MSFT Lowers Expectations and Declares Victory

Microsoft's PR flaks must be encouraging the CEO to get in the news more, and he has been placed in two recent, high visibility stories.  In one, there is a rambling, philosophical interview about long-time insider, CEO Satya Nadella being, in fact, an "outsider" at Microsoft.  There seems to be little evidence so far that (a) this is true, or (b) that it would be making a difference to making this behemoth more nimble, responsive to consumers, and consistently innovative.

In 2014, we wrote,

"The Nokia acquisition could easily become this company's Waterloo.  Value creation at Microsoft won't happen with the Ballmer-created organizational rabbit warren, bloated cost structure, and dysfunctional culture that we've written about in our most widely read posts."

Well, Steve Ballmer has gone to play with new toys, including basketballs.  Microsoft wrote off 80% of the the value of the Nokia acquisition, according to the WSJ; this was inevitable, as we wrote when the Windows Phone forecast of 15% market share was first given.

Now, CEO Satya Nadella has pared back the plans for new Windows Phone launches to what looks like a very singular offering for corporate users.  So that leaves me, an early adopter, and a somewhat satisfied user of the first Nokia Cyan an orphan.  Typical Microsoft.

My first experience with Windows 10, which was okayed for my aging but perfectly functioning Windows 7 laptop, was tremendously dissatisfying. Windows 10 comes with bloated, self-serving products like Microsoft Edge, and it doesn't seem to work well with the free version of Outlook Live. My local copy of Outlook from Office 2013 froze up, crashed, and lost many of my contacts.

Of course, the Waterloo analogy is a bit overwrought, as this company can financially slough off this economic fiasco.  However, this company badly needs a cultural evangelists inside the company that can speak for the consumers, not the corporations.  Inside Apple, that person happened to be Steve Jobs at the top, and throughout the organization it was populated with people obsessed with the user experience and feedback.

Windows is really betting the farm on Windows 10, and Waterloo may be down the road apiece unless things really change.  I hope that the CEO gets a machete and hacks away at the culture inside Microsoft that could have allowed the Windows Phone to be relegated to a meaningless share of the mobile phone market.

A Shrinking U.S. Equity Market?

$173 trillion in investable assets in all forms of retirement funds.  Thousands of mutual funds in the U.S., more worldwide, looking for equity investments, as advisers continue to trumpet the need to own high equity allocations in order to participate in global economic growth, particularly outside of the developed markets.

Of course, developed economies, particularly the U.S., will continue to grow too, despite current doom and gloom.

Right now, governance lawyers trumpet the need for shareholder activism by all institutional investors.

Investors want mature companies to retire their outstanding share bases in order to artificially pump up share prices, never mind the longer term growth prospects for the ongoing company.

Private equity sponsors are awash in dollars, and everyone is seeking higher returns after years of central bank-enabled lower rates around the world.  They look to take out mature firms which they judge to be under performing.

What happens when you look into the stew pot after throwing in all these ingredients?  It may be "Honey, I Shrunk The Investable Equity Market!"  There may not be enough listed, liquid, institutional quality U.S. equities to satisfy the appetites for them!

It's something we've long suspected could happen, and now a National Bureau of Economic Research Working Paper 21181 (May 2015) by Dodge, Karolyi, and Stulz says that we may arrived in such an undesirable situation already.  A copy of the paper just landed on my desk, but interested readers with AEA or other professional memberships can access a copy through NBER.

The abstract has the punchline, and since this is publicly available, I reproduce it:

"The U.S. had 14% fewer exchange-listed firms in 2012 than in 1975. Relative to other countries, the U.S. now has abnormally few listed firms given its level of development and the quality of its institutions. We call this the “U.S. listing gap” and investigate possible explanations for it. We rule out industry changes, changes in listing requirements, and the reforms of the early 2000s as explanations for the gap. We show that the probability that a firm is listed has fallen since the listing peak in 1996 for all firm size categories though more so for smaller firms. From 1997 to the end of our sample period in 2012, the new list rate is low and the delist rate is high compared to U.S. history and to other countries. High delists account for roughly 46% of the listing gap and low new lists for 54%. The high delist rate is explained by an unusually high rate of acquisitions of publicly-listed firms compared to previous U.S. history and to other countries."

If their analysis is correct, the real situation may be worse than it seems. Delists account for 46% of the listing gap, according to the authors. But, the delisting gap should be higher than it is.  There are so many microcap companies that trade below $5, and more below $10 a share that really have no business continuing to be public.  I've long felt that boards should work to perhaps consolidate some of these companies, to create a portfolio of products and revenue that might be attractive to institutional investors.  Institutionally, this isn't possible because companies don't want to throw in the towel and merge with another weak sister.  Most large mutual funds are not permitted to invest in companies like these anyway, since they are extremely illiquid and not followed by Wall Street.

Furthermore, what's coming down the pike in terms of future IPOs?  Let's look at Google, for example.  Everyone is making money on the shares which almost singlehandedly, along with Amazon and other uber-caps, are driving the indexes.  So, no one complains.

Since shareholders can't exercise their rights in Google because of the multiple share classes, they are not owners in the traditional sense.  Activism here has no meaning. The new tech companies have little need for massive capital investments, aside from those arising from pie-in-the-sky projects like driverless cars.  As such they should be poster children for returning cash to shareholders, but au contraire, they have little appetite for doing so.

None of this is lost on the investors and managements of Uber, Alibaba, and all the other supergiant companies that have to eventually become IPOs.  Investors can't continually raise the arbitrary valuations of these companies, and continue to pour in cash when it is becoming apparent that cash balances alone won't capture the growth they require for their current valuations.  Witness Uber and its battle with its Chinese nemesis.  So, if the next wave of IPOs is dominated by these kinds of companies, large cap funds of every stripe--tech sector, growth, new era---will all wind up owning the same companies while charging wildly different fees.

Meanwhile, retirees will need income but the pool of dividend paying companies is shrinking, with mergers being one reason.  They are also buying back their shares.

I get a headache thinking about this, but it is a real problem beyond the current fast food menu in financial journalism.  Keep an eye on this one, and I am doing some work on this for other reasons.

It is Labor Day weekend in the U.S.  Enjoy some time with your family and friends. Equity markets will open next week as usual.

Berkshire Hathaway's Issues Aren't Its Numbers

Berkshire Hathaway's net income for its fiscal 2nd quarter 2015 declined 37% over the prior year period, which generated some market consternation.  However, in a holding company of this size and breadth, driven by insurance businesses, volatility is a fact of life, as the Chairman himself has often said in his letters.

The big question about this company can be framed in terms of corporate succession, and that is certainly where the press reports traditionally have gone.  The genius of the company so far lies in its structure as a holding company and on distinctive features of its operating model.

"There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by our corporate headquarters in the day-to-day business activities of the operating businesses."

One of the companies I followed as a research analyst was RPM, International, the old Republic Powdered Metals.  Founded by entrepreneur Frank C. Sullivan, the company grew rapidly under his son, Tom Sullivan.  The two corporate leaders were Tom Sullivan and CFO Jim Karman, much like Warren Buffett and Charlie Munger.  The paragraph above describing Berkshire applies very well to the RPM I covered. RPM's long-term superior returns and sustained dividend growth have proven out its model, and its market cap today is north of $6 billion, driven by acquisitions, just like Berkshire.

