Best Buy's Smart Move With Samsung

Today's financial press rightly makes a big deal out of Best Buy's move to open up 1,400 of its stores to Samsung's "Experience Stores."  The Korean giant will staff the stores with its own, dedicated cadre of product knowledge experts.  

Back when Best Buy was being left for dead within the analyst community, we made the following observation,

"Some analysts suggest vendors might not have an interest in Best Buy surviving.  Just like 1994, I can't understand what these folks are thinking.  Vendors need Best Buy.  Best Buy hasn't treated the vendors like partners and it hasn't demanded, or merited, the best from them.  This can be fixed."

So, again, I'd disagree with the Wall Street Journal's characterization today that "Samsung's move today throws a lifeline to Best Buy."  Unlike HTC and other companies, Samsung has emerged from Apple's powerful mobile wake as perhaps its only serious competitor.  However, making a retail presence for itself in the U.S., apart from the carriers and Amazon online, would be prohibitively expensive and likely to fail.

Samsung has always made nice, underrated mobile phones.  They work like Swiss watches, have user friendly design features especially in the user menus, and they utilize their batteries well.  Their designs haven't traditionally been candidates for MOMA design awards, but they were fine. I'm on my  second non-smartphone now, only because I lost the first one.  Now, they've sent Apple a wake up call, and they need to make a serious push.

Best Buy's move treats them like a partner, rather than a source of product, and it should expect the best of them in these stores, because it is Samsung's game to win or lose.

Check this out from Samsung's recent Annual Meeting of Shareholders:

"Firstly, Samsung Electronics will work to advance into a company that leads the global electronics industry. To this end, the company has drawn up plans to maintain its lead over competitors in key business areas, including the mobile phone, TV, and memory businesses, while strengthening basic competencies in promoted business areas, including the home appliance, printer, camera, and system LSI businesses. .../

Thirdly, Samsung Electronics will continue to make efforts to solidify its reputation among consumers and gain wider acceptance in society as a trusted and admired company. 

Moreover, Samsung Electronics will continue to advance the culture of mutually beneficial growth with its partner companies, in which knowledge and expertise is shared to enhance the global competitiveness of its partners. 

Don't think for a minute that the presence of  Hubert Joly as Best Buy CEO, an experienced global executive, didn't have a positive impact on this deal.  It should also help its success downstream and open up other opportunities for Best Buy to "Renew Blue."

China's Breakout: McKinsey's Thoughts

McKinsey partner Gordon Orr has written a piece for the McKinsey Quarterly on issues for the Chinese economy in 2013. We recently posted on Ruchir Sharma's "Breakout Nations," which has a longer-run perspective about emerging markets, but Orr's article tangentially touches some issues of longer-run concern.

In the short run, McKinsey expects Chinese banks to underperform. As a result of the post-2009 economic stimulus and programs in prior years, the Chinese banking system has a a large volume of underperforming loans which need resolution.  As the banks looked for new income streams, they sold wealth management products to well-heeled customers and small savers.  These products, McKinsey says, have to right-sized on bank balance sheets.  The net effect, McKinsey says, is that the system will need 1.3 trillion renminbi ($208 billion) in new capital within the next five years.

Even if this problem comes to light in 2013, its resolution will take years, and the initial extent of the banking system's problems should prove, as in the case of every other other national banking crisis, to be understated.

China consumes 50% of all pork produced globally, and its internal food production, storage and distribution system is already pushed beyond its limits. Pork and chicken prices have risen 100%.  In July 2011, prices rose by 57% year-over-year driven by herd thinning due to high grain prices and by disease.  Foreign imports can't fill the gap, especially because of an "extremely rudimentary cold supply chain."  If the Chinese government wants to see a shift towards consumption, shortages of consumer electronics will not be the issue, but shortages of food and packaged food products may very well be the Achilles heel.

Local protests are said to be rising in frequency and intensity, McKinsey says.  The government is reluctant to begin visible clampdowns in a Twitter and SnapChat-filled communications world.  There is, the author says, a growing resistance to building more pollution-generating projects like mining and chemical ventures in the countryside.

