Wednesday, May 28, 2014

Microsoft: A Consumer Company?

Microsoft CEO Satya Nadella's address at the Code Conference was reported in the Wall Street Journal. We're going to focus on a few points.  Here's the first BIG one.  Mr. Nadella says,
We will always be this company that spans enterprise and consumer markets."
We've addressed this issue at length in a widely read 2013 post with the short title, "The Good, Bad and the Ugly."  Especially within the siloed, political, entrenched, labyrinthine culture that is Microsoft, it is highly improbable that there could be a company that could understand and serve CIOs as well as needy, finicky, and fickle consumers.  

Here is a significant data point from the news of the week: Microsoft's launch of the Surface Pro 3. Against the analyst and tech industry reporters grain, we were an early admirer of Microsoft's research and product development process that produced the Surface. Watching my sister, an HR executive, work on it, typing effortlessly suggested that this might be a tablet on which real work might be accomplished, as opposed to downloading movies or watching playoff games. 

The Wall Street Journal's reporter gives a very positive review to her working experience on the Surface Pro 3.  She writes,
"But the Surface Pro 3's greater appeal is as a laptop replacement. In fact, it's one of the most portable PCs ever made. Microsoft has remarkably crammed all the high-power guts of a laptop—in the case of my $1,300 review unit, a Core i5 processor, 8GB of RAM and 256GB of solid-state storage, though sadly only one USB port—into that thin magnesium case. Even the MacBook Air is almost double the thickness and weight." 
 Here's what reinforces my thesis about the company being tone-deaf to consumers:
"Not only did Microsoft not do enough to perfect the Type Cover, that very thing that makes the Surface a laptop, but it still isn't included in the box. It's a $130 add-on. That's like buying a car without tires."
This comment has been made by every writer, blogger, Tweeter and social media dude since the introduction of the first product.  Did the company listen? Of course not.  This is Microsoft, kings of monopolies, profits and cash flows. As Nike suggests in another context, "Just Do It!"  Give consumers what they want.  Make them happy. Sacrifice a little gross margin to buy their loyalty to your innovation.  Not the predatory Microsoft of the Ballmer era. 

For all Mr. Nadella's good intentions, and for his gesture with Office for iPad, it will be very difficult, nigh impossible, for a company that serves, not merely spans, enterprises and consumers to flower from the current organization.  

Monday, May 26, 2014

Exxon Ships LNG From Papua New Guinea

Exxon Mobil's massive $19 billion LNG project in Papua New Guinea, begun in 2010, has shipped gas ahead of schedule. It is a complex project because of the physical and engineering connections among resources in the Southern highlands and underwater transmission and pipeline infrastructure, ending in an export terminal, with the first output going to a Tokyo power utility.

PNG's government has always had a complicated relationship with the Australian government, multinational corporations, and with its own citizenry's various special interests.  The nominal, lifetime production volumes of this first project are 9 trillion cubic feet of natural gas over the 30 year project life.  An economic impact study of the project was commissioned and published.

Without second level, or multiplier, effects the project is estimated to produce 3-6 billion kina of annual net benefits to Papua New Guinea over the project life.  These benefits are the government's take from public and private taxes, royalties, development levies and charges, and return on equity form a 19% stake in the project, which was funded by a controversial loan from UBS.  The costs are the additional expenditure for providing public services to the project environs and residents, both local and expat.  7,500 jobs will be created, of which 20% will be filled by local citizens.

The idea of putting the net cash flows into the creation of a sovereign wealth fund, on the Norwegian model, has been discussed ad nauseum. Were the government able to pull this off, without letting the surplus evaporate or be spent foolishly, this would be a great example for other developing countries looking for a new model for commercializing their natural resources. Other projects linked to this one are waiting in the wings. A new energy exporter has been born!  Let's hope it turns out really well.

Thursday, May 22, 2014

HP's FY14 Q2 Call: Financial Engineering and Confusing Messages

We're more than two years into HP's long journey, which I recall CEO Meg Whitman characterizing as a five year turnaround.  Listening to the analyst questions on the webcast, I can confidently say that I wasn't alone in being confused and a bit concerned about the messaging, particularly from CEO Whitman.

Let's fly over some of the numbers, without going into the minutiae. Consolidated net revenue in the quarter was $27.3 billion, down 1% year-over-year and 3% sequentially.  On a constant currency basis, revenues were flat year-over-year. In the Personal Systems business, revenue of $8.2 billion, increased by 7% as HP regained the leading industry share in corporate desktops and laptops, benefiting from a corporate spend rebound driven by the XP support expiration.  Operating margins continue to be tough in this business, and the OM increased by 30 basis points to a paltry 3.5%.  Printing revenue declined by 4% to $5.8 billion, but the operating margin increased by 360 basis points to 19.5% of revenue.

