Saturday, October 24, 2015

Thinking About HP Enterprise

As we come closer to the official splitting of HP into two companies, I've been listening again to the HP presentations, looking at some of the other big players and reviewing  my SWOT analysis of HP Enterprise.

In the three year turnaround of HP, CEO Meg Whitman characterizes FY 15 as being a year of "accelerating progress," in which the combined company invested in security, networking, and cloud activities and acquisitions, as well as on improving execution.

She noted that research and development as a percent of sales increased in each of the three turnaround years.  The company, she said, introduced new products and services, e.g. all flash memory, 3Par storage, HP OneView, software defined networking, a Gen 9 server, enterprise-wide implementation solution for Office 365, and HP Helion, i.e. the public cloud.

Post-split, HP Enterprise will have pro-forma revenue of about $50 billion, with operating margins of over 9% and operating income of about $5 billion.  Fifty percent of revenue will come from enterprise hardware, 37% from enterprise services, 7% from software, and 6% from financial services.

Notice the absence of any reference to Big Data, a major theme of several conference calls during the three year turnaround period.  IBM still talks about this theme, especially in its research publications, and in connection with Watson.  What happened? Autonomy.  The only way this acquisition made sense was as the analytical engine and product generator for a Big Data effort.  That investment has been vaporized, and whatever remaining products are in the market can't sustain a major presence in this theme. A definite weakness going forward.

We've written for more than three years about the weak, commodity service focus of Enterprise Services.  Despite the cost base restructuring, the fundamental weaknesses of this business compared to others like IBM and Accenture remain.

A $4 billion software business which has flat lined for several years is too small to be important to the needs of CIOs in the transition to the next generation data centers.  Another weakness that we've identified for years is still in the standalone company.

I would surmise that CEO Whitman, in her heart of hearts, sees the same landscape.  How else to justify a statement like more than 90% of the IT spend over the next several years will be what she calls "traditional IT."  This should be comforting to investors, presumably, because 50% of HPE revenue will come from traditional hardware boxes.  Also, traditional hardware sales have historically been accompanied by enterprise services contracts.  Actually, these statements, which may be correct, are reasons to be very much afraid if one were an HPE shareholder.

Traditional IT Spend Means Further Hardware Commoditization

A recent podcast on the Andreessen Horowitz website, entitled "Dell + EMC: Say Why?" gives some interesting views on how CIOs will behave over the next few years.  The first generation model of the data center is what they call the "Wall Street Data Center," made up of server racks from vendors like Cisco, HP, Dell, storage products from EMC, and Oracle software.  The next gen data center is represented by Facebook, Google, and Amazon.

In their deployments, server hardware has been truly commoditized, to the point that the best way for Facebook to achieve performance for its particular business needs is to produce its own customized server designs.  The software layer of the stack is the critical element in this type of data center.

Dell's recent merger with EMC positions it as a systems provider to some types of enterprises in helping them get the the next gen data center configuration.  Dell, which survived commoditization of its once core PC product, is better equipped to survive a commoditization of server hardware than is HP, so the panelists suggest.

What Kind of Cloud For Large Scale Enterprises?

The Andreessen Horowitz panelists agree that the future will largely be made of up of hybrid enterprise clouds, incorporating some legacy structures alongside newer, next gen designs.  Public clouds are a losing business, given the efficient, excess capacity of Amazon Web Services.  As we have written for some time, AWS, despite some recent big wins in the public sector, won't be the option of choice for the largest, multinational corporations in data intensive, higher risk industries like financial services, energy, and transportation/logistics.  

HP recently announced that it is shutting down its Helion public cloud business touted as an exiting new product introduction by CEO Meg Whitman just a few weeks before; HP is sending its customers to AWS.  This leaves HP pursuing the hybrid cloud structure, against stronger competition.

The panelists cite the fact that relatively few companies have the kind of technically savvy, global sales forces to succeed in selling and implementing a hybrid cloud computing offering to the biggest global companies.  They name IBM, Microsoft, and EMC as being the strongest sales forces, and HP are not mentioned.  So, Dell's interest in EMC beyond storage is in acquiring a world class sales force in order to help it become a systems provider and service partner for its customers.  

Most companies, the panelists rightly say, cannot wave a wand, spend billions, and risk their businesses on a straight implementation from a Wall Street data center model to a Facebook-type data center. Instead, they reckon that most CIOs will recognize that there is excess capacity in public clouds and huge price pressures on hardware vendors; the customers will exploit both to give them a multi-year, relatively lower cost glide path to the development of some Facebook-style new data center architectures alongside legacy public clouds.  

The winners in the private enterprise clouds they reckon will be, as we have suggested, Microsoft Azure and IBM.  

HP Enterprises path to generating earnings growth beyond year 1 of easy comparisons will be fraught with difficulty, and raising research and development expenditures significantly or making big acquisitions will both be greeted by consternation on the part of new shareholders. HPE may still suffer from the past sins of the combined HP entity, despite a workmanlike, three year turnaround. 

Tuesday, October 6, 2015

MSFT Lowers Expectations and Declares Victory

Microsoft's PR flaks must be encouraging the CEO to get in the news more, and he has been placed in two recent, high visibility stories.  In one, there is a rambling, philosophical interview about long-time insider, CEO Satya Nadella being, in fact, an "outsider" at Microsoft.  There seems to be little evidence so far that (a) this is true, or (b) that it would be making a difference to making this behemoth more nimble, responsive to consumers, and consistently innovative.

In 2014, we wrote,
"The Nokia acquisition could easily become this company's Waterloo.  Value creation at Microsoft won't happen with the Ballmer-created organizational rabbit warren, bloated cost structure, and dysfunctional culture that we've written about in our most widely read posts."
Well, Steve Ballmer has gone to play with new toys, including basketballs.  Microsoft wrote off 80% of the the value of the Nokia acquisition, according to the WSJ; this was inevitable, as we wrote when the Windows Phone forecast of 15% market share was first given.

Now, CEO Satya Nadella has pared back the plans for new Windows Phone launches to what looks like a very singular offering for corporate users.  So that leaves me, an early adopter, and a somewhat satisfied user of the first Nokia Cyan an orphan.  Typical Microsoft.

My first experience with Windows 10, which was okayed for my aging but perfectly functioning Windows 7 laptop, was tremendously dissatisfying. Windows 10 comes with bloated, self-serving products like Microsoft Edge, and it doesn't seem to work well with the free version of Outlook Live. My local copy of Outlook from Office 2013 froze up, crashed, and lost many of my contacts.

Of course, the Waterloo analogy is a bit overwrought, as this company can financially slough off this economic fiasco.  However, this company badly needs a cultural evangelists inside the company that can speak for the consumers, not the corporations.  Inside Apple, that person happened to be Steve Jobs at the top, and throughout the organization it was populated with people obsessed with the user experience and feedback.

Windows is really betting the farm on Windows 10, and Waterloo may be down the road apiece unless things really change.  I hope that the CEO gets a machete and hacks away at the culture inside Microsoft that could have allowed the Windows Phone to be relegated to a meaningless share of the mobile phone market.

Wednesday, September 23, 2015

More Process Doesn't Mean Better Governance

I've been a presenter at governance classes at the University of St. Thomas Law School and at various professional association fora.  Every once in a while, there is a somewhat smug comment from a presenter about the 'superior' European corporate governance model, which consists of a management board and a supervisory board.

Well, here come the recent revelations about Volkswagen.  I know a lot about Volkswagens, having been an owner of a Beetle and several Rabbits, including a German built Diesel that got 50+ mpg during the era of high U.S. gas prices.  When they weren't in the shop with inexplicable model year problems, e.g. electrical system problems, fuel line problems, and ignition system problems, they were a joy to drive, real German fun for less than a BMW or Porsche.

Well, here is a link to the governance process at Volkswagen Group. Layering on more internal auditors, creating more process, and complicating financial reporting and notes to the financial statements cannot lower the risk of this kind of corporate value-destroying behavior which may have been implemented deep in the bowels of an engineering organization, but which must have had management consent at various levels.

Now, the Wall Street Journal speculates that the potential losses due to regulatory and judicial exposures in America and the EU could wipe out the firm's equity.  But, the truth of the matter is that strategic and executive mismanagement are also culprits, as they have been for years at America's own hapless General Motors.

