Thursday, February 27, 2014

Best Buy's Q4 FY14: Many Points of Light

We go back a long way with Best Buy, recommending the stock when they were on the ropes, with Circuit City knocking at the door. Best Buy did exceptionally well, the stockholders were well rewarded, and the grim reaper eventually came for Circuit City and for many other smaller, specialty electronics retailers.

Renew Blue was a great start to digging out from under a long period of mismanagement that created the opening for Amazon and others to walk through, as electronics became like the grocery store's loss leaders.
Like a patient with heart disease, things looked fine on the surface--snappy new corporate HQ, consultants all over the place, expansion in China--while the patient was heading for the critical, life threatening event.

Like a cardiac patient, putting a stent in isn't the magic bullet by itself.  Renew Blue's first phase was like that stent.  So, in the Q4 FY14 earnings call, the CEO and CFO's commentary struck a good balance among the holiday season, the fourth quarter, and the next phases of Renew Blue.  If this program continues to be executed well, the Best Buy three or four years from now will have been almost totally transformed.  Let's hope the stock doesn't get ahead of itself in the meantime, as it's always had a habit of doing in the past.

Quarterly revenue of $14,470 million declined 3% from the prior year period. On the face of it, the same store sales decline of 1.2% was a bit better than last year's decline of 1.4% but disappointing. The non-GAAP operating margin declined 120 bp to 4.5%, off the long-term goal of 5-6%.  However, against the backdrop of  industry product cycles, competitive dynamics, and Best Buy's own internal changes, this performance seems encouraging.

CEO Hubert Joly said that the management team's focus in the quarter was on the corporation's own controllable levers, maintaining price competitiveness and on keeping the promises made to customers. There were a number of factors that put downward pressure on margins, e.g. 100 bp compression came from changes to a mobile warranty program, while another 125 basis point margin compression came as a result of investment in price competitiveness and promotions.  The press release and financial tables spell out the year-over-year non-comparable factors in detail

On an adjusted basis, the CEO characterized the domestic same store sales decline as being 0.6%, or relatively flat; the non-GAAP operating margin decline of 120 bp, abstracting from some of the tactical investments and other factors declined about 70 bp.

The CFO also noted that the company's guidance for the fiscal fourth quarter had been for a year-over-year decline in the operating margin between 175-180 bp, versus the non-GAAP reported 120 basis point decline. The CFO noted that a less promotional environment than a year ago, vendor support, and cost disciplines were better than expected going into the quarter.

Domestic online sales grew by 25.8% over the prior-year period. Although the company's website has improved dramatically over the pre-Joly version, it still could use a lot more work, and it sounds like things are going to change.

Project Athena was mentioned, which sounds like an internal database project to build customer-by-customer records including website visits and clickthroughs which, in turn, will generate customized texts and email offers based on the visitor's expressed preferences or inquiries. This won't happen overnight, but it is the way the company has to go.

The profitability of online sales today is lower than that of comparable in-store visits. Certainly looking at Amazon's financials, that would seem to be the case, but Best Buy is really changing its customer-facing presence and it will take some time.

Non-GAAP SGaA of $2.3 billion was 15.7% of sales, compared to $2.5 billion or 16.6% in the prior-year period. Domestic SGaA expense was $1.96 billion of 16% of revenue compared to $2.06 billion or 16.5% of revenue in the prior-year period.  Renew Blue's annualized run rate of expense reduction had been targeted at $725 million, and the fiscal year ended, the CEO said., at a rate of $765 million.

In the coming 24 months, the company's Renew Blue will focus on the real guts of the retailing function, namely Merchandising, Marketing, Operations, Stores, Supply Chain,General Systems and Employee Engagement.  The absolutely amazing thing is how much room for improvement there still is, with the stock already having more than doubled.  

The company's local advertising circulars are vendor-paid 1970s vintage to pick on one irritant I see every Sunday. They bear no relation to what is trending in the marketplace.  The CEO has now raised the ante on Renew Blue to run annualized savings of $1 billion!  Merchandising will be tasked with coming up with tailored assortments that matter, not what the vendors want or what the stores want to drive margin through mix. The company loses about $400 million a year from damaged merchandise: very hard to believe in a company this big with this history. 

The Employee Engagement task will not be easy, because the new model revolves around an empowered General Manager, who has variable compensation targets for individual store performance.  This model, especially given the nature of most centralized structures, is not easy to implement.  I have heard this story dozens of times, but I've only seen it done a handful of times..  The corporate functions like to think that they are the brains of the operation.  Mr. Joly's task will be to make them the servants of the stores who are the ones who can see and feel what the customers want or don't like.  

The systems and ordering tasks are onerous and detailed, but they've been done many, many times.

The overall message is that the Best Buy ship has stopped taking on water, has been righted and is once again at sea.  Cash flow from operations of $1.1 billion looks down from last year's $1.4 billion, but much of it seems like timing, apart from what looks like the closing of lots of square footage with the inventory still on hand, not being returned or sold. This number should get significantly better.

Samsung stores, which we wrote about positively at the outset, could do much better next year, as that company slowly seems to be unleashing its innovation engine in phone, phablets, and other consumer health and electronic items. Microsoft's stores too should do better.  

Management's challenge will be to manage expectations and to change around the internal teams and culture, with restructurings and new hires, to transform the company's way of dealing with vendors and customers in the new retailing structure of the future. 

Monday, February 24, 2014

Great Windows Phone: Just Don't Buy It Says NYT

The New York Times reviewed the newest Windows Phone 8 from Nokia, and the headline says "The Phone Is Great..."  This story is about the dilemmas that Microsoft is facing with the acquisition of Nokia's phone business.  The consumer loses out again: a great phone, cheaper than the usual suspects, and it does most of what people want a smartphone to do, but don't make this choice.

