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. 

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.

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.

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.  

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?

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.

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. 

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. 

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!

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.

HP's Unhealthy Obsession With Mike Lynch

We've written about this several times, but HP are back at it again. Just as they approach the biggest event in their corporate history, the splitting off of HP into two companies, the issue of Autonomy's purchase has moved back center stage. This is after Britain's Serious Fraud Office ended a two-year inquiry into Autonomy's alleged misrepresentation of its financial results and deciding to take no further action on the matter.

I can't find the original court document of the current complaint, but the link above outlines the current allegations.  Former Autonomy CFO Sushovan Hussain noted that if $2 billion in fraudulent or imaginary revenue were recognized under Autonomy's IFRS standards, then among other things, an analyst would have a hard time reconciling cash using the balance sheets and income statement. He then essentially dares HP to explain how why this alleged fraud isn't evident from a very conventional analytic method.

Aggressive accounting?  It seems to have been the case, but most of the discussion seems to center on differences between US-GAAP and IFRS. By continuing to pursue this issue, HP is, by inference, casting aspersions on the Big 4 auditors, several of which were involved as auditors or consultants on the transaction.

Why not claw back money from former CEO Apotheker?  HP overruled its own CFO on the transaction.  Suits against HP show some comments by Apotheker that seem to say HP's zeal and haste to close the transaction resulted in shoddy due diligence.

By continuing this unproductive path, HP continues to make its go forward technology company look unworthy of shareholder confidence and the confidence of its customers and business partners. Let it go, HP.  Markets have already long forgotten.

Jamie Dimon's Extraordinary Shareholder Letter

JPMorgan Chase CEO Jamie Dimon has channeled Warren Buffett in his most recent letter to shareholders.  As readers of this blog know, Warren Buffett's letters are on my required reading list, and I have always recommended them to friends, colleagues and students.

Based on his long track record of success in financial services, which I began following during his tenure at Bank One, Jamie Dimon is required listening.  As CEO of one of our nation's Big 4 banks, he was in the eye of the hurricane during the financial crisis, has been pummeled during the political piling on post-crisis, and has now almost completed steering JPMorgan Chase into calmer, post-crisis waters.  There's a lot to learn about his view of finance and the role of JPMorgan Chase in this letter, but there are some real questions that remain for investors, as there should be if there is real content in the piece.

The CEO's Principles for Running A Business

• Especially for a cyclical, highly regulated business which is periodically subject to massive, systemic crises, it's essential to build the company into an "endgame winner." Through the work of his team and those of his predecessors over 30 years, he believes JPMC is in that elite group.
• Compare yourself against your best competitor is each of your businesses, and a convenient chart shows how that comparison looks.  
• A good company doesn't use cycles as an excuse. He is committed to earning competitive margins over the full cycle, whatever its characteristics, while still investing in the businesses and without taking extraordinary risks.  
• A good company, while always investing in its businesses, is always eliminating superfluous waste.  This has been a consistent theme going back to CC and to Bank One. It is also more nuanced and sensible than the somewhat comical and ultimately misguided "reusing paper clips" memos coming out of Bear Stearns.
• Some expenses thought by others to be excessive are in fact essential to achieving the endgame goals: it is something I have lived through myself as a CFO, and I really like seeing this laid out in specifics, i.e. the Retail National Sales Conference for JPM's top 5% producers. CEO Dimon has been to every one going back to Columbus, OH and Bank One.  You can tell I especially like this one, because what matters for a successful company is ultimately what employees think, which informs how they behave. 

As Regulators Sandpaper Away at Big Banks, Who Needs Them?

• Economies of brand name, scale, operation, and technology are important in a global financial services business.  Taking them away, by separating companies, will not be efficient for shareholders and it will leave customers looking for a competitor which can supply exactly what JPMorgan Chase has put together. 
• The CEO uses the example of Commercial Banking which is now 35% of the U.S. Investment Banking business. Out of 20,000 Corporate and Middle Market Banking clients, JPM supplies global banking services--cash management, treasury, currency trading, hedging, and mergers and acquisitions--to some 2,500 of these companies.  With normalized future growth and natural consolidation of customers, these opportunities will grow and become more valuable. 
• The Private Bank, because of the asset base and diverse financial interests will always benefit customers and attract prospects through scale. Right now, through the expanded system there are $190 billion in deposits in the Private Bank system alone. Globally, 2,300 families had assets of $1 billion or more, and as a group they represent over $7 trillion in assets. Having a system that routinely moves $6 trillion in daily funds worldwide gives Morgan bankers credibility with customers.
• In a liquidity or other banking crisis in the future, banks need to keep lending, and especially the Big 4 and beyond. Statistics in the letter talk about how much credit was rolled over to small and medium sized businesses, large customers, state and local governments and to hospitals and nonprofits. As the CEO rightly points out, non-bank entities would not be in this position in the next crisis, the character of which he alludes to in a few, unrelated paragraphs.

