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.

Tech's Four Horsemen: A Midyear Checkup

Some of our leading, bellwether technology companies--Cisco, HP, IBM and Microsoft--have reported earnings recently, and although I have parsed them and listened to the basically uninspiring conference calls, the Four Horsemen all stand at the same crossroads, between reinvigoration or a secular irrelevance.

Notice that I avoid the word "reinvention," as I haven't seen organizations of the sizes of the four ever doing that; the word has become a cliche in financial lingo.  Lew Gerstner didn't "reinvent" IBM; he pruned the portfolio, changed players and shook up a staid culture, all of which together reinvigorated a sclerotic organization.

All of the organizations share one common fault: their boards and executive managements all misunderstood and underestimated the nature of the changing demands of their CIO customers and the rapidity with which their customers were being called on to respond to larger business issues, and not just technology issues as in the past.  They all missed the boat, and there are a lot of sharp people populating these behemoths.

Satya Nadella's remarks during his overview to his earnings call presentation referred to the "market transformation" that was hitting Microsoft, which he summarized as being comprising mobile computing and the cloud.  IBM and HP also talk about "big data," in addition to mobile and the cloud. John Chambers and his team intone about the "Internet of Things."

So, if the five year average revenue growth rates for IBM and HP are -0.6% and -0.5% respectively (according to Morningstar), then why are these companies furiously reacting rather than leading and innovating?  Cisco's revenue growth was 5.5%, and Microsoft's was 8.2% over the same period, but acquisitions and a virtual monopoly in a core business fortuitously helped these two companies perform respectably on the top line.

However, it is Microsoft CEO Satya Nadella who says that his company must undergo a "transformation" which will translate the market transformation into a "growth opportunity" in revenue, earnings and market capitalization.

With the recent CEO change at Cisco and with the relatively predictable character of their financial performance, I really don't have much insight into where this company is going, although with a median operating margin of 22%, healthy interest coverage of 18x, and relatively low debt-to-capitalization, it is positioned well to do something meaningful to reinvigorate a somewhat plodding, methodical story.

HP is creating a buzz for itself by splitting into two companies. HP Enterprise is their corporate IT facing business, the "growth company."  However, it's a very curious thing reading their red herring. Nowhere in the stated advantages of the split is there any reference to improving their ability and agility in serving their CIO customers better!

There are plenty of references to capital market issues, e.g. more strategic focus, better capital allocation, an optimal capital structure, and giving investors a growth company which should be valued better than a more diffuse portfolio.  Serving the customer should always come ahead of serving the shareholder, because without gaining more customers and increasing their retention and lifetime value, there will no source for rewarding the shareholders except financial engineering, up to a point.

For the six months to April 30th, HPE had revenue of $25.6 billion, down 6.4% from the prior-year period, with operating income of $1.2 billion, a 4.5% margin.  The Enterprise Group's revenue of $13.5 billion was relatively flat to a year-ago, and its operating income margin was 15.1%.  The Enterprise Services group had a woeful OI margin of 3.3%, and its issues are longstanding; the Software business revenue of $1.8 billion is far too small to drive the boat, and its operating margin of 17.9% is below par for the industry.  The successful reinvigoration of this company is by no means a slam dunk, and former CFO Cathy Lesjak, the voice of reason on Autonomy, has gone over to the former printer business.

IBM continue to attract the interest of legendary value investor Warren Buffett.  This aside, there is something really wrong at this company.  Writers at Forbes have cannily gone back to the career of retired CEO Sam Palmisano.  Thirteen consecutive quarters of revenue declines for a company of this size and pedigree ought to have generated board members handing in their resignations; it's inexcusable and unbelievable.

Mr. Palmisano's success came as a rainmaking salesman, but unfortunately that way of selling to the largely ignored, relatively lazy CIO has gone forever.  The nature of the sell has changed, and the customer, with some skin in the game for business success, is now asking questions and looking for value and partnership rather than new hardware and modest software updates.  Mr. Palmisano transformed his salesman's passions about quota records into a slavish focus on Wall Street numbers, hence the dreaded "Road Map."

Instead of returning all that money robotically to shareholders with declining revenues, acquisitions like SoftLayer should have been the focus much earlier.  The sales culture and organizational comfort have all got to change.  This late into the game, it won't be easy unless there are big, uncomfortable changes, which might make a somnolent board uncomfortable.  Gradualism has brought IBM's P/E to 10.3 according to Morningstar.  Warren Buffet has always said he is not interested in a mediocre company at a great price.  Does he own a great company at a great price? Only time will tell, along with a whole new attitude within Big Blue, and a new way of coming to market and making technical sales.

When IBM lost the CIA cloud contract assignment to Amazon Web Services, it was a big wake up call that even with a significant portfolio of federal government business, Big Blue lost a marquee contract to a relative upstart with better customer service, technical support, and hourly unit pricing. The company learned from this error and fixed many holes in its offering by acquiring SoftLayer.

Ending our review where we started, with Microsoft, we still wonder as we have since 2012's Microsoft Reboot post, if this company can reinvigorate itself with a portfolio serving two distinct markets--corporate and consumer--with one historically dysfunctional culture.  The consumer franchises should be extremely valuable to a different kind of company.  Despite its relatively high valuation metrics, Microsoft high returns, befitting of a software company, may be justified.  Its median operating margin is 33.2% according to Morningstar.  A true "transformation" of Microsoft in its current form seems very difficult, and some bloggers suggest that shareholder ValuAct has been lobbying for a split-up of the company.  This split-up would have all to do with core competencies, technical and engineering knowledge, versus understanding of gamers and the entertainment industry and what these actors want in terms of content and delivery models. Don't get me started on Windows Phone!

CEO Satya Nadella sounded a little frustrated on the company's most recent conference call, and he seemed to want to impose his stamp on every response to a question, a contrast to his more nuanced answers in the past, where he let his CFO take the lead.

We were very positive about Surface when it was a greenfield development project inside Microsoft, and indeed it sales more than doubled in the recent quarter, year-over-year, to $888 million. What's more the incremental gross profit contribution compared to the prior year was $1.33 billion.  When the company puts its mind to computing and making people more productive, that's more in its wheelhouse than are gaming and consumer entertainment.  Overall, there may have been some disappointment it Microsoft's most recent quarter, but there is lots of potential to unlock significant value if there can be a real cultural shift within this long dysfunctional organization.  Another wait and see.

