Friday, December 28, 2012

HP 2012 10-K: Share Buybacks and Potential Divestitures

HP's share buyback program to-date has been badly managed, as we discussed in a previous post.  Now, although the shares may be undervalued, the company is financially much less flexible than in the past.  In the 10-K, there are several risk factors discussed that militate against further large share buybacks:

  • The paramount need to raise the corporate credit rating;
  • "We may have to continue lowering the prices of many of our products and services to stay competitive.."
  • "We renewed our focus on developing new products, services and solutions..."
  • "W must make long-term investments, develop or obtain, and protect intellectual property and commit significant resources before knowing whether our predictions will accurately reflect customer demand for our products, services, and solutions.."
  • "...we must continue to successfully develop and deploy cloud based solutions for our customers."
  • The company has repeatedly suggested that it has underinvested in research and development in the past.
All of this taken together, along with many other similar statements, suggests that the higher return investments are within the business itself as opposed to in the stock market.  In fact, the company itself may be at risk as a stand-along entity if it doesn't reclaim a place at the table of technology leaders.  The cash needs to be invested in the business, and rationally within the portfolio.

In talking about their services business, particularly the lower value services business like business process outsourcing and staff augmentation, the company talks about not being able to manage the four key drivers of this business: rate, margin, utilization and leverage.  If this is what HP is talking about at this stage of their corporate development, these business segments might be candidates for divestiture to partners, particularly to foreign partners.  Valuations won't be stellar, and HP has no particular comparative advantage in these businesses. Foreign firms may be very interested in them in order to broaden their international scope. Sixty-five percent of HP revenues are outside of the U.S. These commodity businesses probably don't belong in a high performance portfolio. 

Thursday, December 27, 2012

HP 2012 10-K: First Impressions

HP's 10-K for the fiscal year ended October 31, 2012 just came through their Investor Relations site. Weighing in at 223 pages, it isn't a svelte document by any means, so my first reading took me to certain sections where I was looking to get impressions about specific issues.  My pencil and green eye shade were put away for another day.

The document's prose, tone and organization show the hands of new authors, whether internal or external, including additional outside counsel.  It also looks like important parts were written fresh to reflect what the management saw before 2012, the developments in 2012, and some realistic risk assessment about the future.

So, in order of reading the document, here are some things I found noteworthy:

  1. "We also began working to optimize our supply chain... During fiscal 2013, we will be focused on working through the anticipated disruptions expected to accompany the changes made in fiscal 2012 and continuing to implement our cost reduction and operational initiatives."  I presume that the anticipated disruptions, a rather strong phrase, apply to the supply chain optimization.  I'm curious what this means and how it might affect results, given that these risks were called out.
  2. I was encouraged to see a specific reference to the need to "rebuild relationships with channel partners."  The discussion about channel partners, their business models, and the impacts on HP's working capital is a good reminder of how HP's products come to market.  
  3. 29,000 employees will exit the company by the end of 2014.  Much of this will take place in national jurisdictions that make labor reductions difficult, and there was a comment I appreciated about the need to maintain morale within the remaining work force.  These are not issues to be glossed over if the company is going to succeed. 
  4. The Oracle issue continues to be problematic.  There is a clear reference to Oracle as an alliance partner that competes in the server market, and which also in the second quarter of 2011 stopped developing new software for the HP Itanium server product line.  Although HP won a court judgment against Oracle's tactics, the effect on HP customers has led to their delaying and canceling orders.  Although this was discussed during 2012 quarters, it is clearly still a risk going forward the way the disclosure is written.  It is even a risk of spilling over to other alliance partnerships. where the partners may be lured to competitors.  
  5. Margins in the printer cartridge business will come under pressure in Asia, where intellectual property rights are not held in the same judicial esteem as they are in the West. The CEO in one of the 2012 quarters talked about the IP surrounding the printer ink business.  She vowed that HP would defend this IP aggressively.  This must have been the markets to which she was alluding, but if this threat is to be staunched, then courts will not have a great bang for the buck.  
  6. There is a risk factor identified as copyright levies issued against the company in Europe.  I didn't understand what this referred to, but it doesn't remind me of historical boilerplate language. 
  7. Given what happened with Autonomy and the almost inevitable need to take stakes in, or acquire companies, this disclosure language was troubling, "Our ability to conduct due diligence with respect to business combinations and investment transactions, and our ability to evaluate the results of such due diligence is dependent upon the veracity and completeness of statements and disclosures made and actions taken third parties or their representatives.  
  8. "Our due diligence process may fail to identify significant issues with the acquired company's product quality, financial disclosures,accounting practices or internal control deficiencies."
  9. The underlined part of bullet point 7 is written partly to be consistent with the allegations made against Deloitte and KPMG with respect to actions against them and Autonomy in Britain and in the United States.  If one reads this statement literally, it makes HP executives and management seem incompetent.  Astute buy side analysts and their advisers independently and aggressively peel away financial statements prepared by others in order to take long and short positions.  Surely, HP doesn't need to depend on others to the extent they claim.  
  10. Looking at bullet point 8, if the due diligence process is that weak, it probably was weaker in the past two years when big acquisitions were made and written down.  Surely this would manifest itself somewhere as significant deficiencies in the system of internal controls over financial assets. No such weaknesses are identified in the certifications.  This is very disappointing to see.  
  11. I had to laugh when I read that a $1.2 billion charge was taken in the third quarter of 2012 to adjust the balance sheet value of the "Compaq" trade name.  No kidding--it was carried at $1.2 billion?  I'd like to see that valuation model.  
  12. In the fourth quarter of 2012, a two stage test was applied to remaining intangible assets and it is strongly suggested that further write downs will not be necessary.
  13. The implied control premia for each major business segment are the "fudge factors" that make the assertions in bullet point 12 work.
  14. What remains of Autonomy is now in the Software segment, under the executive management of Abdo George Kadifa, which seems like it is in good hands to me. If I recall, Kadifa reports directly to the CEO. 
Enough staring at screens for now.  Good reading!  

Diagnoses of Bipolar Disorder in Children

Reading a book about behavioral economics, I came across some literature references to the over diagnosis of bipolar disorder in children.  A 2007 study  by Moreno and his colleagues at Columbia University and the NIMH, noted the diagnosis of 800,000 children in 2003 alone compared to an annual diagnosis rate of 20,000 children a decade earlier.  This is a shocking, forty-fold increase in the number of cases diagnosed.

The original classification scheme for mental illness was developed in 1920s Germany by a psychiatrist named Emil Kraepelin.  His classification labels included "manic depressive disorder," which has survived today as "bipolar disorder."  Other of Kraeplin's diagnoses did not stand the test of time, and some of his categories, such as "indviduals with distinctly hysterical traits," including "dreamers, poets, swindlers and Jews" were outside of any science or medicine.

Modern professional associations have taken power unto themselves to affect health care costs by defining and classifying medical and psychiatric conditions.  Mental health disorders are governed by the Diagnostic and Statistical Manual of Mental Disorders (DSM-V), which in turn is governed by the American Psychiatric Association.  Over time and intermediate revisions of the DSM, from III to IV, for example, the definitions of bipolar disorder broadened to include vague descriptors of how the patient felt.  Where formerly a prior hospitalization for a manic episode was a prerequisite for a diagnosis, that prerequisite disappeared.

Bipolar disorder became conflated with depression, and this led to the prescription of selective serotonin reuptake inhibitors like Prozac and Zoloft for children and adolescents. Now the pharmaceutical companies saw a large opportunity to expand the use of SSRIs into younger age groups.  Although the prescribing of these powerful compounds is now mainstream, some meta-analysis studies have shown that SSRIs may have little or no therapeutic effect for severe and moderate depression, respectively.

The diagnoses of bipolar disorders can be given by all manner of health care professionals, including medical doctors, psychiatrists, psychologists, counselors, school nurses, and community health educators. For some parents, it comes as a relief to have a label attached to their child's difficult behavior; it can also be a relief to believe that a pill or psychotherapy can solve their problem.

Dr. Stuart Kaplan M.D., Professor of Psychiatry at the Penn State College of Medicine, writes,
"Despite the dramatic surge in the rates of diagnosis of bipolar disorder in children, the number of children under 12 who actually have the disorder is rare, according to a recent (2010) report of the highly influential American Psychiatric Association's Diagnostic and Statistical Manual, Fifth Edition (DSM-V)  Child and Adolescent Disorder Work Group.             
The total yearly cost of psychiatric treatment for youth aged one to 24 years was estimated at 18 billion dollars per year in 2007, according to work jointly sponsored by the National Research Council and the Institute of Medicine.  What have we received for the money we have spent studying and treating bipolar disorder in children and adolescents? How much does the misdiagnosis of child bipolar really cost?"
The adoption of Revision V of the DSM will have very significant effects on the growth of health care spending dollars, and yet the seemingly arcane discussions within the APA are barely newsworthy or worthy of critical scrutiny by legislators and disinterested analysts.