The Jetta, is a car I often coveted.  I didn't see the value in its higher prices over the basic equivalent Rabbit/Golf platforms. However, the Jetta was just beginning to get traction over the far more bland Accords and Camrys.  Management made a decision to make the cars feel more like these cars by---wait for it--taking away the driveability of the car.  These seial changes, described in WSJ articles, are just as much to blame as this recent fiasco about engine management software designed to cheat EPA tests in the destruction of value.

Political forces, particularly in the sunsetting Obama administration will fillet out the coffers of Volkswagen for the benefit of client constituencies and for the benefit of the U.S. Treasury.

A CEO resignation isn't enough to fix this problem, and meanwhile VW can kiss its ambitions in the U.S. market auf wiedersehen for years.

Friday, September 4, 2015

A Shrinking U.S. Equity Market?

$173 trillion in investable assets in all forms of retirement funds.  Thousands of mutual funds in the U.S., more worldwide, looking for equity investments, as advisers continue to trumpet the need to own high equity allocations in order to participate in global economic growth, particularly outside of the developed markets.

Of course, developed economies, particularly the U.S., will continue to grow too, despite current doom and gloom.

Right now, governance lawyers trumpet the need for shareholder activism by all institutional investors.

Investors want mature companies to retire their outstanding share bases in order to artificially pump up share prices, never mind the longer term growth prospects for the ongoing company.

Private equity sponsors are awash in dollars, and everyone is seeking higher returns after years of central bank-enabled lower rates around the world.  They look to take out mature firms which they judge to be under performing.

What happens when you look into the stew pot after throwing in all these ingredients?  It may be "Honey, I Shrunk The Investable Equity Market!"  There may not be enough listed, liquid, institutional quality U.S. equities to satisfy the appetites for them!

It's something we've long suspected could happen, and now a National Bureau of Economic Research Working Paper 21181 (May 2015) by Dodge, Karolyi, and Stulz says that we may arrived in such an undesirable situation already.  A copy of the paper just landed on my desk, but interested readers with AEA or other professional memberships can access a copy through NBER.

The abstract has the punchline, and since this is publicly available, I reproduce it:
"The U.S. had 14% fewer exchange-listed firms in 2012 than in 1975. Relative to other countries, the U.S. now has abnormally few listed firms given its level of development and the quality of its institutions. We call this the “U.S. listing gap” and investigate possible explanations for it. We rule out industry changes, changes in listing requirements, and the reforms of the early 2000s as explanations for the gap. We show that the probability that a firm is listed has fallen since the listing peak in 1996 for all firm size categories though more so for smaller firms. From 1997 to the end of our sample period in 2012, the new list rate is low and the delist rate is high compared to U.S. history and to other countries. High delists account for roughly 46% of the listing gap and low new lists for 54%. The high delist rate is explained by an unusually high rate of acquisitions of publicly-listed firms compared to previous U.S. history and to other countries."
If their analysis is correct, the real situation may be worse than it seems. Delists account for 46% of the listing gap, according to the authors. But, the delisting gap should be higher than it is.  There are so many microcap companies that trade below $5, and more below $10 a share that really have no business continuing to be public.  I've long felt that boards should work to perhaps consolidate some of these companies, to create a portfolio of products and revenue that might be attractive to institutional investors.  Institutionally, this isn't possible because companies don't want to throw in the towel and merge with another weak sister.  Most large mutual funds are not permitted to invest in companies like these anyway, since they are extremely illiquid and not followed by Wall Street.

Furthermore, what's coming down the pike in terms of future IPOs?  Let's look at Google, for example.  Everyone is making money on the shares which almost singlehandedly, along with Amazon and other uber-caps, are driving the indexes.  So, no one complains.

Since shareholders can't exercise their rights in Google because of the multiple share classes, they are not owners in the traditional sense.  Activism here has no meaning. The new tech companies have little need for massive capital investments, aside from those arising from pie-in-the-sky projects like driverless cars.  As such they should be poster children for returning cash to shareholders, but au contraire, they have little appetite for doing so.

None of this is lost on the investors and managements of Uber, Alibaba, and all the other supergiant companies that have to eventually become IPOs.  Investors can't continually raise the arbitrary valuations of these companies, and continue to pour in cash when it is becoming apparent that cash balances alone won't capture the growth they require for their current valuations.  Witness Uber and its battle with its Chinese nemesis.  So, if the next wave of IPOs is dominated by these kinds of companies, large cap funds of every stripe--tech sector, growth, new era---will all wind up owning the same companies while charging wildly different fees.

Meanwhile, retirees will need income but the pool of dividend paying companies is shrinking, with mergers being one reason.  They are also buying back their shares.

I get a headache thinking about this, but it is a real problem beyond the current fast food menu in financial journalism.  Keep an eye on this one, and I am doing some work on this for other reasons.

It is Labor Day weekend in the U.S.  Enjoy some time with your family and friends. Equity markets will open next week as usual.

Thursday, August 13, 2015

Berkshire Hathaway's Issues Aren't Its Numbers

Berkshire Hathaway's net income for its fiscal 2nd quarter 2015 declined 37% over the prior year period, which generated some market consternation.  However, in a holding company of this size and breadth, driven by insurance businesses, volatility is a fact of life, as the Chairman himself has often said in his letters.

The big question about this company can be framed in terms of corporate succession, and that is certainly where the press reports traditionally have gone.  The genius of the company so far lies in its structure as a holding company and on distinctive features of its operating model.

"There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by our corporate headquarters in the day-to-day business activities of the operating businesses."

One of the companies I followed as a research analyst was RPM, International, the old Republic Powdered Metals.  Founded by entrepreneur Frank C. Sullivan, the company grew rapidly under his son, Tom Sullivan.  The two corporate leaders were Tom Sullivan and CFO Jim Karman, much like Warren Buffett and Charlie Munger.  The paragraph above describing Berkshire applies very well to the RPM I covered. RPM's long-term superior returns and sustained dividend growth have proven out its model, and its market cap today is north of $6 billion, driven by acquisitions, just like Berkshire.

A really key difference highlights the uniqueness of Berkshire's model, which is something I've written about for some time: it is the breadth and spread of the business portfolio.  RPM's portfolio is all in specialty chemicals and coatings worldwide.

Berkshire's portfolio encompasses a huge insurance business, spread over personal lines, commercial lines, and reinsurance.  Beyond that, it owns a leading railroad, a significant manufacturing company portfolio, and significant energy utility business.

In the case of both companies, acquisition of portfolio companies has taken place over a long period of time, with the important factor being the operational acumen and character of the target company founders or executives.  All an investor has to do is to read Berkshire's Chairman's Letters over time to see the repeated reference to portfolio company leadership when calling out outstanding results. Judging character and letting the operators run the companies are common features of both company models.

Going back to the Berkshire 10 Q, we read, "Berkshire's senior corporate management team participates in and is ultimately responsible for significant capital allocation decisions, investment activities, and the selection of the chief executive to head each of the operating companies."

It is the husbanding of corporate cash flows from the operating companies, together with the insurance float and holding company financial capacity by Warren Buffett and Charlie Munger and the reallocation of the pool among the different operating companies, investments, and acquisitions that lies at the heart of Berkshire's long-term success.

The operating company executives do their jobs in stellar fashion, and they are in good businesses to start with.  They are extremely well compensated, and they are allowed to act like entrepreneurs, though they are managers.

With this context, let's go back to the question of corporate succession.  Mr. Buffet's son, Howard Buffett as non-executive Chair.  He has written an interesting book, "Forty Chances."  Beyond that, it's frankly hard to see how this succession would give an investor confidence in the future, to be dispassionate about it, as an analyst would have to be.

Next, assume that Berkshire's most successful, adept and widely respected executive in his industry (insurance), Ajit Jain were to be named as Berkshire CEO.  The press talks about him as the leading candidate, whatever that means. Would this be a comforting move for investors?  I would say, "Not necessarily."

First of all, who would succeed Mr. Jain as leader of an insurance empire that contributed $2.3 billion of net earnings over the six months of fiscal 2015 to-date?  Who would have similar insights into the entire panoply of global insurance lines that Mr. Jain possesses?  Without knowing that, it would be foolish to just jump for joy at Mr. Jain's ascension.  Shareholders know nothing about the holding company leadership at the next level in order to make an informed assessment.

