bizzXceleration: Performance, Value and Profit

One of the major risks from a housing downturn listed in the prior post was that the huge raft of sub-prime mortgages would increasingly go to default and drastically lower housing demand. Well that seems to be happening, rather rapidly. Part of the 'propagation mechanism', as my biologist friends put it - or how it spreads - is that the original loan originators re-sold these mortgages to big banks who in turn packaged them together and re-sold them other institutions who created 'mortgage-backed-securities' - essentially an artificial derivative. Since it was/is artificial the instrument can be sliced up into different bundles of risk and returns, tranches, and re-sold to investors. As the result of all this more money has flowed into sub-prime lending than it otherwise would because the downside risks have been so widely spread out. In other words artificial derivatives have been used to create insurance for these highly risky loans.

It seems to be a fundamental law of the Universe that when you lower the price of something people ask for me. So for example when you offer up flood-plain or hurricane insurance more people move to areas exposed to those problems. Who'd have thought ? And of course because they're insured they obviously don't need to put up levees or other engineering works to protect themselves, right ?

Well we ought to be asking, especially as the economy slows, if any other sector of the economy is exposed to credit market risks of this sort ? As it happens one of my favorite financial columnists has taken a good, hard look at the debt-bomb risks to the credit markets:

Debt-market bomb could hurt us all by Jim Jubak at MSN MoneyCentral. 

Highly recommended indeed ! 

Posted by dblwyo at 07:53 AM | Permalink | Comments (0)

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.

Why do we say cheap at the price though ? Well first let's look at the ground-truths and what he did manage to do.

It would appear that Dr. Nardelli turned in an oustanding financial performance, growing revenue by 78% in his five years at the helm and more than doubling EPS. A sustained period of revenue growth, profits and earnings is hard to argue with in anyone's book. That might explain the Board's reluctance to evaluate his performance as anything but stellar. The next question then is how was that reflected in the marketplace ?

Well, when we look at stock prices that stellar financial performance doesn't appear to be reflected in stock prices. If you look at MACD - an indicator of the 'momentum' in price trends - it looks to be approximately zero. And while EPS certainly shows a major uptrend the PE Ratio is just the other way around. Price-Earnings ratios reflect the value of future earnings - at least in theory so let's go with that for the moment. For PE to drop from 45 to about 15 means that the market is looking for HD growth to be low and slow. Yet the numbers indicate otherwise ?

We may have a conundrum here as puzzling as any on interest rates or other interesting facets of the economy. I'd like to suggest two things that only became apparant over time. Let's start by thinking what Home Depot's fundamental value propositions were when it got started: they were good prices for excellent goods supported by outstanding service and knowledgable, helpful sales support staff. The question then becomes what are good people taking care of your customers so well that they come back over and over again, that is they become good, long-term customers, both worth to you.

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 dissatisfations, 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 !

It would seem that when one is hired to both run a major enterprise and find new ways of growing it, sustainably, for the long-term that a better balance between short-term performance and sustainble growth needs to be found than the one Dr. Bob came up with. Lets re-visit our earlier chart and ask what market cap might have been if the right strategic moves had been made:

 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 osten
sibly 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 ?

Posted by dblwyo at 10:17 AM | Permalink | Comments (1)

Is it possible that we're seeing a bottom or is worse to come ? And why does it matter so much ? Both are interesting questions and represent the biggest divide between those with a Goldilocks view of the the outlook and those with a Cinderella view. To review the bidding let's re-visit the YOY% changes and % of GDP statistics for Residential Investment.

All thruout the 90s housing investment was running at 4.5% of GDP and didn't move off of that until the historically low rates lead to a sudden surge to 5.5%. That now appears to be reversing. The real question is whether it stops at the historical average of 4.5% or, like all other economic phenomenon, offsets far above historic trend behavior with significantly below trend behavior. How long, in other words, must housing run at, say 3-3.5% so the accumulated stock of new houses is reduced and offsets the over-building of the boom ? Over the last two quarters YOY% changes in housing investment declined at 8% and 13% respectively and, judging from the curve, is accelerating. Putting the recent headline news together with these longer-term trends one has to think the risks are to the downside.