Besides the waste of billions of dollars that could be better spent in other ways, children can suffer the effects of being labeled for a condition that may not have; they may also be exposed to powerful drugs that don't benefit them and which could do them harm.

Spending more time on candid, fact-based discussion of issues where billions of dollars are being misdirected  has to be an improvement on the current situation of unfettered, economic self-interest among pharmaceutical companies and mental health practitioners.

Wednesday, December 26, 2012

Class Action Lawyers Stick Up Toyota for $1.1 Billion

Here's an excerpt from the February 2011 Report of the National Highway Traffic Safety Administration on their assessment of alleged problems with Toyota Electronic Throttle Control (ETC) systems, which were said to be behind widely reported cases of UA (unintended acceleration).  

"After conducting the most exacting study of a motor vehicle electronic control system ever performed by a government agency, NASA did not find that ETC electronics are a likely cause of large throttle openings in Toyota vehicles as described in consumer complaints to NHTSA.  NASA found that many safety features are designed into the ETC system to prevent UA and, if faults are detected, to initiate safe modes of operation that limit acceleration (e.g, limp home, fuel cut strategies).  NASA found no flaws in the software code controlling the Toyota ETC system that could cause UA.  NASA also found that the electromagnetic compatibility (EMC) testing at exposure levels well above current certification standards did not produce an open throttle.  NASA found no evidence that any failures of the ETC system had an effect on the performance of the braking system. /...

NHTSA and NASA both reviewed relevant consumer complaints and warranty data in great detail.  Both agencies noted that the publicity surrounding NHTSA's investigations, related recalls, and Congressional hearings was the major contributor to the timing and volume of complaints. /...
The results of NHTSA's field inspections of vehicles involved in alleged UA incidents during 2010 supported this analysis.  Those vehicle inspections, which included objective evidence from event data recorders, indicated that drivers were applying the accelerator and not applying the brake (or not applying it until the last second or so), except for one instance involving pedal entrapment."  

So, Toyota will settle all these alleged claims for between $1.1-$1.4 billion, even though  the facts as studied by NHTSA, NASA and the National Academy of Sciences debunks virtually all allegations and public relations grandstanding fomented by the class action law firms.

The benefit from all this? More safety mechanisms aboard Toyotas, for which every consumer will pay more money and which may not add commensurate incremental value.  The class action law firms are slated to take home $227 million out of the $1 billion plus settlement, a historically large share. Let's hope that the courts minimally cap the lawyers fees below the egregious level of $227 million.

Just for comparison, the purported largest insider trading scandal in history, the Matthew Martoma/SAC Capital Advisers insider trading profit on Elam and Wyeth shares netted SAC $276 million. Some of this will be clawed back from Martoma and others.  The Toyota class action law firms will have transferred a comparable amount of wealth to themselves for nothing more than making allegations that have been adjudged to have no basis in reality, according to our own government agencies.

I've been doing a lot of reading on regulatory complexity and its costs, and I am currently reading "Simple Rules for a Complex World, by Richard A. Epstein of the University of Chicago, where he is a Distinguished Service Professor of Law.  He writes,
"More instructive, perhaps, between 1972 and 1987, the number of Washington lawyers increased fourfold from 11,000 to 45,000. The clear implication is that internal composition of lawyers' work is changing as well, away from commercial transactions (which produce wealth) to politics (which transfers and diminishes wealth simultaneously). 

Friday, December 21, 2012

HP, Clouds and Big Data Again

Along with not being a lawyer, I am not an IT professional, and I'm proud to make both statements.  Since my original post on the cloud and big data as it affects HP, I've done quite a bit more research into these issues.  If I can borrow a lyric from Judy Collins' "Both Sides Now," I would say, "I've looked at clouds from both sides now."

I stand by my first, somewhat intuitive conclusion, and that is that "The Cloud" is largely hype, something that IT gurus enjoy as they wrap straightforward concepts in a cocoon of mystery.  At the same time, I've come to a different conclusion about first generation cloud players, namely that many companies will have their hands in delivering cloud solutions.  While the industry giants like IBM, Oracle, Cisco, VM Ware, HP, Amazon and Cray will all have roles to play in different segments, innovative startups will add their secret sauces until the industry inevitably consolidates, once the first generation cloud implementations are mature.

Although "cloud" is the current buzzword, the underlying approach and technologies have been developed over years and decades.  With the explosion of corporate data centers has come a massive sprawl of physical servers, which has flattened out at some 32 million servers, according to a 2011 white paper prepared by IDC, sponsored by HP.

As virtualization of servers really started to take off in the 2005 period, today the installed base of logical servers stands at more than 80 million units, according to IDC.  CTOs benefited from falling unit prices of servers, as well as from the flattening out of demand in units, as virtualization of machines accelerated.  Energy costs of data center management have been relatively constant, helped by more efficient servers, virtualization, stable utility rates, and energy conservation measures within the data centers.

The one cost component that has rampaged out of control is "Management and Administration," according to the IDC report.  The industry wide spend is some $50 billion.  As corporations saw their IT infrastructures start to sprawl, they became choked by an explosion of virtual machine images, the consequent overprovisioning of storage and data network facilities, and even a physical thicket of cabling.

Within the management and administrative expenditures, CIOs/CTOs and data center managers have had to focus on very micro issues like tracking down the causes of individual CPU failures within jerry-rigged racks of servers.  For this problem, HP has developed HP Operations Orchestration software that allows managers to design work flows and automate the processes for monitoring system performance, availability, down times, and the ability to quickly document and identify root causes.

According to the IDC report,
"Many large organizations have serious sprawl and incompatibility issues created by years of meeting their immediate needs by using a project-by-project approach." 
 So, HP and others looking to establish dominant positions in converged infrastructure management and cloud computing have developed offerings that sometimes combine optimized servers, storage and network appliances, along with management software and consulting.

The more a reader looks through the myriad offerings from HP, the more obvious it is that the knowledge, experience, and technical as well as business acumen of the consultants will be the differentiating point for the customer when choosing between, say HP and IBM.

The move to a fully automated converged IT infrastructure will reduce annual IT costs to provide a unit of workload throughput by several orders of magnitude, according to the IDC report.  That's why Meg Whitman talked about the unprecedented opportunity in the "cloud."

Remember, though that some parts of cloud computing, such as public clouds are, and likely will continue to be dominated by Amazon and perhaps other players like it.  This is a commodity business.

Large corporations may choose to develop "private clouds," or hybrid models where some lower-value data are stored on public clouds while mission-critical data remain in private clouds.  HP certainly has the ingredients and a positive legacy of relationships with the big customers to suggest that it can succeed.

It will, however, be competing with IBM, Accenture, Oracle, VMware and others.  It will take time and expense to upgrade and expand the consulting and customer interface talent pools.

A part of the offering for the converged infrastructure solution should be the ability to handle and extract value from "big data," which was one of the main reasons for acquiring Autonomy.  Unfortunately, only about $2.4 billion of the $11.2 billion of assets from the Autonomy purchase remain on the books after the last write-down.

Thinking back to the Analyst Day demo of Autonomy's IDOL engine, it really was a relatively primitive application, in which real time data from various social media channels were monitored, and counts were made by keywords.  The most frequently occurring keywords then scrolled across a dashboard in different sizes and colors of type.  This might be an application that a marketing officer might use, but it hardly seems mission critical.  If HP wants to play in big data, it remains to be seen if the Autonomy acquisition will be enough to provide the offerings HP needs for its customers.

Another area of hype is in the concept of "big data" itself.  The handling of extremely large, complex data streams made up of words, numbers, and symbols, along with real analytical engines beyond counting, is not something that can be done by many players in the business today.  These gigantic data sets are typified by university or private genetic research operations, or global meteorological networks, or private energy development and production companies. These data sets cannot efficiently be moved routinely back and forth among cloud servers.  Cray, Inc.  is very active with these kind of customers, and they lead with customized data appliances and analytical tools.

HP seems to be trying to extract whatever value it can out of Autonomy, but it may need to partner, or perhaps acquire, smaller, more specialized players who develop unique capabilities in  the field of big data.  The whole notion of HP acquiring a company should induce afib in hearts of their shareholders.  Also, aside from a selfish need for liquidity, it's hard to believe an innovative entrepreneur would want to see her company absorbed within a dysfunctional HP.

