IBM Folds the Road Map Hand

As far back as 2012,  we questioned the utility of the 2015 Road Map and its construction. Back in 2013, after CEO Virginia Rometty's overly enthusiastic presentation at Innovation Day, we felt that IBM may have been losing its way.  With the announcement of 3Q 2014 EPS, the Road Map has finally been abandoned. Better late than never.

The CEO's coming on to the investor conference call breaks with an IBM tradition: what a lousy tradition that was!  Abandoning the Road Map, though it came late, perhaps finally symbolizes CEO Rometty's uncoupling from the heritage of her predecessor, under whose leadership the company failed to act on a clearly emerging change in the demands customers would make on their key vendors for IT hardware, software, and services.

Shares outstanding have been reduced by a staggering fifty percent since they beginning of the mega-programs. We have written about these before, so need to go over the ground. Hopefully, it will become less of a focus.

We have always talked about the need for the Tech's Four Horsemen to reinvest in their core businesses, if indeed they want to stay relevant to their customers.  The good news is that IBM, in the CFO's prepared remarks, made specific reference to some sizeable initiatives:

"In the first quarter, you’ll remember that we announced a number of initiatives that
support the shift to our strategic areas of data, cloud, and systems of engagement.
These included the launch of Bluemix, which is our cloud platform-as-a service for
the enterprise, it included a $1.2 billion investment to globally expand SoftLayer
cloud hubs, and it included a $1 billion investment to bring Watson’s cognitive
capabilities to the enterprise. In the second quarter, we made progress to
implement these initiatives, including in June, Bluemix became generally available,
we opened new SoftLayer data centers, we started to ship POWER8, and expanded
the OpenPOWER consortium, and we completed substantially all of the divestiture
of our customer care business.
More recently, we announced additional actions to continue our shift to higher
value. You saw last week that we are investing $3 billion over the next 5 years in
research and early stage development to create the next generation of chip
technologies. Those will fuel the systems required for cloud, big data and
cognitive systems.And just a couple of days ago IBM and Apple announced a strategic global partnership to provide a new level of business value from mobility, for enterprise
clients."

SoftLayer was a big deal acquisition, and making these investments confirms the commitment to add value to it, not just to book revenue.

The next thing the CEO needs to do quickly is to act on something she noted in 2012, the irrelevance and misalignment of the go-to-market model of the old sales force.  Customers are crying out for a change: make it easier to deal with you and to figure out where our ROI lies!

Amazon Web Services Won't Dominate Cloud Computing

Back in 2013, when the the hype about cloud computing and big data was gathering steam, we wrote,

"Unfortunately, none of this really makes it any clearer who is going to carry the day as far as supporting the migration of mega-cap, public multinational corporations to a public cloud computing infrastructure. Will one or more of these companies really want their entire IT infrastructure to reside with a bookseller and operator of global merchandise bazaars?"

Last week, the theory that Amazon Web Services would be the growth and earnings engine for the company was called into question. Data security, risk management, documentation and mitigation of breaches will weigh more heavily on CIOs, particularly in health care and financial services, than saving a few nominal bucks by outsourcing data storage and applications.

Amazon seems to be replacing Apple as the cult stock du jour.  It continues to rate Buy recommendations from major brokerage houses based on long-term dividend discount models that generate huge enterprise values in the indefinite future.  Amazon seems to have corporate ADD.  It touts a business, generates revenue and headlines, loses interest or focus, and then lavishes money on the next, new thing.  Typically, investors don't like this shell game, but Amazon moves on arrogant, uncommunicative and undeterred.

Basic outsourcing of IT services, renting servers and hosting applications, is indeed a commodity aspect of the cloud computing opportunity, and as such it should be the least interesting to investors.

Best Buy's Encouraging Third Quarter

Best Buy's stock trading at $43.58 crashed down to a low of $38.58 before rebounding today.  The price at the higher level was more inflated than the Hindenburg, and I'm sure that most technicians say that a pullback was both warranted and healthy for the longer-term.

Again, it's very funny to see the analyst at Credit Suisse who couldn't like the stock at $12 reiterating a Buy, with the undocumented suggestion of $5.00 per share in earnings power.  The only things missing are when, why and how?

Management's presentation wasn't as polished as in the past.  I know that the executive team are trying their best to give analysts what they want, in what they perceive as their own language. Management always does best when it speaks in their own natural language, expressing who they are and how they think.

The somewhat arbitrary logic of the points presented by the CEO, and the rapid fire basis point differentials between the next quarter and the present quarter for key ratios was hard to follow on the call.  For the CFO to then state that the company was not giving guidance may have been technically correct, but it was also confusing.  Analysts should then make their own revenue projections, plug them in, and then check their margin percentages to make sure the changes fit those given, I guess.  Over time, I hope that they come back to the simpler, clearer, more measured approach that characterized Hubert Joly's first presentation that really calmed the roiling seas when he took over as CEO.

Third quarter fiscal 2014 revenues of $9.4 billion declined 0.2% y/y, due to the effect of store closings in the interim period from the prior year quarter, and softness in international sales, particularly Canada and China. Non-GAAP EPS of $0.18 versus $0.04 was better than expected. Domestic revenues of $7.8 billion increased by 2.3% y/y, which was good news, driven by a domestic same-store sales increase of 1.7%.  So, the streak of declining same-store sales has been broken ahead of the holidays, which seemed like a litmus test for shareholders to believe in the story beyond cost cutting.

Domestic online sales increased 15% over the prior-year period.  So much for show rooming and Amazon. The CFO mentioned the strength of domestic pre-orders for new video game systems and software.  Most of this revenue will be recorded in the fourth quarter of fiscal 2014.  Were these orders recorded as revenue in the current quarter, domestic online sales would have increased over 20%.  New product introductions have always been critical for specialty retailers like Best Buy.

The Renew Blue cost savings programs appear to be on track faster than expectations and faster than those of other mega-cap companies I've followed over the years.  This speaks to the acuity of the current team, and it raises the question of what on earth was going on before they arrived?

In our post of November 16, 2012, we wrote,

"They are shown to have one of the largest customer loyalty data bases in the industry, but it isn't an effective program, especially for inducing activity among inactive customers.  Office Depot, for example, has a better program that requires no customer effort to update and use. This can be easily fixed. 

