Is Uber Overvalued?

In a commentary on venture capital which I wrote as an Editor of the Schulze School of Entrepreneurship's EIX Exchange (University of St. Thomas), I made a reference to a yawning gap in valuations in the following paragraph:

"Uber is the example of a disruptive service that turns a large, existing market of cars-for-hire upside down.  Professor Aswath Damodoran of the Stern School of Business has estimated Uber's global TAM for taxi and car service at $100 billion.  Venture capitalist Bill Gurley of Benchmark Capital, an A Round investor in Uber, argues that over time network effects will expand the TAM to some 25 times Damodaran's estimate.  I inject this real-life example because it is the one I always have in mind when analysts talk about a "disruptive" service or product."

I studied Professor Damodoran's course material on valuation during some work at NYU and through the CFA review course books: he is unquestionably good at what he does, has applied his methods to hundreds of different kinds of companies, and has also consulted with number of big companies on the same issues.  I read his full analysis of Uber, and it is, as all his work, eminently reasonable.

Bill Gurley is a very smart investor and a very wealthy man, but he clearly has a promotional axe to grind with his valuation, since Benchmark is sitting pretty as an early investor in Uber.  "Network effects" are certainly real in particular cases, but they are widely used in this kind of patter as another form of hand waving.   Reading his article, Uber will eventually convince rational economic actors that it doesn't pay to own a car and the roads will be clogged with black Camrys providing transportation services to consumers like kids going to soccer games and grannies going to their medical appointment, even venture capitalists going up to their ski lodges.  Furthermore, it will do this in every country.  Take this fully network effected addressable market, give Uber a huge capture ratio, and you get this kind of 25x difference in valuation.   As the VCs like to say, it all scales.

But, like in every economic problem, there is at least one fixed factor, and that is time.  There are only 24 hours in a day.  Drivers can't drive 24 hours a day, and even the Uber drivers doing 8 hours a night for 5-7 days can't keep it up too long.  As Uber tweaks its model with fees and hurdles for drivers to achieve different payouts, it will run into the issue that drivers making $50,000 or so a year, probably not making their social security contributions and taking all the maintenance, debt service and insurance risk on their vehicles eventually will conclude that it's a great model for a company which is a piece of software, but not for them.  That labor force will churn, and no there's no more disruption: it's a rather typical management problem in lots of businesses.

As for taking over the world, Uber is having trouble in India, and it is using its cash hoard to take over competitors.  However, so are the local competitors doing the same things.  Software is ultimately a commodity, and Indian entrepreneurs are devising their own systems for fleet management and payments.  With all the traffic congestion in cities, owners, chauffeurs, auto rickshaws and Uber taxis are all limited in their ability to turn around rides.  No amount of cash in Uber's coffers can make this problem go away.

More up rounds have, are and will be done, but as Chuck Prince said, "As long as the music is playing, you better be dancing."

Feds Stance on Met Life Shows Irrationality and Will Hurt Shareholders

We've written about Met Life before, first as a well managed company with a strong domestic business, and a growing international insurance business in solid markets like Japan.  It is absurd that is considered to be engaged in non-traditional, non-insurance businesses that could generate systemic risk. In fact, the company's complaint contends that Met Life has been deemed a "non-bank financial company" and therefore falling under Dodd-Frank solely because it has 15% of its assets in foreign subsidiaries.

The Financial Oversight Stability Council's lack of transparency and unwillingness to share its data and methodology for its conclusions with Met Life has pushed the company into either acquiescing to FOSC's banana republic tactics, or fighting the action as the rules allow and incurring the ongoing wrath of the Feds.

The move for summary dismissal of Met Life's protest is again arrogant and ludicrous.  Let Met Life have its day in court.  If the Feds are right, Met Life will have spent its own money, but at least it would have sought to preserve future earnings growth, multiple expansion, which are in the best interests of its shareholders.  This is good governance.

Some so-called analysts have suggested the Met Life management should have agreed to divest its foreign businesses, thereby escaping the classification as a systemically important non-bank financial corporation. That is another irrational suggestion because that would admit that the classification process had validity, and it would sell off future growth engines for revenue, earnings, while increasing the dependence on mature economies for growth.

By the kind of reasoning, Berkshire Hathaway is the ultimate, non-bank financial company, with most of its non-bank businesses being financed by the float from its insurance and reinsurance businesses.  The Feds aren't fools and wouldn't dare take on their friend in Omaha: that battle would end before shots were fired.

As the numbers attest, Met Life operates through highly regulated insurance subsidiaries, both here and abroad, which together generate 95% of corporate revenues, hold 98% of consolidated assets, 96% of consolidated liabilities; these subsidiaries are true operating subsidiaries, selling and servicing insurance policies, while managing the assets which backstop the policies.  What could be simpler? Insurance has long been effectively regulated, as far as risk and policy holder protection, by existing state and federal laws.

Met Life shareholders should be, but are probably not, flooding the mailboxes of their elected representatives to end this folly.  Stay tuned.

Warren Buffett: Gimme Breakfast With My Burger King

The poet and essayist Ralph Waldo Emerson wrote, "A foolish consistency is the hobgoblin of little minds." For poetry, this aphorism is most apt.  For all those politicians and other n'eer-do-wells who have used it, I am not sure. That won't stop me from using it, tongue in cheek, for Warren Buffett's offer to finance 3G Capital Partner's buyout of Tim Hortons.

Tim Hortons, owned by Wendy's, was used side-by-side with a Wendy's, as a way of adding a bigger breakfast day part to Wendy's and adding some real estate synergy to the combined menu offerings of the two restaurants.  It didn't seem to work, and now it's for sale.

We've written in this blog about Buffett's long relationship with Brazilian-led 3G Capital Partners which was behind its stepping up to help finance the purchase of Heinz, and about how that relationship would be a new model for Berkshire going forward, i.e. partnering with private equity to do bigger, better, and faster returning deals than BRK's working on its own.  Here is an example in this deal, and it sounds like it should work out well for the preferred holder, as that instrument has borne much fruit recently, as exemplified by the Goldman deal.

What is rather funny is the philosophical inconsistency being shown by the Oracle of Omaha.  Standing ideologically cheek-by-jowl with President Obama, we heard much puffery about not minding paying more taxes, his secretary's paying more than Mr. Buffett, yada-yada.

Now BRK will help 3G and itself to make a productive investment via a tax inversion to our Canadian neighbors to the north.  The PR firms will all make the mild outrage go away.  President Obama will call Omaha, ask for a bigger campaign contribution, and say he expressed his displeasure to Mr. Buffett.  What could be more consistent?

The Chrysler UAW Bailout

The auto industry bailouts during the financial crisis completely overturned our traditional legal statutes governing how creditors are treated during bankruptcies. With today's announcement that Fiat is buying out the 41.5% of Chrysler which it does not already own, these issues are as evident as ever.

A 2012 Backgrounder from the Heritage Foundation gives good information and references which are very consistent with the most recent October 2013 report from the SIGTARP Inspector General.

Chrysler has been mismanaged for many decades, and it has had several turnarounds.  None of them ever really addressed their operational and product development mismanagement, or their labor costs which were among the highest in the American automobile market.  Pre-bankruptcy labor costs at Chrysler were $76 per hour in May 2012, higher than both GM and Ford at the time and significantly higher than costs at Honda, Toyota and Nissan.

Pre-bankruptcy, Chrysler has $6.9 billion of senior secured liabilities and $2.9 billion of junior secured liabilities, according to the figures in the report.  $5 billion was owed to unsecured trade creditors.  Chrysler owed $8 billion to the VEBA (Voluntary Employee Beneficiary Association) formed in 2007 to assume the liabilities of the employee retirement plans.

Bankruptcy allows the corporation to restructure its contracts, subject to two heretofore inviolable principles. Secured creditors stand first in line for recoveries, including the ability to seize encumbered assets if necessary.  Unsecured creditors are considered the great unwashed, and they are traditionally wiped out or in unusual circumstances get pennies on the dollar as recoveries.

