bizzXceleration: Performance, Value and Profit

Since Dell not only announced it's results this morning and surprised everybody, perhaps itself also, with pretty good numbers we thought a deeper dive on what's going on might be appropriate. And a test of our various toolkits for enterprise and industry analysis. Here we're going to dive into Dell's strategy, commenting along the way, as they see it themselves. And base it on their most recently available analyst presentations. We've argued before that Dell's downturn was visible at least three years before the fecal matter hit the impeller for two reasons. First off their core business - selling cheap beige boxes to large enterprises - was maturing and headed down. Now we also admit that we though their basic business model of low-cycle-time, customized order fulfillment would adapt nicely to a lot of other opportunities. Second we argued that they were cutting way too many corners since their whole business model was based on trust, reliability and outstanding, responsive customer service. When they started off-shoring and that service became non-responsive what had been a competitive weapon devolved into a cost to be shrunk. We won't mention the disingenuous accounting that went along with all this. Well let's not get to excited but things may in fact be turning around...and not because of the numbers. We still have to see how sustainable those are and how the economies hold up. Nonetheless DELL goes on our watch list as a strategic buying potential. Let's talk about why.

The two major challenges Dell had was they needed to re-think their business model for a new world. AND they needed to completely re-think, transform and re-build their operational capabilities to support whatever they finally came up with. Dell had three key initial challenges: 1) face reality, 2) re-think, re-craft and adapt their historic business model and 3) translate that re-thinking into new execution capabilities. We'll take a deeper dive on major aspects of these after the break but here's a composite picture of two key charts from their Apr08 analyst meeting.

The top half lists out the key challenges, where they want to go and where, according to their dashboard they think they're at. Refreshing and honest on many levels take a careful look. The bottom chart focuses on the two key strategic elements of profits and costs. Re-thinking product design and development, both as a cost control and a strategic marketing initiative. And reducing on-going operating expenses. Again both appear well-thought thru and accurate. The proof of course will be in the pudding. 

That is are the new ideas and business models being translated into the key strategic initiatives required to implement them. Well take a look at another composite chart which certainly indicates somebody has done some serious thinking indeed. The top sub-chart shows key strategies combined with the major, DIFFERENT, markets they are going after. Each of which requires different capabilities, business model adaptations and NEW operational capabilities. From marketing to customer service to go-to-market channels, logistics, manufacturing and product design and development.

So the next critical questions are they being put in place - which is preceded of course by recognition, acknolwedgment and commitment. And are they working as planned - likely in the face of economic turbulence and worldwide competition as well as the inherent challenges of doing business in unfamiliar markets. But it is the right, componentized, modular and adaptive Chinese menu of re-structurings that suits the markets they propose to tackle. 

Consumer Markets (US,  RoW, Emerging)

One key area they intend to tackle, looking at the preceding charts, is consumers. In both the US and worldwide. Now bear in mind while Dell has sold to consumers they made their bones selling cheap to big corporations and government organizations. Now they're trying to "re-vitalize" their US consumer image, increase their share in the developed world and go after the emerging world big time. Part of this is operational capabilities because this requires new channels, i.e. the direct order model doesn't work well. Which in turns means a complete re-think of of manufacturing and logistics since their old system was rigidly designed and built for their old strategy. It also means re-branding themselves. Well from the chart at right at least they get the point...we'll have to see but you'll be able to tell for yourselves to some extnet by watching their advertising, web site and the trade press. In any case just starting these sorts of strategic marketing efforts breaks new ground for Dell. They are clearly adapting.

 Business (Large and SMB)

Again across geographies Dell is trying to re-vitalize it's enterprise business but this time it's looking to go after not just desktop PC's for large enterprises. It's also looking to go both worldwide and after the Small/Medium business. Now several years back it was my opinion that Dell's existing business model would readily extend beyond PC's to go after servers, networking gear, printers, etc. in the market segments it was already well-established in. And that it's responsive logistics and order fulfillment ought to give it a leg up on the SMB space. Unfortunately they lost ground in those spaces for the same reasons they lost ground overall...which was really dangerous because it was home turf and the cash cow. 