Friday, February 21, 2014

Europe's Foreign Ministers Get a Truce Done in Ukraine

Foreign Ministers Fabius (France), Sikorski (Poland, and Stanmeir (Germany) all played key roles in bringing about a very promising agreement for cessation of hostilities, amnesty for most protesters, and a call for early elections in 2014, along with a curtailment of Presidential powers and a freeing of opposition leader Yulia Tymoshenko.  It's hard to believe that so much seems to have been agreed upon so fast.  Kudos to the foreign ministers for breaking through official Europe's apathy and indecision in wake of what could have become a global crisis very quickly.  That could still happen, but this is great news.

Ukrainian politician Vitali Klitschko is said to have used his personal charisma in Germany as a world champion boxer to invite German Foreign Minister Stanmeir to visit Ukraine, where he got involved in brokering the truce. Bravo, Champ.

Ukraine is in no position to take upon itself the costly procedures for entering the EU, and the political costs in terms of enmity with Russian President Putin are not worth the dubious economic gains from membership.
European leaders will have to continue with their economic creativity to increase direct investment in Ukraine for logistics and transportation infrastructure products which would yield benefits for grain production and higher potential exports.

Getting to the 2014 elections with a continuing peace, with both sides subduing their extreme elements, will be the next challenge for the President, the opposition, and for all Ukrainians who want their country to prosper.

It was a little noticed fact that yesterday's Europa League play off game between Dynamo Kiev and Valencia  had to be moved to Nicosia (Cyprus) because of the violence; it was played in an empty stadium instead of DK's home stadium, just off the Maidan.  The local population could have used a respite from the months of tension and violence. Maybe that respite has begun.

Thursday, February 20, 2014

H-P Upside Surprise for 1Q FY14: Execution Issues Still Remain.

H-P surprised analysts expectations in terms of revenue and EPS, and the businesses about which analysts were concerned also did better. Revenue of $28.2 billion was down 0.7% y/y and up 0.3% on a constant currency basis; this compared with expectations of a revenue decline of around 4%.

Revenue, Earnings and Cash Flow

Consolidated GAAP operating margin of 7.1% was up 90 basis points over the prior year period; on a non-GAAP adjusted basis operating margin of 8.5% increased 60 basis points year-over-year.

GAAP diluted EPS of $0.74 per share increased 17% over the prior year period level of $0.63.  The company had bracketed its expectation between $0.60-$0.64, a flat to down quarter year-over-year.

Non-GAAP diluted EPS came in at $0.90, representing a 10% increase over the prior year quarter's level of $0.82 per share. The company's guidance had been in the range of $0.82-$0.86.

CFO was $2,990 million, compared to $2, 562 million in 1Q FY13, an increase of 17%, well ahead of all expectations. Free cash flow cited by the CFO was $2.4 billion. The company did a large, well received institutional debt offering of $2 billion in the quarter.  Return on equity was 18%.

$843 million in cash was returned to shareholders in 1Q FY14, comprising $278 million in dividends and $565 million in share repurchases at an average price of  about $28.25.  The percent of free cash flow returned in the quarter was about 35% compared to the target of 50%, which I still believe should not be a focus for management's energy or shareholder capital at these levels.

Surprises in Business Segments

The Personal Systems Group revenue grew 4% to $8.5 billion, which CEO Whitman said was its best performance in the past four quarters, possibly signaling an inflection point in the PC cycle. Analysts had forecast doom and gloom for this business, as the world would be working on tablets, according to them.

Total unit sales were up 6%, with commercial units sold increasing 8% while consumer units declined by 3%. Desktop units in total decreased 3%, while notebook units sold increased 5%.  The Windows XP changeover to Windows 8.1 was not a major factor in the segment's unit sales, according to the CEO. 

Operating margin in the Personal Systems Group was 3.3%, almost 50 basis points ahead of the prior year period. 

PSG revenue accounted for 30% of 1Q FY14 consolidated revenue and about 10% of non-GAAP operating profit. 

The Printing business of $5.8 billion declined 2% year-over-year, and about 1% in constant currency. Printing's operating margin of 16.8% was 50 basis points ahead of last year. Total hardware units sold were up 5%, with laser units sold increasing by 2%, leading to a 2% increase in market share, according to the CEO. Supplies sold decreased by 3%, while ink sales increased.  This business, which for a time was milking consumers for ink sales to maintain its profits, seems to have returned its business model to some normalcy, focusing on units in its key commercial segment.  The CEO gave a "shout out" to her new leadership group in this business. 

Printing accounted for 20% of consolidated quarterly revenue and a hardy 37% of non-GAAP consolidated operating profit.

The Enterprise Group revenue of $7.0 billion increased 1% over the prior year period.  Operating profit of $1 billion represented an operating margin rate of 14.4%, down about 100 basis points compared to the prior year period.  Now that the revenue base has stabilized, the CEO noted that the profit margins really have to increase in this business.  A lot of the margin has to do with mix of sales, she noted. If H-P can mix in more storage and networking products and services into sales, this would be accretive  to margins, whereas higher sales of Industry Standard Servers ("ISS") are dilutive to margins  ISS sales are still 46% of EG sales, and ISS sales grew 6% while storage sales were flat and networking sales were up 4%.  

Highlighting the issue of product line transitions, storage sales were flat overall, but sales of the Converge line of storage solutions increased 43% and the former 3PAR products form the backbone of the new solutions. Traditional, stand-alone storage solutions will have to be transitioned out of the portfolio.  

Two Challenging Areas

Since 2010, we have expressed our view that the Enterprise Services business doesn't really fit as a value contributor.  Representing 19% of quarterly revenue, it contributed only 2% of non-GAAP consolidated operating income. 

This business can't compete with the high end IT consulting groups, and so it cannot aspire to that industry-leading profitability. 63% of its revenue still comes from Information Technology Outsourcing ("ITO") a commodity business in its sunset years, especially for profitability. The ITO business was down 9% year-over-year.  Enterprise Services revenue of $5.6 billion declined 7% year-over-year, while producing a meager $57 million in operating profit, or a paltry 1% of revenue.