A really key difference highlights the uniqueness of Berkshire's model, which is something I've written about for some time: it is the breadth and spread of the business portfolio.  RPM's portfolio is all in specialty chemicals and coatings worldwide.

Berkshire's portfolio encompasses a huge insurance business, spread over personal lines, commercial lines, and reinsurance.  Beyond that, it owns a leading railroad, a significant manufacturing company portfolio, and significant energy utility business.

In the case of both companies, acquisition of portfolio companies has taken place over a long period of time, with the important factor being the operational acumen and character of the target company founders or executives.  All an investor has to do is to read Berkshire's Chairman's Letters over time to see the repeated reference to portfolio company leadership when calling out outstanding results. Judging character and letting the operators run the companies are common features of both company models.

Going back to the Berkshire 10 Q, we read, "Berkshire's senior corporate management team participates in and is ultimately responsible for significant capital allocation decisions, investment activities, and the selection of the chief executive to head each of the operating companies."

It is the husbanding of corporate cash flows from the operating companies, together with the insurance float and holding company financial capacity by Warren Buffett and Charlie Munger and the reallocation of the pool among the different operating companies, investments, and acquisitions that lies at the heart of Berkshire's long-term success.

The operating company executives do their jobs in stellar fashion, and they are in good businesses to start with.  They are extremely well compensated, and they are allowed to act like entrepreneurs, though they are managers.

With this context, let's go back to the question of corporate succession.  Mr. Buffet's son, Howard Buffett as non-executive Chair.  He has written an interesting book, "Forty Chances."  Beyond that, it's frankly hard to see how this succession would give an investor confidence in the future, to be dispassionate about it, as an analyst would have to be.

Next, assume that Berkshire's most successful, adept and widely respected executive in his industry (insurance), Ajit Jain were to be named as Berkshire CEO.  The press talks about him as the leading candidate, whatever that means. Would this be a comforting move for investors?  I would say, "Not necessarily."

First of all, who would succeed Mr. Jain as leader of an insurance empire that contributed $2.3 billion of net earnings over the six months of fiscal 2015 to-date?  Who would have similar insights into the entire panoply of global insurance lines that Mr. Jain possesses?  Without knowing that, it would be foolish to just jump for joy at Mr. Jain's ascension.  Shareholders know nothing about the holding company leadership at the next level in order to make an informed assessment.

Secondly, Mr. Jain's interest in stepping out of an industry he knows like the back of his hand, into a portfolio which goes from box chocolates to railroads and reallocating capital among them might not be very strong.  He probably realizes that this would not be his forte, nor would it be "fun."

CEOs of operating businesses tend to be specialists, which to some extent underlies their success. They know, grew up in, or have a passion for railroads, bending metal, or pricing risk.  I don't know a comparable figure to Warren Buffett or Charlie Munger among all the hundreds of companies I have covered, researched or visited with in my travels.

So, the question really boils down to whether or not the Berkshire Hathaway model and its historical success are inextricably bound up with the business philosophies, characters, and acquired networks of the two current leaders.

Take the next idea bandied about, namely that one of the two new investment executives named to run the liquid investment portfolios were named to lead the company.  Frankly, investors should probably head for the exits.  Their limited experience is in traditional asset management, no matter how sharp they are or how well they are doing with inherited portfolios.

Think about the long-serving operating executives of the holding company subsidiaries.  With a change, would they feel as comfortable and secure with the structure to which they have committed their energies? I don't know, but I suspect that they would have questions and might lose focus for a time.

I suspect the reason why Mr. Buffett has been so coy about the "succession" issue is that he himself knows that (1) too little attention has been paid to it because of the complexity of steering a company this size and growing it through massive acquisition since 2013. And, (2), there is no simple answer in naming two leaders.

Google's New CFO Says Return Money to Shareholders, Maybe?

On June 7th, in the context of the sometimes great hubris of the corporate engineering class, we wrote that Google should consider paying a dividend.

In her first conference call, Google's new CFO thought out loud about buying back shares or paying a dividend.

Peter Lynch, the portfolio manager of Fidelity Magellan during its heyday, warned about public company CEOs succumbing to the siren song of "diworsification," in which they took excess capital beyond that needed to sustain their core businesses and instead burned it up into the next great thing, which, of course, only they were able to identify.

Paradoxically, even as Google's stock reached an all-time high, it is absolutely the right time to begin the process of thinking about diversifying the way in which shareholders earn their required rate of return into some cash and some capital gain.  Nothing wrong with cash and letting the shareholder diversity their portfolios in they way they prefer.

Engineers Are Often Too Smart for Our Own Good

Google's venture into what are now called "autonomous cars" seems yet another example of engineers being, in their own minds, smarter than everyone else.  What problem are these really smart, Googly folks addressing?

There are so many ways to make driving safer for everyone on the road, using technologies about which so much is already known.  A meaningful example would be the issue of glare from the headlights of oncoming cars on two-way, high speed turnpikes without medians.  Tall crossover sport utility vehicles with lights hitting the corneas of most drivers in low-profile sedans is a problem I struggle with, and I see lots of drivers experiencing hesitation, momentary loss of perspective, and just plain visual fatigue.  Semi headlights on trucks are just as bad.

In earlier times, headlights used to be aimed, and annual inspections used to check that lights were aimed at the road a fixed distance ahead.  With the advent of sealed beams, there is no such thing as alignment of the lights; if the car has a certain profile, the light unit is installed and the beam goes Hera knows only where.

How about a form of smarter glass, either in windshields or in optical glass that consumers could buy at their optical store?  This isn't a multi-billion dollar fix, and its an innovation from which many kinds of innovative companies might profit.

Instead, we have a solution in search of a problem.  Lowering highway fatalities?  Lowering insurance rates?  The easier solution would be to get the 25% of motorists who are uninsured off the road, thereby reducing rates for everybody who is insured.  No research and development expense required.

Google's CEO responded to questions about this giant boondoggle by saying that companies had to invest in technologies for the "next generation."  Why not work on food replicators to end hunger?  It works on "Star Trek: Next Generation," after all.

Corporate entities are not particularly adept at making huge investments out of their main areas of expertise and developing next generation products.  Engineers are even worse than marketers and futurologists at predicting cross-generational technology, particularly in the consumer area, like cars.

Look at the Edsel.  One of the great innovative features of that car, which I saw in our neighbor's vehicle was the push button transmission, a series of large buttons with definitive clicks in a panel that resembled what one might see unlocking a bank vault.  Great concept, and seemingly much easier than a stick and even a steering wheel mounted shifter.  There were a few problems, the first being that it didn't work.  Fast forward to today, and the desire to have automatics with a feel of a stick is what people want: push buttons were something that auto engineers wanted, but the public never have.

Google should start paying dividends with their monumental free cash flow, instead of indulging their founders in corporate whimsy.

Jamie Dimon's Extraordinary Shareholder Letter

JPMorgan Chase CEO Jamie Dimon has channeled Warren Buffett in his most recent letter to shareholders.  As readers of this blog know, Warren Buffett's letters are on my required reading list, and I have always recommended them to friends, colleagues and students.

