The Air Goes Out of Arctic Gas Project

Economics has a funny way of intruding into the most complex geopolitical strategies.  It was about a year ago that Gazprom began talks in earnest with international partners Total and Statoil to develop the massive Shtokman Arctic gas field in the Russian offshore Barents Sea.  The Wall Street Journal reported that developments plans for Shtokman have been shelved because of disagreements over the investment terms among the partners.  Gazprom owns the majority stake of 51 percent.

Things have reached the stage where Norway's Statoil has returned its 24 percent stake in the joint venture and written off $340 million of its investment to-date.  The economics of natural gas markets would have certainly turned prospective Shtokman project returns upside down. Gas from this project had been planned for shipment into Europe through the Nord Stream pipeline. 

It has been well documented that, on an energy equivalent basis to oil, natural gas prices in 2012 are at all-time historical lows. 

Put this together with declining demand in developed markets due to economics slowdowns in China, Europe and the U.S., and it is not the scenario for taking on high-risk projects, particularly where the prospects for the partners' getting paid their contractual share on time are subject to political whims.

It also makes little sense for the Russian company to take the risk also, because of their own internal market issues, including competition from newer entities, like Novatek.

Statoil's recent 2012 investor presentations paint a very healthy picture of their operations in North America, where some 30 percent of the corporate resource base is located.  The shale gas boom onshore, and offshore resources offer better opportunities to deploy capital in North America.  There is no geopolitical risk to these ventures.

Energy, in the form of natural gas exports, was to be a near-term, foreign policy lever for Russia.  Global resource markets have put this lever out of service, for the time being.

It's also interesting to note that other commodity markets are being affected by the global slowdown, particularly from China.  The Guardian has noted what seems like a collapse of an "iron ore" bubble. The slowdown of Chinese demand for Australian iron ore exports, which represent 60 percent of Australian merchandise exports to China, puts the Australian currency's exchange rate at risk.  

Our long period of global easy money, which fueled a consumer-driven, housing led boom in U.S. consumption that led to surging imports from China, has created a global economic landscape that is showing some pock marks.  Our demand has slowed, and Europe's slowdown may be accelerating.  Therefore, demand from the Chinese export machine has fallen off to the point that Chinese firms continue to produce, even when merchandise is just being stockpiled, without orders. 

Even if indirectly, the low rates also fueled speculative commodity booms, as the Chinese and EM demand would absorb marginal global supplies.  Some twelve to eighteen months later, these former consensus forecasts now seem like pipe dreams. 

Consumer Deleveraging?

The Fed has put out its 2012Q2 Quarterly Report on Household Debt and Credit. The folks at the New York Fed's Liberty Street blog have kindly teased out the data into a more readily comprehensible format.  A summary table is shown below:

The column, "First-Lien Originations Plus Normal Payoffs" is pretty clear: it represents new mortgage originations net of mortgage payoffs associated with home sales. Look at the 2006 volume of originations at $911 billion, more than double the level in 2001.  We know that 2006 originations included some of the worst performing loans driven by the last gasp originations of notorious players like Countrywide and IndyMac before the music stopped. 2006 charge-offs from consumer credit reports are a modest $41.3 billion. Consumers are furiously pulling equity out of their homes, as shown in the second column under Mortgages, $179.1 billion in equity extraction.  It's good to remember from whence we came.

In 2009, after the onset of the crisis, home sales fall out of bed and new originations are frozen, so First-Lien Originations decline 57 percent from 2008, to $194 billion. Early refis are also in this total, as I understand it.

My point relates to charge-offs. Since 2008, $1.2 trillion in first and second lien obligations have been written off due to default and foreclosure. This is the massive, predominant effect.  How much more charging off needs to be done?  One presumes that industry reserve additions over the past few years have built an adequate cushion to absorb further losses.

The Fed authors make the point that $214 billion in mortgage indebtedness was paid down in 2010 and $242 billion in 2011.  On first blush, this seems promising, but I don't think that it's worth concluding yet that the broad consumer sector is healthy enough to start spending again. The sentiment and confidence numbers suggest the opposite.

Waiting For Jackson Hole: More Life at the Zero Bound

It's testimony to the lack of a fundamental underpinning for our Smiley Face financial markets when the only big news is an upcoming Friday speech from Fed Chairman Ben Bernanke.  Instead of the Oracle from Omaha, we have the Oracle of Jackson Hole. 

We've posted before on Philadelphia Fed President Plosser's concerns about ongoing quantitative easing.  Professor Jonathan Wright's work, cited by Plosser, suggests that early, announcement effects of the QEs are significant, but they seem to taper off and fade quickly.  We've also talked about distortions in resource allocation caused by financial rates and asset prices being so heavily influenced by this unprecedented monetary intervention of the Bernanke Fed.

Dallas Fed President Richard Fisher has commissioned a paper by William R. White, former Head of the Monetary and Economic Department of the Bank for International Settlements. It is a useful and thorough survey paper about the evidence and theoretical underpinnings for and against quantitative easing.  It also makes a strong case for how the backwash from the unintended consequences of the QEs may exacerbate any future downturn.  It is very useful reading, and it is accessible to non-economists. 

White notes that the policy rates and longer-term interest rates we've experienced are even lower than those experienced in the aftermath of the Great Depression. Macroeconomics is a shaky science in the best of cases, but when we can't look at historical antecedents for guidance, we need to be afraid.  The prevailing orthodoxy, including a 2002 paper by Fed Chair Bernanke, suggests that monetary policy going in the aftermath of the Great Depression had not been easy enough.  Intellectually, Bernanke feels the weight of history telling him that the Fed must not be reticent as central banks were after the Great Depression. 

In addition, from 2003-2006, a number of papers were written purporting to demonstrate that a central bank could perform maturity swaps that would have the effect of lowering ten-year rates just as if the central bank had used fresh reserves to buy paper.  From this was born the mania for QEs. 

White's paper notes the work of Professor Axel Leijonhufvud, a distinguished Keynesian economist who has some interesting things to say about Keynesian policies in the aftermath of the financial crisis.  In the world of the Keynesian model, there is no explicit sub-model of the financial sector and no explicit regard for the balance sheets, either of firms or the government.  This, he says, has led to a "fiasco" when Keynesian stimulation has been applied post-crisis. 

If there is a balance sheet meltdown in the shadow banking sector, driven by counterparty performance failures, collateral fire sales, and liquidity issues, then the world will move down a deflationary path. If, on the other hand, the balance sheet issues occur on the sovereign government side, particularly in the United States, then we will have an inflationary surge. The global system could go either way.  Reinhart and Rogoff also document historical precedents for both of these scenarios.

Our current shadow banking credit system was procyclical in the credit upswing.  White makes a convincing case that the same, unreformed system will be procyclical in the inevitable credit downswing.

The paper also brings in Knut Wicksell's concepts of the natural rate of interest versus the financial rate of interest set by markets.  We have been in an environment were the financial rates are well below the natural rate, driven by trend growth rates of GDP.  In Wicksell's model, this disequilibrium creates "malinvestments." 

The paper concludes by saying that central bank actions in the current crisis have served to "buy time" for governments to get their houses in order, by balancing their budgets and by putting in place policies and regulations that provide an environment for sustainable, economic growth.  If governments here and in Europe don't make use of this breathing space, then this crisis will end in "lost decades" for the developed market economies. 

Don't expect much of substance from Jackson Hole.  Do expect the markets to get what they want.  They will party hard going into Labor Day.

