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."

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

HP Comes Full Circle

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

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

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

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

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

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

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

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

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

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

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

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

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

Bank of America, Agency Problems and Selective Blindness in Our Judicial System

We wrote a widely read post about Bank of America's $40 billion mistake in acquiring Countrywide Financial back in 2012, which we link here for context.

The government's 2012 complaint in Federal Court (Southern District) makes interesting reading also for context to the current settlement debates.  According the Feds, Countrywide engaged in a scheme to defraud FNMA and FHLMC, and as a consequence the GSEs suffered more than a billion dollars in unreimbursed losses.

The story picks up, for some reason, in 2007 when Countrywide's originations had fallen from $490 billion in 2005, to $450 billion in 2006 to $408 billion in 2007.  A very superficial discussion of the monthly loan performance monitoring program required of the originators by the GSEs begs a very important question. Surely, delinquent or non-performing loans (here referred to as loans with 'defects') would have been evident from the 2005 vintage long before 2007.  There are mechanisms for dealing with these problems from the GSE perspective, including putting the loans back to the originators.  One would also think that reimbursement or compensation provisions would have been part of normal securitization agreements.  None of this is even mentioned in passing.

As we have said before, agency problems for Countrywide shareholders existed writ large because of the behavior of CEO Angelo Mozillo's outlandish behavior, which has been covered widely in the press. His compensation, bonuses and option grants were conditioned on the volume of originations, even if they were subprime 'stated income,' 'liar loans,' or 'NINJA loans.'

Mozillo, in turn, created compensation opportunities for Franklin Raines, who eventually relinquished $24.7 million of ill-gotten stock options gains from a reported six year earnings manipulation scheme, over which his gains would have surely been greater than $24.7 million. Mr. Raines never felt the heat and wrath of Federal prosecutors, rather his slap on the wrist came from another Federal oversight agency. Why wouldn't the full force of our justice system fall on two kingpins of this mess?  Justice for friends is different from justice for those deep pocketed corporations, who are giving up shareholders' money in the end.

In the government's complaint against Bank of America, there are a few selected quotes from the former CEO and from the current CEO which should arose the ire of BAC shareholders.

"We did extensive due diligence...It was the most extensive due diligence we (Bank of America) have ever done.  So we feel comfortable with the valuation.."  Former CEO Ken Lewis.

"....we will pay for all the things that Countrywide did."  Loose language from current CEO Brian Moynihan.
Fast forward to the recent imposition of fines by U.S. District Judge Jed Rakoff.  As one reads through the 19 page opinion, the judge's conception of gross versus net losses and his infantile examples seem to challenge the usual shibboleth that Federal court judges are more capable of understanding complex financial issues. Recent problems arising in the interpretation of potential sovereign defaults by Argentina raise similar issues.

The total value of 17,611 loans issued by the HSSL loan mechanism of Countrywide amounted to $2, 960,737,608.  But, 57% of these loans were, in the opinion of the government's 'expert' not in fact bad apples.  So the final penalty imposed was 43% of the maximum, or $1,267,491,770.  The wisdom of Solomon!

As Harry Truman said, "The buck stops here."  Well, what about the higher ups who sanctioned all ludicrous, uncontrolled financial malfeasance at their institutions?  According to Judge Rakoff, "....the fact that other, higher-level individuals arguably participated in the fraud but were, for whatever reason, not charged by the government..." doesn't rise to the level of this judge's scrutiny.

Instead, he lays liability at the foot of Rebecca Mairone, a Countrywide executive, who took the actions necessary to perpetuate the fraud described in the complaint.  Was she a lone, rogue agent?  Not hardly. Her crime seems to be having given "implausible testimony."  Judge Rakoff is given to pats on the back and slaps in his opinion. Attorneys on both sides are described as "excellent" (from Wayne's World?) and "superb."  Ms. Mairone apparently wasn't well coached by her excellent attorney to not give implausible testimony.  The jury in fact asked Judge Rakoff why the higher ups weren't being brought up on charges. They got the answer quoted above.