Based on his long track record of success in financial services, which I began following during his tenure at Bank One, Jamie Dimon is required listening.  As CEO of one of our nation's Big 4 banks, he was in the eye of the hurricane during the financial crisis, has been pummeled during the political piling on post-crisis, and has now almost completed steering JPMorgan Chase into calmer, post-crisis waters.  There's a lot to learn about his view of finance and the role of JPMorgan Chase in this letter, but there are some real questions that remain for investors, as there should be if there is real content in the piece.

The CEO's Principles for Running A Business

• Especially for a cyclical, highly regulated business which is periodically subject to massive, systemic crises, it's essential to build the company into an "endgame winner." Through the work of his team and those of his predecessors over 30 years, he believes JPMC is in that elite group.
• Compare yourself against your best competitor is each of your businesses, and a convenient chart shows how that comparison looks.  
• A good company doesn't use cycles as an excuse. He is committed to earning competitive margins over the full cycle, whatever its characteristics, while still investing in the businesses and without taking extraordinary risks.  
• A good company, while always investing in its businesses, is always eliminating superfluous waste.  This has been a consistent theme going back to CC and to Bank One. It is also more nuanced and sensible than the somewhat comical and ultimately misguided "reusing paper clips" memos coming out of Bear Stearns.
• Some expenses thought by others to be excessive are in fact essential to achieving the endgame goals: it is something I have lived through myself as a CFO, and I really like seeing this laid out in specifics, i.e. the Retail National Sales Conference for JPM's top 5% producers. CEO Dimon has been to every one going back to Columbus, OH and Bank One.  You can tell I especially like this one, because what matters for a successful company is ultimately what employees think, which informs how they behave. 

As Regulators Sandpaper Away at Big Banks, Who Needs Them?

• Economies of brand name, scale, operation, and technology are important in a global financial services business.  Taking them away, by separating companies, will not be efficient for shareholders and it will leave customers looking for a competitor which can supply exactly what JPMorgan Chase has put together. 
• The CEO uses the example of Commercial Banking which is now 35% of the U.S. Investment Banking business. Out of 20,000 Corporate and Middle Market Banking clients, JPM supplies global banking services--cash management, treasury, currency trading, hedging, and mergers and acquisitions--to some 2,500 of these companies.  With normalized future growth and natural consolidation of customers, these opportunities will grow and become more valuable. 
• The Private Bank, because of the asset base and diverse financial interests will always benefit customers and attract prospects through scale. Right now, through the expanded system there are $190 billion in deposits in the Private Bank system alone. Globally, 2,300 families had assets of $1 billion or more, and as a group they represent over $7 trillion in assets. Having a system that routinely moves $6 trillion in daily funds worldwide gives Morgan bankers credibility with customers.
• In a liquidity or other banking crisis in the future, banks need to keep lending, and especially the Big 4 and beyond. Statistics in the letter talk about how much credit was rolled over to small and medium sized businesses, large customers, state and local governments and to hospitals and nonprofits. As the CEO rightly points out, non-bank entities would not be in this position in the next crisis, the character of which he alludes to in a few, unrelated paragraphs.

What About the Share Price Lagging Peers

• The CEO won't be driven by goosing earnings or short-term performance by pulling easy levers. (see the principles in how to run a business)
• JPM's price-earnings ratio is lower than peers, he says, due to large levels of legal and regulatory settlements, and to uncertainty about future settlements.  This may be true, but it's a bit hard to understand given some of the issues surrounding Bank of America, for example. 
• Stay focused on what you can control.

What Happens in the Next Crisis for Liquidity?

• More high quality capital is on the books than at any time in its history.
• Compensation levels would be adjusted immediately.
• Dividends would be cut or suspended, and share buybacks halted.
• In other words, the customers and businesses come first: a good recipe.

I'm not doing a full summary of the letter, but these are some of my highlights. What about a question or concern?  It goes back to the London Whale report. 

In the letter the CEO talks about learning a lot, and I am sure he is right. He also talks about many of the bad derivative products having gone away.  The culture described in that report seems totally at odds with what would seem to be espoused by this CEO.  How did it get that way?  Are all the bad actors gone?  There is a reference to "fortress controls."  I think that's just a marketing slogan.  They are neither feasible nor necessary: mistakes will happen, bad trades will be made, and earnings will take a hit, but all of these should be ring-fenced, bounded and fixed quickly.  That is not the company described in the London Whale report.

The CEO does make a reference to consistently espousing the principles in the letter during the year and to audiences in different settings. This could be a big deal.  The question is: who's in the audience? The same folks as before, with religion now?  

I go back to Bill Belichick's adage, "Just Do Your Job!"  CEO Dimon needs to be surrounded by leaders who knowledgeably sit over their global operations moving $6 trillion daily and who can truthfully and with confidence say, "No storms on the horizon" if the CEO asks.  A related question is, of course, who can step into Jamie Dimon's shoes if illness or factors require a successor to step in? 

Having a behemoth of a company so dependent on the acumen, drive and leadership of one person isn't the most risk optimal way of looking at the future: just a thought. 

Will Apple Inevitably Lose Its Way?

This parody of Rene Magritte's painting struck me as being very appropriate for this post. My former colleague Michael Moe's firm, GSV Capital, listed the Top 25 Best Performing Stocks for the period 2004-2014, and Apple was number 9, growing its EPS at a CAGR of 54% over the period and its stock price at a rate of 37% per annum.  In absolute terms, Apple's performance was stunning looking at the growth of its market capitalization: it went from $26 billion at 12/31/2004 to $647 billion at 12/31/2014.  If the Apple of Steve Jobs' reign is painted in the middle, Mr. Jobs left current CEO Tim Cook with his portrait at the left. (not exactly proportionate, but you can see the idea.)  It is almost inconceivable performance, which is why it's unlikely to be repeated.

"Trees don't grow to the sky," as students learn in their introductory microeconomics classes. Also, as GSV notes, ",,if Apple were to notch the same stock performance in the next ten years as it has in the past ten years, it would have roughly a $40 trillion market cap--nearly 2x the entire U.S. Equity Capital Markets."  GSV also notes that no company has remained in the list for two consecutive ten year periods.  

We have always taken the position that Apple is a cult stock, namely most investors buy it for philosophical reasons, e.g. they love Steve Jobs, they work in creative industries that use Macs and want to support the company that makes their great machines, they work in public education and admire Apple's commitment to that market, they believe that Apple's mission is about much more than making money, or they believe that the stock is "cheap," selling at 11x estimated earnings, net of cash. Each one of these reasons has 5 or more variations for cult members. I have considered owning it many times, but couldn't pull the trigger--my loss for the past ten years.

What are some signals flashing yellow, besides those presented above?  Apple is flush with cash.  Most companies in this position have their investors clamoring for a return of the cash through dividends or share buybacks.  The company has arguably responded on both counts by planning to return $130 billion to shareholders through the end of 2015. No yellow here.

The company announces something called Project Titan, a skunkworks to design an electric car. Hello?  This is an industry far away from Apple's core competencies, and one which is cyclical, rife with competitors, and subject to all kinds of regulation, something that Apple strenuously avoids.  This project should sound about as exciting to Apple shareholders as Google's driverless car is to its shareholders.  I don't think either of the two Steves would be excited about this project.