Best Buy's website looked like something from the 1970s, and the navigation and functionality were primitive.  It looks a lot better since Mr. Joly has come on board, and it can do much, much better.  Despite this, the company drew 1 billion online visitors and generated $2.3 billion in sales from the online channel. 

For all the talk about "low hanging" fruit, some of the fruit, like the operations at Best Buy Canada, is lying on the ground. The cultural and organizational issues, which are much more subtle, can yield a lot, but they will take time."

We've talked about Best Buy's having lost touch with their customers over the years.  Much of what we found the most encouraging about the CEO's introductory remarks didn't have a lot of numbers attached, but it was clear why he was talking explicitly about these issues.  The company now sees customers interacting with the company in very personalized ways.  For example, like most customers, we do extensive price and product research online before visiting a Best Buy or before visiting Best Buy online. The customer might order online, come into the store to purchase, or purchase online but come into the store for merchandise pickup.  These might be different customers shopping in different ways, or it might be the same customer shopping in different ways for specific types of merchandise.

 But, it's not all about price all the time, and Best Buy gets this.  So, in this quarter and in coming quarters, some of the savings from Renew Blue are being reinvested in Best Buy's website.  This is a no brainer, and the new CFO has done this kind of major rebuilding of the engine and the body before at Williams Sonoma.

The CEO noted their expenditures on improving site navigation, taxonomy and the results for natural language queries.  Best Buy's site was in the Stone Age when CEO Joly came on.  It's improved, but it has a long way to go. Yet the improvements made already have generated 15% y/y sales increases.

They have combined killing their previously lame customer rewards program and replacing it with a new one, attached to a new private label credit card program from Citi. The company now offers product category guides online, and allows customer reviews to populate the online guides.  In the quarter, the CEO said that the number of customer product reviews posted online went up fourfold. This is slowly catching up to the industry's best practices, but with Best Buy's size and product diversity, making the website a place where customers want to spend time and give input is a big deal for reconnecting with customers.

Best Buy Canada has wound down 15 stores, and Canada has a poor mix of sales and a strongly promotional sales environment in the prior quarter, which contributed to a sixty basis point decline in the gross margin rate.

More than 400 large format stores will soon be equipped to ship to customers from the store.  Two of the corporate distribution centers are being optimized for online order fulfillment.  Amazon is the platinum standard for online fulfillment, but the good news is that there is nothing proprietary about the building blocks of this capability.

The CEO made a couple of references to welcoming show rooming, as the Best Buy stores are great showrooms, and some of them could in effect become fulfillment centers from the same real estate. This is another big deal.

The CFO noted another orchard of low hanging fruit, namely the merchandise from customer returns.  She said, "As we've discussed, customer returns replacements and damages represent approximately 10% of our revenue and over $400 million a year in losses." (Thomson Reuters transcript) 

If the turnaround was in the second or third inning in the last quarter, it is in the top of the third or fourth at this stage.  What's been unveiled so far looks and sounds very encouraging. 

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.

HP Analyst Day 2013: Sober Optimism

HP's 2013 Analyst Day 2013 disappointed the worst skeptics, including those who boldly called for the stock to move to the mid-teens. Hopefully, that analyst's research director is asking some tough questions about the analyst methodology and model.  It was a solid presentation that raised as many questions as it answered. The management team's presentations were well drilled, and everyone hewed to the CEO's key themes.

First, the CEO quoted a statistic about the amount of information that mankind created since the primordial ooze until 2000, which I frankly don't remember; today, that amount of raw data is produced in one year. This theme was echoed by other executives, including by George Khadifa who heads HP's Software businesses. The context here would be that corporations need to store, protect, analyze and extract value from data mountains that are running on IT infrastructures patched together from the sixties through the eighties.

Within this lies the second theme, namely that IT is being reinvented in its mission, strategic importance, and in the way customers use it, pay for it, and in the way they select partners.  Again, the "new IT" theme was consistently echoed by all the executive presenters.  This all seems eminently plausible.

Meg Whitman's Presentation

In this five year turnaround, the first year was spent diagnosing the patient and building the foundation for the turnaround. After that, her focus was on fixing and rebuilding the company, especially the executive team. She characterized a good team as having the "right people in the right places with the right attitudes."  That's an interesting triad, but it doesn't mention the right incentives, which are especially important in a large, sprawling organization like HP.  The good news is that the CEO said that the current group of executives are a team, for the first time, and it is made up of the right players.  That is no mean accomplishment and would seem to bode well for the future.

Meg Whitman said that FCF of $7 billion through nine months of FY13 and net debt reduction of $8 billion both exceeded the guidance ranges provided at the Analyst Day one year ago.  The management team had done all they could to achieve the corporate financial goals, and to exceed some; she was happy with the performance, but she was now looking forward into the back half of the turnaround.

The CEO repeatedly talked about sales forces and their interactions with their customers.  She has formed her opinions from, among other things, personally meeting with 1,000 major customers of HP,  Overall the sales teams lacked focus, metrics, and the technology infrastructure to sell effectively to their corporate customers and partners.  Increasing the quality of HP's interactions with its customers was overall the number one goal for everyone in the corporate leadership down through the next level of executive client-facing management.

She told a story about being with a top tier corporate IT buyer who said that she told her HP leader about some IT problems for which she was seeking a solution.  The HP account leader said that she would go back to corporate and get some ideas.  Before HP responded, the customer told the CEO that she had already received emails from two competitors asking to set up meetings with their senior technical people to talk about solutions.  It was a small story, but it seemed to speak volumes about the inertia and bureaucracy within HP.

Execution, particularly in sales, both growing within accounts, and quickening new product introductions will be critical to fulfilling the shareholder value part of the turnaround.

The other big, recurring theme echoed by all the executives was that HP's future was going to built around four areas: Cloud, Security, Big Data, and Mobility.  She felt that by offering devices, infrastructure, software and services HP was one of the very few players that could provide the new IT buyer with the whole spectrum of products, tools and services to help their businesses.

The CEO reviewed the major businesses. Enterprise Services, a $17.5 billion business (based on nine months, YTD), accounts for 21% of the YTD revenues but only 5% of the non-GAAP operating income. Whitman cited the inconsistent leadership, strategy, lack of EDS integration, and inadequate internal systems as the biggest reasons for its historically poor performance.  This business needs some portfolio pruning, in my opinion, but the CEO said that there would be no major restructurings in fiscal 2014.  The segment's non-GAAP operating margin was said to be at the high end of the outlook given at last year's meeting, but that doesn't change the fact that this is an albatross that needs to take flight.  It clearly has the CEO's attention.

