Wednesday, January 28, 2015

What's Wrong With Technology's Four Horsemen?

It's the season for IBM, Cisco, H-P, and Microsoft to be in the financial news, with earnings results at the front of investor and customer psyches.


On the face of it, IBM appears to be remaking the portfolio with the sale of the commodity server business, semiconductor manufacturing, and exiting the low margin BPO business.  Acquisitions have continued, and the acquisition of SoftLayer looks like a good one, both timely and strategic. 

Along the way of this portfolio make-over, however, execution has really been poor, no matter what the geography and what the business, in constant currency terms. As a corollary to this, the Road Map finally lost any credibility and had to be abandoned.  For all the talk about seamless succession of executives, since this was a cornerstone of CEO Rometty's predecessor, it shows how quickly market changes can overtake even the industry leaders.  

Finally, we have noted before an undercurrent of frustration in the CEO's otherwise aggressively sunny presentation when she talks of "execution" issues.  Whenever this happens, an executive change within the CEO's senior leadership is announced, as it has for IBM and H-P.  More on this later.


Microsoft is trying to be two companies, one consumer-focused and the other aimed at the enterprise customer.  The new CEO was the right choice at the right time and seems to be doing and saying the right things.  This organization, however, isn't doing a great job on the consumer side, as we've said many times before.  

Look at Windows Phone.  Despite having a pretty neat OS that works on good Nokia phones, CEO Nadella's commitment to app developers to work on the Windows marketplace hasn't yielded any increase in the the share of Windows Phone.  Even Windows 10, which looks promising, is all about an operating system; consumers care about their experience on a device, whether a laptop, phone or a tablet. Somehow, in the Microsoft world, it's never as idiot proof to do things as it is in Apple's world. Surface Pro has had a tremendous ad campaign and exposure with the NFL, but it doesn't seem to be gaining meaningful share.

With recent product introductions by Dell and H-P in the laptop/hybrid form factors, maybe MSFT's intention was to force the OEM's to innovate more in response to Surface and Macbooks.  Maybe.

Microsoft's organization can use some serious rationalizing--the ill-chosen Ballmer reorg notwithstanding--- both in numbers and in the way the dual market-facing company works.

The stock has done exceptionally well, and the Enterprises businesses seem to be gaining a lot of traction.  After the recent quarterly results, brokerage houses have meaningfully trimmed EPS estimates for fiscal years ended 6/15-6/17.


Besides managing the fortress balance sheet, their questions about margin compression in their core business product lines while managing their transformation into cloud, data center, and security products are largely unanswered.  The stock looks somewhat less expensive than their peers, but with the financial and operational murkiness, one wonders where this company is going over the next one-two years.


Breaking into two companies, which of course they now admit to discussing over the past year or two, shines a light away from the core concerns about the future, including the board, the M&A process, and how much more heavy lifting has to be done to truly transform the company, as opposed to the impressive and difficult financial realignment that has taken place so far.  

HP, Inc. based on 2014 results would have had $57.3 billion in revenue and $5.45 billion in earnings from operations, with a return on average assets of 24%, driven by a 40% return in Printing.  Future cash flows should be attractive and stable, and thiscompany won't grow too fast but can support debt and perhaps consolidate the printing business over time.  

HP Enterprise would have had $57.6 billion in revenue, $6.1 billion in earnings from operations, and an ROAA of 8.9%.  It is carrying a small, under performing Software segment with a 7.4% ROAA and only $3.9 billion in revenues, with too many small products.  The Services segment carries a 5.4% ROAA, the lowest in the portfolio, lower even than the rebounding Personal Systems group in HP, Inc. 

This business can do much better, but there are still many open questions.  Although the stock has rebounded since 2012, over the past five years it has dramatically under performed the S+P500 and the S+P IT Technology index, according to the 10-K.  

What's wrong with all these companies?  What's the common thread, the elephant in the room?
Going to market---it's the sales forces! Let's think about everything we've been fed by the company CEOs in conference calls, the CIOs, the industry gurus, the software gurus, and corporate governance gurus and put it together.