Here's what we wrote about this business after reviewing the 2013 Analyst Day presentations:
"The CEO reviewed the major businesses. Enterprise Services, a $17.5 billion business (based on nine months, YTD), accounts for 21% of the YTD revenues but only 5% of the non-GAAP operating income. Whitman cited the inconsistent leadership, strategy, lack of EDS integration, and inadequate internal systems as the biggest reasons for its historically poor performance.  This business needs some portfolio pruning, in my opinion, but the CEO said that there would be no major restructurings in fiscal 2014.  The segment's non-GAAP operating margin was said to be at the high end of the outlook given at last year's meeting, but that doesn't change the fact that this is an albatross that needs to take flight.  It clearly has the CEO's attention.
Whitman cited a pretty extensive list of new leadership within Enterprise Services, including executive promoted from within and new hires from Bain, Accenture, Microsoft, and Elastic Intelligence/BMC.  The leadership group has pretty easy comps to have a strong 2014, let's hope that they get there."
Listening to the CEO on this quarter's conference call, it sounds like the group has its sales tools, new leadership and new processes, but the kind of change from putting a bucket out and waiting for renewals to going out and proactively marketing new ideas takes time and nine months of fiscal 2014 seems like a short time.  Let's see.

 Software was the second challenging area, in our opinion, in an otherwise strong quarter that caught analysts off guard on the upside. Something appears wrong in this segment, and the measured evaluation of prospects by George Khadifa at Analysts Day may have been too optimistic. If I recall, Mr. Khadifa was to report directly to the CEO.  Software is only 3% of the first quarter's revenue and 5% of its non-GAAP operating profit. 

Quarterly revenue of $916 million was down 4% year-over-year, while operating profit of $145 million was a sub-standard 15.8% of revenue, a 50 basis point decline over the prior year period. Support revenue which is 53% of the business and an add-on to a project sale was down 2%.  Professional Services, the equivalent of a higher-end offering, declined by 12%.  This business needs more critical mass.

Closing Comments

The CEO, in response to a question, said that acquisitions were back on the radar, and certainly looking at the software business, it's not hard to see why.  Areas that would be considered are in security, big data, mobility and cloud.  Of course, some of these areas are precisely what Autonomy was supposed to provide. The target size was described as "small to medium" sized companies.  The $2 billion in debt, along with continued strong cash flows from operations, and some portfolio pruning could set the stage. 

CEO Whitman talked about increased innovation from inside H-P, and she drew attention to the wide range of new product introductions at the European client meeting in Barcelona.  This is all to the good.

The company guided to 2014 EPS in the range of $3.50-$3.79, on a non-GAAP basis.  This seems like this would support a price from $30-35 a share, absent any collapse in corporate technology implementations for which there seems to be a growing appetite. 

Nelson Peltz: No Fritos with My Pepsi.

Trian Fund Management, LP wrote a letter to Pepsi's board saying that as an owner of $1.2 billion in PEP shares and with experience in the food business, Pepsi should spin off its snack business to shareholders and leave the beverage business as a stand-alone company.

Trian spins its arguments specifically for the seven year period of current CEO Indra Nooyi's tenure, and this seems to coincide with the data points about Pepsi's under performance. Here are the really salient points in their argument:
"As a distant number two competitor in beverages, PepsiCo never had the luxury of following the same strategies as those deployed by industry leader Coke. But PepsiCo nevertheless competed extremely effectively The company did so, from its earliest days through the 1990s, and was known for being faster on its feet, quicker to introduce new products, more willing to take risks and more willing to occasionally fail by doing so. Pepsi not only survived in this role of “industry disruptor,” it thrived. 
Meanwhile, Frito-Lay was known historically for having one of the best corporate cultures in America. Its culture was separate and distinct from Pepsi, which made sense given different category and competitive dynamics – snacks versus beverages, push versus pull marketing, Frito-Lay as #1 in an industry with regional competitors versus Pepsi as #2 in an industry with one large competitor. Frito-Lay’s strong culture, combined with a dominant market share in an attractive category, created a force to be reckoned with in the food industry.
         On the corporate front, PepsiCo was known for running with low overheads, even after the company            moved to Purchase in 1970."

All of these points are on the money.  Pepsi has become the Microsoft of its snack foods and beverages business: a duopolist in colas and dominant in snack foods, but unable to innovate and  really leverage its assets into earnings growth.  Agility, culture and costs should be the bread and butter charters of the board and management and clearly these have to be addressed.

But, to go from here to a spinoff seems to hang on some pretty weak arguments, such as "We've seen Kraft and others do this, so ipso facto, it must be the best thing to do right away."  The board should address how costs are going to be cut visibly and faster, and the right people should be put into the right slots to make the businesses perform better with the assets they have.  Innovation is not as easy, but it's not rocket science either, because this isn't drug discovery, after all.

In recent quarters, Pepsi appears to have actually pulled a few earnings surprises.  It has also given its longer-term projections as being a low single digit revenue growth business with mid to high single-digit revenue growth, with cash flows for dividend growth. This is about all this business can be in the medium term.

Distribution channels in the food business are everything. Frito Lay was the best in breed, and I presume that it still is, abstracting from any overhead allocation issues. Pepsi owns 11 out of the top 15 snack food brands direct delivered to retail, and Fritos are at the top.  Buying its bottlers has been criticized, with Trian quoting the CEO as admitting it was a "mistake."  The argument for doing so was, in addition to competing better with Coke, to give the company flexibility in pushing new and niche volume products through the distribution chain as sugared colas are clearly a declining unit volume business. Independent bottlers wouldn't want to take on a line of new organic juices instead of the larger volume carbonated drinks, the argument would go,

The answers to these questions are nowhere near as clear as Trian's letter makes out. In the emerging markets, much is made of losing share in India: that has more to do with the dynamics of Indian distribution than it does with Pepsi's execution.  Pepsi, unlike Coke, is said to be gaining share in China.

Should Pepsi become leaner, more agile and more efficient?  Absolutely, no doubt, and in a hurry.  Is the holding company structure the best for Pepsi?  It should be, but it isn't because of the above failures of management. Is a structure of two independent companies the best?  Unclear.

