Cutting Military Pay: Don't Play Politics With The Troops

"You can't expect this country to maintain a strong military if we aren't maintaining some kind of common-sense budgeting," Leon Panetta, the former Defense secretary in the Wall Street Journal. 

Of course, this is a complete red herring, as Secretary Panetta is a career politician operating in an arena where common sense is completely absent.  Government budgeting has nothing to do with budgeting or common sense.

"We have the analytic tools that potentially we didn't have before." General Martin Dempsey, Chairman of the Joint Chiefs of Staff, also in the WSJ. 

What tools are those?  Countless commissions of the armed services, think tanks and legislatures have identified the problems over decades.  

These kind of grandstanding comments give cover to focus on relatively small pieces of the puzzle, because the biggest barriers to efficiency, real cost controls and a better military are the political and military elites themselves.

Where does it begin?  According to Professor Andrew Bacevich, Professor of History at Boston University the problems lie at home with our own policies and failed assumptions.  Professor Bacevich retired from active duty in the Army with the rank of colonel. 

Our all volunteer army concept is at the root of our problems that have building for decades, as Bacevich writes in the compelling, "Breach of Trust."  Most observers know that we have too many military bases here at home and worldwide.  Domestic base closures have been identified and recommended, but Congressional leaders always fight to keep their own state's facilities free from right sizing.  Congress members and Presidential staff all agree that development of duplicative weapons systems and aircraft must be stopped, until it comes to closing down research and manufacturing in their home states. The big dollars are here in these issues, and if action is taken here, then headcount reductions follow and compensation would be significantly reduced, but through lower staffing levels and not by pay rates alone. The latter are blunt instruments.

Over time, our military were called on to invade and control Iraq in a traditional style, tank, artillery, aircraft and ground troop invasion, and this was carried out in exemplary fashion.  Then, we asked our military to become 'nation builders,' and we overstayed our welcome. In Afghanistan, our troops were put into absolutely untenable positions with no clear military objectives.  This situation is vividly described in Jake Tapper's "The Outpost." Trained soldiers and their commanders were asked to fight an enemy who couldn't be differentiated from the tribal leaders whose support they were supposed be garnering by winning hearts and minds.  Tours of duty were too long, and farces like "the surge" made us all at home feel safe and sound that things were going well. 

We wind up fighting as a foreign invader against trained foreign jihadists and guerrilla fighters from Chechnya and Pakistan tribal territories while engaging in nation building.  These are tasks that are impossible to carry out simultaneously by troops without the proper military intelligence and support. It's not a matter of pay.  

Further, the illusion of fighting wars with contractors makes no sense, budgetary or otherwise.  So, as the defense budget continues to shrink as a total share of Federal spending, we are staring at an abyss in the future. Having National Guard regiments serve in ways that were never in their traditional terms of reference does nothing to strengthen this service, but it does demoralize troops who have to serve multiple tours abroad. 

Demands on our capability to project our power and to defend our citizens and way of life will grow greater and more complex.  We can do this in an intelligent way, but cutting military pay as a first step is an insult to those who serve and it is shameful posturing by the legislative and military elites who know very well where the big dollar savings lie.  

Germany Steps Up to Work With Ireland

We've talked about the idea of Germany working within the EU, not as the lender of last resort, but as an experienced strategic lender, investor and partner.  Now it appears that Germany is doing just this with Ireland, to the benefit of both parties.  In Ireland's case, they get access to credit without all the intrusive and unnecessary political regulatory baggage associated with EU, ECB, and other facilities.  

"Mr. Kenny said that his government will "work more closely" with German ChancellorAngela Merkel to sustain Ireland's recovery, saying that Germany's development bank KFW had been asked to help provide credit to Ireland's enterprises."  Source: MarketWatch. 

Ireland is not out of the woods by any means, but their ability to stick with their programs and come to an exit from their bailout has been hailed as exemplary, even by the IMF!  

The Irish government did have the ability to exit the bailout with a standby international and EU credit facility, but they again made reference to the additional terms which were not consistent with the Irish government's view of economic sovereignty.  

This announcement was, to our ears, the one tiny, but potentially path breaking news in a long period of EU crisis. 

More Thoughts on Cisco and the New IT

We've been thinking about 'big data' in many posts, and it is now one of the common buzzwords on the lips of most tech CEOs, institutional investors, and analysts. This phrase, along with many others, such as 'software defined networks,' 'virtualization,' 'SaaS,' and 'the cloud,' mean that IT is undergoing a fundamental shift in the way that customers interact with technology, corporations use data, and buyers evaluate and pay for IT equipment and services.