Now it looks like they've come up with the right strategies and value propositions along with a pretty good notion of the necessary operating  capabilities needed to go after the large enterprise and SMB spaces. The latter is particularly important if you'll recall some of our earlier work on the structure of the IT marketspace. 

Go-to-Market Channel Strategies

Whether it's large or SMB, whether it's developed or emerging world the old direct model isn't appropriate for all the target customer sets. In fact for consumers they really do need to go after retailers - this is especially true in the developing world. Which means they need to build a robust channel management capability built around partners that they've never had to have before. And, the good news is that they not only realize that but it appears to be coming into place. Again if these two charts are a fair representation of the thinking and capabilities Dell is well on its' way to building the kind of channel management capacity required. Again of course we'll have to see but this is NOT just a proof of the pudding sort of thing - if you stick with it after getting the initial idea right it becomes a major new competitive weapon.

Services

For Consumers, SMB and Large enterprises the "undiscovered country" for almost everybody is services (recall HPQ's recent acquisition of EDS). Computers are still no easier to use than they were. The catch is that services are hard to do, require lots of bodies and capabilities and can be low margin businesses if you screw up any of these requirements. 

Dell appears to be addressing this in several ways (& being more than a bit disingenuous along the way). They've id'd addon services as a huge marketspace but their counting includes all services, e.g. hugh server install and applications support. Which they are not proposing to do. So the addressable marketspace is much smaller than they told the analysts. Nonetheless by focusing on the picky little stuff they're focusing on stuff that costs their customers, that fixing adds value, are common and repetitive and therefore modularizable. So even if they leave most of the total market on the table the parts they're going after suit them, are amenable to cost efficient management, synergize with their core offerings well and could double the revenue over time. Albeit at lower long-term margins.

Bottomline

At long-last Dell is saying and, apparently, doing a lot of the right things. There's a long way to go before all this stuff is in place and begins to fire on all cylinders. But it wasn't that long ago that they stood up at major national conferences and could NOT present a clear, simple picture of who they were going to become and how they were going to do it.. Now they can. If they can turn these good ideas into new parts of their enterprise DNA they will build a new set of moats behind them and create major new value propositions. I don't know yet whether this can result in returning them to their glory days. Frankly I doubt it. But it will turn them into a large, growing, profitable and well-run company with great, sustainable strategic opportunities in the developed and developing worlds.

All of which doesn't mean they're yet an immediate buying opportunity. Depending on how you think the economy is going, and will go, and how that impacts Dell's business a downturn is likely to take down earnings and therefore the stock price. You'd also want to start testing at least the obvious signs of whether or not they're delivering on these initiatives - from the web site to word of mouth to quarterly analysts reports and annual updates. But right now Dell looks like it goes on your long-term watch list in our humble opinion ! 

And a final caveat, and a major one. Each of these new structural changes/strategic initiatives has a major weakness to be overcome. In the consumer space it'll be re-thinking the product design for appeal as well as function and then marketing it. In the enterprise space it'll require a commitment to on-going innovation in larger servers and networking. As well as the appropriate sales, marketing and channel operations. ALL of which are new capabilities. And future growth is critically dependent on services yet Dell's not equipped to go after the more complex services and isn't. And so on and so on thru each line-of-business, initiative, target market and geography. YET...this is a SEE change. 

Posted by dblwyo at 10:49 AM | Permalink | Comments (0)

It's time to pick up the thread of our readings on the future of the Oil Industry and extend it to a structural picture of the future. Within our limits of course. The prior post provided a sampling of readings as well as a strategic summary (). Here we'd like to tunnel into the big picture and little bit and take a look at price trends, energy demand patterns and long-term supply-demand balances. Or as the case is...supply-demand imbalances. Let's start with the following chart on long-term prices and S/D trends.