Cronyism and the Educational Establishment

Luigi Zingales is Professor of Entrepreneurship and Finance at Chicago Booth School of Business, and a faculty research fellow at the National Bureau of Economic Research.  I just finished his book, "A Capitalism for the People: Recapturing the Lost Genius of American Prosperity." It's written from the perspective of of an adult Italian immigrant who remembers well the cronyism, corruption and limited opportunity in his native Italy.  America offers him limitless vistas of opportunity, as he earns his Ph.D. in economics from MIT and goes on to begin a career as a teacher, academic researcher, and author.  It is a good read. 

Professor Zingales talks about "regulatory capture," which has been evident recently in the battle between the SEC and global Wall Street banks over regulating money market mutual funds.  Corporate lobbyists have been pleading to sustain inefficient domestic sugar manufacturing and favoring the ethanol industry, which has been an economic and environmental albatross.  Examples abound in the book.

When the educational sector is discussed in the media, the word "lobbying" is always replaced by "activism," or "advocacy."  Their regulatory capture is nothing different or nobler: it is just lobbying.  As Zingales writes,

"...the most destructive cronyism that uses lobbying to extract money from the American people in exchange for a product that doesn't meet their needs is the public school system.

In the 2007-2008 election cycle, the National Education Association, the union representing public school teachers was the biggest lobbyist in America spending $56 million. 

...as the teachers union defends the status quo in education, it is killing the American dream for much of the population. 

...the U.S. spends more per capita than almost every other country, with little to show for it.  Between 1980-2005, public spending per U.S. student increased 75% in real terms, with little or no impact on performance." 

Some of the causes identified by researchers include inefficient teaching methods, and technology is the next large topic identified as something which can increase both efficiency and student performance. 

I think that it's a lot more complicated than giving every student an iPad.  Meaningful competition would be the best medicine to improve the public schools.

HP Third Quarter Report: Lost at Sea

Hewlett-Packard has now attracted a larger, quality stable of value oriented investors, and that's a good thing.  Dodge and Cox, which has upped its stake, is no longer alone: Fidelity, Vanguard, BlackRock, and GMO have sizable positions.  

As a prelude to looking at the quarter, I wanted to review some thoughts from Jim Chanos, founder of Kynikos Associates on HP. Jim made these points about "value traps" in a June 2012 presentation at VALUEx Vail. In a nutshell, here are bullet points   taken from his slide along with some additional text. Remember that these remarks reflect his vantage point as of June 2012.

• HPQ metrics, relative to its history and to its industry peers, suggest that it is a value stock.  Forward P/E of 5.2x, forward EV/EBIT of 5.6x.  FCF yield of 10.7%, using LTM FCF before share buybacks and acquisitions.
• Share buybacks and dividends of $6.3 billion in LTM are equal to 162% of FCF.
• Growth through acquisitions has not paid off. This is characteristic, Jim says, of value traps. $36.9 billion spent on acquisitions since 2007, equal to 82% of FCF. Despite the acquisitions, LTM cash from operations is 7% less that it was in 2007.
• Value destroying actions were reflected in Compaq impairment, EDS restructurings, Palm write-off, and Autonomy revenue implosion. 
• HPQ's businesses are struggling.
• Lack of strategy, as evidenced from 3 CEOs since 2006. 

Characteristics of value traps, according to Jim Chanos, include: a stock looking cheap according to management's metrics, a marquis management or a board comprised of famous investors, cyclical products or dependency on one product line, and hindsight driving expectations.  The latter point is a very interesting one in the case of Hewlett-Packard, which clearly Jim Chanos feels is probably not a 'value stock.'

In some convoluted sense, HP was seen as "beating expectations" by reporting non-GAAP adjusted, diluted EPS of $1.00, a sequential improvement over the April quarter's adjusted, diluted EPS of $0.98, and versus adjusted, diluted EPS of $1.10 for the prior year period.  Somehow, this was better than expectations, although the basis of the analyst estimates are never very clear, and they're not very good modelers anyway.

Management has tried to set expectations as low as possible, and they have the convoluted slop of non-GAAP adjustments, which clearly elude many of the analysts before the announcements. 

As a long-time equity analyst myself, I certainly understand the utility that non-GAAP adjustments provide by improving comparability between EPS numbers. However, they sometimes obscure the underlying economics of the business.  I do get nervous when these adjustments are habitually overused for long periods. Here is an excerpt from a footnote to one of the company's own reconciliation slides:

"Impairment of goodwill and purchased intangible assets doesn't affect cash. It does represent the loss of value in these assets over time.  Expense associated with the loss in value is not in non-GAAP measures and doesn't reflect the full economic effect of the loss in value of these assets."

The value destruction from acquisitions continues to reverberate, as the company took an absolutely astonishing $9.2 billion charge in the July quarter for impairment of goodwill and purchased intangible assets relating to the EDS acquisition. On a diluted EPS basis, the charge was a $4.66 hit to reported GAAP earnings per share.  Heavy restructuring charges in the quarter were a $0.91 hit to reported GAAP earnings per share in the third quarter.

Looking at the balance sheet, there are no alarm bells going off, but it has been subject to stress, looking from October 31, 2011 to July 31, 2012.  In this period, long-term debt has increased by $1.5 billion, reflecting both the Autonomy acquisition and aggressive share repurchases. (On a 'net debt' basis, the CFO talked about a $1.5 billion reduction in 'net debt' over the same period) Standard and Poors noted this when they downgraded the corporate credit ratings in November 2011:

The downgrade reflects liquidity and financial flexibility that have been
reduced by more aggressive financial policies, including the use of leverage

to fund the recent $10.2 billion (net) Autonomy acquisition,” said Standard and Poor’s credit analyst Martha Toll-Reed, “and annual share repurchases well in excess of discretionary cash flow"

Stockholders' equity over the same period has declined by $7.0 billion.  No amount of non-GAAP reconciliations can diminish the fundamental challenges facing HP's portfolio of businesses looking forward, as well as the legacy burden on the organization from its "drunken sailor" acquisition spree over the past several years.

The CEO's tone on this call was much more subdued than at the beginning of her tenure.  Then, Whitman made references to having run this playbook before.  Now, the CEO talks about Enterprise Services being in "a multi-year, non-linear turnaround," whatever that means. Whitman also referred to "plate tectonics" moving the industry, and she talked about adjusting the portfolio. 

This portfolio adjustment is just what Cisco has been doing for a few years.  HP will find itself late in the game for a meaningful portfolio reallocation and refocusing. I believe that the CEO herself acknowledged this when she referred to revenue and near-term results "being challenged."  Overall, Whitman's tone is much more sober, as she now understands what she is up against, both inside and outside the company. 

The Personal Systems group's revenues, 28% of the corporate portfolio, declined by 10% y/y, to $8.6 billion. Total units sold in the PSG declined by 10%.  Operating income was $409 million, for a margin of 4.7%, a decline of 120 bp in margin y/y.  The revenue decline was across all areas, but notebooks led the way with a 13% decline in revenue and a 12% decline in units.  This story is the same told by retailers like Best Buy and by other manufacturers like Lenovo and Dell.  Consumers are price sensitive, and wary about making a purchase before the scheduled October 26th launch of Windows 8.  Channels were overstocked, and everybody looked to manage inventory, so margin was less important than a sale.  Overall, the consumer business was down 12% and commercial sales were down 9%. 

As much as Lenovo made noise about gains in its market share, it appears that cementing and increasing its gains in China were more effective than making share gains in North America, Europe and other markets. HP has a future here, but its challenge is how to differentiate itself in a commodity business.  COMPAQ began as a premium, high quality product that became debased from a brand into a commodity offering.