More recently comes the famous Apple Watch.  Initial rumors had this device being the centerpiece of the company's projected foray into consumer healthcare monitoring, patient management and anything called e-health.  However, as the Wall Street Journal reported, none of these features made it into the product to be launched this April.  Besides some features not working or being to complex, the Journal writes, "And still others could have prompted unwanted regulatory insight.."  Okay, maybe, but electric cars?

The watch being launched needs to be near an owner's iPhone in order to have wireless connectivity, and so the Journal notes that it appears to be an add-on accessory to an existing owner's iPhone. Cultish iPhone owners may go for this, but surely new customers wouldn't want to jump straight into a new Apple Watch and iPhone at one go?  That's a big ticket.  

There is a range of price points.  At the the lower end, Apple Watch competes with FitBits and other established products in a crowded segment. At the upper end, the ultra models feature 18 karat gold casing and will retail above $4,000.  Even billionaire oligarchs and young tech company CEOs who have sold their companies to Google may think twice about this.  Isn't there more cachet in a Tag Heuer or some of the newer, ultra-luxury watch brands?  

CEO Tim Cook says to the Journal, "One of the biggest surprises people are going to have when they start using it is the breadth of what it will do."  And what is that?  Even the reviewers can't come up with the wonderful things.  

Probably, the first generation product buyers will be orphaned as the company eventually figures out what the product should really be. In this respect, the company would then appear to be more like Microsoft, which first launched Surface RT before realizing that it was rubbish and launching Surface Pro 3, leaving a lot of unhappy consumers.  

When Apple launched the iPod for music, it wasn't the first player in the market.  Creative Labs made a relatively inexpensive, functional, intuitive series of players called Zen that really served music lovers well.  But, Apple miniaturized the iPod, which was very important to consumers, and it launched iTunes that turned the music business upside down.  A key innovation and a market disruption, and it led to success.  So far, the watch looks like late entry with a placeholder product.  A definite yellow signal, but shareholders have to stay tuned.

What about emerging markets?  Is Apple ceding all but the uber-middle class to Chinese and other competitors?  Will Apple become the Louis Vuitton of electronic gear?  

If Apple wants to get into other businesses like making cars, wouldn't shareholders rather diversify their holdings themselves by buying an emerging car company?  Or, wouldn't they prefer to buy an emerging healthcare informatics company?  What is Apple all about?  Could the story end for shareholders like the third panel on the Magritte parody?  Who knows. 

Telecoms Start Racing to the Bottom

We wrote a while back about Masayoshi Son's potential impact on US retail cellular phone users, particularly because he wants to become number one in his markets.

Predictably, his first efforts at taking over T-Mobile met federal regulatory veto.

T-Mobile has forced some innovation on the industry by making it easier for consumers to get phone upgrades and by doing away with contracts. Their subscriber growth turned around.

Meanwhile, however, spectrum auctions are indicating that others perhaps have a better economic model and can pay more for spectrum that ATT, Verizon, T-Mobile, and Sprint.

So, the major carriers have put forward their "race to the bottom" business model of promising to cut monthly bills in half while offering unlimited data and phone service.  Clearly, this is not sustainable, as we have noted for years.  With spectrum prices rising, the cost of building out different network or adding other services is becoming prohibitive.

So, the WSJ notes,

"What difference does a month make? In telecom, the answer is about $45 billion.

That’s how much market value Verizon Communications Inc., AT&T Inc., Sprint Corp. and T-Mobile US Inc. have lost collectively since mid-November amid a fast-moving reassessment of the industry’s value by investors. The lost value is greater than the current market capitalization of Sprint and T-Mobile combined, and it reflects concern that cellphone service will be costlier to deliver and less lucrative to sell."

The carriers also got dinged on behalf of consumers by the Feds because although they promised "unlimited text and data" to all customers, heavier users faced slower download speeds, of course a form of rationing and making the whales pay for their consumption. If the fines levied are paid, then they either have to adopt some kind of utility pricing which is transparent, or face growing losses because their business models don't create value. 

The Strange Tale of UBS

UBS, as a global bank, has enjoyed a cachet among its high net worth customers in the wealth management and asset management businesses, while U.S. investors have never warmed to its name as a core holding in their institutional portfolios.

Today's New York Times has a disjointed piece on UBS which does nothing to make the investment case for the 'new' UBS, and it shows the continuing disjunction between traditional banking businesses and investment banking.

We learn that in 2011, the current CEO Sergio Ermotti embarked on a strategy to reduce risk-weighted assets that was mandated by Basel regs.  A foundation for accomplishing this was to cut costs, exit capital intensive businesses, and to focus the portfolio on businesses like wealth management and asset management, alongside a smaller, more focused investment bank.

In 2012, we learn that the CEO recruited Andrea Orcel, a long-time Bank of America executive, to head up its investment banking operation.  Here is Morningstar's take on the recent history of the investment bank's contribution to consolidated UBS financial results:

" Investment banking is a risky activity that can cause very large losses. Between 2007 and 2009, UBS lost nearly CHF 30 billion and required a government bailout as a result of its investment banking losses. In addition, losses in investment banking indirectly affect the private bank. UBS was among the banks hardest hit by asset write-downs, which has damaged its reputation as a competent asset manager, and the 2011 rogue trader scandal set back its recovery. UBS suffered nearly CHF 400 billion of net asset outflows as a result of its damaged reputation. UBS' move away from the riskiest investment banking activities, especially those with long tail risks, should help to reduce the risk of further damage."

Naturally, the investment banking business had the normal global, economic cycle rebound in worldwide fee revenue, and it led to Mr. Orcel becoming the highest paid corporate executive in the bank, despite the fact that apart from some some timing and cost-cutting he hadn't done anything very extraordinary. We've written about cultural problems when global investment banks are put together with more traditional banking activities, like client wealth management services.  Shareholders haven't done well, even recently.

Morningstar notes that for the fiscal 2014 second quarter,

 "Return on equity was disappointing at 6.4%, and excluding the litigation provisions doesn’t help much--we estimate that pro forma return on equity was 8.1%, well below UBS’s 12% cost of equity."

So, no EVA inside this combined operation.

We learn that an activist shareholder with 1% of the equity, wants to have two securities, one for the investment bank and the other for the wealth management and asset management businesses; the shareholder could then decide which business they really wanted to own and sell the less desirable one.

The CFO responded,  “We have zero intention of changing our strategy,” said Tom Naratil, UBS’s chief financial officer. Of course not.  The current deal is unbelievably cushy for the entrenched management and board, and it's unlikely that given the regulatory scrutiny on the combined entity along with the history of prior management turnover, another change would be countenanced by shareholders.  The company's presentations assert that financial results would be stronger in a rising rate environment that could come by mid-2015, if Fed watchers are right.

So, investors have a Wealth Management business with extremely attractive returns, According to Morningstar, returns on attributed equity in the Wealth Management business are regularly in the 40% range, and even during the heart of the crisis they were in the mid-teens!  This is a business to own. Investment Management is also a fine business with excellent margins and sticky customers.

Investment banks should be run as partnerships, as they were in the good old, white spats days.  This would, of course, shrink their global reach and risk-based prop trading, but for the public shareholder these aren't attractive businesses to own because of their high fixed costs, volatility, and capacity for major surprises, not to mention a heightened regulatory scrutiny.