Finally, we are left with Bank of America, which recently reported results. Earnings were a bit better than expected, analysts claim because of expense controls, better than expected trading revenues, and lower provisioning, offset by much higher than expected legal expenses.  Revenues from the core banking businesses were, however, disappointing.  I wonder what will drive 2014 incentive compensation for the executive team?  Based on current expectations, BAC looks fully valued, but longer term its future growth, if it can ever put Countrywide issues behind it, still remains in question.

The Uber Tech Bubble

We know from the soporific testimony of former Federal Reserve Chair Alan Greenspan that even the wisest economic oracles and policy wonks can't identify a financial bubble until it has burst.  (This theme is explored in Bill Fleckenstein's "Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve," 2008.)

Years after the global financial management elite are just wiping the soap off their faces from the detonation of the Uber Bubble of 2006, comes what surely seems like deja vu: the $18 billion implied valuation of Uber, the car service.

What is amazing, besides the valuation, are the leaders of the financing round: Fidelity, Wellington Management, and Black Rock. Fidelity once had a value focus, but one could argue that with the growth of Contrafund that it is a growth shop.  Wellington Management was certainly for decades a poster child for Graham and Dodd valuation optics.  I guess that this deal was too good to turn down.

The writers at the Wall Street Journal are trying to sound cautious about this story, but they then bend over backwards to suggest that the valuation might be conservative!  "Some say...." as the saying goes.

The company is already cutting prices by 20% in some markets, perhaps addressing the obvious concerns about the effects of competition.  It is also pitching the story as being one of creating markets, not providing taxis-on-demand.  Part of the pitch made Uber sound like a C.H. Robinson/Expeditors International model for transportation services.

A 20% take of gross proceeds seems pretty outlandish, and somehow the cost of taxi medallions in New York City isn't responding to the alleged inroads of Uber.  Perhaps that is an inefficient market, but it does seem odd.

A stat was quoted about drivers grossing $90,000 or more per year.  That would imply more than $112,000 in annual fares, or $56 per hour average.  Allowing for cruising and dead-heading from airports, that suggests the fares are pretty high.

But who know?  This could be the next big thing, like "Ask Jeeves."  Or, it could be the next Amazon. Why couldn't Amazon launch a service like this?  Never mind.

Jamie Dimon Comment on Share Buybacks

Looking back at my notes on JP Morgan's earnings call, I forgot to recount a somewhat offhanded comment the CEOmad  to a multi-part question from an analyst.  The analyst recounted  how much stock the company had bought back year-to-date, and  he asked whether or not the company would complete the current authorization in a big chunk.  It was an incredibly stupid question, but it elicited an interesting response.

CEO Dimon said something like this paraphrase, "When the stock was in the thirties, it was a once in a lifetime value.  We don't buy back shares just for the sake of doing it.....with the stock where it is now....(trails off)"

This is spoken like a CEO who understands the difference between price and value.  The big technology companies historically like buying shares like automatons.  I give the CEO kudos for saying something his mega-cap CEO peers should understand better.

Bubbles Morph Over Cycles: Web 2.0 Becomes Social Media

In the last Internet Bubble, Mary Meeker was the consensus "Queen of the Bubble," according to CNN. The linked article really portrays the wholly delusional aspect of equity markets and valuations during the last bubble.

"As the Internet exploded, Meeker became bolder about relying on nonfinancial metrics such as "eyeballs" and "page views." Here she is, for instance, in a July 1998 report on Yahoo (entitled "Yahoo, Yippee, Cowabunga ..."): "Forty million unique sets of eyeballs and growing in time should be worth nicely more than Yahoo's current market value of $10 billion." Four months later, when she revisited the company, which had just reported its third quarter, she wrote that there were "five key financial highlights." First on her list--even before revenues or operating margins--was the fact that Yahoo's page views had risen 25%."

Here we are in this market cycle, where the Web 2.0 bubble has reappeared in a different flavor, the Social Media bubble.  

