US Postal Service Reform: A Dead Letter in 2014

Throughout 2014, we read warnings about yet another crisis at the US Postal Service.  Aspects of Congressional regulation regarding prefunding of employee healthcare do have the effect of showing paper losses, and the postal union suggests that removing the prefunding requirement by itself would put the USPS in a healthy condition.

Unfortunately, this isn't the case. Meanwhile, as Congressional bills like Carper(D)/Coburn(R) languish without coming to the floor for a vote, it is clear to anyone who uses the Post Office that delivery times from Minneapolis to New York, for example, which used to be 2-3 days for First Class mail are now 5-7 days, while rates have gone up.

There are too many small post offices, too little self service, and the delivery fleet itself is outdated and antiquated.

The Postmaster-General admitted that its commercial bulk rates were not competitive enough to win share from online retailers like Amazon.  The USPS recently cut rates for holiday shipping by large shippers, and it did take share from FedEx and UPS, much to their chagrin.

Delivering groceries with the current expensive workforce, work rules, and antiquated fleet seems ridiculous. Handling returns for online retailers should help fixed cost coverage and make some money.

However, without dramatically reforming employee heath and welfare benefits, this is all the usual posturing with no real reform.  Carper/Coburn makes noises about bringing these programs in line with other Federal agencies and about enrolling some beneficiaries in Medicare, but why should this be done solely for USPS, when Congress itself and the Federal government are all on gold-plated plans?

The bill also suggests that these proposed reforms are all subject to bargaining.  Goodbye to any meaningful reform.  Look for continued decline in the speed and quality of service ordinary consumers enjoy, and look also for more glum faces and surly workers at the post office.

Telecoms Start Racing to the Bottom

We wrote a while back about Masayoshi Son's potential impact on US retail cellular phone users, particularly because he wants to become number one in his markets.

Predictably, his first efforts at taking over T-Mobile met federal regulatory veto.

T-Mobile has forced some innovation on the industry by making it easier for consumers to get phone upgrades and by doing away with contracts. Their subscriber growth turned around.

Meanwhile, however, spectrum auctions are indicating that others perhaps have a better economic model and can pay more for spectrum that ATT, Verizon, T-Mobile, and Sprint.

So, the major carriers have put forward their "race to the bottom" business model of promising to cut monthly bills in half while offering unlimited data and phone service.  Clearly, this is not sustainable, as we have noted for years.  With spectrum prices rising, the cost of building out different network or adding other services is becoming prohibitive.

So, the WSJ notes,

"What difference does a month make? In telecom, the answer is about $45 billion.

That’s how much market value Verizon Communications Inc., AT&T Inc., Sprint Corp. and T-Mobile US Inc. have lost collectively since mid-November amid a fast-moving reassessment of the industry’s value by investors. The lost value is greater than the current market capitalization of Sprint and T-Mobile combined, and it reflects concern that cellphone service will be costlier to deliver and less lucrative to sell."

The carriers also got dinged on behalf of consumers by the Feds because although they promised "unlimited text and data" to all customers, heavier users faced slower download speeds, of course a form of rationing and making the whales pay for their consumption. If the fines levied are paid, then they either have to adopt some kind of utility pricing which is transparent, or face growing losses because their business models don't create value. 

Economic Winter in Ukraine:Western Allies Distracted and Silent

Politicians are the same the world over.  Dealing with real issues in a principled and economically rational way just leads to attacks from noisy, vested minority interests, or 'activists.'  Their self-interest lies only in their narrow agendas: the pols get instant support and the majority either doesn't know or doesn't care.  What could be better or safer?

So, Europe is worried about climate goals and ECB pronouncements, while in the U.S. we are also worried about climate pacts and yet another government funding impasse. Russian President Putin continues turning the screws in Ukraine, maintaining his currency with his nationalist supporters.

With signs of a better business climate in the U.S., a favorable Ukrainian exchange rate, an idled Ukrainian export capacity in sectors like agriculture and heavy machinery, and an avowed desire to open European markets to exports, this should be a time of optimism for Ukraine.

Instead, we still have the self-proclaimed Donetsk People's Republic in place.  Gas has flowed to Ukraine, the first shipments since June, but these have been prepaid, further draining currency reserves which must be dangerously low.