Whitman cited a pretty extensive list of new leadership within Enterprise Services, including executive promoted from within and new hires from Bain, Accenture, Microsoft, and Elastic Intelligence/BMC.  The leadership group has pretty easy comps to have a strong 2014, let's hope that they get there.

Turning to the Enterprise Group, the CEO noted this is the group that this groups focus is to exploit the industry trend and customer need to build and support a converged infrastructure driven by servers which are increasing dramatically in power, with smaller profiles and lower power consumption.  The Enterprise Group comes to the customer with products like the Moonshot server line, 3PAR storage solutions, networking, security, and data center management tools. Instead of selling a grab bag of discrete products, HP has reset their offerings into a platform called HAVEn for analytics.  The two different capabilities are provided by Vertica for structured data and by Autonomy for unstructured data.  For the nine months of the current fiscal year, Enterprise Group revenues are about $20 billion, with non-GAAP operating income of $2.8 billion.  Enterprise Services, at some point after the ship is righted and the portfolio pruned, should probably be integrated into the Enterprise Group.

Talking about the competitive landscape, Whitman noted the growing population of single technology startups, along with the well known established players.  Partners like Microsoft and Intel are now competitors both on devices, servers and services.  Although she "likes" the assets at HP, she again mentioned the word "execution," which she said will determine HP's degree of success in monetizing those assets. She again reiterated the point that revenue opportunities were being missed at existing large accounts and with partners.  Some of the customer feedback she received is that HP isn't attentive to the customer's thinking and slow to respond.

The response has been to arm the sales organizations with better tools, including Salesforce and Workday. Company-wide, everyone has a Top 40 pairing of opportunities by country, a Top 30 desired innovations for 2014, and a Top 15 growth markets in IT.  All prospecting and market development work, whatever the business segment, will work of the same playbook, and these are expected to have the most financial impact on the CFOs goals.

George Khadifa's presentation on Software was a lot more sober and a little less energetic than the one he did upon joining last year.  It is about a $4 billion on an annual basis this fiscal year. IT operations management is about 39% of the Software segment, applications delivery management about 22%, Autonomy about 23%, Security about 15%, while Vertica is about 1%. 51% of their business is built around software that supports and maintains IT infrastructure: it is recurring revenue. He characterized HP as a large SaaS player, noting that their business is larger than those of Workday and Splunk.

It sounds as if he is quite excited by Vertica, but it is tiny.  It seems that Khadifa has his arms around Autonomy, in terms of getting them to focus their sales and product development efforts around fitting into the HAVEn platform instead of selling the next personal innovation of an engineer.  Khadifa talked more like a corporate insider this time, and he seemed a bit weary from all the infighting and pruning he probably has to do to get this business as a real growth engine, given its relatively small size.  I assume that Khadifa continues to report to the CEO as was announced at last year's Analyst Day.

I continue to believe that Meg Whitman needs more support around her if she isn't going to burn out on this turnaround.  With the repeated reference to execution and the mediocre performance of sales teams, that's too much micro work to land on the CEO's desk, especially if she continues to interact with customers, partners, investors and the board.  A stronger board could provide some counsel and support here, notwithstanding the two new members who are good for the long-term direction.

Overall, she describes HP as growing at GDP rates.  Assuming little inflation, that could be 2-3%.  Lest you think that's pessimistic, she also made repeated references to a balancing act of managing declining or stagnant business lines while feeding and investing in in the future growth drivers.  That is very difficult for the managers of these empires to carry out, unless they think like a CFO or CEO.  So again, if this lands on the CEO's desk, this balancing act of portfolio unwinding and growing is not easy at this scale, espcecially with the business segments being more inter-connected than discrete.  

The research and development budget will be about $3 billion next year.  There will be lots of back office upgrading of systems to manage the diverse portfolio, and these kinds of expenditures were cut off during the Hurd tenure.

Getting back to the GDP-like growth concept for the HP top line, the CEO said that this should be consistent with a 7-9% operating margin and an ROIC of 15-25%.  With limited information and not a lot of effort, it's hard to see how one gets there with the current portfolio.

According to the slides from the CFO's presentation, Printing and the Enterprise Group together comprised  45% of the YTD revenue of $83.2 billion, and 77% of the non-GAAP operating profits.  Enterprise Services and Personal Systems together, account for 49% of revenue and a paltry 14% of operating profit. Software is very profitable but only about 3% of revenue.

The CFO noted that the reduction in force announced over a year ago was stated as being from 29,000 employees plus or minus 15%; the final RIF will be at the upper end of the range.  To date, 22,000 employees have left the company, worldwide.  2014 earnings will get an incremental $1.1 billion of benefit compared to fiscal 2013.

FCF for 2014 is projected at $6-6.5 billion, down from the nine-month pace of the current fiscal year.Earnings per share were projected in the $3.55-$3.75 range.

So the the stock appears to be selling at 6-7x its forward, adjusted EPS level, which is certainly distressed.  The company could just continue to do what it said, and it could show significant gains from multiple expansion alone.  A distressed P/E for tech companies at similar turning points would have been 10-11x.

The consensus which seems to have been a great guide for contrary action on this stock, is Neutral or Hold. I do wonder about the continuing focus on returning 50% or better of the FCF to shareholders through dividends and buy backs. Now that it's clear HP is not a distressed investment, why continue to act as if it's in liquidation?  If there are investments to be made in 64% of the revenue that can be fed by businesses that generate 36% of the operating profit and are stagnant, why not invest what's needed to get out of the gate faster?  Make the shareholder cash return a true residual.  Invest in your growth, unless you really don't have clear projects or you don't believe in them.  It may be splitting hairs, but I think not.

Whether one believes it or not, it is easier to understand what this company is doing and where it's trying to go than it is for that giant ball of yarn in Redmond.  Congrats to HP for trying to be transparent without being blustery or self-congratulatory, like people in blue shirts at Microsoft.

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 Needs A Major Reboot to Stay Relevant

Given the CEO Steve Ballmer's recent announcement of his intention to step down in 2014, I had to reprise this from a recent post.

