Beruflich Dokumente
Kultur Dokumente
Introduction
Below you’ll find a series of blog essays collected into this white paper that examine the roots of business
performance during 2007. That was a period when the early economic indicators clearly told us the Economy was
slowing down and there was trouble ahead. It was also a period when there were clear warning indicators of
trouble in the market’s fragile sensitivity to sudden surprises, yet it kept plowing ahead. Worse yet it was also at
least two years past the time when it was clear Housing was in a Bubble and a major problem in the credit
markets was on the way.
The Finance Industry reacted by tripling down its bets on structured synthetic debt instruments, with results we all
know. As Chuck Prince said at the time, “as long as the music’s playing you’ve got to keep dancing”. That
hubristic and malfeasant performance, not only by Citi but by the entire Industry, has been dissected to a fare-the-
well. But before we judge Finance too harshly we need to look at the decisions and performances of “regular”
businesses.
As the bubble built up the executives didn’t spend their cash flows on capital investment or on hiring. Which is the
major reason the so-called recovery was, at that point, the weakest on record for job creation and stagnant
wages. What they did spend their money on was financial engineering, specifically on stock buybacks, because
that’s where and how they were measured. In effect spending huge cash flows (profits at non-financial
corporations were the largest in several decades during this period) on inflating their own bonuses at the expense
of improving or maintaining the performance of their businesses.
Decisions for which they were roundly applauded at the time by most observers, but not all. In the essays below
we start with a survey of the financial engineering landscape and consider the specific example of Home Depot
and Nardelli. It makes interesting reading because instead of repairing a great franchise and restoring it to health
he cut costs, damaged customer service, made unwise purchases and in general badly damaged the
Corporation. All the while collecting ginormous bonuses. His severance package alone was the GDP for a small
country (exaggerating only slightly).
But one observer, besides ourselves, who tried to hold corporate management to account was Carl Icahn, though
unsuccessfully. We use Kaptain Kar’s views as an excuse and template for inventory a wide-ranging sample of
corporate performances and found few if any positive exemplars.
We then look at earnings vs. business health to reinforce the point that things weren’t very good in River City. The
final essays take a deeper look at general performance analysis.
But the bottomlines are this. First off it was more than possible to analyze corporate performance long before the
downturn, let alone the crisis, was generally recognized. Secondly, as the results of these decisions, many
companies entered the downturn extremely poorly positioned and remain weak to this day.
The approaches, methods and findings from that time period are still applicable to today and also tell us who was
swimming naked then and is really exposed now. So this isn’t just a history review – it’s a set of case studies for
hubris gone awry, with lessons that, tools and techniques that can be applied tomorrow.
The last 3-4 posts in particular provide a pretty good toolkit for understanding business performance and how it
impacts the economy, the markets and the health of individual companies. For example the last Home Depot post
laid out a strategic recommendation based on our framework that, many months later, become exactly what the
Company implemented, is implementing and how they’re running things today.
So the other bottom line is that by understanding business performance we were able, almost two years prior to
the crisis, to assess the strong and weak performers!
Table of Contents
Page 2 of 28
I also threatened to take a deeper dive on the S&P as the representative proxy for much of what' s driving all these
markets collectively - to wit, Liquidities, Buyouts (which are driven by liquidity in turn) and Buybacks. So here let' s
take a look at the S&P, dive a little farther into this liquidity thing and its'consequences (with the thought that we
need to take a separate dive on that sometime) and ask how market performance is being driven by the balances
between fundamentals and internal technicals.
SP500 Performance
If we take a closer look we did indeed get the summer dipsy-doodle drop from 1300 to 1250 but since then we' ve
roared back to around 1525, at least until this last couple of weeks, barring the Feb/Mar Shanghai Surprise when
it looked like the bursting of the Chinese bubble (still to come btw) would take all the other world markets with it.
Once we discovered that Shanghai was a miniscule portion of the world' s capitalization we not only recovered but
plowed thru the prior highs around 1450. Recently, at least to me, it looked as if we were topping out at the
aforementioned 1525 but in the last couple of weeks broke thru the resistance line quite nicely. At least for those
of you looking for continued uptrends, as opposed to those of us looking at fundamentals and economic
performance. In other words the market is up 20% since the beginning of last year and the bottom last July. Half,
10%, of that gain is since it looked like a top was being reached last fall. And from the Shanghai bottom to now
we' re up 15%, 5% of that or so within the last couple of weeks!
Page 3 of 28
Like I said in the prior post - wheee......e! Taking a closer look what's going on? Well for one thing earnings have
continued to go up very nicely as a result of corporate profits being at a post-WW2 high as a % of GDP. Bear in
mind if corporate cash flow is going into earnings and buybacks it' s not going into investment or hiring. Which
means lower demand now and in the future. The other thing that' s going on is, as everybody has acknowledged
and been saying for a while now, there' s a lot of money looking for a home and not finding many good places for
it. Liquidity - cash, funds and borrowings X leverage - has several key sources.