As the push for infrastructure spending increases, the issue of capital efficiency will come to the fore.  Efficient use of capital, some research has shown, is a key for countries to breakout from emerging market status to that of a developed economy.  Chinese capital utilization has been splashy and visible, but not necessarily efficient.

Online retailing may turn traditional Chinese store retailing on its ear.  A particular model being used by Chinese-American entrepreneurs in the U.S. may work very well in China.  The model produces frequently changing designs of consumer textile products on small runs, which encourages new orders and established customers to frequently check the offerings.  If this model were exported to China where labor rates are lower, it might work.  The point is that traditional big box retailing might not have a future in China apart from the super-cities.

Middle class parents are said to be hedging their bets by enrolling their young students in foreign boarding schools, as their parents also acquire property in these countries, from Switzerland to the United States.

Foreign investors, McKinsey says, are increasing their investment in the Chinese Super League, as football club prices in England's Premier League are at relatively stratospheric levels for the top clubs.  This would be a good sign and a potentially good way for foreign investors to indirectly play the rise in consumer income and wealth.  It remains to be seen how, and if, foreign investors can make money and achieve liquidity.

China is increasingly looking to take stakes in foreign agriculture, as it is already the second largest importer of rice and barley, and among the top ten importers of corn.  The country already leases hundreds of thousands of hectares of crop land from Australia to Kazakhstan for growing soybeans. Moving large volumes of grains, seeds and oils is probably one factor in the interesting venture recently announced among Cargill, private equity and Chinese shipbuilders.

Smart, agile traders will have some money making opportunities in the next few years as the Chinese economy adjusts to longstanding imbalances and begins a different stage in its economic development.

CalPERS, the Environment, Clean Technology and Municipal Creditors

Ann Simpson is a senior portfolio manager at CalPERS and heads up their global governance efforts.  The Wall Street Journal's recent report on the Environment has contrasting quotes from two portfolio managers.

Ms. Simpson says,

"The financial crisis we've just crawled out of cost CalPERS something in the order of $70 billion. That's the cost of getting it (?) wrong. So companies, whether it's a high-quality audit or it's environmental reporting or good internal controls, we'd prefer that you think about this (?) as an investment.  ...we really want companies to invest the time and the effort in getting these material environmental issues identified, properly reported and then managed." 

So the $70 billion in losses could have been reduced by spending more money on reporting environmental issues?  I thought that the financial cascade failure in the global financial system was triggered by issues at the Reserve Primary Fund; these reflected massive failures among corporate management, their auditors and financial regulators.  Who knew that there were environmental causes?

Turn the page to the inside of the report, and there's a series of quotes from Joseph Dear, the Chief Investment Officer of CalPERS.  According to Mr. Dear, a CalPERS fund devoted to clean energy which began with assets of $460 million in 2007 has generated an average annualized return of (-9.7%) to date.  So, actually investing in sustainability as CalPERS as an objective has been an awful investment for pensioners. Mr. Dear says,

"We have almost $900 million in investment expressly aimed at clean tech.  Well, for CalPERS, clean-tech investing has got an "L-curve" for "lose."  Our experience in this has been a noble way to lose money.  And we're not here to lose money."  

If these funds had been mutual funds sold to the public, they would be seeing an exodus of shareholders, but  CalPERS is privileged as a public system because of its size and political activism.  As a high profile public scold for corporate n'er-do-wells, it is particularly ironic that in 2013 the former CalPERS CEO was indicted for fraud in a pay-to-play scheme to defraud a private equity firm. I guess that their own internal governance checks and balances were not properly managed.

In the Stockton and San Bernardino, California Chapter 9 municipal bankruptcies, CalPERS is resisting any efforts by creditors and bond insurers to treat them alongside the other creditors.  The bankruptcy judge seems to leaning to the preferential treatment avenue for CalPERS while bond holders will be asked to take a substantial haircut to principal.  Nothing like being able to take advantage of an implicit subsidy, which is what the entire shadow banking system did during the financial crisis.  Mr. Dear said that he was not here to lose money, and if preferential treatment is what it takes, then so be it.