The discussion of this business was all over the place.  Reference was made to the historical lack of innovation to a tired line of multifunction laser printers, which has opened the door to Japanese competition. With a large installed base, toner business was down, but it was unclear why.  An analyst question on this point drew a confusing response. The consumer ink business was said to be "good," whatever that meant.
A 360 basis point increase in margin deserved a simple, clear explanation, but it wasn't forthcoming.

The printing business' segment operating income in the quarter was $1,430 million.  The operating profits of the Enterprise Group and of the Enterprise Services combined were $1,105 million.  This is not a healthy balance for the future.  Unlike Microsoft's consistent demonstration of the power of its Enterprise businesses, HP seems to be treading water by issuing lots of press releases and launching web pages. The Enterprise Services business continues to go nowhere, with operating margins below that of the Personal Systems business.

For example, it wasn't long ago that a conference call heralded the launch of the Moonshot server line, which presumably was going to rescue the company from the commoditization of ISS.  On this call, Moonshot was again mentioned, but with a very cautionary tone. My takeaway? It is a New Thing, but not the Next Big Thing.

On the current call, the CEO lauded the creation of HP Helion, a sort of "Joy of Cooking" for the IT customer looking to create any kind of cloud: the recipe is in Helion.  Have a look at the HP Chief Marketing and Communications Officer explaining what HP Helion means.

Total non-GAAP operating income of $2,341 million was flattish with a year ago, and the operating margin declined by ten basis points to 8.6%.  Net earnings of $1,691 million were flat to a year-ago, and diluted, non-GAAP EPS of $0.88 per share was at the high end of the guidance and of analyst expectations. The EPS compared to $0.87 per share in the prior-year period, on the same basis.

For the six months fiscal year 2014 to-date, the company spent $1,396 million on share repurchases, about 42% of FCF over the same period, and the average price per share received was $29.70. $596 million was paid to shareholders in the form of dividends over the six months.

The CFO made reference to buying shares only with a "return based" focus: the stock was a bargain, her comments implied. With the current revenue outlook, more significant cost cutting, and a P/E which seems to fairly reflect the uncertainty, what kind of internal model would suggest that shares are a bargain at $30?

Confusing Messages

After looking at the company and its businesses for two years, "more opportunity" was found to improve the cost structure and speed up internal customer response and innovation by having an additional 16,000 staff leave the corporate work force!  This raised a pretty high degree of angst among the cadre of analysts who are the leading voices on the stock, no matter what their opinions.  What were their concerns?
  • Much of the success in righting the ship and stopping the hemorrhaging has been accomplished through the 2012 planned reduction in force. If anything, the benefits expressed in future, lower run rates of expenses have been above-plan.
  • The expected turnaround in revenue from an improving IT cycle and the cloud hype has not materialized.  It seems to be pushed out into the indefinite future.
  • $11 billion was spent on Autonomy, and most of that was written off.  Litigation was promised through the British SFO.  Nothing has happened.  Now, in fact, positive references are made about an Autonomy's win for its IDOL system in the current quarter, and its product revenue grew in the quarter. Will this acquisition be the building block to drive the Software segment forward, or will other acquisitions be necessary?
  • George Kadifa, the former operating Partner from Silver Lake, is giving up his position as head of the Software business, after he was brought on with much ballyhoo reporting directly to Meg Whitman. Robert Youngjohns is taking over this portfolio.  What does this mean?  Is it a real move forward, and if so, "Why?"  
  • References were made to being halfway into the turnaround, and in other places, the company was in the "early innings" of improving execution.  Where are we, and exactly when will the right players be in the right place with the right attitude?  
  • Put it all together, and the analysts, each in their different way, expressed their angst.  Does the announcement of another staff reduction of 16,000 mean that this is the only way in which the management can meet its stated guidance?  Is there diminished confidence in the revenue-producing capability of the businesses?  
  • Does this mean that analysts should be raising their estimates for the impact of this new staff reduction? Should they raise for this AND a revenue turnaround?  Their customers will ask them tonight after the conference call, or by the latest tomorrow morning on their morning calls. They were told to wait until October's Analysts Day for additional guidance.  Wrong Answer!!
  • The CFO made a point that she sees the benefits from cost cutting as allowing higher reinvestment in the business, all of which is done on a "returns basis."  When and where would be reinvestment be done?  Research and development takes time and is expensive. This spend has been flat anyway. What does the CFO mean by this, and how would it compare, return-wise, to share buybacks above $30 per share?
  • A legitimate question was asked about the effects on an organization's morale from continued, substantial downsizing.  It is a very real issue,and the answers were, frankly, inept and insensitive. For the survivors, there will be a period of mourning and diminished productivity.  
  • There was a lot of sharp-penciled financial engineering in the quarter, as in getting the DSOs down to very low levels, apparently helped by increasing reliance on factoring of the corporate receivables, if I heard this right.  This is all good, but it won't get this company where it says it wants to go.  
  • All in all, the tone of this call rang hollow. It is very hard for the Buy/Outperform analysts to make a case going forward for multiple expansion when there is nothing to hang their hats on for a revenue turnaround and predictable business outperformance. 