I'll take that Diet Pepsi now, please.

Wednesday, February 19, 2014

More Thoughts on Windows Phone 8

For all our fuming about Windows Phone 8, it's important I remind readers what could be different this time around.

  • The New CEO
Taking Satya Nadella's own words about the future being in software, mobile, and the cloud, then he surely isn't going to accept the dysfunctional culture he inherits from former CEO Steve Ballmer. He had said, it's "renew or die." That's where Microsoft is in mobile and tablets. But, in the words of Lawrence of Arabia, "Nothing is written."

  • Stephen Elop
Reportedly returning to Microsoft to run a portfolio which includes Surface, Windows Phone and Xbox, this would be another smart move. He knows both Nokia and Microsoft. It would also free up the CEO to focus on bigger issues, once he has rounded up his senior executive team.  Mr. Elop, like the Microsoft CEO, realizes the amount of value waiting to be created from a transformation of the lumbering Microsoft.

Here what Nokia says about its cultural aspirations:
Make it great for the customerEveryone in Nokia has a role to play in making it great for our customers. This involves listening and understanding before making the decisions that will provide a great customer experience. It’s about taking accountability, and holding others accountable, for keeping commitments and getting things done on time.Challenge and innovateChallenging the status quo is a prerequisite for change and innovation. Innovation is the lifeblood of our future success and the cornerstone of our product making. This is about not accepting “what is”, but being curious and striving for “what could be”.Achieve togetherResults matter, and we achieve more when we work together. This is about everyone at Nokia taking responsibility for achieving and collaborating across organizational or geographic boundaries to win. It’s about having a diverse and inclusive environment that promotes individual expression.Act with empathy and integrityEmpathy and integrity are our guides for dealing with our customers and each other. It’s about us being honest, transparent and doing the right thing. We inspire trust by speaking frankly and having the courage to call things out on what matters.
 Consumers need more competition, innovation, and value in mobile: if Microsoft can help bring this about, value creation will follow as surely as day follows night.

Tuesday, February 18, 2014

Besides Its Checkbook, Russia May Not Have a Winning Plan forUkraine

A few weeks ago, Ukraine showed  signs of a thaw in tensions, as Orthodox priests kept apart protesters and armed riot police.  Concessions were made to some arrested protesters. Anger had seemingly been dissipated, but now the trends suddenly seem to have reversed themselves.

As deft as Russian President Putin seems to have been in derailing the European Union project, the current tactics will serve only to harden world opinion and to ultimately cripple the economy in Ukraine.  When the 'aid' bill comes due, Russia may find its client unable to pay.

As the Financial Times points out, popular sentiment in Russia sees Ukraine as having deep ties to Russia, and they don't regard it as a former Soviet republic that should be independent.  President Putin is reported to have made this remarkable public statement,
"Mr Putin invoked the “unity” of the Russian and Ukrainian people and said that, as joint spiritual heirs of the baptism, “in this sense we are, without doubt, one people”."
I suspect that for most citizens of Ukraine, the feeling may not be mutual.

At this point, there will be all kinds of manipulation and propaganda put out to western audiences who are viewing developments in Kiev with dismay.  These protesters suddenly seem to be a much more violent crowd than had occupied the square for weeks.  Might some of the more violent tactics be from paid agitators?  The inability of western leaders like German Chancellor Merkel to even get President Yanukovich on the phone seems like he has become a paid puppet.  Again, it was only a few weeks ago that he was said to have listened to suggestions about widening the representation in his government. No more.

If the citizens of Russia and Ukraine are, in the words of President Putin, "one people," then subjecting ordinary citizens of Ukraine to violence, public humiliation, with wanton disregard for its sovereignty is not a winning strategy that Europe and the rest of the world should sit idly by and accept.

Monday, February 17, 2014

What Has Microsoft Bought With Nokia?

New Microsoft CEO Satya Nadella has told his employees that the future will be in software, mobile and the cloud. With the Nokia acquisition on track to close at the end of March, it just seems less and less clear how Microsoft's mobile future will be helped by the acquisition of Nokia's device business, to the tune of $7.2 billion.

I've been doing a lot of reading on choice, starting with classics like Kahneman and Tversky to a Barry Schwartz's "The Paradox of Choice." (the link is to his TED talk, not to his book).  Nowhere does consumer sovereignty weigh more heavily on our choices than it does in personal technology, like smart phones.

Schwartz writes, "But as the number of choices keeps growing, negative aspects of having a multitude of options begin to appear. As the number of choice grow further, the negatives escalate until we become overloaded.  At this point, choice no longer liberates, but debilitates.  It might even be said to tyrannize."

We are there in the world of smart phones.  I've listened in on many interactions between retail customers and store associates as the consumer, with their kid in tow, asks "I want to buy Jane the best smart phone. You know, for school and because she'll definitely need one in college.  Can you help me?"  I've also read, viewed, and heard many of today's tech gurus for CNet, the Wall Street Journal, Money, PC Magazine, and Consumer Reports all hold forth on how to make this decision.

Out of all this confusion, it is very hard to see how Microsoft can be saved from once again being late to the party, for having launched Windows Phone 7 with a thud before eventually designing a decent product around Windows Phone 8, and then for launching Nokia Windows 8 phone but failing to leave the atmosphere.

Here on Presidents Day with the big sales, I find the Nokia Lumia 520 and 521 unlocked for $69 and $59 respectively. These are on the Microsoft Store. These are about the cheapest smart phones a bargain hunter can buy.  They get decent reviews from those kinds of consumers who also acknowledge the limitations, particularly the small Microsoft Apps store.  But now, who would buy one with the clear risk that they could soon be orphaned by possibly abandoning the Lumia line and design.  (Leave aside the issue of abandoning Windows Phone 8, which would be too risky because it would end the "one experience across all devices" mantra.)  The higher end Lumia phones get good reviews for the cameras, but they don't really shine in other areas, and their battery lives are less than the bargain basement phones.

