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.