So, is this sea change the reason that the Four Horsemen of Tech--IBM, Microsoft, HP, and Cisco--are struggling with top line revenue growth and earnings?  Is this why their shares sport historically low absolute and relative multiples?  It could be, but it seems as if there's something wrong with the market's view, as there was during the Internet bubble and during the Y2K crisis-that-wasn't.

Companies in other, more prosaic industries deal with the slow death of their cash flow rich businesses, and the better companies adapt or reinvent their portfolios.  Think about the check printing business for financial printers like Deluxe, Merrill Corporation and John Harland.  Who writes checks?  I use my iPhone and so on, yada yada.  Well, Deluxe has done quite well by branching out into search engine optimization, brand identity, and e-marketing, while still maintaining a check business that is providing cash for an array of financial services.  The Four Horsemen should be able to navigate their industry change, but some are playing a stronger hand than others, but this fact alone won't determine who will take the pot at the end.  That's why stock picking is an art.

Today, in the aftermath of Cisco's sell-off for poor guidance, I read one analyst who essentially said that Cisco was finished because of their dependence on selling high margin gear for an evolving system of software defined networks. The analyst is being myopic just as the banking analysts were who said checks are going away. Cisco management admitted on their call that they realized three years ago that they had to prepare for a major product line shift in their core business, and it is underway in the most recent quarter.  They may take a while to get it right, but having a huge market place presence and a fortress balance sheet is a strong hand for Cisco to hold.

Looking at Cisco's board, I noticed that Dick Kovacevich, the retired CEO of Wells Fargo is a director. Dick made an extremely challenging "merger of equals" work through regulatory, economic, operational, cultural and management challenges.  Wells Fargo was, and is, a bank that had consistently made large investments in technology.  Having the perspective of a financial services buyer on the board is extremely valuable; plus, I know from seeing him operate on the board of one my employers that he is a man of integrity with a strong sense of duty and loyalty to his shareholder constituency.  There are other strong directors who know tech from a different angle, like Marc Benioff and Arun Sarin who provided innovative software and hardware to customers.

Thinking about the "big data" opportunity, it isn't clear that any of the Four is building an insurmountable lead, because the nature of the opportunity, like every market, will have layers and segments which will require different business models and capabilities.  On the high end, for users like the U.S. government and its agencies, and for big university research systems, IBM and Cray Research have established positions and they compete with NEC, Hitachi, and other competitors.  Companies like HP and Dell who want to pursue this opportunity will come into it by building inexpensive high performance computing machines from commodity parts, thus analysts say undercutting margins for products like IBM's Watson and Cray's XC30-Cascade.  I doubt that the buyers will look at their decisions in this simplistic way, but we'll have to wait, see and learn.

HP went and bet the farm on buying an analytic engine through Autonomy.  This may or may not be enough, but they recklessly overpaid. Cisco, meanwhile, is really making a big run at network security and this opportunity can probably be more financially rewarding, faster than the big data opportunity.

Finally, IT buyers are not like Wal-Mart buying shampoo.  The CIO reports to someone who can put her out of a job for a catastrophic failure or a loss of confidential personal or financial data that invites regulatory bodies in for fines and civil lawsuits.  CIOs like meeting their peers and talking about they have recently implemented the 'next big thing.' I have lived through millions being wasted on business intelligence software, digital dashboards for real-time analytics, and data centers with robotic arms to swap data cartridges for IBM and Hitachi mainframes.  None of those CIOs pinched pennies.

Here is an example from a real life customer which is implementing a very large scale super computer project in Japan.  The Railway Technical Research Institute is dealing with a train system that is the transportation backbone for the country, where an unanticipated seismic event affecting bullet trains with several hundred passengers would be catastrophic.  In this case, a provider who could provide experience and a tightly integrated system capable of handling thousands of processors and a tested analytical engine got the bid.  The market for high performance computing and big data will definitely have segments in which many players can participate.



 

Cisco: The Fourth Horseman Reports First Quarter 2014

In Cisco's current 10-K, we note that for the period 7/2008-7/2013, an indexed investment returned an average annual return of 7.4%, trailing both the Standard and Poors Technology Index (up 18% p.a.) and the Standard and Poors Index (up 16.5%) by a wide margin.

Despite the under performance, Cisco's balance sheet is impressive.  For the fiscal year ended 7-2013, free cash flow was $11.7 billion, for the fiscal year ended 7-2012 FCF was $10.4 billion, and for the fiscal year ended 7-2011 FCF was $8.9 billion.