Because of Chrysler's long, troubled financial history its bonds were secured debt, which wasn't typically the case.  Senior secured creditors of Chrysler who were owed $6.9 billion recovered $2 billion, or $0.29 on the dollar.  The junior secured creditors somehow recovered $0.0 on $2 billion owed.

In this kind of structure,  which is very unusual, the unsecured creditors, including the UAW/VEBA, should have expected nothing except to be wiped out. Instead, the Obama administration converted the $8 billion into a 41.5% stake in the reorganized Chrysler, along with a 9% note.  The total 2012 PV of the Chrysler bailout, which only benefited the UAW and its membership, was estimated at $9.2 billion in the report cited.

Labor agreements and labor costs are traditionally renounced and reset in bankruptcy agreements.  While labor costs were adjusted to close the nominal gap to Honda/Toyota/Nissan to around $56 per hour, Chrysler workers will still earn substantially more than the average U.S. manufacturing sector worker, with no ties to productivity or work rule flexibility.

The exercise of Federal control and intervention in financial markets and in matters like executive compensation of corporations in which it has bought a stake at gunpoint will surely be regarded as a weakening of our economic system whose virtues we trumpet so loudly.  The government's facilitating of rent seeking by its favored political constituencies, like auto unions, is also an unprecedented manipulation of the bankruptcy process in which the role of the judges and administrative apparatus have also been marginalized. "If there's money up for grabs, I might as well be the one grabbing," a client once told me. He was a greenmailer, but his motto is still relevant today.

The Poverty of Behavioral Economics

With the awards of the recent Nobel Prizes in Economics to Eugene Fama, Lars Peter Hansen and Robert Shiller, the whole discussion about market efficiency and behavioral economics surfaced anew in the press.  Professor Fama's efficient market theories are said to be discredited, according to the financial press.  The evidence?  The last financial crisis and its aftermath.  Never mind that the supposed evidence is weakly related, if at all, to the theory.

Professor Shiller, on the other hand, is suddenly lionized as a foil to Professor Fama for being a 'behavioral economist.'  Having viewed Shiller's "Financial Economics" class that he teaches at Yale online, I'm very puzzled, as most of that course is a nice exposition of modern portfolio theory, of which Fama is a father along with several others.

In the investments class I taught to upper level finance MBAs at the University of St. Thomas, there was a small discussion from Shiller about how markets can deviate from efficient equilibria due to something he describes as "noise trading."  Since this was a counterargument to the mainline theory from an economist of quality and stature, I dutifully taught it in our discussions.

The problem?  It sounds good, and it intuitively matches our ex-post experience of market runs and crashes.  However, there's no good model for how fundamental traders and noise traders behave, and therefore there is no model to test and no data.  It's an interesting idea, but empty.  It's a metaphor, but little else.

Recently, I received two different kinds of material from Chicago Booth School of Business.  One was an informative and thoughtful piece by Professor John Cochrane, one of my favorite researchers, on why Gene Fama was awarded the Nobel Prize. If you'd like to understand the theory apart from its facile characterization in the press, have a read, linked above.

By contrast, I also received a link to a video in which three 'behavioral' researchers from different disciplines at Chicago Booth expound findings from their latest research.  The research results seemed either blindingly obvious, somewhat puzzling, or downright counterexperiential.  These are all very smart people, but the discussion betrays the real poverty of behavioral economics.

Going into their relatively small experiments, there is no theoretical model from which they can measure their actual results compared to the expected results from their theories.  They find some correlation or trend, give it a name, and say that the result is "quite surprising."  Why?  What exactly did you expect?  I was really interested to know about the relative effectiveness of intrinsic versus extrinsic rewards in the performance of marathoners. I don't know anything interesting, thought provoking or useful after this discussion.

IBM CEO's Email: Lots More in Common With HP

When we compared the quarterly results of HP and IBM exactly one year ago, we noted,

"The reports of both companies show how difficult it is to consistently generate above GDP revenue growth, ex-currency, in this tepid recovery, now almost three years old, from the financial crisis."

In their most recent earnings call, HP CEO Meg Whitman noted the importance of having a team with the right people, in the right place and with the right attitude.  Yesterday, IBM CEO Virginia Rometty announced a reconstitution of the growth markets team at IBM, tasking sales leader Bruno DiLeo  "...to reassemble the team that used to run the growth markets unit, and he will take over responsibility for running the group. Under Mr. Di Leo, IBM's growth markets unit saw a strong run, often generating double-digit revenue growth. The unit was established under Di Leo in 2008 and he ran it until early 2012." 

In passing, I would say that reconstituting a sales team from a few years ago isn't automatically a winning strategy. Five years ago, they may have been the right players in the right place; some of being in the right place at the right time is just LUCK.  They may have been average players entering the business at the inflection of the down cycle, riding the upswing. If they have the right attitude, it has to be that the wind is now in their faces, but they know that they can prevail. Let's hope the move bears fruit. 

Mr. DiLeo's name was mentioned by the IBM CFO in his responses to a question in this week's earnings conference call.  He previewed the culture of performance remarks today when he noted IBM's substantially reduced quarterly incentive payments.  So, really despite the brave face the CFO put on at the beginning of yesterday's conference call, he had to know that it really was a disappointing quarter, with poor execution.

Going back to the 2015 Road Map slides, we see that from the 2010 baseline, the company projects top line revenue growth of about 5%, made up of 2% growth in the core company, excluding divestitures; about 1% from shifting to smaller, but faster growing businesses; and, 2% revenue growth contribution from acquisitions. Now, two years from the End of the Road, revenue growth looks really problematical.  

Bouncing to HP CEO Meg Whitman's continued reference to "GDP like" growth rates, we see that theme in the IBM Road Map projections.  The IBM core businesses are projected to grow at about 3%, composed of 2% organic and a 1% benefit from mix.  Maybe this is the face of our mature technology companies for a while.  Can it be true?

Looking at the at least $20 non-GAAP EPS in $2015, the revenue growth shortfall over the past six quarters compromises both the revenue contribution, but it has a greater effect on the enterprise productivity and on the margin mix contribution.  The contribution from share repurchases in the most recent quarter was a higher contribution than the assumed average from 2010-2015.  That can reverse, to be sure, but the "execution." a.k.a. revenue growth has to turn around. 

The Road Map assumes, on average, 11% a year in constant currency growth contribution from IBM's "growth markets," which means non-North America and developed Europe.  It won't be easy.

Looking back at the whole market this week, it raises a point that appears at the head of this blog post. Technicians used to say that a healthy market "climbs a wall of worry." This far into our so-called, economic recovery, organic revenue growth has been lacking across the board for seasoned, large public companies, no matter what the sector. 

• IBM third quarter revenue of $23.7 billion is down 2% in constant currency;
• Industrial bellwether G.E.'s revenue of $35.7 billion down 1.5%.
• Goldman Sachs reports revenue of $6.7 billion, down 20% yr/yr;
• Wells Fargo revenues decline 3.5%, yr/yr;
• JP Morgan Chase revenues decline 8.1% yr/yr;

There has been some good news as from Google and eBay, but the latter sports a high relative multiple.  The market seems to be trading as a bet on Washington histrionics, but investors' companies seem to be reporting challenging environments across their markets.  European stocks have been touted by lots of money managers and have been bought extensively, despite issues shoved under the rug at the big banks and top line challenges at the larger European non-financial companies.  I don't know what it all means, but it certainly doesn't feel like an environment for hitting new highs, but there it is. 

IBM's 3rd Quarter Report: Issues Outweigh the Financial Engineering

Reading up on IBM's recent history, I was genuinely surprised to see the lack of significant revenue growth since 2008; I know we've had a tech cycle on top of a recession,but still this is Big Blue.  This company likes financial engineering, befitting a company founded by engineers.  According to Forbes, Warren Buffett owns about 6% of IBM, comprising about 19% of the Berkshire equity portfolio.