China Has the Strong Hand in the Russian Gas Deal

Using energy resources, particularly natural gas, as an instrument of foreign policy and for restoring Russian hegemony won't work in the long run. The Russian economy rests on fragile demographic, market, human capital and social foundations.  Actually, the same could be said for China, but they have demonstrated a more flexible pragmatism than has the monomaniacal President Putin, and the Chinese hold the stronger hand in this energy deal with Russia.

Morena Skalamera's piece for the Geopolitics of Energy Project of Harvard's Belfer School is a good summary of the history leading up to this deal and its implications.

The Sino-Russian relationship dates back to the 1950s, when as Skalamera puts it, Russia viewed China as a younger brother to be assisted and guided, especially in the area of technology and nuclear development. With Khrushchev's renunciation of Stalin, Chairman Mao saw an opening for China to take the reins of the global Communist movement.  This was seen as overreaching, and the brothers fell out.  Their subsequent relationship has been distant and aloof, based on mutual suspicion that has continue to the present moment. The writer correctly points out Henry Kissinger's adroit interposition of the U.S. into the bilateral relationship, making it a strategic troika. Our gains have been meaningful over time, our mistakes legion, and our future leverage is significant.

Analyzing this particular natural gas deal without the historical political context leads to making this appear more significant than it really is.

As President Putin mentioned in one of his communiqu├ęs, Sino-Russian bilateral trade is some $90 billion, making China the single largest trading partner of Putin's Russia. The bilateral trade was some $6 billion in 2000.  Russia, by contrast, is China's ninth largest trading partner.  The composition of their bilateral trade is important to consider.  Russia exports raw materials, especially energy, while China exports finished consumer and industrial good to Russia.  

None of this is lost on the Chinese leadership, and they have very clear objectives for their ongoing economic relationships with the Russian energy sector, which go way beyond cutting checks for overpriced natural gas. 

China has massive liquid resources to invest, and they are looking for equity ownership in Russian energy companies, especially upstream.  Why?  Because, deep down the Chinese leadership is rightly suspicious about Russia's reliability as a secure source of supply for gas.  Where would they get this idea?  From President Putin's own statements and gleeful manipulation and strangulation of Ukraine.  

Russia and its oligarchs don't want anybody from outside the brotherhood getting under the covers at Gazprom or any other energy company.

According to the Harvard report, 30 billion cubic meters of natural gas are covered by the agreement, beginning in 2018 for a period of thirty years.  Nice, big round numbers, for sure.  The Chinese government certainly won't want any part of the great deal that Russia gave to the Ukraine.  As Skalamera's piece points out, natural gas is not a global commodity like oil, which can be priced globally as soon as it hits the water for transport.  Natural gas is a regional commodity, where pricing is clouded by the high fixed cost and indivisibilities of pipelines that can't be switched on and off, or have flows reversed for arbitrage. Beijing, the report says, has an eye on a price close to that of gas on the Kazakhstan-China border.  Russia tried to foist off a formula based on Henry Hub-driven indexes.  Billions in pipeline construction won't begin until the real meat and potatoes of this deal are consummated, and we are far from that.

Our shale bonanza has resulted in diverting gas from our relatively low consumption to LNG exports to Europe where it has driven prices down.  This has not beneficial to Russia.  Each dollar/BTU drop in natural gas prices in Europe costs Russia $4 billion in annual revenue, according to a Citibank report cited by the Harvard researchers. Further, Russia needs oil prices above $107/barrel in order to balance its internal finances, or in other words to keep oligarchs and restless people happy.

China has a very large, well drilled and equipped military, so Russia cannot have any leverage from threats, implied or real. Russia knows well that China could, in a pinch, have ambitions for the sparsely populated areas of Eastern Siberia.  Russia doesn't come into this energy "deal" with the kind of power it is exerting over an enfeebled Ukraine.


Look at this photo of the two leaders.  The gentleman on the left looks very calm, relaxed and understands exactly who and what he is dealing with. The gentleman on the right is thinking, "So what do I really have here besides a photo op?  Dealing with Obama was fun: this isn't."