"Snapchat is not even 3 years old. It's run by a couple of twenty somethings with no prior business experience. And it has never made a cent.
Yet investors are fighting for the opportunity to throw hundreds of millions at the mobile messaging service that is all the rage with teens.
The tiny Venice Beach start-up just turned down a $3-billion all-cash offer from Facebook Inc. And then, according to the Silicon Valley rumor mill, it rejected an offer from Google Inc., this one for $4 billion.
That's a big pot of cash for a smartphone app that could vanish almost as quickly as the messages people send on it. .../
Among the better-known Silicon Valley companies with monster truck-sized valuations are mobile payments start-up Square Inc. at $3.25 billion, online storage start-up Dropbox Inc. at $4 billion, private transportation service Uber Technologies Inc. at $3.5 billion and home rental service Airbnb Inc. at $2.5 billion."

How are things different between these two tulip manias?  One major environmental factor is the long-running, artificially induced low rate environment, with the promise of such rates in place for near eternity. Investors are feeling more confident, which I suppose means that the entrepreneurs heading these start ups feel like they might as well grab the candy being handed out by Mr. Market, and the investment bankers who have had a few salad years are only too happy to oblige.

There is nothing new on Wall Street.  Wall Street loves recycling, especially of ideas.  

Microsoft Reports Solid First Qtr 2014: Does 'One Microsoft' Make Sense?

Introducing the quarterly results, Microsoft CFO Amy Hood's talking points script must have had the word, "execution" written in large, bold type.  We would hear over and over about how well the company had executed against its goals in the quarter, given the macro headwinds in tech, the move to "One Microsoft," and the higher "cadence" of the company, as demonstrated by the release of Windows 8.1 less than a year after the initial version.

The highlight on execution was probably deliberate, and it was done to differentiate Microsoft's performance from that of HP and IBM, where both CEOs lamented their teams' lack of execution.  The real story in the quarter was the performance of the Commercial segments, formerly referred to as the Enterprise segment.

Following the most recent Analyst Day, we wrote,

"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."  

 Total Commercial Licensing and Other Business increased 10% yr/yr, from $10.19 billion to $11.2 billion in the current year's quarter.  Commercial Licensing revenue increased 7% yr/yr to $9.59 billion. The more transactional annuity business increased by 8%, which also helped by allowing more revenue recognition in the current quarter; the company said that contract renewals had also been strong. Other Commercial Licensing Business increased 28% yr/yr to $1.6 billion, as Microsoft's cloud conversions and new business gained traction.  The company said that two-thirds of new Microsoft Dynamics ERP customers chose a cloud configuration for the software deployment.

Overall, this segment's performance was clearly head and shoulders above that of the comparable commercial businesses of HP and IBM.  Given that the company has a new segment financial reporting format, the company provided both a new and old presentation to help during the transition.  In what was formerly called "Servers and Tools," revenue increased by 11% to $5.052 billion, while operating income increased by 17% to $2.026 billion.  SQL Server revenue grew by double digits, while SQL Server Premium revenue grew by more than 30%. So the problems HP and others faced with the erosion of commodity x86 server sales and margins did not hit Microsoft in the quarter.

Under the new presentation, which shows Gross Profit contribution by business segment, I took the Commercial Business gross profit as a percent of Microsoft's consolidated gross profit less the 'corporate' gross profit, and one sees that the commercial businesses accounted for 67% of the gross profit dollars in the quarter compared to 62% of the gross profit dollars in the prior year period.The rest of the corporate gross profit comes from Devices and Consumer Licensing. For me, the commercial business performance was the high water mark for performance in the quarter.

The problems in the personal computer markets did affect Microsoft, but not as badly as would have been expected.  Windows OEM revenues fell 7% yr/yr, but that compares to a 15% yr/yr decline in the fourth quarter of FY13.

Bing;s Search advertising revenues increased 47% yr/yr, and the Bing! search engine had an 18% U.S. market share in the quarter.  Search volumes and revenues per search both increased in the quarter, due to better algorithms and advertising.

The model upgrades for Surface generated $401 million in sales, with the 32 MB Surface RT being the popular model. Inventories are in place for the selling season, but the levels are not as aggressive as with the introduction.