Secondly, Mr. Jain's interest in stepping out of an industry he knows like the back of his hand, into a portfolio which goes from box chocolates to railroads and reallocating capital among them might not be very strong.  He probably realizes that this would not be his forte, nor would it be "fun."

CEOs of operating businesses tend to be specialists, which to some extent underlies their success. They know, grew up in, or have a passion for railroads, bending metal, or pricing risk.  I don't know a comparable figure to Warren Buffett or Charlie Munger among all the hundreds of companies I have covered, researched or visited with in my travels.

So, the question really boils down to whether or not the Berkshire Hathaway model and its historical success are inextricably bound up with the business philosophies, characters, and acquired networks of the two current leaders.

Take the next idea bandied about, namely that one of the two new investment executives named to run the liquid investment portfolios were named to lead the company.  Frankly, investors should probably head for the exits.  Their limited experience is in traditional asset management, no matter how sharp they are or how well they are doing with inherited portfolios.

Think about the long-serving operating executives of the holding company subsidiaries.  With a change, would they feel as comfortable and secure with the structure to which they have committed their energies? I don't know, but I suspect that they would have questions and might lose focus for a time.

I suspect the reason why Mr. Buffett has been so coy about the "succession" issue is that he himself knows that (1) too little attention has been paid to it because of the complexity of steering a company this size and growing it through massive acquisition since 2013. And, (2), there is no simple answer in naming two leaders.

Tuesday, August 11, 2015

Google's Alphabet: Seizing the Day

Our mid-July post on Google focused directly on corporate structure, focus and returns to shareholders, especially dividends to return excess cash.  It looks like Google's founders have learned their lessons quickly with a dramatic announcement of a reportedly Berkshire Hathaway-like holding company structure and a division among their core businesses and their longer-lived, investment businesses which will be run by their founders.  Here is the quote that piqued my interest from Larry Page's letter,

"We've long believed that over time that companies tend to get comfortable doing the same thing, just making incremental changes. But in the technology industry, where revolutionary ideas drive the next big growth areas, you need to be a bit uncomfortable to stay relevant.
          Our company is operating well today, but me can make it cleaner and more  transparent"

Talking about the Four Horsemen of tech--Cisco, HP, IBM and Microsoft--we feel that it isn't at all guaranteed that all of these players will stay relevant to their customers just by shuffling the asset deck among separate companies, or by just selling businesses.

Concerning IBM, it has been reported that Berkshire Hathaway has continued to buy IBM shares, thereby somehow comforting retail investors that holding on is a good thing.  Tech darlings can become irrelevant: remember Digital Equipment, the darling of Harvard Business School professors for their innovation and culture?  Remember Wang Labs?  Remember Cray Research? (not the current company)  It can happen.

It can happen to Microsoft too.  Larry Page hits the nail on the head. You need to stay relevant, and incremental changes, like reorganizations or shuffling executive portfolios, won't do it.  Big company boards and executives like stability and comfort: being uncomfortable is a cultural shift, which IBM, Cisco, HP and Microsoft all need, some worse than others, but all basically the same.

To be fair, though the BRK analogy has some flaws.  Berkshire Hathaway works for, among several reasons, the capital reallocation process from subsidiary income dividended up to the holding company level, where Warren Buffet, checked by Charlie Munger, makes the critical decisions.  I suspect these decisions will continue to be made by founders Page and Brin, with a bias towards the long-tailed investments.  More clarity is needed here.

Sundar Pichai has earned his spurs in the core businesses, through managing and growing several very large ventures, and it's great that Google's founders have moved rapidly to put the company jewels in safe hands.  He will need some help dealing with Wall Street and adding other duties to his operating portfolio, but this kind of transition is done very slowly at most NYSE-size companies. Here it was done with a quick strike, but there's nothing wrong with that.

Shareholders have reasons to have expectations biased to the upside. Their co-CEOs have been listening and reflecting, as engineers often do, but they have acted at a stroke, which engineers are often wont to do.


Tuesday, August 4, 2015

Andreessen Horowitz and The End of Windows

I read a very interesting post by Ben Evans, a partner at Andreessen Horowitz, titled "Microsoft, capitulation, and the end of Windows Everywhere."

In many ways, what he says about Microsoft is right in alignment with our writing over the past few years.  In some other ways, namely about the future of computing, I am not sure that extrapolating the present gives the picture about the future winners.  It almost never does.

Mr. Evans introduces his article by saying that it's very difficult for large companies--like Cisco, HP, IBM and Microsoft--to throw in the towel on a business.  His identification of internal corporate processes driven by strategy teams and abetted by high price, outside consultants as outlawing giving up is hilarious, and true. I've sat through many of the "hundred-page decks" myself, arguing that tacking while staying the course was the best.

Back in 2013, we wrote,
  • Establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.(This means that the legacy though currently very profitable will inhibit real innovation.  Microsoft needs to let go of Windows and its legacy)
Ben Evans puts it succinctly, "Windows is not a point of leverage for Microsoft in mobile."  

He also debunks the strategy put forward by Microsoft CEO Satya Nadella which emphasized courting the developer community to build apps for Windows 10, which will appear across all computing form factors, from tablets to phones and desktops.  Again, Mr. Evans writes, "Uber doesn't have a desktop Windows app, and neither does Instacart, Pinterest, or Instagram.  The apps and services that consumers care about are either smartphone-only or address the desktop using the web, with only partial exceptions for the enterprise." 

He unfortunately confirms my suspicion that my value-driven move to Windows Phone on Nokia devices will leave me abandoned in the desert, as Microsoft often does to its loyal customers. Windows 10 will mean nothing to me on this device, as I have the look and feel, and the great apps like Here Maps already.  

We are in rabid agreement that "Microsoft has missed mobile," but I am not sure that I agree with Ben's  conclusion that all computing will be done on phones.  

The most current, relatively disinterested data on smartphone usage comes from Pew Research, and I direct my readers to their surveys and conclusions.  But, let's go back to another strand from the IT Guru Business, namely "Big Data," and Smart Cities and Smart Corporations.  We know that the back end of these houses are going to need massive computing power, mainly driven by cloud-style models with consulting and analytical support.  

On the front end, where are the analysts, directors, and VPs going to do all their data analysis, scenario testing, and supporting work for presentations?  Certainly, none of this can or will be done on a phone, unless people start carrying around 30" flat screens!  If this phenomenon is real, as all the tech CEOs have said, since they are reporting their multi-billion dollar revenue run rates on every conference call, then surely this significant transformation of enterprise research, analysis, business forecasting, risk management, and financial forecasting won't by supported by the growth in the number of smartphones.

Suddenly, a device like Microsoft Surface looks like a godsend, or Apple's Macbook Airs.  

Pew's research shows that, especially for younger users, whether students or entry level employees, smartphones are used to relieve boredom, to text, send photos, find friends who are in the neighborhood and other non-GDP enhancing uses.  

Is the smartphone the future of "computing?"  Who knows?  But, it surely depends on what's meant by "computing," The venture backed companies developing apps are doing it in office spaces, on big displays, backed by computing power supplied by Amazon Web Services and others.  They may use their phones to order pizza at the desk, but the future of computing is surely more complicated and nuanced than that.  

Tuesday, July 28, 2015

Cisco Hightails It Out of Some Businesses

Cisco made two executive announcements, namely a new CTO and a CDO ("Chief Digital Officer"--whatever that means).  The announcement about flattening the organization by eliminating layers of xVPs is long overdue, and it is a good, but unquantifiable, omen.

The more significant announcement is one about throwing in the towel on a September 2013 acquisition of flash storage provider Whiptail for $415 million. The legendary ability of Cisco to integrate acquisitions seamlessly has always seemed to me just that, a legend.

I have yet to learn about a large company acquisition of an entrepreneurial company that has resulted in an effective integration, including that of the founders and their internal teams. The particular fable of Whiptail is informatively told by a UK tech publication.

There will have to be more of this portfolio rationalization, given all the acquisitions Cisco has made. Cisco seems to have a really sales driven culture.  Delivering internally sourced, innovative new product on time seems not to have been a core competency, hence the acquisitions.

What will this look like going forward?  That will be the question for the new leadership team, with Mr. Chambers looking over the shoulders as Chairman of the Board.

Well, on the subject of the cloud, we really missed the boat on Amazon Web Services (AWS).  3 month revenue for AWS for the period ended June 30, 2015 was $1,824 million up 81% from the prior year period.  Even though segment expenses increased 54% on the same basis, the segment margin for AWS increased to 21% from 8% in the prior-year period.