At the end of the day, these municipal creditors have only themselves to blame.  If they were too lazy or too stupid to understand their real downside risk, then that's the way it goes: they deserve the pain.  Chapter 9 is good for city managers and  for CalPERS.  Everybody else is left holding the bag.

Breakout Nations: Investors Have to Pick Winners

Ruchir Sharma, who heads up Morgan Stanley Asset Management's Emerging Markets efforts, has written a thought-provoking book for investors and economic analysts called, "Breakout Nations." I'm basing this post on reading the book and on an interview Sharma gave with Professor Robert Wade of the London School of Economics.

2007 was the best year for investment returns from emerging markets, capping off their best decade as an asset class.  Sharma says that the macroeconomic foundations of this outperformance were provided by the easy money policy of the Greenspan Fed, a global commodities boom, and the "financialization" of commodity markets.  Of course, these three  turbochargers can't sustain superior returns against the prior periods.

The overarching premise of the book is that during the decade ending 2007, an investor could have bought almost any emerging stock market or an emerging market index fund and achieved market-leading returns.  Going forward, country allocation, in addition to company selection, will be critical for investors looking for superior returns.  The potential winners in the coming decade may not include the choices trumpeted in the financial press.

In the book, Sharma describes his personal research process when he visits a country.  He meets with a wide variety of non-financial and non-corporate, and non-governmental people, including movie stars, sporting celebrities, and the luxe consumer classes about which so much is written.  He takes auto journeys away from the corporate islands and metropolitan centers.  As he paints his mosaic, he then uses this to challenge the quantitative, financial analyses of Morgan Stanley's analysts and portfolio managers,  He uses these economic travelogues to frame a 3-5 year economic cycle for each emerging market, incorporating the data produced by his analytical organization.

In 2010, money flows into emerging markets were massive, and countries like India recorded record investment inflows.  Of course, the macro drivers included the Bernanke Fed's policies that drove investors to take more risks in order to generate their required rates of return from financial assets. Around this time period, the Economist magazine featured several cover stories about the Valhalla of emerging markets for investors in developed countries.

Of the approximately 180 countries, excluding failed states, 35 are developed market economies, and the rest are either emerging markets or frontier markets, according to Sharma.  Looking at cycles of economic growth, he says that economic growth and stock market performance is never an unending, upward trend line; it is more like a game of Snakes and Ladders.

He cites the probability of a country experiencing GDP growth of 5% per annum or better for a decade as being one in three.  The odds of a fast growing decade being followed by a similar growth decade, he says, is one in four.  The probability of a third consecutive growth decade drops to one in ten.

The literature is filled with linear extrapolations of growth that appear naive and foolish, ex post. Sharma cites the IMF's forecast that the world's developed economies would now have welcomed Brazil, the Phillipines and Sri Lanka.  Going a bit farther back, Sharma cites a projection by Nobel Laureate economist Paul Samuelson that Russia would overtake the U.S. in terms of the size of its economy.  Those are some really lousy forecasts!  Warning: treat all long-term economic forecasts with a great deal of skepticism, as they will be hazardous to your wealth.

So, looking back, what were the real breakout nations?  South Korea and Taiwan.  Both countries have grown their GDP at an average annual rate of 5% for five decades.  For other emerging market stars, the 1980s and 1990s provided global market headwinds, like the '94 Mexican crisis, the '97 Asian crisis, and the '98 Russian crisis.  During these periods, Sharma says, emerging markets as a group average slightly above 3% GDP growth.

Russia, which has experienced GDP growth rates of 7% is seeing forecasts ratchet down to the 3% level.  In terms of the Billionaires Index, something cited by Sharma, Russia is number two behind the United States, despite the fact that its economy is relatively small by global standards.   There has been relatively little churn in the composition of the Top Ten, something which Sharma sees as a negative indicator for the future.

A static composition of the top tier suggests a lack of innovation, a concentration of power, and the suggestion that wealth is created and maintained by preferential connections to the government.  In the case of Russian oligarchs, this is a truism.  Aside from the Russian natural gas  hammer being applied to Western Europe, there appears little to underpin a strategy of strong economic growth in the coming decade.