For Google to exit making devices showed, in my opinion, a lack of courage, but it was cynically pragmatic given Google's goal to bring tens of millions of new people peering into their devices and seeing Google Search and other services. Let others mess around losing money making devices.

Microsoft too, under Steve Ballmer, has said "it's all about services," but the current Nokia platform is poorly positioned to garner anything more than the current 2-3% of all handset sales.  At this level, it's not worth developers' time to build apps for Windows Phone 8 and so how does the store grow?  More time will be lost.  In the meantime, consumers are faced with replacing or adding smart phones to their family plans. What to do?

The Wire Cutter, a highly regarded tech consumer products site, rates the Apple iPhone as their Favorite Smart Phone, with Motorola's Moto X as the best Android Phone. But now, with the sale of Motorola Mobility to Lenovo, consumers who opt for Moto X may, like Lumia buyers, see their phones marginalized or quickly obsoleted.  Now Moto X owners will no longer be assured automatic updates to the latest version of Android, and they may now get versions with Lenovo's front end piled on top which may diminish the user experience that the Wire Cutter likes.  Do you think the carriers might consider returns or clearing out the Moto line's early products?

The consumer decision paradigm for an Android phone is way too complicated, and the risks of dissatisfaction are high: none of these states are where consumers like to find themselves after spending $400-500+ for a cell phone, call it what you will.

When the Nokia deal goes through I will be curious to read the level of charges taken for workforce reductions in Finland and for the allocation of the purchase price to intangibles and to goodwill.  That will tell a lot about this story will work, or not, in the future.

Thursday, February 13, 2014

Cisco's Fiscal Second Quarter 2014: Nothing New From the First

After looking back at our lengthy post on 1Q FY14, Cisco's recent announcement of 2Q FY14 results didn't seem surprising. The bottom line is that analysts rate a fair value of $20 for the stock based on about $2.00 in EPS and a P/E about 70% lower than that of a competitor like Juniper Networks.  Again, I get concerned when stocks are priced for perfection, but when they're priced like a "going out of business" sale that's the time to look closely at the risk/reward ratio.

Quarter two's revenues of $11.2 billion were 8% below the prior year, which is at the low end of the projected range of an 8-11% decline.  Non-GAAP net of $2.5 billion was down 7%,  and adjusted EPS of $0.47 compared to $0.51, including a substantial charge for defective component chips from a trusted vendor.

The gross margin pressure which everyone is looking for continues apace. The product gross margin of 59% is, as one analyst pointed out, the lowest rate in ten years. The consolidated GAAP gross margin rate was 53%, but 61% on a non-GAAP basis. Again, not nice to look at, but this is a common phenomena among all the tech giants, save for Apple and Google, whose models are quite different.

For example, Cisco has decided to get out of the low margin set top business, while today's papers have stories about Apple reportedly getting ready to launch a set top business.  Inconsistent?  Different business models.  For Apple, it has yet to launch a product for which its customers aren't willing to pay a premium price, and so given their proprietary, closed iOS and their approach to content, this could be a nice niche for them.  Or, it could be their first stumble: I surely don't know.  For Cisco, with its goal to be the leading provider of infrastructure and management across the Internet and its plumbing, it makes perfect sense to get out of the box business.

Free cash flow of $2.3 billion was 6% ahead of the prior-year period. $4.9 billion was returned to shareholders, comprised of $4 billion in share buybacks and $900 million in dividends.  This was a record. The quarterly dividend was raised from $0.17 per share to $0.19.  Shareholders are getting paid for waiting.

Meanwhile their list of acquisitions and continuing integration of prior acquisitions continues.  If they are overpaying, it isn't hurting the balance sheet.  Emerging markets are a weakness.  They are in total chaos for all vendors in many product lines.  Is this a big deal now?

Cisco still has one of the strongest sales forces in the industry.  If they didn't, how did they get to this point?  To grow and retain this force, they have to execute a strong new product portfolio refresh, and this is where they should be putting money and management time. Share buybacks above $20?  Back off the accelerator unless the stock craters, which doesn't look like it's in the cards.

Cisco, IBM, HP and Microsoft.  There's value in there somewhere.

Friday, February 7, 2014

H-P's Approach to Executive Comp Is a Lot Better Than JP Morgan's Handwaving

We posted recently about the formulaic and uninformative discussion of JP Morgan Chase's executive compensation philosophy and metrics that might justify a $20 million compensation award to CEO Jamie Dimon. 

Today, in HP's proxy we see the kind of approach that is both mandated by SEC guidelines and which gives a shareholder an insight into how the board looks at the task of setting executive compensation.  Their approach stands in stark contrast to that of JP Morgan Chase's board. 

Having sat on both sides of the board table for public company executive compensation discussions, I can tell you that cannot be solely a highly quantitative, black box process, no matter what the consultants say. There is quite a bit of luck in how equity-based compensation can work out. (see Rakesh Khurana's writings on this issue) It is not the magic bullet, but it is an important part of the compensation tool kit. 

There is no perfect structure that can apply to all companies.  That is why the issue of setting out the philosophy and choice of metrics is important.  Shareholders deserve to know, and management needs to understand, how targets are being set and how they are designed to align with shareholder interests.

HP states that their Human Resources Committee, which met eight times during the past fiscal year, reviews their process and structure annually.  Like management, boards can always get better. 

Their institutional audience of 5% owners has remained unchanged from the prior year: Dodge & Cox own 8.1% of the equity, BlackRock own 6.1%, and on behalf of mutual fund owners State Street holds 5.5%. 

Whereas JPM's board uses the boiler plate term "alignment," the HP board shows how they interpret and implement the concept both in executive compensation and in corporate governance.  I think a diligent analyst or shareholder familiar the company's history can glean a lot from this presentation. 