1. With an anemic recovery there's little demand for investable funds at the same time businesses
are throwing off a lot of cash flow since it's no going to equipment or people. That explains the
conundrum of why long-term rates were and are so low btw.
2. With the trade balances a lot of US funds are going abroad (primarily to Asia and Japan) to pay
for imports. They then have the option of letting it into their economies and creating their own
unsustainable booms, letting it bleed into the consumer sector and driving up inflation or
watching their currencies appreciate dramatically. That would mean lower export growth and, a
major socio-economic risk - especially for China were job growth IS social stability and the
alternative to a revolution. The alternative is to absorb it into reserves and use those reserves to
buy US assets, which is what they're doing. It makes a nice co-dependency - we consumer and
pay them with funds they re-loan to us so we can keep buying stuff and so on around the circle.
One wonders, doesn't one ?
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To make it even more fund, I mean fun, there are structured, securitized debt derivatives in various flavor and
forms. The process for constructing securitized and "structured" debt instruments is shown courtesy of our friends
at the WSJ but captures the basic process pretty well for all the various derivates built on all the various assets.
That money the banks loaded, I meant loaned - just one darn Freudian typo after the other today, to the LBO guys
gets turned into another asset, a virtual one this time. Then the investment banks pool a bunch of these new
virtual assets together and re-slice them into pieces with various levels of risk and return. These slices, or
tranches, are re-sold to say the Hedge funds as high-grade debt instruments with lower risk according to the
models being used. Note - mathematical models not actual markets - it' s a critically important distinction.
But the end result of the that is the Hedge funds who have been raising their own equity pools and also leveraging
up now can leverage the leverage by buying up these structured derivatives. Thereby further increasing the pool
of funds - liquidity creating liquidity creating liquidity and providing more fuel to the fire of more money chasing few
good real assets.
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That's what's happened to Bear-Sterns. Well actually two things. First, the sub-prime implosion made the real
payment flow look a lot less certain and much more risky so the value of the core assets went down. And
secondly, the value of those assets were based on math models built on statistical estimates of the risks and
performance relationships. Guess what - each new instrument is unique and priced by a model based on the
assumption that nothing will change from history. That'
s how statistical modeling works. Whoops.
By the way my favorite financial columnist has a fascinating illustration of all this which is well worth your time to
watch. I guarantee it'
ll help make all this rocket science stick in your mind.
Jubak’s Journal: Emotions and the market Confidence is just an emotion, but a loss of it can cause the
bond market to rumble. The recent case of a Bear Stearns hedge fund forced to liquidate billions is an
example, MSN Money’s Jim Jubak says.
And the article that goes with the video plus a couple more that are also well worth your time (including the embedded videos)
can be found here:
Let me repeat that - markets price assets because a lot of people have
different views and debate and arbitrate them. That means, necessarily, that
there has to be a common set of characteristics. It'
s why there are standard
commodity contracts for example - Cargill got started in part to create
standard markets based on defined standard agricultural products. To this
day the culture views reserved grain barge slots not as ways to move grain
to market but as speculative hedges that can be liquidated by re-selling the
capacity and dumping the grain :).
Meanwhile another little chart captures the consequences of all that leverage
building on leverage in terms of the rapid, one is tempted to call it
exponential, growth in the buyout market.
And another little historical note. The great German mathematician Gauss -
the "Prince of Mathematicians", invented linear regression analysis to correct
sampling errors in survey data and ESTIMATE what the real data was and
improve the representation of the real world. Mathematical models with
parameters based on statistical analysis aren' t they underlying reality. They
are a representation of it and much farther detached - after all Gauss was
looking at real earth. The derivatives rocket scientists are looking at theories
based on history and assuming it won' t change and selling that as reality.
A set of assumptions we' re in the process of testing!
Page 6 of 28
Actually it'
s not a coincidence at all and is both driven by some of the same forces and being driven directly by the
buyout boom. The theory of the latter is that going private improves the effectiveness of capital structure by
increasing debt held and getting better returns thru leverage. Company executives prefer to reserve their powder
for long-term contingencies so you have two views of the world. But with highly conservative investment plans, no
accelerated hiring and no capex there was and is a lot of cash being thrown off that has to go someplace.
And on top of that as the amounts of firepower accessible to the LBO community exponentiated public company
execs came under the same pressures to re-factor their capital structure as if they'd been taken private. That is,
add lots of debt to the balance sheet and pay out the free cash in dividends or buybacks.
Oh yeah, we should mention that shareholder and executive interests aren' t entirely congruent here - buybacks
keep stock prices up and bonuses are paid on stock prices. And it' s actually gotten to the point where pubco' s are
borrowing to pay dividends and make buybacks. In other words, and this could potentially be really important,
they are re-leveraging their balance sheets at what increasingly looks like the best the economy is going to be; i.e.
when revenues, profits and cash flow have nowhere to go but down.
