bizzXceleration: Performance, Value and Profit

It's long been a truism that 'people are our most important asset' but anybody with a little bit of real-world experience has plenty of ground to question that. If you want some interesting evidence follow an old colleague's advice and read a Dilbert book from cover-to-cover, if you can. Amusing one cartoon at a time but taken as a series deadly depressing. Many things are embedded and embodied there but one of the keys is this fundamental question:

Are people truly assets or are they consumbles that're easily replaced ?

Now if people were really and truly assets we'd apply the rigors of capital budgeting, discounted cash-flow analysis and IRR assessments. Despite the unhappy reactions I've gotten to that suggestion stop and think about it for a while: we look at capital over it's total lifetime, understand that regular maintenance and upkeep is required and the total life-cycle costs and benefits do NOT happen with one fell swoop. Why can't we apply the same logic to people.

With at least two fundamental differences:

1. People are appreciating assets - unlike others they accumulate experience, training, contacts and knowledge. Their productivity and value should grow over time. 

2. People are the last thing between you and your customers - and your suppliers for that matter. If you'd like to establish viable and effective long-term relationships it should pay to treat them well. 

If you stop and think about it for just a bit the widely shared tribal folk wisdom of business and organizations is that in fact people are treated, depending, as anything but assets. Somebody who's made a major part of his career in examing the characteristics and consequences of that 'strategy' is Prof. Bob Sutton of Stamford who has an excellent blog up at Work Matters .

Bob has recently published his latest book "The No Asshole Rule" which has gotten a huge jumpstart in the blog community and is know a bestseller on Amazon before even hitting the mainstream. Highly recommended as is his blog.

There's a recent entry on the blog on the "Waste of Talent" which reflects the huge outpouring of painful stories that indicate how widespread the problem is. I'm sure Bob's e-mail is getting swamped. You can read my comment there but let me put it up here as well. In my earlier, first post on Nardelli's impact on Home Depot enterprise performance I tried to link external performance measures, market value, to the treatment of employees and customers. That approach is a top-down one that reflects Mr. Market figuring out something is wrong, rather badly wrong, and adapting valuations accordingly. The Efficient Market Hypothesis is all well and good but it takes a while for the distinctiveness of new information to be absorbed by the collective. It's fairer to describe the market, in the short-run, as Adaptive.

I'm not sure that Dark Minions actually do make money at all for themselves or their company. Rather it's a question of the measurement and management systems not capturing the damage they do. One could take that top-down or bottom-up. For the latter consider - if an asshole is abusing their team then more and more of the team's efforts (as ALL your stories show) goes into avoiding him/her and diverting their effort into other directions. And that generalizes to a company-wide basis - can't tell you for example the number of folks at well-known large companies who've told me how bad things are.

If after several rounds of over-work, bad measurement, etc. etc. the bulk of the employees keep reducing their efforts while spending all their time watching their backs and looking for alternatives you get an original 80% effort reduced by, say, 20%, at several rounds of stupidity.

Well .8 x . 8 x .8 X .8 is 40% or so. In other words one gets 1/2 the effort from skilled employees that one is ostensibly paying for.

It doesn't take many iterations for this to destroy a company's capabilities. Yet because people are treated as fungible commodities instead of (uniquely) appreciating assets they're grossly mis-managed.

Turn it around - good service is a major requisite of good competitive position yet employee abuse causes them to spend less and less on attending to customers and you get the external death spiral going. For one perspective on how that played out and is "measurable' at Home Depot see the prior post on Nardelli: Cheap at the Price ? 

 Interestingly enough there's reverse evidence when you look at how the military performs. Despite the reputation of top-down, rigid hierarchies the modern US military has gone, and continues to go, to great lenghts to push empowered decision-making as close to the frontline as possible. In some cases, for example, USMC doctrine calls for local operating authority to devolve to the squad leader, a corporal. And the Corp expects all its' leaders to take care of the folks underneath them. Which makes perfect sense on several levels when you stop to think about, and for many reasons.

One of which is the joint benefit to all the team-members is pretty clear. Have you ever stopped to wonder why everyone who works for an effective startup is excited and works long hours at 120% efforts levels. Sure, some of it is the wealth prospects and some of it's the challenge. But a lot of it's the fundamental satisfaction we all get from doing good work that is worth doing and makes a difference.

The real question is why don't we manage our organizations to maximize total performance by managing people as assets ?