A New Selling Paradigm

  1. Tech sales people have generally always made a great living, whether they sold hardware of software.  Marginal product improvements and enhancements, new models, and industry gurus crying wolf about security or energy efficiency were all enough to generally carry the day over a cycle.
  2. IT executives were generally left alone by senior management, unless a VP were brought into the CEO's office to fix a printer or reboot a system.  Despite the governance gurus and folks Accenture and McKinsey protesting,  CIOs weren't real players in the C-suite.  I would bet most investors couldn't name the CIO of their portfolio companies. 
  3. Business segment leaders cried directly to the CIOs about what they needed, and because they were the profit centers, they got it.  As long as the big budget came in where it needed to, nobody cared.
  4. Sales were organized by geography, by product line, by type of account (national, global, key strategic etc) with lots of cross-over "sales teams" which never worked for the insiders or for the customers.
  5. Going forward, things have to change.

  • Issues like data security, especially in the case of global financial firms, e.g. JP Morgan Chase , now land right in the board room and the CEO's office.  It has to be a new kind of CIO, probably supported by other key executives like a Chief Data Security Officer, who is in the CEO's office answering questions and having accountability for lots more than a budget.  
  • This new CIO will have to have a new relationship with the heads of business units, actually trying to understand their businesses, as opposed to just IT.  This CIO will have to respond quickly, without time for multi year major system makeovers or delayed data center openings. 
  • IT, whether hardware, software, or services, probably won't be bought blindly from one vendor, just because of a history with a key sales person. The CIO and her staff won't have time for sexy sales presentations.
  • The corporate sales staff too will have to understand their business unit customers and how they actually work, much better than in the past.
  • In a sense, a new sales force will have to be more like Accenture-style consultants, but with specific product, software and application knowledge across a variety of offerings.
  • This means a new kind of sales team, but a real team with accountability for more than hitting a quota or making the President's Club by individuals.  
IBM and H-P for sure have these issues to address, and the repeated references to "execution" during conference calls over the past two years have made this clear.  The Enterprise businesses within Microsoft have probably operated under the radar because all analysts used to care about was PC sales and Windows licensing.  VARs and other channels should be rationalized and used where appropriate, not just to move volume for reporting periods.  

Taking care of the new CIO and their more complex demands in a unique way with a best-of-breed offering and hands on service, perhaps at lower margins, will carry the day in the "new IT."  

Thursday, January 22, 2015

The Serious Fraud Office Finally Passes on Autonomy: HP Should Move On

As recently as Q2:FY14, we had Autonomy on a list of big questions, not just from the legal and financial implications, but because the overhang was distracting for the marketplace. This acquisition again points to failures of the company's outside directors, the naive vision and defective business acumen of former CEO Apotheker, and an acquisition process which had run amok. 

Now, after three years of spinning its wheels, Britain's Serious Fraud Office concluded, "In respect of some aspects of the allegations, the SFO has concluded that, on the information available to it, there is insufficient evidence for a realistic prospect of conviction."  Presumably, potential civil issues will be picked up by the SEC. However, this shouldn't be a fertile ground for large cash fines given HP's having already consolidated and settled many shareholder derivative claims.  HP's impending break-up and its ability to thrive going forward should be where investor and management energies should be spent.

The most illuminating document summarizing the Autonomy acquisition debacle is the January 10, 2014 report of the" Hewlett-Packard Company Independent Committee's Resolution of Derivative Claims and Demands."

HP had a business relationship with Autonomy since Q4 2009, and so the IDOL product and Autonomy's management, especially founder Dr. Mike Lynch, should have been well known to HP's technology, business, and marketing executives.  In fact, thoughts of acquisitions had been circulating with HP for some time, but the disconnect between Autonomy's stand-alone valuation and its revenues precluded any pre-acquisition work. 

During HP board meetings from July 19-21, 2011 CEO Apotheker made a case for a "transformational acquisition" of Autonomy, which was to be the centerpiece of a complete makeover of HP from a hardware company into an enterprise software giant. 

The standalone value of Autonomy was set at $9.5 billion, and HP's internal business development group and others concluded that there were $7.4 billion of "revenue synergies" between HP and Autonomy, presumably with IDOL and Vertica's offerings primarily. This is an extraordinary number, even laughable.  $0.157 billion in integration expense and fees offset these numbers, and there were said to be $0.322 billion of tax synergies available to a combined company. All of this made for a value of $17.1 billion!

Apotheker argued to the board that HP had in place extensive, proven and reliable processes for screening, valuing, and integrating acquired companies, and the board should feel comfortable relying on the output of this machinery, along with the extensive roster of supporting advisers, like KPMG for accounting due diligence, and a bevy of American and British law firms and investment banks.