Cray, by contrast, seems to be effectively implementing a partnership model for many of its offerings.

2013 should be a "proof of concept" year for HP in the whole area of "cloud computing."

Tuesday, December 18, 2012

HP Ends 2012: Hope to Anger to Apathy

Jim Chanos had a clear thesis on HP which he made public in mid-2012, and the market proved him correct.

On the long side, HP was able to generate a lot of hope among value investors, such as Dodge and Cox.  Dodge and Cox has been overweight technology for years, as their portfolio manager and Assistant Director of Research David Hoeft explains in the linked video.  As of September 30, 2012, the Dodge and Cox Growth Fund alone owned 64.5 million shares worth $1.1 billion, or an average of $16.78 per share.   The firm's total position was 142 million shares at 9/30/2012! Today, the stock closed at $14.53.

In talking about how they evaluate technology, David talks about the importance of management, the long-term growth prospects, and the margin opportunities.  I wonder which management he's referring to, as the position was developed over a long period of time.  Their interest has spanned Hurd, Apotheker, and Whitman, at least. He then talks about using traditional valuation metrics to give a point of entry, with a traditional margin of safety.

Later in the talk, David refers to HP as an "older" technology holding, which he lumps with Dell.  He contrasts this with "more innovative" technology companies like Google, NetApps, Adobe, and curiously, eBay.  Perhaps their comfort with HP's CEO change to Meg Whitman was because they admired her work at eBay.

David pooh-poohs the consensus "death of the PC" world view, saying that it is priced into the stock.  He suggests that the portfolio of non-PC businesses within HP is much more valuable that the market is giving credit for in the share price.

He then makes a very curious statement, namely that companies like Intel and HP have "said" that 70% of their incremental growth in the next 3-5 years will come from emerging markets.  I haven't understood that to be the expectation of HP management from anything they've said in 2012.  It also doesn't seem obvious which businesses in the portfolio might provide this kind of incremental contribution.

It certainly wouldn't come from the PC, tablet, SmartPhone, or printing businesses because HP is so late to the game in mobile devices and printing faces other Asian-based challengers.

Going back to the Analyst Day and the subsequent disappointments, downward revisions, and the fiasco with Autonomy, sell-side analysts got blindsided and got angry.  Analyst Shaw Wu reduced his rating to "Sell" and made the incendiary statement that on a tangible book value basis, the equity was worth -$2 per share.  Talk about anger, and it was all the company's fault for how they handled disclosures.

At this point, though, analysts who suggest that the company is worth $20 per share sold for parts must be doing a 'back of the napkin' calculation.  If that were true at cyclically low valuations for much of HP's portfolio, then HP must be worth much more as a continuing business, given a modicum of astute management and a global economic rebound. The talk about creating a hive of independent public companies from HP is nothing but an investment banker's pipe dream.

There are real, nagging questions about the board and the financial acumen inside of HP.  Think about their own statements for how HP looks at share buy backs.  According to the CFO's presentation, the company buys back shares only when:

  • There are ample funds available while building financial strength and investing for the long-term;
  • HP shares trade at a significant discount to conservative calculations of the intrinsic value of the shares;
  • No higher ROI opportunity exists.  
Now, think about this time profile for quarterly share buybacks:
FY 2010= $11.1 billion
FY 2011= $7.6 billion
FY12 1Q=$1.6 billion ;  2Q=$800 million ; 3Q=$365 million and 4Q=100 million.

When the company's credit rating was downgraded, the rating agency made reference to the profligacy of share buybacks and their limits on the company's financial flexibility.  It is incomprehensible how under any set of reasonable, conservative inputs, a defensible model could have generated significant discounts to  intrinsic value for three years.  The board and the CFO must accept accountability for this gross mismanagement of funds.  

Meanwhile, the commercial printer line, it was later admitted, hadn't had a model refresh in seven years.  Surely, this would have been a better investment of funds into the basic business than financial engineering and buying back shares.  

The next 10-K, proxy, audit opinion and Section 404 certifications of internal controls need to be carefully examined to see if the company has learned anything from the last three years of mismanagement. 

We leave this story for 2012 as we began.  Unless this company does a major refresh of its board membership, internal controls and processes, financial acumen, and shareholder communications, then 2013 will be another year of Wall Street apathy towards HP shares.  That would be a shame for the organization, its employees and customers.  

Wednesday, December 12, 2012

SEC Goes Way Off Base On Netflix

Having been an analyst in the heyday of "whisper numbers" and companies preferentially leaking good news to analysts who worked for their underwriters, I was really happy to see former SEC Chair Arthur Levitt's vision of "fair disclosure" enshrined in Reg FD.  Contrary to the CEOs and CFOs who railed against Reg FD, I always thought that it was a good tool which served its purpose, both by leveling the information playing field and by encouraging companies to share their thinking and forecasts with the Street in a safe harbor.

One of the unfortunate tendencies at financial regulatory agencies, like the SEC, has been the need to justify their existence by appearing to be tough on the Street. Here's an excerpt from a recent press release announcing SEC Chair Mary Schapiro's stepping down:
"In a news release, the SEC said that under Schapiro it brought a record 735 enforcement actions in fiscal 2011, and 734 in fiscal 2012. It also prosecuted the largest insider-trading scheme in its history, winning a record $92.8 million fine in the case against Raj Rajaratnam, the CEO of Galleon hedge fund."
 There it is: it's all about taking scalps and not about really changing the way Wall Street does its business.  And, it shouldn't be about pursuing trivialities just to up these numbers.

The serving of a Wells notice on the CEO of Netflix is a self-serving stunt. It is a waste of their limited resources.  Of course, to be fair, this CEO himself is not the model for mature communications with Wall Street. The CEO posted on Facebook that in June, Netflix viewers' monthly viewing of company media exceeded a billion hours for the first time.  Really?

Imagine that you are Raj Rajaratnam is the elevator with your analyst, as he pulls this post up on his SmartPhone.  When Raj hit the trading floor, would he really give the order to get as big a position in Netflix as he could?  Not in a million years.  It's not a tradeable byte of information.  It doesn't fit into a bullish mosaic on the company.  

This is a company whose entire existence is being called into question.  The CEO is held in low regard among institutional investors.  Their streaming service is widely acknowledged to have inadequate breadth and depth.  Red Box and others have nibbled at the core DVD rental business.  This singular factoid about hours, without any ability to take it into historical context or to make it sing in a financial model, is fascinating, interesting, and ultimately trivial.  It's not actionable, except by a fool. 

The SEC and its bloated staff of lawyers have still not been able to assign responsibility for Jon Corzine's inability to account for $1.6 billion of his investors' supposedly segregated funds. Of course, Mr. Corzine is much more dangerous game to bag than was Mr. Rajaratnam.  The SEC, despite earnest leadership of outgoing Chair Schapiro, has really not covered itself in glory before, during, and after the financial meltdown whose effects still cloud the economy and markets.  Close the books on your really important issues, and let's leave Netflix to the discipline of the stock market.

Thursday, December 6, 2012

U.S. LNG Exports? No Bonanza

There was a lot of excitement today from the release of  reports from the Energy Information Administration and a report commissioned by NERA Economic Consulting.  The basic conclusion: the U.S. has potential to become a significant exporter of liquefied natural gas (LNG).

To readers of this blog, this issue shouldn't be a surprise, as an April 2012 post was entitled, "Can The U.S. Increase Natural Gas Exports?" Older posts talk about the potential for natural gas to serve both economic and carbon mitigation objectives.

So, what's new today?  Nothing really. Higher U.S. exports of LNG leads to higher prices than in the baseline scenario AEO2011, or the Annual Energy Outlook 2011.  Domestic markets respond to the higher prices with additional supplies to replace 60-70% of the exported gas, with most of the additional supply coming from unconventional sources, specifically shale.  Electric utilities, in this forecast, respond by switching back to coal, which is not good for carbon dioxide emissions.

The NERA group makes a calculation of net economic benefits from the LNG exports and concluded that all the scenarios tested show net economic benefits from exporting LNG, even after taking into account higher prices paid by utilities, consumers, and commercial energy users.

Trade associations representing manufacturers have already spoken out against the export strategy.  However, NERA states that only about 10% of U.S. manufacturing sector shipment values have energy content that represents more than 5% of their shipments.  The potential loss of output or employment in these resource processing industries is at most about 1% per year.