A lot is expected from the Xbox product launches, but I have some doubts about the heavy duty gamers caring that much about a somewhat incremental hardware upgrade.  The gamers care about the games, and Microsoft is not in that business.  The future of Surface, Windows 8.1, Windows Phone, and Xbox are all TBD.  It sounds like the company is trying to improve its own lackluster performance, but it remains to be proven, beyond one Christmas season.

The company returned $3.8 billion in cash to shareholders in the quarter, with a 22% increase in the dividend.  This is certainly nothing to sneeze at.  However, looking at where profits are generated in the consolidated company, it still isn't clear at all that there should be "One Microsoft."

Finally, I would question if there exists one person who could make a believable claim to have the skill sets and the inside credibility to lead this company on a multi-year path to sustained organizational optimization and shareholder value creation.  More on this later.

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. 

U.S. Equities: An Expensive, Clean Dirty Shirt?

I'm paraphrasing Bill Gross' comment about U.S. Treasuries and expanding it to the U.S. equity markets.

Cliff Asness of AQR Capital Management put out a third quarter bulletin to investors in which he talked about the Cyclically Adjusted Price-Earnings ratio ("CAPE") of Robert Shiller.  Depending on how you look at the long-term picture of CAPE, the equity markets are relatively cheap, or not.

The bullish case would say that the CAPE at 9/30/2012 was 22.5 times the average of ten year trailing real earnings.  This is one-half the level of 1999-2000, at the peak of the market bubble.  So, we should feel 'the pump' as the weightlifters would say.

When I first looked at his chart, it's clear to see the bullish conclusion, but then the other side is also evident. Asness notes that the CAPE time series has spent 80% of its time below the current level of 22.5.  So, he concludes, based on some additional partitioning of the long period, that someone expecting a 10% nominal equity return (about 8% real) is betting on exceptional returns compared to history.

This gets us back to Bill Gross' metaphor. Emerging markets, for all the bullish broker comments, aren't attracting the big money, such as Norges Bank Investment Management. There has been a flight to liquidity, size and decent dividend yields, which largely spells U.S. equity markets.

However, we've seen in repeated corporate reports a blizzard of financially engineered quarters, with simultaneous challenges expressed about future revenue prospects.  Next year, comparing to these strong quarters might be problematical.  Shouldn't the market move downward?

The typical buy and hold investor, who isn't foolish enough to think that he can trade against the market with their broker's option software, should find his prospective returns being truly circumscribed.  Thanks, Uncle Ben, for nothing!

Meg Whitman: It's Not Easy Being Me

HP's media advisers placed a prominent, but curious story in September 29th's New York Times.  It would seem to be timed to October 3rd's Security Analyst Day at HP.  Hopefully, the story will set up some announcements or perspective that will shape a more positive Wall Street view on HP's share price.

The Times writes that Meg Whitman,

"...believes that Wall Street doesn’t quite get it — doesn’t quite see the promise she sees."

I don't know how many times I've heard this quote from incoming CEO's over my years as an analyst.  In most cases, what Wall Street saw was very much closer to future reality than what the CEO saw through rose-colored glasses.  Meg, please drop this line and never repeat it, even if fawning analysts pitch it to you.  The smart investors never got Enron or Tyco either.

A Bernstein analyst/cheerleader is quoted as saying, "This is now the cheapest big stock in the past 25 years."  He must "get it."  How many of the hundreds of other, historically cheap big stocks got cheaper or went to zero?  It's an empty statement.

Institutional portfolio managers are generalists, and even their analysts follow multiple industries.  They need to be educated, in market and financial terms, about where the company is going, how it's getting there, and what's at the end of the rainbow in terms of margins and returns.  The sins of the past and even the challenges of the present aren't that important: investors are buying the future. If the present weren't challenging, Leo A. would still be here. 

Meg Whitman says,

“It (cloud computing) is a shift bigger than anything in our memory,” Ms. Whitman says. “We have to get ahead of the curve.”