However, this assertion was belied by facts, including the most recent failure of the EDS acquisition and integration, which itself resulted in an $8 billion write-down.

Apotheker's putting forward that the acquisition of Autonomy would be "financially accretive" in addition to have strategic transformational value had to be a critical element in the board's giving him Authority to Negotiate with Autonomy.  Any board member, even those without financial background, should have disregarded a "revenue synergy" number equal to almost 80% of the target's standalone value.

During an August 8, 2011 conference call with Deloitte, Autonomy's auditor, questions were put forward about "revenue recognition, instances of fraud, control mechanisms" and the like.  Deloitte just answered questions, and no work papers were provided to demonstrate the revenue recognition processes.  Deloitte also noted that an individual whistle blower had filed a complaint about financial irregularities which Deloitte (and presumably Autonomy's audit committee) had investigated and found to have had no merit.  Apparently, this kind of lack of sharing of audit material or detailed financial records is the norm for British acquisitions, according to the report.

CFO Cathy Lesjak objected to the acquisition of Autonomy, but not for the specific valuation process or numbers.  She felt, (1) shareholders would object to the size of the premium paid; (2) HP's bankers underestimated the impact of the announcement on HP's share price, and (3) HP's "history of not executing on major acquisitions" should give the board and management pause about going forward.

Post-acquisition, Ernst and Young were hired as forensic accountants.  They received Deloitte's work papers on Autonomy and identified red flag areas, including audit issues such as differences between the principles-based IFRS and rules-based GAAP that could be problematical.  These were all ignored or swept under the rug during the out-of-control due diligence process.

Vertica and IDOL's product lines could not be integrated, which caused problems during conference call presentations by CEO Meg Whitman when she had to be very careful with her language about the future of HP offerings in the software area.  Revenue synergies clearly had been illusory; the synergy modelling had been prepared by the company's own Corporate Development Group, or internal bankers.  This is not the best way to go about this exercise.

HP's CEO Whitman's characterization that some $5 billion of the $8.8 billion write down of Autonomy post-acquisition was due to "accounting improprieties," "misrepresentation," and "disclosure failures" seems misleading, after reading the text of the report.

According to the report's description of the HP impairment model, the $9.5 billion standalone value of Autonomy had to be reduced by some $6 billion!  If this write down were due to differences interpreting the appropriate treatment of Autonomy's fiscal 2011 results under IFRS and the subsequent translation to US GAAP, this isn't improper or misrepresentation on its face; over a long-time horizon, the cash flows should be the same, unless the fundamentals of the companies technology products were misrepresented; this hasn't been suggested, and so HP's claim is, at best, unproven.

$5.3 billion of the assumed $7.4 billion of revenue synergies were deemed impaired. $3.9 billion of the impairment came from the decline in HP stock and the subsequent effect on the market capitalization reconciliation. This calculation accounts for former Autonomy CEO Lynch's assertion that $5 billion of the impairment came from HP's own reckless assumptions about revenue synergies and not from any proven accounting fraud.

$11 billion in carrying value of Autonomy less the net $2.2 billion revised value yields the $8,8 billion impairment charge.

If the SFO couldn't find the evidence to pursue and win a criminal conviction for accounting fraud, then CEO Whitman's claims don't seem to be above reproach.  Just for the other side, the report details Dr. Lynch's behavior and assertions when the integration work and post-acquisition forensic accounting work were going on.  His behavior seems inexplicable, petulant and unprofessional.  After all, he had just enjoyed a huge payday, and was likely still a contract employee of HP. Professionally and personally, his conduct wasn't exemplary.

For all the 'smart' people in Silicon Valley, this episode should underline for equity investors the need to really investigate, understand and monitor the qualifications, personal character and conduct of the the board members and managements whom they entrust with their clients' funds.

Monday, January 19, 2015

China's Slowing Growth Rate

China's economic growth rate is characterized as "slowing," to 7% per annum; but, this means that the giant economy can be extrapolated to double in ten years.  Given recent economic and financial developments, is this really plausible?

The Chinese Economic Miracle was predicated on two key slogans, "Privatization," and the evergreen "Growing Middle Class."  In the intervening decades, we know that privatization meant a selective treatment of some private companies and more the creation of grossly inefficient state-owned enterprises.  Financing of the latter in an environment of low, falling interest rates and growing state surpluses of foreign exchange wasn't an issue as far as the eye could see.

