Alliance Bernstein economist Joe Carson's March letter notes that U.S. non-financial corporations' total holdings of liquid assets are 1.8x the dollar value of their fixed investments and that they have not held this level of cash relative to investment at any time in the past fifty years. At the end of 2009, using Federal Reserve Board numbers and estimates from Haver Analytics, Carson notes that the cash and liquid assets total $1.8 trillion.
The cash hoard was a natural consequence of the response to the financial crisis: slashing payrolls and operating expenses, reducing inventory investment, and deferring capital spending. The question is what to do next?
Conoco Phillips recently made a clear, informative presentation about its medium term strategy to improve operating performance, raise return on capital employed, and create shareholder value. To this end, they announced goals for dividend growth and a share buyback program, some of which would be funded by redeployment of cash from asset sales, specifically the sale of a 10% stake in Russian energy company LUKOIL. Additional free cash flows generated by the multi year strategy would go to retiring debt. It's a thoughtful approach.
A friend who is a mutual fund manager mentioned to me that Medtronic had indicated to analysts that up to 40% of future free cash flows would be dedicated to returning funds to shareholders, again through a combination of dividend growth and share repurchases.
It will be interesting to follow this stream of cash in the coming months, to see if there is a rebound in capital spending, which would then put some economic foundation under the market valuation.
Tuesday, March 30, 2010
Thursday, March 25, 2010
What's Underpinning This Market?
From my perspective, the news from the housing and mortgage market isn't good. February new home sales declined 2.2% versus the consensus 2% increase, while the supply of homes for sale continues to increase. The MBA refinance index, according to Ned Davis Research, fell 7.1%, its fifth decline in six weeks. Correlating this data point with what's going on in markets I can observe, it seems as if the "Sold" signs and closings are on entry level homes, because of the first time buyer tax credit. Those who can refinance appear to have already done so. The sales in the middle and upper end appear to be below even the reduced local assessed values, never mind what the seller bought the home for. This is to be expected, but not indicative of a robust market recovery.
Meanwhile, companies I talk to are still dealing with challenges in getting top line sales going on a consistent basis. I was reading a report on Hewlett-Packard, a bellwether stock that is owned in dividend-paying mutual funds, quality growth funds, and value funds. They did a great job when the crisis began by cutting staffing, reducing compensation (in which everyone shared the pain), and by doing unheard of things like substituting video conferencing for routine business travel. Driven by their new CFO, it worked like a charm, both financially and culturally. However, reading their performance by business group, it's fairly lackluster. It seems to me that a disproportionate share of their income still comes from consumables, and that's not healthy. That may be why their relative P/E lags their competitors. Great company, great products, but its performance will be driven by earnings going forward and not by higher valuations. The same seems broadly true for this market.
Where is the engine for our continuing economic, as opposed to stock market, recovery? I'll let you know when I find it, and if you find it first, let me know.
Meanwhile, companies I talk to are still dealing with challenges in getting top line sales going on a consistent basis. I was reading a report on Hewlett-Packard, a bellwether stock that is owned in dividend-paying mutual funds, quality growth funds, and value funds. They did a great job when the crisis began by cutting staffing, reducing compensation (in which everyone shared the pain), and by doing unheard of things like substituting video conferencing for routine business travel. Driven by their new CFO, it worked like a charm, both financially and culturally. However, reading their performance by business group, it's fairly lackluster. It seems to me that a disproportionate share of their income still comes from consumables, and that's not healthy. That may be why their relative P/E lags their competitors. Great company, great products, but its performance will be driven by earnings going forward and not by higher valuations. The same seems broadly true for this market.
Where is the engine for our continuing economic, as opposed to stock market, recovery? I'll let you know when I find it, and if you find it first, let me know.
