmailer, but his motto is still relevant today.