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Oddly enough the punditrocracy has been reporting on this story since at least ' 04, and I think '
03, and always
concluding with the notion that lots of funds are available for investment. Which will then of course either keep the
economy growing or even accelerate it. Judging from the chart we' re just seeing basic replacement spending.
NOT investment for new growth.
So, whether you're an employee, an investor, a stakeholder or one of the buyout and/or other investment
folks you have to ask yourself is this what you want?
Consider my "textbook" case of Home Depot. After getting nicely compensated by pushing up earnings at the
expense of the long-term health of the company but "upsetting" nearly everybody the board finally pushed Nardelli
out after an activist hedge fund came to town as the new sheriff. In an earlier post we suggested six major
strategic initiatives that HD needed to pursue to survive the housing downturn, stabilize the company and return
to organic, long-term growth and profitability. ALL of those strategies - which are inter-dependent, require serious
investment. Yet HD just announced a major buyback and dividends. Will their cash flow cover all three
requirements - re-development, dividends (to payback the Hedgies) and buybacks ? An interesting question
indeed.
Or consider Cerberus'in-process acquisition of Chrysler. What kind of investment funding will be required to
recover that situation? Where' s it coming from? And what kind of operating performance will be required from
Chrysler in the short- and long-runs? Even in the short-run serious additional funds will be required. And how
Page 8 of 28
These are really beginning to look like interesting times indeed, aren'
t they?
It strikes me that enterprise performance is going to be an increasingly critical requirement for mere survival. But
we' ll see.
Despite the outrage let me suggest that his departure was cheap at the price. And that the real question was why
it took the Board so long to reach the necessary conclusions. Perhaps the short-term lesson is that dissing the
Board, as he did by not inviting them to last year'
s annual meeting, is not in any CEO's interest. On the other hand
after six years he walks away with at least $20M in cash and the rest of the package.
Page 9 of 28
Good people and good customers are long-term soft assets that don' t show up in the accounting. But,
nonetheless, we need to ask if, eventually the value of those soft assets isn'
t reflected in the value of the
company. That leads to two major questions about Nardelli and HD:
1. If you put so much pressure on your people that they spend more time watching their backs is
the resulting decline in morale and performance worth the short-term gains in financial
performance ?
2. And if that deterioration in service and support increases customer dissatisfactions, ditto. Seth
Godin noted on his blog that he gets more complaints about HD customer service, by a ratio of
4 or 5:1 than any other major corporation. And this from the outfit that helped right the book!
This is all hypothetical of course but we see HD taking the PE Ratio hit everybody took after the bloom went out
of the boom in ' 00 with a drop from 46.4 to 18.6 - in other words profitability growth wasn't going to go on forever.
The 'magic beans'in reverse factor. You can see the recovery from 18.6 to 22.7 as being Nardelli' s first
contribution as a lower and slower growth rate was ostensibly being restored. And the impact of investor' s and the
markeplace' s realization that, no, in fact long-term strategic growth wasn't being restored.
It'
d be unrealistic to expect very high PEs but even if modest prospects had been convincingly established instead
of sacrificed PE's might, let'
s say for the sake of discussion, have been pushed back up to the 21-22 range. The
difference between that range and what Dr. Bob actually achieved represents a difference of $56B in market
value.
Like I said - $210M was cheap at the price. Of course the question is, what do they do now?
Page 10 of 28
So here's our preliminary shopping list - things to focus on now and things to do to set the table for the future. In
other words while emergency repair and recovery needs to be pursued with all due haste and effort those short-
term focused efforts need to segue into longer-term and deeper changes or they will be unsupportable.
1. Economic Deterioration - unfortunately HD got a real lift over the last few years from the housing market
and judging from the last quarter’s earnings and the outlook is just beginning to see severe pressures
from dropping demand. More unfortunately that would argue for decreased spending just when increased
spending is required for repair. Mr. Nardelli truly left some conundrums behind him.
2. Employee Morale - this isn'
t just doing away with excess pay or special priveleges while Mr. Blake eats
in the regular cafeteria. Good gestures and tokens of sincerity and commitment. Any good leader knows
that symbolic gestures are essential communication tools - as long as they reflect deeper efforts.
o Fixing morale really means changing staffing patterns - put more people on the floor, give them
time to spend with customers and pay them for good service. Ka-ching $$ !
o In case you missed it an earlier post riffed on some of the work on Bob Sutton'
s blog on morale
and company performance and takes a bottom-up approach to translating morale into
measurable impacts: People & Performance:Assets or Fungible Commodities ?
3. Customer Satisfaction - investing in better service is the first major step in recovering the faith & trust of
the customer base. Now HD still has lots of customers but Lowe'
s wouldn'
t be doing as well as it has
without a lot of looking for alternatives. So in addition to better staffing and service this means paying
attention to store appearance, product mix and quality, pricing and all the other standard '
appurtances'of
quality retailing.
o And another post translated the vicious down-cycle created by cost-cutting and the impact on top-
down performance and tried to proxy the impact on total market value: Cheap at the Price:
Nardelli, Home Depot and Performance
Page 11 of 28
Those are all hard, hard questions and will have to get equally hard, serious attention.