Posted by dblwyo at 05:09 PM | Permalink | Comments (2)

A lot of data that is critical to understanding where the economy is headed and what the context for businesses and investors has come out in the last few weeks - including Durable Goods Orders,Employment, CPI/PPI and, today, New Home Sales. In all cases there are pretty profound differences between the headlines, the underlying data and the structural characteristics of that data. One of the major secondary purposes of this blog is look beneath the headlines and understand the trends and structural characteristics of what's really going on, as best we can, and translate that into information useful for making decisions. And understanding the likely impact on the business environment.

As it happens New Home Sales are a perfect poster child for illustrating this point as well as being important in their own right. In fact all of the data sets listed above are worth investigating and over a period of time we'll build up a pool of economic analysis tools that allow us to make a ready and rapid assessment of the state of things. Housing's important for its own sake for at least two major reasons. First, by itself, it's a major sector of the economy and influences how the overall economy performs. But in this particular business cycle, which is so vastly different from every other post-war cycle, housing has played the unsual role of being the stimulas - the accelerator if you would of the economy. As a result understanding the current state of play is much more important than usual.

This chart is a little hard to decipher (please click on it for a larger version) but shows Permits, Starts (left) and New Home Sales(right) monthly, from Jan79 to now, courtesey of the Census Burea and the St. Louis Fed. A couple of things to draw your attention to - first, the montly data is noisy and it is hard to see the correlations and turing points. Nonetheless, it is also pretty clear that the series move together. Some other things to notice are that there was a long, un-interupted boom from from the mid-90s to, roughly, Q206. It doesn't look like much of a recovery to me. But please take a look for yourself and decide.

For our next trick we'll look at the quarterly averages from 1980-2006 and see if the noise is reduced, the data smooth out and if the relationships are clearer.

Looking at quarterly averages reduces the noise and smooths the data so it turns into information and the relationships are much clearer. Again the long-boom seems to stand out but what's even more interesting to me is that there was a downturn in Permits, Starts and Sales in the '89 and '94 downturns but nothing seems to have happened after that long boom in the remainder of the 90s. In fact housing accelerated despite the short-recession and longer downturn in the economy in '00-'03. Looking even a little more closely two other things seem to jump out as well. If anything the housing indicators accelerate in the last few years until they rather abruptly 'fell off a cliff'. Again the question is when and where will they stop ? And what will be the impacts ?

 Let's add one more picture to do a little more stage setting before focusing on that question and look at year-over-year % changes in the three series. Now the structural relationships are almost entirely clear. All three series move, by-n-large together. They show some very wild swings in the early 80s as we went thru two different short-term and abrupt recessions, there was a clear period thruout the 90s and early 00s of an almost "Golden Age" and there's been the abrupt cliff recently. It would also seem fair to argue that if we look at Sales we're safe in assumming Permits and Starts behaved similarly.

Now the interesting question is - what's the relationship between GDP and New Home Sales ? Or in other words how's the economy influenced by, or how does it influence, Housing ? Below is a chart that shows YOY% changes in Sales and GDP as well as the best-fit polynomial trend for Sales, which gives us some idea of how Sales is behaving over time.

While GDP and Sales aren't closely co-incident they do, broadly, move together. In the 80s the initial decline and ultimate downturn in Sales actually led the fairly serious downturn in GDP, reinforcing the notion that Housing is indeed a major influence on overall economic health. That gets even more heavily reinforced when Housing led a sharp upturn in GDP in '91. Notice (or let me mention) that Sales is graphed on the Left scale and is highly(!) volatile while GDP is on the right and shows the same structural swings but not as severely. Which is highly fortunate as a 20-30% downturn in the entire economy is not something we want. Yet, quite oddly or it would seem, housing kept chugging right along since 2000 while GDP begain to turn down abruptly and sharply. And while GDP is slowing it is NOT sharp or abrupt whereas the recent downturn in New Home Sales is.

Obviously something else has been going on and that is the influence in once-in-a-lifetime low interest and mortgage rates which created a boom in housing. But now we're faced with the prospect of a return to historical norms as the underlying cycle re-asserts itself.

So we're back to the questions everybody has been asking - where's housing going and will it take the economy with it ? Questions we'll look at more in the future but my current best guess is that the sub-prime contagion will spread at least thruout the rest of the housing market and accelerate. And that we've just barely begun to see the impact of slowing Starts on construction employment. 