The most economically beneficial scenario modeled by NERA is one in which gas produced from shale is produced in volumes at low cost enough to replace all the exported gas, something which is not yet proven.  World gas demand rising sharply would drive prices up, benefiting the liquefaction projects that have four year build cycles and twenty year lives.  If LNG supplies were to be constrained in the rest of the world, particularly Asia, that would be very beneficial to this scenario.  However, this scenario seems to be wishful thinking.

An important thing to keep in mind is the fundamental difference between international markets for natural gas and for crude oil and liquid hydrocarbons.  The latter are globally integrated, so local prices cannot deviate much from world prices except for commodity differences, transport costs and taxes. Natural gas markets are not globally integrated, so gas can be priced at $0.75 per MM Btu in Saudi Arabia, $3.50 per MM Btu in the United States, and $16 per MM Btu in Asia.

The EIA report does not make it clear where the U.S. LNG exports would go, but we have written in the above linked post that it seems unreasonable to expect that U.S. exports could displace Russian exports to Europe. The first reason is that Russia and the former soviet republics represent the number one global production base, and second,gas exports into Western Europe are a pillar of Russian strategic foreign policy.

The likely destination for U.S. LNG exports would be Asia, particularly China and Japan.  Japan especially looks like a promising market whose potential may have been enhanced by the decision to exit  nuclear energy production. Political relations between the U.S. and Japan would probably clear international supply and construction agreements quickly.

As Rice University's Baker Institute research has pointed out, the global elasticity of supply for natural gas may be significantly higher than most sources project because of the "shale revolution" and other potential new sources.  The recent natural gas price situation in the United States is somewhat anomalous because Baker researchers say it is the product of  relatively mild winters and a long, deep recession. Were natural gas prices to normalize into the $4-6 MM Btu range, then gas supplies could significantly exceed projected global demand in the period 2020-2035.

What is happening in the U.S. shale industry is somewhat akin to what happened in the early wildcatting days in Pennsylvania when oil was truly "black gold."  The gold rush is on in the Bakken.  This industry is still young, evolving, and untested by an environmentally-related production crisis.  This does bear watching.

So, yes there is certainly potential for the U.S. to export LNG, particularly to Asia, but it won't right our trade balance by itself.  Some things that we should not forget that would be helpful in preparing ourselves for a more energy-efficient and carbon-mitigating future include:

  • a carbon tax
  • building a smarter and more efficient energy grid with lower transmission losses
  • attacking commercial and residential energy consumption through better design and retrofitting. 
  • reconsidering the role of nuclear energy in reducing carbon emissions in a portfolio with natural gas, oil and renewable sources at the margin.

Wednesday, December 5, 2012

The JCP Turnaround: Don't Write It Off

J.C. Penney, a century old name in U.S. retailing, has been badly under managed for many years.  We've largely seen the demise of the traditional department store, with a few exceptions. Growing up, my family took me shopping at J.C. Penney for my school clothes--white shirts and navy blue pants--because Penney's had good quality clothes at lower prices than Macy's.

Over time, their brand assortment became an incomprehensible jumble, and their lead private label brand Stafford became real junk.  At the height of apparel outsourcing to China, Penney's gave up every quality detail in softlines for a few margin points in initial markup.  Inside the store, most of the table tops became dump tables like Odd Lots, as their coupon-mad customers threw around merchandise looking for mispriced items on which to use their fistfuls of coupons.  None of this happened overnight: it went on, unchecked, for years.

When Kohl's pulled the rug out on MSRP for clothing, and went with their low cost, high efficiency stores, it was a shot across the bow for retailers like Sears and Penney's.  The latter were in costlier mall real estate and  wedded to a high IMU, heavy markdown model with incessant coupon circulars.  I'm not sure who the Penney's customer is; I think that you see them go from Penney's into Marshall's, looking for more junk at heavily marked down prices.  JCP was on its way to the retail grave yard before it undertook the current turnaround with CEO Ron Johnson and his team, which is nine months into the turnaround.

I used to put the Penney's Sunday circular unread, straight into recycling until the appearance of the new logo  and look caught my eye.  For the first time, it seemed as if someone like my daughter and my wife might have cause to leaf through the merchandise.  That certainly sent a good signal.

The current turnaround is being criticized because it may have driven away their coupon-addicted customer. Where is this customer going for clothes?  Wal-Mart?  Marhsall's?  Sears?  If they are the store's "cherry picker" customers, perhaps they need to go somewhere else, because a chain can't thrive on serving them with this model.

The daughters of the customers, while they are in the mall, are going to sales at American Eagle and Old Navy.  The clothes are generally junky, but they have style, which JCP has traditionally lacked in their merchandise offering.  Under the new advertising, JCP is clearly trying to change its image and to close this fashion gap.  These customers can be won back.

Having worked in a lot of front-end and back-end retail operations, I can tell you that JCP had lousy, unmotivated buyers and merchants and a dispirited store staff, a deadly combination which produces the assortment that the retailer had to coupon so heavily.  Hopefully all of these functions will be turned upside down and reenergized.

Although the new CEO's background at Apple retail has been incessantly trumpeted, I note that his tenure as VP of Merchandising at Target, will be equally, or perhaps more valuable to new investors.  Target is a heavily planogrammed, highly disciplined, merchant-driven buying and selling operation.  This kind of discipline should yield great benefit at JCP.

Even Target does a mediocre job in its private label clothes.  Merona, its flagship private label apparel brand, had much better advertising than its product.  It has gotten better, and its sales increased.  Private label is not easy to do well, and JCP used to do a horrendous job.  They should only do better.

For the most recent quarter and the nine months, JCP traffic is down and comps were down 12% for the quarter, the third consecutive quarterly decline.  The GAAP gross margin rate declined year-over-year from 37.4% to 32.5% in the current period third quarter.  As the management explained, however, the marking down and clearing of current and outdated inventory, as well as the elimination of a traditional month-long, intra-quarter "value price" all contributed to the decline in the GAAP GMR.

Overall, clearance was a lower percent of third quarter business than it was in the prior-year period. Looking at gross margin realizations at "every day low prices," the rate was 48.1% in the prior-year period, compared to 51.7% in the current third quarter.

Store expenses seem to be in line with management guidance, although there is definite evidence from the stores that you need a GPS system to find help in the store.  This level of staffing and training can be raised as the better merchandise assortment and value pricing starts to take hold.  There's no guarantee that it would, but this kind of reimaging has been done before at Target and elsewhere.

The company also has the advantage of some strong institutional shareholders already.  Pershing Square, which unsuccessfully took on Target, owns 17.98% of the equity.  Vornado Realty Trust (10.77%),  and Evercore (6.74%) are also among the active shareholders. The CEO himself owns 3.62% of the equity, and directors and officers as a group own 31.7%.  Having the CEO invested as well as other insiders, along side a strong institutional base is a good thing.

It's early to say this, but I wonder about Penney's commitment to housewares and small appliances.  If they keep their same merchandise focus, I feel that the day has been lost to Kohl's and Target.  Penney's would be squeezed between these two giants, unless it comes up with a unique merchandising mix and value proposition. Let's see how this goes.

I'm not suggesting that this is the right comparison, but Von Maur has built a very successful model built on limited assortments of high quality apparel, beauty, and gifts, limited sales, and high service levels.  They don't sell cutlery, china, or kitchenware appliances as traditional department stores did.  It may be something to consider later.

Sometimes, a successful business has to "fire" some of its customers.  JCP's coupon-addicted customers and their disappearance from the traffic flow needs to be investigated.  It might get worse before it gets better, but JCP surely had to undertake the current kind of transformation if it wants to remain an iconic retail brand.