Page 12 of 28
You' ve probably all heard the metaphor about boiling frogs - how do you boil a frog? Slowly - it'll just sit there and
not notice that the water temperature is rising until it'
s soup. Well there'
s a lot of changes going on in the
worldwide economy and business pictures that are the same. But our companies, our industries and related
decision makers are so trapped into dealing with the day-to-day crisis that the bears and alligators are winning
and the swamp is rising higher and higher.
Some time ago I happened to take a general overview of the situation and pulled together some themes. Having
just found and re-read it let me share it. Despite being a couple of years old it holds up pretty well. An assertion
that I'
m happy to have tested and countered by the way. Please feel free as it would make me feel better.
Meanwhile here' s (hopefully) some food for thought on the strategic prospects for industries in general with some
examples from the steel, textile and airline industries.
There are several factors which should be carefully considered in investing and enterprise management over the
next several years. First, the nature of this business cycle is different from any prior post-WW2 experience and as
a result most analysis continue to be unduly optimistic. This problem is made much worse by growing worldwide
competitive pressures that receives a lot of discussion but little actionable attention.
Next, without exception, all domestic industries have reached a level of maturity and thereby market saturation
that is still un-appreciated; and therefore when considering investments in particularly sectors or industries that
needs to be a major consideration. As a result all industries are facing severe over-capacity that also increases
the competitive pressures. In other words, that every industry can exceed customer requirements for capabilities
and functionalities is a major fact of life. Furthermore, most enterprises’ business models are sclerotic and have
limited capacities to renew themselves without major structural change.
This combines with the continued inattention to key operating capabilities, especially in critical functional areas
like sales and marketing, core operations, logistics and supply chain management, and business-aligned
technology management to increase the inefficiency of most enterprises. In conjunction poor operating disciplines
and a general lack of management systems means their abilities to be successful and profitable are being
overestimated.
On the other hand though it also means that there are tremendous opportunities for improving the coupling of
strategic innovation with operational effectiveness with improved enterprise operating systems. Put another way
there is tremendous scope for private investment to leverage these operating changes into profitable investments.
The situation can be compared to that which faced the steel industry over the last 35+ years. In an environment of
over-capacity and poor execution the industry took thirty years of denial to achieve a level of consolidation,
operating workouts and re-structuring that has taken it back to potential profitability. The same situation now faces
every major industry.
Within those umbrella statements the next level of detail is that one needs to understand the secular dynamics of
particular industries and selected enterprises within industries.
Page 13 of 28
An earlier post (On Being a Boiled Frog) talked about the strategic outlook for US industries and enterprises and, hopefully,
made the major point that business as usual - tending to internal agendii and quarterly earnings - is not a recipe for success.
Rather it'
s a recipe for declining performance without a fundamental re-thinking of value, strategy, execution and performance.
Which is the point the Kaptain makes to my mind. The final conference interview with Icahn is here and the panel interview
with Alan Murry below. http://link.brightcove.com/services/link/bcpid86195573/bclid1078608424/bctid1079215502
A prior post looked at Carl Icahn's (Kaptain Karl) views on enterprise performance, which he found broadly
deficient through too many nice guys moving up the hierarchy thru political management rather than focusing on
what their companies needed to do to perform and create value. Or at least that' s my reading-between-the-lines
interpolation (the video is posted, please feel free to review it).
For several years now I've been tracking those companies which make the headlines for performance problems
(and occasional successes - unfortunately the former dramatically out-number the latter). But stop and consider
for a moment...since the beginning of the year how many companies have made major earnings announcements
and executive changes based on strong earnings and positive strategic outlooks ? We have whole industries just
beginning to go through major transformations after, literally, decades of denial.
What names come to mind for you ? How about Dell, Wal-Mart, JP Morgan, Citigroup, Microsoft ? And more ?
We' re talking here about the bluest of blue-chip companies that not to far back, say 3-4 years, were the poster
children of doing it right. All the bizz schools, trade press and general business press were lauding these folks for
the strategies, operational execution, delivered customer value and postitive outlooks. Why just yesterday the
WSJ had a major front-page story on MSFT' s struggles with innovation ( Behind Microsoft's Bid To Gain Cutting Edge
).
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The numbers in parens (x) are sequences where a (1) means that' s the first entry while as a company evolves it
might move to a different column, or even the next chart on good-performance.
