Uptick In Student Loan Delinquencies

The Wall Street Journal featured this NY Fed chart showing an uptick in student loan delinquencies.  There has been much written about millions of homeowners with negative equity "strategically" going delinquent if there were a whiff of an election year bailout.  This strategic delinquency phenomenon hasn't occurred, although economists have written that it is economically rational. 

I'd offer the theory that students might be different.  Students, particularly college students, were said to be a big factor in the last Presidential election, both in terms of organizing, turning out and voting. Students are a pragmatic group, with little ethical baggage and no stakes in preserving a credit rating.  They also have a strong sense of entitlement.  My tuition's too high.  Too much homework. My grades are too low because my professors are lousy.  The dorm food's awful.  It's not my fault!( remember John Belushi's lament in the "Blues Brothers"?)

If the President were to give college students a pour boire from the Federal trough before the election in some form of loan forgiveness it would probably depend on balances and being in delinquency.  Why not get your name on the list now?  Behavioral economists--what do you think?

More Tiles in the HP Mosaic

I've only seen a limited sample of analyst research on HP, but frankly it's pretty mediocre, especially the financial statement models and the valuation arguments.  The equity analysts want to like the stock, for different reasons, but they seem to be struggling to come up with compelling reasons.  The equity sales people cry out the familiar mantra, "It's dirt cheap!"  So is a wooden nickel. 

I've met a few people who work with the company in a variety of functions, and without looking for anything in particular, I hear some consistent sentiments.  The prevailing opinion is that former CEO Mark Hurd "gutted" the company with no rhyme or reason, strictly driven by making short-term numbers.  He is not held in high regard.  On the other hand, CEO Meg Whitman gets high marks for communication inside the company and for taking a measured approach to tough decisions.  This, for me, is an important tile in the information mosaic about a company. 

However, I continue to be puzzled by the total absence of insider buying.  At some point, the CEO needs to say something like this, "Listen team, I've brought you all on board with me to engineer one of the biggest corporate and market turnarounds in history.  If you're with  me on this, then we all have to have skin in the game.  We can't go and peddle this story to institutional buyers if we don't have our own net worths at risk, and I don't mean through options. I mean after-tax cash. The other directors and I are on board with this, and I need each and every one of you to come join us according to your circumstances.  Come to me in confidence if you have any questions or concerns."  This could be well orchestrated and done in a compliant way fairly easily. 

The institutional ownership trends are not very encouraging.  Dodge and Cox has clearly put a big stake in the ground through several funds, and the rest of the significant owners are index funds.  Some of the other well known value players have chosen other names.  I wonder what the value houses are concerned about?

It's a limited data point, but Standard and Poor's research concludes with this paragraph:
"We apply a peer-discount target multiple of 6.0X to our calendar 2012 EPS estimate of $4.16 to arrive at our 12-month target price of $25. This is toward the low end of the seven-year historical range for HPQ, reflecting near-term pressures and our lack of confidence in the company's turnaround prospects."  They talk about being in unattractive businesses (PC's and printing) as well as price pressures in the ESSN hardware products.  Standard and Poor's sees it as a trade, not as a BUY. 

Finally, on the cloud arguments we laid out in the last post, I still believe that if CIO's are going to make big investments in big data and utility (cloud) computing, they will need help in selling the expenditure story to CEOs and support will have to come from the high concept, high science types like Dr. Mike Lynch.  Much of the money spent may be mix-and-match projects put together with small and big company offerings which work together.  The "one stop shopping" concept for these projects might be a dead letter. 

HP, Cloud Computing and Big Data

Cloud computing has become the workhorse cliché of tech analysts, CEOs and journalists.  Here's a link to a cogent presentation on cloud computing by Ramamurthy and Madurai which helped me to frame my thinking about what this means for tech industry leaders.

I found an analyst report which picked Cisco as the "big winner" in the move to cloud computing.  Remember. Cisco's original advertising positioned the company as supplying the "plumbing" for the Internet.  Making routers and switches, like plumbing fixtures, should not remain a high margin business as Asian companies start to get global scale.  Despite integrating hundreds of acquisitions over the years, the company has settled into a low growth phase, when it has to go out and acquire software companies.  Making components and even boxes, like servers, shouldn't attract new shareholders.  To its credit, CSCO has been able to maintain margins in its core router and services business, while also generating very healthy service margins.  Despite its healthy business and modest valuation why it would be a big winner in cloud computing doesn't follow for me.