Tuesday, November 27, 2012

HP: The Elephant's Been In the Room All Along

August 2010:
"HP shares continue to look like a value play, but I suspect that there's a very large, cultural elephant in the room that could slow any transformation into a sustainable, growth story."
 September 2011:

"Here's what's reported in the NY Times about the final process leading up to the selection of Mr. Apotheker as the CEO:
"Before a final vote on Mr. Apotheker, H.P. search committee members again urged other directors to meet him. No one took them up. At least one director, Ms. Salhany, tried to slow the process, worrying aloud that “no one has ever met him. Are we sure?” But her concerns were brushed aside." Without making reference to a duty of care, this is a total abdication of any professional responsibility for a business decision that would be critical, given the recent history of CEO failures and their effect on business under performance.
Now, more shareholder value will be destroyed by paying the exiting CEO, which makes the company even more of a laughing stock.  More important is the fact that a successor will have to make sense of an acquisition for which HP is acknowledged to have grossly overpaid. Integrating Autonomy's corporate culture with the divided, rudderless and dysfunctional HP culture will be a Sisyphean task. The frustration and disappointment of customers, as for example Fluor's CIO saying that HP is "lost now," will haunt the new CEO also.  Without some fresh air in the board room, it's hard to see how HP becomes anything other than a "value trap."
September 2011:
"The same board is in place, with the same unhealthy dynamics and deeply flawed visions.  Board chair Lane's public flip flops on former CEO Apotheker don't give any comfort about temperament or judgment, and there's the continuing question about how much his position as Oracle's #2 is an asset to HP or a liability.  Oracle's poke in the eye to HP by hiring Mark Hurd was great PR grandstanding. 
Value investors looking at HP won't get an extra reward for being early, because so many of the risks are unknown at this time.  Technicals and noise trading should dominate the stock in the near term, Time is the friend of a new, fundamental investor looking at this stock."
August 2012:

"The board at IBM knew that the company was in trouble to the extent that it went to a total outsider as their new CEO, someone who understood the mechanics and language of efficiency and cost.  It's unclear whether the HP board really understands anything. At some point, some of the new investors like Dodge and Cox and GMO should get involved in planning for a significant refresh in the HP board for the next proxy season. 
 Aside from looking at metrics relative to HP history or industry comps, it's hard to make a bull case for HP.  This argument sometimes appears as, "It can't get much cheaper."  Investors who got in at $20-25 felt this way, and we disagreed in prior posts. Unless HP as an organization believes it is in trouble and acts that way, as Gerstner says, then it may be a short-term trade from depressed levels, or a value trap.  Time will tell, and it's very early in this story, with no clarity."

" The Autonomy question still needs to be answered.  Besides the CEO having a digital dashboard (another hackneyed IT phrase) for Autonomy, is this the platform to take HP into the Big Data future?  Any more writedowns?  Some industry types suggest that their sales penetration pre-acquisition was narrowly focused on areas of Internet security rather than on the broader analytics of Big Data.
 Meg Whitman also says for the Times, "I am the the first (HP) CEO in a long time who is from the Valley."  This statement sounds a bit delusional.  Having board members or the CEO from a geographical provenance wouldn't seem to be associated with value creation." 
October 15, 2012:
 "The board of directors that CEO Whitman needs to help her move the company forward is a different one from what is there today.  Now that the CEO has finished the fact-finding, channel checking and strategic reset, she should take on this task because it will be critical, in my opinion, for moving the company away from some of the flawed assumptions of the past which led to the acquisition of EDS and the absurd price paid for Autonomy."
November 1, 2012:
" We've heard good things about the internal bureaucracy busting, cultural changes being initiated by CEO Whitman.  This is akin to taking down a fifty foot oak with a tomahawk.  The new CEO needs lots of help from her executive team, middle management, and her board."
Can you identify the elephant?  Institutional shareholders shouldn't need an ISS report to think about what has to be done to light a fire under this company.  If they remain passive, then they are not acting to protect the best interests of their own fund shareholders.

It will also be interesting to see if the CEO and CFO can sign the fiscal 2012 Section 404 certification attesting to the existence and effectiveness of  financial controls over use of corporate assets and financial reporting.Can the auditors give their blessing again without identifying significant deficiencies?  Billions in value were destroyed while the controls were apparently in place and effective. If this fiction continues, then Sarbanes-Oxley is another example of regulatory form over substance.

Sunday, November 25, 2012

Former NY Governor Pataki Speaks on Smart Grid

The Wall Street Journal has a column penned by former New York Governor George Pataki, who says,

"Damage to substations, poles, transformers and power lines causes most power outages during storms. Even so, improvements to other parts of the grid can protect us against disasters. One improvement would be to expand the use of distributed power generation through fuel cells, microturbines, and the simultaneous "cogeneration" of both heat and power. 
Such distributed power sources have very small installation footprints—fitting even on the roof of a building—and can provide secure power regardless of other outages on the electrical grid. During and after Sandy, cogeneration allowed pockets of New York City (such as the large Co-op City neighborhood) never to lose electricity or heat. Crucially, favorable amortization schedules and tax treatment, along with operational cost savings, can make these power sources attractive investments for building owners and other investors. They can even generate revenue by selling excess electricity back into the marketplace during times of peak demand, a practice known as demand response. 
Finally, the way the Federal Emergency Management Agency works with electrical utilities after disasters needs reform. Under the current system, utilities receive federal emergency funding to replace damaged electrical components only if they replace them "in-kind" with the same technology. This means that all sorts of antiquated components are simply being replaced. This makes no sense. The federal government should promote modern technologies and best practices.
Officials at all levels of government should work to ensure that structures rebuilt after Sandy are more resilient and energy-efficient than their predecessors."           
As a popular, previous post noted, a smart grid should not become something that accommodates all kinds of inefficient energy inputs because of popular green ideology.  Such a grid would be prohibitively expensive and inefficient.  We have the knowledge in our universities and private research institutes to build a grid which is orders of magnitude more reliable, efficient and "green" than what we have.  Let's get going and build it.

Wednesday, November 21, 2012

Dumb and Dumber: HP and Autonomy Dueling PR

So much has been written about HP's fiasco in voluntarily, with open eyes agreeing to acquire Autonomy for more than $10 billion, which had no grounding in any reality.  Here are some concluding observations, ahead of getting ready for Thanksgiving.

  • Autonomy founder Dr. Mike Lynch is a quant and a promoter. As the Wall Street Journal Deal Blog noted, Silicon Valley's iconic deal maker Frank Quattrone shopped Autonomy to Oracle's Larry Ellison and former HP CEO Mark Hurd.  Lynch's protestations to the contrary are laughable and not worthy of someone whose academic discipline revolves around accuracy and precision. Oracle laughed at a $6 billion valuation. Slowing growth and the evolving market cachet on "big data" made the timing right to pitch a sale.
  • Ten out of the current eleven member HP board, including the current CEO Meg Whitman, hired CEO Leo Apotheker, who was clearly unsuited to be the CEO of a mature public company in need of a turnaround.  This same board acquiesced, or perhaps even advocated, the acquisition of Autonomy for the outrageous price paid.  While Apotheker was discharged, there has been no other senior executive management or board accountability for this, and other, value-destroying acquisitions. 
  • CEO Whitman's laying accountability at the feet of an HP strategy officer is unseemly and shows no respect for the intelligence of the stakeholders.  Whatever PR flak suggested this cop out should be fired. Saying that the solution is to now have a different strategy officer report to the CFO makes the board and executive team seem like idiots.  A reporting line in an org chart caused a loss of of $8.8 billion in value?  I don't think so.
  • What about the CFO?  A strategy officer is looking at the merits of entering into high powered analytics through acquisition.  The officer might be looking at product synergies and opportunities for cross-selling. Examining the financials of a target company, looking at its controls and financial reporting practices, seeing how its results would translate into HP, thinking about integration of financial reporting, and making projections about synergies and potential dilution are within the CFO's bailiwick and nowhere else.  Deloitte and KPMG would per force have had to report their findings to the CFO and to the Audit Committee Chair.  The whole strategy officer taking a fall discussion is a red herring.
  • As Jim Chanos and others have done, looking at the 2010 Annual Report for Autonomy raises a lot of questions.  However, looking at the financial statements alone is not sufficient; they have to be read with the notes to the statements, as a whole.  The notes are poorly written and uninformative.  Under these circumstances, the two accounting firms should have been able to uncover the accounting deficiencies now claimed as deceptions before the purchase. The Audit Committee Chair should have demanded nothing less.  Revenue recognition is widely recognized by any finance MBA as a major issue for software and technology companies with multi-element product sales and licensing. 
  • The culture and executive compensation practice at Autonomy should have been another warning sign, quite apart from the financials.  
  • At the HP Analyst Day, an HP executive made some carefully worded, but telling comments about Autonomy.  He said that their processes were not reproducible or scalable.  One of his goals was to bring discipline and process to all their functions, including product development.  These were clearly warning signs of things to come. How were product development issues not spotted in a due diligence process?  
  • Having HP's top lawyer issue a press release about clawing back value for shareholders is not comforting.  Recently, a small cap technology company I'm familiar with did a relatively small investigation into an issue at a foreign subsidiary; it generated $2 million in non-recurring expense in a quarter.  I can't imagine what this investigation is going to cost.  It will also now figure in non-GAAP earnings.  It is going to be an expensive, distracting and potentially embarrassing fight with no net benefits. 
  • As we posted recently, the entire board should voluntarily request not to be renominated for election.  The future board should not be filled with homogeneous Valley pals and insiders. It would be appropriate, in my opinion, for CEO Whitman to voluntarily forgo current year incentive compensation  for her role as a director in hiring Apotheker and in acquiring Autonomy.  In previous interviews, she has said she didn't come back to HP for the job or money, but for the challenge.  Giving back incentive compensation would acknowledge that the CEO wasn't up to the acquisition challenge as a director and that nobody is above being held accountable.  The effect on HP's corporate culture would be breathtaking. 
  • Good things are happening inside the company.  It is time to play the hand the company has now for all its worth and to move on.