Each company is its'own individual case. In fact we ended up starting a detailed review sequence of HD and
have several posts starting with Nardelli' s dismissal and working on up to a suggestion of Six Major Strategic
Initiatives. In their case the executive change was a good thing and they appear to be doing the right things but
the jury is still out. Far out actually. And some of the entries are probably dated, both good and bad. But some are
not. For example Chuck Prince took over a badly faltering Citi which was facing serious charges and had major
performance problems. He seems to have cleaned those up but at the same time, and despite the spinoff/sale of
many of the acquired operations, Citi still isn' t either getting the most out of any division that I can tell. And
certainly not getting the sum is greater than the parts synergies. Ditto for Time-Warner. And so on and so on.
Page 15 of 28
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While those are the sorts of headlines you' d expect in the financial press, especially in these times, notice that
after a couple of quarters of "how-to-fixup-HD" articles the summer to date is primarily about buybacks, financings
and deteriorating sales with a little buyout thrown in to flavor the buyback. On the surface you' d have to ask
yourself is this HD just being coy, preserving competitive information while it explores those options or is the lack
of information a lack of action?
Given a downtrending economy, increased financial pressures, and an imploding primary market then using
scarce & expensive capital resources to buyback shares, especially when you' re having to borrow and increase
leverage to do it, doesn'
t make much sense. Even if you' re a PE guy this outfit is going to spend the next couple
of years fighting down pressures on EPS. Pressuring management to buyback shares makes sense if they' re
under-valued. Using scarce capital to hold back the tide and worsen performance is in nobody' s interest. Or so it
seems to me.
And judging by the stock chart so it would seem to Mr. Market. Now if you' re buying back stock at $37 that then is
worth $32 you better hope Warren buys it for $35 or more and reduces your loss. It seems to me that now would
be a good time to hunker down, explain what' s going on, make some judicious investments and get set for an
upturn that would/will hopefully follow what'
s likely to be another two tough years. And for gosh sakes - tell your
people that too. Not use borrowed money to prop up your stock and paper over the deep challenges.
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• Putting serious efforts and funds into employee training, recruitment, compensation, store layout, cleanliness,
purchasing and stocking as well as supporting marketing and sales efforts, e.g. more readily accessible experts
which are still non-existent, are very high strategic priorities. Since everybody can see all this for themselves here'
sa
major factor to judge how things are going.
4. Operations/Product Development - here we effect a timeframe shift. Whatever we' re buying and putting into
the stores in the next 18 months is most likely what we' ve agreed with the supplier base to sell us. Similarly how
we run the warehouses, stores, transportation and buying operations is also pretty fixed. Yet these are major
opportunities for huge performance improvements (the whys and wherefores are discussed in previous posts).
Not being on the inside (fair disclosure) it' s hard to tell what'
s in train. At the same time after all the supposed
internal deep-dives on Six Sigma you' d think a) the analysts and the MSM types would have an interest and b) the
analysts certainly would. Unfortunately it takes a certain level of understanding of how these operating functions
actually work, and their critical role in the overall Retail enterprise, to know why you should be digging.
That said it's definitely in HD management and shareholder interest to at least let the world know these are
serious issues for serious people - which are getting, or planned to get, serious resources. HD has NO better set
of strategic opportunities once short-term fixes are funded, designed and underway. If I was one of the PE or
Hedge folks poking at this company this is where I' d put some attention. Bottomline NG/NG since we have no
observables. You have to wonder though if it shouldn' t be an F.
These are the sorts of major strategic initiatives that when you start evaluating HD's recovery chances that you
should be looking for, monitoring and, if possible, encouraging.
5. Innovation -again a low to no-observable though the announcement in Oct. that there' s trialing of some warm
and fluffy versions of design centers is work a look. That'
s encouraging - so is it a NG, a D+/C- because it looks
little and late and needs to be improved (what' d your teacher used to write - you've got talent but need to apply
youself ?). Or an F because so far it'
s not much and way late?
Certainly HD has the smarts, people and resources to be running some major innovation efforts. In fact when the
old Business Model cratered at the end of the 90s and Nardelli was brought in this is the sort of combination,
blended and balanced recovery agenda he should have applied. It' s the sort of thing Kilts did at Gillette over 5-10
years, that Boeing has done over the last ten and Cisco as well. It is in fact what Nardelli needs to come up for
Chrysler now that it'
s his watch again.
But what we have here is an evaluation framework that looks at Business Model & Strategy, key operating
functions, people and service issues and lays them out over immediate, tactical and strategic timeframes. And is
a foundation for investing in HD should you care to apply it.
In that wise you' ve got a couple or three tacks to consider. As things begin to flatten and turn around with Housing
HD is likely to improve. Spotting that a couple of quarters ahead of time makes you a worthy value investor. Of
course without the other initiatives HD will crater again for the same reasons.
What makes us mini-Buffetts is if we spot the long-term turnaround taking hold, down the blueprint, and get in
early enough. Or contrawise if we want to be speculative Buffetts (huh?) it'
s realizing when the Street'
s recovery
fantasies are going to be disappointed and getting out :) !