This may very well be true.  It does create problems for analysts and investors who are modelling the company's future today.  This statement suggests that an investor who took the local peak margins in HP's business segments, grew revenue forward at a modest single digit rate, and took in restructuring benefits to estimate the future peak margins, might be totally off base.  But, this is exactly the calculation that most investors do to project an upside. 

Some of the current business segments may never achieve their former peak margins precisely because these big shifts will obsolete some of the business offerings and their pricing.  So, HP needs to help investors understand how this will play out.

The other bromide that HP bulls bring forward is the notion of being a "one stop solution" for the corporate IT buyer.  What if the future buyer refuses to spend that way?  What if the buyer demands interoperability of components, "plug and play?"  Software architectures have to be open.  No proprietary systems.  Buy the "best of breed" for every node of the operation.  This would be a "big shift," and it is already taking shape in areas like health care IT. 

HP provided this picture of a self-contained self-contained "cloud pod" of servers, storage and networking.  HP says that 20 units per month are being produced in its Phoenix operations, and each would sell for $20 million.  The advantage, ostensibly, for the corporate buyer would be that it could be deployed sooner than the 18 months needed to build a conventional data center. I'm not sure I get this idea, as shielding these kinds of units from all kinds of attacks would require significant site preparation also.  Again, let's get the context for why this might be important.

The Autonomy question still needs to be answered.  Besides the CEO having a digital dashboard (another hackneyed IT phrase) for Autonomy, is this the platform to take HP into the Big Data future?  Any more writedowns?  Some industry types suggest that their sales penetration pre-acquisition was narrowly focused on areas of Internet security rather than on the broader analytics of Big Data.  Meg, please put some meat on these bones, and be specific.

Saying that HP needs four more years to get "confidence in itself" is a troubling statement.  By that time, hopefully the company should be making some real money, which is the biggest single factor in generating confidence among employees.  Options that are in-the-money are a real tonic for the middle and upper management ranks.  Hopefully, your statement was quoted out of context. 

Why not give some guidance on where the company is going revenue and earnings-wise?  Put all the caveats and risk factors out there.  Have the CFO run this gauntlet: it's not that hard.  Put some kind of floor on the expectations and let them (hopefully) rise from there. 

Meg Whitman also says for the Times, "I am the the first (HP) CEO in a long time who is from the Valley."  This statement sounds a bit delusional.  Having board members or the CEO from a geographical provenance wouldn't seem to be associated with value creation. 

The New York Times writer, Quentin Hardy had some interesting asides in his text, apart from all the feel good material,

• "Ms. Whitman has plenty of impressive-sounding stats at her fingertips." (they're not really ones you'd write down in your notes)
• "The fact is, HP isn't what it used to be."
• "Profit margins at I.B.M. and Apple are several times that of H.P. And H.P.’s share price, at just over $17 on Friday, is about where it was in 1995."
•  "Instead of standing at the confluence of the phenomenon (mobile, cloud and Big Data), though, H.P. is on the sidelines, with most of the parts but none of the integration to make it a leader. ....H.P. sometimes seems like a place of siloed relics...:
• "Everyone knows viscerally how fast change can overtake a legacy business — and how hard it is to change."

HP, and its new CEO, needs to meet all these questions head-on and answer them clearly and with numbers which show the contours of the way forward.  No more excuses about the "mess I found." 


Here's hoping for a successful Analyst's Day.

Grazie Signore Draghi!

Bill McBride of Calculated Risk has the following chart on his blog.  Get out those rose colored glasses from your last Grateful Dead concert, here it is:

Our equity markets are 112.5% above the financial crisis lows.  Investor sentiment, a contrary indicator, is extremely negative, as further evidenced by the continuing outflow from stock mutual funds into bond funds.  Keeping the macro focus paradigm, our markets should be healthy into midweek, when thoughts turn to the next EuroConfab on Thursday. 

What about the "fundamental" side, if that means anything anymore?

This quote is from Reuters,

"In fact, the recent price-to-earnings high was 13.5 in February 2011, just above current levels. If you are of the view that little has changed since then, there is no reason for the ratio to go much higher. That combined with a slowing earnings picture inevitably means lower prices.