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.

HP's Unhealthy Obsession With Mike Lynch

We've written about this several times, but HP are back at it again. Just as they approach the biggest event in their corporate history, the splitting off of HP into two companies, the issue of Autonomy's purchase has moved back center stage. This is after Britain's Serious Fraud Office ended a two-year inquiry into Autonomy's alleged misrepresentation of its financial results and deciding to take no further action on the matter.

I can't find the original court document of the current complaint, but the link above outlines the current allegations.  Former Autonomy CFO Sushovan Hussain noted that if $2 billion in fraudulent or imaginary revenue were recognized under Autonomy's IFRS standards, then among other things, an analyst would have a hard time reconciling cash using the balance sheets and income statement. He then essentially dares HP to explain how why this alleged fraud isn't evident from a very conventional analytic method.

Aggressive accounting?  It seems to have been the case, but most of the discussion seems to center on differences between US-GAAP and IFRS. By continuing to pursue this issue, HP is, by inference, casting aspersions on the Big 4 auditors, several of which were involved as auditors or consultants on the transaction.

Why not claw back money from former CEO Apotheker?  HP overruled its own CFO on the transaction.  Suits against HP show some comments by Apotheker that seem to say HP's zeal and haste to close the transaction resulted in shoddy due diligence.

By continuing this unproductive path, HP continues to make its go forward technology company look unworthy of shareholder confidence and the confidence of its customers and business partners. Let it go, HP.  Markets have already long forgotten.

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. 

The Serious Fraud Office Finally Passes on Autonomy: HP Should Move On

As recently as Q2:FY14, we had Autonomy on a list of big questions, not just from the legal and financial implications, but because the overhang was distracting for the marketplace. This acquisition again points to failures of the company's outside directors, the naive vision and defective business acumen of former CEO Apotheker, and an acquisition process which had run amok. 

Now, after three years of spinning its wheels, Britain's Serious Fraud Office concluded, "In respect of some aspects of the allegations, the SFO has concluded that, on the information available to it, there is insufficient evidence for a realistic prospect of conviction."  Presumably, potential civil issues will be picked up by the SEC. However, this shouldn't be a fertile ground for large cash fines given HP's having already consolidated and settled many shareholder derivative claims.  HP's impending break-up and its ability to thrive going forward should be where investor and management energies should be spent.

The most illuminating document summarizing the Autonomy acquisition debacle is the January 10, 2014 report of the" Hewlett-Packard Company Independent Committee's Resolution of Derivative Claims and Demands."

HP had a business relationship with Autonomy since Q4 2009, and so the IDOL product and Autonomy's management, especially founder Dr. Mike Lynch, should have been well known to HP's technology, business, and marketing executives.  In fact, thoughts of acquisitions had been circulating with HP for some time, but the disconnect between Autonomy's stand-alone valuation and its revenues precluded any pre-acquisition work. 

During HP board meetings from July 19-21, 2011 CEO Apotheker made a case for a "transformational acquisition" of Autonomy, which was to be the centerpiece of a complete makeover of HP from a hardware company into an enterprise software giant. 

The standalone value of Autonomy was set at $9.5 billion, and HP's internal business development group and others concluded that there were $7.4 billion of "revenue synergies" between HP and Autonomy, presumably with IDOL and Vertica's offerings primarily. This is an extraordinary number, even laughable.  $0.157 billion in integration expense and fees offset these numbers, and there were said to be $0.322 billion of tax synergies available to a combined company. All of this made for a value of $17.1 billion!

Apotheker argued to the board that HP had in place extensive, proven and reliable processes for screening, valuing, and integrating acquired companies, and the board should feel comfortable relying on the output of this machinery, along with the extensive roster of supporting advisers, like KPMG for accounting due diligence, and a bevy of American and British law firms and investment banks.

However, this assertion was belied by facts, including the most recent failure of the EDS acquisition and integration, which itself resulted in an $8 billion write-down.

Apotheker's putting forward that the acquisition of Autonomy would be "financially accretive" in addition to have strategic transformational value had to be a critical element in the board's giving him Authority to Negotiate with Autonomy.  Any board member, even those without financial background, should have disregarded a "revenue synergy" number equal to almost 80% of the target's standalone value.

During an August 8, 2011 conference call with Deloitte, Autonomy's auditor, questions were put forward about "revenue recognition, instances of fraud, control mechanisms" and the like.  Deloitte just answered questions, and no work papers were provided to demonstrate the revenue recognition processes.  Deloitte also noted that an individual whistle blower had filed a complaint about financial irregularities which Deloitte (and presumably Autonomy's audit committee) had investigated and found to have had no merit.  Apparently, this kind of lack of sharing of audit material or detailed financial records is the norm for British acquisitions, according to the report.

CFO Cathy Lesjak objected to the acquisition of Autonomy, but not for the specific valuation process or numbers.  She felt, (1) shareholders would object to the size of the premium paid; (2) HP's bankers underestimated the impact of the announcement on HP's share price, and (3) HP's "history of not executing on major acquisitions" should give the board and management pause about going forward.

Post-acquisition, Ernst and Young were hired as forensic accountants.  They received Deloitte's work papers on Autonomy and identified red flag areas, including audit issues such as differences between the principles-based IFRS and rules-based GAAP that could be problematical.  These were all ignored or swept under the rug during the out-of-control due diligence process.

Vertica and IDOL's product lines could not be integrated, which caused problems during conference call presentations by CEO Meg Whitman when she had to be very careful with her language about the future of HP offerings in the software area.  Revenue synergies clearly had been illusory; the synergy modelling had been prepared by the company's own Corporate Development Group, or internal bankers.  This is not the best way to go about this exercise.

HP's CEO Whitman's characterization that some $5 billion of the $8.8 billion write down of Autonomy post-acquisition was due to "accounting improprieties," "misrepresentation," and "disclosure failures" seems misleading, after reading the text of the report.

According to the report's description of the HP impairment model, the $9.5 billion standalone value of Autonomy had to be reduced by some $6 billion!  If this write down were due to differences interpreting the appropriate treatment of Autonomy's fiscal 2011 results under IFRS and the subsequent translation to US GAAP, this isn't improper or misrepresentation on its face; over a long-time horizon, the cash flows should be the same, unless the fundamentals of the companies technology products were misrepresented; this hasn't been suggested, and so HP's claim is, at best, unproven.