What About the Share Price Lagging Peers

• The CEO won't be driven by goosing earnings or short-term performance by pulling easy levers. (see the principles in how to run a business)
• JPM's price-earnings ratio is lower than peers, he says, due to large levels of legal and regulatory settlements, and to uncertainty about future settlements.  This may be true, but it's a bit hard to understand given some of the issues surrounding Bank of America, for example. 
• Stay focused on what you can control.

What Happens in the Next Crisis for Liquidity?

• More high quality capital is on the books than at any time in its history.
• Compensation levels would be adjusted immediately.
• Dividends would be cut or suspended, and share buybacks halted.
• In other words, the customers and businesses come first: a good recipe.

I'm not doing a full summary of the letter, but these are some of my highlights. What about a question or concern?  It goes back to the London Whale report. 

In the letter the CEO talks about learning a lot, and I am sure he is right. He also talks about many of the bad derivative products having gone away.  The culture described in that report seems totally at odds with what would seem to be espoused by this CEO.  How did it get that way?  Are all the bad actors gone?  There is a reference to "fortress controls."  I think that's just a marketing slogan.  They are neither feasible nor necessary: mistakes will happen, bad trades will be made, and earnings will take a hit, but all of these should be ring-fenced, bounded and fixed quickly.  That is not the company described in the London Whale report.

The CEO does make a reference to consistently espousing the principles in the letter during the year and to audiences in different settings. This could be a big deal.  The question is: who's in the audience? The same folks as before, with religion now?  

I go back to Bill Belichick's adage, "Just Do Your Job!"  CEO Dimon needs to be surrounded by leaders who knowledgeably sit over their global operations moving $6 trillion daily and who can truthfully and with confidence say, "No storms on the horizon" if the CEO asks.  A related question is, of course, who can step into Jamie Dimon's shoes if illness or factors require a successor to step in? 

Having a behemoth of a company so dependent on the acumen, drive and leadership of one person isn't the most risk optimal way of looking at the future: just a thought. 

HP's First Quarter 2015 Surprises Some

HP reported revenue of $26.8 billion for the first quarter of fiscal 2015, a year-over-year decline of 2% on a constant currency basis.  Diluted EPS on a GAAP reporting basis was $0.73 per share, and $0.92 on an non-GAAP basis, which was at the high end of the guidance range for the quarter.

All of the operating businesses has yr/yr improvements in their non-GAAP operating margin rates, the CEO noted.  65% of corporate revenue was recorded OUS.  Despite hitting the top end of the non-GAAP EPS guidance range, the impact of currency in the quarter was stronger than expected, and will be substantially stronger than prior expectations for the balance of FY15.

As happens in corporate reporting, especially in a behemoth like HP with distinct businesses with some many moving parts, a number might have been reached, but it was reached in a completely different way than the forecast assumed.

Currency headwinds seem more appropriately characterized as currency typhoons.  Current expectations for EPS impacts of currency were characterized as $0.60 per share gross, and $0.30 per share net, on an annual basis.

The forecast of flat revenue for FY15 yr/yr seems particularly challenging in light of the heightened currency impact, but management cited continuing progress in printing revenue, enterprise businesses, as well as a meaningful improvement in Enterprise services revenue.

All of the analysts completely missed on cash flow from operations for the quarter, as the costs of separating the company in to HP, Inc. and HP Enterprise were omitted from their models, even as guesstimates.  $80 million of expense was recorded in the quarter, $250 million is now expected in the second quarter, and $1.3 billion in corporate cost and additional taxes are expected for the full fiscal year 2015.