Mr. Buffett likes company management, its levered return on equity, and the large return of cash to shareholders through buybacks and dividends. The relatively flattish share price alongside the continuing buybacks allows Berkshire to wind up owning a proportionately larger share of the company over time. In many ways, this is the dream profile for the ultimate value investor.

Going into the call, it struck me that HP, Microsoft, IBM and Cisco, despite the varied regard in which the companies and management are held by investors,  all share the same problems.  They have all built very large, profitable businesses selling hardware, associated middleware, application software, consulting and enterprise management services to large corporate customers.  Now, everyone agrees that what buyers purchase and how they pay for it, will be rapidly changing.  So, the common challenge is to turn these aircraft carriers around on the high seas.  As their legacy businesses decline, they have to manage a transition to an environment that won't require or favor aircraft carrier organizations in the future.  They're all in the same boat, which I guess I didn't realize.

The third quarter 2013 conference call was led by a very fast talking, matter-of-fact CFO who dutifully read the results, which he characterized as representing solid accomplishments.  There were some, but overall this quarterly report, taken in the context of no revenue growth from 2008-2012, should have been a major disappointment to management.  The financial engineering that permeated the GAAP results, on top of of significant non-GAAP adjustments, made for a very low "quality of earnings."

Consolidated revenues of $23.7 billion in the third quarter, declined 2 percent yr/yr on a constant currency ("c.c.") basis.  59% of revenues came from Global Technology Services ($9.5 bn) and Global Business Services ($4.6 bn).  These businesses were the bright spots in the quarter, which we'll see later.  The Systems and Technology group revenues of $3.2 bn declined 16 percent yr/yr, in c.c. More on this later too.

GAAP gross profit was $11, 380 million, but with $102 million in adjustments for acquisitions and $154 million in adjustments for pension plan investment assumptions, transition expenses, and plan terminations, non-GAAP adjusted operating gross profit was $11, 636 million, or a very healthy gross margin rate of 49.1 percent. The rate increased one hundred basis points, yr/yr, due to margin expansion in the services businesses (against easy comparisons) and to a better mix of software sales, due a 2 percent c.c. increase in software and to the double digit decline in hardware sales.

GAAP total operating expenses were $6,567 million in the quarter, but after adjusting for acquisitions and pension expenses, they were reduced to $6,352 million, on a non-GAAP basis.  GAAP pre-tax income of $4,812 million, after acquisition adjustments of $214 million and pension expense adjustments of $257 million, translated to $5,284 million of non-GAAP, pre-tax income.

The GAAP tax rate for the quarter was a financially engineered 16 percent, down 860 basis points over the prior year quarter.  Wow!

Diluted EPS for the third quarter of 2013 were $3.68, on a GAAP basis, compared to $3.33 in the prior-year quarter, on the same basis, an increase of 10.5 percent.  This was characterized as a solid performance, but it was really financial engineering.

The company's supplementary slides had a good reconciliation bridge from last year's third quarter diluted EPS to the 2013 year level: $3.33  was reduced by ($0.14) due to the lack of revenue growth, while margin expansion in the services businesses contributed $0.33 per share yr/yr.  The effect of share repurchases in the quarter added $0.16 per share on a yr/yr basis.  All this yields the current year's $3.68 per share. Note that the tax rate effect wasn't explicitly called out.

54 percent of the yr/yr improvement came from the margin expansion and 5% sales expansion in Global Business Services, while 46% of the yr/yr improvement came from the effect of share repurchases.  One could characterize this as a 'balanced scorecard' between operations and financial balance sheet management, but given the history of recent years and quarters, I don't think this is justified.

Anticipating the forthcoming questions about execution, the CFO mentioned the culture of performance and accountability in IBM; he noted that quarterly incentive payments declined by $177 million (if I heard this right) year-over-year to affirm the comment.  Of course, it's not clear what this means: quarterly bonuses or reduced sales force commissions which would automatically follow from lower sales, or both.  He didn't put the comment out clearly or with much conviction.

Regionally, sales in the Americas were $10.3 billion, flat on a c.c. yr/yr.  So, Big Blue or no, the IT spending cycle is stuck in neutral for all the players.  EMEA sales of $7.3 billion were down 2 percent in c.c.  Asia-Pacific sales of $5.5 billion declined 4 percent on a c.c. basis.  Together these regions account for 97% of consolidated revenue.  The BRICs amount for the remaining 3 percent. so for all the commercials about a globally smarter planet, virtually all of IBM's sales really occur in traditional markets, not a bad thing but different from the commercials.

The good questions from analysts centered on the same issues that we noted at the beginning of this post. If I can paraphrase Toni Sacconaghi of Sanford Bernstein, he said something like the following. " I want to step back a bit from the current quarter. IBM has reported negative revenue growth for the past six or seven quarters.  Without the tax rate benefit in the current quarter, this quarter would have been considered a 'miss.' What has changed at IBM, and should we think about IBM in a different way going forward?  Is this a company that reports no growth on the topline and reports less than double digit earnings growth on the bottom line?"  Questions from Goldman Sachs, Stiefel Nicholas, and Barclays were basically around the same point, namely "What does the company model look like in the future? "

For the much heralded "Road Map," the question was how to get from here, about $16 in EPS to $20 in two years.

The CFO's responses, sad to say, generally evaded the core question.  I think that he himself was thinking aloud through the questions, which is amazing, since they are the critical issues that he must have briefed about beforehand.

There was a reflection about IBM's China business that was said to be about 5 percent of IBM's revenue, which is a bit inconsistent with the geographic presentation of sales, but it could be rounding. Of this, forty percent was in hardware which declined precipitously due to the country's slowing of outside procurement as it develops a new five year plan, slated for completion in November 2013.  The CFO opined that once the new plan was published, business should return to normal in the first quarter of 2014.  Talk about rose colored glasses!  Chinese global enterprises like Lenovo, Huawei and others are integral parts of the economic plan since, in some cases the government itself is a large stakeholder.  Their designs, like IBM's are global, and to think that a US company will be able to continue with business as usual under a different Chinese economic worldview may be ill conceived.

An analyst noted that achieving the Road Map's $20 EPS would require 12 percent yr/yr earnings growth in 2014 and 2015.  What is required for this kind of acceleration?  The CFO said that Systems and Technology would have to stabilize its level of profitability compared to 2013.  To achieve this minimalist goal, he said, that the STG would have to successfully introduce new products that are planned for launch. Services should minimally require low single digit growth, although it wasn't clear what these businesses would look like ex-planned divestitures. The cloud businesses, just like HP, will have to grow at double digit rates, but not all of this will be incremental, but it should be more profitable. If I were building a model with what little I know, I would have to do a lot of hand waving to get my desired end product of $20 in earnings.

Somewhere in the end of the question period, the CFO's position changed and he said that the quarter had been challenging or disappointing, I don't recall his exact language.  Finally, this was an honest reaction. Judging from the stock trading down six percent right after the call, others agreed.

With a consolidated debt/capitalization of 64 percent, and a non-financial debt/capitalization of 39%, IBM has a strong balance sheet.  It did not make an egregiously bad large acquisition like HP did with Autonomy. It should be able to plug in several smaller, tuck-in acquisitions to help its cloud efforts.  The four horsemen will be trampling each other in the field to overpay for innovative, niche companies.  Given their lackluster revenue growth and their changing markets, they probably have little choice.

The question of "execution" is referred to often in HP CEO Meg Whitman's remarks.  Clearly, this has been a sore point too for IBM, but their stock of goodwill with the Street has insulated them from more strident choruses.  Their multiple, highly compensated sales forces and distribution channels probably need to be rationalized too over time.  Unfortunately for shareholder most of this will be under the covers.  If the customer is changing, and their budgets and desired ways of using technology are changing, then it follows that corporate go-to-market organizations will have to change with them.