I liked this quote which I read as part of an IBM cloud computing discussion: "IT industry must go beyond delivery of components—even integrated components. This environment demands that the IT industry deliver integrated expertise."

In this regard IBM overall looks like it is positioning itself well as a provider of solutions to businesses looking at implementing private cloud computing models in stages. Their offerings feature well designed, integrated systems which I presume are manufactured for them by others.  At the heart of their offerings is the image of deep expertise both at the customer level and at the research scientist level.  The magic of expert knowledge should enable them to earn a healthy profit on customer implementations, because they are not selling boxes, or blades, or plumbing. Biri Singh seems to be HP's internal cloud computing guru, and hopefully his team will be built out and his portfolio should grow.
 
An entirely discrete  issue is the so called "big data" opportunity.  Years ago, the buzz word was "business intelligence," or "BI."  Most of those implementations came in late, over budget and didn't provide value.  Nobody that I've talked to at some mega-cap user companies can really describe what this might mean for their companies in specific, operational terms. Selling this concept to users will require some magic, and again the magic won't be in boxes, switches, routers, or servers.  Autonomy seemed like it was to be the magic that might differentiate HP's offerings in this field in the future. 
 
CEO Whitman made this statement in the conference call: "And we want to transition this to faster-growing, higher-margin sections related to strategic enterprise services. What we consider strategic enterprise services, cloud, security, information management and analytics, and application modernization."  Looking at the Autonomy website, this seems to be the portfolio of offerings which it successfully brought to market to top tier customers around the world.  Putting HP's Chief Strategy Officer in charge of this business seems like it will make extracting value from this acquisition take longer to realize.
 
As the CEO stated, the core of HP will be the ESSN business, along with Services and Financing.  As this business builds and receives a bigger R and D budget, its revenue and earnings should increase.  Offsetting this will be a drag from PSG and a transitioning IPG. It's too early to get excited about this stock unless the price were lower.  Can several companies co-exist on The Cloud?  Not according to the Rolling Stones:
 
 

 
Enjoy the Memorial Day Weekend.

Another Desultory HP Second Quarter Call

The first confusing signal on the second quarter conference call came from the CEO's remarks.  She described spending time at Tech Con, an internal HP innovation show which used to have a blog populated by HP Fellows talking about big ideas in the mode of IBM's Watson Research Center. This wasn't a forum about new products, but about big ideas, which seemed to be the point of HP's acquiring Automomy. CEO Whitman was "blown away" by ideas discussed at Tech Con.  Upon announcing the expensive acquisition of Autonomy in past quarters, the CEO could then scarcely contain her enthusiasm about the synergy in customer and prospect lists and near-term opportunities.  Autonomy was almost not to be found in this quarter, so it would seem as if its offerings were no longer mind blowing.  More on this later.

Overall, the quarter looked pretty lackluster, with the reported diluted EPS of $0.81 being below a consensus $0.91, but non-GAAP, diluted EPS of $0.98 coming in above the $0.91, a number whose basis was unknown.  It was a positive surprise, and the lifeless analysts on the call were congratulatory about the "execution" in the quarter.  I can't find what these analysts were pleased about reading through the financials.

The Enterprise Server, Storage and Networking (ESSN) segment saw revenue decline 5.5% to $5.2 billion, while the segment's pre-tax margin declined 260 basis points to 11.2%.  The problem for HP and for the entire industry is that servers and storage have become commodity boxes and services.  These items may have to be bundled or serve as loss leaders in a larger, solutions package.  CEO Whitman made a strange comment about HP not being penalized as much as larger companies because HP has a $5 billion business in ESSN and not a $30 billion business.  This went over my head.  Recent newspaper reports have the CEO describing HP's unequaled opportunities in cloud computing. This segment's results are troubling no matter what the spin and don't seem to back up that assertion.

The Services segment reported revenue of $8.8 billion, a decline of 1% year-over-year.  Pre-tax margins in this segment declined by 410 basis points to 11.3%. If HP were going to morph into IBM, these kinds of margins won't carry the day for shareholders.

The Imaging Printing Group (IPG) reported a 10.4% decline in revenue to $6.1 billion, with the pre-tax margin dropping by 340 basis points to 13.2%.  In a sidebar conversation with an analyst about printer pricing in emerging markets, the CEO said the company was finding that higher printer prices at retail, along with lower supply prices led to better market share and consumer satisfaction.  This is just the opposite of the U.S. market strategy, and the pricing of U.S. cartridges and ink has probably peaked out. 