"Our view is that the next double digit move in the market is down not up," said Morgan Stanley in a research note.

The analysts, led by equity strategist Adam Parker, believe the S&P 500 will finish the year at 1,214, 15 percent below where it is now."

Slowing earnings and no multiple expansion...hmmm. 

A Moth Eaten Groupon and Other Issues

In June 2011, we were totally flummoxed by the market's enthusiasm for Groupon, Open Table and other similar businesses. We ended that post with the observation,

"It just feels like this euphoria for these types of businesses has to end badly.

Then, in October 2011, when Wall Street's marketing tanks rolled out, we wrote,

"With the powerhouse banks behind the deal, a deal will get done. Lucky flippers will have a nice payday. The Groupon model is not healthy for most restaurant businesses, but if this industry manages to get a footing, then it will take its profits out of the hides of their small business customers. In the meantime, I can't wait to see which mutual funds wind up listing Groupon as 2% of their fund assets. An absurd valuation is now merely ridiculous. Caveat emptor! "

I had put Groupon out of my consciousness until I received a received a communication from Uber-tech Guru Om Malik, reflecting on private versus public valuations of the "new" social media companies.  This chart is from Om. 

With the exceptions of some flipppers getting out early without their usual vigorish, it has been a Davos-quality ski slope downward.  It really drove home something I've always known, reinforced by some of the savviest mentors on the Street: "There's nothing new on Wall Street."  Or, put another way, "This time it's different."  It never is.

Even long-running Amazon, which had a few early naysayer credit analysts on Wall Street, reported better than expected revenue gains, but puny profits.  Net income per share of a penny compared with $0.41 per share last year, but its services business were said to be roaring, and it was going to put fulfillment centers on every corner.  It all sounds good, but how can an investor make a silk purse out of a sow's ear?  A penny isn't forty-one cents, end of story. 

Exxon Mobil's quarter was characterized as "challenging" by the financial press, and it certainly wasn't glorious by any means.  Their oil and gas production slipped, and their realizations were down.  However, they continued to invest in their core business which has very high returns on capital.  Their down stream refinery and chemical operations showed strong results according the New York Times, "Refinery profits increased by 14 percent, while net income for the chemical manufacturing business improved by 21 percent. Both units benefited from the lower gas and oil prices, the vital feedstocks for refining and chemical production"   Good, fundamental results in a difficult macroeconomic environment.

Now, Royal Dutch Shell, owned by some value investors, reported a pretty dismal quarter with some real warning flags.

With both these companies, a good analyst or investor can pencil their way through the extensive disclosures and come to a reasonably informed decision about their company's prospects.  With the "new" social media companies, it's not a wing and a prayer, just a prayer that there's an honest man or woman somewhere in the executive suite. 

Finally, a good former institutional customer sponsors a successful international equity mutual fund, and looking over their holdings, I noticed Alcatel-Lucent, S.A., owned in the Sponsored ADR form.  I haven't looked at this company since Carly Fiorina was working her magic at Lucent in 1999.  You don't have to be an electrical engineer to understand these businesses, although much of the foggy commentary about these companies, like Juniper Networks, is replete with capitalized acronyms.  I read the press release and was a bit distraught.  I then went to the company's website and listened to the conference call.  Wow!  This was truly a dismal performance, and the cash flows in the quarter were awful, especially given the reduced outlook for 2012, a large debt load, upcoming rollovers, and loss of revenues as the company leaves behind "legacy" technology and moves to "new platforms."  I went back to my fund's annual report, and they've taken a forty percent hit from last December to date.  Value investors may not get it right very time, but they probably can demonstrate their thesis with some numbers.  I may have to call my fund and find out.

As the Dow closes about 13,000, I just don't feel the buzz, but I'm happy not to be losing my shirt on "new" social media.

             

Wellington's View on Microsoft

I just received a copy of the November 30, 2011 Annual Report for the Vanguard Wellington Fund (VWELX), a balanced fund with a long, consistent track record  Ed Bousa, manages the equity portfolio which was about 66% of net assets at fiscal year end.  The management team wrote this about  Microsoft (MSFT).