Morningstar's Stewardship rating for UBS went from Poor to Standard.  I guess that's progress.

Bill Gross Leaves Pimco

Back in January we posted our answers to the question of "What's Wrong with Pimco?"  One of the issues was succession for Bill Gross, and that was answered today as the author at the top of our fixed income reading list for the past several decades is leaving to go to Janus.

Again, it has little to do with fund outflows and all to do with organizational issues at PIMCO and perhaps a heavier hand being exerted by its German owners.

We wrote about Pimco's astonishingly inept roll-out of equity mutual funds, and the wave finally hit their bellwether product the Total Return Fund and its high profile manager.

Janus was a hugely mismanaged organization for decades, but perhaps it is living up to the name of the Roman god of new beginnings with the hiring of Mr. Gross.  Love your essays, Bill!  Keep 'em coming.

CalPERS Throws in the Towel on Hedge Funds

In organizing the posts on this blog, I've favored the label "alternative investments," as opposed to, for example, just "hedge funds."  In the past, we've written one of the most widely read posts about the public's "Two Faces on Private Equity." Rereading this, it is ironic that Warren Buffett, a vociferous critic in print at the time, has now thrown in with Brazilian private equity partners 3G on major investments.

The Yale endowment fund, led by Dave Swensen, has been one of the institutional models for successfully using alternative investments, including hedge funds, private equity, and real estate. Harvard's endowment has been in the news recently because of its falling down repeatedly in its once legendary investment management.  This post makes good background reading for today's issues about CalPERS.

CalPERS has assets of $298 billion in its investment portfolio to support 1.6 million members, either currently working or retired,or a stunning $186k per member, most of whom are working so the retirees should be quite comfortable.  The trouble is that for all their shareholder activism, self-promotion, and expensive internal management, CalPERS cannot select, construct and manage an alternative investment portfolio, in this case specifically hedge funds.

According to the Wall Street Journal, the fund's fiscal year-ended June showed its hedge fund portfolio of $4 billion returning 7.1% versus Vanguard's Balanced Index return of 12.5%.  The prior year too showed dramatic under performance at 7.4% versus 10.8% for Vanguard's Balanced Index.

The Journal notes that HFR's index of 2,000 hedge funds has been under performing its benchmark since 2009.  It points out that even in the down year of 2008 hedge funds lost 19%, not much less than traditional equity investors who lost 22.2%.  So, the $24 trillion hedge fund industry doesn't protect the downside in any significant way.

However, just to note that I got an interesting post from AQR's Cliff Asness which raises a very interesting point on which he has hammered for a while. To paraphrase, much of the institutional investor's market-like performance for hedge funds comes from the fact that their positions, whether in outside funds or in funds-of-funds, have too much of a net long position and therefore shouldn't be expected to perform too differently from traditional longs, like balanced funds. CalPERS and Harvard and others suffer from this disease of not being short enough in their hedge funds.

Proponents of hedge funds claim that there are good managers out there who can point to long-term out performance.  Who are they?  What's the basis for this claim?  What are the strategies and processes in this opaque world that can produce this alleged out performance?

Even Morningstar rates hedge funds for individuals.  If CapPERS concludes that hedge funds are too complex to manage, produce little diversification benefit, are too expensive and not scalable at their asset level, how can a small investor ever hope to benefit from these investments.  You can guess my answer.

Royal Dutch Picks A Page Out of Exxon's Playbook

Royal Dutch Shell plc appeared to be one of the relatively cheap stocks among the global intergrated majors; at the start of 2014, the share price of 20 EUR was below the 52 week low as of today. For the rest of 2014 year-to-date, the share price has rallied to the upper end of the 52 week range.

Why? Exciting new discoveries in existing territories?  Another super giant oil field in the Saudi Empty Quarter? A huge new gas field in the U.S. Gulf?  None of these.

No, it was probably a couple of speeches by new CEO Ben van Beurden in which the WSJ has him saying,

"We cannot deny that our returns are too low," Mr. van Beurden said. "We don't have a [production] volume or capital-employed target. What I want to show is that we can grow free cash flow."

The new message has resonated with Wall Street, as the Journal writes again,

" Since he said in January that Shell needs "better operational discipline," the company's shares have climbed 5.8% and hit a two-year high last week. Shell's 2013 earnings fell 38% from a year earlier to $16.8 billion, while its capital spending was 15% over initial projections, at $46 billion. Shell's refining profit was "simply too low" and the company's performance in North America wasn't acceptable, Mr. van Beurden said at the time."

The emphasis on ROIC is a page right of Exxon's top corporate board, management, and operators' metrics. which we have written about for years.  It's one thing to talk about 'operational excellence,
but pushing a return on invested capital mentality, translated down to the operating company level is something else entirely.

If RDS gets the Exxon playbook into its DNA, it will go from a stock that always looks relatively inexpensive to one that is 'fairly valued," which is a good thing.

Microsoft Is Changing For the Better: Evidence From 2014 4Q

Before looking at the numbers for FY14 Q4, I think it's more important to cover the many tells that things are really changing at Microsoft, for the better.

The first signs appear in Mr. Nadella's memo to employees about the 18,000 employee workforce reduction. Having been responsible for a reduction myself (about 1% of MSFT's, but 15% of our workforce), and having been part of several Wall Street reductions myself, I can say that they are almost always done badly for the organization's survivors and inhumanely for the affected employees. So what about this announcement?

The first was a quick reprise of contextual messages.  The company is on the road to becoming a platform and productivity company, which employees had heard the previous week. Having a focus, however, isn't a be all and end all.  

Aligning the organization, changing its culture, and improving communications and decision making within the organization are key initiatives that will take time.  The organizational staff reduction, unfortunately, is part of that longer-term change.  Thus, the CEO makes it clear that this is not an effort to cost cut one's way to success, as has been done with blazing incompetence by the likes of  "Chainsaw" Al Dunlap, and Ed Lampert at Sears, to name two. Along with these reductions will come resource additions in other areas.  The key message to employees: your organization is committed to grow, not to shrink its way to success. 

Finally, there is a human element, expressed in the statement, "We will offer severance to all employees impacted by these changes, as well as job transition help in many locations, and everyone can expect to be treated with the respect they deserve for their contributions to this company."  This isn't a phrase that would normally be offered by HR or by the general counsel; it really seems like it is a sentiment coming from the CEO, and that's good for the effected employees and for the survivors as they go through the grieving process with their former colleagues. 

On the quarterly conference call, there was a clear distinction between the styles, presentations, and nuances of the CEO and the CFO.  In fact, CFO Amy Hood sounded absolutely liberated from her former role of merely explicating and micro-parsing the financial numbers (deferred revenue forecasts, contracted versus billed revenue), and she added the CFO's restrained nuance to the always more enthusiastic and high level comments of a new CEO. Long term investors expect and like this differentiated,tag team approach. Together, it was a much more well stitched together set of messages than the previous environment, dominated by the overbearing Steve Ballmer.  
GAAP revenue for FY14 Q4 increased 18% year-over-year to $23,382 million, which included $1.99 billion of revenue from the inclusion of NDS for a partial quarter.  GAAP gross margin  of $15,787 million increased by 10%, and the GMR was a robust 67.5%, although this was down from an unusually higher rate in the prior year period.  