The Software segment increased revenue by 21.7% to $970 million, due to the inclusion of Autonomy's revenues for the full quarter.  Margins in this segment too fell, by 210 basis points to 17.7%.  Autonomy founder and CEO Mike Lynch is leaving the company, which to me doesn't seem to be a good thing and is inconsistent with some of the CEO's remarks about the "big data" opportunity. 

Lynch is a Cambridge Ph.D. mathematician who founded Autonomy and got it into FTSE 100 index in London as a global leader in turning mountains of files and data into usable information for decision making and risk management. While he is sometimes equated to Bill Gates, I think that the more appropriate pairing to someone like Steve Wozniak.  Selling Autonomy and helping to define the field of big data is something to which Mike Lynch is uniquely suited.

Perhaps HP could have helped him run the business by hiring him a Chief Operating Officer or a smart CFO who would remove all the headaches of running the back office interface to HP and keep the metrics on track.  There was a comment about developing a better interface between Autonomy systems and those of HP.  Now I know that they really overpaid for Autonomy, but letting Lynch leave seems to make no sense, since the British press suggests he wanted to stay and grow the company he founded in 1996.

The last item for me was the 33% decline in cash from operations to $2.5 billion.  This doesn't speak to execution of any kind.  Management can produce all the non-GAAP numbers they want, but this is a metric where the rubber meets the road.

Bernstein analyst Toni Sacconaghi suggests that the forward growth rate for HP might be 1%.  The company is going to be in a turnaround mode for quite some time, even after having lowered expectations below the level of the roadway.  The CEO seems to be trying to convince herself that she can turn this ship around when she makes repeated reference to having been through "a number of these (?) turnarounds."  Based on what knowledgeable investors can see forward, it's hard to make a case for the stock, except for appealing to some historical average margins and multiples which are no longer relevant.

The company suggested that there could be a sharp sequential growth in diluted EPS from Q3 to Q4, due to seasonality and to restructuring efforts.  Since this is a one-time item, hopefully it is priced in and ignored.  I wish I could take a trip to Suffolk and find Dr. Lynch in his favorite pub to talk about "big data."

Emerging Market Investors Should Get Warning Label

It's curious to me how often I see asset allocation recommendations from brokerage houses suggesting investors increase their exposure to "emerging markets."  Let's take the case of India, which seems to have some advantages when compared to fellow BRIC Brazil, which is very sensitive to global commodity prices. India, by contrast, has a burgeoning domestic consumer sector which requires consumer products, retailing and financial services. This provides opportunities for domestic firms because of the restrictions placed on foreign firms looking to expand into Indian markets. 

In my mind, a U.S. investor has no reason to look at a significant portfolio exposure to Indian equities, because the potential returns aren't at all commensurate with the risks. The free fall of the Indian rupee leaves it 22% lower against the dollar than a year ago. Indian stock market indexes are down 11% in local currency terms for the three months, and about 18% in U.S.dollar terms according to the Journal.

The Journal says foreign investors put $9 billion into Indian equities in the first three months of 2012, and they are clearly trapped given the illiquidity in equity markets and the currency issues. Morningstar's highest rated fund for Asia ex-Japan is Matthews Pacific Tiger, which has 16% of assets in India, number two behind China in country allocation.  However, only one equity, Tata Power, is in the fund's top ten holdings. 

Morningstar analyst Patricia Oey says that five year Indian equity market volatility is 39%, measured as a standard deviation, which is higher than the S and P 500.  The currency market is probably a much more efficient predictor of future market performance than are the small, inefficient Indian equity exchanges.  A U.S. investor could, for the same or lower risk, probably make more money trading in small and micro cap stocks in the U.S., where the investor would have access to managements, Wall Street research, and managements more accustomed to the needs of equity investors. 

The Morningstar analyst says, "India also has an unfriendly business environment and widespread corruption."  This isn't news, but it's unusual to see it so plainly stated in a research piece.  Less well appreciated is the fact that Indian boards and managements are completely tone deaf to their responsibilities towards equity stakeholders, since many large companies are really family companies in public garb. 