"We increased our position in Microsoft, as we see an extremely attractive risk-to-reward ratio at current valuations. The price of the stock suggests market participants do not have particularly high expectations, yet earnings growth at the company remains strong, driven in part by businesses' cyclical computer upgrades.  Cash-flow generation is solid and may be under appreciated by the market as well.  In our view, the upside potential of this stock more than adequately compensates investors for the downside risks they bear."

On the other side of the coin, the biggest detractor to the fund's performance, in absolute terms, for the year was their holding of Bank of America, which they reduced.  Wellington Management Company has always been populated by sharp, value-oriented investment managers, but they like every market participant didn't get the risk-reward ratio right for Bank of America.  

[Nothing in this post should be construed as investment advice or as a recommendation of any mutual fund or equity security.]

Deutsche Telekom: Still Nobody Home

U.S. markets are in an uproar about the failure of the ATT-DT deal for T-Mobile.  The management of Deutsche Telekom has, in our opinion, bungled its US investment right from the start.  An acquisition of Sprint by one of the U.S. wireless behemoths has already been deemed anti-competitive, as has now the acquisition of T-Mobile.  If maintaining some semblance of competition is important then some sort of partnership between T-Mobile and Sprint would seem to have the best potential for regulatory approval, as well as offering opportunity to add value. 

In all the talk, the fundamental problem is being overlooked: the U.S. wireless industry is killing itself slowly with its irrational pricing paradigms.  New customers are lured in with money-losing deals, while the most profitable customers are left to themselves, with the option of switching to get one of these deals.  Much of the movement to Sprint among people I know was driven by their irrationally priced "all in one" plans with unlimited data access.  Most of these people complained about the phone coverage but suffered it for the data plans.  Not surprisingly, Sprint gained lots of prepaid subscribers, but lost money, which is not a recipe for sustainable value. 

Surely, data plan users should be charged by the volume, time period, speed, and types of data that they are downloading over cellular networks.  Gas and electric utilities charge by the time period and time of year, since everyone accepts that it is the cost of building and sustaining the peak load capacity that has to be paid for at the margin. Cable is different because of the monopoly status of local carriers and the fact that their networks were built with generous subsidies.  Wireless is really just another utility.  Credit Suisse too notes the elephant in the room: "declining profitability of the whole U.S. (wireless) market." 

Sprint's disastrous commitment to buy 30.5 million i-Phones for $20 billion will keep the company in the red until 2014, according to the Wall Street Journal and other sources.  T-Mobile, by contrast, is projected by Credit Suisse to generate $5 billion in EBITDA or better in 2011, which would meet or exceed early 2011 guidance. Credit Suisse, which has recently reinstated coverage of DT, projects 2012 EBITDA of about $5 billion for T-Mobile, despite negative industry fundamentals and economic weakness.  This is pretty good performance in the face of strategic and operational mismanagement from the parent company.  An acquisition of Sprint would not make financial sense nor would it pass regulatory muster. 

Performance of the DT parent is another story altogether.  DT sports a 7.9% dividend yield today, and the German government's large stake in DT precludes management from pursuing any strategies that might add shareholder value but that would require reducing the dividend.  According to Credit Suisse, the ROIC for DT will be in the 5% range for 2012 and 2103.  The stock is rated by Credit Suisse as "Underperform."  All of this complicates the future of T-Mobile and puts its valuable franchise at risk.  U.S. regulators should be working proactively to ensure that corporate inaction or irrationality does not inadvertently make the U.S. wireless industry anti-competitive. 

However, a partnership makes sense, with perhaps Sprint differentiated as the "Wal-Mart of Wireless" and T-Mobile as the preferred brand for price conscious, loyal postpaid customer who wants a global network.  Data hogs should be priced so they either pay their freight or go to Verizon where they will generally pay more for their plans anyway.  A partnership would only work, in my opinion, if (1) it went away from encouraging adverse selection and churn by only talking price; (2) stopped letting the data hogs crowd profitable users out of the trough, and (3) the partnership didn't cut costs to the point where the service culture of T-Mobile disappeared.  Good people are leaving T-Mobile in droves.  This would have to stopped and the company would have to find a way to become a "hipper" organization to work for as opposed to say, ATT. 

