Europe's Foreign Ministers Get a Truce Done in Ukraine

Foreign Ministers Fabius (France), Sikorski (Poland, and Stanmeir (Germany) all played key roles in bringing about a very promising agreement for cessation of hostilities, amnesty for most protesters, and a call for early elections in 2014, along with a curtailment of Presidential powers and a freeing of opposition leader Yulia Tymoshenko.  It's hard to believe that so much seems to have been agreed upon so fast.  Kudos to the foreign ministers for breaking through official Europe's apathy and indecision in wake of what could have become a global crisis very quickly.  That could still happen, but this is great news.

Ukrainian politician Vitali Klitschko is said to have used his personal charisma in Germany as a world champion boxer to invite German Foreign Minister Stanmeir to visit Ukraine, where he got involved in brokering the truce. Bravo, Champ.

Ukraine is in no position to take upon itself the costly procedures for entering the EU, and the political costs in terms of enmity with Russian President Putin are not worth the dubious economic gains from membership.
European leaders will have to continue with their economic creativity to increase direct investment in Ukraine for logistics and transportation infrastructure products which would yield benefits for grain production and higher potential exports.

Getting to the 2014 elections with a continuing peace, with both sides subduing their extreme elements, will be the next challenge for the President, the opposition, and for all Ukrainians who want their country to prosper.

It was a little noticed fact that yesterday's Europa League play off game between Dynamo Kiev and Valencia  had to be moved to Nicosia (Cyprus) because of the violence; it was played in an empty stadium instead of DK's home stadium, just off the Maidan.  The local population could have used a respite from the months of tension and violence. Maybe that respite has begun.

H-P Upside Surprise for 1Q FY14: Execution Issues Still Remain.

H-P surprised analysts expectations in terms of revenue and EPS, and the businesses about which analysts were concerned also did better. Revenue of $28.2 billion was down 0.7% y/y and up 0.3% on a constant currency basis; this compared with expectations of a revenue decline of around 4%.

Revenue, Earnings and Cash Flow

Consolidated GAAP operating margin of 7.1% was up 90 basis points over the prior year period; on a non-GAAP adjusted basis operating margin of 8.5% increased 60 basis points year-over-year.

GAAP diluted EPS of $0.74 per share increased 17% over the prior year period level of $0.63.  The company had bracketed its expectation between $0.60-$0.64, a flat to down quarter year-over-year.

Non-GAAP diluted EPS came in at $0.90, representing a 10% increase over the prior year quarter's level of $0.82 per share. The company's guidance had been in the range of $0.82-$0.86.

CFO was $2,990 million, compared to $2, 562 million in 1Q FY13, an increase of 17%, well ahead of all expectations. Free cash flow cited by the CFO was $2.4 billion. The company did a large, well received institutional debt offering of $2 billion in the quarter.  Return on equity was 18%.

$843 million in cash was returned to shareholders in 1Q FY14, comprising $278 million in dividends and $565 million in share repurchases at an average price of  about $28.25.  The percent of free cash flow returned in the quarter was about 35% compared to the target of 50%, which I still believe should not be a focus for management's energy or shareholder capital at these levels.

Surprises in Business Segments

The Personal Systems Group revenue grew 4% to $8.5 billion, which CEO Whitman said was its best performance in the past four quarters, possibly signaling an inflection point in the PC cycle. Analysts had forecast doom and gloom for this business, as the world would be working on tablets, according to them.

Total unit sales were up 6%, with commercial units sold increasing 8% while consumer units declined by 3%. Desktop units in total decreased 3%, while notebook units sold increased 5%.  The Windows XP changeover to Windows 8.1 was not a major factor in the segment's unit sales, according to the CEO. 

Operating margin in the Personal Systems Group was 3.3%, almost 50 basis points ahead of the prior year period. 

PSG revenue accounted for 30% of 1Q FY14 consolidated revenue and about 10% of non-GAAP operating profit. 

The Printing business of $5.8 billion declined 2% year-over-year, and about 1% in constant currency. Printing's operating margin of 16.8% was 50 basis points ahead of last year. Total hardware units sold were up 5%, with laser units sold increasing by 2%, leading to a 2% increase in market share, according to the CEO. Supplies sold decreased by 3%, while ink sales increased.  This business, which for a time was milking consumers for ink sales to maintain its profits, seems to have returned its business model to some normalcy, focusing on units in its key commercial segment.  The CEO gave a "shout out" to her new leadership group in this business. 