In some ways no big surprises, at least until you look fairly closely. The top sub-chart shows annual growth rates in world supply, demand and the balance along with trends for the former. The bottom sub-chart shows oil prices, real oil prices and YoY% changes in real prices since '64. A couple of "small" surprises. While we did our own calculations of real prices, so they're at odds with the official ones, our guesstimate is that they are as high as they've ever been and climbing. The surplus of S>D has shrunk abruptly but the rate of growth in Demand has now shrunk below that of Supply ! If that were the long-term trend we'd be pretty happy. That reinforces many of the arguments we made.

After the break we look at the bigger picture strategic issues but here's the bottomline, again. Oil is economically and affordably available but is increasingly controlled by non-market decision-making. And we are increasingly hostage to that decision-making almost entirely thru our own choices. Until we have a major national commitment to a national energy policy that is pragmatic, workable and realistic these trends will continue. And will likely accelerate. And you should note that this is NOT something foisted off on us. Who owns an SUV ? What's the H.P. in your car ? We choose to pay bottom-dollar for gas in the last several decades instead of pursuing alternatives. No the vultures are coming home to roost. 

Energy Consumption vs Supply

Consider the chart from the most recent National Energy Plan (NEP) which dates from circa '01. It tells us something we've known for a long-time. That is, demand >> supply. The problem is that while we've known we haven't done much about it. And since this work was done the entire structure of world energy supply and demand has undergone a major structural shift. Which means these estimates are likely conservative in the extreme. Not in terms of our D>S but it terms of supply availabilities.

Long-term World Oil Prices

Nor is this problem likely to go away anytime soon. Here are DOE's assessments of long-term oil prices under high, base, and low oil-price cases from now until 2030. A couple of key points to notice. These were done long enough ago that we've already blown thru the high price. Even under the high price scenario total demand keeps growing steadily. And the underlying realities that oil could be available are reflected. So we're back to geo-political and offshore-control premia being built into the current prices. Which suggests in the short- and intermediate-terms that prices could come down. 

World Reserves Sourcing

Remember we keep talking about the huge structural changes. Well here's one way to look at it. BigOil no longer controls its' fate nor ours. More and more of the world's oil reserves are somewhere else. In fact if the WSJ's take is correct approx. 7% of the world's oil reserves are open to free, market-based competition, with another 12% under limited access. Which leaves 65% + 16% = 81% of the world's oil under restricted, controlled access.

Which would actually be o.k. if we were sure it'd come onto the market according to economic and not political forces. Reinforcing our point out oil being available. But also reinforcing the two critical points. Decision making is political and they're enforceable. And second, most/many/all of the political entities are not investing in existing production as required to maintain flow. Nor in exploration and development to replace declining production from old fields. Oops...or better yet damm.

US Political Choices

While Peak Oil Theory would argue that much of the US's continental reserves have been discovered, developed and used up we don't know about our own offshore reserves. Which judging from prior geological work as well as recent discoveries, e.g. Brazil, may in fact offer extensive resources for development. Unfortunately, like almost every other energy policy switch we could throw, this one is also in the OFF position.

We need a sustained, multi-decade effort to develop new sources of energy, new technologies for using what we have, promoting conservation and demand reduction and we need to commit to it. This is our choice. How do you vote ? Meanwhile just remember when you buy an OECD oil major you're buying the cash flow of a depreciating asset. And you can't invest in that other 80%+ of the world's oil. 

Posted by dblwyo at 10:49 AM | Permalink | Comments (0)

Needless to say oil prices are occupying everybody's mind right now - particularly since you can't go down the street without seeing $4/gal gasoline prices. Congress is holding hearings to chastise the speculative excesses with "inside baseball" players using the correlation is causation argument to prove widespread evil-doing. My favorite bloggers (BigPicture, CalculatedRisk) and financial writers (Jubak, Mauldin) have all put together excellent summaries recently that are worth reviewing. And of course the MSM (WSJ, NYT, et.al.) is covering the issue extensively. So here's our collection which we've been putting together for a couple of weeks now, and for which the time seems ripe.