Sunday, May 18, 2014

Cisco's Third Quarter and Cloud Computing

Whereas the fiscal second quarter for Cisco wasn't a barn burner by any means, the fiscal third quarter ended April 2014 did have some encouraging signs.  The third quarter results evidenced that while the IT industry and its customers struggle to get their arms around cloud computing models, any company that wants to be around for the party needs to be able to manage its legacy businesses through a halting transition. Cisco seems to be very capable of doing this, despite its flat stock performance over the past twelve months. Its financial strength and balance sheet also give it a big advantage over some other aspirants.

Revenue of $11,545 million was down 5.5% from the prior-year period, and 46% of the revenue came from the core businesses of switching and routing, which declined 6% and 10% year-over-year, respectively. Service revenue of $2,725 million has been flattish quarter-to-quarter in the current fiscal year, but it increased 3% year-over-year in the third quarter.

The future core of Cisco will include Data Center revenue, which increased 29% year-over-year to $662 billion, and Security revenue of $361 million that increased 10% year-over-year.  So, these two businesses already account for almost 10 percent of consolidated revenue.  That is not to say that some portion of Wireless and Collaboration revenues won't move over into this future core offering, but Cisco seems to be making a successful marketing effort to help customers understand their commitment to a broad and deep product and service offering for cloud computing.

Revenue in the Americas increased 3% year-over-year, with Enterprise customers increasing their purchases by 6% and Commercial customers growing by 3%.

While investors are legitimately concerned about gross margin compression, the company continues to manage this transition well. GAAP consolidated gross margin rate in the third quarter was 60.7%, down 80 basis points compare to the prior-year period.  Product gross margin declined by 120 basis points on a GAAP basis; on a non-GAAP basis, the decline was 70 basis points.  Service gross margin rates were flat on both bases, at 65.4% on a GAAP basis.  On a year-to-date basis, the GAAP gross margin comparisons were distorted by a significant supplier component remediation charge.  All told, revenues in the legacy businesses declined, and gross margins are under some pressure.

However, in the quarter, there was a discernible improvement in the order trends.  Total US orders increased 7%, and Enterprise and Commercial orders both increased by 10% year-over-year.  Orders in developed Europe increased by 7% in the UK and by 4% in Germany. Orders in the global Security business were up 20%.  This is a change from the prior quarters of the current fiscal year.

Emerging markets continue to show weakness across the board, but we don't think that investors will perform their litmus tests for the company on these markets.  Sales and gross margins in Asia Pacific Japan and China are weak, with gross margin rates at 58%, which is a real problem.

Non-GAAP net income of $2.64 billion compared to prior-year period net of $2.5 billion, on the same basis. Diluted EPS of $0.42 compared unfavorably to last year's $0.46 per share, but the non-GAAP EPS of $0.51 exceeded analyst expectations.

Operating cash flow was $3,198 million in the third quarter.  Share repurchases were $2,005 million and dividends were $974 million, so nominal cash returned to shareholders was $2,979 million, virtually all of the OCF in the quarter.  While this is commendable, given the importance of the transition to a new business, it just feels like this mechanistic, formula-driven capital allocation may be overdone.

Worldwide cash balances were $50.5 billion, of which $4.6 billion is domiciled in the U.S. The ongoing issue with repatriation and potential taxes should be cleared up in order to take this economic distortion off the table.

The company issued $8 billion of debt in the quarter, of which $3.3 billion was devoted to refinancing maturing debt.  The company said that the dividends and share repurchases were funded by $3 billion out of the net new cash raised of $4.7 billion.  More tax and financial engineering, but that is what a strong balance sheet affords this company.

At a presentation given at a Cisco UCS (Unified Computing System) meeting, the speaker reported on a survey which said that top corporate IT departments allocated 75% of their resources--essentially skilled labor--to management of their applications, software layers and infrastructure.  A meaningful implementation of cloud computing would require this allocation to fall to 25%, with the rest of the resources devoted to strategic development of IT resources to achieve specific business goals.  Clearly, the institutional structure of corporate IT workflows and their own bureaucratic cultures offer both barriers to, and opportunities for blue chip cloud providers to expand their sales of software, services and management to their corporate customers.

The technologies themselves aren't the big problem, but the siloed, reactive setups in corporate America and Europe are.




Wednesday, May 14, 2014

Reconsidering Cloud Computing

I've spent quite a bit of time with my eyes and ears open, watching and listening to expert practitioners in my professional network talk about, and work on, cloud computing projects.  A reconsideration, and a sharpening, of my position is in order.