Printing, 20% of the consolidated revenue for the quarter, generated a non-GAAP operating profit of $1,067 billion, 39% of the segment total, with an operating margin rate of 19.2%.  The margin rate was consistent with the prior period and described as "unsustainable" and "bad for business" by the new business leader.  Supplies were down 5% and total units down 4%, as competition from Japanese vendors in corporate accounts was strong due to a weakening yen.

Personal System sales were 31% of revenue, producing non-GAAP operating margin of $313 million, a margin rate of 3.7%; PS contributed 11% of segment income, and HP reestablished itself as the leader in the notebook segment.

So, the core of what will become HP, Inc. accounted for 51%  of quarterly consolidated revenue and 50% of segment operating income.

The Enterprise Group accounted for 25% of quarterly revenue, earning $1,090 in operating profit, a margin rate of 15.6%, which was a healthy 40% of the segment operating profit total.

Enterprise Services accounted for 18% of quarterly consolidated revenue and only 5% of segment operating profit, but  the stage was being set, management said, for a better performance in the back half of FY15.  The latter two groups, plus Software, will comprise HP Enterprise.

The CEO pointed out that two Fortune 50 global companies were being created out of the separation of HP.  As complicated as the separation sounds, it is ultimately lots of nitty gritty work, expensive but very doable.  Changing the culture of one behemoth serving two distinct markets with so many different offerings would be well nigh impossible.  In this sense, the split is better for the businesses, their employees, for customers and shareholders.

Referring to our recent post the go-to-market problems facing companies like HP, the CEO noted that some "realigning of sales incentives" had occurred in the Enterprise businesses in the quarter, and it's clear to us that a different kind of sales team with different incentives will be an indispensable part of a successful tech company in the future.

A big corporate client win at Deutsche Bank was highlighted during the call, and it illustrated the nature of such wins for the future HP Enterprise.  It involved lots of different strategic business units, was led by Enterprise Services, and the Helion offering was a pivotal differentiator.

CEO Whitman noted that despite the fact that 44,000 employees have left the company since the beginning of the restructuring and more is to follow, employees with new, client-facing skill sets will have to be hired, and there are even more opportunities for HP and HP Enterprise to become internally much more efficient in their own systems and processes.

Currency aside, the softer items in the call seemed the most encouraging.

Apple Pay on Your Apple Watch?

I forgot about the biggest head scratcher in thinking about Apple and what it really wants to be: Apple Pay.  There's nothing more profitable than a large payment network: just have a look at Visa, MasterCard, Discover and American Express.

Private label cards using the MasterCard or Visa networks are a wonderful business for their retail issuers, as research shows that they actually engender loyalty to the co-brander and, provided card users don't abuse their main card, the retail private label cards often get paid more consistently in times of financial difficulty for the card holder.

So, back to Apply Pay. Why?  Check out this link to the Apple Pay site. Look in particular at the picture that goes with this text:
"Apple Watch
 Double-click to pay and go. You can pay with Apple Watch — just double‑click the button next to  the Digital Crown and hold the face of your Apple Watch near the contactless reader. A gentle pulse  and beep confirm that your payment information was sent."

So, in order to save yourself the trouble of scanning the magnetic stripe or reading a security chip on a Bank of America card (pictured on the site), you are going to press a button on a screen which most people can barely read in order to save yourself a second or two, so your funds are debited faster? This physical action is exactly what I have to do on my old digital watches in order to change the modes: it's an awful movement, and in the case of the old watches, sometimes you have to press twice to engage the electronics properly.  The Apple consumer with a $500 watch gets her kicks out of this?

So, again, Apple wants a piece of the action from the big payment networks?  A company with a $700 billion capitalization is wasting its time doing this?

Meanwhile, MasterCard and Silicon Valley Bank have launched their own VC type effort to help entrepreneurial companies interested in setting up their own payment networks to profit from MasterCard's expertise on security and scale up strategies. The beauty of this effort is that MasterCard keeps tabs on what's out there, Silicon Valley Bank eventually gets a lending relationship with lots of warrants, and if successful, MasterCard buys new business.  Meanwhile, what will Apple Pay be doing?  Probably floundering around.

Much as I dislike the monopolistic payment networks whose interchange fees are still monstrously expensive given their economies of scale, it is good to deal with them when there are illegal or problem transactions on the card.  Because of bank and credit card industry regulations, it is easy to get problems on the record, with documentation, and eventually resolved, almost always to the consumer's satisfaction.