"Here is my first clue that this announcement spells trouble:

                                                                                            credit: Getty Images
This is the CEO who wrote the 2,700 word memo communicating the reasons why Microsoft was going to re-energize itself and its customers with a reorganization that would unleash "One Microsoft."  One small problem: this man looks incredibly tired, bored, and devoid of any energy and enthusiasm for the message he is delivering.  This is not a man who is going to take names; he badly wants to take a nap. He doesn't believe in what he is preaching: a Chinese menu of platitudes and buzz words."

Now, of course, the reason is clear: Mr. Ballmer knew he was a lame duck and was probably exhausted from coming to terms with the end of his tenure on a terrible quarter and on this dolorous announcement. 

Microsoft is a AAA corporate credit with no net debt and $77 billion of cash on its balance sheet.  Its operating income return on average equity for the fiscal year ended June 30, 2013 was 37%.  Yet for investment returns over the trailing ten year period, its performance was marginally different from that of Cisco and Hewlett-Packard.  Since 2000, according to the New York Times, Microsoft's shares are down 33 percent.  Cisco shares are down 54 percent, Oracle's down 30 percent, and Dell is down 70% over the same period, according to the NYT. 

Microsoft is a growth stock selling at 11x forward earnings?  What gives?

The Windows Division is what the company was founded on in 1975, and 65% of the division's total revenues comes from the sale of the Windows operating system to OEM manufacturers who pre-install it on their desktops and notebooks.  It also houses the Windows services and web services products like Outlook.com and SkyDrive.  In the fiscal year ended 6/30/13, the Windows Division recorded $853 million of Surface RT and Surface Pro revenue. Sales of PC accessories like keyboards and pointing devices are also in this group.  The operating margin for Windows Division, adjusted for the $900 million writeoff related to inventory of the Surface product inventory, was an incredible 54% of revenue.  

This wonderful legacy business, which has a quasi-monopolistic stranglehold on corporate and consumer desktops, is also an Achilles Heel.  The New York Times quotes Zach Nelson, CEO of Net-Suite saying, 

"Microsoft had phones, Microsoft had tablets, but they tried to put Windows in them.  They couldn't leave the PC world behind, even though they saw the change coming." 

Do you think that this issue is in the past? Think again.  Read the Microsoft 10-K for the fiscal year ended 6/30/13, where the company talks about its big picture market opportunity.  The company talks about (p.24, Pt. II, item 7) devoting substantial resources to:

•  "Developing new form factors that have increasingly natural ways to use them, including touch, gesture, and speech. (Surface and successor devices which will mix segment margins down as volume increases.)
•  Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command.(Ray Ozzie's idea?  AI may be for geeks, but this functionality is probably not  what consumers will want)
• Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals.(Everybody is in this game. The winners could be new and several.)
• Establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.(This means that the legacy though currently very profitable will inhibit real innovation.  Microsoft needs to let go of Windows and its legacy)
• Delivering new high-value experiences with improvements in how people learn, work, play, and interact with one another." (This sounds like a gaming company, like Nintendo, or a media company, or perhaps a new e-learning company.  It doesn't sound at all like Microsoft.)

Culturally, it has long been the case within Microsoft that the Windows cabal carried the day for resources and rewards within the company.  The degree of this dysfunction may be subsiding but it is real and very problematic for the company and for its next CEO.  As Zach Nelson says later in the NYT article, "You can imagine a world without Windows..."  Microsoft itself needs to do this, but within the current corporate organization, addressing this kind of change is impossible no matter who the next CEO is.

Can Microsoft "increase agility." Former CTO Ray Ozzie didn't see it MSFT's DNA in 2010 when he wrote, "Certain of our competitors’ products and their rapid advancement and refinement of new usage scenarios have been quite noteworthy.  Our early and clear vision notwithstanding, their execution has surpassed our own in mobile experiences, in the seamless fusion of hardware, software and services, and in social networking and myriad new forms of internet-centric social interaction."

Steve Ballmer's announcement of the most recent reorganization was probably something that should have been left for a new CEO.  What if (s)he has a completely different vision?  This reorganization truly does look like rearranging deck chairs and a waste of resources, as we've said before.

Microsoft's board of directors is totally out of step with a company trying to step out and lead the transition to the kinds of market opportunities listed above in the company's own 10-K.  The President of Harvey Mudd College.  The CEO of Seagate, a key legacy device in the legacy PC.  The former Vice Chairman of Bank of America.  An investment banker with roots in the earliest days of the company.  I've been tough on HP and its board, as have others, but this board is unworthy of one leading a company which, along with Intel, created a whole new industry and probably needs to reinvent that industry again.

They have left the succession issue too long, and the timing has been about as bad as it could be.  The final reason for not owning the company now?  Have you heard the names of some of the touted successors to Steve Ballmer?  Carly Fiorina!  Mark Hurd!  Legacy CEOs-- and bad ones at that-- for a company struggling to go beyond its operating system legacy are not what the company needs. The stock should go down significantly on the announcement of either of these two candidates, and if it doesn't, a short position would probably pay off handsomely. Within eighteen months, the company would implode under the leadership of either of these two candidates.

More tech savvy CEOs who are strong operators have been mentioned, but one hire alone cannot overcome the cultural morass that is present-day Microsoft.  The new CEO would get no useful assistance from the current board of directors.  Overall, things are set up for the failure of a real outsider CEO.  You say that Lew Gerstner did a comparable turnaround at IBM?  The big difference is that the IBM board, a pretty decent one at the time, knew exactly what it wanted to do about its cultural issues, and it was willing to throw its intellectual and relationship capital behind their one and only preferred candidate.  The Microsoft board has no comparable capital to offer a young CEO.

What's the real issue?  As we've said before, and as you can see from Microsoft's own avowed market opportunities, there are probably three distinct technology companies within the current Microsoft.  The first is the legacy Windows Division, which would have the enormous but tapering cash flows from OEM/PC Windows to switch over to Web based applications and services, along with tablets and phones for its future.  If it wanted to develop a Windows replacement in parallel, it would have the cash to do so.

The second would be a fairly powerful and attractive Microsoft Business Division which would also include Servers and Tools.  Revenues of this company would be north of $50 billion, and it would have extremely healthy operating margins, along with robust growth prospects compared to weakened competitors like Dell and others.

The third MiniMicrosoft would be an entertainment/gaming company with online services.  This would be the company where, freed from an O/S legacy, some real risk taking and innovation could take place.  It would need funding, but it would probably draw interest from institutional and strategic investors, provided that it had totally new management and a new culture.