Printing accounted for 20% of consolidated quarterly revenue and a hardy 37% of non-GAAP consolidated operating profit.

The Enterprise Group revenue of $7.0 billion increased 1% over the prior year period.  Operating profit of $1 billion represented an operating margin rate of 14.4%, down about 100 basis points compared to the prior year period.  Now that the revenue base has stabilized, the CEO noted that the profit margins really have to increase in this business.  A lot of the margin has to do with mix of sales, she noted. If H-P can mix in more storage and networking products and services into sales, this would be accretive  to margins, whereas higher sales of Industry Standard Servers ("ISS") are dilutive to margins  ISS sales are still 46% of EG sales, and ISS sales grew 6% while storage sales were flat and networking sales were up 4%.  

Highlighting the issue of product line transitions, storage sales were flat overall, but sales of the Converge line of storage solutions increased 43% and the former 3PAR products form the backbone of the new solutions. Traditional, stand-alone storage solutions will have to be transitioned out of the portfolio.  

Two Challenging Areas

Since 2010, we have expressed our view that the Enterprise Services business doesn't really fit as a value contributor.  Representing 19% of quarterly revenue, it contributed only 2% of non-GAAP consolidated operating income. 

This business can't compete with the high end IT consulting groups, and so it cannot aspire to that industry-leading profitability. 63% of its revenue still comes from Information Technology Outsourcing ("ITO") a commodity business in its sunset years, especially for profitability. The ITO business was down 9% year-over-year.  Enterprise Services revenue of $5.6 billion declined 7% year-over-year, while producing a meager $57 million in operating profit, or a paltry 1% of revenue.

Here's what we wrote about this business after reviewing the 2013 Analyst Day presentations:

"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."

Listening to the CEO on this quarter's conference call, it sounds like the group has its sales tools, new leadership and new processes, but the kind of change from putting a bucket out and waiting for renewals to going out and proactively marketing new ideas takes time and nine months of fiscal 2014 seems like a short time.  Let's see.

 Software was the second challenging area, in our opinion, in an otherwise strong quarter that caught analysts off guard on the upside. Something appears wrong in this segment, and the measured evaluation of prospects by George Khadifa at Analysts Day may have been too optimistic. If I recall, Mr. Khadifa was to report directly to the CEO.  Software is only 3% of the first quarter's revenue and 5% of its non-GAAP operating profit. 

Quarterly revenue of $916 million was down 4% year-over-year, while operating profit of $145 million was a sub-standard 15.8% of revenue, a 50 basis point decline over the prior year period. Support revenue which is 53% of the business and an add-on to a project sale was down 2%.  Professional Services, the equivalent of a higher-end offering, declined by 12%.  This business needs more critical mass.

Closing Comments

The CEO, in response to a question, said that acquisitions were back on the radar, and certainly looking at the software business, it's not hard to see why.  Areas that would be considered are in security, big data, mobility and cloud.  Of course, some of these areas are precisely what Autonomy was supposed to provide. The target size was described as "small to medium" sized companies.  The $2 billion in debt, along with continued strong cash flows from operations, and some portfolio pruning could set the stage. 

CEO Whitman talked about increased innovation from inside H-P, and she drew attention to the wide range of new product introductions at the European client meeting in Barcelona.  This is all to the good.

The company guided to 2014 EPS in the range of $3.50-$3.79, on a non-GAAP basis.  This seems like this would support a price from $30-35 a share, absent any collapse in corporate technology implementations for which there seems to be a growing appetite. 

Nelson Peltz: No Fritos with My Pepsi.

Trian Fund Management, LP wrote a letter to Pepsi's board saying that as an owner of $1.2 billion in PEP shares and with experience in the food business, Pepsi should spin off its snack business to shareholders and leave the beverage business as a stand-alone company.

Trian spins its arguments specifically for the seven year period of current CEO Indra Nooyi's tenure, and this seems to coincide with the data points about Pepsi's under performance. Here are the really salient points in their argument:

"As a distant number two competitor in beverages, PepsiCo never had the luxury of following the same strategies as those deployed by industry leader Coke. But PepsiCo nevertheless competed extremely effectively The company did so, from its earliest days through the 1990s, and was known for being faster on its feet, quicker to introduce new products, more willing to take risks and more willing to occasionally fail by doing so. Pepsi not only survived in this role of “industry disruptor,” it thrived. 