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Seeing the elephant is an old phrase borrowed, I think, from the British Army and used by many armies now and
refers to one's first experience of something new and shocking. In their case combat - which is about as shocking
as it gets. Fortunately our experiences aren' t going to be on anything like that level. But still the Elephant here is
learning that for the first time the old linkage between GDP, Profits and organic economic growth appears to be
frayed to the breaking point (Dr. Pangloss Treating Goldie: Markets, Profits & Earnings, The Heart of the Matter:
Profits vs Earnings ? ).
But first a small confession. My early religious training was in economics and after spending several years as a
novice and then a few more in monastic retreat (otherwise known as grad skul) I went apostate and joined the
real world. Now economics would tell us that any industry or product that gets a large return/profit must be serving
someone somewhere. Yet as the share of Financial companies in profit has gone from 10% to 20% to, in just the
last few years, 30% I begin to find myself turning into a modern Physiocrat. They were some of the earliest formal
economists and started with the argument, in late 18th C France, that the only true source of wealth was
Agriculture. Given the structure of the economy at the time they had a point if not a case. But other sectors like
trade, manufacturing and finance were important contributors who' s outputs made the functioning of the
agricultural sector more efficient - thereby raising overall output and productivity. Nonetheless I still find it difficult
to believe that Finance contributes so much to the effective functioning of the economy that a 30% share of
returns is warranted. Oh well...
Back to the Elephant and this time we' ll go to the central cathedral of capitalism the Wall St. Journal - specifically
it'
s recent reporting on quarterly profits and earnings. Which, BTW, they report as net operating income, NOT
EPS!
On both absolute and relative basis we also don't see much to argue for a great outlook for any industry or sector.
Energy and Materials looks pretty flat as do Consumer related industries (green-shaded) and Industrials/Utilities.
Even Tech/Telecom, other than the spectacular performance of a few select (NDS, QQQQ) firms undergoing
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So we come full circle on four different but complementary data sources: GDP accounts, National Income
accounts, quarterly Operating Income and reported earnings. With the economy slowing into a growth recession,
with Housing much worse than anticipated and likely to still be worse yet over the next two years and with
problems with asset pricing and valuations in the credit markets one would have to conclude that the outlook is
not very sanguine :).
Too namby, pamby a conclusion ? Try this - there is NO indication that a better outlook for earnings is based in
any reality I can investigate. Yet the Markets and Wall St. maintain a very upbeat outlook. Puzzling indeed, isn'
t
it? Feel free to chime in - variant opinions would be welcome.
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In the second sub-chart Industrial (blue) and Tech (green) are shown doing well, with Telecom in particular
projected to turn in a fabulous performance, rising to 50% EPS growth in early ' 08. Even Finance is shown
returning to 20-30% growth rates in late '08.
And there you have IT - the nub of several matters. If any of these projections turn out to be in the ballpark any
dips right now are buying opportunities.
Of course that all hinges, in general, on a U-shaped path for the economy with the current low growth (< 2%)
being followed by more robust > 2% growth and eventually getting back over 3%. And of course with no further
impacts from Housing or the Credit Market problems, especially in the Finance sector.
Fascinating isn't it? The gap between current economic outlook and earnings projections I mean. Let alone all the
major risk factors. It'
ll be interesting to see how S&P and other analysts change their forecasts over the next few
months.
November 5, 2007
I'
d like to weave several threads together here and a recent CNBC vidclip offers up a perfect excuse. In it Robert
Pozen, MFS Investment CEO says public companies should think like PE guys. Well, maybe, but there are a
couple of caveats and exceptions. But take a look for yourself to start. In fact our argument is that there's good,
bad and incompleteness - the trick though is to think it thru against the right shopping list of understanding
performance.
The threads we' re weaving together are the role of enterprise performance in generating profits and earnings
(Have You Seen the Elephant ?: More on Earnings) with some earlier discussions of the widespread failures of
enterprises to deliver value (Kaptain Karl's Test: an Icahn-like Inventory of Enterprise Performance).
http://video.msn.com/video.aspx?mkt=en-US&brand=money&vid=b133fcfe-1b17-4abe-a557-dfc4385efc07
His five factors are Cash (too much on the balance sheet),
Capital Structure (not enough debt), the Operating Plan,
Management Incentives and Board involvement. Well that' s
all great in theory. In practice the theory hasn'
t held up very
well though the argument for PE firms is that they can
radically improve performance. In actual practice, and
especially over the last several years, PE firms buy a
company, Fluff it and Buff it, Leverage it up using funny
money, drain it with special returns (lowering their risk and
investment while guaranteeing return) and Flip it.
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2. Strategy (goals, activities and actions, resources & capabilities, plans & controls
and timeframes)
4. People
5. Execution
At any given time you should know what these factors are for a value investment, how well the company is doing
with them and what' s likely to happen in the future. If you look at the good companies, for example Toyota, P&G,
Tesco, GE, McDonald' s, et.al. it'
s pretty clear where they'
re firing on all cylinders or not. And conversely if you
look at the headlines for mal-performing namebrands, MSFT, WMT, Dell, Citi, Pfeizer you can see where
breakdowns that are destroying value are happening.
