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.