To move into Thanksgiving with some more uplifting reading, here's a link to Japanese views on gratitude, as specifically integrated into Morita Therapy

Tuesday, November 20, 2012

Turnarounds and Turkeys: BBY and HP

The Macy's Thanksgiving Day parade is two days away.Wall Street got an early start trotting out some turkeys with today's earnings announcements: HP and Best Buy led the way, for different reasons.

Best Buy closed down 13 % for the day, but it is up a couple of cents in aftermarket trading.  The fundamentals weren't good, but the reaction of the stock seemed more a continuing plebiscite on the turnaround plan and arbitrageurs playing an offer from Dick Schulze, than it was an evaluation of the results themselves.  

The company's CFO Jim Meuhlbauer, who we were told has been at his post for ten years, allowed a very confusing discussion to ensue about gross margin dollars versus gross margin rates.  He made a remark, and analysts asked questions about what he said; then merchant Mike Vitelli seemingly contradicted what the CFO said.  Finally, the CFO noted that everyone agreed.  Since the 160 basis point compression in the gross margin rate was clearly the concern for analysts modeling the forward rate, this discussion should have been short, sharp and precise.  Instead, I'm sure that it confused analysts.  

The issue came back in a different way in the Q&A when Mr. Muehlbauer was asked to give some thoughts about the biggest drivers between what the analyst said was the 130-150 basis point gross margin rate compression over the past two years. The CFO said that the entire margin compression was due to sales mix, which really makes no sense.  

U.S. same store sales declined by 4%, which was affected by the smaller number of stores in the base due to closings.  Online sales of $431 million in the quarter grew by 10%.  Domestic selling, general and administrative expense grew by 15% y-o-y, but adjusted for the sales force training expenses related to the new product launches and for the absence of Best Buy Mobile profit-sharing payments, they were flat.  Not a great performance by any means, but not the end of the world either.

The international business, which has always been undermanaged, saw same-store sales decline by 5.2%, with European sales increasing, while Canadian and Chinese sales declined. Gross margins in the international business declined by 280 basis points, which clearly needs some explaining.  Selling, general and administrative expense in the overseas portfolio increased by 7%.  Now that Best Buy has a CEO with some  international credentials, this portfolio needs to be rationalized and optimized.  The Chinese market needs to be re-examined.

The company significantly lowered its guidance for the range of FY 2013 FCF to $850 million-$1.05 billion, down from a recently announced range of $1.25- $1.5 billion.  The explanation was lower projected profit levels and higher inventories.  The lower projected profits gets back to the same store sales, the overseas business, the gross profit margin rates, and mix of sales.

An analyst who asked a question about the wisdom of maintaining a $225 million annual dividend, seemed to surprise the CEO, which means he was poorly prepped.  The CFO added no light.  The board hasn't decided was the CEO's answer: not very clear or comforting.  If there were a choice between improving ROIC through higher volume, better margins or asset management, then that is a superior use of cash than dividends in a higher tax environment for investors.  Give investors some guide into how the board and management think about the issue.

The adjusted ROIC was 10.1% versus 10.6%, which not bad, given the weakness in the same store sales, both domestic and foreign.

I was very surprised that no analyst chose to ask for an update on the buyout plans of Dick Schulze's group. It could have easily been asked in a way which simply requested an update of prior public announcements.  The entire group was silent about the elephant in the room.

Bottom line, the results weren't good, but the new CEO has been in place a grand total of eleven weeks.  He has expressed a lot more clarity that the previous CEO did in his entire tenure.  Unfortunately, it was not a well prepared conference call, and the Q&A went off track.

The King Turkey award for the day goes to HP which reported Q4 2012 results that were right down the middle of their guidance, and in some important ways like FCF even better than expectations.  Adjusted EPS for the quarter was $1.16 verus $1.17 in the prior-year period, on the same basis.

The company's revenues were $30 billion in the quarter, down 4% y-o-y in constant currency.  Adjusted gross margins increased were 24.2% up 90 bp y-o-y, despite expected weak results in personal computers, offset by strong revenue and margin growth in software and an unexpected increase in printing margins. Operating cash flow in the quarter of $4.5 billion was 69% ahead of the prior year period, and and FCF was $3.5 billion in the quarter.  What is not to like about this quarter?

Answer: another massive writedown of $8.5 billion for impairment of goodwill and purchased intangible assets from the acquisition of Autonomy.  Some $5 billion of this amount relates to alleged fraudulent accounting at Autonomy prior to the acquisition; the fraudulent practices relate to revenue recognition and to the allocation of costs to expenses versus product costs that made product sales margins look like software transactions.  The fraud allegations have been referred to the SEC and to the UK Serious Fraud Office.

(Before I go on, I want to give a shout out to Jim Chanos, who often writes and speaks at Columbia's Graham and Dodd Institute: you had it pegged perfectly, Jim.)

To his credit, Barclay's analyst Ben Reitzes, with the first question on the call, asked CEO Whitman how she evaluated her own responsibility as a director of HP during the hiring of former CEO Apotheker and for the approval of his proposed acquisition of Autonomy.  Her answer was less than courageous.  All the directors feel really bad!  However, those responsible have been discharged: Apotheker and a VP of strategy.  What a limp fish of an answer.

About a month ago, we wrote about CEO Whitman's need to focus on internal issues and to change over the board of this company.   CEO Whitman should politely suggest to those long-standing directors, all of whom were there for the botched transaction not to stand for renomination by the Nominating Committee.  This company cannot move forward with these same directors in place.  It would be courageous for CEO Whitman to pass on a significant portion of her 2012 incentive pay for her part in the botched acquisition.

There was a period of time when HP insiders talked with pride about being from "the (Silicon) Valley."  All of the directors should be ashamed of themselves.  To say that they relied on audited statements alone is a failure of duty to the corporation and its shareholders.  Forget about suing Deloitte or KPMG: that is a distraction and a waste of money and time.

The "rocket scientist" founder of Autonomy, Mike Lynch, now appears to also be a very savvy promoter.  Another name from the "Valley," Frank Quattrone of Qatalyst Partners seems to have been involved in introducing Lynch to Oracle, ostensibly to talk big data, but really to shop the company. As this ploy was failing, HP was being driven, even against the first instinct of its board, to not only acquire Autonomy, but to pay a fool's price for merchandise passed over by Oracle.Oracle had also hired Mark Hurd.  It's an embarrassing story with a horrible ending for shareholders' equity.

The new CEO is making her impact felt among the rank-and-file and the producers at HP: this is a great thing, which reverses the Mark Hurd era's style and culture. She's definitely on the right track, and people are listening. If she holds herself and her board accountable, the troops will really be galvanized into believing that there really is a new day dawning. With the support of a new, talented and committed board, which also shows its belief in owning shares personally, this may still prove to be a value-creating turnaround.

Even with all the corporate mismanagement around us, we can all find much to be thankful for.  Happy Thanksgiving!

Sunday, November 18, 2012

Star Trib Story on Best Buy

Ahead of Tuesday's earnings for Best Buy, the Minneapolis Star-Tribune ran a lengthy piece on Best Buy, with reporter Thomas Lee heading up a team of reporters.  Overall, it's a useful placement for the Schulze-led private equity group looking at making a bid for Best Buy.

Investors who saw Dell's quarter, presumably shouldn't be surprised by Best Buy's being hit by the same lackluster reaction to the Windows 8 release and consumer reticence towards upgrading to ultrabooks, netbooks, or new laptops. Unless Best Buy sales declines open up a gash in the hull, it would seem as if the stock might churn, but shouldn't react too much by the end of the day. Bad news should be baked in.

Overall, the story is pretty well balanced, which is unusual for newspapers these days, which have a clear axe to grind.  It does refer to some of the same internal issues that we suggest are at the heart of Best Buy's losing its way as a market leader.

Here are a few relevant quotes,
"But former and current executives described a chaotic, adrift culture. The company encouraged employees to experiment but without real follow-through."
"They said all the right things, but there was no action."
There was clearly no accountability for mistakes, particularly at the executive management level and down to senior management.