$5.3 billion of the assumed $7.4 billion of revenue synergies were deemed impaired. $3.9 billion of the impairment came from the decline in HP stock and the subsequent effect on the market capitalization reconciliation. This calculation accounts for former Autonomy CEO Lynch's assertion that $5 billion of the impairment came from HP's own reckless assumptions about revenue synergies and not from any proven accounting fraud.

$11 billion in carrying value of Autonomy less the net $2.2 billion revised value yields the $8,8 billion impairment charge.

If the SFO couldn't find the evidence to pursue and win a criminal conviction for accounting fraud, then CEO Whitman's claims don't seem to be above reproach.  Just for the other side, the report details Dr. Lynch's behavior and assertions when the integration work and post-acquisition forensic accounting work were going on.  His behavior seems inexplicable, petulant and unprofessional.  After all, he had just enjoyed a huge payday, and was likely still a contract employee of HP. Professionally and personally, his conduct wasn't exemplary.

For all the 'smart' people in Silicon Valley, this episode should underline for equity investors the need to really investigate, understand and monitor the qualifications, personal character and conduct of the the board members and managements whom they entrust with their clients' funds.

Cisco's 1Q FY15: Looking Forward and Back.

Looking Back at Our Cisco Posts

"Cisco's 4th Quarter: A Tiger Changes Stripes," 8/16/2012

• Credit Suisse worried about 250-300 bp erosion in the gross margin rate going forward! (the time frame is not specified)

"Cisco: The Fourth Horseman Reports First Quarter 2014," 11/13/2013

• For the period 7/2008-2013, Cisco's shares return an average rate of 7.4% per annum, trailing both the Standard and Poors broad index (16.5%) and the Tech Index at 18%.
• $12.1 billion in revenue increases 1% y/o/y.
• It will take 4-5 years to transition the company away from a heavy reliance on its traditional core of switching and routing.  
• From 2008-2013 the gross margin rate declined 800 basis points.
• Long-term growth rates of 5-7% expected from a reconfigured Cisco. 
• If this were combined with operating leverage on a leaner company and better supply chain efficiencies, long-run value creation would be significant.

"Cisco's 2013 Financial Analysts Conference," 12/14/2013

• Core business growth might average 0-1% per annum over the next 3-5 years!
• Hardware still accounts for about 30% of data center spend.
• Servers account for 29%.
• Software accounts for 22% of the data center spend.
• "stock could have legs in 2014."

"Cisco's Fiscal Second Quarter 2014: Nothing New From the First," 2/13/2014.

• "When...(a stock is) priced like a 'going out of business' sale that's the time to take a look at the risk/reward ratio." 

"Cisco's Third Quarter and Cloud Computing," 5/18/2014.

• Customers apply 75% of their skilled labor to the management of their applications, software layers and infrastructure.  Over time, this ratio must fall to about 25% in order for them to meet the new demands on IT departments.
• This is the opportunity for vendors like CSCO, HPQ, MSFT, and IBM.

"Cisco's 4Q: FY'14: Low Quality of Earnings Concerns," 8/14/2014

• Concerns on the analyst call about the effects of software defined networks (SDNs).
• Switches are 30% of the quarter's revenues
• Acquisitions mentioned: Tail-f Systems; ThreatGRID; Assemblage, for mobile collaboration.
• Expect the share price to be range bound between $20-25 for the balance of the year.

Coming into 1Q FY15

• Facebook's announcement about its new data center architecture was seen as a negative for Cisco's earnings announcement and for sentiment on the stock's prospects: 

"Our previous data center networks were built using clusters. A cluster is a large unit of deployment, involving hundreds of server cabinets with top of rack (TOR) switches aggregated on a set of large, high-radix cluster switches. More than three years ago, we developed a reliable layer3 “four-post” architecture, offering 3+1 cluster switch redundancy and 10x the capacity of our previous cluster designs. But as effective as it was in our early data center builds, the cluster-focused architecture has its limitations.
First, the size of a cluster is limited by the port density of the cluster switch. To build the biggest clusters we needed the biggest networking devices, and those devices are available only from a limited set of vendors. Additionally, the need for so many ports in a box is orthogonal to the desire to provide the highest bandwidth infrastructure possible. Evolutionary transitions to the next interface speed do not come at the same XXL densities quickly. Operationally, the bigger bleeding-edge boxes are not better for us either. They have proprietary internal architectures that require extensive platform-specific hardware and software knowledge to operate and troubleshoot." [I love the unconventional use of the mathematical term 'orthogonal' in the press release]

The bears on all the Four Horsemen of Tech, especially CSCO and HPQ, would say that the mega-users are rebuilding their next-Gen data centers with their own designs, which include more software defined network architectures. (remember the concerns on the prior 4Q FY 14 call)

The 1Q FY 15 Results

• Revenue of $12.2 billion increases 1.3% over the prior-year period.
• The gross margin rate of 63.3% is the highest level in three years. (Remember Credit Suisse's projections from 2012)
• The operating margin rate is 29.2%
• Switching and routing are 47% of consolidated revenues versus earlier projections of two-thirds. (some of this might be bleeding off into new categories, but it shouldn't be that significant)
• New product introductions are cited, including ASA with FirePOWER, an industry-first threat focused firewall.  Perhaps the latter feature came from the ThreatGRID acquisition mentioned a quarter earlier.
• The stock price which began the year at $21.98 is at $26.59 intra-day as of this writing.  The stock indeed had legs in 2014!

What's Ahead?

• The world won't belong to Huawei.
• Even thought IT purchasers are taking longer to make their big purchase decisions, very few of them are going to design their own data center configurations.  Mix and matching will have its limits, as IT officers rise higher up in the executive chain with more visibility and accountability for performance and for mistakes. 
• The succession plan for CEO John Chambers is being signaled as evolving.  The revenue growth under Mr. Chambers has been nothing short of astonishing, although some of it was riding a tech wave for sure.  
• The next alignment of the executive team, the culture, and the ability to tell their story better will tell all about the stock's price appreciation potential.  Some board refresh would be appropriate.  
• So far, Cisco has been doing exactly what it said in 2012, which itself is unusual for mega-cap companies.  