Checking In With Tech's Four Horsemen: HP

Let's recap in broad strokes how we got were we are.  Meg Whitman takes over as CEO, gets a brief honeymoon.  She eventually produces not only a clear, new strategic plan and resets expectations for a multiyear horizon.  From the fourth quarter of 2012 until recently, the stock goes on a tear from $12ish to $27ish, before pulling back testing the $20 support level.

The initial guidance strategy, depending on your viewpoint, was to take investor expectations to the sub-basement.  Another way of looking at it would be to say that management told it "like it was."  A multi-year turnaround.  Lots of industry and macro headwinds.  Lack of innovation and commitment to deliver new products.  Sales organization problems.  Executives in the wrong spots on the roster.  And so on, and so on.

The promised staff reductions came quickly, and the ramp up of this program caught some skeptical analysts by surprise.  Along with some one-time factors, good tax planning, and cash flow management, debt was paid down faster than expected and the share repurchases continued.  What was not to like about this?

We believe that the dysfunctional culture within HP and the organizational discouragement precipitated by the reigns of the imperial and imperious Mark Hurd and the clueless Leo Apotheker have gained traction and buy-in within the rank-and-file.  The new board members, given their stature and experience would certainly not have come on ship if they didn't fully vet the longevity and outcome of the turnaround.

So, here we are, but where is that?  The consensus view of analysts for the Analyst Day outlook revisions are that the company, which has already cautioned about no 2014 revenue growth, will revise this outlook down sharply, for both the revenue and earnings lines.  In other words, "No Expectations."

Targets have been lowered, and some analysts have projected a price decline to the mid-teens, post the revised outlook.

In the meantime, the company seems to have introduced both Windows and Android tablet lines aimed at the corporate accounts.  So, their stated intention of being the best, platform-agnostic supplier of hardware, software and services to global corporate accounts seems well underway.  That's pretty encouraging.

As we've said before, there is still some significant portfolio optimization to be done, e.g. on corporate technology services.  Lowering expectations would give good cover to announce this now, but I'm not sure that it's on the radar at the moment.  Not a big deal.

Given that Dell has shot itself in the thigh with its acrimonious deal that couldn't have given its customers or employees much comfort, HP's visibility with corporate accounts should continue to increase.  That's good.

So, we definitely go into Analyst Day, with "No Expectations," which is okay, and we return to the Stones for a closing serenade,

Microsoft Analyst Day: The Good, Bad and the Ugly

The good, bad and the ugly were all on display at Microsoft's 2013 Financial Analyst Day.  I didn't have the stomach for the whole shebang, but looked through COO Kevin Turner's slides and listened to part of the Questions and Answer session before succumbing to reading the transcript.

The good stuff is not new, and it all appears in Kevin Turner's slides. The issues for concern are in the behavior, body language and interactions among the COO, CFO and CEO that are evident in the video of the question and answers.

I was surprised by the amateurish character of  the whole setup for a global technology industry leader. How can they help their customer companies do better when they can't even run an important corporate presentation for themselves?  Despite all the remote mikes, a webcast viewer can never hear the questions from the audience.  The transcripts reflect gaps by saying "Off mike," when they can't pick up the speaker. How 1980's!  The lighting is out of balance, poorly placed and gets so bad at one point both the CFO and CEO put their hands over their eyes to look out into the audience.

For a small cap company, this is trivial; for Microsoft at an equity market capitalization of $273 billion, this is just inexcusable and, worse, inconsistent with their image and messaging.  Indicative, but small.

Here is the first question in the Q+A:

"QUESTION:  (Off mike.)  Just a real quick question for Amy, the $6-1/2 billion of CAPEX that you have for Fiscal '14, obviously a big step up from previous years, is that a one-time step up and then back down, or is that a sustainable level for the next several years?

AMY HOOD:  Well, what I would say is that if you're in the devices and services business and you're successful, I would hope that we continue to need to invest capital to build out the infrastructure and the server capacity over time.  So that's how I would think about it."

Simple question.  In fact, to open a session, it's clearly a softball, pitched for the CFO to hit it out of the park. This is the role of the first questioner who wants to do the company a favor.  The answer is not only non-responsive, it makes no sense.  The first thing to do is to reject the "one time" argument as this would make no sense either.  After that, some general comment about a range for the representative level of capital expenditures in the coming years, without making a forecast, would suffice.  Or, to work off the COO's slides, "Look we're pursuing a $181 billion market opportunity in cloud computing, and you see how fast we're already booking business from Kevin's slides, so we'll commit to higher levels because we already see the returns from that business."  

We have expressed concerns about the incumbents in the CFO chair before, and based on what we see and here in this exchange, it is still a real issue for shareholders.  The CFO has to be a strong personality, and shareholders look to that chair as a counterweight to overly optimistic, aggressive CEOs who are expected to be over the top.  The CFO has to make sure that the shareholders' money and interests are well protected.  Here's the flip side of the problem from an extremely loud and overcaffeinated Steve Ballmer. 

"STEVE BALLMER:  I don't know what really happens in all the telecom companies, but at least the myth of the telecom companies from 20 years ago, we should make the investment, huge CAPEX, and then it all goes away, success as Amy said breeds new CAPEX here.  There's no sort of point of saturation if our customers continue to buy more stuff from us.  We would consider that a first rate problem."

Talk about making no sense! Who cares about telecoms from 20 years ago?  Did Amy say "success breeds new capex?"  Capex of $6 billion is not any kind of "problem" for a company with no net debt and $75 billion in cash: that wasn't the question.  It was a softball question for an analyst modeling free cash flows for the next few years.  Mr. Ballmer stepped in with both feet because he didn't like his CFO's answer, but the trouble is, he made it worse not better.  Watch the CFO cringing as he speaks.  

Having a weak role and a revolving door of undistinguished players as CFO will be an issue for the company going forward. 

A critical question was asked in a very soft way by another analyst, and the way it was treated demonstrates the basis for our concerns expressed in a previous post.  

"QUESTION:  (Off mike.)  There is the perception that you need different types of skill sets to operate both in enterprise and the consumer business.  I guess as you see this leadership transition coming in, I guess do you feel that internally you have the skill sets to manage both a very large enterprise company as well as a very large consumer company, and does ‑‑ I guess how does that impact your view or the board's view of who makes sense to take over for you?  Thanks.

STEVE BALLMER:  I mean this is one people like to jawbone about, and I don't quite get it. We've been selling to consumers and enterprises basically since about 1985.  It used to be people thought we were better at the consumer side and worse at the enterprise side.  Now people think we're better at the enterprise side and worse on the consumer side.  I'd love everybody to say you're good at both sides, but I don't see the fundamental disconnect.  I really honestly don't feel it even in the culture of the place."

This is a problem, and will be a problem for the new CEO as (s)he struggles with the Microsoft Leviathan. Mr. Ballmer's history and biases dominating a weak board along with Mr. Gates will stand in the way of Lew Gerstner-style actions from a strong CEO.  Here's a different way of looking at the past.

Microsoft was only "better on the consumer side" because of the OS monopoly created by the WinTel axis and by the domination of the PC in the corporate workplace.  Monopolists make profits not because they're smarter, but because they don't have to compete. 

When Microsoft competed as a monopolist, their culture was not to beat any competition, but to nuke them out of existence.  They were able to do this by dint of their lockup with Intel and by the huge cash flows from the boxed software licensing business. 

Remember when Microsoft wanted to buy Quicken, the best consumer money management software by a mile?  When the regulators stopped this, what did Microsoft produce?  Micrsoft Money!  This was a terrible product even for Microsoft, and I speak as a user who abandoned ship early.  When Personal Information Managers (PIMs) first came out, there were a number of innovative products first-to-market, but somehow they all disappeared and Outlook eventually took over.  Remember Netscape?  Now we have the bloated, resource-hogging Explorer xx.  I use Chrome, which runs fast, smoothly and almost never crashes. But, Microsoft Web Apps don't play well in Chrome, so a user is often forced to go back to Explorer.  