Smartphones and tablets are things which HP is coming into with no consumer share of mind and with little heritage of design innovation.  If the corporate motto is "Invent," they need to start here by launching great products either on the Apple model or on the Google/Android model.

The Services business is 29% of the corporate portfolio at $8.8 billion in revenue, which declined 3% y/y.  Operating income was $959 million, which is a margin of 11.0%, but the margin declined by 270 basis points from the prior year period. The biggest revenue decline in Services came from infrastructure technology outsourcing, which declined by 6% y/y to $3.7 billion.  It's hard to understand the future of this business from the conference call commentary or Q and A. 

Imaging and Printing (IPG) is 20% of corporate revenue at $6 billion, and it declined by 3% y/y.  Operating margins were 15.8% in the fiscal third quarter, an increase of 160 basis points from the prior year period.  Analysts seemed surprised by this performance, probably because they had the operating margins for all businesses declining y/y.  The current margin rate hearkens back to the halcyon days of 3Q-4Q 2010 when the margin was 16-17%. 

The commercial hardware segment within IPG increased revenue by 4% y/y to $1.4 billion, which is 24% of IPG revenues. Commercial hardware units increased by 4%. The CEO mentioned a sale of 10 HP Indigo presses to Consolidated Graphics, Inc., the printer with the largest digital footprint and a committed user of HP products; the new presses list for about $1.5 million each.  The larger digital presses have components which were negatively impacted in last year's third quarter by the Asian tsunami and related parts shortages.  Finally, the CFO said that the company had a better mix of laser printer sales versus deskjet sales in the quarter. 

Consumer printer sales declined 13% to $567 million, with units declining by 23%.  Between commercial and consumer hardware sales in IPG, total units declined by 17%.  Supplies still represent 67% of revenues for the IPG, and supply revenues declined by 3% y/y.  Oddly enough, in IPG, it looks like the consumer printing segment has problems on the hardware side with a confusing array of old and new models, some design flops like the Envy printers, and declining reliability and quality overall.  Consumer resistance to high ink prices is resulting in almost continuous promotions and discounts on ink at major retailers.  The IPG doesn't seem to one of the bigger headaches for the CEO but it too seems directionless.

Enterprise Servers, Storage and Networking (ESSN) saw revenues decline by 4% to $5.1 billion, with 62% of ESSN revenues coming from Industry Standard Servers.  Operating profit margins in ESSN were 10.9%, a rate 200 bp below the margin for the prior year period.  ESSN is the segment CEO Whitman described as being in a multi-year transition. 

Software business revenues of $973 million increased 18% y/y. The operating margin for the software business was 18% of revenue, or $175 million.  The operating margin declined 150 bp y/y.  Support provided 48% of software revenues and increased 16% y/y.  Services were 21% of segment revenues and increased by 65% y/y.  License revenue accounted for 31% of segment sales and grew 2% y/y.  The Software segment is 3% of consolidated revenue and 5.7% of consolidated segment earnings from operations.  It is also difficult to understand the vision for this business.  It is too small to move the corporate needle.

There you have it: a grab bag of products and services sold primarily to businesses but with a large segment of earnings coming from consumer sales, specifically ink.  Leaders are being replaced, and surely the key sales people in some of the larger businesses are probably being lured elsewhere.  The reduction in company headcount is set to be larger than initially announced. 

"Investing" in cloud computing sounds almost as scary as the government's "investing" in education.  With PSG, Services, IPG and ESSN, the future seems driven by the hindsight of historical, normalized profit margins.  With the businesses themselves being transformed by technology and customer demands, this does not seem to be a suitable way to look forward. 

CEO Whitman drew a parallel to IBM in the 1990's. Let's think about that one. Lew Gerstner told students at the Harvard Business School, "

"Transformation of an enterprise begins with a sense of crisis or urgency," he told the students. "No institution will go through fundamental change unless it believes it is in deep trouble and needs to do something different to survive."

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.

HP's portfolio superficially bears more resemblance to Cisco's than it does to IBM's. I guess I end with the same point I've made before: it's almost impossible to understand where HP is going, as opposed to where it was or where it is, because of the sins of the past. 

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.





Two Face, Private Equity and Saving Jobs In Philadephia

                                 Bloomberg News

Rumor has it that Two-Face was seen hanging around the Sunoco refinery in Philadelphia (pictured above), hoping to work the dark side, to see the owner close the plant, raising Northeast gasoline and heating oil prices and eliminating 850 lucrative union jobs. 

But wait!  The Wall Street Journal reports that the White House Economic czar got on the Batphone and called an evil private equity group, Carlyle which was the only viable bidder for the refinery.  Did he berate Carlyle for stealing money from widows, exporting jobs, and bringing global climate to the tipping point? 

No, the White House was instead a catalyst for a tri-partite process involving Sunoco, Carlyle, and a Republican Governor of Pennsylvania in which Carlyle took a two-thirds equity stake in the refinery alongside Sunoco, investing $200 million to upgrade the facility and preserving 850 union jobs with modest concessions from the unions.  Carlyle negotiated a good deal for itself because it paid nothing for its majority stake, but it also contributed the cash and expertise to the upgrade, something few players could provide.

Governor Corbett (R) brought $25 million in subsidies and incentives to the table to make the deal work. In one of the many ironies of this story, a 2005 EPA consent degree with Sunoco regarding limiting emissions from its plants would have scuttled the deal from Carlyle's view.  The White House elected to have the EPA modify its own consent decree to let the project go forward, by creatively transferring emission credits from Sunoco's closed Marcus Hook facility.  In fact, Carlyle will not need to use the credits, and net/net the revamped refinery will end up having lower emissions under its new owners than it did under Sunoco.

Even Two-Face must have had a migraine at this point.  Governor Corbett puts it well when he says,

 "... the lesson "is that private-equity firms are not evil. Even though campaigns may say that, administrations understand they're necessary to get deals done." There were no other realistic buyers for the refinery, he said, and if Carlyle didn't invest, a deal to save it "just wouldn't have happened."

But no!  The union boss whose workers had jobs saved said that he wouldn't have taken the same deal if "Bain had been across the table."  There's a class act.  Why?  Because he knows that "they (Bain) strip and flip and walk out with as much as they can." 

Since Carlyle was identified as the only viable bidder, it had to have been because Bain was unwilling to provide capital for the upgrade, wasn't perceived to have the expertise to handle the project, or had other terms that were not acceptable to Sunoco.  Not every private equity firm is equally adept in every industry, and Sunoco may have had its own preferences for operating partners.

However, if Bain had been switched for Carlyle in this same deal, what or how could they strip and flip?  Sunoco would still have a one third stake in the venture, and any joint venture document acceptable to Sunoco would have constrained the private equity partner from pulling the rug out from under the venture. So the union leader's comment, just like White House rhetoric and campaign fog on private equity, was meaningless and unseemly.

A Bain spokesperson notes, 

"During a campaign, some may distort our record for political purposes, but the truth is that revenues have grown in 80% of the more than 350 companies in which we have invested,"

Overall, this project was a good example of the political machinery acting rationally to help private interests achieve an economically and socially superior outcome to Sunoco's closing the plant, as it had done with Marcus Hook.  It looks like Two-Face's coin came up heads for adding value through private equity.

Groupon: Poster Child of Social Media Bubble?

We've heard about the Groupon investors heading for the exits, including some of the early and later round VC investors who now claim that they told the company it was not ready for an IPO.  I can't find the exact reference, but I read that an investor counseled the company that its business metrics might not stand up to Wall Street scrutiny.