Credit Suisse opines that after the failure of the ATT-TMo deal, TMo is left with "more spectrum, less debt, and a bigger range of U.S. options." We have always believed this to be the case, as it certainly is now.

Fundamentals in a Down Market

David Katz of Wachtel, Lipton & Katz and his co-author, Laura McIntosh published a survey article about the results of the 2008 proxy season. Here is a link to the article via a Harvard Law blog:

http://blogs.law.harvard.edu/corpgov/files/2008/11/shareholders-focused-on-stability-in-proxy-votes.pdf

Shareholder communications are vitally important, and they do yield tangible results in cases where there are direct inquiries about executive compensation plans, for example. The authors cite a union that withdrew more than half of its proposed pay-for-performance proposals after direct negotiations with the target companies. So, when a company is under the gun, well constructed outreach to shareholders yields results.

Looking beyond the state of the current market, investors still care the most about fundamentals, like the strategic direction of their portfolio companies, returns, and on management's creation of long-term shareholder value.

Edwards Life Sciences

Here is a solid, low-growth, small cap medical device company with good cash flows that was always underwhelming at analyst conferences, where I got to listen to their presentation, after having presented for Possis Medical. I posted earlier today about acquisitions, and just got an email from the Canaccord Adams medical device analyst about Edwards ("EW")

"EW signed an agreement with Dexcom to develop continuous glucose monitors for the hospital market, which represents a multi-billion dollar annual revenue opportunity, in our estimation. That said, product and market development are long-term projects at this point." (Nothing wrong with that!)

Access to this opportunity costs a small upfront R&D payment, plus ongoing product development support for three years, the net effect of which, according to Canaccord Adams, is to raise the ratio of R&D to sales by ten bp or so in that period. Big deal!

For Edwards, which has historically had free cash flow not returned to shareholders, this seems very much in the spirit of our thoughts in the previous post about acquisitions. Good luck to Edwards and congratulations for not standing pat, but for taking what seems like a minimal, measured risk for a potentially large reward.

Isn't It Strange?

During the pre-crisis market euphoria, M&A activity was robust. Multiples offered by buyers were rich, and premia to market prices of public companies sometimes took the breath away. Think about the many deals that were put on hold or which are no longer on the radar screen of the acquiring company's board. Does this make sense?

If an acquisition fills a legitimate strategic need, bankers are hired, spreadsheets are cast, fairness opinions abound, the acquisition is now teed up. Markets freeze and the deals wither. However, if all the reasons for looking at the acquisition were truly of strategic value, then all that should have changed--in many cases--is just price. Markets handle this issue all the time.

I remember some McKinsey research that said in market downturns, 60% of companies that made acquisitions in frothy markets choose to do nothing in a downturn. Isn't that strange?

Seller's expectations will be brought back down to earth. This is particularly true for private companies that are now facing a change in the capital gains regime from a new, activist administration in Washington. Weakened currencies of the buyers hamstring their ability to be indulgent with their owners money. If the strategic reasons are still there, come up with a new deal structure, or start with some form of partnership that leads to a deal later.

There are a number of microcap public companies that are profitable, with cash on their balance sheets that can earn higher valuations if their growth prospects are visibly enhanced. Acquisition targets for these companies are most likely private companies. It would seem that CEO's and their boards, instead of worrying about next quarter's earnings--which are probably going to worse than plan--should be looking at acquisitions.

Some key criteria for the acquisitions? A business with good long-term economics. A business that adds luster to the portfolio. Honest, trustworthy and committed management. A reasonable price.

Boards and management almost never talk about overpaying in a frothy market, and yet it is almost always the case that the acquirer does so. In these kinds of markets, there is some risk that prices continue to decline for targets, driven largely by macro issues that diminish the economic value of the target. Again, these are things that can be negotiated into a structure provided that both sides see the strategic benefits of the acquisition.