As an exportable machinery manufacturer in Ukraine tells the Journal: why worry about exporting machinery when I don't know how to find a customs official?

Germany, which seems to have become even more inward looking than the U.S., should be taking the lead, but after reported talks with President Putin weeks ago, Chancellor Merkel is probably off to holiday parties.

Ukraine deserves better from the U.S. and the European Union.

HP in Barcelona Discover 2014

If like me you weren't able to attend the HP techfest in Barcelona, you can watch most of the speaker presentations on video.

As we said back in 2012, IT buyers needed a provider like HP that could deliver them solutions for their systems issues--legacy systems, burgeoning data, mobile applications, and higher hurdles for system security and compliance to name a few.  CEO Meg Whitman's accomplishments include convincing them that HP was such a partner.  Barcelona drives the same messages given consistently throughout 2014 with updates on new products and services, along with customer participation. 

A staple menu item in all the presentations is "Big Data," a term which clearly causes audiences to either cringe, yawn or glaze their eyes over.  

Software EVP Robert Youngjohns gave an interesting presentation on the New IT, forged from the fires of Big Data.  HP's approach, he says, distinguishes among three distinct types of Big Data:

• Business data, coming from traditional sources like the corporate ERP, CRM, BI, and HR systems, for example).
• Machine data (examples were log files and sensor data, i,e, the Internet of Things)
• Human data (Email, video, photos)

The first category, which seems to be where the corporate data engine room hits the financials, is growing slowly.  It is the other two categories, particularly the third where the growth is explosive. He went on to say that the HP big data platform distinguishes among each big data category and tailors the offering accordingly.

His presentation brings up my concerns about the vacuity of the term Big Data.  Businesses are still growing, in broad terms, at GDP-like rates, or at the upper end, single digit multiples of the same. Machine and human data are exploding at ridiculous rates.

He quotes another fluff statistic: more photos are being produced each day than in the first 100 years since the invention of the photographic process.  Surely, the obvious conclusion is that the value of machine and human data are fractions of traditional business data, from data about exploration wells to customer purchasing patterns. 

If the value were commensurate, IBM, Exxon and other Big Data producers capable of deploying new systems would be seeing explosive growth in revenue or profit.  However, nothing like this is visible. Bellwether companies like Cisco sometimes see revenue shrinking. 

Youngjohns gives a personal example that raises the same issue.  He is a tech geek at home too.  His home wireless network is very complex. He has the controls for his climate system managed by sensors and a panel.  He has imaging, music, television and other activities on wireless subsystems. He decided to find out why NetFlix was operating very slowly, and so created a reporting system of activity logs which, he said, soon generated a terabyte of data!  

Now, I couldn't hear anyone laughing in the audience, but they should have been. The architecture of this network is clearly faulty, at least the infrastructure and maybe more. Leaving this aside, big data in this case was bad data, and unproductive for its expected benefit, namely to make NetFlix run faster.  The hardware and software costs per unit of data are so low, which merely masks the unproductive nature of the activity. 

Moving on to another presentation on Data Centers and the Cloud, the same issues came up in a different way.  Data centers, we are told, have to provide services for all kinds of devices, like fitbits, videos, and sensors, again the Internet of Things. These apparently create large data streams. 

However, much of this are personal data, surely. Why should a commercial infrastructure expand to support this data demand?  One of the speakers really struggled to come up with examples of supported devices that didn't sound as ridiculous as Fitbits, but he couldn't.  The demands being put on data centers from personal uses like Instagram, SnapChat, Facebook and other social media stem from the BYOD policy that has become the standard in corporate America: it is a policy that requires more resources and which ultimately reduces employee productivity.  

He did cite an example of instrumenting the corporate vehicle fleet, where a large volume of operational data (speeds, routes, mileage, fuel consumption) would create large data center demands. This doesn't sound earth shattering, but just a move up from what's being done currently by operators like UPS.

The Haven platform brings together ArcSight, Autonomy and Vertica for data analytics, while also providing a broader platform and tools for asset and security management. Sounds like things are being put into place for HP.

Of course, now it is going to split into two pieces. Stay tuned. 