Despite its long history of acquisitions, which have become fewer in number and larger, Cisco has a tangible book value of about $6.24 even after stripping out goodwill and intangible assets.  The company recently closed on the $2.7 billion acquisition of Sourcefire, a leading innovator in the cyber security field.  In one of their slide presentations about the acquisition, Cisco talks about the importance of compatible corporate cultures when considering a target.  This acquisition is very consistent with CEO John Chambers' remarks on the FY14 1Qtr conference call where he said the number one concern of Cisco's top 95 global IT CIOs was IT security.

While acknowledging the maturity and scale of the current Cisco, the company returned $3.3 billion in dividends to shareholders in the fiscal year ended 7-2013, more than double the $1.5 billion returned to shareholders through dividends in the fiscal year ended 7-2012.

So, a company with a fortress balance sheet and high returns has dramatically under performed its peers and the broad market. Let's look at the recently announced FY 14: 1Q.

Revenue of $12.1 billion increased 2% yr/yr.  $9.4 billion revenue came from selling products, and $2.7 billion came from services.  Subsequent line items are non-GAAP numbers. Cisco's consolidated gross margin is an extraordinary 63%, and that rate increased by 30 basis points over the prior-year period.  Product gross margin was 62% and increased 50 basis points, while services generated a 67% gross margin, which also increased 30 basis points over the prior-year period.

Operating expenses were 33.7% of revenue, down 110 basis points yr/yr reflecting the significant worldwide reduction-in-force throughout the enterprise.  Operating income was an extraordinary 29.3% of revenue, up 140 basis points over the prior-year period.  Net income of $2.9 billion reflected a margin of 23.7% and income grew 12% yr/yr on a non-GAAP basis.  Diluted EPS of $0.53 increased 10% yr/yr.

During the quarter, the company repurchased 84 million common shares at an average price of $23.65 and returned $2 billion to shareholders.  The company also paid dividends of $914 million.

As of the fiscal year ending 7-2013, the company had 75,049 employees.  26,416 worked in research and development. 25,938 employees worked in sales and marketing, a number which clearly reflects the importance of consultative selling in the corporate culture. 7,546 employees worldwide were in administrative positions.  Research and development expenditures were about $6 billion in the last full fiscal year.

Analyst questions and concerns after the management presentations centered on the forward guidance for the next quarter.  One analyst said that he was "floored by the guidance."  Management suggested that revenues for the current quarter might be down as much as 11% sequentially.  While this seemed like a discontinuous change, the explanations were fairly clear.

The first quarter ended with a shortfall in bookings versus sales forecasts in the last two or three weeks of the quarter, and the backlog going into the second quarter was correspondingly low. Combined, these two factors comprise somewhat more than a $1 billion shortfall in the current quarter.

Their core set top box market will decline by about 4-5% in the next two quarters, as a technology transition continues to take place.  Emerging markets, including China, are and will continue to be very challenging. Each of Cisco's top ten emerging market countries missed their sales forecasts for the first quarter. The top five markets had yr/yr sales declines of 18-30%.

The CEO noted that Cisco had relied too much on core switching and routing product sales for many years, without being ahead of technical and engineering developments that would require new platforms for the high end customers.  He said that it took 4-5 years to fix this oversight, and it is done or their two core product segments.  Routing and switching are in the midst of major product line transitions.

The worry is that consolidated gross margins will decline, and they most likely will.  On a GAAP basis, consolidated gross margins have declined about 800 basis points from 2008-2013,  the period of the stock price under performance.

In the meantime, the company's work force has been right sized to work with significant margin pressure, if it comes. The substantial dividend increase and the commitment to share buybacks would suggest a company that should generate substantial free cash flows.  In fact, the company just announced an additional share repurchase authority of $15 billion.

Cisco's goal is to become the number one provider to its top global corporate customers.  It has the sales organization and culture and the balance sheet to make this happen.  Their acquisitions and new product platform launches seem to be in the right direction for their customers.  Their guidance for long-term revenue growth is 5-7%, which is above the "GDP rates" suggested by HP.  If this happens alongside some operating leverage, then the stock would appear to be undervalued, given its capability of producing prodigious cash flows.  

QE A Feast for Wall Street

"Unless you're Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.

As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again "bubble-like." Meanwhile, the country remains overly dependent on Wall Street to drive economic growth."

Andrew Huszar in the Wall Street Journal

What Kind of A Recovery Is This?

I've spent some time thinking through a typically informative presentation by my former colleague, Dr. Ward McCarthy and his partner Tom Simons, CFA of Jefferies, Inc, "U.S. Economy and Inflation: Economic Recovery in the Era of Conflicting Monetary and Fiscal Policy."

I want to pick out some points the authors make and then express a different set of questions and concerns.

• "The U.S. economy entered the 5th consecutive year of growth in Q3 of 2013."