This kind of change is unlikely, but it is necessary.  Perhaps a holding company structure, where excess capital were dividended up to the HC and reallocated would be best.  Some analysts talk about improving capital allocation within the new Microsoft.  Highly unlikely.  Microsoft is hugely overcapitalized, which is inefficient for investors in the current structure.

Put it all together, and there's no reason to own the stock now, but it does pay to keep the radio dial tuned to WMSFT-FM.  I'll be listening.

HP's Separation Anxiety: Take A Deep Breath

A friend of mine who is a globally traveled, senior tech industry executive and problem solver asked me this question, "How did HP do in its most recent quarter?."  The best answer I could give him was. "That depends on what you're looking at."

Overall, the quarter ending 7/31/13 was greeted by Wall Street sending the stock down 12% on the day: a pretty strong reaction.  But, putting it in perspective this left the stock's YTD run up at over 66% versus the prior day's number of 78%. This is still an extraordinarily robust gain, no matter how an investor looks at it.

GAAP revenue was down 8%, and down 7% on a constant currency basis.  Clearly this was a disappointment to the CEO, and a brave face couldn't disguise that it took some air out of her best positive face.

Total Personal Systems sales were down 11%, but really this shouldn't have been a surprise in direction, but perhaps in degree; industry reports on PC shipments and other anecdotal information intra-quarter would have suggested that it was going to be a tough quarter.  Notebook sales were down 16% in dollars, 14% in units and 2% in price.  Desktops were down 10% in sales, 9% in units and 1% in price.  Given the bad timing for the release of Windows 8.1, the notebook retail channel is probably congested with stale product. Pricing didn't collapse, but the fourth quarter might not be pretty either. Again, none of this is new.

Total Printing sales were down 4% y/y, with consumer hardware sales flat.  Overall, not a real negative surprise.

The real stinkers in the quarter from the revenue perspective were the Enterprise Group and Enterprise Services.  Again, the CEO made reference to the Enterprise Group's go-to-market issues which were clearly not something she expected with a mature product offering and long-serving executives.  ISS revenues were down 11%, but again this shouldn't have been much of a surprise since Dell's quarter showed a phenomenon, namely that industry standard servers are commodity products whose scale, cost, energy performance and computing power per rack will make them dinosaurs in an industry transition.  Overall, Enterprise Group revenue of $6.786 billion were down 9% y/y, with the higher margin Technology Services business declining 7% also. The Enterprise Group's operating margin had compressed sharply in the fiscal first quarter, and with continuing sales declines, this business needs to get its act together, but it's not exactly rocket science to determine what needs to be done.

The Enterprise Services Group, a business which we don't think is critical to HP's future in the current configuration, declined 9% y/y with the fading BPO business declining 7% and the Application and Services Business declining 11%.  This business carries a 3.3% operating margin which is comparable to that of the PC business, and yet this ESG gets no discussion on the investor calls.. We've said it before: HP can't be Accenture or IBM in this business, and it doesn't need to be in order to succeed.

So, to this point, the answer to my friend's question would be "It was a lousy quarter."  GAAP diluted EPS was $0.71 versus ($4.49), but clearly this isn't a useful comparison and it meant nothing to a trader reading the headline.  Adding back $0.15 per share for amortization of purchased intangibles, restructuring charges and acquisition-related charges, third quarter Non-GAAP diluted EPS was $0.86 versus $1.00 in the prior year period, on a comparable basis; the prior year period had $5.57 per share in charges for the same categories. Without the promised and delivered cost cutting, the comparison would have been much worse because of the revenue shortfalls discussed above.  The non-GAAP operating margin in the quarter was 8%, a 100 bp decline over the prior year period margin, despite an 8% decline in net revenue.

Cash flow from operations surprised most analysts to the upside with $2.7 billion in CFO, declining 6% y/y; total cash returned to shareholders is something we liked because of the $253 million returned in the fiscal third quarter, only $3 million came from share repurchases and $250 from dividends.  Altogether, looking at Non-GAAP EPS, CFO, funds returned to shareholders and paydown of debt it was really a solid quarter of financial performance.

Here are some bullet points from the Wall Street Journal's discordant story, "H-P's Separation Anxiety"

• Meg Whitman is shuffling deck chairs;
• Her strategy could "still sink Hewlett-Packard;"
• Ceding market share in order to maximize profitability "seems misguided."  
• The company seems as "strategically moribund and unmanageable as ever."
• Lenovo could be a strategic bidder.
• Dell is "cutting price on its gear so that it can grab customers who then sign higher-margin service contracts."  
• Bernstein analyst says the company is worth 50% more than its "current" price being sold for parts.

Let's start from the most trivial points first.  The same analyst who called the stock more undervalued than any stock he'd ever seen at $12 and stayed neutral as it ran away, and in January 2013 his sum-of-parts guesstimate was $29 per share.  Well, it's $22.40 today, with about $0.26 per share also having been returned to shareholders in the interim period.  This is beating the bushes for a deal and just self-serving. 

Dell: well there's certainly an industry leader worth emulating.  If they were cutting prices to grab customers, then that explained their most recent, horrendous quarter on all counts.  The CEO himself, in a totally disingenuous way, has said that he can't take the measures he needs to take to fix his business while all the financial dirty laundry is public.  Is there any evidence that Dell landed major service contracts from giving away gear?  That's a one-time only deal anyway, if it were true.  Trivial point two is laughable.

Lenovo a bidder?  Not likely, unless the Chinese government were to write the checks.  Even in that case, the announcement would crater the HP credit rating, hit the IGC bond holders--who are, in some cases, also equity holders--, and it would rile the U.S. Government and CIOs around the world.  Talk about uncertainty: if you thought the Dell process was a mess, this one would be a value destroying debacle. 

Picking up on the last point, the CEO in her opening plenary statement to Discover 2012 in front of 15,000 participants and 120 Chief Information Officers, said "You want us to win."  We've made this point before, namely that the CIOs want to have at least one or two viable global players who can sell and service platform agnostic solutions, as opposed to shilling appliances and applications separately. 