GAAP operating income of $6,482 million grew 7% over the prior-year period, and the margin was 27.7%, with all the moving parts. Nokia NDS contributed $(692) million to the quarter's operating income, of which $127 million was for integration and restructuring expense in the period. 

Diluted EPS of $0.55 per share declined 7% on a GAAP basis from $0.59 in the prior year period.  Dividends per share were $0.28 in FY14 Q4.  On a non-GAAP basis, which is interesting but not decisive to an investment thesis, diluted EPS of $0.66 increased 10% over the prior-year period. 

This Is A Software Company

While HP struggles to become more software-oriented, and while IBM divests a commodity server business to become more software oriented and relevant to corporate buyers, MSFT already is a software company with robust margins, despite appearing to become more of a hardware company through acquiring Nokia NDS.  

What's more important than this artificial hardware/software duality is the nature of the enterprises who will operate data centers, private, public, and hybrid clouds.  These are the customers who need to make significant investments, and they look to their trusted vendors to help them through their decision making process,  

Another thing about the new CEO is that it is clear that he can talk about customer requirements, hardware, software, data security, and computational issues with engineering, product development, and real life, customer-facing experience.  This kind of credibility will resonate with Microsoft sales forces and with the customers: this is a big deal and a big change from an MBA-type blathering on about "the cloud."  

This shows up, in our opinion, in the quarterly results where commercial cloud revenues increased by 147% year-over-year, driven by Azure, storage, computing services and the CRM online product.  The annualized revenue run rate for cloud revenues was cited as being $4.4 billion at the end of the quarter.

Microsoft Dynamics revenues were up 13%.  As a small enterprise, one of my companies adopted an early version of the former Great Plains/Dynamics software, and as a non-IT user, I found it uninviting and logically convoluted. However, for small and medium size businesses, facing the prospect of Oracle or SAP, is even more unpalatable. 

What About Commodity Hardware?

Server licensing revenue increased by 14% year-over-year.  Server product revenue increased by 16%. The Microsoft SQL Server product line had a major refresh with Server 14, and its revenues were up 19%.  

The corporate IT executives are under more and more pressure to deliver services of demonstrable performance and value from among the buzzwords, of clouds, big data, business intelligence, and BYOD. CEO Satya Nadella made the point when Microsoft, "operating some of the planet's most massive data centers," approaches customers with their Cloud OS platform, they build instant credibility.  He said that this platform represents one of the company's largest revenue opportunities, for as public cloud use increases the data center is where revenue growth will come from. 

Even, the much maligned Bing! search engine continues to garner share of U.S. searches, now north of 19% and revenue per search went up in the quarter.  This business is targeted to be stand alone profitable in 2016. 

Late To Tablets?

Microsoft Surface, for all of its being late to market, was built from the ground up on a totally different premise from most tablets, which as we've said are put to non-productive uses.  For business users, small, medium and large, productive work will involve working on documents, spreadsheets, and presentations. Surface has, and continues, to make its point that it is a viable laptop replacement with the virtues of a tablet. The CEO noted that a new form factor launch of Surface was tabled.  

The Surface Pro 3 is aimed at facilitating easy note taking, as with a pen, tying it in easily with One Note, which had been a forgotten application for a long time. 

Making Outlook.com and Office 365 accessible through apps for iOS was a small, but master stroke. Google Docs won't be the answer for most users, nor will Chromebooks for price/value.  The jury is still out on this venture, but Microsoft has planted a viable flag in the marketplace. 

The CEO's core investment principles were also interesting:

• Invest in the core platform and productivity businesses, e.g. cloud and device operating systems.
• Consolidate overlapping development efforts, which is a corollary of the reductions and reinvestment in fewer management layers and fewer competing groups.
• Run all businesses on a clear, simple model of business and productivity metrics.  This will be interesting and if it takes, it will mean that the culture will have changed dramatically.

There is a lot to like in the way FY 2014 closed under CEO Satya Nadella. 

GE Puts Appliances On the Block

General Electric's CEO has long stated that one of his goals was to refocus the company away from financial services and more towards manufacturing value-added products for specialized industries. The next phase of that strategy was to change the mix towards industrial and away from consumer businesses.

Having followed the appliance business as a research analyst, I always felt it was a matter of time before the appliance business was pruned from the portfolio, and now the announcement has been made.

Just having returned from India, we noted that economic liberalization of decades ago has allowed appliances to permeate middle class households to an eye-popping degree.  The labels we saw in homes were Electrolux, Samsung, and LG, all of which should be interested in GE's business.

Domestically, GE has lost its way, and this will put a bit of a cap on the price as there will be some cleanup to be done by any buyer.  It is ceding entry level products, and trade-up brands to the Korean manufacturers. Even its experiment at the high end with Profile has lost ground.  With global markets so ebullient, this would seem like the opportune time to divest this business.

HP's Business Risks

The "Risk Factors" section of a company's 10-Q is almost always a cover the waterfront, throw in the kitchen sink list that, once drafted at the behest of corporate counsel, is too rarely refreshed.  According to the securities regulations, however, it must bear some relationship to reality.  In that spirit, we looked at this section in the company's most recent quarterly for Q2 2014.

If we are unsuccessful at addressing our business challenges, our business and results of operations may be adversely affected and our ability to invest in and grow our business could be limited.
Three broad categories are discussed:

• Dynamic and accelerating market trends, but especially "the market shift to cloud-related infrastructure, software, and services, and the growth in software-as-a-service business models. After all, the CEO has said that this is the single most significant business development she has seen in her career. 
• Major competitors, e.g. IBM and Cisco, are expanding offerings of integrated products and solutions.
• Business specific competitors are targeting specific areas of HP's portfolio and going after new markets.
• Emerging competitors are introducing new technologies and new business models. 
• The final set of challenges "relates to business model and go-to-market execution."

The reference to business models is interesting: what does it mean?  It surely cannot refer to Software-as-a-Service, as this has been bandied about for a decade or more.  It also appears in relation to outside competition, and in the final bullet point as an internal challenge.  I believe that this could refer to the antiquated sales model in a large organization like HP, where sales forces are organized by consumer versus enterprise, by product, by customer size, geography, public versus private enterprise, and by product versus services.  Sales force effectiveness is often referred to in CEO code as "execution," which we have often heard from the CEO of IBM and the CEO of HP recently.  

Competitive pressures could harm our revenue, gross margin and prospects.

 "We have a large portfolio of businesses and must allocate resources across all of those businesses while competing with companies that have much smaller portfolios or specialize in one or more of these product lines. As a result, we may invest less in certain areas of our businesses than our competitors do, and these competitors may have greater financial, technical and marketing resources available to them than our businesses that compete against them. Industry consolidation also may affect competition by creating larger, more homogeneous and potentially stronger competitors in the markets"

This seemingly boilerplate paragraph addresses some of our repeated concerns.  HP's CFO has repeatedly made reference to decisions about share repurchases and other investment decisions being "returns based." HP's portfolio has some businesses that are being obsoleted by technological developments or changing customer requirements, e.g. UNIX based servers, developer reluctance to write new software for Itanium products, or lower demand for hardware being switched to cloud-based configurations. There is little reason to invest in these businesses from a returns standpoint.  The market will prune these parts of the HP portfolio.