Critics, of which I was one, will say that this public cloud revenue isn't where the action will be.  The truth is: nobody knows.  The CIA win for AWS over IBM was a real shot across the bow for the industry.  AWS revenues are annualizing at almost $7 billion based the six-month fiscal year-to-date numbers.  That Amazon was able to staff up both the technical, back office and sales organization for this kind of business growth so quickly should put the incumbents on notice.

What do you expert readers out there have to say about AWS?

Friday, July 24, 2015

Tech's Four Horsemen: A Midyear Checkup

Some of our leading, bellwether technology companies--Cisco, HP, IBM and Microsoft--have reported earnings recently, and although I have parsed them and listened to the basically uninspiring conference calls, the Four Horsemen all stand at the same crossroads, between reinvigoration or a secular irrelevance.

Notice that I avoid the word "reinvention," as I haven't seen organizations of the sizes of the four ever doing that; the word has become a cliche in financial lingo.  Lew Gerstner didn't "reinvent" IBM; he pruned the portfolio, changed players and shook up a staid culture, all of which together reinvigorated a sclerotic organization.

All of the organizations share one common fault: their boards and executive managements all misunderstood and underestimated the nature of the changing demands of their CIO customers and the rapidity with which their customers were being called on to respond to larger business issues, and not just technology issues as in the past.  They all missed the boat, and there are a lot of sharp people populating these behemoths.

Satya Nadella's remarks during his overview to his earnings call presentation referred to the "market transformation" that was hitting Microsoft, which he summarized as being comprising mobile computing and the cloud.  IBM and HP also talk about "big data," in addition to mobile and the cloud. John Chambers and his team intone about the "Internet of Things."

So, if the five year average revenue growth rates for IBM and HP are -0.6% and -0.5% respectively (according to Morningstar), then why are these companies furiously reacting rather than leading and innovating?  Cisco's revenue growth was 5.5%, and Microsoft's was 8.2% over the same period, but acquisitions and a virtual monopoly in a core business fortuitously helped these two companies perform respectably on the top line.

However, it is Microsoft CEO Satya Nadella who says that his company must undergo a "transformation" which will translate the market transformation into a "growth opportunity" in revenue, earnings and market capitalization.

With the recent CEO change at Cisco and with the relatively predictable character of their financial performance, I really don't have much insight into where this company is going, although with a median operating margin of 22%, healthy interest coverage of 18x, and relatively low debt-to-capitalization, it is positioned well to do something meaningful to reinvigorate a somewhat plodding, methodical story.

HP is creating a buzz for itself by splitting into two companies. HP Enterprise is their corporate IT facing business, the "growth company."  However, it's a very curious thing reading their red herring. Nowhere in the stated advantages of the split is there any reference to improving their ability and agility in serving their CIO customers better!

There are plenty of references to capital market issues, e.g. more strategic focus, better capital allocation, an optimal capital structure, and giving investors a growth company which should be valued better than a more diffuse portfolio.  Serving the customer should always come ahead of serving the shareholder, because without gaining more customers and increasing their retention and lifetime value, there will no source for rewarding the shareholders except financial engineering, up to a point.

For the six months to April 30th, HPE had revenue of $25.6 billion, down 6.4% from the prior-year period, with operating income of $1.2 billion, a 4.5% margin.  The Enterprise Group's revenue of $13.5 billion was relatively flat to a year-ago, and its operating income margin was 15.1%.  The Enterprise Services group had a woeful OI margin of 3.3%, and its issues are longstanding; the Software business revenue of $1.8 billion is far too small to drive the boat, and its operating margin of 17.9% is below par for the industry.  The successful reinvigoration of this company is by no means a slam dunk, and former CFO Cathy Lesjak, the voice of reason on Autonomy, has gone over to the former printer business.

IBM continue to attract the interest of legendary value investor Warren Buffett.  This aside, there is something really wrong at this company.  Writers at Forbes have cannily gone back to the career of retired CEO Sam Palmisano.  Thirteen consecutive quarters of revenue declines for a company of this size and pedigree ought to have generated board members handing in their resignations; it's inexcusable and unbelievable.

Mr. Palmisano's success came as a rainmaking salesman, but unfortunately that way of selling to the largely ignored, relatively lazy CIO has gone forever.  The nature of the sell has changed, and the customer, with some skin in the game for business success, is now asking questions and looking for value and partnership rather than new hardware and modest software updates.  Mr. Palmisano transformed his salesman's passions about quota records into a slavish focus on Wall Street numbers, hence the dreaded "Road Map."

Instead of returning all that money robotically to shareholders with declining revenues, acquisitions like SoftLayer should have been the focus much earlier.  The sales culture and organizational comfort have all got to change.  This late into the game, it won't be easy unless there are big, uncomfortable changes, which might make a somnolent board uncomfortable.  Gradualism has brought IBM's P/E to 10.3 according to Morningstar.  Warren Buffet has always said he is not interested in a mediocre company at a great price.  Does he own a great company at a great price? Only time will tell, along with a whole new attitude within Big Blue, and a new way of coming to market and making technical sales.

When IBM lost the CIA cloud contract assignment to Amazon Web Services, it was a big wake up call that even with a significant portfolio of federal government business, Big Blue lost a marquee contract to a relative upstart with better customer service, technical support, and hourly unit pricing. The company learned from this error and fixed many holes in its offering by acquiring SoftLayer.

Ending our review where we started, with Microsoft, we still wonder as we have since 2012's Microsoft Reboot post, if this company can reinvigorate itself with a portfolio serving two distinct markets--corporate and consumer--with one historically dysfunctional culture.  The consumer franchises should be extremely valuable to a different kind of company.  Despite its relatively high valuation metrics, Microsoft high returns, befitting of a software company, may be justified.  Its median operating margin is 33.2% according to Morningstar.  A true "transformation" of Microsoft in its current form seems very difficult, and some bloggers suggest that shareholder ValuAct has been lobbying for a split-up of the company.  This split-up would have all to do with core competencies, technical and engineering knowledge, versus understanding of gamers and the entertainment industry and what these actors want in terms of content and delivery models. Don't get me started on Windows Phone!

CEO Satya Nadella sounded a little frustrated on the company's most recent conference call, and he seemed to want to impose his stamp on every response to a question, a contrast to his more nuanced answers in the past, where he let his CFO take the lead.

We were very positive about Surface when it was a greenfield development project inside Microsoft, and indeed it sales more than doubled in the recent quarter, year-over-year, to $888 million. What's more the incremental gross profit contribution compared to the prior year was $1.33 billion.  When the company puts its mind to computing and making people more productive, that's more in its wheelhouse than are gaming and consumer entertainment.  Overall, there may have been some disappointment it Microsoft's most recent quarter, but there is lots of potential to unlock significant value if there can be a real cultural shift within this long dysfunctional organization.  Another wait and see.

Thursday, July 23, 2015

Memo to CNOC: We Told You So About Canadian Oil Sands

In 2010, no less, when Canadian heavy oil deposits were beginning to have financial and energy pundits breathe heavily we posted about the economic and environmental problems associated with these deposits, based on our own work on these resources decades back. First of all, not all these deposits are created equal.

Extractive technologies may have improved, but the political and environmental risks, required returns on all-in costs, and realistic oil prices continue to place these resources, as a broad class, relatively low down the value chain.

Today, the CNOC's policy of trying to anticipate global energy futures and cement a strong position in extracting oil sands from its Long Lake project ran aground, according to the Wall Street Journal.
The problems are easy to enumerate, and they are not happening to state-owned Chinese enterprises for the first time:

  • When venturing into production areas that are beyond the corporate technical competencies, don't go it alone and don't make big bets.  For this, see also Petrobras' experiences with deep offshore oil.
  • Pick an established global partner, even if you have to give up some economics.
  • Control is an illusion.  Global markets have confounded smart players in many fields since time immemorial.
  • Environmental risks in environments like Alberta and the Arctic, for example, should never be underestimated.
Reducing its capital spending program will make it very unlikely that CNOC can fulfill its global aspirations without significantly reinventing its business model and strategy. 

Saturday, July 18, 2015

Google's New CFO Says Return Money to Shareholders, Maybe?

On June 7th, in the context of the sometimes great hubris of the corporate engineering class, we wrote that Google should consider paying a dividend.