Remember when G.E. was the global darling of the financial press in Jack Welch's hey day?  Their corporate slogan was "We want to be #1 or #2 in every business we're in, otherwise G.E. will get out of that business." Well, according to Meg Whitman at Discover 2012, HP is #1 or #2 in every business in which it competes.  Now this clearly can't line up with the reporting segments, but I think that you get the idea.  HP has global distribution, presence, and scale that mimics the customers who will need to served in an IT industry that is going to shed many of the go-to-market practices of the past thirty years.  

So, what are the questions and some of the substantive issues at this point in the incipient turnaround?

First, the current strategy has been vetted and belongs to the board; it is not Meg Whitman's strategy any longer.  This is certainly more than can be said for those of Mark Hurd and Leo Apotheker, who did things that the board learned about by reading the newspaper.  It's a nuts and bolts, fundamental strategy of sizing the cost structure to the future business, and as such it's a marathon not a sprint. 

The CEO made a telling comment at Discover 2012, "It's hard to kill founder's DNA."  She was trying to portray the DNA of the founders as being in customer service.  I don't think that's what the business historians would say was the legacy of the founders. One element of their culture was clearly innovation.

CEO Whitman makes proud reference to the work of HP Labs, which is their equivalent of the iconic Bell Labs of the old ATT.  In an environment where the IT customer can't keep up with the future evolution of the industry, credible global players have to do this for the customers.  The CEO has refreshed HP Labs, but she has also said that they need to speed up the transition from a lab idea to a commercial product.  I would guess that the HP Moosnhot server platform is probably one such innovation, but there have to be more and they must be produced on a faster cycle.

The structure and culture of the company has become sprawling and ossified.  The CEO clearly has been giving unprecedented access to employees deep within the senior ranks through different communications media, and this takes time but it has impacted morale for the better.  To switch again would be deadly.  

The one valuable discussion that took place on the third quarter conference call was one about the to-date almost exclusive reliance on HP veterans to lead all the businesses, with the exception of Software.  This seemed to catch the CEO a bit by surprise, and she thoughtfully stated that she had looked to insiders for their knowledge and presence with customers, but that it was something to consider.  I do think that this is something to consider, and what looks like shuffling of deck chairs could be a prelude to more fundamental leadership changes, from which the company's strategy would benefit. 

The issue of Autonomy should be addressed once and for all. If the U.K. Office of Serious Fraud has yet to opine on Autonomy's numbers, it suggests that perhaps there was nothing there.  In her 2012 remarks to Discover, the CEO says that the company is "100 percent committed to Autonomy and Vertica" for products, technology and innovation.  She made specific references to Autonomy capabilities in new products.  If this is so, it's time to tell shareholders that a lot of remarks were made in the heat of the moment, perhaps driven by board members trying to save face and that the company has moved on.  

The final point: the new board members are promising, but an entire board that reflects the cloud, mobility and big data--the essence of the future HP---would be a boon to the CEO and for shareholders.

P.S. Another company in Redmond, WA announced earnings and an executive change.  Now this one should be drawing a lot more attention than it has.  More later.

Dell's Special Committee Backed Into A Corner: The Company is the Loser

CEO Michael Dell and his reluctant partners at Silver Lake have come with a "dime," that is they have upped their price for Dell to $13.75 a share.  Their only condition: the Special Committee of the board has to change the election rules so that the decision would turn on a majority of the unaffiliated common shares voting in person or by proxy; the non-voting shares would no longer be automatically considered as voting against the proposed transaction.

On the face of it, an impartial observer without any history or context, might say that this is reasonable.  Dell/Silver Lake's letter characterizes the previous schema for counting votes as not being "rational."  This is overreaching.  Let's go back to get some context.

Dell has been mismanaged during Michael Dell's second apparition as CEO.  All the current challenges of the PC business have been evident for many years, although the trends have certainly accelerated.  According to Bloomberg, Dell spent $12.9 billion for 18 acquisitions from 2009 to 2012, and then spent $5 billion in 2012.  These were to transform the company into a higher end server, storage, and SaaS company.  Remember that the shareholders' cash was spent under the glare of being a public company.  There was no shareholder revolt, but so far the value of these acquisitions has not materialized.  The board during all of Mr. Dell's tenure never held the management team accountable for mismanaging operations and the firm's financial resources.  

Once the CEO came forward with Silver Lake Partners, the board had to be very careful about not appearing as patsies for Michael Dell coming in to rescue the shareholders from the fruits of his own mismanagement at a bargain price.  They went so far as to survive shareholder actions in Delaware court, where the Chancellor described the Special Committee's "go shop" process as being transparent, value seeking, at arm's length from the CEO, and otherwise exemplary of the duty to maximize value.  Part of the process were the election rules, which Michael Dell and Silver Lake had agreed to before the current kerfuffle began.  Apparently, the rules were palatable then, but not now. 

Probably, the Dell/Silver Lake team were convinced that tired, frustrated, long suffering shareholders would be happy to get some cash back, take their losses in a frothy market and move on.  PC results continued to move south as industry shipments declined 11% in the most recent quarter. So, either the team were expert game theorists or they were hugely overconfident.  

On the other side, Carl Icahn's mercurial, press release-driven behavior did nothing to give shareholders an apples-to-apples value to compare to $13.65 a share from Dell/Silver Lake.  It seems like the Special Committee did its best to engage the Icahn/Southeastern group to come up with a firm, fully financed offer, but this didn't happen.

Stopping the election in mid-process makes a joke out of corporate governance.  This kind of tactic is more proper to banana republic-style elections, but it is inexcusable for an NYSE company.  Perhaps, the Special Committee feared that the $13.65 offer would be rejected without a firm alternative in place.  Stopping the process would give a last chance to either get Dell/Silver Lake to raise their offer OR for Icahn et al. to come up with a definitive offer.

In actual fact, Silver Lake Partners would walk away with the most money under the latter scenario of a superior offer from others.  Rationally (and I use that term loosely), Silver Lake probably would rather get their expenses paid, take a pour boire and walk away for better risk-adjusted investment opportunities.  

So, in the end where is the biggest loser?  Dell Inc.--the company management, its employees, supply chain partners, developers and stakeholders here and abroad.   Value has been consistently destroyed by a process that has been allowed to run amok.

In the end, the Special Committee which received Chancellor Stine's kudos for running such a great "go shop" process, may prove to have been an unwitting, or half-witted, patsy for a CEO's simple mismanagement and extraordinary chutzpah.  