So why is this so important ? Housing is, after all a major but not the major or dominant sector of the economy. There are three reasons that will become critical:

1.  As housing starts slow, and indeed if they follow off the cliff, then several hundred thousand construction jobs will be lost. Construction was a major driver of the extremely limited employment growth in the 'recovery'.
2. In the last two years much of the above-trend investment was driven by sub-primate ( Freudian slip but left) and what is known as 'Alt-A' mortgage financings. This looks to be unraveling under rising interest rates and the resetting of adjustable terms. It is likely to spread thru the rest of the housing market by reducing overall demand. And it is possible it will spread thru the rest of the credit markets by impacting the condition of the major banks and institutions that created leveraged, mortgage-backed securities as investment vehicles.
3. Earlier we pointed out that Consumption was very unusual in this cycle in that it did NOT follow the declines in GDP downward as it has in every other post-WW2 business cycle. For consumption to hold up there has to have been an unusual source of funds. That source was mortgage-equity withdrawls. A support mechanisms for consumer spending that is now going away rapidly.

The bottomline here is that housing doesn't appear to have reached a bottom but in fact looks like it's accelerating over a cliff. While we'll have to keep a careful eye on the data, trends and turning points all the risks appear to be on the downside.

Prior Posts:

Investment, What's Going On With Investment 

Update:

CalculatedRisk has just put up an excellent post on the long-term lag structure relationships between the three major components of Investment (Residential, Equipment & Software and Structures) that points out the high correlation between Res. and E&S and the resulting liklihood that it too will begin an abrupt slowdown. CalculatedRisk: Investment Lags .

Posted by dblwyo at 09:04 AM | Permalink | Comments (0)

BigPicture (Barry Ritholz's outstanding blog on the economy, markets, et.al.) has mentioned some serious difficulties with 4th quarter GDP numbers that are really worth drawing your attention to. Because of problems with inventory estimates Q4 GDP is likely to be quite a bit lower than the preliminary number officially reported on.

There's potentially a big problem with that however. As we've discussed the current number would indicate a continued slowing in the economy - a sort of sideways/downways drift continuing if you would. HOWEVER, the suggestions are that the real GDP number might get revised back down to 2.75-2.5% (or various blog rumors have it - lower). Anything below 3% would indicate that the downtrend is accelerating below the "side & down" range we've been talking about. In fact 2.5% would indicate an acceleration of the trend. But let me let you judges for youself. The chart below shows the existing GDP numbers in blue and the revised series in red. And continues to show the sharp downturn in investment due to  residential investment problems.

 PREVIOUS POST:

A Little Finer Detail (GDP, Consumption, etc.) 

BigPicture: Revisting GDP 

UPDATE:

whee are we having fun now. My other favorite econ blog (Calculated Risk) just threw up the backup notice with pointers to other serious players as well as Rex Nutting's column in Marketwatch:  Big Downward Revision to GDP Coming.

Calculated Risk's headsups here.

Posted by dblwyo at 06:39 PM | Permalink | Comments (0)

Investment is reported as Residential and Non-Residential Investment with the latter broken down into Structures (the buildings) and Equipment & Software (the stuff in the buildings). They move to very different rhythms sometimes. In the downturn of the early 90s all three had dropped significantly and then eventually moved together throughout most of the 90s. Notice also that Investment, looking at the scale, is very volatile. If Consumption is the engine then Investment is the turbo-charger of the economy, only this one isn’t just On/Off it also has a reverse switch. The ‘slight’ drop in GDP in ’00 and ’01 lead to major drops in business spending – the action vs reaction of an investment-driven boom & bust. Yet Residential spending kept going and even had a sharp upturn until Q304 when it abruptly slowed. From Q1/Q206 however the word cliff comes to mind.