Wednesday, March 17, 2010
Royal Dutch Shell: A Matter of Returns
RD announced its year-end results and made an extensive investor presentation in London. It's relatively easy to see why its valuation is lower than many of its peers, and why its shares carry a Hold recommendation versus a Buy for some of its peers. RD's returns on average capital employed peaked at about 20% around 2005 (hard to read from a graph) but sunk to around 3% in 2009. Contrast this with the high and persistent returns on capital earned by Exxon Mobil, and for me it explains a lot.
What underlies this difference is too much for a brief post, but here are some interesting takeaways. RD forecasts crude oil prices in a band of $50-$90/bbl through 2030. Current producing fields show declining output over this time horizon. Meanwhile, production of natural gas liquids (NGL's) increases, and gas continue to be a big source of production and target for exploration, including some interesting possibilities offshore Australia.
Refining capacity continues to be in oversupply, to the extent of 1 mmbd. Operating margins have sunk to about 2%. Capacity will be rationalized and the average size of refinery will increase over the planning horizon.
The dividend will be maintained at the prior year rate for 2010, and the company seems to be looking for creative ways to grow the payout, e.g. making it somewhat performance-related. Capital spending will be relatively constant at a high rate, and the gearing ratio may increase from its current level of 34% debt/capital. All-in-all, a riskier profile than some of its peers, arguing for a lower relative PE.
A positive takeaway is the fact that RD's exploration activities resulted in a 266% reserve replacement to production for 2009. However, in some ways, the portfolio looks like it's supporting too many diverse activities and it should be pruned over the medium term horizon.
RD has been a pioneer in unconventional resources such as the Athabasca tar sands heavy oil project. Most recently, it announced a joint venture with Cosan of Brazil, which is expected to produce 35 K boed when it is up and running. Shell gets a strong retail presence in Brazil plus a number one status in the sugarcane based biofuel market. Beyond that, a partnership with Iogen gives it exposure to cellulosic ethanol technology, but Iogen has been progressing relatively slowly relative to the hype from four or five years ago. Strategically, a company has to choose where it plants its flag in biofuels and unconventional resources, and RD has chosen sugarcane based ethanol and biomass as opposed to wind. In the medium term, it's probably not a bad choice, but this investment won't move the corporate needle.
What underlies this difference is too much for a brief post, but here are some interesting takeaways. RD forecasts crude oil prices in a band of $50-$90/bbl through 2030. Current producing fields show declining output over this time horizon. Meanwhile, production of natural gas liquids (NGL's) increases, and gas continue to be a big source of production and target for exploration, including some interesting possibilities offshore Australia.
Refining capacity continues to be in oversupply, to the extent of 1 mmbd. Operating margins have sunk to about 2%. Capacity will be rationalized and the average size of refinery will increase over the planning horizon.
The dividend will be maintained at the prior year rate for 2010, and the company seems to be looking for creative ways to grow the payout, e.g. making it somewhat performance-related. Capital spending will be relatively constant at a high rate, and the gearing ratio may increase from its current level of 34% debt/capital. All-in-all, a riskier profile than some of its peers, arguing for a lower relative PE.
A positive takeaway is the fact that RD's exploration activities resulted in a 266% reserve replacement to production for 2009. However, in some ways, the portfolio looks like it's supporting too many diverse activities and it should be pruned over the medium term horizon.
RD has been a pioneer in unconventional resources such as the Athabasca tar sands heavy oil project. Most recently, it announced a joint venture with Cosan of Brazil, which is expected to produce 35 K boed when it is up and running. Shell gets a strong retail presence in Brazil plus a number one status in the sugarcane based biofuel market. Beyond that, a partnership with Iogen gives it exposure to cellulosic ethanol technology, but Iogen has been progressing relatively slowly relative to the hype from four or five years ago. Strategically, a company has to choose where it plants its flag in biofuels and unconventional resources, and RD has chosen sugarcane based ethanol and biomass as opposed to wind. In the medium term, it's probably not a bad choice, but this investment won't move the corporate needle.
Monday, March 15, 2010
Blame The Shorts?