In her first conference call, Google's new CFO thought out loud about buying back shares or paying a dividend.

Peter Lynch, the portfolio manager of Fidelity Magellan during its heyday, warned about public company CEOs succumbing to the siren song of "diworsification," in which they took excess capital beyond that needed to sustain their core businesses and instead burned it up into the next great thing, which, of course, only they were able to identify.

Paradoxically, even as Google's stock reached an all-time high, it is absolutely the right time to begin the process of thinking about diversifying the way in which shareholders earn their required rate of return into some cash and some capital gain.  Nothing wrong with cash and letting the shareholder diversity their portfolios in they way they prefer.

Wednesday, July 15, 2015

Microsoft Says "Näkemiin" to Value from Nokia

Just before the closing of the Nokia acquisition, we had our doubts about Microsoft's ability to realize value from it. Some comments,

  • "Microsoft too, under Steve Ballmer, has said "it's all about services," but the current Nokia platform is poorly positioned to garner anything more than the current 2-3% of all handset sales."
  • "When the Nokia deal goes through I will be curious to read the level of charges taken for workforce reductions in Finland and for the allocation of the purchase price to intangibles and to goodwill.  That will tell a lot about this story will work, or not, in the future."
Well, the auditors went along with whatever rosy forecasts Microsoft had for handset sales, and they waited.  CEO Nadella made very bullish comments about understanding how app developers looked at the world; he was very bold in personally engaging with them about the future merits of writing for Windows 10 on multiple platforms, including tablets, combos, and mobile. 

Bulls talk about the fact that a $7.6 billion impairment charge on a less than $8 billion acquisition, net of cash, only enhances shareholder value because losses will be stemmed after the restructuring and the company can get on with its business of being a cloud services and enterprise software company. That is a pretty mechanical, textbook accounting view of the world.

As a shareholder, what if your company continues to trail developments in its industry?  What if it is always the perennial bridesmaid, late for her own wedding?  As a pure play cloud company, MSFT is probably overvalued, or fairly valued at best. 

What is the future for Windows Phone owners?  What if 2% of the handset owners switch over to Android?  

HP recently released a Red for its upcoming creation of HP Enterprise.  Among the reasons for the split, there was nary a single one that had to do with how the company put on a better face or presented a better value proposition to customers.  The rationale had to do with other things: you can guess what they were. 

After announcing the write-off of Nokia, it is very unclear what the Microsoft value creation proposition is going forward.  "One Windows Experience" across all platforms is pretty lame.  What if there is no one on the mobile platform?  Windows 10 has some slick features as far as controlling and working with smart tvs and other devices, but this isn't a big deal.  It's just catch-up....again. 

Tuesday, July 7, 2015

Greece Moves to Become a Banana Republic

Here is a picture of what a real European leader looks like (Associated Press):

Greek politicians have overplayed their hand. "Give me more money, or I'll shoot myself!"  Let's say, in the eternal Euro-Optimist view, French mathematics are applied to Greek sovereign debt, i.e. stretched out to 40 years, with rates and face values TBD.  It is guaranteed that there will never be any meaningful economic reform in Greece, other than maintaining the current government employment/pension mess and taxing a small private sector into oblivion.  The European Union itself is the big loser, but Chancellor Merkel will earn the devil's horns, while the French and the French-led IMF will proclaim victory.  The ECB will live to waste capital another day.  Other peripheral countries, and perhaps some core members, will realize that there are no teeth in the rules of the EU.

We hear from private economists and a few think tanks that Greek sovereign debt risk has been "ring fenced."  If that is true, then the only real impact of Greece's ill conceived intransigence will fall on their own people, which may be appropriate and the best thing for their democracy in the long run. What comes after the debacle will bear watching, but the economic risk to the EU can be absorbed

Greek PM Tsipras has 61% of his electorate behind him.  If he really is leading his country down this path, he needs to accept the consequences, get driven from office eventually, and the body politic can repair itself.

The only European politician who has stubbornly and effectively tried to show leadership on key bilateral and multilateral issues, like Ruusian sanctions,  has been Chancellor Merkel.   Strong and effective leadership in Europe is something at which elitists crinkle their noses.

If Greece defaults, it is their medicine of choice, and a convulsive purging is much better than a 40 year, slow bloodletting, where spending trajectories don't change and economic growth will be minimal.

Friday, July 3, 2015

France Reappears To Support Greece?

From the very beginning of our posts on the Euro, dating back to 2011 we have talked about the fundamentally divergent interests of France and Germany. For a while, French President Sarkozy made a concerted effort to have arms outstretched for his partner, Chancellor Merkel.  Since the next regime, things have become somewhat aloof, if not frosty.

We noted in a recent post, that French President Hollande was not visible as Chancellor Merkel was playing the despotic aunt, refusing to finance her profligate nephew, Greece.  The Wall Street Journal reports that President Hollande is visibly counseling about the risks of continuing to play hardball with Greece and a consequent default and Grexit.

It comes down to the original conception of  the European Union, which dates back to 1950-51 and initiatives championed by French foreign minister Robert Schuman, whose work we studied in our European economics seminar at the University of York, which I attended as an overseas student during my junior year of college. Here is a quote ascribed to Schuman,
  • "Europe will not be made all at once, or according to a single plan. It will be built through concrete achievements which first create a de facto solidarity."
Customs union, currency union, free movement of capital and labor, harmonization of regulation, abolition of non-tariff barriers, and the unspoken political union.  It was a grand vision, to be sure, but more than half a century later, its defects and limitations continue to show.  

Looking at the history and origins of the two world wars, one would be very hard pressed to make a case for the notion of 'solidarity' across national boundaries, when solidarity within those same boundaries is becoming more questionable.  

Greece and its vaunted talent bank of American-trained economist/politicians have been irresponsible, but their actions are rational responses to the sometimes perverse incentives built into the whole currency union operations.  If money and credit are being given away, why not take it?  

We may now see the consequences of that strategic gambit. 

Tuesday, June 30, 2015

The EU and Greece Share a Cup of Hemlock

Since 2012, we have written about the inevitability of the events the European union are facing today, a Greek sovereign debt default, an exit from the euro currency zone, political chaos at home, and a fundamental failure of the grand European experiment.

To reach this conclusion, no complex economic models are needed.  The design of the system and the notion of divergence, along with the history of relationships within the zone, point the way.

To be sure, along the way, there were many false dawns, as European politicians do what they do best summit meetings and consultations with smiling faces and bowed heads, walking in some countryside.  Hedge fund managers used their tools to call a bottom in bond prices and got involved.

Fast forward to today, and there are no financial markets to impose any discipline on Greece.  Hedge funds have gone home chastened with their losses, and Greek sovereign debt is owed to the IMF and to the ECB, with the biggest chunk being owed to Germany.

For all the Ph.D.s among the Greek expat intelligentsia, for all the worship of game theory and Nash equilibria, Greek politicians have gone beyond brinksmanship to simple economic lunacy.  Asking the EU to wait for a Greek national referendum was irresponsible. Greek government pensioners don't want any changes in the status quo and blame outsiders, like the IMF, for their problems.  A "No" to acceding to further fiscal discipline may be a vote against the EU, but it is also a repudiation of failed Greek political parties.  It does no one any good, except to save face for the Tsipras leadership failure.

For Germany, not how French President Hollande is no longer at the Chancellor's side, as they were inseparable a few years ago, co-leaders of the European experiment, along with the IMF, now led by a French national too.  Chancellor Merkel is now by herself forcing Greece over the cliff.  Of course, she has no real choice.

The Greek alternative to fiscal austerity has been a plan in which, for example, pension payouts were guaranteed, and a plan dependent only on revenue raising through taxes on small businesses, with no more fiscal austerity.  No Ph.D. is needed to see how this plan would turn out.  So, any rational observer has to realize that Greece is no longer serious about reforming its economy to meet substantially higher growth targets.

But, since the Maastricht Treaty is silent about unilateral exits and the mechanics thereof, a Grexit really calls into question the whole value of the euro, the ECB, the ESM, and all the bureaucratic empire that has been created in Brussels.  Which peripheral member would be the next to take bitter medicine?

Although Plato took liberties with the poisoning of Socrates, in terms of describing symptoms and a drawn out death, it probably applies well to Greece and to European Union.  If Greece takes its bitter medicine and defaults, leaving the Eurozone, there will be great economic weeping and gnashing of teeth.  But, Greece will have made Europe pay a price too, finally exposing the emptiness and futility of the eurozone as it has been laid out and administered so far.