As readers know, I have been very skeptical about the whole catch phrase called "cloud computing" since its inception, which seems to have been over six years ago, if one were to take serious discussions in professional IT forums.  Dr. Irving Wladawksy-Berger is a retired IBM scientist who writes a rich blog on computing topics, with lots of links that allow me, as a primary source, research-driven type, to delve into some of the seminal research publications in this field.

As Dr. W-B points out, most of the meetings from five or six years ago began with the question, "What Is Cloud Computing?"  The various, vague, contradictory answers given, along with the obvious self-interest of the consulting groups, made me comfortable that it was hype, full of sound and fury, signifying nothing of lasting value.  Today, he suggests that Cloud is a new model of computing, but that there is no single dimension to define a computing model.  Taken together, this means that Cloud, like pornography, may a priori resist definition, but we'll know when we see it. 

An IBM glossy publication says, "Cloud computing is a pay-per-use consumption and delivery model that enables real-time delivery of configurable computing resources (for example, networks, servers, storage, applications, services)."  The term pay-per-use wasn't adeptly chosen, but you get the idea.  It is a workable definition from which to start.

IT consulting companies, such as Accenture, like to trumpet lots of advantages for cloud computing, but the ones that don't require using IT to become a "disrupter" are cost flexibility and scalability.  The cost flexibility comes from taking large fixed costs of buying computing power (servers, or even supercomputers), storage, data analytic software, applications, development tools, and services up front and either capitalizing or expensing them; a preferred vendor could provide them customized and bundled on a metered, or variable cost basis. The second benefit, related to this one, would be avoiding the lumpiness of buying a big system and growing into it.

We've always felt, from some of the linked posts above, that IBM would have a compelling offering in cloud computing.  We also suspected that HP could also be a player, once it had raised itself from its self-imposed, corporate death bed.  We are wondering about HP's role, beyond their many pronouncements.

As Dr. W-B writes about cloud computing, "The cute child in now a teenager, still full of promise, but also full of mischief if not properly handled."  This is  a very appropriate metaphor.


Tuesday, May 6, 2014

Target CEO Change Was Long Overdue

Retailing industry stocks were my institutional research bread and butter for many years, and I followed Target when it was a budding business within Dayton Hudson.  It has been a remarkably successful business, carving out a distinctive niche, while tweaking its merchandise offerings to adapt to changing consumer tastes and trends.

Like many early department store companies, whether public or private, Target is a merchant driven company.  Any initiative that serves the merchants is a good investment from the corporate management, and it was usually good for earnings too.  Merchants don't know, or care, about data security.  That is why the notion of spending millions on data security, which insiders felt was needed as the credit card portfolio expanded, was never considered important.

This attitude is amazing, because in many fundamental ways, Target's success came from being heavily programmed and systematized in things like store formats and their roll-outs.  Nothing was left to chance or to local improvisation.  No detail was too small for corporate attention.  Data security should have been on the radar screen for the board.

Post-data breach, the way Target has handled it has been so abysmal even for a bad retailing company; for an industry leader, it is shocking.  Aside from a full page ad in the Wall Street Journal, and from commiserating with other customers, Target has, to my knowledge, never sent out letters to all their private label and bank debit card customers telling them what happened, how serious it might be, and offering them solutions to protect their accounts. We never got any communication, and our family spends a lot of money at the store; and we replaced our bank cards on our own and received no notice of free credit monitoring, as alleged in newspapers.  I doubt that a large proportion of their customers, excuse me "guests," read the Wall Street Journal.

Unlike the press characterization of the intrusion as being high tech, it seems that it was decidedly low tech. In fact, one of the Target systems actually detected it, but the culture of Target either placed no confidence in their own systems, or the IT department's processes for communicating upward don't work.

Canada has been written about, but these kinds of execution shortfalls in an adjacent market is inexcusable.

The stock price spent much of 2013 in the seventies, before languishing downward to the low sixties in the face of a market fleeing to big capitalization, high quality names.

The problem going forward is this.  Bringing in a retailing star from another company, like Walmart for example, isn't guaranteed to work because of the huge differences in the business models and management cultures. The new CEO would have to spend time sorting out her team while learning where the bodies were buried.  Elevating a top merchant sounds fine, except merchandising is where some of the fundamental mistakes have been made, like going too far upscale with programs that had to be closed out.  Target is having a bit of an identity crisis, and it has been going on for some time.

Financial engineering with real estate and returning money to shareholders wasn't a solution when Pershing Square beat its chest, and that is the same story today, if the company wants to remain a major league player.  At least this change gives the board the opportunity to get things right.  The question will be "Have they left it late?" A dead stock for a while?