There are other parts of the portfolio that HP should probably prune itself, like portions of Enterprise Services. 

HP has invested $1.4 billion through the first six months of fiscal 2014 for share repurchases.  There is no reason to make the suggestion that HP is at a disadvantage compared to competitors because it has to invest across a broader portfolio.  If "more homogeneous" competitors are potentially stronger, then surely HP can become more homogeneous, if the numbers and the customers will support this.  This shouldn't be a risk, nor should it be an excuse.  

Research and development expenditure of $873 million in 2Q 2014 increased 7.1 % year-over-year. Should it increase faster?  A big acquisition at this point, beyond the financial and integration risks, seems like it is unlikely to be successful because if the target had an entrepreneurial culture, it would have a difficult time maintaining that spirit in a behemoth that is in a continuing human capital restructuring that has just been extended.  

The post about 2Q 2014 is our jumping off point for this post, so have a look back. HP's evolution from this point forward has to move beyond quarterly guidance and forecasts.  The company is on a stable footing, and the financial risk has been sharply diminished, at great credit to the management.  However, from here it really has to be about a much more focused and clear picture of the future portfolio and investment requirements going forward.  

Productivity Growth and Corporate Underinvestment

Share buybacks have entered the realm of the new corporate orthodoxy.  Much as we have liked, and ourselves implemented, buybacks, they are now being used somewhat mindlessly, especially by mature technology companies, like Cisco and H-P.

When a corporate CFO says that "We see no better investment than our own shares," that statement shouldn't be allowed to pass without some clarification.  Likewise when the target of returning fifty percent of quarterly free cash flow to shareholders in the form of dividends and share repurchases is adopted, a question should be raised about how the math works on this kind of capital utilization.

These statements co-exist with the statements that cloud computing, for example, is the most disruptive technological change since Silicon Valley became a brand.  If this is true, and earnings are under pressure from short-term and long-term trends, then wouldn't it be better to invest in corporate internal projects to position the company for the new future?

Likewise, acquisitions when public market valuations are at local historical highs wouldn't seem to be obvious choices for use of cash.

Where may some of the fallout from these trends be seen?  Productivity, which is measured in many different ways, e.g. output per hour worked, total factor productivity, and capital per worker.  The macroeconomic analysis of productivity has always been a relatively weak area of economic research, but the various time series put out by our BLS do have the advantage of going back a long way.

Looking at one series, real output per hour worked for non-financial corporations, something noteworthy can be seen. The series is indexed to 2009=100, to coincide with the business cycle recovery. The linked chart shows the index at 107.1 in January of 2012, and stuck at 107.7 as of October 2013.

On a broader front, U.S. GDP growth fell to 1.9 percent in 2013, while hours worked rose by 1.1 percent, according to the Conference Board. So output per hour grew by 0.8 percent, and output per hour in manufacturing actually fell.

None of these trends bode well for labor incomes.  Companies like Exxon which are increasing their exploration and capital budgets are largely doing it outside of the U.S. as environmental regulations and energy policy politics make it rational for them to look for opportunities elsewhere.  Tech companies with huge cash hoards held abroad, which are then leveraged for share buybacks and dividends don't serve the long-term interests of shareholders.

Surely, there must be some politicians somewhere who could team up with corporate executives to create a framework for better capital allocation and investment in our businesses rather than in financial engineering. Continuing down this pathway may feed equity markets, but it won't fuel the economic future for the next generation of our labor force.

What Microsoft Doesn't Understand About Consumers

Microsoft and Apple are both in NDXT, the NASDAQ-100 Technology Sector Index, along with Intel, Cisco, Google, Facebook and other mega-cap companies.  Apple, in a real meaningful sense, achieved its post i-Phone success by becoming much more of a consumer-focused company.

We've written before about Apple's always having been a technology and design innovator, but this led it to many dead end devices like Lisa, which was nice to look at and cleverly designed; ultimately, it was too expensive in price-performance terms, and it was anything but intuitive to use.  It died.  More of these machines and Apple would have been  in a microcap technology index.

We recently wrote,

"Apple can charge outrageous prices for their devices for a few reasons: they all work relatively intuitively, the design and functionality of the phones and tablets are clean and present a consistent philosophy, the attention to detail even in the packaging is obsessive, and if there is anything wrong with the consumer's experience with the device or using it, the company stores make it right."

Right after this post came the announcement that "Apple has determined that the sleep/wake button mechanism on a small percentage of iPhone 5 models may stop working or work intermittently.  iPhone 5 models manufactured through March 2013 may be affected by this issue. Apple will replace the sleep/wake button mechanism, free of charge, on iPhone 5 models that exhibit this issue and have a qualifying serial number."

The process is clear, simple and owners have up to two years from their purchase to have their phone fixed or replaced.  I can tell you from experience that people on the floor are empowered to make a decision in the store to give a customer a deal, even if they strictly don't qualify.  I have never heard of a customer leaving their retail stores angry or unhappy. 

Apple has become a technology company with the customer focus and post-purchase relationship mindset of a premium consumer product or luxury goods company.  People are so satisfied that they rarely think about the cheaper price of a comparable Android device.  Of course, this can be pushed too far, but why does the opportunity persist?  Because of the engineering-driven, MBA mindset of Microsoft.  

The Nokia acquisition could easily become this company's Waterloo.  Value creation at Microsoft won't happen with the Ballmer-created organizational rabbit warren, bloated cost structure, and dysfunctional culture that we've written about in our most widely read posts.  

Analysts are making a big deal about the emerging hockey stick for revenue growth from Office 365, and since Microsoft is adopting the Intuit model of shoving customers into death march upgrades, it is true in the short term the revenue per conversion is significant.  This is certainly good for cash flow and margins.

We pointed out in our last post that over 80% of revenue and 95% of gross margin come from software licenses and the enterprise businesses.  In the future, this behemoth needs to lose weight and get a different culture in charge of businesses like phones, entertainment, and games.  

Our Biggest Banks Are A Mixed Bag

Our March post on the Fed stress tests on our "Four Horsemen" of banking seems like a good background for discussing the first quarter's results for Bank of America, JP Morgan Chase, Wells Fargo and Citigroup.

Bank of America had a lackluster quarter with the biggest surprise being its $6 billion in litigation expense five years into the purported economic recovery.  Analysts concluded that litigation expense was impossible to model, especially given the Catch-22 of the company's not wanting to tip its hand to the plaintiff's bar about how much goodies the legal reserve cookie jar held.  The acquisition of Countrywide Financial continues to plague this company, and no one is in jail.

The return on equity was a paltry 4.6%.  Yet, the P/E is the highest among JPM, BAC, and WFC.  Merrill Lynch may eventually be passed for the most AUM by Morgan Stanley Wealth Management, and it's unclear what synergy the Thundering Herd gets from association with Bank of America.

We've said for a long time that the biggest problem at JP Morgan Chase was not size but complexity.  We characterized this leviathan as "Too Complex To Manage," even for the loquacious, highly numerate, quick witted Jamie Dimon, as the London Whale episode pointed out.  His lieutenants, through all the musical chairs, have not served him well. As time has gone on, our faith in the TCTM thesis is stronger than ever, no matter what any cyclical improvement over trashy quarters might suggest.