In fact both CalculatedRisk and BigPicture have excellent posts on Starts. I'd particularly point to CR for understanding the impacts on employment and the likely future course of events:

Posted by dblwyo at 03:06 PM | Permalink | Comments (0)

Well let me try and get back to discussing Home Depot and the lessons therein for corporate performance. While my primary purpose and focus here is on enterprise performance I keep letting economic and market events seduce my attention away - largely because it's hard to sail the boat well if you don't know where the wind and the currents will take you. That said I'm liable to succumb in the future somewhat often to build up my collection of tools and observations.

In the prior HD post we talked about Nardelli's short-term focus doing tremendous damage to the soft-assets of customer value and employee morale; and that enormous asset depreciation being reflected in a long-term decline of PE Ratios and the associated drop in enterprise value. With a couple of toolkit posts on PE trends and valuations in the market we can turn around and dig a little deeper now into HD's history. Unfortunately the Nardelli experiment in excessive cost control for apparent short-term earnings not only spent soft-assets but squandered a major market opportunity. Now that housing is slowing dramatically the new management must not only re-build the company that was but face severe down-pressures in demand. It won't be easy but perhaps a look back may help.

Full disclosure - I'm not now nor ever have been an HD employee. But people on my teams have worked for them, they've been customers and friends and family are expert home re-builders and shop their extensively. I've even been known to do that myself a little and have watched the deteriorations in customer service with dismay. 

 Taking a look at HD's stock performance from Jan05 to now we can see the early days followed by the rapid rise of the late 90s. Some of which was due to the general market boom but much of which was due to the real and true growth of the company. And of earnings based on fundamental, organic growth. HD had a great value proposition - you went in with a problem, they had plenty of skilled, knowledgable staff to guide you in solving it and they had high-quality, fairly-priced products where that staff would help you pick something just right. At the end of the day it was a true business win-win story driven by service and value.

As HD grew they put more and more stores in more and more locations to the point where some cities and areas were getting saturated. Something that's not well known is that a key to their service capabilities was the store manager's direct-to-supplier ordering which was delivered directly to the store and, because the stored ordered it and it was shipped directly, the manager had complete visibility to what was on hand, what was ordered and what was inbound. The store could then manage in near real-time as day-to-day customer demands fluctuated. Unfortunately as more stores crowded into more areas the congestion rose, the upstream distribution system came under increased pressure, shipping was consolidated more and more into lower-cost, traditional modes and the store lost a large service responsiveness capability.

Put more simply the system rapidly outgrew its' operational capabilities to support growth and maintain the service levels required by the overall value proposition. To address it required serious investments in information systems, transportation and distribution and operational management. More importantly it required treating operations and execution as fundamental strategic capabilities; AND...very important... thinking outside the box to be as innovative on operations as the original strategic concept was on that level. Now that wasn't the only thing going on but it was a major one, and one that was missed and doesn't currently appear to be on the table for re-evaluation.

If we were to summarize it seems to me that three things were likely to be going on:

1. Previous success served as a model for competitor's and led to increase competition from folks like Lowe's (who not only modeled the HD value proposition but put a more innovative operational infrastructure in place).
2. Greater presence and penetration of most markets led to the 'tiring' of the value proposition. Which means that news sources of value innovation were, and still are, required.
3. Growth swamped the operational capabilities of the execution infrastructure to continue to support growth while maintaining and increasing the service which was fundamental to the strategy.

Now that's an outside-in look without having been part of the internal strategic discussions, of course. And therefore based on the best available information combined with some industry and operations knowledge. But it is, at the very least, plausible and perhaps likely. Certainly the deterioration in HD's growth and financial performance led to the replacement of the founders. Who were, by all repute, innovators and merchantes but not operators.

So the question then becomes what next ? The new CEO has certainly taken a bunch of excellent short-term steps from moving to restore morale, improve service, reach out to hostile investors and also to the founders. But the original challenge from seven years ago remains. Only this time it's coupled to major depreciations in critical soft-assets and rapidly declining market demand. Fixing these various problems is going to be challenging and not an over-night or cost-free effort. 

For any stakeholder in HD (employee, supplier, investor or a major investor, e.g. private equity funds) new management alone won't solve these issues. It'll take a concerted effort that combines short-term improvements with significant investments in staffing, system and operational capabilities and - ultimately - the innovative creation of new sources of value. Home Depot is a great company with a lot of talent and can address these challenges.

Whether or not it's a sensible investment will depend on when and how well. In any case it will be interesting to watch. 