I was the CFO of a growing public company that had as much of 20% of its float sold short. Never having seen this kind of shorting up close and personal, it certainly gave me pause. Our executive team was conditioned to blame the stock price performance and all our out-of-the money options on Wall Street short sellers.
In reality, the short side of the market had it right: our forecasts were out of touch with reality, and although sales were growing at 50%, the company was hemorrhaging cash. Another dilutive private placement was the only option, and so the short trade had to be the winner. Sitting inside the company blaming the short sellers deflected focus from the real problem, namely a faulty strategy and business model.
There's no asymmetry to the market, that is both longs and shorts have their place. That's not to say that some short sellers, particularly those with "unaffiliated" research efforts and inside funds, don't focus on rumor and innuendo. They do this to create price down drafts with their research for the benefit of their own in-house fund that has the short trade in already. This practice should be outlawed or at a minimum be disclosed.
I believe that analysts on the short side often do more thorough, close to the ground research through good independent sources, and they are often better at putting together an information mosaic than are the rah-rah, dictaphone sell-side analysts who rehash the company's press releases. We are now hearing about David Einhorn and some of his early work ferreting out inconsistencies in Lehman's public disclosures that the Wall Street Journal suggests led to the replacement of the Lehman CFO. Good for Mr. Einhorn. His good, solid work earned its reward. That's the way the market should work. As a CFO, I always wanted to know that the "short story" was on my company. The market is an excellent learning laboratory.
However, I also believe that we need transparency on all sides of the market. Short-selling should be just as visible in real-time as on-exchange and other forms of institutional trading. As Arthur Levitt advocated, the information playing field for all market participants (institutional, retail, domestic, overseas, short and long) should be level.
In reality, the short side of the market had it right: our forecasts were out of touch with reality, and although sales were growing at 50%, the company was hemorrhaging cash. Another dilutive private placement was the only option, and so the short trade had to be the winner. Sitting inside the company blaming the short sellers deflected focus from the real problem, namely a faulty strategy and business model.
There's no asymmetry to the market, that is both longs and shorts have their place. That's not to say that some short sellers, particularly those with "unaffiliated" research efforts and inside funds, don't focus on rumor and innuendo. They do this to create price down drafts with their research for the benefit of their own in-house fund that has the short trade in already. This practice should be outlawed or at a minimum be disclosed.
I believe that analysts on the short side often do more thorough, close to the ground research through good independent sources, and they are often better at putting together an information mosaic than are the rah-rah, dictaphone sell-side analysts who rehash the company's press releases. We are now hearing about David Einhorn and some of his early work ferreting out inconsistencies in Lehman's public disclosures that the Wall Street Journal suggests led to the replacement of the Lehman CFO. Good for Mr. Einhorn. His good, solid work earned its reward. That's the way the market should work. As a CFO, I always wanted to know that the "short story" was on my company. The market is an excellent learning laboratory.
However, I also believe that we need transparency on all sides of the market. Short-selling should be just as visible in real-time as on-exchange and other forms of institutional trading. As Arthur Levitt advocated, the information playing field for all market participants (institutional, retail, domestic, overseas, short and long) should be level.
Friday, March 12, 2010
Read Alongside The Examiner's Report
Elsewhere, I've reviewed the book, "A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers," by L.G.McDonald and P.Robinson. Here's the review, which still rings true in light of the new data:
"This is a very compelling, informative, and irreverent account of the housing bubble and Lehman's demise. McDonald's distressed debt group was making money shorting the bad actors in these markets. Independently, Lehman's CEO was drinking poison by directing the irratonal purchase of large commercial properties around the world based on no analytics and with no oversight.
Lehman CEO Dick Fuld comes off as aloof and totally isolated from the people who were taking huge risks and making money for his firm. When the fateful meeting with Treasury Secretary Henry Paulson took place and Lehman was at death's door, Fuld's arrogance, a lack of mutual respect , and a misplaced sense of competition with Goldman Sachs probably made Paulson uninterested in bailing out Lehman. In the end, whether it's at Yalta or on Wall Street, so much turns on personalities and on their interactions.