What I don't understand about that comment is how could the Groupon metrics stand up to the scrutiny of the late stage private equity investors?  Do these investors use some imaginary, alternative accounting standards?  Either the business model and metrics are real or they are not.  Whether the company is public or private should be irrelevant to that issue.

Advertising industry analyst Rakesh Agrawal put our concerns into more colorful language when he called Groupon's business model "a loan sharking business."

The accounting professors at Grumpy Accountants point out a questionable accounting gain from a swap of equity stakes in Chinese companies in Groupon's last quarter.  The economics of this accounting maneuver should have been questioned by Groupon's auditors, and it's not a new dodge to boost earnings.  The one which is more telling, is the fact that the company and its auditors acknowledge that Groupon may not be able to benefit from its tax losses capitalized in deferred tax assets.  Why?  Because the prospect of Groupon generating taxable income from its current business model may be unlikely.  In that case, the auditors should be considering a "going concern" opinion at some point.  In the quarter, the company increased the valuation allowance against the deferred tax asset.  Perhaps the management talked the auditors out of this opinion for the quarter by appealing to the "new" Groupon Goods business model.  Either way, the business model is the fundamental problem for the tone deaf management team. 

We've had the "Internet bubble," and a few years from now, scholars will be writing about the "social media bubble."  If I can paraphrase the Dos Equis spokesperson about Wall Street, "Stay cynical, my friends."

Charles Plosser and the Monetary Hawks

Charles Plosser, President of the Philadelphia Fed, is routinely described as a monetary policy "hawk."  I guess that I don't understand what this means.  I do know where he stands by his writing and speeches.

A very clear and readable expression of Dr. Plosser's approach to monetary policy can be found in a paper given to the Inaugural Meeting of the Global Society of Fellows of the Global Interdependence Center, hosted in Paris by the Banque de France, in March 2012. 

He points out the inherent tension between an independent central bank and fiscal authorities.  He notes, "History teaches us that...they (governments) often resort to the printing press to try to escape what appear to be intractable budget problems."  Independence is especially tricky given that monetary policy and fiscal policy are "intertwined through the government budget constraint." 

Everyone agrees that our politicians on both sides of the aisle have been kicking the deficit can down the road for decades.  The severity of the last financial crisis, and cries about "saving the system," led the current Federal Reserve Chairman to cross the boundary into what Professor Jonathan Wright of Johns Hopkins University describes as "unorthodox monetary policies." 

Plosser's paper talks about pressures for the central bank to be "lender of last resort," something which is a hot topic in Europe.  He also cites Federal Reserve establishment of credit facilities to support specific markets for private instruments like commercial paper and mortgage-backed securities.  Support for the latter has turned into massive purchases of MBS, which he says have blurred "the traditional boundaries between fiscal and monetary policy."

Like an overweaning parent kowtowing to a spoiled child, both parties are negatively impacted by the recurring pattern of manipulation by the child and indulgence by the parent.  The current monetary policy environment at the zero bound has, in my opinion, taken a lot of the information content out of market interest rates.  Markets are now driven almost solely by what participants believe the Fed will do in response to perceived macroeconomic risks.  Thus, global markets switch "risk on/risk off" based on the statement of the ECB President.  When the market cries, the Fed comes with some candy and the child feels better.  This is not a good environment in which to allocate capital for long-term projects, which should be the real forte of the financial markets.

Plosser's fundamental objections to the Fed enabling irresponsible behavior by the government fiscal authorities are supported by some innovative econometric work by Professor Wright.  Wright comes to the conclusion that since November 2008, QE1, QE2 and QE3 (maturity extension program) have had "a significant effect on ten-year yields and long-maturity corporate bond yields that wear off over the next few months."

The quantitative easing programs, Professor Wright concludes, "were all characterized by declines in interest rates that were reversed over the subsequent months."  The market behavior seems to have been to move on the announcement effect, overreact on the upside in anticipation of future announcements, and then to correct the overshoot.  

This Federal Reserve, having gone down a political road to underwrite unprecedented fiscal profligacy and excessive financial market risk-taking, may not be able to show the courage to reclaim its independence.  Let's hope that it finds a way to go back to just being the guardian of our currency's value and long-term price stability.    That's a plenty big enough charter.

Cisco's 4th Quarter: A Tiger Changes Stripes

I had to reread Cisco's release for the fourth quarter and fiscal year ended 7/28/12 a few times to be sure.  Cisco is defying the old aphorism about a tiger not being able to change its stripes.  It has done so. The board and management should be commended for laying out their approach to creating shareholder value clearly in the whole body of the release.

Credit Suisse writes, "Cisco's declaration that it plans to return at least 50 percent of FCF to shareholders represents a watershed event."  Absolutely.

During the quarter, the company repurchased 108 million shares for $1.8 billion, at an average price of $16.62 per share.  It also raised its dividend by 75 percent, to $0.14 per share, which gives an annualized dividend yield of 3.2%.  Finally, the company made the above statement about use of its free cash flows in the future. 

By taking these actions, the company has just significantly widened its universe of potential institutional owners for CSCO shares.  Having a large cash horde is problematic for equity holders, as their fear is about management squandering the cash overpaying for acquisitions, as tech companies are wont to do.  Now, it's easier for an analyst to isolate what an investor would be paying for future growth and what they can expect from dividends and buybacks. 

Management of growth companies always fear dividends as signaling the company has run out of ideas and is on the way to becoming a pedestrian performer. It's really nothing of the kind.  With the current outlook for lower, mean-reverting equity returns, giving an investor a 3.2% yield takes quite a bit of risk out of the investment decision, assuming that the dividend can be funded, which it easily can.

All in all, using the most simplistic assumptions, it suggests that earnings growth moves to a mid to high single digit trend rate.  In the New Normal (I'm getting tired of this term, but I don't have a better one), this is pretty good for a large, liquid industry leader's shares.

Management is also having to tweak its business portfolio management to achieve its new goals, and again, this is commendable.  According to Credit Suisse, the company is dealing with a very significant 250-300 bp year-over-year rate of price erosion in product gross margin. 

Supply chain efficiencies and manufacturing cost reductions are offsetting the margin decline by 100-150 bp, according to Credit Suisse. The rest, CS says is from unfavorable product mix, especially weak growth in the core switching and routing proucts, about 31 percent of revenue. 

The flip side of the product mix issue is what seems to be stellar performance on the services side.  Services represent 21.1 percent of fiscal 2012's $46.1 billion in revenue. Sequentially, services held flat at $2.5 billion against a difficult market for product.  Services help customers solve problems, implement solutions, and they cement relationships for company equipment.  According to CS, the services gross margin rate of 67.1 percent has held for the preceding seven quarters and is close to the historical peak gross margin.  This compares exceptionally well when viewed against HP's issues in the same kind of business. 

The company's continuing adjustment of headcount seems geared to, among other things, maintaining the corporate operating margin as much as possible.  Operating expenses as a percent of revenues were 34.5% in the fourth quarter, which CS notes is near "the all-time low post-telecom bubble levels." 

For the fourth quarter, the operating margin compressed by 100 basis points sequentially to the fourth quarter.  However, given the weak revenue growth in the core, higher margin businesses, continuing and growing weakness in Europe, and some firming in U.S. enterprise order patterns, this isn't bad performance at all. 