In addition, Best Buy fell prey to the siren song of the big consulting firms, with almost all the leaders coming up with expensive, misguided projects directed away from the core issues.  The most astonishingly ill conceived decision was to outsource IT, the LAD artery of a transaction driven company, to Anderson Consulting.  That is now on track to being internalized, which is not without risk.  I can clearly see the consulting company slides that advocated this misguided step.

The Napster acquisition is not mentioned in the article.  After apparently passing on discussions with Richard Branson of Virgin about developing an Internet music service, Best Buy bought Napster for $122 million and essentially wrote it off for some stake in Rhapsody.  Probably another consulting company slide set drove this lunacy.

Best Buy's board and management would be foolish not to work with Dick Schulze, the entrepreneur-founder and largest shareholder, to turn this company around.  The "Renew Blue" presentation seems to provide a good road map focused on fundamentals that might be a good start for working together.

Turning the company upside down with a leveraged buyout might be a quick, tax-efficient tonic for fatigued portfolio managers and arbs, but it might not be the best thing for long-run value creation.

Friday, November 16, 2012

"Renew Blue" Is A Good Start for Best Buy

When I followed Best Buy as a sell-side analyst in the early nineties, it wasn't even "chopped liver" on Wall Street.  Specialty retailing analysts who followed electronics unanimously preferred Circuit City, the foie gras of electronics retailers. Between Circuit City's taking the higher end, tech savvy consumer and Wal-Mart's capturing the low-end, the only future for Best Buy was bankruptcy. Even Radio Shack got more respect for high sales per square foot and its gross margins.

This is a perfect scenario for a value investor, like myself.  When the Street hates a stock, it's easier and more fun to conduct in-depth research. Those of you who've read this blog over the years know how much I learned from Ben Graham's approach, and from his accomplished disciples like Max Heine, Bill Ruane, Warren Buffet, Charlie Munger, Chris Browne, John Spears and others.

In the spring of 1994, I put a 'Buy' recommendation on the stock, and by mid-July it was at a three month low and had fallen 11 percent in one day on fears of slowing growth. The shares got caught up in negative market sentiment about high multiple stocks, and there were fears about Circuit City's aggressive entry into the Twin Cities market with their new superstore format.  Needless to say, the shares did exceptionally well from that point, as did a number of large institutional investors in Boston who came on board in front of rapidly improving fundamentals. 

This is just for context and not to ressurect history.  I've never lost touch with this story.  I can honestly say that for the past decade, Best Buy has made about every fundamental market, operating, strategic and cultural mistake that a maket leader can make. 

Technology product cycles and frothy equity markets can often mask weakening fundamentals.  Just as sentiment worked against them before, analysts are now negative: 2 hold 'Buy' ratings, with 19 'Hold' ratings, and 2 'Underweight' or 'Sell.' 

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. 

So, CEO Hubert Joly's investor presentation "Renew Blue" is most definitely on the right track.  What's surprising to me is that Best Buy is still in a relatively strong market position despite shooting itself in the foot in ways which are handled gingerly in the slides. I believe that I can also see the imprint of the new CFO on the presentation.

Best Buy's core market is $228 billion for fiscal 2012, and it has been growing at a three year CAGR of 3.2%.  This is certainly a nice market to be in, and just as in 1994 it is still fragmented.

48% of Best Buy's market is served by retailers with market shares of 4% or less. 

According to Best Buy's research, it still has the number 1 market share at 16%, followed by Wal-Mart at 15%, followed by Apple, Sears, Target, and Amazon with a 4% market share. 

Best Buy has lost connection with its customers, which is the biggest knock against management.  Their big market characterization of their customers a few years ago, which probably cost millions was foolish. Their current survey shows that they have even managed to lose their "low price" identity, which is quite a feat.

They are shown to have one of the largest customer loyalty data bases in the industry, but it isn't an effective program, especially for inducing activity among inactive customers.  Office Depot, for example, has a better program that requires no customer effort to update and use. This can be easily fixed.

Best Buy's website looked like something from the 1970s, and the navigation and functionality were primitive.  It looks a lot better since Mr. Joly has come on board, and it can do much, much better.  Despite this, the company drew 1 billion online visitors and generated $2.3 billion in sales from the online channel.

For all the talk about "low hanging" fruit, some of the fruit, like the operations at Best Buy Canada, is lying on the ground. The cultural and organizational issues, which are much more subtle, can yield a lot, but they will take time.

Appliances are still a square peg in a round hole.  The good news is that nobody in the
"big box" format does a very good job, with the exception of Sears which is a historical artifact ready to be picked off by a better merchandiser.

The presentation about ROIC in the stores is very interesting.  It parallels issues faced by Home Depot in the recent past.  When they fixed this issue, the stock took off in a period of peer and market outperformance.

The Geek Squad is their best acquisition, but still underleveraged.  Experiments like Simplicity need to be multiplied and rolled out when ready.

Some analysts suggest vendors might not have an interest in Best Buy surviving.  Just like 1994, I can't understand what these folks are thinking.  Vendors need Best Buy.  Best Buy hasn't treated the vendors like partners and it hasn't demanded, or merited, the best from them.  This can be fixed.

The whole managment tier under the top management has to be redone, both the cast and the script.  This will be critical to translating this presentation into sustained performance in earnings and in shareholder returns.  Now that the overture has played, I'm anxious to see Act I. 

Thursday, November 15, 2012

Google's High Speed Internet Comes to KC

In a recent post about Google and the wireless industry, we wrote,
"A friend in the IT business told me that Google has a broadband experiment in Kansas City where they are offering customers the fastest broadband and online storage for a fraction of what the cable companies charge. Go for it, Larry and Sergey!"
In today's Wall Street Journal Online, the journal reports,
"This week, Google began installing fiber-optic cable to homes in Kansas City, Kan., as part of a high-speed Internet and video service that competes with incumbents such as Time Warner Cable Inc. and Dish.

Google hopes to expand the service around the country, according to people familiar with its plans.  /....
Many of Google's moves to directly oversee the way people access the Web are driven by a belief: that faster Internet download speeds at home and on mobile devices mean people can use more Google services such as Internet search, Gmail and YouTube video, translating into more revenue for the company."

Attempts to break cable's monopoly in both video content and high-speed Internet have been relatively minor incursions that are primarily rent sharing among the industry.  Let's hope that this seedling venture grows into something that gives the consumer a high quality product at a significantly lower price.

Wednesday, November 14, 2012

Politics Will Determine the Fate of the Euro

It has always been clear to me the European Monetary Union (EMU) and the single currency were poorly designed as both a political system and as a common currency area. Roland Vaubel, of the University of Mannheim, is a distinguished economist who has followed the euro from birth, and his podcast tells the story eloquently.

For example, I never really understood what would have motivated Germany to be interested in a common currency, given its strong economy, currency and its clear understanding of the weaknesses in the euro's design.  It goes back to the Franco-German relationship, which has always been one of mutual suspicion and grudging acceptance, at best. 

German Chancellor Helmut Kohl was extremely interested in common European Union foreign and defense policies, and he felt strongly that a European defense policy had to have a nuclear component.  France, of course, was especially loath to give Germany access to a common nuclear capability. Kohl was willing to talk about a common currency in exchange for his larger interest in a common EU foreign policy and defense structure. So began the bargaining.

When the Berlin Wall fell in the autumn of 1989, the former Federal Republic of Germany had reunification thrust upon it.  President G.H.W. Bush was an early supporter of unification.  France and the United Kingdom were publicly cool and privately opposed.  According to Professor Vaubel, French President Mitterand got his euro in exchange for lending his support to German reunification. 

There is a well established body of economic research, begun by Professors Peter Kenen, Charles Kindleberger and Robert Mundell, on the "optimum currency area."  The original eleven members of the economic and monetary union (EMU) in no way fit the criteria for an optimum currency area.  Everybody knew this from the outset, but rules were put into place which were consistent with such an area. These rules were flouted openly to admit the weaker members.  These flaws have come become manifest in the secular budget deficits, inefficient labor market productivity, and high public debt to GDP ratios.

The original charade with eleven members has been expanded, in violation of the system's own rules, to seventeen members.

Before the formation of the euro, French monetary policy had to react to and align with German monetary policy, something which rankled French political sensibility. 

The German government hoped, according to Professor Vaubel, to maintain control over the euro by having veto power over the European Central Bank board's decisions, and the earliest supervisory board was stocked with supporters of a "hard currency."

The Maastricht Treaty of 1991, at the behest of France, specified that a European monetary union would be established by 1999.  This and some other subtle changes were apparently not appreciated by German negotiators until it was too late.