The authors note that the recovery and expansion phases of the current business cycle "have been slow to date."  Not only is this true, but the nature of the recovery and expansion has been singular among recent cycles in that it hasn't featured an early-cycle housing recovery.  Instead, it has featured a "late-cycle housing recovery," which along with a recent pickup in CAPEX spending are both "important for the continuation of the economic expansion."

The consumer sector has usually been one of the engines of recovery in prior business cycles, but not in this one.  How could it be otherwise?  The authors note,

• "The unemployment rate has declined from 10% in October 2010 to as low as 7.2%, but remains high by historical standards."
• "Real Personal Consumption Expenditures has been remarkably steady and sluggish for an extended period." 

What of the miraculous, unconventional monetary policy of the Bernanke Fed?  It appears to be the only thing propping up the stock market, because even the faintest whisper of a taper sends the market into atrial fibrillation. The authors note, "Consumer spending behavior provides evidence that the Fed's QE has not had a widespread impact on the consumer sector outside of housing activity."  

On a broad macroeconomic front, productivity growth in the U.S. economy has been one of the biggest contributors to economic growth and wealth creation for decades.  But, a secular shift in the composition of output may not bode well for this in the future. The authors put the problem in simple terms, "It takes 85% of the U.S. labor force to generate a monthly trade sector surplus of less than $20 bn."  

So, ironically in this recovery, "The decline in goods-producing activities has been fundamental to the sizable monthly trade deficits in goods that have been a drag on the economy and growth."  

In secular terms, this could change, were higher value-added manufacturing to be "right shored" to the U.S. The biggest barrier to this happening is our own fiscal, political and regulatory irresponsibility.  

During this recovery, the Federal government has run annual deficits of over one trillion dollars.  While an observer could point to a short-term decline in the ratio of the deficit to GDP ratio, the total stock of Federal debt stands at an astounding $16.7 trillion, according to the St. Louis Fed.  

The Congressional Budget Office forecasts of tax revenue, spending and deficits are inherently untrustworthy. The authors note that the most recent CBO forecast has discretionary spending "rising for the remaining 8 years in the forecast horizon" beyond FY14.  

This is before yesterday's announcement that Medicare spending shall treat mental health expenditures equally to medical expenditures. The impacts of the 39 million or so additional consumers coming into the plans before this expansion have been dramatically understated, but out politicians are looking no further than the 2014 election campaigns. 

Finally, our banking system is holding excess reserves of over $1.9 trillion, and the Fed's balance sheet may not normalize until 2019 or beyond.  Meanwhile, studies from the New York Fed show that unwinding the Fed's balance sheet will remove the patent medicine of Fed remittances to the Treasury which have been widely hailed as demonstrating the 'success' of the bailout and unconventional monetary policy.  We'll look at these issues in some later posts.

So we have a five year old recovery that is built on pretty sandy soils.  

Showrooming and Best Buy: Wall Street Consensus Discredited

Almost a year ago, looking at the beleaguered Best Buy shares, we wrote,

"The fundamental issues at Best Buy have nothing to do with "showrooming," but everything to do with the company's own internal issues.  Back in the time when I rated the stock a 'Buy' the internal organization and culture were strengths, while during this long down cycle, the opposite has been true."

Renew Blue was a valuable start to a turnaround process that is still in its early innings.  The Wall Street Journal reports today, "Recent results suggest that last year's fears over showrooming were overblown"  My basic principle for reading the financial press has a three-fold test: a trend being written about has either (1) long ago gone out to sea and is of historical interest only, or (2) it is a manifestation of the herd instinct and is of limited substance, or (3) it is entirely self-serving for some interest group, in which case the investor has to 'follow the money.'  Reading the financial press for a glimpse into the future is not time well spent.

All this being said, Best Buy's meteoric share price rise is way ahead of any reasonable projection of earnings growth, unless it is getting an unwarranted multiple expansion.  Technology choices for consumers, especially when looking at manufacturer's websites or undifferentiated websites like Amazon, are overwhelming and confusing.  Price may be important when the consumer has settled on a specific product.  

Let's say a consumer is looking for a new laptop.  Windows or Mac?  If Windows, then go to Windows 7 and skip the new OS. or go to Windows 8.1 now, but with touchscreen or not?  If Windows 8.1 touchscreen, then convertible or not?  Windows 365 or Windows single, permanent license? What about a Chromebook to avoid the issues of OS and Office?  But, more expensive WinTel laptops offer better performance and screens than Chromebooks for viewing movies.  What to do?  It makes my head spin. 

Like George Zimmer or Joe Namath, I "guarantee" that the average consumer can use help to make the best decision for their own, misunderstood needs.  This is where a store-based retailer could add value to the consumer's tech choice nightmare.  Is that retailer Best Buy?  That result isn't in yet.