The company's OCF was $3.1 billion for the fiscal fourth quarter, roughly flat to the preceding two quarters.  Of $48.7 billion in gross cash at the end of the quarter and fiscal year, some 87% is held outside of the U.S.  A fair and simple mechanism to repatriate corporate profits held outside of the U.S. would be helpful to a large number of our leading global companies.  However, there is no question of Cisco's ability to fund its higher dividend payout, now or in the future, according to the company.

The clouds on the horizon in terms of geographical mix of business are well laid out, so there shouldn't be negative surprises in the next few quarters, unless Europe collapses. 

This quarterly report is quite a refreshing change for a technology bellwether like Cisco, and lots of other Standard and Poors 100 "growth" companies ought to re-examine their stated growth objectives and consider raising their dividends.

The Banana Man: Sam Zemurray and Leadership

                                 Getty Images

I just finished Rich Cohen's memorable book, "The Fish That Ate the Whale: The Life and Times of America's Banana King." Ostensibly about the life of Sam Zemurray, pictured above, it's a provocative book about the Cold War, the CIA, American foreign policy under Truman, Eisenhower and Kennedy, Central American dictatorships, and corporate leadership in an entirely different era from today. 

Cohen writes, "If you want to understand the spirit of our nation, you can go to college or you can study the life of the Banana Man."  I know that I could build a great course around this book, which is replete with extensive source materials and people whom Cohen consulted for background information. 

Bananas first made their way into the United States in 1870, when a ship captain named Dan Baker brought Jamaican bananas into Jersey City, where, according to the National University of Ireland, he sold 160 bunches for $2 each.  Baker would become one of the co-founders of the Boston Fruit Company, which became one of the largest banana runners in the port of Mobile, AL where the trade really began to grow.

In 1877, Cohen writes about a 14 year old Russian Jewish immigrant from Moldavia, Sam Zemurray (born Zmurri), who comes to Selma, AL to work for his peddler/shopkeeper uncle. Sam Z's curiosity takes him to Mobile where he learns about the banana trade by talking to stevedores, captains like Baker, and peddlers.

Sam finds the banana crop to be graded into three categories: "ripes" (shipped 50-80 miles away from the docks), "overripes" (sold in Mobile and Selma), and "about to be ripes" (shipped as far as Memphis and Birmingham). 

The Boston Fruit Company graded ripes this way: one freckle, the banana was turning; two freckles, the banana was ripe.  Even though ripes were flavorful and good to eat, they couldn't be sold through the distribution chain before they softened, smelled and contaminated a whole load of fruit.  These ripes routinely became trash.

Young Sam saw opportunity in the industry's discards.  If he could sell the ripes within three days, he could make money.  He invested $150 to buy Boston Fruit's ripes from the docks, and he rented boxcar space on the Illinois Central's trains out of Mobile.  His intention was to hawk the bananas at each stop along the train route. 

In addition to his vision, Sam was able to enlist people's support for his enterprises.  The train conductors suggested sending telegrams ahead to the train stations so that people would know the Banana Man was coming. Customers would be waiting.  Having no cash for the telegrams, Sam cut the conductors in for ten percent. He wound up making a profit of $35 on his investment, and Sam had a vision for a business selling ripes.

After growing his business as a jobber for United Fruit, Sam and his partner Hubbard invested $20,000 and founded Cuyamel Fruit Company in 1910 to buy 100 acres of land near the Cuyamel River in Honduras, along with some ships.  Cohen describes Cuyamel as the "Green Bay Packers" of the banana business. 

One of Sam's first principles was to learn a business "from A to Z," by talking to everyone involved in the business on the ground and by listening and observing. In that way, he felt, any problem that came up could be solved, armed with this foundational knowledge. He loved to drink with the sailors and other rough characters.  He said that if you drank with a man, you got to know what he was thinking. Sam knew the banana business, end to end, better than any other manager, operator or executive in the industry.

Cuyamel introduced the practice of selectively pruning banana stands, a practice which the industry bean counters found wasteful.  He got higher yields, and less waste. Even though much of the crop was grown in well drained, loamy soils, Sam insisted on adding additional drainage and spillways. In lands often hit with torrential rains, he added overhead irrigation for critical times when hot spells affected the health of the bananas. 

In 1917, when Cuyamel was regarded as a dangerous rival to United Fruit, the two companies targeted the acquisition of 5,000 key acres of land claimed by owners in Guatemala and Honduras.  United Fruit took the issue to their lawyers and board of directors for analysis.  Sam, who didn't believe in wasting time on petty issues, just bought the land twice, from both owners.  The key asset was the land in a time of explosive growth in demand and pestilence affecting existing plantings; the additional money paid was small potatoes. 

In 1923, Sam Z incorporated Cuyamel as a Delaware corporation.  According to papers in the Lehman Brothers Collection at Harvard College, Cuyamel had assets of $4 million, liabilities of $691,000 and earnings of $1.2 million at the end of 1924. In that year, the company imported 6.6 million banana stems into the United States, according to the Lehman papers.  By 1927, Cuyamel imported 9 million banana stems or 14% of the total imports to the United States. 

Sam Z had gone from a young peddler, to the "Banana Man," to a full fledged corporate executive of a very profitable and well funded corporation.  It did, however, carry a substantial debt load, required to buy more Central American land, build additional rail lines, and more towns for Cuyamel workers and staff.  Cuyamel's 1925 offering of $5 million of first mortgage, fifteen year sinking fund gold bonds was underwritten by Lehman Brothers, Goldman, Sachs, A.G. Becker and Ames, Emerich.

Sam Z was now a wealthy, powerful man, who still lived in New Orleans, though his company was incorporated in Delaware and his financiers located on Wall Street.  He loved the allure of the docks, the company of stevedores and captains, and the jungles of Honduras, where he grew his bananas.  He cleared out his first stake of land by himself, wielding a machete side-by-side with the best of his men. He and his crews had to deal with snakes, scorpions, and mosquito-borne malaria in creating land that could be planted. 

Meanwhile, United Fruit the Boston-based industry Goliath was run by Boston Brahmins, professional management types who viewed the business from reports and accounts.  This cultural difference would come into play later in the story, as the global banana business continued to grow.

In 1929, Sam Zemurray sold the assets of Cuyamel Fruit to United Fruit Company. Cuyamel owned 35,000 cultivated acres in Honduras, Nicaragua and Mexico, fifteen top of the line refrigerated banana boats, and the capacity to produce more than six million stems a year.  United's shares were selling at $100 per share, and after the deal, Sam Z became the largest shareholder of United Fruit. 

Sam knew that the way to succeed in the business was to get bigger, work more efficiently, and diversify the crops.  He had done all of these things, since Cuyamel's assets included things like the Sula Sugar Company.  A penny a pound tariff, such as the one contemplated in 1913 by Underwood-Simmons bill, would have been devastating to a leveraged business with high fixed costs.

Sam sold out, became the largest shareholder of United Fruit, and was freed from the constant worries about being extended too far with his creditors. United Fruit, which reported 1928 profits of $45 million, was happy to have taken out its strongest competitor, who they still regarded as a Jewish peddler with a thick Russian accent.

With the Great Depression and its aftermath, United Fruit's 1932 profits fell to $6 million, and its share price plummeted to $10.25, according to Cohen's book.  As the largest shareholder, seeing his wealth depleted, Sam took action in the way he new best.  He went to "see for himself."  Unlike the Brahmin professional managers at United Fruit, he didn't rely on reports.

Sam went to the warehouses and talked to the peddlers and sea captains about the banana business. The Boston boat captains mentioned that corporate policy had ordered captains to slow steam their ships to save fuel on the voyage from Central America,  Sam quickly did the calculations and found that the company lost more in spoilage than they saved on fuel. 