As the bubble grew in earnest from 2003 through 2006, there were ample warning signs, but few took the time, and had the industry and horsepower to challenge the Kool Aid being handed out in the housing market. Distressed debt analyst Christine Daley does old fashioned, analytical grunt work under enormous pressure, and her conclusions that Delta, Calpine, and New Century Financial were going under provided the foundation for traders like McDonald to place enornous bets against these firms that resulted in a $5 million trading profit DAY for the Lehman distressed desk. I know that I would like her if we met--she did the work, took a contrarian stand, felt the heat and made lots of money for herself and the firm. If you haven't worked in or around a trading desk, you'll get a great flavor from reading this book.
If you're interested in genuine financial market reform and what we've learned, you'll have a Scotch and turn out the lights. (From where we are now, this seems prophetic)
The stories and sequence of events in this book dovetail very well with the dryer, more analytic and legal document provided by the Bankruptcy Examiner. It's a sad tale, and one that will likely be repeated sometime in the next up leg of the cycle.
"This is a very compelling, informative, and irreverent account of the housing bubble and Lehman's demise. McDonald's distressed debt group was making money shorting the bad actors in these markets. Independently, Lehman's CEO was drinking poison by directing the irratonal purchase of large commercial properties around the world based on no analytics and with no oversight.
Lehman CEO Dick Fuld comes off as aloof and totally isolated from the people who were taking huge risks and making money for his firm. When the fateful meeting with Treasury Secretary Henry Paulson took place and Lehman was at death's door, Fuld's arrogance, a lack of mutual respect , and a misplaced sense of competition with Goldman Sachs probably made Paulson uninterested in bailing out Lehman. In the end, whether it's at Yalta or on Wall Street, so much turns on personalities and on their interactions.
As the bubble grew in earnest from 2003 through 2006, there were ample warning signs, but few took the time, and had the industry and horsepower to challenge the Kool Aid being handed out in the housing market. Distressed debt analyst Christine Daley does old fashioned, analytical grunt work under enormous pressure, and her conclusions that Delta, Calpine, and New Century Financial were going under provided the foundation for traders like McDonald to place enornous bets against these firms that resulted in a $5 million trading profit DAY for the Lehman distressed desk. I know that I would like her if we met--she did the work, took a contrarian stand, felt the heat and made lots of money for herself and the firm. If you haven't worked in or around a trading desk, you'll get a great flavor from reading this book.
If you're interested in genuine financial market reform and what we've learned, you'll have a Scotch and turn out the lights. (From where we are now, this seems prophetic)
The stories and sequence of events in this book dovetail very well with the dryer, more analytic and legal document provided by the Bankruptcy Examiner. It's a sad tale, and one that will likely be repeated sometime in the next up leg of the cycle.
Thursday, March 11, 2010
Lehman's Failures: Lots of Blame to Be Shared
The Wall Street Journal has published the 2,200 page Examiner's Report on the Lehman Brothers Holdings bankruptcy. Here's what I gleaned from volume one of nine volumes. First, the Lehman bankruptcy was part and parcel of the global meltdown rather than being the trigger. Lehman's business model was not dissimilar to that of the other major investment banks, except to the extent that it relied on repos to open for business on a daily basis, which was something I didn't realize. Repo markets more than others, rely on confidence of counterparties, and this had to be maintained at all costs, or Lehman couldn't make it through a trading day. Basically, a $700 billion balance sheet was supported by $25 billion in equity. So, we have a highly leveraged business running on a very short term funding mechanism that could freeze up at any moment.
To rush ahead, high level decisions are made, as the subprime crisis was starting to emerge, to "double down" and raise Lehman's exposure in order to gain market share at the expense of competitors who were pulling back. The two mortgage companies that Lehman bought had their "weightlifter" sales people generating all types of "ninja" and "liar" loans in the hottest markets, and Lehman was already having trouble securitizing them, and so they remained on the balance sheet. At the same time, other businesses were increasing their risk profiles, such as leveraged loans to private equity groups and global commercial real estate transactions. These stories have been documented in other books.