Thursday, June 18, 2015

Satya Nadella Shuffles Executives: Microsoft Still Too Ponderous

One of our best read and most forwarded posts was about the accession of Satya Nadella to the Microsoft CEO chair, which really excited us, in the midst of all kinds of Wall Street consternation.
Perceptions about Microsoft among its customers, developers and Wall Street really picked up quickly, and the contrast with the imperial Ballmer Reign was also a refreshing change.

Microsoft continues to be a cash flow behemoth, with untold flexibility to speed up product development and to rebound from its historical behavior of misreading consumer trends and being a clumsy, heavy handed late follower.

But really, the latest executive shuffling is just the traditional reversal, which puts more and more onto the plates of two existing executives.  Here is the relevant quote from the CEO,
"To better align our capabilities and, ultimately, deliver better products and services our customers love at a more rapid pace, I have decided to organize our engineering effort into three groups that work together to deliver on our strategy and ambitions."
Delivering better products and services faster, which work together the way customers want, is something that needs to be achieved now, not ultimately. Making this change doesn't really seem to be demonstrably positive for the important goal.

Microsoft still seems like a big, ponderous organization that is hanging the hat on making the "Windows experience" available across all platforms.  That may be a noble goal, and Windows 10 seems to be generating a lot of excitement among Microsoft store employees, but so many of its features and capabilities, though a move up for Microsoft, will probably be leapfrogged by the far more consumer-aware and organizationally agile Apple.

If the culture of Microsoft is ever going to change it has to be at the layers below the EVPs and deep into the structure of the organization.  I still wonder how this can be done, and how long it will take.

Tuesday, June 16, 2015

Greek Default Without Leaving the Euro? The Wrong Question.

The Wall Street Journal online header asks this question, which John Cochrane of Chicago Booth and many others have answered, "Most definitely, yes."

However, it is the wrong question to ask. For Greece, its political leaders and the electorate have to decide about the rising costs and declining benefits of staying in the eurozone, including the never spoken about effective loss of national sovereignty and damage to the Greek democracy of being beholden to the ECB, ESM, and the IMF, all faceless bureaucrats with other agendas and different cost-benefit ratios.

Greece has lots of economic problems, one of which is the relatively small size of its export sector which has also been hurt by its growing, self-inflicted loss of manufacturing competitiveness, as pointed out in the financial press.  If Greeks are ever to turn their economy into something other than an object of derision and pity, they need to take charge of it, apart from a non-stop, weekly crisis in the world view.

Yes, that pathway will be messy and their will be prices to be paid.  However, the current situation, even with sovereign debt holders taking a haircut, won't end the problems of a "transfer union" that is the euro today.

The EU needs to look at itself, a Greek settlement with significant investor haircuts and write downs, even without a Grexit calls into question the value of the currency union in its current design.

It is not just Greece that faces a day of reckoning.

Uber Plans to Master Delivery? It Hasn't Yet Mastered Its Core Business.

The $50 billion implied valuation of Uber must have everyone scrambling to come up with a new twist on the story while putting their brains on the sideline. 

According to the Wall Street Journal, " Investors are counting on Uber to upend the delivery business much as it has for taxis.." 

The first problem is that Amazon, a public investor darling which has actually proven that it can upend and dominate traditional businesses, starting with books, has targeted rapid delivery with drones. Amazon, unlike Uber, has figured out that it's not worth using a service like this to deliver burritos.  As an investor, I wouldn't feel comfortable putting in capital to take on Amazon.

The next problem is again a limiting factor in Uber's phantasmagorical world of network effects: curb space.  In cities, like San Francisco or New York, there is no curb space, period.  Now, the Uber driver has to leave his car to pick up the burrito, during which time it may be ticketed or worse, and then do the same thing at the destination end to bring the merchandise to the customer. Spoilage and dissatisfaction, including cancelled orders, are another headache, cited in the article.

Assume that Uber wakes up and realizes there is no value-added in delivering low tickets.  Doing this kind of work isn't additive to the core business of driving customers, rather it detracts from it and really raises the stress levels and lowers the returns for its already taxed drivers.  

Even early investor, relentless cheerleader and company director Bill Gurley has trouble choking out this story.  Witness this quote, "Bill Gurley, a partner at venture-capital firm Benchmark in San Francisco and director at Uber, says he has never seen a financial projection for Uber which includes revenue from deliveries. “This company is growing faster than any company I think there’s ever been in Silicon Valley, and that’s on the core product offering,” Mr. Gurley says.

In other words, if this puffery turns out to be nothing, we don't need it to justify the valuation; never mind that other early investors are being mouthpieces now.  Signs of a market top? 

Monday, June 15, 2015

Starr CEO Greenberg Wins Against the Lawless and Discriminating Feds

The Federal Claims Court today ruled in favor of Starr International Company, the largest shareholder of AIG, against the Federal government's treatment of AIG during the "Lehman Weekend" and its unprecedented, claimed illegal extraction of equity in exchange for an $85 billion rescue loan.  No damages were awarded, and though that outcome seems inconceivable, Judge Wheeler's logic had some very weak merit.

 It is a clean, well written opinion, in which the text's many pithy sentences speak for themselves:

  • "This sizable loan would keep AIG afloat and avoid bankruptcy, but the punitive terms of the loan were unprecedented and triggered this lawsuit." 
  • "Operating as a monopolistic lender of last resort, the Board of Governors imposed a 12 percent interest rate on AIG, much higher than the 3.25 to 3.5 percent interest rates offered to other troubled financial institutions such as Citibank and Morgan Stanley. Moreover, the Board of Governors imposed a draconian requirement to take 79.9 percent equity ownership in AIG as a condition of the loan. Although it is common in corporate lending for a borrower to post its assets as collateral for a loan, here, the 79.9 percent equity taking of AIG ownership was much different. More than just collateral, the Government would retain its ownership interest in AIG even after AIG had repaid the loan. 
  • The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance. In September 2008, AIG’s international insurance subsidiaries were thriving and profitable, but its Financial Products Division experienced a severe liquidity shortage due to the collapse of the housing market. Other major institutions, such as Morgan Stanley, Goldman Sachs, and Bank of America, encountered similar liquidity shortages. Thus, while the Government publicly singled out AIG as the poster child for causing the September 2008 economic crisis (Paulson, Tr. 1254-55), the evidence supports a conclusion that AIG actually was less responsible for the crisis than other major institutions.
Though the opinion doesn't recount the discussion, the mere association of an $85 billion loan facility to fund a relatively small Financial Products Division with an 80% stake in a holding company with extremely profitable insurance businesses defies logic; surely other arrangements for collateral pledges could have been made had the Feds decided not to put the gun to AIG's head.  

  • The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. Indeed, with the exception of AIG, the Government has never demanded equity ownership from a borrower in the 75-year history of Section 13(3) of the Federal Reserve Act
The government is cited by Judge Wheeler as carefully orchestrating the taking of equity, installation of management, and overrunning of the company by its favored consultants without requiring a shareholder vote, and to maximize the benefit to AIG Financial Products Division counterparties, the taxpaying public and to the U.S. Treasury.  

On the fundamental issue of illegal extraction of value from AIG shareholders, the court found,
  • "Having considered the entire record, the Court finds in Starr’s favor on the illegal exaction claim. With the approval of the Board of Governors, the Federal Reserve Bank of New York had the authority to serve as a lender of last resort under Section 13(3) of the Federal Reserve Act in a time of “unusual and exigent circumstances,” 12 U.S.C. § 343 (2006), and to establish an interest rate “fixed with a view of accommodating commerce and business,” 12 U.S.C. § 357. However, Section 13(3) did not authorize the Federal Reserve Bank to acquire a borrower’s equity as consideration for the loan. Although the Bank may exercise “all powers specifically granted by the provisions of this chapter and such incidental powers as shall be necessary to carry on the business of banking within the limitations prescribed by this chapter,” 12 U.S.C. § 341, this language does not authorize the taking of equity."
Oops.  While the smart folks at the Fed and the Treasury were working hard to save us from a thirties style depression (a red herring), they did manage to violate a fundamental statute of the Federal Reserve Act in the process.  However, when an enemy with unlimited time, funds and access to the court of public opinion comes gunning for you, surrender might be the lesser of two bad alternatives, and so the AIG board capitulated based on that logic. 