The Stability and Fiscal Pact of 1996 represented another German attempt to put some discipline into the dismal fiscal performance of euro currency zone members by establishing limits for the ratio of sovereign debt to GDP of euro zone members.  The three percent limit was quickly violated by most of the members.

The EMU attempted to emulate the U.S. Federal Reserve by establishing a 2 percent inflation target for union members.  This target has not been consistently achieved, and now inflation is running at three percent with economies heading into recessions. 

Germany is the largest shareholder of the European Stability Mechanism, which has 80 billion euros in contributed capital and 620 billion euros in callable capital.  Exposures to large losses from this facility will be political poison for the current German government, which faces Federal elections in September 2013. 

According to Professor Vaubel, two-thirds of the German electorate have consistently opposed bailouts for Greece and other weak euro periphery members.  So, no matter how badly the Chancellor is painted in the European press, it seems unlikely that any decisive breaks from her basic position will be translated into real, additional financial commitments before the 2013 election. 

Friday, November 9, 2012

Banks and Rating Agencies Behave Badly in Australia

Floyd Norris in today's New York Times Business section, tells the story of an Australian federal judge who ruled that investors in a CPDO (Constant Proportion Debt Obligation)  can sue Standard and Poors for assigning a AAA rating to a structured finance vehicle which seemed inherently unsuitable for any qualified institutional buyer.

This is from issuer ABN AMRO's draft marketing materials cited in the Australian court's judgment:
What is the CPDO?

  • A CPDO is a fixed income instrument with cashflows that have a high and rated likelihood of payment
  • A CPDO aims to pay the stated coupons by taking leveraged exposure to a notional portfolio of credit indices. It comprises of exposure to a Credit Index Portfolio and a cash deposit
  • The Credit Index Portfolio aims to generate sufficient returns to enable the coupon payments to be made
  • The Target Portfolio Size of the Credit Index Portfolio is set such that the present value of the expected income from the Credit Index Portfolio is linked to the difference between the present value of the coupons and principal due under the Note and Note NAV
  • Once the current Note NAV equals the present value of the payments due under the Note, the Credit Index Portfolio will be unwound and no further credit exposure taken ...

The Floating Rate Notes were issued in the amount of Aus $45 million.  The notes are not backed by ABN AMRO or any other institution. ABN AMRO sold the Notes to its client, an Australian workers' compensation fund.

According to the issuer,
"The CPDO is suitable for investors who:
– Seek to take high grade exposure in a form that has not had value eroded by movements in correlation as has occurred in the CDO market
Require high rating of principal and coupon payments, but without the necessity of principal protection
– Wish to diversify their current structured credit portfolio
– Require liquidity for structured products."

Let's start by saying that ABN AMRO should not have marketed this product to its customer in any case. The prospectus should have had much more meaningful and transparent risk disclosures.  Standard and Poors didn't seem to have any reasonable basis for rating these securities AAA.  Even though in the court document, there is a convoluted battle among experts on what an AAA rating means (better than AA relatively) or doesn't mean (the highest absolute rating or lowest risk), there is a pretty telling statement in the prospectus which says,
"The probability of receiving the rated coupons and principal at maturity is benchmarked to the default probability of an S&P bond with the same rating and tenor."
On this definition, and given all of the email exchanges and witness testimony, a rating of AAA seems beyond reason.

However, it also seems clear that the client probably violated their own statutory investment policy guidelines for selecting and evaluating this investment.  So Floyd Norris' comment below is equally unreasonable:
"But the buyers of C.P.D.O.’s did not understand what they were doing. It appears that those investors, including an agency that managed investments for Australian local governments, and some of those governments themselves, did not bother to go into details."
The investment process laid out in the judgment has steps and particular measures which should disallow investing inappropriately, i.e. without understanding the investment's suitability and risk profile. To suggest that they "did not go into details" is a failure in their duty of loyalty.  Investors should not be protected by the government for being lazy, or for failing to exercise due care and diligence in accordance with their own published, statutory guidelines.

We've written about the failure of the rating agencies during the 2004-2006 runup to our own credit crisis.  Nothing was done to hold them accountable.  The investment banks have moved on to sunnier earnings and increasing management compensation after drinking at the public trough.

The investors should be compensated if the investments were (1) not suitable for their clients, (2) marketed with incomplete, misleading or false claims about their risk-return profiles, and (3) the expected performance of the Notes under reasonable scenarios did not warrant a AAA rating, according to SandP's own internal standards.

Institutional investors should not, however, receive government help to generate recoveries for their own greed, laziness or stupidity.

Wednesday, November 7, 2012

Smart Grids and Utilities of the Future

Since we've written before about investing in our electric power distribution and transmission infrastructure as a potentially superior choice for government stimulus funds, we try to keep up with industry discussions by advisory firms such as KPMG's Global Energy Institute. A recent webcast talked about a number of issues relating to the Electric Utility of the Future.  

Investment is certainly needed simply to maintain reliability, as one speaker noted: approximately one-third of the national grid's equipment is at or beyond its economic life.  About $12 billion per year is required to maintain the grid for anticipated future demand.  Significant upgrades to new technologies for better performance, efficiency or other goals would require additional investment beyond this maintenance capital spending level.  

The electric utility of today is a heavily regulated enterprise, and the utility of tomorrow, in my opinion, won't be much different, especially in light of the twin-headed hydra of government mandates and regulation.  

Energy Secretary Steven Chu took up his position with a strong technical and academic background, and he has ridden his hobby horse of renewable energy hard.  Electric utilities were given mandates, often by their states in response to federal guidelines, to generate a minimum percentages of their electricity generation from a renewable portfolio, primarily wind and solar.  Xcel Energy, our local utility, is mandated to produce 30% of its energy for Minnesota customers from renewable sources by 2020.  

The utility of the future would be one in which distributed power would be a significant part of the mix of power on the grid. For example, the KPMG speakers noted, there was a federal goal of having 1 million plug-in electric vehicles (PEV) in operation by 2015.  Clearly, we're going to miss this goal by a mile. The current estimates are for between 200,000-700,000 PEV nationwide, with the upper end almost certainly unattainable.

A national fleet of PEV were regarded, in the federal government's grand vision, as distributed users of electrical power for recharging, and as "load balancing" factors. Trying to imagine how the load balancing would work is laughable: Two pm on a hot summer's day in Fresno.  The power company is approaching peak load.  Gmail messages are sent via smart phone to all local Nissan Leaf owners to drive to a recharging station and to all plug into the grid, to have their batteries drained to shave the peak load.  Seriously!

The electric utilities themselves note that were PEV to achieve a 10% penetration into the nation's auto fleet, concentrated episodes of recharging could affect local substations, leading to larger system shutdowns. 

A more significant example of distributed power are the large corporate data centers of companies like Google and ATT.  The companies reap benefits, in that they do not pay transportation and distribution charges like other customers, for power that they use or supply to the grid.  

However, utilities are caught in this conundrum.  Investing in a smart grid, in which there is distributed power, means significant dollars for the additional, improved infrastructure. Sales to a Google data center, for example, will mean lower revenue for the utility than would the same amount of power sold to traditional retail or corporate customers.  

Lower revenue, because of their enormous high fixed costs, is Code Red for the utility of today, and it will continue to be so for the utility of tomorrow.  

Xcel Energy has filed with the PUCO for a $285 million rate increase, about 11 percent, for 2013, which will amount to $9 per month, on average, per customer. This is in an environment of slow growth, job loss, and declining customer usage of electricity.  Here's what Xcel has to say about the effects of lower customer usage,
"Finally, Xcel is asking ratepayers for $75 million, or about 26 percent of the increase, to account for lower electricity usage. The utility has projected that customer usage will be 4 percent less in 2013 than this year..."

Customers react to their economic circumstances by reducing their usage, but paradoxically, they have to pay more because of the nature of the regulated utility.  

Xcel is also using about twenty percent of the proposed rate increase to" pay for upgrades to its electrical grid, including both high-voltage transmission and lower voltage distribution lines typically found in cities.
Some of that money will be used to pay for the high-voltage CapX2020 transmission lines approved by Minnesota and Wisconsin regulators."

The utility of the future will be subject to the same efficiency and equity issues as the utility of today:

  • The requirement to comply with arbitrary and costly mandates about portfolio mix in its power generation;
  • Investments to make their grids compliant with new power sources and demands;
  • The inability to maintain debt service and cash flow without significant counter-cyclical rate increases;
  • The need to make smaller retail customers pay increases which are substantially above economic or income growth rates at a time in which their reduced demand is the rational economic response.
None of this sounds very smart.