In order to appease the credit rating agencies and to lower its reported leverage ratios, Lehman's financial team created an accounting subterfuge called Repo 105 that allowed the troubled assets to be treated as sales rather than as a financing and hence to disappear from the balance sheet for a short time. These transactions are quoted by senior financial staff, from the Controller on up, as being sham transactions with no economic purpose. Remember Enron? Does this sound familiar? They had no purpose other than to temporarily shrink the balance sheet and to allow the CEO, amid rising losses, to report that Lehman had lowered its leverage ratio, when it had done no such thing.
The external auditor, Ernst & Young, received a copy of a warning letter from a senior financial staffer, Mr. Lee, that these transactions had no substance and needed to be looked into. The audit committee apparently specifically requested that the auditor look into Mr. Lee's allegations and report back. Ready? E&Y apparently did not look into the Lee memorandum and did not follow up with the audit committee!
According to the report, "There are colorable claims around Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in their financial statements." A colorable claim is one that would support a recovery.
So, the audit committee was apparently not aware that these transactions were behind the decrease in leverage ratios, and neither were the shareholders because they were not called out in any notes to the financial statements. This kind of complete breakdown of the audit function is eerie, because if reminds me of the very similar breakdown in the bankruptcy of New Century Financial.
Law students and business school students may pore over this examiner's report, but the sad thing is that there won't be any penalties or clawbacks. The examiner notes that the Delaware business judgment rule will cover the decisions to increase the risk profile of the Lehman book of business. That is disappointing, but not unexpected. To paraphrase a Chancery judge, "The business judgment rule does not outlaw or punish stupidity."
To rush ahead, high level decisions are made, as the subprime crisis was starting to emerge, to "double down" and raise Lehman's exposure in order to gain market share at the expense of competitors who were pulling back. The two mortgage companies that Lehman bought had their "weightlifter" sales people generating all types of "ninja" and "liar" loans in the hottest markets, and Lehman was already having trouble securitizing them, and so they remained on the balance sheet. At the same time, other businesses were increasing their risk profiles, such as leveraged loans to private equity groups and global commercial real estate transactions. These stories have been documented in other books.
In order to appease the credit rating agencies and to lower its reported leverage ratios, Lehman's financial team created an accounting subterfuge called Repo 105 that allowed the troubled assets to be treated as sales rather than as a financing and hence to disappear from the balance sheet for a short time. These transactions are quoted by senior financial staff, from the Controller on up, as being sham transactions with no economic purpose. Remember Enron? Does this sound familiar? They had no purpose other than to temporarily shrink the balance sheet and to allow the CEO, amid rising losses, to report that Lehman had lowered its leverage ratio, when it had done no such thing.
The external auditor, Ernst & Young, received a copy of a warning letter from a senior financial staffer, Mr. Lee, that these transactions had no substance and needed to be looked into. The audit committee apparently specifically requested that the auditor look into Mr. Lee's allegations and report back. Ready? E&Y apparently did not look into the Lee memorandum and did not follow up with the audit committee!
According to the report, "There are colorable claims around Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in their financial statements." A colorable claim is one that would support a recovery.
So, the audit committee was apparently not aware that these transactions were behind the decrease in leverage ratios, and neither were the shareholders because they were not called out in any notes to the financial statements. This kind of complete breakdown of the audit function is eerie, because if reminds me of the very similar breakdown in the bankruptcy of New Century Financial.
Law students and business school students may pore over this examiner's report, but the sad thing is that there won't be any penalties or clawbacks. The examiner notes that the Delaware business judgment rule will cover the decisions to increase the risk profile of the Lehman book of business. That is disappointing, but not unexpected. To paraphrase a Chancery judge, "The business judgment rule does not outlaw or punish stupidity."