However for those expecting business investment to pick up the slack of slowing consumer spending and offsetting the implosion in residential investment notice that Equip/SW is also slowing noticeably. Nor is the % jump in facilities that encouraging because it is both the smallest portion of GDP investment and has been decreasingly steadily for over two decades as a significant factor. As highlighted here Equip/SW followed the business-cycle while Housing followed it’s own rhythm until low rates drove it up over the long-term 4.5% average – which raises the fascinating (scary) question of will the 13 quarter bump over 5% (Q303-Q306) have to be an offset by a decline below 4.5% for another thirteen. Which would take the real estate downturn into and thru the end of 2009 ! Meanwhile Structures has shown a long-term secular decline from 4% of GDP to 2.5%.

Just as a little side note if we notice that in 1990 Structures, Equipment & Software and Residential investment were all roughly equal portions of the total Investment pie while in 2006 the proportions were widely and wildly different we might come to think we're looking at a much structural change in the economy. It turns out there might really have been a "New (Information) Economy" after all. Even more interesting Investment as a percentage of GDP grew substantially - from about 13% of the economy to about 17%, give or take a cycle stage or three. 

PREVIOUS POSTINGS:

A Little Finer Detail On GDP, et.al. (Why Investment is so important)

Posted by dblwyo at 11:26 AM | Permalink | Comments (1)

A little finer scale makes the recent trends clearer here as real growth has slowed from 4.7% or so in ’04 to 3-3.5% recently. The economy is neither as bad or good as the various headlines would have it and the power of this approach is that it turns the chaos of monthly statistical reporting and puts it into a clear, easy-to-see context that shows trends, and critically more important, turning points and patterns, much more clearly. On this line then it’s important to note that industrial production – basically the output of the ‘old’ economy is slowing appreciably and the rate is increasing. Notice that PCE and GDP have been slowing gradually since Q104 with the deceleration beginning with consumption before showing up in GDP. There has been a recent uptick, which is encouraging and needs to be watched.

Even more worthy of interest is the sudden sharp fall off in investment, which appears to have fallen off a cliff. Since investment is, in some ways, the indicator of anticipated future demand this could be an important trend to pay extremely close attention to. Notice it began in Q206, turned sharply downward in Q3 and went negative in Q4. Coinciding with the downturn in housing.

The preceding analysis means that the course and speed of Investment spending is critical to understand and it helps to have a longer-term context for perspective.

PREVIOUS POSTINGS:

The Real Data (Output, Consumption, etc.) 

Posted by dblwyo at 11:15 AM | Permalink | Comments (2)

The chart below shows YOY% changes in GDP, Consumption, Production (IndProd) and Investment. Since it's % changes what it really shows you is cycles around trend - for example from '94 to middle '00 the economy was growing around 4% a year with the exception of that little blip in '95 which seemed so bad at the time. Notice when you look for real changes in direction and strength that the major downturn in '01 was pretty visible if you knew to look at these sorts of charts. Not only did GDP and PCE slow abruptly and rapidly in middle '00 but the downturn in GDP was preceeded by several months by a downturn in PCE. 

 Historically consumption decreases roughly as much as GDP, or at least it has in every other post-WW2 business cycle. But just as this investment-driven boom and bust was different from all the post-war predecessors so was the downturn because consumption stayed relatively high. It did that because of tax cuts and Fed rate policies. The good news is that we avoided a major downturn (fair disclosure: real word is depression but we don't want to say that).The bad, that there's no more pent up demand as there usually is. This is as good as it gets.

Which shows up in the lower growth rates in GDP and PCE from '04 forward and their gradual slowing. Here's the Goldielocks part of the economy ! We are continuing to grow, it IS slowing, but it's still decent. AND, most importantly, so far no abrupt downturns in consumption have appeared to pre-sage another significant downturn in the overall economy.