If Apple Pay were ever to become a significant enterprise, can you imagine contacting their customer support?  Who would they be?  Where would they be?  That organization would probably be as consumer friendly as Comcast.  What business is Apple in?  I think everyone knows.  Going forward, it may not be so clear, probably to the detriment of returns relative to the past decade.

Will Apple Inevitably Lose Its Way?

This parody of Rene Magritte's painting struck me as being very appropriate for this post. My former colleague Michael Moe's firm, GSV Capital, listed the Top 25 Best Performing Stocks for the period 2004-2014, and Apple was number 9, growing its EPS at a CAGR of 54% over the period and its stock price at a rate of 37% per annum.  In absolute terms, Apple's performance was stunning looking at the growth of its market capitalization: it went from $26 billion at 12/31/2004 to $647 billion at 12/31/2014.  If the Apple of Steve Jobs' reign is painted in the middle, Mr. Jobs left current CEO Tim Cook with his portrait at the left. (not exactly proportionate, but you can see the idea.)  It is almost inconceivable performance, which is why it's unlikely to be repeated.

"Trees don't grow to the sky," as students learn in their introductory microeconomics classes. Also, as GSV notes, ",,if Apple were to notch the same stock performance in the next ten years as it has in the past ten years, it would have roughly a $40 trillion market cap--nearly 2x the entire U.S. Equity Capital Markets."  GSV also notes that no company has remained in the list for two consecutive ten year periods.  

We have always taken the position that Apple is a cult stock, namely most investors buy it for philosophical reasons, e.g. they love Steve Jobs, they work in creative industries that use Macs and want to support the company that makes their great machines, they work in public education and admire Apple's commitment to that market, they believe that Apple's mission is about much more than making money, or they believe that the stock is "cheap," selling at 11x estimated earnings, net of cash. Each one of these reasons has 5 or more variations for cult members. I have considered owning it many times, but couldn't pull the trigger--my loss for the past ten years.

What are some signals flashing yellow, besides those presented above?  Apple is flush with cash.  Most companies in this position have their investors clamoring for a return of the cash through dividends or share buybacks.  The company has arguably responded on both counts by planning to return $130 billion to shareholders through the end of 2015. No yellow here.

The company announces something called Project Titan, a skunkworks to design an electric car. Hello?  This is an industry far away from Apple's core competencies, and one which is cyclical, rife with competitors, and subject to all kinds of regulation, something that Apple strenuously avoids.  This project should sound about as exciting to Apple shareholders as Google's driverless car is to its shareholders.  I don't think either of the two Steves would be excited about this project.

More recently comes the famous Apple Watch.  Initial rumors had this device being the centerpiece of the company's projected foray into consumer healthcare monitoring, patient management and anything called e-health.  However, as the Wall Street Journal reported, none of these features made it into the product to be launched this April.  Besides some features not working or being to complex, the Journal writes, "And still others could have prompted unwanted regulatory insight.."  Okay, maybe, but electric cars?

The watch being launched needs to be near an owner's iPhone in order to have wireless connectivity, and so the Journal notes that it appears to be an add-on accessory to an existing owner's iPhone. Cultish iPhone owners may go for this, but surely new customers wouldn't want to jump straight into a new Apple Watch and iPhone at one go?  That's a big ticket.  

There is a range of price points.  At the the lower end, Apple Watch competes with FitBits and other established products in a crowded segment. At the upper end, the ultra models feature 18 karat gold casing and will retail above $4,000.  Even billionaire oligarchs and young tech company CEOs who have sold their companies to Google may think twice about this.  Isn't there more cachet in a Tag Heuer or some of the newer, ultra-luxury watch brands?  

CEO Tim Cook says to the Journal, "One of the biggest surprises people are going to have when they start using it is the breadth of what it will do."  And what is that?  Even the reviewers can't come up with the wonderful things.  

Probably, the first generation product buyers will be orphaned as the company eventually figures out what the product should really be. In this respect, the company would then appear to be more like Microsoft, which first launched Surface RT before realizing that it was rubbish and launching Surface Pro 3, leaving a lot of unhappy consumers.  