The point is that I, as a Microsoft consumer user from the earliest days can honestly say I never have regarded them as being good at anything, but there was never a seamless alternative.  The switching of the consumer software model to Office 365 really doesn't make a lot of sense unless a home has five PCs which is probably a 1% group.  That model for consumers is not attractive.  How Microsoft does as a consumer company going forward  cannot be predicted from the past; if it were extrapolated from the past, the future would be grim indeed.  

What are some of the points from Kevin Turner's presentation?  A balanced revenue portfolio.  Good, but let the company focus, and let investors diversify their portfolios themselves.  We've talked extensively about capital allocation.  The Enterprise businesses are attractive and Microsoft may ultimately be a stronger competitor than Oracle and other established players on the software and services sides, but that is still an open question.

One of the most interesting slides from Kevin Turner's presentation is one depicting revenue from three large scale corporate customers, pre and post-cloud computing services.  It shows Office 365 and Azure customers, and the year-over-year revenue gains are on the order of 20% or better.  Again, the problem is that the sales efforts and compensation models for these businesses are quite different from the consumer businesses.  Let the Microsoft Enterprise stand alone and do its thing while creating value unencumbered by the legacy of a consumer-unfriendly culture endemic to Microsoft.  

I know that these Microsoft posts are very widely read around the world from the stats, but send me some comments because I want to know about other ideas too. 

Microsoft's 22% Dividend Hike: What's The Signal?

So Microsoft raised its dividend 22% ahead of its Analysts Day.  This compares to a widely expected level of 15%.  It also announced a $40 billion share buyback authorization. From John Lintner's 1956 publication, the notion of dividends as signals to the investor marketplace is widely spouted, but not well understood.

So, in the case of Microsoft what could the dividend and the buyback be signaling?  Here is a succinct summary of the signaling case from a 2011 paper by Baker and Wurgler of Harvard Business School and Stern School, respectively,

"Standard dividend signaling theories posit that executives use dividends to destroy some firm value and thereby signal that plenty of value remains. The money burning takes the form of tax-inefficient distributions, foregone profitable investment, or costly external finance."

The research from investment analysts and management consultants on whether share buybacks add or destroy value has generally been negative.  According to a Credit Suisse report by Zion, Varshney, and Burnap from June 2012, the information technology sector bought back $619 billion of stock from 2004-2011, accounting for about 23% of all buybacks from the ten Standard and Poors industry sectors; information technology was number one by a wide margin.  So, in a sense, buybacks come with the territory of being a technology leader.

The Credit Suisse analysts, when they use a benchmark cost of equity against which to evaluate the economic value-added from a buyback, note that only 36 percent of the Standard and Poors companies which bought back $2.7 trillion of their shares during 2044-2011 added value by doing so.  So, 64 percent of our leading public companies destroyed value by their share buybacks.

What's more out of the Top 10 companies that spend more than $1 billion in share buybacks and earned the highest annualized returns above their costs of equity, none of them were in the information technology sector. Rather they were in prosaic industries like tobacco, retailing, and distribution. One financial services firm and a medical device company were in the group.  So, tech companies don't seem to play this game well, according to the most recent period surveyed.

(A 2012 paper by Lambrecht and Myers of the University of Lancaster and MIT Sloan, respectively gives another, more provocative theory about share buybacks.  For those readers who like academic research.)

Microsoft is being set up by the press as facing a tough Analysts Day.  Compared to the HP Investor Day, this one looks extremely bland, more like an extended conference call. Investors have seen their company destroy value through repeated, fundamental misreadings of the evolution of personal and business technology, together with acquisitions that seem to trail innovation rather than blaze the path.

Investors are not worried about the level of dividends or share buybacks.  They want to know if their company will continue to be a leader in the new technology bazaar, not the old Technology Officers Club. Some of the key questions are corporate organization, executive management, the portfolio, allocation of capital, the innovation process, management incentives, and the CEO succession.  Unfortunately, all of these are effectively off the table due to the timing of announcements, by fiat in the case of CEO succession, and by the fact that there are no answers now.

$1.5 billion in Office 365 revenue is pointed to as indicating great things.  I have my doubts, but the truth is that the rationale for consumers and business adopting this model has not seemed convincing.  I recognize that there is some rationale for big corporate licensees, but that's assuming that they don't eventually get fed up and go to a better option being developed elsewhere.

Arrogance and the power of the monopolist is what built the company's cash horde.  The Windows model is winding down, perhaps slowly but inevitably. Trying to become a consumer oriented company around hardware goes against the company's evolutionary DNA.  Consumers are price-driven, fickle, demanding and always set to move to the next big thing.  Microsoft is unlikely to become a leading gaming or entertainment company under its current structure.  How are these issues going to be resolved?

This is where the value will be added, not by short-term share buybacks and dividend hikes.  Microsoft's board charter should to make sure that the company stays in business forever, to paraphrase Harvey Mackay.  Given its current financial strength and many assets, investors need to understand how the past egregious destruction of value will give way to a new era of value creation.  That is the beginning and the end of the story.

Let's see if we know anything more after the Analysts Day.

Guaranteed To Fail: A Great Analysis of Systemic Risk

Guaranteed To Fail is one of the best books on the global financial meltdown and its aftermath. If you have any interest in these issues, I offer it as recommended reading. It reflects some pioneering applied research by Professors Viral Acharya, Matthew Richardson, Van Niewerburgh, and Lawrence White. It is concise and well written.  Many of the points they make have been corroborated by other reputable researchers in the field, and their final achievement is the establishment of the Stern School V-Lab, which is an analysis of systemic risk to the global financial system far superior to the banal and manipulated models  like VaR and self-administered bank stress tests.

We know now, for example, that in recent times of financial crisis, correlations among asset classes have converged, thereby vitiating the traditional benefits of portfolio diversification.  We also know that individual security betas and correlations within sectors like the banks change dramatically; yet, most published estimates of these betas and correlations are poor estimates and misleading for policy and financial management.  The Stern V-Lab does daily estimates of all these factors using a variety of powerful modeling techniques, and it uses them to generate daily estimates of systemic risk and the contribution to systemic risk by individual banks.

Acharya et al focus on the role of  the Government Sponsored Entities(GSE's) Fannie Mae and Freddie Mac in the crisis, noting that they were run as the largest hedge funds on earth.  The GSE's were run at a gearing ratio of 39:1!  The authors note that 15% of the mortgage purchases went to low quality mortgages, totalling $1.7 trillion.  These estimates are very consistent with findings of the Congressional Research Service and by Professor John Coffee of the Columbia University School of Business. 

In addition to leverage issues, the GSE's woefully undercharged for their mortage backing service.  They charged $0.20 per $100 of mortgage assets, which still allowed the entities to record revenues of $7 billion. They were also woefully underreserved by design, since this highly leveraged business model maximized executive compensation, which was built on private industry comparables. Reserves were built at $0.45 per $100 of mortage assets. Please refer to the above discussion to recall what they were buying. 

According to the CRS, "In broad terms, the GSEs purchased slightly more than $169 billion of private label subprime MBS in 2006 and 2007; they purchased slightly less than $58 billion of Alt-A MBS in the same time period out of combined total mortgage purchases of $1.677 trillion. At the end of 2007, the subprime and Alt-A MBS represented 13.5% of the GSEs’ total assets."   These assets, purchased under political pressure from Congressional leaders and by private originators like Countrywide Financial, were among the most toxic in the marketplace. 

The authors note that the 2007 vintage had 23% of loans with equal to or greater than 80% LTV and 18% with FICO scores below 660.  The 2006 vintage was composed of 23% subprime mortgages and 15% interest-only loans.  These vintages were purchased in a concentration of zip codes which had historically poor mortgage performance, according to an analysis done by the Columbia Business School. 

Former Federal Reserve Bank of St. Louis President Bill Poole, a Professor at Johns Hopkins when I was a graduate student, noted in this week's conference at the Witherspoon Institute  that the big bailout costs have been for Fannie Mae and Freddie Mac.  According to his estimate, they stand at $150 billion and counting. 