  • In the end, the Achilles’ heel of Starr’s case is that, if not for the Government’s intervention, AIG would have filed for bankruptcy. In a bankruptcy proceeding, AIG’s shareholders would most likely have lost 100 percent of their stock value.
The last sentence threw me because I thought surely that the extremely profitable insurance businesses would have provided some real residual value to shareholders. However, state regulators which are charged with protecting policy holders at all costs, would have brought assets which supported those policies into their ambit through existing state insurance regulations, as well as through other protections.  

In some ways, Starr and Mr. Greenberg are to be congratulated for using their slingshot against our own rapacious, selective prosecuting, and plundering financial regulatory Goliath.  Goliath has almost finished plundering the financial services sector for cash, and as it continues to selectively apply its novel legal theories to its enemies, perhaps other victims may stop and say "Basta!"  Let's see how Met Life does.  

Friday, June 12, 2015

Twitter's Blue Bird Has the Blues

I confess that I have a Twitter account, at the suggestion of a tech industry CEO/founder friend who said it is essential to life on earth, but I also confess to not using it at all. I acknowledge that without Twitter, mainstream and cable news shows would almost certainly have less to talk about and therefore less broadcast time during which they can generate ad revenue.  They owe Twitter a debt of thanks.

I really enjoyed Twitter co-founder Biz Stone's book, "Things A Little Bird Told Me," which is about startups, a personal odyssey, the founding and internal culture of Twitter, and about his ultimate separation.  I really don't like business books, but this one rang true for me and was a fun read.

I remember from Stone's book that he was really the co-founder who interacted with the Twitter user base who, he says, effectively told the company how they wanted to use a new feature the company introduced.  There was such a community among the users, Stone, and the rest of the executive team that in the midst of one of Twitter's frequent outages, some users sent pizzas to the development team and Stone whom they all knew were pulling all-nighters to get things up and running.  When the delivery of the pizzas went momentarily unacknowledged, a big user Tweeted, "Didn't you get the pizzas?"  Such was the level of community among the corporation and the user community.

Stone goes to great lengths to say how much the 140 character limit, an inadvertent limitation caused by the early technology base, forced people to edit themselves and to be creative in how they did this.
Fast forward to today, and things seem different and exactly the same.  Instead of listening and watching how the user community deploys a new tool or feature, the corporation now uses the traditional A/B testing methodology used by direct marketers and catalogers since time immemorial.

The small, understaffed startup described in Stone's book now looks like a very bureaucratic, overstaffed, top heavy organization. It superficially seems like Google, but it seems more sclerotic.  It competes with Facebook for investors hearts, but it doesn't seem to have Facebook's culture.

Finally, executive infighting and the clash of personalities among co-founders has been going on since Biz Stone's early days.  This is exactly what the company doesn't need.

As the Wall Street Journal points out, the company seems afraid to incur the wrath of their high volume users, i.e. those who have trouble editing themselves; now the company is doing away with the 140 character limit which will encourage the fill the news feeds with endless oceans of boring and self-indulgent text.  But alienating these folks might be fine, if the company can find features and capabilities that will generate a large stream of new, active users.

This all feels so familiar, but Twitter had better rid itself of its worst cultural and organizational  practices before it becomes yesterdays news.

Thursday, June 11, 2015

Mickey Drexler's Outdated Playbook

Having been a retailing industry analyst on the equity side, I came across Mickey Drexler many times in my travels.  I know that I have visited many hundreds of stores all round the United States, looking at my companies, their competitors and emerging concepts.  I had a passion for what these businesses were doing, and the best place to learn is on the ground.  As Sam Zemerray's motto goes in "The Fish that Ate the Whale,"  "Go See for Yourself."

In Drexler's old modus operandi he and his family traveled on road trips during which he visited every store under his management umbrella, talking to store managers, coaching employees on how to restock the floor and keep displays clean, and generally introducing them to what otherwise is the remote, hierarchical, hands off management style of the typical chain.  I can speak to this from experience.

In fact, the Wall Street Journal's story on Mr. Drexler from 2010 calls him a "retail therapist," which is a clever moniker for the grinding, time intensive, heavy personal engagement style described above.  Of course, this style can't be sustained for many, many years and ultimately employees become inured to repeated CEO visits.

Subsequent to the huge success of the GAP, Mr. Drexler as CEO began a series of discussions with investors about taking the company private.  His behavior as CEO wouldn't win any corporate governance awards, to say the least.

Many fast growing retail concepts from the bygone era of the nineties floundered as their concepts stagnated, as they failed to stay ahead of emerging competition and changes in consumer demographics, income and tastes.  Abercrombie & Fitch, The Gap, and J. Crew are among the big ones.  The trends which launched these companies continued and even drew more customers into their ambits, e.g. adventure travel, classic but functional clothing and accessories, crossover between outdoor suppliers like REI and fashion, and completely new purveyors of fashion and function, like Nike and Under Armour.

All of these concepts missed the boat completely, and now Mr. Drexler has his hands all over every aspect of retail operations, including merchandising, which is where he started his career at low end department store Abraham and Strauss.  Making the success of J. Crew rely on one executive, no matter how much pixie dust he spread in the past, is foolish.

Apparel production, sales and merchandising are both commoditizing and breaking into finer and finer niches, in store and online, all the time. The field isn't just shifting, it's like trying to have an office on a water bed.

Even hot teen chains emerge and burn out faster than ever before.  I fear this playbook is badly outdated.

Sunday, June 7, 2015

Engineers Are Often Too Smart for Our Own Good

Google's venture into what are now called "autonomous cars" seems yet another example of engineers being, in their own minds, smarter than everyone else.  What problem are these really smart, Googly folks addressing?

There are so many ways to make driving safer for everyone on the road, using technologies about which so much is already known.  A meaningful example would be the issue of glare from the headlights of oncoming cars on two-way, high speed turnpikes without medians.  Tall crossover sport utility vehicles with lights hitting the corneas of most drivers in low-profile sedans is a problem I struggle with, and I see lots of drivers experiencing hesitation, momentary loss of perspective, and just plain visual fatigue.  Semi headlights on trucks are just as bad.

In earlier times, headlights used to be aimed, and annual inspections used to check that lights were aimed at the road a fixed distance ahead.  With the advent of sealed beams, there is no such thing as alignment of the lights; if the car has a certain profile, the light unit is installed and the beam goes Hera knows only where.

How about a form of smarter glass, either in windshields or in optical glass that consumers could buy at their optical store?  This isn't a multi-billion dollar fix, and its an innovation from which many kinds of innovative companies might profit.

Instead, we have a solution in search of a problem.  Lowering highway fatalities?  Lowering insurance rates?  The easier solution would be to get the 25% of motorists who are uninsured off the road, thereby reducing rates for everybody who is insured.  No research and development expense required.

Google's CEO responded to questions about this giant boondoggle by saying that companies had to invest in technologies for the "next generation."  Why not work on food replicators to end hunger?  It works on "Star Trek: Next Generation," after all.

Corporate entities are not particularly adept at making huge investments out of their main areas of expertise and developing next generation products.  Engineers are even worse than marketers and futurologists at predicting cross-generational technology, particularly in the consumer area, like cars.

Look at the Edsel.  One of the great innovative features of that car, which I saw in our neighbor's vehicle was the push button transmission, a series of large buttons with definitive clicks in a panel that resembled what one might see unlocking a bank vault.  Great concept, and seemingly much easier than a stick and even a steering wheel mounted shifter.  There were a few problems, the first being that it didn't work.  Fast forward to today, and the desire to have automatics with a feel of a stick is what people want: push buttons were something that auto engineers wanted, but the public never have.

Google should start paying dividends with their monumental free cash flow, instead of indulging their founders in corporate whimsy.

Saturday, June 6, 2015

T-Mobile and the Dish Network: Please Let It Happen!

The corporate merger dance can be a protracted one, with partners eyeing each other and making inviting gestures, before suddenly leaving the dance with another partner; or, it can be a case of eyeing each other and suddenly the suitor aggressively carries off the apple of his eye.

T-Mobile badly needs a merger partner, and more than that it BADLY needs spectrum, more towers and better service for its growing, but often poorly served customers.  Dish Network needs a merger partner, although their mercurial CEO isn't sure what he wants to merge and what industry he wants to dominate, e.g. wireless, home entertainment or content.  It has plenty of spectrum that is essentially sitting around like excess cash, it makes shareholders antsy.