Is Twitter For the Birds?

I recently read Biz Stone's book, "Things a Little Bird Told Me: Confessions of a Creative Mind." As a rule, I avoid business books because of their short half-lives, and in other cases their blustery tones from self-absorbed authors.  This book is relatively short, easy to read, and Stone co-founded Twitter whose market capitalization is $26 billion today.  Stone's personal story is interesting and different from that of the traditional, elitist Silicon Valley entrepreneur.  There are some interesting observations about start-up dynamics, personalities, and product development. I enjoyed the read, and wanted to catch up on Twitter today.

Among my network, there are lots of people who like Twitter for a variety of reasons.  I signed up without a smart phone, found it a bit hard to understand, and I am a member of the inactive users metric category.  Any way you cut it, Twitters valuations are off the charts, and today's junk credit rating from Standard and Poor's isn't encouraging.

In Biz Stone's book, he points out that Twitter's early user base helped define the platform's best features, like the hashtags and retweeting.  At the same time, he notes that the company's developer platform, today called "Fabric," was badly constructed and led to so many system crashes that users went to a site "IsTwitterDown.com."

Twitter had created something different, and its 140 character limit, which people loved or hated, turned out to be a real asset.  Users looked beyond the system issues and really became emotionally engaged with the company itself. Twitter goes public, and today it is close to where it started and the sentiment is decidedly negative.

I invested some time listening to a couple of presentations from their recent Analyst Day webcast.

The Public Company

Looking at the board of the company, two of the three (or four) co-founders remain on the board of directors, Evan Williams and Jack Dorsey.  So, in a sense, there should be continuity with the values and commitment to customer engagement which Stone writes about in his book.  

The board of directors seems okay for now.  There are two directors with venture capital and financial experience.  

It seems clear from the capital expenditures for the past two years that the company had been underinvested for some time, which is somewhat consistent with the crashes and continuous fire fighting recounted in the book.  Stock compensation expense is off the charts, but it's also clear that Twitter has built out a real management team befitting a valuable tech company, with the kind of experience it needs to go forward and innovate around its platform.  

The CEO and CFO presentations reflect the CEO's career at Anderson Consulting and they are cogent and pretty self-explanatory.  

The most interesting presentation for me was that of Adam Bain, President of Global Revenue and Partnerships. Given his prior corporate experience, he understands first-hand how advertisers work, think and buy media; he is a board member of the Ad Council.  If monetization is one of his main charters, this is the kind of profile he needs.

Having served as an officer of an NYSE direct marketer and with my analyst bent, I fully understand the importance of metrics.  This is where the bears are feeding on the Twitter story.  But, I also know from being a NASDAQ med device CFO that analysts can fixate on metrics that are important to them but that are not required for profit growth and success.

Some of My Bullet Point Notes

• Twitter has to become easier to use, for the novice user and for the discouraged, inactive user.
• Biz Stone noted this from his days at the company.
• Company acknowledged this under objectives "Strengthening the Core," and "Reducing Barriers to Use."
• Twitter connects users to their world and to the world, which are different.  The first is served by their current chronological stream of updates, while the latter will be served by tailored or curated products like "While You Were Away" under development. 
• Their approach to rolling out new products will be to do lots of testing before launch. This was spoken like a real, engineering driven company under some strict development protocols. This can be good and bad; I've experienced the bad, and I suspect Twitter has also.
• The last observation is based on executive comments about Engineering and Product teams being on the same page, with everyone having visibility into the timelines and to who is accountable.  This can be a real nasty problem, and it sounds like they've taken care of it going forward.  This can be a big deal.
• An analyst put forward his own metric on minutes spent on Facebook per user log-in versus minutes spent on Twitter; his score card was 40 minutes per user for Facebook and 3 minutes per user for Twitter.  
• There was a good response about looking at frequency, velocity and distance between visits at Twitter.
• The best response was "No advertiser buys on the basis of time spent on the site," which is paraphrasing Adam Bain, I think, since the speaker didn't identify himself. 'nuff said.
• Twitter commissioned interesting neuropsychological research from a British firm, 
• Twitter's emotional engagement with its sample users was 75% higher than the baseline sample population for similar brand and social network companies. This difference was the highest in the firm's experience.  Similarly, Twitter users' sense of relevance to their feeds were 51% higher than the baseline norm. Both of these translate into higher level memory retention, or "top of mind" which means more likely action.
• All of this is very consistent with the stories in Biz Stone's book.  (Look for the story about the tweet "Did you get the pizzas?" )
• Twitter has 672 million tweets sent out during the World Cup, the most watched sporting event in the world. I think that seems low, since the Cup usually has 900 million+ viewers: they can do better.
• But, when Luis Suarez of Uruguay bit Italy's Giorgio Chiellini, Twitter users got so emotionally engaged, it triggered a wave of targeted advertising by some of the biggest global advertisers for brands like Adidas, Snickers, McDonald's, and Cinnamon Toast Crunch.  
• It reinforced the immediacy of Twitter with both its users and the big advertisers who covet the ability to make multiple, direct connections to customers.
• 70% of their users are outside of the U.S., and the platform will be designed to work even in "low connectivity" environments which means for the emerging and frontier markets. 
• Analysts worried about their ability to get "free content" from big partners like the NFL.
• An executive gave a very cogent explanation why a rational mega-player who looked at their ROI would not immediately turn to a strategy of making Twiiter pay for highlights.
• Great example of a campaign for HP's "bendable laptop."
• Strong executive endorsements from T-Mobile, Pepsi and General Electric.
• Quite a spread of industries and customer types.

There's no hurry on this stock and although it appears priced for perfection, it may finally be on its way to becoming a company that creates shareholder value. 

Catching Up With the Financial Press: Nothing Has Changed

U.S. equity markets have had five consecutive record closes. Governments in the U.S. and Europe continue to view financial sector public companies as ATM machines, with a steady stream of announcements of higher reserves for legal settlements.  Everybody's happy.  Where are we now compared to the dark days of 2006-2007?