Checking in on Intermediate-Term Bond Funds

Year-to-date, according to Alliance Bernstein, U.S. stocks are up 14%, compared to a gain of 4.2% for bonds.  From the local market peak on 9/18 to the trough on 10/15, bonds showed their shock absorbing qualities as they declined by only (-1.4%) versus equities at (-7.4%).

It's unclear what fund managers at intermediate-term bond funds are thinking, as the most recent published disclosures are from 9/30, but much has been made of higher cash levels at many funds. Morningstar data shows overall bond fund cash at over 8% of assets, which is alternatively attributed to bond sales, cash inflows, or raising cash for expected redemptions as equity markets continue to rise.

We lean towards the importance of the last factor, especially in light of the growing uncertainty about when and how the Fed plans to raise interest rates.

If bond funds behaved like equity funds, there's no doubt that they would be taking some money off the table because their winners have had long runs and the relative rewards going forward look less inviting.

Investment Grade Corporates issued by financial institutions had a total return of 2.5% in 2006, 11% in 2012, and 8% in 2013, according to Dodge and Cox portfolio managers whose allocations to IGCs is twice as high as their benchmark index.

If there were to be a flight away from bond funds to equity mutual funds ( a sure sign of a market top looking at retail funds), portfolio managers would be challenged because bond markets are relatively thin and inefficient, something we have noted before.

Financial regulation post-crisis has made the dealer market more risky and less profitable.

The favorite financial company issuers in the IGC sector include: Bank of America, JP Morgan Chase, Goldman Sachs, Morgan Stanley and Wells Fargo.  Bank of America, according to Bloomberg data from April 2014, had 1,295 bonds outstanding, but only 53 of these were liquid enough to included in the Barclays US Corporate Index, a popular benchmark.  But, these 53 issues, 4% of total bonds issued, amount for 46% of the dollar amount of Bank of America's debt outstanding. These bonds are over-owned because of their inclusion in the index, and because of their liquidity; investors who chose from the other 1,242 Bank of America issues will be in real trouble if there is a market traffic jam in a bond exodus.

According to BlackRock, market reform in bonds is long overdue, and aside from proposed regulation on mutual fund bond sales our regulators have not seen the improvement in bond markets themselves as something worthy of their serious interest.

IT Buyers Face More Regulatory Risks For Business Interruptions

In yesterday's post about Cisco, we stated our belief that IT buyers, whatever their justifiable complaints against their traditional suppliers, need them as real partners going forward because of the increasing risks IT leaders face if their systems suffer business interruptions.

In today's Journal, the case of Royal Bank of Scotland made the business pages as RBS paid a fine of $88 million for an IT failure that kept customers from accessing or transacting from their accounts reportedly for weeks.

British regulators opined that there wasn't a underinvestment in IT systems which led to the failure, but rather an absence of adequate software testing systems which led to the outage.  Heaven only knows how regulators who were asleep during the global financial meltdown suddenly have become expert in software implementation and testing.  This is, however, the world in which IT buyers, particularly in financial services, are going to function from now on.

To save pennies on a project, bring in newer,smaller unproven partners, or to piece together hardware, software and services on an a la carte basis would be a risky way to do business and it wouldn't be good for an IT exec's career.

The Four Horsemen of Tech will continue to have an advantage going forward in the new world of IT, if they can change their go to market strategies and become more customer-centric: they don't have any other options.

Cisco's 1Q FY15: Looking Forward and Back.

Looking Back at Our Cisco Posts

"Cisco's 4th Quarter: A Tiger Changes Stripes," 8/16/2012

• Credit Suisse worried about 250-300 bp erosion in the gross margin rate going forward! (the time frame is not specified)

"Cisco: The Fourth Horseman Reports First Quarter 2014," 11/13/2013

• For the period 7/2008-2013, Cisco's shares return an average rate of 7.4% per annum, trailing both the Standard and Poors broad index (16.5%) and the Tech Index at 18%.
• $12.1 billion in revenue increases 1% y/o/y.
• It will take 4-5 years to transition the company away from a heavy reliance on its traditional core of switching and routing.  
• From 2008-2013 the gross margin rate declined 800 basis points.
• Long-term growth rates of 5-7% expected from a reconfigured Cisco. 
• If this were combined with operating leverage on a leaner company and better supply chain efficiencies, long-run value creation would be significant.