On the other hand both production and investment haven't just slowed in '06. They've turned down rather abruptly and sharply - that is the rate appears to be increasing. The description 'driven off the cliff' doesn't appear out of line here. So what does that mean for the longer term outlook ? 

So is the part where we start talking about Cindy's economy or not ? Stay tuned because we need to look at several things, including investment, housing, employment and a couple of other things.

PREVIOUS POSTINGS:

What's REALly Going On ?

Posted by dblwyo at 06:12 PM | Permalink | Comments (0)

The trick with economic data is to get beyond the meaningless statistics and look at the repeating patterns that structure and order the business cycle. As we all lurch along looking just at the headlines, not even the explanations, we tend to completely miss several critical things:

1. The trends of the key variables (Output - GDP, Consumption - PCE, Production - Industrial Production (IndProd) and Investment for example) over time.
2. The deep, recurring structural relationships between the key variables.
• 70% of the US economy is consumption and it, or the anticipation of growth in it, are the driving engines.
• That means that Consumption drives GDP which drives IndProd which drives Investment and Employment.
3. The turning points - the most important and generally the hardest to predict characteristic of the business cycle. But one that the repeating patterns and structural relationships will help us see better.
4. And something almost as important - the lead and lag structure. If consumption is the driving engine then businesses invest in anticipation of future growth in consumption. Not to replace because they have cash on hand.
• We'll go over this in the future but it's critical to note that investment lags consumption and when the latter turns down so will investment - generally speaking.
• Similarly employment is very much a lagging indicator. Job growth today reflects business decisions months past and consumption trends months earlier than that.

The 'trick' to filtering out the noise, making the patterns and relationships clear and seeing the turning points and lag/lead impacts is to shift from month-to-month(MTM) headlines and look at Year-Over-Year(YOY) % changes. As we'll show. 

PREVIOUS POSTINGS:

Whose Economy: Goldie's or Cindy's ? 

Posted by dblwyo at 05:47 PM | Permalink | Comments (0)

There's been lots of discussion about the Goldielock's economy for several months now, upto and over a year, depending on what you care to track. For it to be Goldie's economy growth, though slowing, must continue, inflation needs to stay under control, new jobs need to be created - in the right numbers (over 150K/month at least to stay ahead of labor force growth and to absorb productivity increases over the long-run), interest rates need to stay benign or 'neutral' without having any unpleasant suprises from the dollar, etc. etc. And of course even more little unpleasant surprises from the world of geo-politics - say a regional ME war that drives oil to $120/barrel - need to not make an appearance.

So if that all came to pass would that be Goldie's economy ? Is it what we want ? And how likely is it ? Well we're going to take those questions apart in several pieces and take a pretty good look at each one of them in several comments here in the next few days. But to save the suspense the economy is neither as good or bad as the headlines at various times would have you believe over the last several quarters. It is in fact slowing and job growth, the foundation of the driving engine - which is consumption, has been the lowest of any post-WW2 'recovery' but things look fairly sanguine.

So why would we raise the question of whether or not it's Cinderella's economy ? And the implied one of - so, what time is it ? Five minutes to midnight or 10 o'clock ? Interestingly enough the answer to that question seems to lie, largely, in where the housing sector goes. Put another way there are two questions about housing. First are we done with the downturn or are we just started ? Next how important is housing to the economy and what might be the impact if it really goes south ?

The real trick is digging underneath the headlines and looking at what the real numbers tell us about structures, business cycle stage, trends, patterns and turning points. As the business news said, 'some meaningless statistics were up 1.5% this morning and people wrote a lot about it but this afternoon some other meaningless statistics were down 2.3% so they took it all back and wrote something else !"   Huh ? Well if you ever have that reaction we're going to try and help by taking our little walkabout using some pretty straight-forward graphical techniques that make the patterns and relationships a lot clearer. You'll have to judge fore yourselves but they've been pretty powerful for us.

Posted by dblwyo at 05:16 PM | Permalink | Comments (0)