India has had no churn among its top billionaires.  Sharma sees a widely held perception during his visits to India that the populace sees the blessing of the Central government as being the key to economic success.  He goes as far as saying that this feeling about big business being in bed with a corrupt government is what fuels sometimes violent popular movements like the Naxalites.  China and Korea, by contrast have high degress of churn in their top ten billionaires and millionaires.

China has experiences average annual growth rates of GDP of around 10% for three decades.  It is on its way to becoming a middle income country, and he says that the narrative of the "disappearing Chinese consumer" is a myth.  He also says, however, that the IMF forecast of future GDP growth of 8% is probably unlikely.  China's chances of moving into to the top tier of developed economies is around 50/50 due to the often discussed economic, political, and financial imbalances within the economy.

Brazil has used its riding of the commodity booms of past decades to create a welfare state, and a corrollary has been the almost total neglect of internal infrastructure, which we have alluded to in a previous post about global food production.  Sharma's outlook for commodities in general is bearish going forward.

The overriding influence is China's growth rate, which is slowing, as has its demand for raw materials, including for strategic stockpiling, as for rare earths.  In addition, markets have developed substitutes for certain key materials and reduced the resource content for key manufactured goods.  China's demand accounted for 30-60% of global raw material demand for certain commodities when its economy was growing at 10% per annum during its construction boom decades.  All of these trends, Sharma suggests, are reversing.

The availability of capital from global banks, he says, is drying up compared to prior decades. Fiscal issues will be difficult for some economies, e.g. India were growth is slowing, rural wage inflation is rising, food prices are increasingly volatile, and the current account deficit is large and growing.

Sometimes Sharma's interviews lapse into a journalist's superficiality, but there's no doubt that he's put together a very readable book, identifying food for investor thought.

Dell's Proxy Materials: Deal or No Deal?

For those who want to add to future global warming by killing lots of trees, Dell has issued hundreds of pages of proxy materials, including the background and timing of board discussions from the earliest days of going private to the opinions of JP Morgan, Evercore, and Goldman Sachs regarding alternative transactions.

Without doing a close reading of the materials with my  Eberhard Faber No. 2 Blackwings, here's what I put into my notebook.

The advisors agree that the issues for Dell going forward as a public company in the status quo mode include,

1. The medium-long term growth of the PC market will be challenging, with low unit growth and lower margin sales driving gross margin downward by historical standards.  This would contrast with Dell's historical strength in sales of higher margin machines, driven by its premium name and efficient manufacturing structure. 
2. The company has yet to demonstrate an ability to penetrate the tablet and smartphone markets.
3. Dell has yet to leverage the more than $13 billion of recent acquisitions into a "compelling enterprise stack."  Of course, this is the peer sector where the higher valuations reside for a "new" Dell. 
4. Can the company make the difficult, long and expensive transition from an equipment-based sales force to an Enterprise-based solutions sales force?  This is a critical question, which almost certainly accounts for the issue in point (3).  
5. By all measures, Dell's stock performance has been abysmal, and it has almost no goodwill with equity shareholders, even with "deep value" investors. Over the past five years, Dell's stock performance was (47.6%).  HPQ was even worse at (64.1%).  Dell's PC-heavy peers were down (11.2%) as a group, excluding HPQ.  Dell's Enterprise peers were up 34.7% over the five year period.  

Put all this together, and it could make a case for taking the company private, depending on the near-term outlook for Dell as it exists today.  Well, guess what?  The near-term outlook is dismal.  Surprise, surprise!

In the earliest version of FY14, management's internal plan presented to the board,  projected revenue of $59.9 billion, with non-GAAP gross margin of $13.6 billion, and non-GAAP operating income of $4.1 billion.  The board eventually realized that this was a "pie in the sky" plan, and after a downward revision that was still not convincing, management was directed to work with board member Shantaru Narayen, the CEO of Adobe, to come up with a FY14 plan in which the board and management could be confident. 

The final FY14 plan had projected revenue of $56.5 billion, about a 6% reduction from the prior plan. Gross margin was reduced to $12.5 billion, an 8% reduction better reflecting the pressures on the PC business.  Finally, a 27% reduction in projected non-GAAP operating income to $3 billion became the latest benchmark. 