"Cisco's 2013 Financial Analysts Conference," 12/14/2013

• Core business growth might average 0-1% per annum over the next 3-5 years!
• Hardware still accounts for about 30% of data center spend.
• Servers account for 29%.
• Software accounts for 22% of the data center spend.
• "stock could have legs in 2014."

"Cisco's Fiscal Second Quarter 2014: Nothing New From the First," 2/13/2014.

• "When...(a stock is) priced like a 'going out of business' sale that's the time to take a look at the risk/reward ratio." 

"Cisco's Third Quarter and Cloud Computing," 5/18/2014.

• Customers apply 75% of their skilled labor to the management of their applications, software layers and infrastructure.  Over time, this ratio must fall to about 25% in order for them to meet the new demands on IT departments.
• This is the opportunity for vendors like CSCO, HPQ, MSFT, and IBM.

"Cisco's 4Q: FY'14: Low Quality of Earnings Concerns," 8/14/2014

• Concerns on the analyst call about the effects of software defined networks (SDNs).
• Switches are 30% of the quarter's revenues
• Acquisitions mentioned: Tail-f Systems; ThreatGRID; Assemblage, for mobile collaboration.
• Expect the share price to be range bound between $20-25 for the balance of the year.

Coming into 1Q FY15

• Facebook's announcement about its new data center architecture was seen as a negative for Cisco's earnings announcement and for sentiment on the stock's prospects: 

"Our previous data center networks were built using clusters. A cluster is a large unit of deployment, involving hundreds of server cabinets with top of rack (TOR) switches aggregated on a set of large, high-radix cluster switches. More than three years ago, we developed a reliable layer3 “four-post” architecture, offering 3+1 cluster switch redundancy and 10x the capacity of our previous cluster designs. But as effective as it was in our early data center builds, the cluster-focused architecture has its limitations.
First, the size of a cluster is limited by the port density of the cluster switch. To build the biggest clusters we needed the biggest networking devices, and those devices are available only from a limited set of vendors. Additionally, the need for so many ports in a box is orthogonal to the desire to provide the highest bandwidth infrastructure possible. Evolutionary transitions to the next interface speed do not come at the same XXL densities quickly. Operationally, the bigger bleeding-edge boxes are not better for us either. They have proprietary internal architectures that require extensive platform-specific hardware and software knowledge to operate and troubleshoot." [I love the unconventional use of the mathematical term 'orthogonal' in the press release]

The bears on all the Four Horsemen of Tech, especially CSCO and HPQ, would say that the mega-users are rebuilding their next-Gen data centers with their own designs, which include more software defined network architectures. (remember the concerns on the prior 4Q FY 14 call)

The 1Q FY 15 Results

• Revenue of $12.2 billion increases 1.3% over the prior-year period.
• The gross margin rate of 63.3% is the highest level in three years. (Remember Credit Suisse's projections from 2012)
• The operating margin rate is 29.2%
• Switching and routing are 47% of consolidated revenues versus earlier projections of two-thirds. (some of this might be bleeding off into new categories, but it shouldn't be that significant)
• New product introductions are cited, including ASA with FirePOWER, an industry-first threat focused firewall.  Perhaps the latter feature came from the ThreatGRID acquisition mentioned a quarter earlier.
• The stock price which began the year at $21.98 is at $26.59 intra-day as of this writing.  The stock indeed had legs in 2014!

What's Ahead?

• The world won't belong to Huawei.
• Even thought IT purchasers are taking longer to make their big purchase decisions, very few of them are going to design their own data center configurations.  Mix and matching will have its limits, as IT officers rise higher up in the executive chain with more visibility and accountability for performance and for mistakes. 
• The succession plan for CEO John Chambers is being signaled as evolving.  The revenue growth under Mr. Chambers has been nothing short of astonishing, although some of it was riding a tech wave for sure.  
• The next alignment of the executive team, the culture, and the ability to tell their story better will tell all about the stock's price appreciation potential.  Some board refresh would be appropriate.  
• So far, Cisco has been doing exactly what it said in 2012, which itself is unusual for mega-cap companies.