After countless unwelcome phone calls into United executives, he wrote a letter to the board of directors with a detailed plan to improve the company financials.  This included repurposing the underutilized fleet to carry additional cargo, fallowing some of the fields, and otherwise controlling the supply in order to firm up prices. His letter was ignored. 

In 1932, at a board meeting which Sam attended, a manager in Guatemala wanted $10,000 from the capital budget to put in an irrigation ditch.  His request was denied by the bean counting executives without any first hand research.  Sam Z was outraged. He said to them, "We are here. He (the manager) is there."  In other words, he has better data. Sam had actually garnered enough shareholder proxies in his hand to replace the board, but he had been reluctant to pull a power play.

He gave a long, impassioned review of the business, its problems, and his solutions.  About the manager's request, he said, "If you trust him, trust him.  If you don't trust him, fire him and get a man you trust to do the job."   Of course, the board didn't know if they trusted the manager, since none of them had ever met him. 

After Sam had completed his presentation to the board, as the company's largest shareholder and as the "Banana Man," he awaited a response.  The board Chair smugly replied that he hadn't understood a single word because of Sam's thick, Russian accent. Sam flashed his proxies and announced that he was firing the board Chair.  United Fruit named Sam as its new General Manager. 

Sam began his GM's tenure with a six week tour of United's banana lands. "Go see for yourself," and "Don't believe the report" were again his guiding principles. The stock doubled in the first two weeks on the announcement of his new position.  The price ended 1933 at $26 a share.  His energy and commitment alone made a strong impression on the company's far flung managers who never met the Boston executives who sent all those memoranda about how to run their businesses. He replaced about 25 percent of the managers with people he trusted to move quickly and decisively to fix the business. 

In his latest position with United Fruit, Sam started to come across things which would transform him emotionally and the company.  Sigatoka disease initially threatened the entire banana crop, which was entirely one species Gros Michel (Big Mike).  Using techniques adapted from Sam's Cuyamel Company, United warehoused fallow land, diversified the cash crops, and tried their best to research solutions to Sigatoka.

Company scientists soon came up with something called the "Bordeaux mixture," a mix of copper sulfate and lime which was found to combat the Sigatoka disease.  Men were enlisted to go into the fields and apply the mixture to all United Fruit fields.  Unfortunately, the men, called "Los Pericos," lost all their sense of smell and began to glow like parakeets, hence their nicknames.  These men sacrificed their health for a bit of hazard pay.  Pragmatism took precedence over humanity for the Banana Man.  This episode seemed to mark a turning point in Cohen's narrative about the history of United Fruit. 

Of course, bribery had always been a feature of doing business in the banana trade.  Every player from Boston Fruit to Cuyamel to United Fruit built their businesses on buying deputies, customs men, and politicians in every country of operation.  Sam is reported to have said, "A mule costs more than a deputy."

The book's narrative soon turns away from the story of Sam Zemurray and towards the narrative of "The Ugly American." The banana companies were allies of convenience for American foreign policy dating back to the 1900's when London bankers wanted to collect on $100 million of Honduran debt used to build the boondoggle national railway.  President Taft and Secretary of State Knox were fearful of British marines landing in the Americas to collect Honduran debts to their London bankers. Knox used J. Pierpont Morgan to refinance the Honduran debt and to forestall foreign military action in the Americas. The banana companies were allies in this effort, and now U.S. foreign policy and the interests of these companies became inextricably entwined.

Fast forward to the 1950's and the administrations of Truman, Eisenhower and Kennedy.  The Cold War was in full swing.  United Fruit only planted 15% of the land it owned in Guatemala, using this as a hedge against Panama disease which threatened to finally eradicate cultivation of bananas in Central America. Eventually, disease wiped out Big Mike as a viable crop for the Americas, and today the Central American countries export the Cavendish banana.  In 1952, President Arbenz of Guatemala passed Decree 900 which confiscated foreign land holdings for redistribution to native landholders ostensible for the creation of indigenous banana growers.  With the full, active cooperation of United Fruit and the leadership of the CIA, President Arbenz was overthrown in the guise of a sham popular uprising. 

Unlike the story of the rise of a 14 year old banana peddler to an innovator, corporate philanthropist, and hugely successful corporate CEO, this story has little to recommend it.  It has also been told in great detail elsewhere. 

Revolution was spawned in Central America by Che Guevara as a lightning rod.  It found a home in Cuba, and the story in Cohen's book ends with the Bay of Pigs invasion.  In the history of United Fruit, Sam Zemurray appears to be just one of many actors.  To be fair, Sam Z had left the business by the time the ugliest acts took place. 

I enjoyed reading about Sam Z and his rise.  I also admire his optimism, work ethic, loyalty to the workers who got results for the company, and for his philanthropy to Tulane University, and to education and health in Central America.  Solving problems at some point became an amoral exercise, as Los Pericos showed.  Many other corporate actions were as bad or worse.  Author Rich Cohen doesn't pretend to know what was in Sam's mind, and the reader can't guess either. 

Unfortunately, from studying Latin American history, I know that things are rarely what they seem.  The military have always played an outsized role in economic life, business and politics.  Before United Fruit, the military aligned themselves with the caudillos. United Fruit displaced the ruling families or caudillos for a time.  When United Fruit was declawed and left, it's very hard to evaluate if what was left has been more democratic and egalitarian than what had existed for generations.  That's another book, though.

Sam's picture reminds me of some gentlemen who lived in our old neighborhood in New York growing up.  I think that I would have enjoyed talking to the Banana Man.  Reading Rich Cohen's book is like the next best thing, and it makes a less than exemplary period in American foreign policy come alive.


Additional resource materials for article;

1. Lehman Brothers Collection--Contemporary Business Archive http://www.library.hbs.edu/hc/lehman/company.html?company=cuyamel_fruit_company
2. Maria-Alejandra Gonzalez-Perez and Terence McDonough, "Chiquita Brands and the Banana Business: brands and labour relations transformations," CISC Working Paper 23, January 2006. National University of Ireland.
3. United Fruit Historical Society.  http://unitedfruit.org/

Nadeshiko Courtesy and Brazilian Women's Team

Going into the final days of Olympic media overload, I remembered another detail about the Nadeshiko that made me smile.  When several of their key players, like Kumagai, were substituted at the end of the game, they faced the field, bowed to their fellow players, officials and fans as they left the field.

This gesture reflects the virtue Rei, courtesy, which is foundational for any martial artist.  After studying for many years with Kaicho Tadashi Nakamura in New York, all the honbu students heard about courtesy and respect as being required for a true karateka.  To see this kind of small courtesy on a soccer field on a global stage was so different.  I really appreciated the players who did this, and I wonder if it was a personal choice or a team practice.  I did notice when the young striker Ohno left the field, she did not bow. 

I don't mean to criticize Ohno.  However, amid the loud, over the top media coverage of the game, a small gesture like bowing, which went totally unacknowledged by the commentators, seemed all the more meaningful.  Osu!

On the other end of the spectrum, one of the worst games I watched involved the Brazilian women's team. They were a polar opposite to the Nadeshiko. They were not a team at all, but a collection of individuals who didn't care.  Every player looked sullen, angry and unhappy.  Former World Player of the Year Marta stood around looking lost, and when she got the ball, she tried to do too much by herself. Marta was dispossessed easily.  Her skills have faded, and the competition has caught up.