In the Stern book, the authors quote Minneapolis Fed President Narayana Kocherlakota as saying that the Federal Reserve's balance sheet in twenty years will likely still have $250 billion of mortgage backed securities on the books.  Unwinding the Fed's $2 trillion balance sheet will not be easy, as we've written about before. 

Right now, 59% of all financial sector liabilities are underwritten by taxpayers in some way.

Having at look at today's V-Lab, among the Global Systemic Risk Top 10 Banks, we find at the top in descending order, Deutsche Bank, BNP Paribas, Credit Agricole, and Barclays plc.  We find a German bank, two French banks, and a British bank.  No European capital will be immune from the ongoing stalemate in the euro crisis, whether in the currency union or not.  Incidentally, Bank of America is also in the top 10. 

It's great food for thought, and if you're so inclined, beyond reading "Guaranteed to Fail," have a look around at the V-Lab. 

Deutsche Telekom: Hello! Anyone Home?

Responding to widespread consumer sentiment, the FCC has opposed Deutsche Telekom's proposed sale of T-Mobile and its subsequent merger with ATT.  The FCC draft study released today forcefully rebuts all the benefits of the merger to US wireless services, consumer pricing, and job creation. 

I went to T-Mobile's IR site and looked over their recently reported fiscal third quarter results.  It's hard to imagine what management was thinking in their running of U.S. T-Mobile.  Overall, adjusted EBITDA for US operations increased 9.2%, which is nothing to sneeze at, and the adjusted operating margin was 27.8%.  Again, no alarm bells going off yet. 

However, the adjusted operating margin in the US compares to an operating margin of 41.5% in Germany and 36% in the rest of Europe.  One thing that jumps out notably is the investment and roll out of network investment and product innovation for German customers, essentially bringing multimedia services to smart phones and other devices.  It is very impressive, and probably accounts for revenue growth, subscriber growth and EBITDA margins in Germany and probably in Europe.

There has been essentially no such investment in the US T-Mobile network.  For full disclosure, I have been with T-Mobile as a personal customer for probably more than a decade.  I've also experienced ATT as a corporate customer a few times.  T-Mobile's early decision to build a GSM network seemed savvy to me, since it allowed a customer to be able to operate easily in Europe where GSM was the network choice, as opposed to ATT's original CDMA.  Rates per minute were always the best, and the customer service was top notch, miles ahead of any of our other providers.

T-Mobile poured millions into a wildly successful brand identity campaign with Catherine Zeta-Jones, but the campaign was focused solely on price, with no reference to the network or customer service.  One of the reasons was the DT was investing nothing in T-Mobile's network, which makes no sense.  For wireless, the network is the product.  Verizon, meanwhile, beat us to death with the "Can you hear me now?" 

Over the past five quarters, T-Mobile has had an exodus of contract customers, about 1.2 million customers lost.  But, what would one expect?  The announcement of the merger made it an open field for everyone, including the moribund Sprint to poach customers.  Plus, anyone who has dealt with ATT probably went to jump into the arms of Verizon.  So, the result shouldn't have been surprising.

On the other hand, over the same past five quarters, T-Mobile has added about 1.2 million pre-paid customers, which seem like they should be more profitable than some big users on T-Mobile data plans.  Overall, net adds were about zero for the trailing five quarters. 

US revenue for the fiscal third quarter was down to 3.7 billion euros from 4.1 billion euros in the prior year period.  Data network development expenditures by DT in the US had been flat at fairly low levels for the past five quarters.

Talking as I do with T-Mobile retailers and customer service people, you can feel the demoralizing effect of the proposed merger and the subsequent exodus of contract customers.  They were told to bombard existing customers with trade-up offers and useless text offers. It's not their fault, but the fault of poor management.

It appears during the entire tenure of DT's ownership of T-Mobile that it has been run in almost a harvesting mode.  This market is full of customers who are knowledgeable, demanding and sticky.  DT has made a mess of their investment, which is curious given their strong track record.  However, look at their competition in Europe.   That probably explains much of their monopoly-like 42% operating margins in Germany.

I hope that T-Mobile is not collateral damage in this tug of war with regulators about the ATT deal. 

HP Conference Call Gives No Comfort For Investors

HP's 4th Quarter and fiscal year-end conference call marked new CEO Meg Whitman's debut after eight weeks on the job; it gave no comfort for investors, and analysts from Goldman, Morgan Stanley and Citigroup seemed almost comatose, not challenging the disjointed and contradictory presentation.  The stock sunk immediately after the call, on healthy volume.

One fundamental comment concerns the financial statement presentation: Big 4 auditors in my experience are usually reluctant to permit widespread use of non-GAAP financial measures in presentation of results, and they try to limit their use and keep the corresponding GAAP measures adjacent to the non-GAAP measures.  Although HP provides reconciliations in their slides (what they call a "bridge"), the management leans totally on non-GAAP measures of performance.  One of the problems with the non-GAAP measures is that they are not comparable across companies, since companies differ in what they consider one-time or non-operating items.

For the full fiscal year 2011, HP reported GAAP pre-tax income of $8,982 million, or $3.32 net per diluted share. Adding back charges for impairment of goodwill and purchased intangibles, amortization of purchased intangibles, restructuring, and acquisition related charges, produces $4,350 million of adjustments to pre-tax income.  At a 22% tax rate, non-GAAP adjusted EPS for 2011 becomes $4.88, like magic!  Similar hand-waving for the fourth quarter turned reported EPS of $0.12 into a non-GAAP EPS of $1.17.

By making these adjustments for comparability, the board and the management escape the fundamental problem that these large acquisitions now being written down were the avowed strategy of the company over a long period of time.  The adjustments are economic testimony to the fact that they were poorly conceived and executed.  Aren't these "operating" items for a company whose stated goal has been to make mega-acquisitions?  I realize that I'm mixing accounting with what the statements are trying to represent, but I hope the reader will indulge me.  In fact, CEO Whitman continued to talk about acquisitions in HP's future, saying only wanly that there might not be any more mega-deals. I certainly hope not!

In an amazing show of chutzpah, the management said that they would no longer give any forward guidance, except for EPS.  Consider what they said.  For fiscal 2012, management expects the company to earn at least $3.20 on a GAAP basis, compared to $3.32 on the same basis in the prior year, a decline of 3.6%.  I sincerely doubt that management will be compensated for 2012 on EPS, as suggested by CEO Whitman.

On a non-GAAP basis, management said that the company is expected to earn at least $4.00 per share, compared to $4.88 in the prior year period, on the same basis, a decline of 18%!  Buried in a footnote in one of the presentation slides is an item that says, "Full year fiscal 2012 non-GAAP diluted EPS estimates exclude after-tax costs of approximately $0.80 per share, related primarily the amortization and impairment of purchased intangibles, restructuring charges and acquisition-related charges."  So, the stream of "one time" items continues into 2012, and there will again be a difference between reported EPS and non-GAAP EPS.

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.

The Personal Systems Group (PSG) which was going to be sold off by Whitman's predecessor will now be retained.  Based on its performance and outlook, it must be an industry No. 2 because there are only two horses in the race.  The company's commentary during the call was guiding strongly to single digit declines in PSG revenue in 2012 compared to 2011.  Disk drive shortages from Thailand flooding, widespread consumer spending declines for both notebooks and tablets, the failure to have an established tablet product in the market, and a decline in ASP's will all militate against revenue growth and margins may touch record lows. Fourth quarter 2011 operating margins in PSG were 5.7%, typical of a commodity business.  In the first half of FY 2012, these margins may drop as low as 2-3% before a macroeconomic industry upturn in the second half starts to raise units, price, and mix.  2012 seems like just putting a finger in the dike for this business.