The number driven, traditional banker's philosophy that Jamie Dimon brought to Bank One was one of the reasons for its success, plus it was already a well established, high quality name before he became CEO. JP Morgan Chase is a completely different animal, crafted by putting together one of the premier investment banks in the history of American finance with a badly managed Chase Manhattan, a well managed Bank One and many other acquisitions which all together result in the beast that is now a collection of very large fiefdoms.

The management should clean up the portfolio and structure before multiple regulators so something more damaging to shareholders. Average loan balances fell across all market segments, and mortgage originations fell by 68% over the TTM.

Wells Fargo's performance was the best overall in the quarter with its 17th consecutive quarter of earnings growth (+14%) and its dividend increase of 17%, without any surprise in its capital plans with the Fed. It continued with its share repurchases as well.

Deposits grew by 8%, a very healthy number in this environment. Net charge offs were 0.41% of average loans in the quarter and they were down 42% year-over-year.  ROA was a healthy 1.57%, up 76 basis points, and ROE was 14.35%.

The company has quietly moved its institutional and high net worth asset management businesses upstream to customers with significantly higher minimums, and in some areas like stable value the Galliard Capital subsidiary will end the quarter with assets over $100 billion.

The one thing missing from WFC which JPM and C have is significant international exposure.

Which brings us to Citi.  This is still the biggest rabbit warren. It is a structurally messy, grossly under managed managed bank, but the problem didn't originate with Vikram Pandit or even with Charles Prince.  It goes right back to the Sandy Weill-John Reed fractured relationship over decades ago.  Citi, however, has the potentially most valuable future franchises in Asia and Latin America.  It must escape its legacy of Citi Holdings and somehow craft a rational organizational structure and a responsible culture, which it sorely lacks.  It has no Jamie Dimon or John Stumpf.  It could use some activist investors to help whip itself into shape.

Warren Buffett's 2013 Shareholder Letter: Gems From The Chairman

We are usually on Berkshire Hathaway's Letter to Shareholders earlier than this, but it was buried under a huge pile of back reading.  The 2013 edition doesn't break any new ground, but it has a few gems for anybody interested in wisdom distilled into relatively few words.

Talking about the non-insurance businesses, the letter notes that the "Powerhouse Five" earned $10.8 billion in pre-tax earnings in 2013.  The five all-stars include MidAmerican Energy, BNSF, Iscar, Lubrizol and Marmon. In 2014, these five companies could increase their pre-tax earnings by $1 billion or more, assuming no economic downturn. The rest of the non-insurance portfolio produced $4.7 billion in pre-tax earnings, so the Powerhouse Five accounted for 70% of the income from this portfolio of  non-insurance businesses. Remarkable performance from easy to understand businesses like a railroad and a regulated utility, among others. BRK paid about $3.5 billion to acquire the rest of Marmon and Iscar formerly owned by the founding families.

The Heinz deal is something we considered remarkable from the announcement, both in the target and the private equity structure of the deal.  At some point, the letter makes it clear that BRK might bid for the rest of the equity (47.4%) which it does not own now.  The gem in all this discussion?  "...better to own a partial interest in the Hope diamond than to own all of a rhinestone."

Messrs. Buffett and Munger don't overpay for acquisitions with expensive stock either. Of the Powerhouse Five, BRK issued shares only for the acquisition of Burlington Northern Santa Fe; stock was used to pay for 30% of the deal, and dilution was 6% for the premier company in the industry, which itself is undergoing an economic renaissance of sorts.

As I work through Larry Haeg's book, "Harriman vs. Hill: Wall Street's Great Railroad War," I understand much better why Ben Graham and his student Warren Buffett had railroads on their minds. As the letter points out, in terms of freight efficiency over long hauls rail is hard to match: 550 ton-miles on a gallon of diesel fuel. (lots lower sulfur now),

The insurance underwriting business contributed $3 billion in profit in 2013.  The performance of these businesses, given what I have seen about Property and Casualty is breathtaking.  Whereas State Farm Group is the largest direct premium writer of insurance in P+C at $54 billion, and a well managed company according to the Oracle of Omaha, it has sustained underwriting losses in nine of the twelve years ending in 2012.

By contrast, Berkshire Hathaway's insurance businesses have had an underwriting profit for eleven consecutive years, with a cumulative total of $22 billion income earned. The Chairman regularly skewers his favorite GAAP accounting peeves---acquisition accounting and the treatment of insurance float.  The latter has been vital to the success of the holding company over the years.

Rather than being treated as a liability for the purposes of focusing on solvency by NAIC, it should be regarded as a revolving fund.  Berkshire paid $17 billion in 2013 to 5 million claimants for old claims, but with new business being written, the float continues to grow.  Even as the letter notes several old contracts are rolling off, the worst case scenario might have the float declining by something like 3% in a year.

The Berkshire Hathaway Reinsurance Group generated $37 billion in float in 2013.  CEO Ajit Jain also started a business called BH Specialty Insurance under a new senior executive, and it is being well received in an industry crying out for capacity and financial strength. General Re's float was $20 billion. GEICO, despite its irritatingly cutesy Gekko, weighs in with $13 billion of float through an efficient, low cost gathering system. All told, these insurance businesses supplied the holding company with $77 billion in float in 2013.

I hadn't realized the critical role that Berkshire Hathaway played in the reorganization of Lloyd's which was on the brink from catastrophic losses and a failure of some of their newer names.  The company took on Lloyd's pre-1993 claims book in exchange for a policy with a $15 billion limit. Clearly, in the property and casualty reinsurance business, BRK has the bluest of reputational blue blood.  Or, maybe the greenest.

One peculiar reference is to the importance of wind energy in the MidAmerican Energy portfolio.  I looked up the financials and the notes, and it's clear that without federal subsidies and some "wink, wink" reporting this industry wouldn't exist. Looking at the financials of MidAmerican, wind and hydro renewable sources of energy are not reported at their total facility accredited net generating capacities, but rather at a name plate capacity provided by the manufacturers under specific conditions,  The upshot of all this? The wind portfolio might have a name plate capacity of $2,369 MW, but the equivalent accredited net generating capacity might be nearer 286 MW.  All of this capacity, built and under construction cost about $5 billion.

The good news is that the utility is guaranteed an ROE of 12%, which is about the historical rate of growth of BRK's book value over time.  The notes to the financials state that wind depends on, among other subsidies, the federal production tax credits.  As the Chairman notes, "...we put a large amount of trust in future regulation." Or to put it another way, we put a large amount of trust in the largess of our friends in the federal government.

New investment managers Combs and Wechsler each manage about $7 billion in portfolios which have outperformed the holding company.  BRK increased its stakes in WFC (8.7% to 9.2%) and IBM (6% to 6.3%) through purchases of additional shares.  Stakes in AMEX and KO increased as a result of sustained corporate share repurchases. The company has options to purchase 700 million shares in Bank of America for $5 billion, and the Chairman says he anticipates exercising the option as he likes the company.  The tax basis for the equity investment portfolio is $56,581 million while the market value is $117,505 million.

The equity base is $225 billion. I am not going into the last few pages of the letter which have a nice primer on investment lessons learned and applied by the Master.  Take out a pencil and enjoy this perennial educational read.

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.