The team had no leadership on the field, and it appeared that they had no tactics except to go one-on-one or to shoot randomly from long distances.  It was truly depressing to watch. Their coaches should be ashamed of themselves.  I believe that it may have been Judy Foudy, an analyst, who said something really interesting.  She said that the players look exhausted and frustrated from enduring years of neglect by the Brazilian soccer establishment.  I think she has hit the nail on the head.

Brazil wants to take its place on the world stage as an emerging economic and political power.  As a nation, it possesses enormous wealth in its natural resource endowment alone.  Some of its companies are among the largest in the world, and its wealthy industrialists certainly rank among the world's elite.  It lobbied hard and spent millions to get the Rio Olympics as a showcase, just as China did for the Beijing Olympics.

The entire machinery of professional soccer in Brazil is, and always has been, intensely corrupt.  Pele has said this for decades, and even took a turn as a Minister of Sports to try and clean up the game.  He failed. Besides developing and selling players to sell to foreign clubs, the Brazilian professional soccer machine had little to commend it.  The reason I mention this is to say that this machinery has no interest in developing women's soccer in Brazil. 

How about an organization like Petrobras?  How about some wealthy corporate or social leaders from the very large Japanese-Brazilian community?  Some new leadership needs to grab a hold of the objective to create a large, sustainable, grass roots women's soccer program in Brazil, with a high profile professional league at the organization's apex. 

The way these incredibly skilled women players from the Selecao have been treated is disgraceful and not worthy of a country which aspires to the status of a global power, as Brazil does.  They should be playing with smiles on their faces like the Nadeshiko. 

Nadeshiko Take Olympic Silver Medal In Style

The 2012 Nadeshiko featured nine players from the World Cup winning side, but the team is clearly in a  transition.  The U.S. prevailed thanks to some passive defending by Japan, good shooting by Carli Lloyd and critical saves by Tweeting keeper Hope Solo. Missing an obvious U.S. hand ball by an experienced German referee and her crew was inexcusable.  The outrageous delay of game call on the Canadian goal keeper late in the semi-final with the U.S. helped the U.S. team get to the final.

The Canadian defenders in the wall blocked the kick, but a defender was judged to have used her hand in the box.  The subsequent penalty tied the score.  The Canadians eventually went out.  Fifteen year national team player Christie Rampone was asked when she could recall last seeing the six second delay of game penalty being called on a goal keeper: she replied "Never."   

The U.S. team, for all the talk about their new coach's tactics, plays about the same way as it always has, relying on physicality and a lot of hoofing the ball in the air.  Barcelona it's not.  Midfielder Megan Rapinoe adds technique, industry and a good shot that energizes a team that can spend long periods standing around. We should be proud of our gold medal winners, but we got a nice boost from two mediocre refereeing crews.  If this game were really about "redemption" for the U.S. as the pompous NBC announcers suggested, then it came with some human intervention too. 

The Nadeshiko deserve praise for the way they accepted their silver medals, with smiles of joy and pride.  This stands in stark contrast to the immature, surly, sullen and unsportmanlike women's gymnasts, including the one whose pout went viral.  A medal is a great accomplishment and is an occasion for celebration in the Olympic spirit.  Throwing a match or openly pouting do not reflect well on the Olympic ideals.

The fixers got punished and expelled.  The pouters get their just desserts by being immortalized on YouTube.

Playing the ball out of the back with short passes to feet was really fun to watch in this edition of the Nadeshiko.  The players, as a group, have some of the best technical passing and trapping skills of all the women's squads, and their give and goes look very Barcelona-like. 

Their finishing relies generally on short passes and dribbling with tight control in the box.  Again, it's great to see the style that Coach Sasaki has imprinted on this team.

The defending in front of the back four was a weakness for Nadeshiko in the tournament.  For some reason, defenders showed one side and backed off their attackers even as they hit the top of the box.The Barcelona defending style would have won the ball back early.  An Italian defending style would have set the defense to dispossess at least twenty five yards from the goal. 

By the time the U.S. attacker reached to top of the box, two or three Japan defenders were standing too close to each other. No one stepped up to actually tackle the ball.

Carli Lloyd's two goals were good shots that resulted directly from this indecision. Lloyd should have been dispossessed higher up the pitch, or her shots smothered at the top of the box.  Some of the back line looked a bit more passive and unsure of themselves, which comes with the passage of time.  It's a small point, in a final that reflected good football and good sportsmanship.

Congratulations to both teams.

Barofsky on Principal Reduction

We wrote in July,

"TARP and HAMP, programs of the Obama White House and its Treasury Department, were abject failures which threw billions at policies that benefited precious few homeowners. First and foremost, these programs were hare-brained in their design and therefore doomed to fail from the start. We've written before about the unregulated mortgage servicing industry and it being a stone wall to any rational, large scale mortgage resolution effort. Commentators like Joe Stiglitz described the public-private partnership idea for purchasing troubled mortgage assets as "ersatz capitalism." To let TARP and HAMP go forward without a legal plan and funding to bring the mortgage servicers into line with the government's objective was simply dim witted or cynical."

Today, Reuters reports these quotes from Neil Barofsky.

By late 2009, it was becoming apparent that HAMP would never come close to its stated goals. The program was designed poorly, and Treasury refused to hold the banks accountable for the abuses to which they subjected homeowners in the program. In one meeting I attended, after Secretary Geithner was pressed about the flaws in the HAMP program, he justified Treasury’s actions by explaining that the program would “foam the runway” for the banks by extending out the foreclosure crisis over time. In other words, Treasury was far more concerned with using HAMP to soften the blow of the housing crisis for the banks – just as the FAA once recommended spreading protective foam over a landing strip to prevent a disastrous crash of a malfunctioning airplane – than with helping millions of struggling homeowners. Now, three years later, with a tightening presidential election and a Democratic base disillusioned by the government’s abandonment of its promise to help homeowners (less than 8 percent of the funds originally allocated in TARP for foreclosure relief has actually been spent), Geithner and the administration would like to present themselves as having undergone a conversion.

Let’s be very clear about what is going on here. This is not a conversion – it is a political convenience. Geithner may well be correct when he wrote in a letter to DeMarco that an effective principal reduction program would “help repair the nation’s housing market” and that the refusal to do so is not “in the best interest of the nation,” but it is his own policies that are primarily to blame for where we are today."

Come crunch time in election season, look for a politically convenient, economically bad deal to be done for mortgagee votes in another late innings bailout with more taxpayer money. 

Confusing Pronouncements From PIMCO

Bill Gross has made provocative pronouncements about the "Death of Equities."  I have the highest respect for the wit, clarity and investment insight that Bill Gross has brought to his investment commentary over several decades.  His early comments about the unsustainable nature of G.E.'s corporate earnings growth from GE Capital, for example, were way ahead of Wall Street analysts and strategists.  This latest commentary seemed a bit huffy, and lacked his usual clarity.

Equities can't sustain their historical real return of 6.6% per annum, given prospective low growth rates for global real GDP.  Equities are very volatile, and a decade of returns can be given back in a year or two. Both of these statements seem eminently reasonable. But, the death of equities as an investment class?  I get lost here. 

Bonds certainly won't be able to maintain their recent historical performance, even given a benign inflation outlook.  Too much money has piled in, chasing returns.Valuations on high quality corporates and even junk bonds, are stretched. 

Now, Robert Arnott, who is involved with PIMCO's asset allocation and equity-related products has made a pronouncement about the tripling of inflation rates. 

"Round 1 of the inflation debate has seemingly been won by the doves. But Robert Arnott believes the hawks will be proved right, and soon. The inflation rate has "an 80% chance of topping 5% within five years," says Mr. Arnott, founder of Research Affiliates, a Pasadena, Calif. investment firm whose strategies are used to manage $100 billion worldwide."