Prior Posts: Cheap at the Price

Posted by dblwyo at 11:01 AM | Permalink | Comments (0)

In the prior post we looked at the Grahm-Dodd PE valuation formula, built some useful tables and talked a bit about applying the approach to both company and market performance assessment. It seems like it might be a good idea to test it a little bit so let's walk thru SP500 quarterly earnings, PE's and compare the latter to what might be calculated using average earnings growth rates and AAA-rates. This will turn out to be a little rough and approximate but nonetheless be useful - at least in thinking about trends in valuations. Let's start with the following chart that looks at earnings from Q11990 to Q42006 and compares actual PE ratios to calculated ones.

 Here the dark blue is SP500 quarterly earnings on the left axis while reported PE and the 3Mo Moving Averge of GD calculated PEs (MAGDPE) are on the right. Not suprisingly the latter is volatile but the polynomial trend is revealing. Notice the converence of the two PEs in the mid-90s, their wide divergence in the late 90s and now the new convergence. Also notice that the GDPE is quite a bit more conservative than market-based PEs. A final, very interesting thing to note is the recent continued decline in market PEs over the last several years with the exception of the very last quarter. I think we'll find that this is a fair estimate on the long-term growth prospects of the economy as well as that of the market, profits and earnings.

If we drill down a bit to more recent dates some of these trends in valuation are a little more clear.

 Here we can see earnings growing steadily until the last quarter but market PEs showing a relatively steady decline. Based on the logic of the G-D framework that would mean that the market as a whole view long-term growth prospects for earnings, and therefore the economy, as not very good. In fact given how well profits and earnings have done over the last several years the relatively flat markets of '04, '05 and mid-06 can really only be explained by lowered earnings growth expectations. Conversely the sudden drop in oil prices as well as the 'apparent' containment of inflation expectations - so that interest rates will stay relatively low - may have led to the Q3/Q4 surge in the markets. Ironically however Q4 saw one of the more serious downturns in earnings.

The question now becomes how do we expects the economy to do and what impact will that have on profits, earnings and expecations ? And of course, not to forget where we started, how do we apply these sorts of questions to corporate performance analysis ?

Prior Posts:

Value, PE and Mr. Benjamin 

Posted by dblwyo at 01:57 PM | Permalink | Comments (0)

The great, as in superlative, grandfather and progenitor of stock market analysis and valuation is Mr. Benjamin Grahm. While other anlaysts have evolved different methods and techniques Mr. Benjamin's emphasis on understanding stock value as a function of performance and outlook will always be with us. As well as notions of letting Mr. Market do his thing while concentrating on value but under-standing what the margin of safety is; i.e. what's something really worth as a going concern, do we know where we can get it for a much lower price than it's worth, how far could it fall in market gyrations and, best yet, do we know where can sell it to realize a major gain. Those are indeed interesting questions.

Earlier commentators and correspondents pointed to the assessment of Bob Nardelli's performance at Home Depot and asked whether or not the rapid deterioration in PE ratios didn't reflect better alternatives. Exactly. But the question is bigger and more important than that. It also helps us gain some insight in looking at the overall market. In fact it's been a suprise to me that over longer timeframes PE ratios are so revealing of long-term performance trends for companies, though quarterly there's a lot of noise and confusion. Mr. Benjamin's work (as adapted by the AAII) suggested a simple formula for first-pass valuations based on longer-term performance, company outlook and market/economic conditions:

PE = (8.5 + 2XG) X 4.4/Yield.

Here G is earnings growth and yield is AAA-rated corporate bond rates. 

The following table shows expected 5-year annula growth rates (columns) verses AAA-rated corporate yields (rows).

The preceeding table works out the formula for a wide range of earnings growth rates and for interest rates. It's an interesting exercise to go back to, say, the heights of the Internet/Telecom boom and see whether or not using the Grahm-Dodd PE formula lent us any insight. At the beginning of 2000 Cisco's PE was 200 while EPS had grown from about 1.20 to 1.80 or so (judging from some hard to read charts) while interest rates were around 7%. So (8.5 + 2*30%) X 4.4/7 is 43 or so. Still an incredibly respectable number but a long way from 200, or 100 or even 50.

The real point here is not that the G-D PE formulat is precise but that it is accurate in the sense of providing a test of reasonableness and under-lying value. Especially when one keeps applying it over time because the trends, patterns and turning points might be even more interesting than the number at any particular given point.

By and large we're quite a ways beyond the days, until they come again of course, of 20% interest rates, 50% earnings growth in multi-$B companies and 200 PE's. So the following table looks a little more closely at details more immediately useful. 