Meanwhile, Frito-Lay was known historically for having one of the best corporate cultures in America. Its culture was separate and distinct from Pepsi, which made sense given different category and competitive dynamics – snacks versus beverages, push versus pull marketing, Frito-Lay as #1 in an industry with regional competitors versus Pepsi as #2 in an industry with one large competitor. Frito-Lay’s strong culture, combined with a dominant market share in an attractive category, created a force to be reckoned with in the food industry.

         On the corporate front, PepsiCo was known for running with low overheads, even after the company            moved to Purchase in 1970."

All of these points are on the money.  Pepsi has become the Microsoft of its snack foods and beverages business: a duopolist in colas and dominant in snack foods, but unable to innovate and  really leverage its assets into earnings growth.  Agility, culture and costs should be the bread and butter charters of the board and management and clearly these have to be addressed.

But, to go from here to a spinoff seems to hang on some pretty weak arguments, such as "We've seen Kraft and others do this, so ipso facto, it must be the best thing to do right away."  The board should address how costs are going to be cut visibly and faster, and the right people should be put into the right slots to make the businesses perform better with the assets they have.  Innovation is not as easy, but it's not rocket science either, because this isn't drug discovery, after all.

In recent quarters, Pepsi appears to have actually pulled a few earnings surprises.  It has also given its longer-term projections as being a low single digit revenue growth business with mid to high single-digit revenue growth, with cash flows for dividend growth. This is about all this business can be in the medium term.

Distribution channels in the food business are everything. Frito Lay was the best in breed, and I presume that it still is, abstracting from any overhead allocation issues. Pepsi owns 11 out of the top 15 snack food brands direct delivered to retail, and Fritos are at the top.  Buying its bottlers has been criticized, with Trian quoting the CEO as admitting it was a "mistake."  The argument for doing so was, in addition to competing better with Coke, to give the company flexibility in pushing new and niche volume products through the distribution chain as sugared colas are clearly a declining unit volume business. Independent bottlers wouldn't want to take on a line of new organic juices instead of the larger volume carbonated drinks, the argument would go,

The answers to these questions are nowhere near as clear as Trian's letter makes out. In the emerging markets, much is made of losing share in India: that has more to do with the dynamics of Indian distribution than it does with Pepsi's execution.  Pepsi, unlike Coke, is said to be gaining share in China.

Should Pepsi become leaner, more agile and more efficient?  Absolutely, no doubt, and in a hurry.  Is the holding company structure the best for Pepsi?  It should be, but it isn't because of the above failures of management. Is a structure of two independent companies the best?  Unclear.

I'll take that Diet Pepsi now, please.

More Thoughts on Windows Phone 8

For all our fuming about Windows Phone 8, it's important I remind readers what could be different this time around.

• The New CEO

Taking Satya Nadella's own words about the future being in software, mobile, and the cloud, then he surely isn't going to accept the dysfunctional culture he inherits from former CEO Steve Ballmer. He had said, it's "renew or die." That's where Microsoft is in mobile and tablets. But, in the words of Lawrence of Arabia, "Nothing is written."

• Stephen Elop

Reportedly returning to Microsoft to run a portfolio which includes Surface, Windows Phone and Xbox, this would be another smart move. He knows both Nokia and Microsoft. It would also free up the CEO to focus on bigger issues, once he has rounded up his senior executive team.  Mr. Elop, like the Microsoft CEO, realizes the amount of value waiting to be created from a transformation of the lumbering Microsoft.

• Nokia's Culture Could Invigorate Microsoft

Here what Nokia says about its cultural aspirations:
• Make it great for the customerEveryone in Nokia has a role to play in making it great for our customers. This involves listening and understanding before making the decisions that will provide a great customer experience. It’s about taking accountability, and holding others accountable, for keeping commitments and getting things done on time.• Challenge and innovateChallenging the status quo is a prerequisite for change and innovation. Innovation is the lifeblood of our future success and the cornerstone of our product making. This is about not accepting “what is”, but being curious and striving for “what could be”.• Achieve togetherResults matter, and we achieve more when we work together. This is about everyone at Nokia taking responsibility for achieving and collaborating across organizational or geographic boundaries to win. It’s about having a diverse and inclusive environment that promotes individual expression.• Act with empathy and integrityEmpathy and integrity are our guides for dealing with our customers and each other. It’s about us being honest, transparent and doing the right thing. We inspire trust by speaking frankly and having the courage to call things out on what matters.