The basic argument, which we plan in expanding into an analysis in a follow-on Part II, is the fight between fundamentals and speculators. As you skim over the readings below you'll find a wide sampling of sources and informed opinions but here's our take. Of the ~ $150 price/barrel target price the long-term fundamental price is in the $80-100 range. Another big chunk of that target is caught up with geo-political risk factors. And a third with speculative feedback on short-turn prices. Let's say that the proportions are roughly 60% fundamental, 20% risk and 20% speculation.

Except for one thing. The basic structure of the oil industry is that the major cost drivers are exploration and production; then distribution and processing (refining). As oil has gotten more scarce in inexpensive and readily (politically) accessible areas of the world there are non-linear rising costs to the two fundamental drivers. That's lead to a fundamental and long-term supply-demand imbalance as new oil production hasn't been keeping up with new oil demand and consumption. A partial result of that long-term dynamic of skating on the margin is that the system has been and is increasingly vulnerable to shocks as its' fragilities grow.

That's been the basic dynamic for at least three decades only it's gotten much more pronounced in this century. HOWEVER....there is another fundamental shift well underway that is greatly exacerbating all these innate structural characteristics.

Not only are new oil sources in increasingly hard to get to areas but the bulk of the world's known and potential reserves are no longer market priced nor controlled by private companies. Rather they are controlled by national oil companies or other political entities. Who's priorities are NOT long-run profit maximization.

Worse yet for those reserves controlled by political entities they are milking existing reserves to fund socio-political priorities and significantly under-investing in maintaining current flows while not developing new ones.

There are two bottomlines here:

1) oil is likely available but is getting increasingly scarce at prices we're comfortable with; i.e. the $80-100 baseline structural price, which shifted up from $40-50 in the last ten years, is likely go toward $150+. 20% X $150 = $60. 2 X $60 = $120. $150 + $120 ==> ~ $300 oil !

2) because oil is depletable and demand is growing there is a long-term scarcity premium that's being increasingly reflected in the base (cf. Prof. Hamilton's discussions below). In other words there is a rising scarcity rent being built into l.t. prices that's feeding speculation.

So below you'll find readings on the short-term and long-term pricing factors as well as the impacts on gas prices and the survivabilities of the refiners, or refining operations. You'll also find some fundamental re-thinking about the future prospects of Big Oil as we know. Which is pretty good though it generally doesn't reflect these deep structural changes evolving in the fundamentals of the industry....yet....other than by symptom.

The next steps of course are diagnosis and treatment....otherwise known as a National Energy Plan. Yeah, right. 

Short-term Pricing Factors

Oil: Key players and movements The rising oil price, which topped $130 a barrel this week, risks pushing the global economy into a deep and prolonged slowdown. As long as demand from leading developing countries such as China and India remains strong, the price is likely to stay high. A combination of other forces, including the weakening US dollar and geopolitical tensions, is driving prices higher. Our map examines the world’s largest oil producers, consumers, and how oil flows around the world.

• ·         Whither the Price of Oil? Why has the price of oil risen so much in the past few months? Is it a supply and demand issue as some believe; or is it because of an out-of-control futures market driven by the proliferation of commodity index funds and rampant speculation, as everyone tries to get in on the rise in commodity prices? This is a very complex issue, with a lot of emotion attached to it. This week I try to give you an understanding of why oil prices have risen and whether they are likely to stay at such lofty heights or maybe even fall! And we look at a very odd statistic: where are all the tankers? There are some very unusual things happening in the oil patch. If you are currently exposed to the energy or commodity markets, or are thinking about it, I believe you will find this letter of interest.