• Our banking system is more concentrated than ever, with the top 4 banks controlling 47% of domestic banking assets.  Weighed down by an unending stream of regulatory and capital constraints, their business models need revision. 
• Despite all the research on the role of Fannie Mae and its central role in the subprime mortgage debacle, no meaningful diminution of its role has occurred through legislation or regulation. According to Goldman Sachs in "The Mortgage Analyst," May 2014: "Mortgages implicitly or explicitly guaranteed by the government are 90% of all loans originated, compared to two-thirds before the crisis." To cap it off, a new executive has called for Fannie to once again increase home ownership by loosening credit standards!
• QE has been a windfall to some market participants but a policy bust.  Even career Fed watchers can't make sense of pronouncements about the path of interest rates.  We have long said there is no fundamental economic case for raising rates. Minneapolis Fed President Kocherlakota let the cat of the bag first when the noted that the Fed couldn't right size its balance sheet for decades.  
• Europe's Fed-lite and QE-lite have been even worse failures, and their banking system still hasn't done its penance.  What's worse, economic fundamentals remain weak, with capital spending reflecting the negative sentiment of business executives.  
• The marriage of IFRS and GAAP was called off when bride and groom refused to show and the minister went home.  More than a decade worth of meetings, workshops, presentations, interim proposals, and investors have more verbiage and less clarity in disclosures than ever.  
• The IMF, of all players, has opined that a risk heat map for some markets like high yield, leveraged loans, and even corporate bonds show levels comparable to the 2006-2007 peaks!

I'm going to cut the list off at this point, but you get the picture, dear reader.  Words over action, form over substance, special interest politics above all, that's 'market reform' American style. 

HP Comes Full Circle

The whisper wire says that "Hewlett-Packard Plans to Break In Two." The stock has done well off its lows, and shareholders have been returned significant free cash flows through dividends and share buybacks, while corporate bondholders have also been satisfied with their holdings, despite some concerns about bondholder unfriendly payments from free cash flow.

So, we have gone all around the mulberry bush. In the first half of 2012, bearish analysts were calling for the sale of the company in parts, which they claimed would be worth more than the consolidated corporate equity's value at the time. This made no sense. Fortunately, neither the board nor management bit on the fire sale scenario.

The bullish analysts believed in the single powerful vendor selling the full line of hardware, software and services for the enterprise and for the consumer.  It wasn't obvious to us that sophisticated buyers would build their IT infrastructures on this "one stop shop" model, either.

It made more sense to us to focus on the financial stabilization, improvement of core metrics, and pruning the portfolios of marginal businesses, and focusing on faster innovation, even as the CEO touted HP Labs.

In the first quarter of FY13, we wondered if the realignment of some sector reporting pointed to future divestitures. But during the same conference call, we also noted that,

"The CEO clearly rejected any conversation on the call about breaking the company into pieces or divesting large businesses like Personal Systems and Printing."

In between these points, there were also regular allusions to the need for significant acquisitions, despite the colossal failure of the Autonomy acquisition.

So, today, coming full circle, HP has leaked the news that it will split itself into two companies: a PC/Printer business and an enterprise company, with the PC/Printer business being dividended to shareholders through a tax-free distribution.  Well, it isn't technically a divestiture. And, this way, the management of the PC/Printer business can continue to improve its business using the large free cash flows from printers and supplies, while eventually selling itself at a much higher price than would have been the case in 2012.

What is surprising is that the SEC/IRS would have agreed that the two businesses had been operating separately and distinctly from each other before the transaction.  The company itself said that HP was calling on global IT companies with one voice and one product portfolio.

Who gets the debt? Are bond covenants conveniently renegotiated?  What is the most important factor in the success of this deal going forward.?  The inter-company agreement must be thousands of pages long.  The settlement of the power struggle in the terms of the agreement will give important clues as to which company gained at the expense of the other.

The Journal's reports of customer comments like these are a sad commentary,

• “What I really noticed is that they had not evolved their products, and they were not necessarily involving their customers, who wanted to help them.” Senior Data Architect, Coach, Inc.
• “HP has been slow to embrace the cloud, and it lacks certain capabilities of rivals.”
• "slow to react to market forces"

Selling the company for parts wasn't the right strategy.  Improving the company has paid off.  This latest announcement says that continuing the current operational plan would be a long slow grind. It will be interesting to hear management talk about how the two companies will work together, post the spin off. 

Looking at Alibaba 38% Higher

Alibaba's IPO predictably blew the doors off, up 38% after the first day close with market makers doing their best to rein things in from super heating. Aside from the scale, which is inevitable from the passage of time with markets, it was all pretty much according to the Wall Street script.

Of course, things should go swimmingly for a time, otherwise lynch mobs would be seeking the bankers with malice in their hearts.  But, a quick look at Alibaba's press says that the story has legs in the medium term.

The Wall Street Journal curiously takes the position that "this time it's different." Shareholders needn't worry.

"But shareholders can choose whether to live under these limitations (structure, governance, no voting power for the common....). They understand the convoluted workaround was dictated by Chinese law, which restricts foreign ownership. And, let's face it, when investors begin to worry about the actual rights specified in a share agreement, it usually means something has already gone seriously wrong.

True comfort for shareholders comes not from legal boilerplate, but from incentives. Alibaba founder Jack Ma could take the $22 billion raised Friday and stiff his foreign partners. That's a risk. But his self-interest is otherwise. He wants a strong stock as a currency for acquisitions. He wants stock options to motivate his increasingly global management team. He wants easy liquidity for himself and other insiders.

Of course, a lot can go wrong with a company, and Mr. Ma told a road show audience last week that his most important task was government relations back home. That's another risk. But Chinese officials have incentives too."

Common shareholders claims on their company are residual.  They don't have the covenants, protections, clear judicial means to exercise their claims, and even claims on specific assets, as some other investors do.  Something clearly has gone wrong in this structure, for the common equity investors, but they don't care because everybody knows the short term outlook should be a lay up.

I wonder if the Journal remembers the agency problem.  Incentives existed for the managements of AIG, IndyMac Bank, Bank of America, Countrywide Financial, Metris, Green Tree Financial and so on endlessly, and that's just for financial services.   The boards did not represent shareholder interests and rein in their managements.  I would bet that few shareholders of Alibaba could name one of their corporate board apart from Mr. Ma.

"A strong currency for acquisitions."  The management of every public company wants the same thing.  It's no magic elixir.  Remember HP? Remember Compaq and other failed acquisitions before their currency became seriously devalued?