Ironically, the genesis for taking the company private was a friendly approach from Southeastern Asset Management, which was kind enough to present its spreadsheets to CEO Michael Dell. For whatever reason, SAM was never a part of the MD-SLP transaction.  Now, fast forward to evaluations of various alternatives to shareholder value creation.

JP Morgan's slides do consider a leveraged recapitalization alongside an alternative for a special dividend payment to shareholders in conjunction with going private.  The leveraged recap is said to have certain benefits for supporting the share price and perhaps being EPS accretive in the short-term; the obvious drawback, not unique to the recap, is the pressure on uncertain cash flows, given the continuous weakening in the near-term projected results.  It doesn't appear that the leveraged recap as contemplated by SAM gets the same level of consideration as does the MD-SLP plan at the given price.  

It is clear that the executive suite in a private Dell should be cleared of the executives who occupy it now, as they haven't been delivering and they are probably not suited to where the company would have to go in the future.  There are questions about Michael Dell himself: he made the $13 billion in acquisitions and allowed them to flounder.  

"Go Shop" procedures, according to Evercore's slides, produced a 6% median increase over the initial announced transaction price in larger deals.  This is a benchmark that could be met. 

It's pretty easy to see a scenario where the board could accept the MD-SLP deal at a 6% or so higher consideration.  The other players, at this point, might be out in the cold in this very cynical process.  

Dell's Process: Go Shop or Store Closed?

There seems to be a distinct lack of buzz surrounding the Dell board's go shop process for the company. Here are some of the more puzzling developments.  First, as Fortune reports,

"Sources close to the situation say that Blackstone (BX) repeatedly requested the concession, threatening to otherwise walk away from the table during the "go-shop" process. Dell's (DELL) special committee eventually favored the move, believing that it would increase the odds of getting a superior offer."

The concession is that Dell would reimburse Blackstone for its due diligence costs, regardless of whether or not Blackstone were to make a serious, formal bid.  This makes no sense from the perspective of the current shareholders.

Also, Dell's former executive leader of mergers and acquisitions, Dave Johnson, moved to Blackstone in January 2013.   Among other acquisitions, he was responsible for the decision to acquire storage company Compellent and Quest Software, among others. If anyone knows where the bodies are buried and if anyone can do surgical due diligence on Dell, it should be Blackstone under Johnson's direction.

If Carl Icahn is not getting his due diligence fees reimbursed, and he hadn't even requested such a thing, then why on earth would the Dell board succumb to Blackstone's rather brazen ploy?

Southeastern Asset Management, apart from a puff piece in the New York Times about one of its founders, has been very quiet.

Finally, none of the rumors about who might run Dell in the future are comforting.  First is the rumor that founder Michael Dell would remain as CEO under a combined Blackstone/Icahn bid.  But, since the founder returned to spend billions in acquisitions and failed to energize the company's results since his return, is this a variation of the Jerry Yang story?  New money, new ideas and new management usually come together.

Finally, there is a rumor that HP/Oracle exec Mark Hurd would come to run the new Dell.  Now there's a scary thought for new investors.

Could it be that even with a peek under the covers, folks are trying to figure out a face saving exit for all concerned?

Cargill's 2012 Report: Thinking About Food.

Cargill's 2012 revenues of $133.9 billion increased by 12% over the prior year. Earnings from continuing operations were $1.17 billion, down 56% from the 2011 record level of $2.69 billion.  Cash flow from operations in 2012 was $3.51 billion.  The company deployed $4 billion in capital, including $2 billion to acquire Provimi, an animal nutrition company.

Despite the sharp drop in earnings, one third of their businesses exceeded the prior year's results.  The Food Ingredients business, comprising 26 business units, produced record earnings in 2012.  Among other 2012 record-setting businesses:

• Brazil--grains, oil seeds, cocoa and foods
• North America--corn milling
• Trade finance
• Specialty canola oils and industrial oils.

So, where did things go badly wrong?  Cargill's agricultural supply chain results were well below the prior year, as the CEO noted the trading giant "misread markets."  Cargill has operations in 65 countries, of which two-thirds are classified as "emerging market economies."  