His suggestions for investors?  Gold: too late, too risky and not well correlated with superior, risk-adjusted returns.  TIPS: not enough of them to satisfy the demand.  Junk bonds: I have a hard time with this quasi-equity asset class being the answer.  Emerging market debt and equity: investors won't get compensated adequately for the risks they are taking, and I don't just mean currency.  Real Estate: depends on what you mean.  Residential or commercial, and the vehicles.

PIMCO's push into alternative equity strategies and products has, I believe, produced tepid results and yawns in the market place. This has never been in the PIMCO wheel house historically. 

If inflation does rear its head, it would seem as if the equities of strong global companies with a degree of pricing power would be the place for investors to put their money.  That pricing power could come from technological leadership (like Apple) or from commodity-style pass throughs (Food or commodities).  Either way, it wouldn't seem like "death" were likely for these equities. 

Equities may have a longer term problem which will spill over on to global asset managers as a group.  However, I don't think that this has to do with mean reverting returns for the asset class, but, as the Pythons would say, "for something completely different." 

Natural Gas Markets and Geopolitical Change

Harvard's Belfer Center hosted meetings from May 9-10, 2012 on "The Geopolitics of Natural Gas" with the industry and economic modeling done by Rice University with the support of the James Baker III Institute for Public Policy.  It makes for some very interesting reading, and the model's supply side estimates are based on fairly disaggregated production area data for oil and gas, particularly shale gas.  What's not readily visible are the economic assumptions--like GDP growth-- driving the demand scenarios, but let's look at some of the highlights.

U.S. shale production was virtually zero in 2000, and rose to 10 billion cubic feet per day (bcfd) in 2010.  This is really a gold rush which doesn't make much news.  The reference (baseline) scenario has North American unconventional (shale) gas production quadrupling over the next two decades to more than fifty percent of North American gas production by 2030.  The North American recoverable shale resource is about 25% of the global recoverable shale resource of 4,000 trillion cubic feet (tcf). 

We've always contended that the U.S. has substantial export capacity, and the reference scenario confirms this, as it has U.S. LNG exports growing to 720 mcfd by 2030.  Qatar will however be the dominant global export of LNG, followed by Australia. These producers together will account for 40 percent of global LNG exports by 2040. 

It seems as if U.S. LNG export capacity must be hampered by structural and regulatory  inefficiencies in the global gas markets.  In the Belfer/Rice reference scenario U.S. LNG terminal capacity remains underutilized over the time frame.

The U.S. will enjoy lower natural gas prices than in Europe and in Tokyo in the three sub-decades of these long range forecasts.  There is no natural ability to arbitrage away price differentials in the world gas markets because of regulatory constraints on imports, guaranteed long-term contracts, shipping monopolies, and long lead-times for constructing alternative supply channels.  Hedge funds should have a field day in these markets, which should be more exciting than stocks or bonds.

The other bit of interesting news is that Russia's leverage with a natural gas choke on Europe is dissipating and continues to dissipate under the reference scenario.  Falling demand due to the economic slowdown and ample global supplies of gas, including LNG, are already forcing concessions on indexes used to compute European pricing. Indexes for Russian gas are said to be referenced on market rates for gas rather than on crude oil prices. 

Global gas demand growth comes at the expense of coal, and it almost doubles from 2012-2040.  China becomes a net importer of LNG under this research scenario.

Energy supply changes, coupled with economic slowdowns and pickups in German and American manufactured export production drive some complicated geopolitical changes in the scenarios, particularly Scenario 1 which has high unconventional gas exploitation with low liberalization of national gas markets.

Exxon Mobil's investments in gas projects, according to Credit Suisse, show rising production in 2014 and beyond which dovetails nicely with the scenarios in the Belfer/Baker forecasts. 

What could get in the way of a rosy outlook for the U.S. economy and the energy industry?  Tax, regulatory and environmental changes, including cap and trade schemes, or continuation of the ridiculous mandates for wind, solar and ethanol could all get in the way.  The industry itself should be more positive and open minded about environmental monitoring for protection of water quality. Given how fast shale production has ramped up in a short time, some circumspection is warranted. These future scenarios are quite different and quite a bit more bullish than relatively recent talk about the "end of cheap energy" and "peak oil."  Stay tuned. 

Power Blackout Indian Style

India is a big country.  So when a blackout hits India, it's not like upper Manhattan or parts of Queens going dark.  Early reports had 10 percent of the world's population being without power.  A more thoughtful piece from INDIAREALTIME puts the actual number at around 320 million people going without power, since you had to have had electricity in the first place before you suffered a power loss.

Much better than any of the Indian jokes circulating about the blackouts is this statement from a 2003 Indian Ministry of Power report,

"Power plays a vital role in all economic activities leading to a better quality of life. The Ministry of Power has set a goal to provide "Power for all" by 2012."

The summary states that 70,000 rural villages are not electrified as of 2003.  According to IndaiRealTime, about 303 million people live in the states of Uttar Pradesh and Bihar, where the percentage of households with electricity is 37 percent and 16 percent respectively.  It looks like about thirty percent of the households without power were in these two states.  Per capita income in New Delhi is said to be 5x the level of per capita income in Uttar Pradesh and 7x the level in Bihar.  The Central government in India is incapable of dealing with even managing the current electrical grid. 

Large businesses and outposts of multinationals are able to have standby and backup generators for their operations.  Commuters on the rails, and folks looking to draw water for cooking and bathing are out of luck.  From a 2009 post,

"India's economic development has been misguided since the 1950's, when teams of Harvard and MIT development economists were relentless advocates for heavy industrial development. Today, the new mantra is to develop the Internet infrastructure. We're told that 30% of the population now live in urban areas. However, that means 70% of the population still live in villages, and Silicon Valley expats not withstanding, India is still a nation of villages.


Clean water, sanitation and reliable power are keys to sustainable economic growth. In the villages, people need simple, low cost and reliable ways to use sustainable fuels for cooking meals, and foodstuffs that don't rely on high cost inputs. Power, water and sanitation are large-scale public works projects, and the government has to find a way to become more effective at delivering these needs."

When the United Nations talked about completely redoing the infrastructure around  its Headquarters, it got into a unbelievably complex bidding process, driven by politics among American and European companies bidding for the job. In the end, Donald "The Donald" Trump said that he would do it for less and have it finished in less than a year.  Since he was too busy firing people on television, he wasn't taken up on his offer. 

I think that the Indian government should call in mega-moguls Mukesh Ambani and Sunil Mittal and give them the job of getting India a modern, universal electric grid.  Refuse to grant them any licenses to put up a 4G wireless network and force a truce in their power struggle over this vanity issue.  They would have to come up with financing plans, aided by the Government, to get the job done.  Everything would be on the table to discuss. When the grid gets done, we can talk about 4G.

Think about how ridiculous it is to hear them talk about the need for India to have a 4G network so that a wealthy New Delhi resident can call her favorite quick service restaurant to have her order ready upon arrival.  Let's scrap all this nonsensical talk and get down to providing one of the backbones of civilized living for all Indians, namely widely available, stable electrical power. 

By the way, I would propose that Messrs. Ambani and Mittal get a completely free hand to hire whatever firms they want to get the job done.  If they need to fire Indian bureaucrats, they are able to sub-contract that job to The Donald.  Seriously, let's try to harness the abilities of our biggest, most powerful moguls to a meaningful, high private and social rate of return project. I fear that this kind of solution is the only way for an Indian government to deliver critical social needs.