Wednesday, March 3, 2010
Congress To Design Your Brakes
Executives of Toyota America are now bleating in the press for more transparency from Japan about "quality issues." It seems as if they are trying to avoid accountability for the current issues. Customer complaints on American-made Toyotas originate here, and they are either reported through dealers or directly to Toyota America phone numbers. The NHSTA regulates the handling of these complaints. It's a pretty clear cut issue, and much simpler than the broader issue of quality.
Customer complaints about braking, sudden acceleration and the like entail the technician hooking up a handheld unit to the on board computer and downloading the error codes; the technician then checks the codes against the service bulletins issued by the company. I think that one mistake Toyota is making, at the behest of its lawyers probably, is not being more candid about what error codes it has or has not found in the reported complaints to date. One Toyota official somewhere stated that they had been unable to recreate the "situation" that generated a sudden acceleration incident. This statement is problematical because it suggests that the dealer's tech found a code that related to the sudden acceleration problem, and was unable to recreate sudden acceleration. If such a code exists, it must be in some service bulletin. Why not just report the facts?
Right now, the biggest problem is the dearth of facts. The only numbers tossed around are complaint numbers. We know that self-reporting systems typically under-report the number of real problems. Per mile-driven, it seems as if the number of sudden acceleration complaints for Toyotas is relatively small, but it would be nice to benchmark these against the same complaints for midsize sedans from all other makers. The NHSTA must have all this data. Meanwhile, the press reports a large number of compaints about sudden acceleration, but it seems as if 80 percent of these came after the announcement of the recall, so they should be viewed with caution.
Senator Jay Rockefeller chided the NHSTA for not being expert enough on sudden acceleration issues. If they don't have engineers who can work with the industry to understand this problem, then heaven help us. However, Congress is expert enough to recommend smart brake pedals being installed on all new vehicles. Congress can't balance a budget, but they can design our brakes!
Now, suddenly we have large recalls coming from other makers like Nissan also. Is everyone afraid of legislative scrutiny? The auto industry here is being its own worst enemy, and instead of increasing advertising to get minor changes in share, they should really work together to get to the bottom of complaint reporting, analysis, and data sharing with the Federal government. In the end, candor and real transparency will benefit consumers and the industry.
Customer complaints about braking, sudden acceleration and the like entail the technician hooking up a handheld unit to the on board computer and downloading the error codes; the technician then checks the codes against the service bulletins issued by the company. I think that one mistake Toyota is making, at the behest of its lawyers probably, is not being more candid about what error codes it has or has not found in the reported complaints to date. One Toyota official somewhere stated that they had been unable to recreate the "situation" that generated a sudden acceleration incident. This statement is problematical because it suggests that the dealer's tech found a code that related to the sudden acceleration problem, and was unable to recreate sudden acceleration. If such a code exists, it must be in some service bulletin. Why not just report the facts?
Right now, the biggest problem is the dearth of facts. The only numbers tossed around are complaint numbers. We know that self-reporting systems typically under-report the number of real problems. Per mile-driven, it seems as if the number of sudden acceleration complaints for Toyotas is relatively small, but it would be nice to benchmark these against the same complaints for midsize sedans from all other makers. The NHSTA must have all this data. Meanwhile, the press reports a large number of compaints about sudden acceleration, but it seems as if 80 percent of these came after the announcement of the recall, so they should be viewed with caution.
Senator Jay Rockefeller chided the NHSTA for not being expert enough on sudden acceleration issues. If they don't have engineers who can work with the industry to understand this problem, then heaven help us. However, Congress is expert enough to recommend smart brake pedals being installed on all new vehicles. Congress can't balance a budget, but they can design our brakes!
Now, suddenly we have large recalls coming from other makers like Nissan also. Is everyone afraid of legislative scrutiny? The auto industry here is being its own worst enemy, and instead of increasing advertising to get minor changes in share, they should really work together to get to the bottom of complaint reporting, analysis, and data sharing with the Federal government. In the end, candor and real transparency will benefit consumers and the industry.
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