 Consumers need more competition, innovation, and value in mobile: if Microsoft can help bring this about, value creation will follow as surely as day follows night.

Besides Its Checkbook, Russia May Not Have a Winning Plan forUkraine

A few weeks ago, Ukraine showed  signs of a thaw in tensions, as Orthodox priests kept apart protesters and armed riot police.  Concessions were made to some arrested protesters. Anger had seemingly been dissipated, but now the trends suddenly seem to have reversed themselves.

As deft as Russian President Putin seems to have been in derailing the European Union project, the current tactics will serve only to harden world opinion and to ultimately cripple the economy in Ukraine.  When the 'aid' bill comes due, Russia may find its client unable to pay.

As the Financial Times points out, popular sentiment in Russia sees Ukraine as having deep ties to Russia, and they don't regard it as a former Soviet republic that should be independent.  President Putin is reported to have made this remarkable public statement,

"Mr Putin invoked the “unity” of the Russian and Ukrainian people and said that, as joint spiritual heirs of the baptism, “in this sense we are, without doubt, one people”."

I suspect that for most citizens of Ukraine, the feeling may not be mutual.

At this point, there will be all kinds of manipulation and propaganda put out to western audiences who are viewing developments in Kiev with dismay.  These protesters suddenly seem to be a much more violent crowd than had occupied the square for weeks.  Might some of the more violent tactics be from paid agitators?  The inability of western leaders like German Chancellor Merkel to even get President Yanukovich on the phone seems like he has become a paid puppet.  Again, it was only a few weeks ago that he was said to have listened to suggestions about widening the representation in his government. No more.

If the citizens of Russia and Ukraine are, in the words of President Putin, "one people," then subjecting ordinary citizens of Ukraine to violence, public humiliation, with wanton disregard for its sovereignty is not a winning strategy that Europe and the rest of the world should sit idly by and accept.

What Has Microsoft Bought With Nokia?

New Microsoft CEO Satya Nadella has told his employees that the future will be in software, mobile and the cloud. With the Nokia acquisition on track to close at the end of March, it just seems less and less clear how Microsoft's mobile future will be helped by the acquisition of Nokia's device business, to the tune of $7.2 billion.

I've been doing a lot of reading on choice, starting with classics like Kahneman and Tversky to a Barry Schwartz's "The Paradox of Choice." (the link is to his TED talk, not to his book).  Nowhere does consumer sovereignty weigh more heavily on our choices than it does in personal technology, like smart phones.

Schwartz writes, "But as the number of choices keeps growing, negative aspects of having a multitude of options begin to appear. As the number of choice grow further, the negatives escalate until we become overloaded.  At this point, choice no longer liberates, but debilitates.  It might even be said to tyrannize."

We are there in the world of smart phones.  I've listened in on many interactions between retail customers and store associates as the consumer, with their kid in tow, asks "I want to buy Jane the best smart phone. You know, for school and because she'll definitely need one in college.  Can you help me?"  I've also read, viewed, and heard many of today's tech gurus for CNet, the Wall Street Journal, Money, PC Magazine, and Consumer Reports all hold forth on how to make this decision.

Out of all this confusion, it is very hard to see how Microsoft can be saved from once again being late to the party, for having launched Windows Phone 7 with a thud before eventually designing a decent product around Windows Phone 8, and then for launching Nokia Windows 8 phone but failing to leave the atmosphere.

Here on Presidents Day with the big sales, I find the Nokia Lumia 520 and 521 unlocked for $69 and $59 respectively. These are on the Microsoft Store. These are about the cheapest smart phones a bargain hunter can buy.  They get decent reviews from those kinds of consumers who also acknowledge the limitations, particularly the small Microsoft Apps store.  But now, who would buy one with the clear risk that they could soon be orphaned by possibly abandoning the Lumia line and design.  (Leave aside the issue of abandoning Windows Phone 8, which would be too risky because it would end the "one experience across all devices" mantra.)  The higher end Lumia phones get good reviews for the cameras, but they don't really shine in other areas, and their battery lives are less than the bargain basement phones.