Blame Wall Street for Oil at $135 a Barrel as Traders Cover Wrong-Way Bets Oil's rally to a record above $135 a barrel came as traders bought crude to cover wrong-way bets that prices would decline, according to data from the New York Mercantile Exchange. The number of outstanding futures contracts, known as open interest, fell 8.1 percent in a week to 1.36 million at the same time that prices rose 2.6 percent, the data show. Falling open interest and rising prices are signs that traders are buying to exit so-called short positions that would profit if oil fell, and lose money as they rose. Oil prices have closed at record highs on 27 days so far this year, prompting OPEC oil ministers including Saudi Arabia's Ali al-Naimi to declare that the rally is led by investors, rather than a shortage of supply. U.S. oil executives told Congress yesterday that prices should be between $35 and $90 a barrel. John Hofmeister, president of Shell Oil Co., the Houston-based subsidiary of Royal Dutch Shell Plc, pegged the proper range ``somewhere between $35 and $65 a barrel.'' Saudi minister al-Naimi said in March when oil was trading near $100 that prices were unlikely to fall below $60 or $70, representing the cost of producing alternatives such as biofuels or tar sands.

Soros, Ghanem, Tanaka, Chalabi's Own Words on $135 Oil May 22 (Bloomberg) -- Crude oil rose to a record $135.09 a barrel, an increase of 19 percent in the month of May, on supply concerns. This report compiles comments on the outlook for oil prices and factors affecting demand from International Energy Agency head Nobuo Tanaka, Chairman of Libya's National Oil Corp. Shokri Ghanem, billionaire investor George Soros, Fadhil Chalabi of the Centre for Global Energy Studies in London, Ashley Heppenstall, chief executive officer of Lundin Petroleum AB, Manoj Ladwa, a derivatives broker at TradIndex, Rachel Ziemba, an analyst at RGE Monitor, and Kevin Daly, a portfolio manager at Aberdeen Asset Management.

Long View: Classic films shed light on commodities boom Instead, the debate is narrowing around two explanations. The Jean de Florette thesis is that supply is being tightly constrained. The Trading Places thesis is that the new speculative money moving into commodity futures has distorted the market. The former leads to tragedy – a return to the 1970s, with commodities fuelling inflation while imposing a brake on growth. But the latter does not have ahappy ending. Instead, commodities’ new investors could lose their shirts as the bubble bursts. How does the evidence for the two hypotheses stack up? UBS details the constraints that are stoppering up the supply of oil. The big oil companies have made their plans on the assumption of $60 per barrel oil, it takes time to develop new supply, and so there is little relief in sight. According to UBS, 72 per cent of new global supply in the foreseeable future will come from just eight companies. Neither story explains everything. Tim Bond of Barclays Capital says many commodities that cannot be traded via futures and are closely held, such as tungsten and cobalt, have risen as much as mainstream commodities. Speculators have nothing to do with this.

• The Oil Speculation Debate , Speculators & Oil Price Spikes, Part II, The Short View: Commodity speculation

Long-term Structural Factors

IEA May Slash Oil-Supply Estimate The world's premier energy monitor is preparing a sharp downward revision of its oil-supply forecast, a shift that reflects deepening pessimism over whether oil companies can keep abreast of booming demand. The Paris-based International Energy Agency is in the middle of its first attempt to comprehensively assess the condition of the world's top 400 oil fields. Its findings won't be released until November, but the bottom line is already clear: Future crude supplies could be far tighter than previously thought. A pessimistic supply outlook from the IEA could further rattle an oil market that already has seen crude prices rocket over $130 a barrel, double what they were a year ago. For several years, the IEA has predicted that supplies of crude and other liquid fuels will arc gently upward to keep pace with rising demand, topping 116 million barrels a day by 2030, up from around 87 million barrels a day currently. Now, the agency is worried that aging oil fields and diminished investment mean that companies could struggle to surpass 100 million barrels a day over the next two decades. The decision to rigorously survey supply -- instead of just demand, as in the past -- reflects an increasing fear within the agency and elsewhere that oil-producing regions aren't on track to meet future needs.