The central government, which seems to be at sixes and sevens these days about its own agenda has recently gotten into a spat with the Italian government over the trial of Italian sailors accused of murder in India for a crime which may have been committed on an Italian ship in international waters.  The Italian envoy has been recalled, and the Italian government has expressed its "strong displeasure" with the Government of India.  On the face of it, this may not seem like much to an investor, but it's symptomatic of a central government which seems to take every opportunity it can to make India seem like an erratic, unpredictable, unsophisticated international wannabe rather than an emerging power on the international stage.  Investors should get a warning label with their mutual funds: "Investing in India Could Be Bad for Your Wealth."

European Economist De Grauwe on EU

My former graduate school colleague, Paul De Grauwe is currently Professor of Economics at the London School of Economics, and he has written a tome, now in the eight edition, Economics of Monetary Union. I saw him today on Bloomberg video talking about some of the same issues in our last post. 

A word he uses quite often in discussing the problems within the European monetary union is "distrust."  He applies this term to bond markets.  He compares the debt ratios of Spain and the U.K., which he says are broadly similar. Yet, Spanish yields are much higher than U.K. yields, and he notes the difference is that the Spanish sovereign issuer is not in control of the currency in which it issues the debt, namely the euro.  In this case, liquidity leaves the Spanish system when markets lose faith, and a liquidity crisis quickly ensues.

He calls for the ECB to become the lender of last resort, to draw a line in the sand and to provide any amount of liquidity to bail the union out of the current crisis, without looking over its shoulder for German support.  This is wishful thinking.  The ECB is constitutionally directed by its board, over which Germany controls only its own vote.  Yet, it will shoulder a disproportionate risk in any such open-ended bailout.  So the German interest in this mechanism is what? 

Paul does admit in his paper that Greece was probably insolvent at the time it was admitted into the eurozone.  Now we start to get to the root of the issues.  The EU never hewed to its own published rules and public rhetoric either in admitting new members or in calling them on the carpet for breaking budget or trade deficit guidelines.  If the EU has behaved like this for decades, then any practitioner knows that the market comes armed with distrust and its own discipline. 

We again reiterate that Spain's problems should all be addressed by cleaning up its own banking system, which would rebuild trust in the credit markets.  De Grauwe also makes the point, in another research paper, that Ireland has already undergone a painful "internal devaluation," in which case it might be at the point where it would be better for it to voluntarily leave the euro and grow with an improved relative competitive position.  Paul's work is interesting reading.

Euro Bunds Not A Rational Option

Today, we know that the young, photogenic Greek leftists were full of bluster but no bite.  Instead, they are now going in search of traditional political support for a combination of Euro bonds, debt write downs, and traditional bailouts with "other people's money."  Meanwhile, French socialists are behaving no differently from the deposed conservatives in trying to paint Germany in a corner as the obstructionist force to progress.  IMF Director Lagarde has joined in on cue, as the WSJ writes the "campaign for join Euro bonds gathers pace."  The pace may not be sustained.

No German politician of any stripe, Social Democrat or otherwise, would be able or willing to cede political and economic sovereignty to the extent triggered by issuing a Euro bond instrument.  France may be "jousting" with the Germans about Euro bonds, but aside from rhetoric and public relations, the Republic has no leverage.

The BBC did a series of walk around interviews with German citizens about the Euro crisis this morning, and I was amazed at the thoughtfulness of all the answers.  Certainly nobody offered a solution.  But, I would describe the sentiment as being (1) we wouldn't like the European union/currency/experiment end, but (2) Germany certainly can't be expected to write blank checks or to carry the burden for Greece and others.

There has never been any doubt that a euro zone fracture or breakup would be costly.  An economist at the University of Cologne mentioned something that I wasn't aware of: Target 2 funds of the European Central Bank.  (I regret not being able to credit his name because it wasn't very audible on my feed) These funds were, in his words, meant to slosh around European central banks to ease short-term liquidity crises without triggering public concerns.  He calculates that there are 240 billion euros issued under Target 2, with no clear requirements for repayment.  He estimates a Greek exit would wipe out repayment prospects, costing Germany almost thirty percent of this amount, which was its contribution.

Spain's issues are within the purview of a traditional central bank: a real estate bubble.  It has already put some of its smaller institutions under central bank control, and it just needs to act quickly and decisively.  The sooner it does this, the sooner the rest of Europe can own up to where some of the bad Spanish paper lies. 

As some of the German citizens interviewed by the BBC said, it would be a shame if Greece, at 2% of EU GDP could call the day for the end of the euro.  The Greeks don't seem ready to march off the cliff today.