When Apple launched the iPod for music, it wasn't the first player in the market.  Creative Labs made a relatively inexpensive, functional, intuitive series of players called Zen that really served music lovers well.  But, Apple miniaturized the iPod, which was very important to consumers, and it launched iTunes that turned the music business upside down.  A key innovation and a market disruption, and it led to success.  So far, the watch looks like late entry with a placeholder product.  A definite yellow signal, but shareholders have to stay tuned.

What about emerging markets?  Is Apple ceding all but the uber-middle class to Chinese and other competitors?  Will Apple become the Louis Vuitton of electronic gear?  

If Apple wants to get into other businesses like making cars, wouldn't shareholders rather diversify their holdings themselves by buying an emerging car company?  Or, wouldn't they prefer to buy an emerging healthcare informatics company?  What is Apple all about?  Could the story end for shareholders like the third panel on the Magritte parody?  Who knows. 

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.

IBM

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

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.

Cisco

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.

H-P

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."  

Telecoms Start Racing to the Bottom

We wrote a while back about Masayoshi Son's potential impact on US retail cellular phone users, particularly because he wants to become number one in his markets.

Predictably, his first efforts at taking over T-Mobile met federal regulatory veto.

T-Mobile has forced some innovation on the industry by making it easier for consumers to get phone upgrades and by doing away with contracts. Their subscriber growth turned around.

Meanwhile, however, spectrum auctions are indicating that others perhaps have a better economic model and can pay more for spectrum that ATT, Verizon, T-Mobile, and Sprint.

So, the major carriers have put forward their "race to the bottom" business model of promising to cut monthly bills in half while offering unlimited data and phone service.  Clearly, this is not sustainable, as we have noted for years.  With spectrum prices rising, the cost of building out different network or adding other services is becoming prohibitive.

So, the WSJ notes,

"What difference does a month make? In telecom, the answer is about $45 billion.

That’s how much market value Verizon Communications Inc., AT&T Inc., Sprint Corp. and T-Mobile US Inc. have lost collectively since mid-November amid a fast-moving reassessment of the industry’s value by investors. The lost value is greater than the current market capitalization of Sprint and T-Mobile combined, and it reflects concern that cellphone service will be costlier to deliver and less lucrative to sell."

The carriers also got dinged on behalf of consumers by the Feds because although they promised "unlimited text and data" to all customers, heavier users faced slower download speeds, of course a form of rationing and making the whales pay for their consumption. If the fines levied are paid, then they either have to adopt some kind of utility pricing which is transparent, or face growing losses because their business models don't create value. 

HP in Barcelona Discover 2014

If like me you weren't able to attend the HP techfest in Barcelona, you can watch most of the speaker presentations on video.

As we said back in 2012, IT buyers needed a provider like HP that could deliver them solutions for their systems issues--legacy systems, burgeoning data, mobile applications, and higher hurdles for system security and compliance to name a few.  CEO Meg Whitman's accomplishments include convincing them that HP was such a partner.  Barcelona drives the same messages given consistently throughout 2014 with updates on new products and services, along with customer participation. 

A staple menu item in all the presentations is "Big Data," a term which clearly causes audiences to either cringe, yawn or glaze their eyes over.  

Software EVP Robert Youngjohns gave an interesting presentation on the New IT, forged from the fires of Big Data.  HP's approach, he says, distinguishes among three distinct types of Big Data:

• Business data, coming from traditional sources like the corporate ERP, CRM, BI, and HR systems, for example).
• Machine data (examples were log files and sensor data, i,e, the Internet of Things)
• Human data (Email, video, photos)

The first category, which seems to be where the corporate data engine room hits the financials, is growing slowly.  It is the other two categories, particularly the third where the growth is explosive. He went on to say that the HP big data platform distinguishes among each big data category and tailors the offering accordingly.

His presentation brings up my concerns about the vacuity of the term Big Data.  Businesses are still growing, in broad terms, at GDP-like rates, or at the upper end, single digit multiples of the same. Machine and human data are exploding at ridiculous rates.

He quotes another fluff statistic: more photos are being produced each day than in the first 100 years since the invention of the photographic process.  Surely, the obvious conclusion is that the value of machine and human data are fractions of traditional business data, from data about exploration wells to customer purchasing patterns. 