What the Export Land Model Means for Energy Prices To understand the importance of exports when discussing peak oil, ask yourself the question, "What's more important: the fact that global oil production is falling ... or that the oil-exporting nations are cutting off their exports?"  The basic thesis is that, to fully appreciate the impact of peak oil, you cannot look only at the production declines so presciently anticipated by MK Hubbard in 1956. You also have to look at the rate of local consumption and the effect of that consumption on the ability of a country to export its oil. Mexico provides about 14% of the oil the US imports. On any given day that makes it either the #2 or #3 leading source for US oil imports after Canada and Saudi Arabia. Given that the US currently imports close to 70% of its oil needs, the Mexican oil is critical. But here's the thing. Using straightforward ELM calculations, Jeffrey Brown is confident that Mexico will ship its last barrel of oil to the United States -- or anywhere else, for that matter -- about 6 years from now, in 2014. In my interview, I also asked Jeffrey to share his thoughts on the situation globally. Here's his response. "Global production peaked in 2005, and we're now into the third year of decline. And the critical point to keep in mind is, our model and case histories show that the decline rate accelerates, year by year. Using the Lower 48 in the United States as an example, you can see the annual declines going 2%, 3%, 5%, 7%, 10%, 15%, 20, on and on. So it's an accelerating decline rate." Underscoring Brown's concerns: On April 15, 2008 the Russians, the world's second largest oil exporter, announced that their oil production appeared to have peaked, with production in the first quarter of this year declining for the first time in a decade. If they have indeed peaked then, based on the ELM, the world could lose Russia's current ~7 million barrels a day in exports within 6 to 9 years. Echoing the baseline premise of the ELM, Herman Franssen, president of International Energy Associates, projects that Iran, the world's fifth largest exporter, may consume an amount equal to their exports by 2015. Most concerning, this April Saudi Arabia's King Abdullah announced they were not going to raise oil production above 12.5 million barrels a day.

Understanding crude oil prices How would one go about explaining what oil prices have been doing and predicting where they might be headed next? This paper explores three broad ways one might approach this. The first is a statistical investigation of the basic correlations in the historical data. The second is to look at the predictions of economic theory as to how oil prices should behave over time. The third is to examine in detail the fundamental determinants and prospects for demand and supply. Reconciling the conclusions drawn from these different perspectives is an interesting intellectual challenge, and necessary if we are to claim to understand what is going on. In terms of statistical regularities, the paper notes that changes in the real price of oil have historically tended to be (1) permanent, (2) difficult to predict, and (3) governed by very different regimes at different points in time. From the perspective of economic theory, we review three separate restrictions on the time path of crude oil prices that should all hold in equilibrium. The first of these arises from storage arbitrage, the second from financial futures contracts, and the third from the fact that oil is a depletable resource. We also discuss whether commodity futures speculation by investors with no direct role in the supply or demand for oil itself could be regarded as a separate force influencing oil prices. In terms of the determinants of demand, we note that the price elasticity of demand is challenging to measure but appears to be quite low and to have decreased in the most recent data. Income elasticity is easier to estimate, and is near unity for countries in an early stage of development but substantially less than one in recent U.S. data. On the supply side, we note problems with interpreting OPEC as a traditional cartel and with cataloging intermediate-term supply prospects despite the very long development lead times in the industry. We also relate the challenge of depletion to the past and possible future geographic distribution of production. Our overall conclusion is that the low price-elasticity of short-run demand and supply, the vulnerability of supplies to disruptions, and the peak in U.S. oil production account for the broad behavior of oil prices over 1970-1997. Although the traditional economic theory of exhaustible resources does not fit in an obvious way into this historical account, the profound change in demand coming from the newly industrialized countries and recognition of the finiteness of this resource offers a plausible explanation for more recent developments. In other words, the scarcity rent may have been negligible for previous generations but is now becoming significant.