As the Chinese economy grew to the sky, the ruling members embarked on a strategy to corner all the key resources needed to fuel the growth of an industrial economy, from recycled PET to paper, rare earth minerals, copper, and food commodities.

Prices for clean, post-consumer baled PET began a rapid ascent about fifteen years ago, and when I called some of the companies gathering this commodity from municipal waste streams, they all told me that the demand was Chinese and "insatiable."  Chinese consumers also wanted their clear beverage bottles for water and soda.  Today, prices are quite different.

Chinese companies owning copper mines in Chile have seen prices collapse recently.

Again, risk is one thing for a private company with lots of debt and relatively small equity, but it is another thing for the Chinese central banking system.  However, economics ultimately carries the day, especially in an environment when the music appears to be stopping, i.e. rates may be rising.

However, it is also difficult to see what would justify raising rates when Europe, apart from Germany and Switzerland, is a basket case.  Traders are reported to be hoarding oil in a carry trade awaiting normalized, higher prices. Great Britain has an economy where consumers are being offered credit cards on television with 50% A.P.R.s.

Barron's columnist and legendary investor Jim Rogers recently said that he was long Indian equities, which have done extremely well.  However, he said too that he had his doubts about the intentions of the Modi government to really deregulate and reform the Indian economy so as to unleash a real economic miracle consistent with all the press releases.  I think that his skepticism is well warranted.

In the U.S., talk of higher taxes, redistribution and a U.S. National Health threatens the longevity of what has been a slow, lethargic recovery.  As Bill Gross said in a different context, the U.S. may be the "cleanest dirty shirt," among global economic leaders, and it still has the primary reserve currency and liquid markets, so far....

Tuesday, January 6, 2015

Brazil's 3G Capital Still Has More Appetite for Deals

From a recent blog post after the Heinz deal,
"We've written in this blog about Buffett's long relationship with Brazilian-led 3G Capital Partners which was behind its stepping up to help finance the purchase of Heinz, and about how that relationship would be a new model for Berkshire going forward, i.e. partnering with private equity to do bigger, better, and faster returning deals than BRK's working on its own.  Here is an example in this deal, and it sounds like it should work out well for the preferred holder, as that instrument has borne much fruit recently, as exemplified by the Goldman deal."
Now comes hunting season on the corporate savannah for new targets.  Campbell's Soup, as we've said before is a bad company that has confounded corporate makeover artists before: buying a bad company at a great price is not Warren Buffett's model.

Pepsi would be a very expensive deal, and it would have to feature the tired idea of spinning off the snack food business. The 3G model seems to focus on making operations better, including cutting costs.  Financial engineering doesn't seem to be in their wheel house.  As the Journal mentions, taking on part of the company might work, but this would take time, be complicated for Pepsi and wouldn't seem to offer the right size deal.

Thursday, January 1, 2015

Oil Prices Collapse: Everyone Got This Wrong

Financial pundits routinely make howler forecasts, but the good news is that they forecast so often and the public has no memory. so it doesn't matter.  Industry executives are supposed to be closer to markets, smarter and more circumspect, and they often are.  But, just as often, they assume the trend is their friend.

Here's a quote from the CEO of Chevron,
"This past year was expected by many to bring stable, triple-digit oil prices. Chevron Corp. ’s chief executive declared in March that “the $100 barrel is the new $20,” and traders complained that several years of low volatility had made it difficult to make money buying and selling oil."

Boy, was this ever off the mark!  We've never been a participant in this game, except to say, 
"If there are intrepid forecasters out there who could explain $100 a barrel oil for me, I'd love to hear from you." (2011)

Short-term supply interruptions aside, it was impossible to justify prices above $100/bbl on economic fundamentals.

The one year price chart for crude oil is remarkable, showing a decline from $100 in July to $54 presently, with some industry forecasters projecting $60 in a year.

Longer-term sources of crude oil will be more expensive, technologically difficult to access, and fraught with political risk for multinationals in areas like the Arctic or deep ocean sources. Current prices have taken these off the table.

It is ironic that activists still talk about solar as the global savior, except that it is little more than a hobby farm for NGOs and their patrons.  Natural gas and nuclear which are better from a rational environmental calculus have been bullied off the table by sheer volume of propaganda.

The winners, of which there are many, and the losers, of which there are fewer big ones, are shaking out in predictable economic fashion.

The oil price consensus forecast was probably one of the biggest consensus market misses of 2014.