We've written before about HP's being overly reliant on the printing supplies business, which is included in Imaging and Printing Group (IPG).  The company pushed too much product into their wholesale and retail channels in 2011, and it hopes to work these off in the first half of FY 2012.  Operating profit in this segment had a recent peak at 17% in FY 2010, and it may spend FY 2012-2013 in the 13-14% range.  This is an industry leading business, but to paraphrase the CEO, "Printing is a coincident indicator of economic and business confidence and sensitive to price in a downturn."  Remember how we were all going to print studio-quality photos on our printers at home?  Not!

Services 2011 revenues of $36 billion is just behind PSG's 2011 revenues of roughly $40 billion.  As I think of the industry leaders in this segment, I think of IBM and Accenture, not HP.  CEO Whitman's talk about this business was not at all enthusiastic.  She talked about a multi-year turnaround for this business, the need to hire people who "can actually deliver what the customer wants," the need to invest in better quality sales people, and margin pressure in the basic service offerings. This does not sound like a No. 1 or No. 2 business leader in the industry.

IBM Global Services Revenue, by contrast, is projected by Credit Suisse to be $63 billion in 2012, with 33% gross margins and 15% pre-tax margins.  HP's management has suggested operating margins for Services in the 10-12% range for 2012-2013 on flat to low single digit revenue growth.

The Enterprise Server, Storage and Networking Business (ESSN) The company is one of the market leaders in Industry Standard Serves (ISS), but even this segment of the business would, according to management, be facing macroeconomic deceleration in upgrade and replacement cycles, continuing problems with Oracle's move away from the Itanium chip,  Facebook, Google and others building their own servers, and a deterioration in HP's traditional storage offerings. Now that Dell has acquired Compellent, they would seem to have a more innovative and attractive set of options for large volume storage customers. Operating margins in this business should continue to be under pressure in 2012.

The company will be ramping up its R&D spending, something which does not give us comfort given that previously high levels appear to have yielded nothing, which then required the company to purchase innovation expensively in the capital  markets.

Whatever FCF the company generates in FY 2012, it will be dedicated to paying down debt related to the Autonomy acquisition, and so cash returned to shareholders, which is a healthy percentage of the free cash flow, probably won't grow too much.

The HP value creation machine may be stuck in neutral almost certainly through Q1-2 FY 2012, and time continues to be on the value investor's side to see if this is the board and management team has the ability to restore the company's tarnished luster.

QE2 Hasn't Affected The Economy

I noted this comment from my former colleague, Dr. Ward McCarthy, Chief Monetary Economist for Jeffries:

"...the logjam in the banking system is evidence that QE2 has not filtered into the real sector of the economy to any significant degree. So long as this persists, it will be an indication that the monetary policy transmission mechanism has not worked efficiently."

Yet we continually, and with blind faith, talk about monetary policy not being out of bullets in reducing the employment rate through a QE3.  I wish that Chairman Bernanke would get on a National White Board and explain this in five minutes without any acronyms or jargon. 

Pimco's Kashkari Gloomy About Equity Returns

Pimco has always been a bond house, but lately they've made a concerted effort to develop mutual fund products for equity investors.  The equity mutual fund field is like the favela in Sao Paulo: dangerous and overcrowded.  Neel Kashkari, a Goldman and U.S. Treasury alumnus, is leading that charge into equity.  In a recent interview with Morningstar, Neel  didn't take a sunny view of equity returns.

Instead, he says that the U.S. is in a long period of adjustment which will mean much lower economic growth and lower asset returns than historical norms.  Like our posts on the so called consumer deleveraging, he says that it has barely begun and has a long way to go.  Large corporations, and to some extent the mid-market firms, have completed their deleveraging and are flush with cash.  However, they will find precious little sales growth here at home if the consumer sector continues on life support.  It's an interesting interview.

Of course, what's the conclusion following from Kashkari's world view?  Get connected with emerging markets. Brazil is apparently fully valued.  China has already produced negative surprises and may have more skeletons emerging from the closet.  Apparently, selected Russian companies may be value plays.

How can a U.S. investor, particularly an individual investor, take these kinds of risks in a low return world without significant risk premia?  Macroeconomic data for all these countries is barely acceptable, the financial press is weak or non-existent, corporate governance is of poor quality and not monitored by strong watchdog groups, and the auditing function is hostage to low quality national partners and shielded from accountability by the structures of the major accounting firms.  Does this sound like an answer to low U.S. returns? 

Look at what happened to Southeastern Asset Management, which runs the Longleaf Funds, very successful long-term value oriented investors.  Mason Hawkins and Stanley Cates have put together the ingredients I look for in a good equity mutual fund manager: good people, an ethical culture, a sound research process and approach to valuation, and manager incentives that are aligned with shareholder interests. Their employees are the largest shareholders across their family of equity mutual funds and have been since time immemorial.  This is the way it should be, but it's rare.

Southeastern has been rattled by being a long-term 5% plus shareholder in Japan's Olympus Corporation, which may have been hiding trading losses for a decade or more.  This is a Tokyo Stock Exchange listed large capitalization company with good businesses and a long track record.  I understand the statistical issues of this being "an n of one" on the TSE or in a diversified portfolio.  My point is look what is still happening even in foreign markets which we consider "developed."

Think now about the same investor's position in a Brazilian oil company, software company, or REIT?  The outside investor is at a tremendous information disadvantage.  Even depending on analysts stationed in the country is no assurance of risk mitigation.  It depends on culture, people and processes in those local operations, which are difficult to manage from afar.  If emerging market investing is an answer, it will have to be on a company-by-company basis.  I don't think it makes sense for investors to buy into, for example, the "Brazilian Miracle," or the "Indian Miracle," or any other gold rush country. 

Reading Kashkari's piece made me lament for the eras of 8% equity returns, which are still embedded in the long-term projections of many public and private pension funds.  The maiden of high returns has vanished, as Neel suggests.   I had to turn to Bill Withers and his baleful tune, "Ain't No Sunshine When She's Gone."  I can go back to my investment statements with some comfort.  Thanks, Bill.

Papendreou Agonistes: Greece Throws Down The Gauntlet

For all the hectoring that Greek Prime Minister Papendreou may soon face from the German Chancellor and French Prime Minister, his gambit of calling for a referendum seems politically and economically rational.  Under a scenario of further fiscal discipline mandated by the EU, economic growth prospects are dismal which means growing political unrest and instability in Greece.  The Greek political leadership will not be able to influence the path of future events, other than to be reacting to serial crises.

If, on the other hand, a referendum goes were to go forward and pass, Greece could resurrect the drachma, gain control over its future monetary policy and have an exchange rate to adjust for differential inflation levels with the rest of the EU and for payment imbalances.  A run on the banks would have to be forestalled, but Argentina suffered through a bank run in 2001 and reemerged healthier five years later.

Asset markets would be thrown into turmoil, but everything would eventually be remeasured, and life would go on, with limited access to the capital markets for some time.  However, from the political standpoint, Greece would be in charge of its monetary and fiscal policies, as opposed to the popular perception that the country is at the mercy of Germany and France.  Short-run economic growth prospects in this scenario shouldn't be much worse than under the current euro structure, assuming that fiscal discipline continues and revenues are eventually raised through higher taxes and better collections.

The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years.

Back in July, we wrote about the limited options for the European Central Bank. We focused on " the fundamental problem of economic imbalances within the European Union."  Professor David Beim of the Columbia University School of Business puts forward a cogent analysis in his October 9 paper, "Can the Euro Be Saved?"

The seminal formulations of the economic and currency union idea were put forward by Robert Mundell, Roland McKinnon, Peter Kenen, Douglas Dosser and others in the 1960s.  As Beim rightly points out, these models were predicated on the countries being broadly similar, especially as regards having common or similar rates of inflation. If they were not, a currency union must inevitably end in a debt crisis, driven by persistent payments imbalances.  That's where the EU is today.

We've said from the beginning that no politician on our planet will willingly cede national sovereignty over fiscal policy, because that would be either a literal or political death sentence. We've written earlier, "we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro."