Brazil Oil Trapped by 500-Degree Heat, Salt Barrier Brazil's plan to become one of the world's biggest oil exporters hinges on exploiting crude six miles below the ocean surface in deposits so hot they can melt the metal used to carry uranium to nuclear plants. Tapping what may be the biggest oil finds in the Western Hemisphere in three decades will require equipment that can withstand 18,000 pounds per square inch of pressure, enough to crush a pickup truck, pipes that can carry oil at temperatures above 500 degrees Fahrenheit (260 Celsius) and drill bits that can penetrate layers of salt more than one mile thick. Petroleo Brasileiro SA, the state-controlled oil company, is betting on the Tupi and Carioca fields to become one of the world's seven biggest crude exporters. Until the tools needed to exploit the reservoirs are invented, the crude will remain locked under the sea, said Matt Cline, a U.S. Energy Department economist.

• Powering Brazils Economy Petrobras, Brazils state-controlled oil producer, is rapidly emergin as a major player in the global energy empire, with Jose Sergio Gabrielli de Azevedo, Petrobras CEO and CNBCs Maria Bartiromo.

Gas Prices and the Refining Industry

AP IMPACT: What makes up the price of gas? So how exactly are gas prices set? What determines the hair-pulling figure you see displayed in large electronic or plastic numbers? Why is a gallon of gas, say, $4.11 -- not $4.10 or $4.12? Why is the price different across the street? It all starts with oil. The biggest factor in the skyrocketing price of gasoline is the historic ascent of crude oil, which has surged from $45 per barrel in 2004 to more than $135 this past week, setting new record highs all the while. In the first quarter of this year, based on a retail price of gas that now seems like a steal -- $3.11 a gallon -- crude oil accounted for all but about a dollar, or 70 percent, of the cost, according to the federal government. The rest is a complex mix of factors, from the cost of turning oil into gas to taxes to marketing costs to, sometimes, nothing more than the competitive whims of your local gas station owner.

• ·         If $4 Gas Is Bad, Just Wait

Brough Expects `Huge Demand' for Oil Exploration Stocks May 23 (Bloomberg) -- Andy Brough, who helps oversee about $6.5 billion at Schroder Investment Management Ltd., talks with Bloomberg's Sara Walker in London about the impact of higher oil prices on his strategy for stocks and billionaire Warren Buffett's plans for acquisitions in Europe. Halliburton Co., the world's second-largest oilfield contractor, offered to buy Expro International Group Plc for 1.71 billion pounds ($3.4 billion), topping a 1.61 billion-pound offer by Candover Partners Ltd.

Oil Refiners See Profits Sink as Consumption Falls While drivers are facing sticker shock at the pump these days, here is a bigger shock: high prices are putting a strain on oil refiners. After last year’s stellar profits, American refiners are going through a traumatic period. In a time of record gasoline prices, some of them actually lost money in the first quarter, and for virtually all refiners, profits are down sharply. Experts say the refiners are caught in a double bind. The price of their raw material, oil, is rising because of strong global demand. At the same time, consumption of gasoline in the United States is falling as a result of slower economic growth and consumer efforts to conserve. However much the companies would like to raise gasoline prices enough to pass along the full increases in oil, analysts say they have been unable to do it. Oil prices doubled in the past year, while wholesale gasoline prices rose a mere 39 percent.

Chevron Plans to Fire Up to 1,000 Refining Workers After Profit Drops 84% Chevron Corp., the U.S. oil company that reported an 84 percent drop in quarterly refining profit, said it plans to fire as many as 1,000 employees in its refining, marketing and transportation divisions. About 300 workers, mostly located outside the U.S., received termination payments in the first quarter, according to a regulatory filing today by the San Ramon, California-based company. Most of the firings will occur this year, and the restructuring program is forecast to be completed in 2009, the filing said. A call to the company wasn't returned. Chevron, the second-biggest U.S. oil company after Exxon Mobil Corp., said on May 2 first-quarter net income rose to $5.17 billion, or $2.48 a share. Per-share profit was 8 cents higher than the average of 18 analyst estimates compiled by Bloomberg. Record crude prices in the quarter pared refining earnings because gasoline failed to rise as fast, narrowing profit margins. Chevron's refining earnings dropped 84 percent from a year earlier to $252 million.