Regulators, for some unknown reason want four strong wireless companies.  Right now the former Bell stepchildren, Verizon and ATT are the giants, and Sprint and T-Mobile the runts of the litter. Absorbing T-Mobile would give them a much stronger third player, and it would satisfy the long-held desire of Deutsche Telekom to divest its investment.

As a long-suffering T-Mobile customer, I am hopeful, but listening to the T-Mobile CFO talk about a potential deal or "partnership," I wonder if anything will come of this.  Watching for my text of the deal being done!

Wednesday, May 27, 2015

HP's 2Q FY 2015 Conference Call: Restructuring Fatigue

I listened to the entire conference call for HP's 2Q 2015, and it was all I could do to stay awake, and I have a huge appetite for these calls after twenty or more years doing them as the CFO/emcee or as the analyst/shareholder consumer.

Just for the context, here are the big numbers.  Revenue of $25.5 billion, down 7% year-over-year and down 2% in constant currency.  Nothing new here, the same quarterly profile and investors exhale that it wasn't as bad as the bears thought.  Diluted EPS of $0.87 were down 1%, better than expected I guess, but GAAP DEPS were down17% y/y at $0.55.

Cash flow from operations of $1.5 billion was down 51% over the anomalous prior-year.  $950 million was returned to shareholders. $950 million was returned to shareholders, of which $659 million were wasted on shareholder repurchases, but this was the same old song.

So, why I am I writing this post?  I honestly feel that everyone believes that there is a very weak case for splitting up the two companies, and you can hear it in the CEO's progress reports and in the tortured analysis of synergies and "dis-synergies," broken into one-time charges, general charges, and further amounts not suggested before.  It's too late now, everything has to go forward.

Really, what the split discloses is this: rationalizing the monster that is HP is akin to a neurosurgeon's separating Siamese twins joined at the brain.  Delicate, long, massively complicated, and the patients could die after a long effort.  No CEO or board has the stomach for this, and so split the company. It is disappointing, because there should be one customer-facing company, but there it is.

Nowhere was this feeling reflected more in the discussion of Enterprise Services: lousy results, changed management, business runoffs, executive changes, lots of new signings, but the same lousy results.

Enterprise was about 43% of quarterly revenue, and Printing about 21%. Personal Systems were 30% of revenue.  HP Enterprise will be a GARP stock according to the CEO, but Cathy Lesjak won't be the CFO, instead she will be going to the value stock, HP Printing.  It should be pretty restful for Cathy counting all that cash and perhaps consolidating some of that business over time.

It should be interesting, but the bear is in the details in this kind of split, as we said from the outset.The inter-company agreement is where things are really fought out, tooth and nail.

Monday, May 25, 2015

A Greek Exit May Be the Lesser of Two Evils

One of my favorite financial commentators, Professor John Cochrane of Chicago Booth pooh-poohs talk about a Greek exit from the euro, saying essentially that we are used to sovereign defaults and this issue is separate and distinct from a decision by Greece to exit the euro.  He writes,
"Greece no more needs to leave the euro zone than it needs to leave the meter zone and recalibrate all its rulers, or than it needs to leave the UTC+2 zone and reset all its clocks to Athens time. When large companies default, they do not need to leave the dollar zone. When cities and even US states default they do not need to leave the dollar zone. A common currency means that sovereigns default just like large financial companies."
But, unlike the U.S. dollar which gained wide acceptance after the detailed architecture of the United States of America had been put in place and operating, the euro was created as a common currency without a political union in place, so I would argue that John's comment misses an essential political difference. Finance, more often than not, turns on politics, which is logical since markets are themselves social constructs in which the rulers of the nation-state have an intense interest.

Going back to 2011, we wrote, "...a paralyzed Europe has to come to terms with the failure of the notion of their common currency union."  

In 2012, we wrote, "Meanwhile, the economic and social  costs of the adjustment to the weaker EU members will be genuinely painful."

I can't believe that it's taken four years for the financial press to wake up to the realities as opposed to covering EU press conferences. The Greek government played chicken with Germany, and Greece blinked. Cash was found, debt repayments were made, but they were made with prior loaned amounts found laying around, lent by the IMF/ECB. This was a cruel joke, and the charade continues, but at what cost?

Greece is a sovereign state, and it should have the freedom to make its own foolish economic decisions and to run itself into the ground, if there is no domestic political will.  Instead, its economy is chronically mismanaged, but more so than Italy or France?  And, though its electorate expressed revulsion at the euro scenario by bringing in a reform party, the people's will continues not to be carried out because of the eurozone's fiscal and economic reform requirements.  Sooner or later, this lack of political freedom is a genuine cost of belonging to the euro zone.  

The contagion issue is a technical red herring, in my opinion.  Policy pundits have argued about this before, to no real conclusion or benefit.  Greece needs to confront its own economic and social mismanagement and deal with monetary issues through its own elected representative government.  If Greece were to reissue the drachma, try to prohibit capital flight, and the drachma rose to 500 drachma/euro, then a rather painful adjustment process would begin and a new equilibrium found. But this process might be less destructive to the Greek polity than the slow bloodletting under the ECB/IMF/ESM, Whatever path chosen, it would be chosen by the Greek voters, without outside pressures, other than by market price signals. 

Greece would also being doing a favor for the rest of Europe by exposing the economic fraud which is the EU, that shouldn't have allowed most of the periphery to join the eurozone had it enforced its own rules.  

Friday, May 22, 2015

Is Uber Overvalued?

In a commentary on venture capital which I wrote as an Editor of the Schulze School of Entrepreneurship's EIX Exchange (University of St. Thomas), I made a reference to a yawning gap in valuations in the following paragraph:
"Uber is the example of a disruptive service that turns a large, existing market of cars-for-hire upside down.  Professor Aswath Damodoran of the Stern School of Business has estimated Uber's global TAM for taxi and car service at $100 billion.  Venture capitalist Bill Gurley of Benchmark Capital, an A Round investor in Uber, argues that over time network effects will expand the TAM to some 25 times Damodaran's estimate.  I inject this real-life example because it is the one I always have in mind when analysts talk about a "disruptive" service or product."
I studied Professor Damodoran's course material on valuation during some work at NYU and through the CFA review course books: he is unquestionably good at what he does, has applied his methods to hundreds of different kinds of companies, and has also consulted with number of big companies on the same issues.  I read his full analysis of Uber, and it is, as all his work, eminently reasonable.

Bill Gurley is a very smart investor and a very wealthy man, but he clearly has a promotional axe to grind with his valuation, since Benchmark is sitting pretty as an early investor in Uber.  "Network effects" are certainly real in particular cases, but they are widely used in this kind of patter as another form of hand waving.   Reading his article, Uber will eventually convince rational economic actors that it doesn't pay to own a car and the roads will be clogged with black Camrys providing transportation services to consumers like kids going to soccer games and grannies going to their medical appointment, even venture capitalists going up to their ski lodges.  Furthermore, it will do this in every country.  Take this fully network effected addressable market, give Uber a huge capture ratio, and you get this kind of 25x difference in valuation.   As the VCs like to say, it all scales.

But, like in every economic problem, there is at least one fixed factor, and that is time.  There are only 24 hours in a day.  Drivers can't drive 24 hours a day, and even the Uber drivers doing 8 hours a night for 5-7 days can't keep it up too long.  As Uber tweaks its model with fees and hurdles for drivers to achieve different payouts, it will run into the issue that drivers making $50,000 or so a year, probably not making their social security contributions and taking all the maintenance, debt service and insurance risk on their vehicles eventually will conclude that it's a great model for a company which is a piece of software, but not for them.  That labor force will churn, and no there's no more disruption: it's a rather typical management problem in lots of businesses.

As for taking over the world, Uber is having trouble in India, and it is using its cash hoard to take over competitors.  However, so are the local competitors doing the same things.  Software is ultimately a commodity, and Indian entrepreneurs are devising their own systems for fleet management and payments.  With all the traffic congestion in cities, owners, chauffeurs, auto rickshaws and Uber taxis are all limited in their ability to turn around rides.  No amount of cash in Uber's coffers can make this problem go away.

More up rounds have, are and will be done, but as Chuck Prince said, "As long as the music is playing, you better be dancing."