Corporate Governance
The majority of target total direct compensation for executives is performance-based as well as equity-based
We generally do not enter into individual executive compensation agreements
Total direct compensation is targeted at the median of our market
We devote significant time to management succession planning and leadership development efforts
Actual total direct compensation and pay positioning is designed to fluctuate with and be commensurate with actual performance
We maintain a market-aligned severance policy for executives that does not have automatic single-trigger equity vesting upon a change in control
Incentive awards are heavily dependent upon our performance against objective financial metrics which we believe link either directly or indirectly to the creation of value for our stockholders. In addition, 25% of our target annual bonus is contingent upon the achievement of qualitative objectives that we believe will contribute to our long-term success
The HRC Committee utilizes an independent compensation consultant
We balance growth and return objectives, top and bottom line objectives, and short- and long-term objectives to reward for overall performance that does not over-emphasize a singular focus
Our compensation programs do not encourage imprudent risk-taking
A significant portion of our long-term incentives are delivered in the form of performance-contingent stock options ("PCSOs"), which vest only if sustained stock price appreciation is achieved
We disclose our performance goals and achievements relative to these goals
We provide no special or supplemental pension benefits
We conduct a robust stockholder outreach program throughout the year

Instead of talking about reasonable compensation, HP's board talks about targeting direct compensation at the median of its market, or peer group.  The interesting thing is the choice of peer group, which is effectively very close to the top ten or twenty stocks owned by institutional investors who might look to own HP. At least, this is how I interpret the table.  In addition to Microsoft, Cisco, Google and other technology bellwethers, the peer group also includes Pepsi and Johnson & Johnson two high quality growth stocks which often appear in their 5% owners' portfolios.  As a whole, the peer group companies are subject to economic forces, market forces and technology cycles which should make the median comp metric an appropriate measure. 

In fiscal 2013, 75% of the incentive comp targets were made up of quantitative metrics: revenue (25%), corporate net earnings (non-GAAP) also 25%, and corporate FCF as a percent of revenue at 25%. The other 25% were composed of qualitative factors. 

Management delivered revenue of $112.3 billion, short of the target $117.9 billion, attaining a 19.6% incentive payout versus the target 25% available. The actual payout on corporate net earnings fell 5 percentage points short of target, whereas FCF as a percent of revenue was 8.1% versus a target of 6.3%, and the outperfomance on the latter metric, along with some consideration of the total stockholder return of 81 percent put the overall achievement for the quantitative metrics at 2 percentage points above target.

Our objective is not to provide a complete review of this document, but to show that there is plenty of meat for an interested party to consider in their decision whether to own, hold, or sell HP shares.The document gives a clear picture of management's performance and a window into how the board looks at that performance and pays for it. 

By contrast, JPM's discussion of executive compensation reflects poorly on their board and on their governance.  

Thursday, February 6, 2014

Sony Bows Out of PCs

I've always admired Sony Corporation, from that day in eighth grade when my parents gifted me an AM pocket radio which was one-third the size of the better known radios from Zenith. It was a beautiful object with good sound for a great price, and I still have it, but alas no one makes the transistor which has burned out. In those days, nobody bought Japanese products because they were "cheap" and lacked our technology. Well, my radio was way ahead of its time, and Sony shook up our industrial smugness.

From there, I always admired the iconic CEO Akio Morita whose introduction of the Sony Walkman changed the way people interacted with their music.  Innovation and great design were hallmarks of the Sony brand.  I've had two of their Trinitron color televisions, each for about twenty years: the best color tube around, and they both still work.

So, it's a sad day today to learn that the new CEO, charged with rescuing Sony from its serial reorganizations and shuffling its business portfolio, announced a one billion yen loss and another restructuring which involves the sale of the Vaio computer business to a Japanese private equity group.  This line was innovative, well designed and always got high ratings from tech magazine reviewers.  Sales and market share never followed those great technical reviews.

So, yet another giant bows out of making machines which were commoditized and may be on their way to becoming dinosaurs.

Samsung, as I look at the Galaxy phone and their smart televisions, reminds me of today's Sony.  The fate of today's Sony though may be in doubt.

Banks and Regulators Break Faith With Consumers

Bank managements have put their institutions down a path away from their traditional mission, namely to take in deposits and, acting as intermediaries, to transform this base into consumer and commercial loans, using a modest amount of leverage. Financial intermediation and maturity transformation were the bread and butter of the banking model.

Having sat at the side of a respected banking analyst for many years, I was troubled by the increasing number of bank CEOs who trumpeted the growing importance of fee income, as opposed to net interest income, in their revenue lines.  Next, came the move to get into all sorts of other businesses, like asset management, mortgage lending, investment banking, trading, and unsecured lending, or credit cards. Consolidation, driven by changes in banking laws, was the next step.

Soon, consumers were faced with fewer choices for their banking needs.  Finally, the current financial crisis made the U.S. consumer banking  highly concentrated.  The top ten banks hold about a 50% share of deposits, according to the FDIC. The extensive network of community banks, your friendly neighborhood banker like Jimmy Stewart, can't really compete with their 20-30 bp cost of funding disadvantage compared to the larger banks.

After the latest financial crisis, with the advent of regulatory schemes advocating for bigger layers of equity and higher capital reserves, regulators are making the traditional bank model even more unattractive than ever.

The upshot of all this?  According to the WSJ, 80% of  U.S. financial institutions offered free checking accounts as recently as 2008, but the number is down to 59% now.  What this number doesn't highlight is that the biggest banks have abandoned this model almost completely, even for their better customers as everyone migrates into an asset gathering model, as opposed to a banking services model.

Credit unions and community banks which should really be havens for new immigrants to begin building their financial relationships are increasingly marginalized, and so piranhas like the pay day lenders and all other forms of predatory financing are flourishing among a vulnerable population.

All these regulators looking backward at yesterday's problems have created incentives for rational bank CEOs to walk away from their primary mission as bank charter holders, viz. to serve consumers and small business customers with affordable, high quality financial services while earning attractive, but not outlandish, returns on equity.