One of the hot topics at forums on global food issues is that of food security.  The big question is "Can the world feed itself?"  Cargill's CEO noted in a 2012 presentation, "It's demonstrably true that the power of the currently existing technology--without the need to invent new technologies--will allow us to use existing water and soil to feed the anticipated 9 billion people expected to inhabit the planet by 2050."  This view is not out of the mainstream, and it's certainly encouraging, as it should allay the neo-Malthusian concerns expressed by professional alarmists.  

Cargill uses the numéraire of calories to measure the output of world food production, and it is certainly convenient.  While the total supply of calories produced is adequate to satisfy demand, there are surplus and deficit areas, as the theory of comparative advantage would suggest. World trade in agricultural products and foodstuffs should reallocate the supplies to satisfy demand.

Unfortunately, some 85% of global agricultural output is consumed where it is grown, and only 15% enters the world trading system.  So, part of Cargill's "essential work" is described as trading and logistics that connects surplus calorie areas with deficit calorie areas. Some of the trading vehicles, such as management of agricultural pools in Australia provide a flexible menu of options for grain farmers.  

Of the 15% of global output that is traded--such as corn, wheat, soybeans (whole, milled, and oil), rapeseed oil, cocoa, sugar, coffee, rice---Cargill's largest share of any particular commodity is said to be 25% or less.  

Price volatility shows up only in the traded commodity sector, as governments manipulate their own stocks in order to keep local food prices stable for political reasons.  Recent periods of higher price volatility have been laid at the feet of corporate commodity traders.  These arguments are unconvincing and unreasonable.  So what else is going on? 

Biofuel mandates in the United States are certainly a factor, as forty percent of our corn production is absorbed by ethanol as a result of non-market, Federal mandates.  All this for food which goes into the fuel tanks of our SUVs.  Also, ethanol has a marginal, if any, benefit to net GHG reduction.  So, in the words of Cargill CEO Page,

 "If we have the demand for 40 percent of our food production as completely inflexible (because of government mandates) then movements in supply..are going to have an outsized impact on price.  Today, 2 and 3 percent changes in supply are causing 40 percent changes in price, and much of that volatility is caused by the inelasticity in some portions of the mandated demand." 

A second factor is a global transportation, distribution and storage infrastructure which contributes to delays, higher costs, and significant crop spoilage. In the U.S., our inland waterways, including canals and river locks, have been neglected for decades and slow the movement of goods along major arteries like the Mississippi River.

Even in poster child success stories like Brazil, the picture isn't rosy for realizing its agricultural potential.  As a recent Bloomberg story points out,

"However, some problems may take years to sort out. The growth of the past decade has left Brazil's infrastructure straining to keep up, and cash crops often rot while trucks wait in lines to get into overcrowded ports. Companies struggle to find qualified workers due to poor quality schools." 

So despite Cargill's 2012 success in moving certain Brazilian commodities, Brazil itself lost potential export or consumption volumes to infrastructure inefficiencies that cannot be cured in the short term due to the inability to finance significant investments.   Today, paradoxically, the US imports corn from Brazil because of our own ill-conceived ethanol mandates.

According to Robert Zoellick, the President of the World Bank,

"First, we need to increase food productivity and production in developing countries, especially in sub-Saharan Africa and with smallholder farmers. To do so, we need to fix problems all along the value chain, including property rights, research and development for seeds and inputs, irrigation, fertilizer, agricultural extension, credit, rural infrastructure, storage and connection to markets."

Writing on the issue of food security, Roz Naylor, of Stanford's Center on Food Security and the Environment, notes,

"The third and much more difficult issue is the lack of political stability that would enable markets to work efficiently so food producers could sell their commodities and consumers could buy them at a reasonable price."

In fact, global companies like Cargill and Bunge step into this breach by providing training, agricultural extension services, and financing to small farmers in Asia and Africa.  People in the developing world need their own governments to step up and take responsibility for their own food security.

To put the somewhat abstract discussion of global distribution of calories into perspective, here's a story about the experience of one village in India.

There's no doubt that we've made progress, but there is so much more to do.