A previous post complete' s a series of deeper digs into these factors for Home Depot and is worth taking a look
at: Performance Re-visited: Another Trip to HD's Woodshed
Let'
s consider the five factors in a little more depth:
1. Core - they key questions to look into are what products or services is a company providing and what value do
they provide to their target customers. And then what is their Business Model. Many of the badly performing
bluechips problems stem from the exhaustion of the business model and the need to re-think it. You also need to
apply this to investigating each major line of business for large companies.
• For example WMT' s basic model is EDLP (Every Day Low Price) yet it's saturated the domestic US market and
getting beat by TGT which has higher priced products but much better service and higher value. Similar assessments
could be made of Dell, MSFT, PFE and others.
2. Strategy - what methods or approaches are these companies taking to realize their value ? What actions and
activities are they pursuing, are the right resources and capabilities in place, is there a good management system
to provide the right plans and controls, and is the right set of timeframes being pursued ?
• For example the recent headlines on Citi, Bear-Stearns and Merrill suggest, at least to me, that they all jumped on the
structured debt bandwagon late and in a me-too fashion. And without the right capabilities, people or managment
controls, especially for risk. They'
ve basically shot off their own feet - at the knee and we'
re in the process of finding
out if it'
s higher.
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• MSFT gets its'money from Window and Office where the core competency is coding and product development. Yet
Vista has orders of magnitude less functionality than Longhorn was intended to. Why ? Because (do a search on
Code Red and MSFT) they lost their touch in this core capability.
• Dell'
s value proposition was a good box at a decent price. Plus the customer service wrapped around it that made
them a safe, reliable choice and was really the key strategic factor behind their early acceptence and growth. When
they started treating Customer Service as a cost to control instead of a strategic investment the handwriting was on
the wall - three years before it blew up visibly. Imagine, taking a critical & differentiating factor that made your whole
business model work and letting it wither in support of cost control.
4. People - are the right people with the right skills and right attitudes in place ? You can judge this just by talking
to the frontline folks - are they interested, attentive and customer-oriented ? If no there' s problems big problems.
On the other end are the right executives in place ? Both Chuck Prince and Stan O' Neal drove off their
competitors for the top job, in a set of maneuvers worthy of an Italian city-state' s princely court and testimonials to
Machiavelli. In the process deep skills in the critical risk management core competency were driven off. More to
come on that.
5. Execution - is there a plan in place, is it backed up by firm commitments of time, returns, actions and
measurements? In other words is the strategic plan being executed, in support of the business model and are the
operating plan and strategy aligned ? If you look at our shopping list of troubled bluechips the thing you find most
often is a lack of effective execution. And a substitution of internal agendii for focus on value delivery. That'
s
otherwise known as politics - the bane of empires and enterprises. At least when narrow political goals are given
priority over doing what' s best for the business.
• Pozen suggests a critical factor is management having the right incentives - Here, Here ! When
executives are getting the vast majority of their compensation from stock options and when they are
rewarded for short-term stock performance all their incentives are to manipulate stock price at the
expense of long-term performance. A perfect case in point is Eisner and Disney (the book to read is
Disney Wars -outstanding and insightful).
• Pozen also suggests that Boards are not paying enough attention, don'
t have the right skills and are
spread too think. Again, Here,Here ! When companies lack a good management system that lays out a
clear strategy based on the Business Model, when operations and strategy are mis-aligned and when
there are not clear measurements of success then there'
s little chance of the Board knowing what should
be done. Let alone being capable of getting it done. If Executive management had to present worked out
operating plans and demonstrate strategic alignment Boards would have the sort of control mechanism
that would be reduce or eliminate many of the problems we'
ve seen; and are seeing again with the credit
market problems and the financials.
• Ironically a good integrated operating plan coupled to a decent management system would make the
company run better, define a whole new way of measuring executive performance, give Boards a clear,
simple and structured way of monitoring and managing that performance and enormously improve
communications to the market. In other words the right kind of structured execution framework fixes both
the management incentive and board oversight problems. And does so organically and constructively.
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It's up to the investor, or employees for that matter, to do their homework. But there are major opportunities here -
if you seize them. And don' t we come full circle or won'
t we ? In other words more than any other investor the PE
guys should be applying versions of this sort of analysis.
November 5, 2007
Now we get down to putting some rubber on the road - what have the businesses who generate a lot of this news
actually been doing. And again it's been an interesting week. Before reviewing the news let me point to some prior
postings that should be interesting and define the filter we use to select and analyze these folks.