The smart but inevitable move that Mr. Jack Ma made was to cut the Chinese government in on his deal. The selected list of Chinese officials was not created by accident.  It is why Mr. Ma spends so much time on government relations back home.

The payment network may be an undervalued jewel.  The money market mutual fund may revolutionize investing in China.  Unless the Chinese government decides at some point that this capitalism thing needs to have its model adjusted. Years from now?  Probably, but at some point inevitably.

At some point when Mr. Ma is the wealthiest man ever in recorded history, will the siren song of marginally more money still attract him?  What if he decides to invest money, perhaps with the encouragement of the Chinese government, on Chinese tourism to Mars?  What if  his vision and attention wanders to personal causes?

Governance often becomes boilerplate because that makes careers for politicians and their cronies, but it is really about meaningful, properly defined rights and obligations, the right people and the right processes to manage a company in which shareholders get a strong say.

Prediction: 100% of the analyst reports will be Buy or Strong Buy.  There are no new tricks on Wall Street: only the names, dates and scale changes.

Alibaba: Open Sesame To the Uber Humongous IPO

In a recent post about emerging markets as an asset class for foreign equity investors, we wrote about some things they should look for in selecting their markets and their issuers:

"In order to translate these into growth in corporate earnings and portfolio returns, investors need: political stability, strong respect for property rights, effective dispute resolution, a predictable regulatory and tax regime, a positive foreign investment climate, efficient markets, strong corporate governance, reliable corporate auditing and financial reporting, ethical managements, transparent corporate structures, and economies balanced between exports and internal consumption. Divining the strengths and weaknesses of an EM in these areas can only be done by active management, with experience in the markets, boots on the ground and a disciplined investment process." 

Despite the fact that the Alibaba IPO will be a record breaker in all investment banker metrics, it seems to lack these basic, critical features and it seems ripe for momentum investors and flippers, aka hedge funds.

A June 2014 staff report of the U.S.-China Economic Security Review Commission goes into the issues clearly and raises the potential legal, investment and governance issues for U.S. investors.  The Chinese government itself makes it a public policy to keep foreign equity investors in disadvantaged positions in their companies.  Yet, Chinese Internet companies have pursued foreign listings with a structure called Variable Interest Entities, which the report says may in fact be illegal under Chinese law.

Templeton's Mark Mobius points out the two-tier equity structure that clearly entrenches management and gives it and the preferred class effective control over corporate assets.  Disputes, he notes, must be settled in Chinese courts, despite the overseas listings.  Good luck with that venue for the poor common equity investor.

The reporter interviewing Mr. Mobius notes that Hong Kong regulators passed on allowing Alibaba to list on their exchange, in part because of the opaque corporate structure.  Asked why U.S. regulators allowed the listing on NYSE, he quietly notes several points, which I may paraphrase a bit:

• U.S. markets have never reformed, post-crisis.
• U.S. regulators serve their customers, namely the broker-dealers and their investment bankers.
• Out equity markets are driven by short-term investors who will flip the shares.

Ironically, some part of Templeton may get a few shares and flip them too.  If they are passing out free candy, why not take it?  But, the comments are sobering coming from one of the oldest companies in the emerging foreign equity investment business. 

Professor Anant Sundaram of Tuck Business School has made comments on the deal from the governance standpoint that worth reading, published in Barron's and the New York Times. 

When Ali Baba opened the door, it was to a wonderful land.  It will remain so until the door closes and investors long to return to the other side.  

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.

Emerging Markets Revisited

Here's a short piece I wrote for a financial executives professional group on emerging markets.  Since I did quite a bit of research beyond this, you'll see more on this topic in the coming weeks.  Incidentally, there has been a problem with hijackers taking control of the referring website function for this blog. It has been reported to Google, so we'll see where this goes.  

Emerging market equities (“EME”) belong in an investor’s broadly diversified portfolio because they offer higher prospective returns albeit with higher expected volatility. Going forward, we believe that a selective approach to ownership, meaning active management, may be superior to one hewing closely to a broad, EM index. 

The economic case for EME centers on several themes: higher GDP growth rates; younger populations; increasing investment and efficiencies from infrastructure development; maturing financial services companies; export growth, and growing middle class discretionary spending. Ruchir Sharma, Head of EM at Morgan Stanley, makes this case well in a readable book.

In order to translate these into growth in corporate earnings and portfolio returns, investors need: political stability, strong respect for property rights, effective dispute resolution, a predictable regulatory and tax regime, a positive foreign investment climate, efficient markets, strong corporate governance, reliable corporate auditing and financial reporting, ethical managements, transparent corporate structures, and economies balanced between exports and internal consumption. Divining the strengths and weaknesses of an EM in these areas can only be done by active management, with experience in the markets, boots on the ground and a disciplined investment process. 

From 2000-2010, the annualized return on the MSCI Emerging Markets Index was 10.9% vs. 1.3% for the MSCI World Index of developed markets.  Since then, performance across the MSCI index universe of 21 EM and 24 frontier markets has been uneven and disappointing, with volatilities up to 50% higher than developed markets, and high correlations.  In recent times, it has mattered greatly what an investor owned and didn’t own. 

What went wrong?  What can investors do moving forward with their EME sleeves of their portfolio?

Some EM countries like Brazil and Russia are heavily tied to commodity exports, from oil and gas to soybeans and minerals.  In the case of Russia, demographics aren’t favorable, and political issues don’t point to stability going forward.  China’s planners are working hard to swing their export juggernaut more towards producing for domestic consumption. This requires more access for multinationals, but they are coming under scrutiny for breaking price regulations, which serve as a form of non-tariff barrier to growth. 

A CFA Institute paper suggests that historical exposure to India and South Africa, while excluding Russia and Brazilian holdings, can generate incremental portfolio return and perhaps reduce overall portfolio risk.  Selectivity in EM portfolio structuring seems to be better for portfolio risk management.

Indian equities, according to Morgan Stanley, are up 33% YTD (7/31) compared to the diversified EM index up only 8%.  This market offers rising middle class consumption, a growing financial services sector and a relatively balanced economy, among other attributes.  On traditional portfolio metrics, EM markets are not cheap, but investors must make their decisions on a longer-term horizon in order to reap their expected returns.  Morgan Stanley’s Lisa Shalett writes that Mexico offers similarly attractive features in the current environment.  Taking a long view, a selective EM portfolio, with the right countries and some more small and midcap exposure, will probably yield superior returns to broad indexing.