Wednesday, February 5, 2014

Jamie Dimon's Pay Raise: It's About Principles Not Personalities

When a company like JP Morgan Chase raises their CEO's 2013 pay to $20 million, a 74% increase, the public markets should try to process this information to see what it really means. Unfortunately, with Jamie Dimon the discussion is always about personalities and not about fundamentals.

Back when there was talk about splitting the roles of CEO and board Chair, his buddies from Greenwich weighed in.  Why should their opinions matter in a public forum, rather than over a beer? With the latest news, Warren Buffett opined that $20 million was a "bargain."  It might be, but again, with all due respect, shareholders and the capital markets need and deserve more.

When the SEC greatly expanded the required disclosures about Executive Compensation in corporate proxies, it was done to at least provide some insight from the board on how they, as stewards of stakeholder interests, approached issues of compensation.  This is where an analyst or shareholder should look for answers about the $20 million and not to the interesting, but off point opinions of pals and pundits.

Ben Heineman, Jr. of the Harvard Law School's corporate governance project has written the most reasoned introduction to this issue.  After reading his piece, we went back to the original document, namely the proxy: it doesn't give a shareholder any comfort.

Here's what a reader finds about principles for governance and compensation:

  • Maintaining strong governance: Independent Board oversight of the Firm’s compensation principles and practices and their implementation
  • Attracting and retaining top talent: a recognition that competitive and reasonable compensation helps attract and retain the high quality people necessary to grow and sustain our businesses
  • Tying compensation to performance: A focus on the qualitative as well as the quantitative performance of the individual employee, the relevant line of business or function and the Firm as a whole.
  • A focus on multi-year, long-term, risk-adjusted performance and rewarding behavior that generates sustained value for the Firm through business cycles.
  • Performance assessments that are broad-based and balanced, including an emphasis on teamwork and a “shared success” culture
  • Aligning with shareholder interests: a significant stock component (with deferred vesting) for shareholder alignment and retention of top talent
  • Very strict limits or prohibitions on executive perquisites, special executive retirement severance plans, and no golden parachutes
  • Integrating risk and compensation input into compensation determination.
It's hard to disagree, because much of this is the same boilerplate that was produced by most companies before the change in requited disclosure.  What is "competitive and reasonable" compensation? Is $20 million such a number?  "Competitive" is still beset with the same peer group, compensation consultant problems which have always existed.

"A significant stock component with deferred vesting" certainly works on the upside, especially when the big grant is given post-trough with $20 billion in various case settlements having already been agreed.  

To one of Heineman's key points: there is one reference to corporate culture, that of "shared success." What does that mean?  Is that a sufficient description of what kind of corporate culture is required to assure meaningful, risk-adjusted success apart from cycles in the financial sector? 
The author writes,

"The case against the raise begins and ends with JPM’s corporate culture, for which Dimon also bears ultimate responsibility. The broad array of issues for which JPM has paid settlements totaling billions all took place on Dimon’s watch. Except for the inherited Washington Mutual and Bear Stearns bad practices, they all involved JPM employees. They involved core bad behavior: collusion, inadequate disclosure, money laundering, abusive behavior towards debtors, indifference to red flags of massive fraud. They arose in different parts of the bank, not just one dysfunctional unit. They substantially impacted profitability. They have seriously corroded the bank’s reputation with regulators, a number of investors, and the public. JP Morgan’s own report on the matters surrounding the London Whale indicates broad failings. Dimon himself, after virtually all the problems had surfaced, admitted that under his leadership the bank had failed to pay enough attention to controllership issues, and had failed to create an appropriate culture of integrity, compliance and risk management."
We wrote in a prior quarter about the strength of the JPM's last quarter and the platform it provides for future growth.  We also have to admire the CEO's rough hewn New Yorker's approach to evergreen questions like share buybacks. But, the board of JP Morgan Chase--which is not of the quality that a global financial powerhouse deserves--failed to give shareholders a window into their thinking about the $20 million which was based on their fundamental views about economic, management, and ethical principles which underpin the corporate culture that governs the firm they oversee on behalf of stakeholders.

Tuesday, February 4, 2014

Satya Nadella's Letter to MSFT Employees (Times of India)

The Times of India posted this letter from Microsoft CEO Satya Nadella to all Microsoft employees. It makes good reading,

"Today is a very humbling day for me. It reminds me of my very first day at Microsoft, 22 years ago. Like you, I had a choice about where to come to work. I came here because I believedMicrosoft was the best company in the world. I saw then how clearly we empower people to do magical things with our creations and ultimately make the world a better place. I knew there was no better company to join if I wanted to make a difference. This is the very same inspiration that continues to drive me today.

It is an incredible honor for me to lead and serve this great company of ours. Steve and Bill have taken it from an idea to one of the greatest and most universally admired companies in the world. I've been fortunate to work closely with both Bill and Steve in my different roles at Microsoft, and as I step in as CEO, I've asked Bill to devote additional time to the company, focused on technology and products. I'm also looking forward to working with John Thompson as our new Chairman of the Board.

While we have seen great success, we are hungry to do more. Our industry does not respect tradition — it only respects innovation. This is a critical time for the industry and for Microsoft. Make no mistake, we are headed for greater places — as technology evolves and we evolve with and ahead of it. Our job is to ensure that Microsoft thrives in a mobile and cloud-first world.

As we start a new phase of our journey together, I wanted to share some background on myself and what inspires and motivates me.

Who am I?

I am 46. I've been married for 22 years and we have 3 kids. And like anyone else, a lot of what I do and how I think has been shaped by my family and my overall life experiences. Many who know me say I am also defined by my curiosity and thirst for learning. I buy more books than I can finish. I sign up for more online courses than I can complete. I fundamentally believe that if you are not learning new things, you stop doing great and useful things. So family, curiosity and hunger for knowledge all define me.

Why am I here?

I am here for the same reason I think most people join Microsoft — to change the world through technology that empowers people to do amazing things. I know it can sound hyperbolic — and yet it's true. We have done it, we're doing it today, and we are the team that will do it again.