Now there's plenty of room here for informed judgement as well. If you think that rates are going to change direction or that corporate performance is going to surprise, up or down, from the broad run of expectations then using this chart will help you do a quick scan of what it might be worth.

In the earlier entry on Home Depot it was this valuation philosophy we were essentially pointing at - and arguing that, over time, the market was arriving at. At least as the longer-term consequences for HD performance became clearer. We'll be re-visiting HD in future posts to re-test this but from the last couple of week's headlines and earnings reports it does indeed look as if the chickens came home. 

Posted by dblwyo at 12:28 PM | Permalink | Comments (0)

Now that the dust has settle a bit maybe we should take a look at Tues. sudden market drop and ask what's going on, if anything ? First, did the title resonate ? For literary types it's Fitzgerald's last novel but for boaters, especially sailors, a tender boat is one that's overly reactive to control changes and environmental conditions. Suitable for racing and light water/air conditions - i.e. lakes and coastal waters. But risky in heavy weather and heavy seas.

The proximate 'cause' (trigger) was an 8% drop in the Shanghai index followed up by concern over the US economic outlook. Well that sounds good but there are three things we might want to look at. First, the rest of Asia didn't follow off that particular cliff but waited until the next day (Wed.) to follow, as they usually do, the European and US markets. Hmmm.... Next new orders for durable goods weren't all that bad - relative to the rest of the economic news that's been both discernable for months and discussed here a bit. And third - we have to ask how seriously do we take the drop in a highly restricted and government controlled index ?

1. Round the World (just not in 80 hours) - if you take a look at the chart below courtesy of the WSJ a couple of things jump out.

 First, most of the Asian markets didn't fall all that much. Indeed it wasn't until they followed the US markets down on Wed. -and thruout the rest of the week - that they showed significant declines. We should also notice, not widely commented on at all, that the Chinese gov't still owns the majority of A shares and what's traded are B shares. Jim Jubak has an excellent column dissecting the regulatory changes that more fully de-regulate these markets and bring them farther into the modern world where some shares instead of all can sold and traded. Actually a huge step forward. That means that the drop in Shanhai was not the cause but perhaps an easily 'blamable' trigger. Second, notice that the Shanhai index showed significant declines from '01-'05 following the very poor profit performance of Chinese companies who are under extreme margin pressures due to excess liquidity, resulting over-building and over-capacity and price pressures (with inputs going up and their own going down). Also notice that that same excess liquidity shows up as speculative excess in '06. Extraordinary excess in fact, judging from the graph.

Thruout the rest of the week Asian and European bourses followed the US market down, as they typically do. So it seems fair to conclude that Shanhai may have been an excuse to trigger the downturn but its' not a legitimate cause.

2. During Tu.'s rout another finger was pointed at recent economic data for capital spending as durable good orders declined. We'll have more to say about durable goods in another post to put that all to bed but....Dec. orders fell -1.5% year-over-year, or rose .4% excluding aircraft. Given that orders have been slowing for some time, along with and in nearly perfect parallel, GDP and other economic indicators, that seems like conincidence as well.

As you can see DG Orders and ex-Aircraft orders on a YOY basis have been slowing for some time. Also, We. saw the release of revised Q406 GDP numbers. On a quarter-to-quarter basis the headlines shouted that they were only 2.2% instead of the originally posted 3.5%. Now that's a big swing but one that was widely expected (cf. our previous post).

3. It seems more likely that the market was overdue for some sort of correction. The real questions we should be asking ourselves is this just an internal technical correction or a wakeup call pointing to the underlying economic data. Which has been weakening for some time. With the Dow and SP500 down over 4% for the week and the Nasdaq and R2000 down almost 6% it could be an important question.Perhaps we're back to Goldilocks vs. Cinderella ? Returning to the boating analogy we seem to be in a tender market with some major gusts blowing up and warnings of heavier weather to follow. Now whether or not we have a few more 'hours' to play before the storm gets here or not two things are very clear.

1. Keeping on eye on the weather is a very good idea.
2. And it's more than past time to think out your plan for getting back to safe harbor - even if you want to stay and play for a while longer.

Sources & References:

Top Ten Myths of Tuesday's Correction from BigPicture

Shanghai's 8.8% Tumble Slams Emerging Markets from the WSJ

China's Meltdown No Surprise and Jubak's follow-on Which Market Will Blow-up Next

Previous Posts

Will the Real GDP Please Standup ?

Posted by dblwyo at 05:01 PM | Permalink | Comments (0)