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.