For Google to exit making devices showed, in my opinion, a lack of courage, but it was cynically pragmatic given Google's goal to bring tens of millions of new people peering into their devices and seeing Google Search and other services. Let others mess around losing money making devices.

Microsoft too, under Steve Ballmer, has said "it's all about services," but the current Nokia platform is poorly positioned to garner anything more than the current 2-3% of all handset sales.  At this level, it's not worth developers' time to build apps for Windows Phone 8 and so how does the store grow?  More time will be lost.  In the meantime, consumers are faced with replacing or adding smart phones to their family plans. What to do?

The Wire Cutter, a highly regarded tech consumer products site, rates the Apple iPhone as their Favorite Smart Phone, with Motorola's Moto X as the best Android Phone. But now, with the sale of Motorola Mobility to Lenovo, consumers who opt for Moto X may, like Lumia buyers, see their phones marginalized or quickly obsoleted.  Now Moto X owners will no longer be assured automatic updates to the latest version of Android, and they may now get versions with Lenovo's front end piled on top which may diminish the user experience that the Wire Cutter likes.  Do you think the carriers might consider returns or clearing out the Moto line's early products?

The consumer decision paradigm for an Android phone is way too complicated, and the risks of dissatisfaction are high: none of these states are where consumers like to find themselves after spending $400-500+ for a cell phone, call it what you will.

When the Nokia deal goes through I will be curious to read the level of charges taken for workforce reductions in Finland and for the allocation of the purchase price to intangibles and to goodwill.  That will tell a lot about this story will work, or not, in the future.

Cisco's Fiscal Second Quarter 2014: Nothing New From the First

After looking back at our lengthy post on 1Q FY14, Cisco's recent announcement of 2Q FY14 results didn't seem surprising. The bottom line is that analysts rate a fair value of $20 for the stock based on about $2.00 in EPS and a P/E about 70% lower than that of a competitor like Juniper Networks.  Again, I get concerned when stocks are priced for perfection, but when they're priced like a "going out of business" sale that's the time to look closely at the risk/reward ratio.

Quarter two's revenues of $11.2 billion were 8% below the prior year, which is at the low end of the projected range of an 8-11% decline.  Non-GAAP net of $2.5 billion was down 7%,  and adjusted EPS of $0.47 compared to $0.51, including a substantial charge for defective component chips from a trusted vendor.

The gross margin pressure which everyone is looking for continues apace. The product gross margin of 59% is, as one analyst pointed out, the lowest rate in ten years. The consolidated GAAP gross margin rate was 53%, but 61% on a non-GAAP basis. Again, not nice to look at, but this is a common phenomena among all the tech giants, save for Apple and Google, whose models are quite different.

For example, Cisco has decided to get out of the low margin set top business, while today's papers have stories about Apple reportedly getting ready to launch a set top business.  Inconsistent?  Different business models.  For Apple, it has yet to launch a product for which its customers aren't willing to pay a premium price, and so given their proprietary, closed iOS and their approach to content, this could be a nice niche for them.  Or, it could be their first stumble: I surely don't know.  For Cisco, with its goal to be the leading provider of infrastructure and management across the Internet and its plumbing, it makes perfect sense to get out of the box business.

Free cash flow of $2.3 billion was 6% ahead of the prior-year period. $4.9 billion was returned to shareholders, comprised of $4 billion in share buybacks and $900 million in dividends.  This was a record. The quarterly dividend was raised from $0.17 per share to $0.19.  Shareholders are getting paid for waiting.

Meanwhile their list of acquisitions and continuing integration of prior acquisitions continues.  If they are overpaying, it isn't hurting the balance sheet.  Emerging markets are a weakness.  They are in total chaos for all vendors in many product lines.  Is this a big deal now?

Cisco still has one of the strongest sales forces in the industry.  If they didn't, how did they get to this point?  To grow and retain this force, they have to execute a strong new product portfolio refresh, and this is where they should be putting money and management time. Share buybacks above $20?  Back off the accelerator unless the stock craters, which doesn't look like it's in the cards.

Cisco, IBM, HP and Microsoft.  There's value in there somewhere.