I believe over the next decade computing will become even more ubiquitous and intelligence will become ambient. The coevolution of software and new hardware form factors will intermediate and digitize — many of the things we do and experience in business, life and our world. This will be made possible by an ever-growing network of connected devices, incredible computing capacity from the cloud, insights from big data, and intelligence from machine learning.

This is a software-powered world.

It will better connect us to our friends and families and help us see, express, and share our world in ways never before possible. It will enable businesses to engage customers in more meaningful ways.

I am here because we have unparalleled capability to make an impact.

Why are we here?

In our early history, our mission was about the PC on every desk and home, a goal we have mostly achieved in the developed world. Today we're focused on a broader range of devices. While the deal is not yet complete, we will welcome to our family Nokia devices and services and the new mobile capabilities they bring us.

As we look forward, we must zero in on what Microsoft can uniquely contribute to the world. The opportunity ahead will require us to reimagine a lot of what we have done in the past for a mobile and cloud-first world, and do new things.

We are the only ones who can harness the power of software and deliver it through devices and services that truly empower every individual and every organization. We are the only company with history and continued focus in building platforms and ecosystems that create broad opportunity.

Qi Lu captured it well in a recent meeting when he said that Microsoft uniquely empowers people to "do more." This doesn't mean that we need to do more things, but that the work we do empowers the world to do more of what they care about — get stuff done, have fun, communicate and accomplish great things. This is the core of who we are, and driving this core value in all that we do — be it the cloud or device experiences — is why we are here.

What do we do next?

To paraphrase a quote from Oscar Wilde — we need to believe in the impossible and remove the improbable.

This starts with clarity of purpose and sense of mission that will lead us to imagine the impossible and deliver it. We need to prioritize innovation that is centered on our core value of empowering users and organizations to "do more." We have picked a set of high-value activities as part of our One Microsoft strategy. And with every service and device launch going forward we need to bring more innovation to bear around these scenarios.

Next, every one of us needs to do our best work, lead and help drive cultural change. We sometimes underestimate what we each can do to make things happen and overestimate what others need to do to move us forward. We must change this.

Finally, I truly believe that each of us must find meaning in our work. The best work happens when you know that it's not just work, but something that will improve other people's lives. This is the opportunity that drives each of us at this company.

Many companies aspire to change the world. But very few have all the elements required: talent, resources, and perseverance. Microsoft has proven that it has all three in abundance. And as the new CEO, I can't ask for a better foundation.

Let's build on this foundation together.


Reported by the Times of India.

Monday, February 3, 2014

Samsung's Mobile Ambitions Getting Squeezed

We posted last week about pressures on Samsung from Google's sale of Motorola Mobility.  Today, the Wall Street Journal carries a story about wireless carrier resistance to rollout of Samsung's proprietary mobile OS called Tizen

Again, consumers will wind up paying in terms of price and competitive phone products for all the strategic chess games among Google, Apple, and Microsoft.

Saturday, February 1, 2014

Satya Nadella: The Best of All Possible Directions for the new CEO of Microsoft

If the Wall Street Journal is right, then the agreement being hammered out this weekend for Microsoft executive Satya Nadella to take over the reins of Microsoft as CEO means that the company is making the best possible decision for succession, changing the internal culture and for its strategic direction.

This is quite a different position from the comments in the finance and tech press that this would be a 'safe decision.'  I'd take the polar opposite position.  The choice of a superstar CEO from the automobile or aviation industry would, in many ways, have been the "safe" decision.  The cult of the superstar CEO is alive and well in corporate America.  The buy and sell sides of Wall Street would have applauded a bold choice, like looking beyond technology, and at the same time they would be forced to hold off judgment until the new CEO learned more about the business and about Microsoft. Valuable time would have been wasted. The new CEO would be beset by the culture, as the heads of fiefdoms nipped at his heels trying to protect their empires, while undermining the CEOs effectiveness. If, at the end of the day, the superstar failed, a big severance would have been payed and Microsoft would have little credibility with investors or customers. Microsoft would then be in real danger of becoming irrelevant.

Instead, there's no question that Mr. Nadella not only knows technology, but he understands software for the powerful SQL server business, and he understands search from working with Bing.  He also, according to the Journal, had to apologize to an international customer for business losses arising from an outage of the cloud-based Azure service.

Two things about that last point.  Mr. Nadella has been on the line with a customer taking the heat for the failure of a product. Software glitches and loss of service are routine. Mr. Nadella understood the importance of an outage to a smaller customer.  His choice of personal accountability to a customer is something that has not a hallmark of Microsoft's customer relations, especially on the Windows side.  Don't think that the internal development and sales teams didn't notice what Mr. Nadella did either. All of this is a big deal for the future.

Also, don't underestimate the impact on international markets and on Microsoft's sprawling operations in countries like India.  A Redmond-centric culture may finally start to understand what it means to be a truly successful global technology leader, and that belief will be made manifest in its new CEO.

From his position within the company, it will be much more difficult for intransigent insiders to dig in their heels to cultural changes. Here again, the story talks about an executive whose personality is the antithesis of his predecessor; it also talks about people coming out of conversations feeling better than they went in. Again, things like this are a big deal.

When Mr. Ballmer launched Bing! it was a venture widely criticized by Wall Street, which said it should be shuttered. Mr. Nadella was part of the leadership team that made this venture, which we've supported in this blog, a necessary and successful part of Microsoft's technology portfolio.  Mr. Nadella's relationship with Mr. Ballmer provides a good foundation for the future.

Finally, whether or not this is speculation, the notion of founder Bill Gates taking the time and specific interest to mentor the new CEO, while relinquishing his board chair for another acceptable role would be another inspired decision for the future.

Ray Ozzie wrote, "Those who can envision a plausible future that’s brighter than today will earn the opportunity to lead." I expect that Mr. Nadella has earned this opportunity, and he would be leading with a lot of help from inside Microsoft. 

There's reason to put Microsoft back on the radar screen again, after this announcement has been made.