Where To From Here for HP?

HP reported results for Q3 FY14, and there were some things to like, and some weaknesses, but questions about the future still remain.  No one doubts that the company is on stable footing, and that CEO Meg Whitman has done a great job of convincing customers that their need for a reliable stable  of 'full service' IT providers will include an HP committed to providing the products and services their CTOs need in a world of complex and rapidly changing corporate demands.  This is no small achievement, and the stock price appreciation from the lows recognizes this.

However, what about the future beyond the next quarter?  What does HP want to be, and what is the future business model going forward?  Based on this quarter, it is more incrementalism, balance sheet management, and repeated references to acquisitions.  But the same issues have been on the table, in our mind, since 2012.

 "The new CEO says that the number one question she faced when going out and talking to customers, partners and investors was "What is HP?"   She characterized the company as being No. 1 or No. 2 in all of its operating business segments.  Based on the performance of the segments and on their outlook, this statement seems inaccurate.  There was talk about how smoothly the Autonomy acquisition was going, with the companies "exchanging hundreds of sales leads," and yet the acquisition seemingly has no impact on EPS in 2012, but without any detailed guidance, this isn't easy to tease out.  Autonomy's website claims the company has 25,000 customers worldwide, many of which must be small and scattered across a variety of product offerings from social media analytics to eDiscovery."

Before returning to these ideas, let's quickly review Q3 FY14.  Revenues of $27.6 billion were up 1% on a constant currency basis.  64% of revenues come from outside the U.S. which is encouraging because it speaks to the global reach of the company's offerings and to HP's not being tied to U.S. business trends (36% of consolidated revenue came from the U.S. in the quarter) for future growth.

20% of revenues, or $5.6 billion came from the Printing business, which declined 4% y/y.  Printing accounted for 38% of the company's adjusted, non-GAAP operating income of $1,026 million and an operating margin of 18.4%.  Supplies contributed 66% of the business operating income, but sales of supplies increased 4% y/y in constant currency.

Personal Systems sales of $8.6 billion, were 30% of consolidated revenue, and $346 million in non-GAAP operating income amounted to a 4.0% margin rate and 13% of consolidated non-GAAP operating profit--a contribution as opposed to a drag..  Revenue was up 12% y/y!  Commercial sales were up 14% y/y, and unit sales of notebooks were up 18% y/y in units.  There's no doubt that this is encouraging news, along with printing's solid performance, despite its lackluster y/y comparisons.

Enterprise Services continues to look like a boat rowing in circles.  $5.6 billion in revenues were 20% of consolidated revenues, but only 8% of consolidated, non-GAAP operating profit with a paltry 4.1% operating profit margin.  Overall revenues for the segment were down 6% y/y.  The information technology outsourcing business was down 6%, and the systems consulting business was down 5%.  This has been like a broken record for quite a while, and it is a fundamentally flawed business model.

Software contributed was a paltry 3% of consolidated revenue, and something is also amiss in this business, which contributed 7% of consolidated non-GAAP operating profit, at an operating profit margin rate of 21.2%.

Cash flow from operations was $3.7 billion compared to $2.7 billion, increasing 36% compared to the prior year period.  Free cash flow of $2.7 billion compared to $2.0 billion in the prior year period.

YTD FY 14 share repurchases amounted to $1,978 million versus $1,053 million for the comparable period in FY13.

The strength in U.S. sales was encouraging, helped by the rebound in the PC business, especially to corporate customers. Along with the performance of the Enterprise Group, it underlines HP's importance to large corporate buyers.  Foreign sales were also encouraging.  However, there was nothing new on the road ahead.  The easy work has been done, although that might not be the right word.

CEO Meg Whitman needs to freshen her message away from the that of the days when HP had a loaded gun to its head.  She has taken that away, moved the patient off the respirator, and instilled some confidence and discipline into the business. However, a turnaround like this can still go awry when the ship really has to go off in search of a New, New World.  Does the ship have the right crew?  Are they all on board?

The Autonomy fiasco still lingers.  Documents filed in the action by former Autonomy CFO Sushovan Hussain have some interesting passages.  They reveal that HP was preparing to buy Autonomy for $11 billion in 2011, HP CFO Cathy Lesjak said the price was too high and that HP was not prepared to integrate the organization.  Her adamant opposition was steam rollered by former CEP Apotheker, and by board member Lane and others.

The UK Serious Fraud Office has not moved forward at all in investigating HP's charges made after the $8.3 billion write off, and now HP has made a 'settlement" that really calls into question why it is looking to save face for its directors and previous management instead of 'fessing up to the incompetence and value-destroying behavior.

This company is clearly incapable of valuing, making and integrating large acquisitions to add value.  Witness EDS and Autonomy.  Therefore, why make the argument now that acquisitions are essential?  There's no reason to think anything has changed.  We've said before, the board should  be flushed out in one way or another before shareholders can have faith in an acquisition-driven strategy going forward.

Cisco's 4Q FY'14: Low Quality Earnings Concerns

Cisco reported a heavily financially engineered 4Q FY'14.  Revenue of $12,357 million was down 0.5% from $12,417 million a year ago. The gross margin rate of 61.8% declined 30 bp from 62.1% in 4Q FY'13. Operating expenses as a percent of revenue decline 10 bp to 33.8% on $4,181 million. Net income of $2,835 million compared to $2,847 million, translating into GAAP diluted EPS of $0.43 versus $0.42 in the prior year period, an increase of 2.4%. Full year GAAP diluted EPS for FY'14 of 1.49 compared to $1.86,  a decline of 20%.

To get to the non-GAAP EPS for the full year, there were $3,998 million in adjustments to GAAP pre-tax income, compared to $2,486 million in adjustments to GAAP pre-tax income in FY'13, an increase of 61%. For the fourth quarter of FY14, non-GAAP diluted EPS of $0.55 compared to $0.52 in the prior year period, an increase of 6%. For the full year FY'14, non-GAAP diluted EPS was a 'record' $2.06 per share compared to an adjusted $2.02 in the prior year, an increase of 2%, and above internal expectations.