If the value were commensurate, IBM, Exxon and other Big Data producers capable of deploying new systems would be seeing explosive growth in revenue or profit.  However, nothing like this is visible. Bellwether companies like Cisco sometimes see revenue shrinking. 

Youngjohns gives a personal example that raises the same issue.  He is a tech geek at home too.  His home wireless network is very complex. He has the controls for his climate system managed by sensors and a panel.  He has imaging, music, television and other activities on wireless subsystems. He decided to find out why NetFlix was operating very slowly, and so created a reporting system of activity logs which, he said, soon generated a terabyte of data!  

Now, I couldn't hear anyone laughing in the audience, but they should have been. The architecture of this network is clearly faulty, at least the infrastructure and maybe more. Leaving this aside, big data in this case was bad data, and unproductive for its expected benefit, namely to make NetFlix run faster.  The hardware and software costs per unit of data are so low, which merely masks the unproductive nature of the activity. 

Moving on to another presentation on Data Centers and the Cloud, the same issues came up in a different way.  Data centers, we are told, have to provide services for all kinds of devices, like fitbits, videos, and sensors, again the Internet of Things. These apparently create large data streams. 

However, much of this are personal data, surely. Why should a commercial infrastructure expand to support this data demand?  One of the speakers really struggled to come up with examples of supported devices that didn't sound as ridiculous as Fitbits, but he couldn't.  The demands being put on data centers from personal uses like Instagram, SnapChat, Facebook and other social media stem from the BYOD policy that has become the standard in corporate America: it is a policy that requires more resources and which ultimately reduces employee productivity.  

He did cite an example of instrumenting the corporate vehicle fleet, where a large volume of operational data (speeds, routes, mileage, fuel consumption) would create large data center demands. This doesn't sound earth shattering, but just a move up from what's being done currently by operators like UPS.

The Haven platform brings together ArcSight, Autonomy and Vertica for data analytics, while also providing a broader platform and tools for asset and security management. Sounds like things are being put into place for HP.

Of course, now it is going to split into two pieces. Stay tuned. 

A Wow! Quarter for Microsoft

Listening to the rebroadcast of the earnings call without visuals, one could sense CEO Satya Nadella verbally punching the air expressing his pleasure about Q1 2015's results demonstrating real changes at Microsoft in terms of execution, innovation, and putting the customer at the heart of what Microsoft does.  The customer is now regarded as a partner, not just as an ATM.

Look at what is happening to the competition. HP has chosen to split itself apart, which is probably the right action at the right time, but it will distract their customer-facing activities as the go-to-market operations change in size and charters.  IBM finally needs to go CEO Rometty's woodshed and reinvent its market proposition beyond the Smarter Planet commercials.  Cisco sits on its balance sheet and continues to blather on about the "Internet of Things."

Things don't buy hardware and software: people do.  Corporate buyers clearly want more from their go-to providers.

MSFT reported Q1 2015 revenue of $23,201 million, up 25% over the prior-year period, or up 11% excluding the $2.6 billion in Nokia Phone revenue (9.3 million Lumia smart phone units) included in the fiscal 2015 number.  Gross margin dollars increased 11% despite the inclusion of lower margin phone revenue and an unfavorable mix to low end equipment in that business.

Research and Development expenditures of $3,065 million increased 11% over the prior-year period. In addition to returning cash to shareholders, the company sends a message that it will continue to invest in innovation on behalf of the customer's future needs.

$1,140 million of integration and restructuring expense was recorded in the quarter, amounting to $0.11 per diluted share. GAAP diluted EPS of $0.54 in Q1 2015 compared to $0.62 in the prior-year period.  DPS of $0.31 increased by 11% year-over-year.

Apart from OEM Windows licensing revenue declining by 2% and Consumer revenue decreasing by 5% as the transition to Office 365 continues, all the businesses performed well, certainly compared to the competition.

Computing and Gaming Hardware revenue of $2,453 million grew by 74% year-over-year, and the gross margin rate increased by over five percentage points. $908 million of Surface 3 revenue in the quarter continued to demonstrate the potential for a device that can do real work, while having the look and feel of a tablet.

Devices and Consumer Other revenue of $1,809 million increased 16% year-over-year.  Search advertising revenue increased by 23% and Bing's share of U.S. search increased 140 basis points to 19.4%.  7 million Office 365 subscribers increased 25% sequentially over the prior quarter.