Why HP Has An Edge on Microsoft in Consumer Markets

HP is a hardware company trying to reinvent itself into a software and cloud computing company, which will include some high end servers/storage appliances.  Microsoft has a business with high end servers and business software, but with a consumer business which is stumbling out of the gate.

Is there a difference between the two?  HP's long experience with home and small business printers is a differentiator.  HP translated a dominating market share in high volume, business laser printers into a cash cow franchise, based on supplies, for the consumer market.  It learned about models for different retail channels and constantly tinkered with the printer itself to make it lighter, cheaper and almost disposable.

On the laptop side, it translated a leading position with the business enterprise into a leading position with the home user, despite the presence of Dell.

HP has also entered the tablet market alongside Dell and other Android OS manufacturers.  It hasn't had a real winner yet, but its Slate has earned some passable reviews compared to the Nexus 7, and it has responded to the market by cutting prices to clear inventories, hopefully in preparation for a new model. Like many of its laptops, their tablet is private-labeled by Asus.

Since HP uses Android for the OS, it isn't saddled with Microsoft's problem of loading Windows 8 onto the Surface, which is where Microsoft shot itself in the foot.  Knowing that developing a separate OS for tablets was out of the question, they opted instead to handicap their tablet and confuse customers with Windows 8 and Windows 8 RT.  The Windows cash cow became an albatross in the tablet market.

What Microsoft does next after the Surface write-down, with the new Hardware organization in place, will be telling.  As the Stones put it musically, I've got "No Expectations."

Microsoft's Blown Quarter: Reflecting on the Aftermath

Now it's easier to understand why CEO Steve Ballmer looked dyspepsic announcing Microsoft's latest reorganization: he knew that a guano-tinged quarter was coming down the pike. In the post about the reorganization, we noted that "this company is its own worst enemy."  

The company took a $900 million inventory write-down for its Surface RT units, parts and accessories.  Beyond the obvious financial impact, it's hard to see the way forward coming into the Christmas selling season. Those hardy souls who opted for Surface won't come back, and their friends with Apple or Android tablets have their decisions re-affirmed. 

Even though we believe that Microsoft engineers and partners did a nice job of designing a form factor for Surface with decent durability and features, it was not ready for the burden of Windows 8.  Worse, users of tablets don't use them to deploy Office applications and do their work-related projects on the tablet.

Apple got it 100 percent spot on: tablets are used to browse the web, check emails, read e-books, take videos and photos,watch videos and television, and update their social media sites.  It may have sounded like a rational step for consumers to do their Powerpoint on Surface, but it's not what they wanted.  Microsoft executives don't understand their retail customers at all, whether for tablets or for gaming.

Whereas Office 365 might make some sense for very large corporations, it's not because of the savings of subscription versus licensing, but for the potential to economize on IT resources to make sure applications are always up, desktop users are being supported, application security, and upgrades. For the retail consumer, at the prices being announced, a subscription seems like anathema. 

Where Bing has made real progress (Credit Suisse reports its 18% market share is up 230 basis points year-over-year), Online Services is still a peanut in the corporate structure. 

Entertainment and Devices continues to lose money, despite the strong brand equity of Xbox among gamers. The company alienated younger gamers with the announcement of the requirement to be online to play and for the ban on reselling the consumer's own games.  Windows Phone seems too little and too late given that the consumer mobile market itself is hitting a wall, just as the number of makes, models, and plans has grown too expensive and too confusing.  For your first smartphone, who would take a flyer on a Nokia Windows phone? This division lost $110 million, down from last year, but its future seems uncertain. 

The Business Division is the other strong performer, and somehow, it seems to keep growing and performing well, despite competition from other large players. It's almost as if there are two Microsofts: the dumb consumer folks and the smarter business division folks.  Or, maybe it's the executives who direct the smart engineers to do stupid things in the consumer businesses.

Jeff Ubben of ValueAct Capital is apparently now a shareholder of Microsoft.  Mr. Ubben knows the company well from his Fidelity Value Fund days.  A press release said that independent directors have already had a conversation with him.  As we wrote in our last post, 

"A better question for the board is this one: should Microsoft continue to exist in its current corporate form, given how badly it has consistently missed industry waves like the Web, tablets and mobile devices?  Can any executive lead such a bipolar organization effectively?  Now that there is one corporate CFO, you better believe that the investment bankers are asking themselves this same question and will be coming up with some ideas."

Apart from these short-term pressures, it's clear to me that Microsoft cannot deliver value with the culture that produced the venture portfolio strategy, acquisitions in online advertising, Windows 8, Windows Phone, the debacle with Surface, and a reorganization that fails to address any of the cultural issues.  This is rearranging deck chairs again. Steve Jobs cracked Apple's engineering culture by sheer force of personality and will. No one person can perform this job within Microsoft.  It really needs to be shaken up beyond org charts.

Bank of America: Good Fundamentals But Not Yet Ready for Prime Time?

Bill Murray in "What About Bob?" plays a hyper-neurotic, emotionally stuck man who can't get out of bed in the morning.  In this clip, he achieves a breakthrough and goes "sailing." But, his version of sailing is not ours: he is lashed to the mast high above the water.  I hope this lightens up the end of a heavy earnings week.  There is a loose analogy to Bank of America's position after the second quarter. (An aside: Richard Dreyfuss as Bob's hyper-anal shrink resembles which current Fed Chairman?)

It was an eye opening quarter in a lot of ways:

• $1.1 trillion in deposits, up 4%;
• Net income of $4 billion;
• Non-interest expense down $1 billion from the prior quarter;
• Net credit loss rates at 0.94%, the lowest since the second quarter of 2006.

The problem?  BAC is hamstrung by two distinct legacies.  The first is of its own corporate actions: the acquisition of Countrywide Financial and its consequences which resonate throughout the consumer business.  The second is the overhang related to the Federal bailout, impending regulations and restrictions on dividend policy.  

The company increased its consumer and commercial banking sales force (financial solutions advisers, mortgage loan officers and small business bankers) by 21% year-over-year in order to extract more relationships, products and revenue from the huge deposit base.  However, the company has to judiciously balance this against the ongoing costs of dealing with the thousands of mortgages which had to be restructured due to errors in applying fees and foreclosures by the mortgage servicers. The former Countrywide mortgages and loans (PCI--"purchased credit impaired") are reported separately and are still a drag.  