The shareholders were returned $2.5 billion in 4Q FY'14, through $1.5 billion in repurchases (average price of $25.11), and $1.0 billion in dividends, comprising 69% of the quarterly CFO of $3.6 billion, above the economically meaningless target of 50%.  For the full year FY'14, CFO amounted to $12.3 billion and $13.3 billion was returned to shareholders, comprised of $9.5 billion in repurchases ($22.71 per share) and $3.8 billion in dividends.  Since inception, the average price per share repurchased was $20.63.

Somehow expectations were met, cash was returned, and the analysts on the call seemed chloroformed.

CEO John Chambers noted orders were up 1%, book-to-bill ratio was up 1%, and the backlog was $5.4 billion.  The company, which knew in 2011 about the coming tsunami of change in the way IT services were bought and deployed, during this call talked about "significant risks" to the business.  It also announced that it was reducing its work force by 6,000, or 8% of the force. Pre-tax charges of FY'15 income will be up to $700 million, or an astonishing average of $117k per headcount reduced. Non-GAAP diluted EPS will benefit over GAAP diluted EPS to the tune of $0.14-$0.18 per share.

If the company is so far ahead of the curve, why is it seemingly reacting reflexively after the fact to the increased pace of change in IT?  Someone asked the question, "Why now?"  I can't remember what was said. because it was meaningless.

Domestic U.S. business was up 5%, with Government business up 6%.  In the U.S. orders larger than $1 million increased by 22%. This was about the only real, meaningful ray of light in what was called a "solid" quarter that decidedly "mixed," at best.

EMEA in the quarter grew by 2%, with the U.K. being the strongest at 8%.  Russian business declined by 35%, and excluding Russia, the EMEA region's sales would have increased by 4%.  Looking at a half-empty glass through 3D glasses makes it seem like two half empty glasses, which is a full one!  The BRICs were assigned a dire outlook for the indefinite future: we'll let you know when we think things are getting better. As off handed as this sounded, all of the Tech Troika (IBM, HP, Cisco) are in the same boat, but it does make Cisco's ability to grow beyond non-GAAP adjustments questionable.

Collaboration declined by 4%, and TelePresence sales also declined, which seems odd since it was one of the subjects of a WSJ article ahead of the earnings report.

The big question investors have about Cisco is the effect of software defined networking (SDN) on gross margins, as hardware components (switches are 30% of revenue) become commodity products.  How will Cisco manage the declines without growing the total revenue base at mid to high single digits?  No answer was forthcoming, but the CEO blew lots of sunshine up the analysts' kilts.

Cisco will be the leader in SDN, said the CEO, without saying by when, by what measure, or how.  There was the announcement of a mind-numbing collaboration with Microsoft, but I couldn't understand what it meant.  The CEO assured investors that SDN will not drive gross margins down for Cisco, again without any elaboration or explanation, simply an assertion. No analyst had the energy to challenge the salesman/cheerleader CEO.

The network will be at the heart of the corporate future, and Cisco will be at the core.  I don't know what this means.  The example of a taxi company was cited, but it wasn't clear if it was Uber, Lyft, or a new competitor.

The CEO referenced three recent acquisitions: Tail-f Systems ( cloud virtualization), ThreatGRID (Internet security), and Assemblage (collaboration on mobile platforms). In reality, nobody knows how well Cisco has done with its huge number of acquisitions over CEO John Chambers' tenure. Amortization of purchased intangibles from acquisitions is a perennial feature of adjustments to GAAP income in Cisco's results.

Cisco's sales force and channel partners make for a complex distribution system, requiring inventory management which is hampered by the terms required to compete for strong channel partners who are also competitors of the company, in some product areas.  I suspect Cisco's sales force needs some rationalization, particularly as the company shifts to more software-oriented sales. Leadership changes were referred to several times on the earnings call by the CEO.

All in all, the numbers were made, but like other tech companies driven largely by financial engineering, including share buybacks.  It's hard to see how this company can be valued outside of a range of $20-$25, given the magnitude and quality of the Q4 FY'14 numbers and the lackluster guidance from the perennially optimistic management. Perhaps there is little downside risk, but there is also no compelling case for owning the stock now either.

Market Winds Stall

From the Wall Street Journal, we see that the market has given back seven months of gains in a day. Well, a day does not a correction make, but at least some cautious sentiment is taking hold.  Looking back at some recent points, what still looks concerning?

• According to Fed presidents, the labor markets remain weak, unhealthy, in flux or whatever euphemism is acceptable to the Yellen regime. [Despite the recent job numbers, and the trend of a few months nobody is willing to declare victory yet]
• The housing "recovery" has stalled, weakened, sputtered.[No change here.]
• The Fed won't tie monetary policy to rules, but some Fed Presidents feel that rates may rise sooner rather than later. [The confusion and dissonance among Presidents continues]
• Our larger, more concentrated banking sector is shelling out billions in shareholder equity to the government without admitting any crime they've committed.  Meanwhile, their fundamental businesses, with some lending growth, are lackluster.[Still in place: look at Bank of America]
• Trading revenue continues to flounder for the investment banks.[Bank of America excepted: probably a timing issue]
• Top line revenue continues to be hard to come by, and earnings gains continue to be of low quality, especially in the tech sector, where retirement plan commitments are excluded from "normal" earnings.[IBM's ninth consecutive quarter of declining revenue from core businesses and low quality EPS; the $20 per share "earnings road map" number has been dismissed as meaningless as a barometer of fundamental future prospects]

In Europe, all our points remain in place and some look worse on recent news:

• Germany's Chancellor getting ready to impose sanctions.
• Elysee Palace will impose sanctions and export restrictions, but they will not impact the export of Mistral systems to Russia.
• Sanctions will take some time to gain traction.
• Is Britain part of Europe? Jury still out.
• Daily operations at Banco Espirito Santo even worse than anyone expected.  Board and management were unaware of assets and balance sheet commitments. Inquiries underway. 
• Europe was 'cheap' and getting 'cheaper.'

The Middle East will be descending into a more complex maelstrom, which the U.S. does not understand. Israel must complete whatever action it is contemplating against Hamas soon. Sentiments pro-Israeli military action and pro-Hamas are both increasing: not a stable outlook.