Professor Beim agrees, "Greek debt restructuring and exit from the euro needs to happen in the near future and will happen with certainty in the medium future."

Professor Beim raises a really important point, which has been glossed over in all the focus on Greece, and that is the balance sheet of the European Central Bank.  He reads the September 30, 2011 balance sheet showing 2.3 trillion euros of assets, composed of 1.14 trillion of bank loans and distressed sovereign debt!

As he says, "The ECB itself needs to be bailed out, replacing its risking assets with European Financial Stabilisation Mechanism (EFSM) euro-bonds, to the extent that this can be done at this late stage." 
This recapitalisation itself will be a Herculean undertaking.

Auditor Term Limits: Another Irrelevant Idea

Arthur Levitt, former SEC Commissioner, has weighed in favor of "auditor term limits."  This will do nothing but impose costs on companies, and, as usual, those costs will fall disproportionately on smaller companies which don't have armies of people in finance, tax, treasury and accounting.  As a stockholder, already facing meager returns, I wouldn't get excited by this proposal.

It will also add to SOX expenses for no value-added, as auditors will not agree on the identity and number of key controls, which in turn will lengthen audit committee deliberations, particularly for companies which are trying to remediate already existing weaknesses and deficiencies.

This foolish idea will not:

1. Result in higher quality audits
2. Reduce risk for institutional investors.
3. Improve transparency or utility of financial statements produced by issuers.
4. Make auditors work harder on existing engagements.
5. Have any economic benefit beyond political window dressing.

Expect to see board expenses go up because of more audit committee meetings, legal fees go up for outside counsel reviews, and watch audit fees and SOX consulting fees rise also.

As we enter the campaign season, it makes for good headlines, though. 

AIG Enterprise Risk Management: Tougher Than It Sounds

             Photo credit: Philip Montgomery for the Wall Street Journal, Online Edition


AIG has a new "risk czar," Peter Hancock, an economist by training I'm happy to see, who heads up the Chartis unit charged with doing "enterprise risk management."  I have yet so to meet a public company director who can describe in concrete terms what this means for their company, and especially so for financial companies.

One of the operational problems generally, and especially for financial companies, is that risk is generated in silos.  An example of a large silo would be proprietary trading, and a sub-silo might be what's called Delta-1, where the latest rogue trader has surfaced at UBS.  Every profit center will have its own system of reporting, especially for the purposes of calculating bonuses and incentive compensation.  Lots of magic takes place when financials are rolled up for the purposes of external reporting.

Since risk is being generated in large numbers of relevant silos, how can a person at one desk look at a chart, report, or dashboard and monitor risk on an enterprise-wide basis?  I don't believe its possible for an investment bank, which is why we've had rogue traders since way in the early days of MBS trading in 1987.  Howard Rubin generated $377 million in losses which were not discovered until he left Merrill Lynch, and somebody found the unreported trade confirms in his locked desk drawer; he was banned from the industry for nine months and eventually joined Bear Stearns.  Joe Jett was another prominent "profit center" for Kidder Peabody who created some fictional profits of $350 million and paid himself a $9 million bonus before being discovered.  A Japanese trader for Royal Dutch Shell lost $1 billion in unauthorized commodity trading.  Nick Leeson was a recent example who lost $1 billion for Barings, and apparently Kweku Adoboli of UBS has hired Lesson's attorney to defend him in his court action. Sounds like a prudent move for the trader.

The point is that rogue traders are nothing new, and the ones in the news are really a subset of those who are out there and undiscovered, or who had big exposures that reversed themselves before they were found out.
Bonuses, like those that Joe Jett generated for himself, are done in the profit centers themselves and on a basis that is too fast for any effective risk management, except well after the fact.

Managers in the profit silos will complain to risk czars that rigorous systems of oversight and reporting will negatively impact their ability to recruit superstar trading talent.  Guess which side is going to win this argument?  Not somebody like the man in the picture above.

Now AIG is supposedly a simpler business than before, with the demise of their specialty financial businesses.  If this is true, and it has gone back to its traditional  insurance and reinsurance businesses, then it might be possible that a risk management system could be devised and operative.  I can't conceive of how this can be done for a traditional global investment bank.

Dodd-Frank does not give any degree of comfort. Banks will have to divest their prop trading desks, but the problem is that nobody can agree on what constitutes a prop trading desk.  Witness the confused discussion on whether or not Adoboli's Delta 1 desk constituted a prop trading operation, or one that worked on behalf of UBS clients!  The more things change, the more they remain the same.

The ECB Built the Euro On A Shaky Foundation

I found an interesting ECB press release form 1999, in which  Tomasso Padoa-Schioppa, a Member of the Executive Board of the ECB talks about the founding and construction of the European currency.  The discussion is all from a central banker's perspective, and the "primary objective assigned by the Treaty.." is "price stability."  This is to be achieved by a coordinated lowering of interest rates and target growth rate of 4.5% for M3.

What's really curious about this release is the lack of any reference to the financial markets and their role in setting the value of the euro.  The oblique reference to fiscal harmonisation presages today's issue.

"The situation (stability of prices and interest rates), however, would change if the currently perceived risks of fiscal relaxation in Europe were to materialise. The European policy mix might then become unbalanced, and market developments could adversely affect long-term interest rates and the exchange rate. These risks should be considered carefully when assessing the stance of fiscal policies. Reducing deficit and debt levels must therefore remain the objective of European governments, in particular where the public debt is large. This is a pre-condition for a balanced policy mix, one that will keep interest rates low and make the euro a stable currency. You may say that this is the traditional central banker's argument. Yes, it is; but that does not mean that it is not valid."

There never was any incentive or regulatory mechanism for member countries to keep the fiscal policy mix stable.  It was hopelessly naive to have assumed otherwise.  Governments cannot cede sovereignty over fiscal policies to bureaucrats in Brussels, so it still is huis clos.

The market's taking a hatchet last Friday to the share prices of the supposedly stronger European banks was ominous.  Again, the rating agencies went from having their faces splashed with Canoe for their bravado in taking the U.S. credit rating down, to having their faces covered in egg, as they chase the ambulance on the euro.

As we said back in June, the Greeks hold the cards in the short-term in this crisis, which is why it took until September for things to come to a head.  Now that the markets have awakened from their stupor on the euro, there is no really attractive option on the European table which is politically palatable.  In the US markets, meanwhile, it is the spectre of the 2012 elections that is forcing at least some political posturing on our own budget deficit woes. 

EU and Euro Are Still Not Out of the Woods

Germany's high court ruling saves face for Chancellor Merkl, but it isn't a resounding endorsement either.  It's unclear to an English speaking reader what the basis was for rejecting the constitutionality of the German government committing taxpayer funds to sovereign bailouts.  However, it does require that the Chancellor seek approval from the parliamentary budget committee before taking on future obligations, as opposed to the current practice of notice after the fact.

Again, there is an element of pragmatism in the high court's directive to go to the budget committee as opposed to the full parliament, which would have meant gridlock and political grandstanding.  In reflecting this pragmatism, the German courts seem vastly more enlightened than our own.

What happens from here?  The pressure will continue to mount.  Finland's demand for its own dedicated collateral in exchange for participating in the current bailout commitment is still on the table, unresolved.  If the Finns back down, they face political issues at home, while if they are accommodated, the flood gates open and the deal falls apart.  The weaker players are currently being subsidized by the ECB's buying of their bonds, supposedly to keep credit spreads narrower than they otherwise would be.

What awaits them down the road?  Greater austerity and fiscal oversight from the EU.   For Italy, this seems like an unacceptable bargain for the shrewd Italian P.M. Berlusconi, whose balanced budget bill requiring a constitutional amendment is on the table today.

There is simply no significant sentiment behind fiscal harmonization in the EU, and any leader from a peripheral country who dared to back the concept would probably be ousted in a snap election.  Failing fiscal harmonization, the ultimate owner of systemic risk in the Eurozone would be Germany.  Do they want to be in that position?  I think not.  Stay tuned.