Finally, the Commercial Business revenue of $12,280 million increased a solid 10% over the prior-year period. Server product revenue grew 11%, and revenue increased across the range of servers from SQL to the newer, data center-oriented specialty servers.

Other Commercial Revenue of $2,407 million increased 50% over the prior-year period, driven by Commercial Cloud revenue growing 128%. The CEO noted in his remarks that 80% of the Fortune 500 use Microsoft's cloud infrastructure and services, while at the same time it was noted that the Azure pay-by-usage computing model is enjoying significant penetration into start-ups.  With Amazon's recent record losses, one would suspect that its commodity cloud services might be looked at askance as that company comes under pressure for its suspect business model.

Free cash flow in the three months ended September 30, 2014 was $7.1 billion, and $2,307 million in dividends were paid and $2,888 million in common shares were repurchased.

Finally, two new board members were joined the Microsoft board, both of whom add professional profiles and board experience that should serve the new CEO and the management team well.  Charles Scharf is the CEO of Visa, and he held senior executive positions at Bank One Corp., JP Morgan Chase, and Salomon Smith Barney.  Financial services companies with their massive volumes of transactions and their growing need for robust data security should be prime customers for Microsoft's commercial data center and cloud offerings.  Teri List-Stoll is the CEO of Kraft, Inc., and her twenty year career at Procter and Gamble should give her insight into the management and development of brand equity for consumer products; her service on the Danaher board is also useful because Danaher's culture (http://www.danaher.com/our-culture/danaher-business-system) which centers on the customer, measures efficiency and performance, and looks to optimize the portfolio is consonant with CEO Nadella's aspirations for the future Microsoft.

Overall, this quarter, especially in the current tech environment, demonstrates exceptional focus and performance across Microsoft, both in its business execution and its governance.  

IBM Folds the Road Map Hand

As far back as 2012,  we questioned the utility of the 2015 Road Map and its construction. Back in 2013, after CEO Virginia Rometty's overly enthusiastic presentation at Innovation Day, we felt that IBM may have been losing its way.  With the announcement of 3Q 2014 EPS, the Road Map has finally been abandoned. Better late than never.

The CEO's coming on to the investor conference call breaks with an IBM tradition: what a lousy tradition that was!  Abandoning the Road Map, though it came late, perhaps finally symbolizes CEO Rometty's uncoupling from the heritage of her predecessor, under whose leadership the company failed to act on a clearly emerging change in the demands customers would make on their key vendors for IT hardware, software, and services.

Shares outstanding have been reduced by a staggering fifty percent since they beginning of the mega-programs. We have written about these before, so need to go over the ground. Hopefully, it will become less of a focus.

We have always talked about the need for the Tech's Four Horsemen to reinvest in their core businesses, if indeed they want to stay relevant to their customers.  The good news is that IBM, in the CFO's prepared remarks, made specific reference to some sizeable initiatives:

"In the first quarter, you’ll remember that we announced a number of initiatives that
support the shift to our strategic areas of data, cloud, and systems of engagement.
These included the launch of Bluemix, which is our cloud platform-as-a service for
the enterprise, it included a $1.2 billion investment to globally expand SoftLayer
cloud hubs, and it included a $1 billion investment to bring Watson’s cognitive
capabilities to the enterprise. In the second quarter, we made progress to
implement these initiatives, including in June, Bluemix became generally available,
we opened new SoftLayer data centers, we started to ship POWER8, and expanded
the OpenPOWER consortium, and we completed substantially all of the divestiture
of our customer care business.
More recently, we announced additional actions to continue our shift to higher
value. You saw last week that we are investing $3 billion over the next 5 years in
research and early stage development to create the next generation of chip
technologies. Those will fuel the systems required for cloud, big data and
cognitive systems.And just a couple of days ago IBM and Apple announced a strategic global partnership to provide a new level of business value from mobility, for enterprise
clients."

SoftLayer was a big deal acquisition, and making these investments confirms the commitment to add value to it, not just to book revenue.

The next thing the CEO needs to do quickly is to act on something she noted in 2012, the irrelevance and misalignment of the go-to-market model of the old sales force.  Customers are crying out for a change: make it easier to deal with you and to figure out where our ROI lies!