The net charge off rate for consumer and business loans was 0.94%, but if the PCI loan portfolio were included the reported rate increases very modestly to 0.97%, because of the fact that most of the principal is insured, even though interest in not accruing on the loans.  If the PCI write-offs are included then the NCO rate goes to 1.07%.  

Overall fee income was down in the quarter compared to the prior-year period.  Having to deal with the Countrywide legacy has resulted in BAC ceding mortgage market leadership to Wells Fargo, in terms of originating new home mortgages and refinancings.  

Overall, for Consumer and Business Banking, the return on average allocated capital (a non-GAAP measure) was 18.6% in the second quarter, down from 19.5% in the first quarter.  Average loans in the second quarter were flat to the first quarter and down $10 billion from the prior-year period. 

So, things are improving in terms of banking relationships and credit quality, but the company can't go full speed ahead to capitalize on its opportunities because of the legacy of bad loans, especially those associated with the Countrywide acquisition.  

Global Wealth and Investment Management (GWIM) comprises Merrill Lynch, U.S. Trust and other operations.  In the second quarter of 2013, this business recorded $4.5 billion in net revenue with non-interest expense a surprisingly high 72% of net revenue. The pre-tax margin for this business was a record high of 28 %.  GWIM's return on average allocated capital was 30.6% , ahead of the prior quarter's 29.4% and compared to a return of 18.6% for the capital-intensive core banking business.

The problem with GWIM and core banking, as we have written about before, is one of cultures.  They are totally different, and I don't believe that any company has been able to make them work together to effectively cross-sell and work together on accounts.  GWIM responds instantaneously to rising equity and bond markets, as they did in the second quarter.  Right now, GWIM fits into BAC, but let's see if the marriage has legs, or if, at some point, Merrill Lynch's leaders cry to be on their own.  

Global banking and investment banking had nice quarters, and Bank of America's global banking franchise, like that of Citi, is something of real value.  

Capital ratios for all the current and soon-to-be standards are improving and close to where they need to be.

Tangible book value at the end of the quarter was $13.32, and most analysts argue for an appropriate P/TBV multiple of less than one, around 0.95 in the case of Credit Suisse.  On their projected 2014 TBV of $15.12, the stock appears fully valued after the strong second quarter.  It has had a glorious run from the low, though.  One day it may really be sailing!  

HP: Stairway to Heaven or Road to Irrelevance?

Opinions in the financial press seem to line up at both extremes today.  Thus, headlines say things like,

• HP's strategy is not sustainable;
• HP has a big slog ahead;
• Time is not on HP's side;
• HP needs growth;
• HP is mortgaging its future;
• The bullish case for HP;
• HP is still a real value.

The risk-reward ratio for HP in the short run is pretty uninspiring, with the dividend to give some comfort until revenue growth and real, as opposed to non-GAAP, earnings growth appear.  Just as we noted for Best Buy, where we said vendors needed the company, we'd say that customers need HP.  If it didn't exist, a company like it would have to be invented.

Yes, it has some legacy businesses, but so did IBM and surely Dell does.  Cisco is slowly trying to reinvent itself, but it still derives the lion's share of its revenue from mundane products in the Internet plumbing. Lenovo and other PC makers?  Not hardly, not now.  Microsoft and Oracle?  Quasi-monopolists who are also using their enormous cash flows to reinvent themselves also. 

So, to beat the drums about legacy businesses for HP alone, one would have to be wearing blinders.  IBM can't be the IT company for all shapes and sizes of commercial and governmental organizations.

Another interesting comment CEO Whitman tossed off in her response to a question went something like, "Dell trashed its quarter to move x86 servers."  Yes, it did.  In the end, besides clearing inventory, it does nothing for the company as it moves to privatization.  After it goes private, how will Dell spend money on research and development, new classes of servers, and the things that all companies need to prosper in the watershed changes to a new definition of IT? The new owners will be focused on one thing only, cash for distribution and debt repayment.   Dell may be the company on its way to irrelevance. 

The Moonshot server line has been referred to by CEO Whitman in the last two or three quarterly calls.  It's evident now why.  She talks about the generational transformation in information technology underway as being the biggest in her career.  The Moonshot server program is one pretty significant step for HP in addressing this change for and with customers. 

So much has been written about data centers, but they too are in the midst of a major transformation, because of the different devices on the network endpoints and because of the rivers of different kinds of data being processed, stored and analyzed.  An HP-funded white paper describes the new Moonshot 1500 platform as blade servers "on steroids."  It is described as the first software defined server to run Internet scale applications.  Clearly, this is the direction the company needs to go, and the project was green lighted in 2010. 

The charter for the group was "to break out of HP's mainstream enterprise value propositions."  This formulation is very encouraging, and clearly it was not a skunk works.  The platform is now out in the market place.  This probably reflects decisions by the new CEO to accelerate this project at the expense of others, and it seems like exactly where the company needs to go.

What are some of the risks?  The company's board is still not worthy of an industry leader.  The discussion with former board Chair Ray Lane, who rejected the advice of Dodge and Cox to step down, was embarrassing for the company; Mr. Lane was magnanimous enough to give up the Chair and deign to remain on the board.  Remember, he is from the "Valley."  Tone deafness has a high incidence rate in Silicon Valley.

Time isn't working against the company. Expectations are rock bottom, and valuations are appropriate.  Rebuilding the balance sheet, improving cash flows, paying down debt and changing capital allocation will give the company plenty of capacity to weather competition and the IT cycle.

Share buybacks should soon have seen their day, provided the board doesn't push management to put another big program out there.  If another program is announced, please go slow and leave it fallow.  Reinvestment in initiatives like Moonshot and in core businesses are paramount.  Research and development needs to drive differentiation of products and services.  That's where the high returns are, not in chasing the share price for the benefit of short-term shareholders.  

The mediocre board could also harm the company again in selecting and valuing acquisitions.  Their massive incompetence speaks for itself.  In this regard, a revival of the Autonomy flap could divert management time, but hopefully it goes away quietly, another legacy of board mismanagement.

I have a suggestion for the new board Chair, if the company can persuade him to accept: Mr. Bill George, the former CEO of Medtronic. I've followed his work at Medtronic, read his writings, spoken with and heard him speak, many times.  He has the stature, experience, business acumen, and moral leadership qualities to help the CEO and management navigate their way to real value creation.  I can't think of a better choice.