With those tools in mind let' s talk about the listings in our ReadFest below. First we' ve brought up to the front two
very interesting articles that nicely complement our approach. One is TheStreet' s look at the correlation between
payroll and performance in MLB - which by and large turns out to be none. It turns out that working harder and
harder but not very smart doesn' t yield a very good payoff. On the other hand if you' re a big team in a wealthy
market who runs both a smart team AND a smart business then things can get pretty rosey indeed (if you think
I'
m thinking of the SOX you' d be right). Another view that kinda converges on a similar conclusion is an interesting
column from Jim Jubak pointing that there' s no corner of the market that's currently under-valued and many that
are very much over-valued, e.g. emerging markets which are definitely bubblicious. He suggests that the only
pockets of mis-priced opportunity are companies with good growth prospects beyond the next 12-18 months, i.e.
over the event-horizon of the market. Sounds Buffet-like to me and leads to the question of how to analyze those
opportunities. To which we point to the toolkit we' re building in the above links.
Next in the Business section are a few general articles that may talk about specific companies but also say
something about bigger issues. At the end of the 90s four representative name companies were Cisco, Schwab,
Wal-Mart and Dell who were taken to represent the mark by which everyone else should be measured. Well all
four hit more than major turbulence after the bust as their core business models, strategies and operational
execution came under major pressures to adapt. WMT has only recently admitted that it needs to start doing
some new thinking but continues to run itself, as the company it was, reasonably well. Dell' s admitted -
involuntarily to be sure - that there were major problems but is still thrashing around violently looking for new
directions. BtW - if you think selling brightly colored boxes into WMT is the answer let me ask you how well will
their supposedly unbeatable new age processes adapt to the Retail channel?
On the other hand both Schwab and Cisco went thru deep, soul-wrenching adjustments and innovations. Last
week we pointed to an excellent article on Schwab and this week there'
s an even better one on Cisco. That one is
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Two other general articles point to the Pharma and Oil industries. The latter is seeing a major structural shift to
what looks like a permanent supply/demand imbalance as long as the BRICs keep booming. But they have
serious problems nonetheless. The Pharma industry on the other hand is between a rock and a hard place
because their basic business model is built around a drug development process that isn' t working well, is
increasingly expensive and non-productive and the need to change both their R&D and their go-to-market
operations. The word is OUCH.
No surprise that Merrill makes the reading list and for similar reasons. It turns out it wasn'
t all about hubris and
unmanaged risk chasing for return. It had and has something to do with not building up your basic capabilities.
Other news covers Chrysler, Lenovo (who' s another good example of adaptation and innovation) and Alcatel-
Lucent (who' s very definitely NOT).
Happy reading.
http://llinlithgow.com/bizzX/2007/12/wrfest_30dec07business_fragili.html
If it'
s not clear at this point we think the
economy is slowing and seriously exposed
to sudden & sharp disruptions as Housing
and the Credit crisis worsen and it
becomes more fragile. We also think that
the Markets still haven' t grasped this nor,
definitely, is it reflected in pricing, earnings
outlooks or valuations. Even on current
course and speed with no major
disruptions there' s some serious re-
thinking that needs to happen, at least
IMHO. But if you start looking now and
understand what' s going on then there are
going to be industries and enterprises that
weather this storm, if not with style and
grace.
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Here's the key point - on a macro level buybacks, real declines in profits and increased leverage indicate that
business enterprises are very exposed to shocks if/when they come. In other words a hurricane will breach the
dike and it'll take a well-founded company to manage the floods :). So pay careful attention to Paul'
s words and
charts - think about ' em, ' cause they could be incredibly important.
Now it’s your turn, Corporate America. For starters, the growth in your “operating” profits has slowed to a crawl –
just 1.9% year-over-year in the third quarter (Chart 13). Moreover, if it were not for your earnings from overseas
operations, which are inflated when translated into depreciating greenbacks, your profits would be contracting
(Chart 14.) As Merrill Lynch’s chief North American economist, David Rosenberg, has reminded us, corporate
hiring of U.S. domestic residents and capital spending in the U.S. depend on corporate profits generated in the
U.S., not corporate profits generated in Germany or China. And while we still are on the subject of domestically-
generated profits, note that profits from the nonfinancial sector have contracted four quarters in a row and the
growth of profits from the financial sector have slowed significantly (Chart 15).
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We start by looking at the basic core value proposition and it’s translation into the Business Model and Strategy. Typically we
next examine Marketing and Sales operations, where it is possible to reduce operating costs by 30%, shorten the sales cycle
by 30% and increase the closure rate by 30%. This is primarily the result of establishing good processes and discipline.
BizzXceleration is comprehensive but integrated across the total reach and range of business activities and issues. And
emphasizes a pragmatic, workable approach that results in a stepwise path to performance improvement. We believe that our
approach mitigates business risks, improves operational performance and can lay the groundwork for 10-30% EBITDA
improvements in post-deal execution.
If you would be interested in further discussions, more detailed descriptions or the review and testing of specific opportunities
we would enjoy hearing from you. We can be reached at contact@llinlithgow.com .
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