Big-Oil Futures

Time for big oil to explore places it would rather avoid In fact the best-performing oil companies globally have been the ones that have had exploration success, such as Petrobras in Brazil. Rising costs and taxes, and limited access to new supplies help explain why BP and Shell have performed so badly and underperformed US peers ExxonMobil and Chevron. But other factors have been at work, such as the fatal accident at BP's Texas City oil refinery and the reserve misreporting scandal at Shell. Analysts estimate that underlying operating costs and capital expenditure across the oil industry are increasing 10 to 20 per cent a year. Taxes have also been rising. The Labour government has increased corporation tax on North Sea oil profits from 30 to 50 per cent in the past few years. Another way to look at rising costs and taxes is the impact on returns. Return on average capital employed at Shell was 24.5 per cent in the first quarter of 2008. That is only 10 percentage points higher than a decade ago. Yet in that time oil rose by $80 a barrel. Finding oil is also more difficult, and big western oil companies are forced to explore in places they would rather avoid. One of Shell's big projects is extracting oil from tar sands in Canada, and BP is drilling in ultra-deep waters in the Gulf of Mexico. In these large, complicated projects costs per barrel are high. Production at Shell has almost stood still in the past 15 years and BP's first-quarter figures showed production flat at 3.9m barrels of oil equivalent per day. A step change in output at both companies is not expected until 2011 when new but risky projects come on stream. Big oil is also facing lower returns in projects that are already running. Oil-rich nations no longer feel they have to call in one of the large integrated oil companies to exploit natural resources. They can buy expertise in large project management direct from oil-field services companies such as Schlumberger. This puts host governments in a very strong position to demand better terms from production-sharing contracts.

Is ExxonMobil's future running dry? Are we witnessing the death of ExxonMobil ? Strange question to ask with oil above $120 a barrel and ExxonMobil reporting $11 billion in first-quarter profits? Not if you understand that ExxonMobil's management has bet the company. If that bet is wrong, over the next 15 years or so, investors will get to watch the gradual disappearance of ExxonMobil.  In one scenario, the company disappears as a public company, going private by 2018 after buying up all its public stock. In another, the company simply liquidates as it distributes its cash to shareholders until there's nothing left. Far-fetched? Not at all. The warning signs were pasted all over the company's May 1 earnings report. Yes, revenue for the quarter was up 34%, to $117 billion, from the first quarter of 2007. And, yes, net income climbed 17%, to $10.9 billion. But production of oil and natural gas was down almost 6%. All the evidence argues that the company will report lower oil and natural-gas production for all of 2008, even though new projects are scheduled to come on line in the second half of the year. Looking just at oil, the company's production will not grow at all through 2012. But falling production is only part of the problem, the consequence today of a longer-term problem that seems to worsen each year. You see, not only is production likely to stay flat or fall through 2012, but proven oil and gas reserves are declining. Proven oil and gas reserves fell by 3.1% at year-end 2007 from the end of 2006, according to Standard & Poor's. What's going on here? If any oil company in the world should be able to find more oil and natural gas, it's ExxonMobil, with its immense reserves of both engineering skills and cash resources. Today, though, the positions of the Western and national oil companies are reversed. Now the national oil companies control about 80% of the world's proven and probable reserves, and they're keeping the most promising geologies for themselves. As a result, Western oil companies with the cash reserves of an ExxonMobil, a Chevron or a Royal Dutch Shell simply don't have enough places to put their cash to work. Further, that money doesn't go as far as it used to when it comes to finding new reserves. The places Western oil companies can put their money to work are among the world's most hostile environments and most challenging geologies: in Siberia or beneath a mile of water and a mile of salt, for example.

Big Oil's big 'problem' While many Americans struggle to fill their gas tanks, big U.S. oil companies are making so much money that they literally don't know what to do with it. Instead of reinvesting more of their newfound wealth to increase supplies or develop emerging technologies that might one day reduce energy costs, they are giving much of the loot to shareholders already enjoying outsized gains. In a capital-intensive business, giving cash back to shareholders is often the equivalent of throwing in the towel. It's saying "we can't do anything with this money to improve our business." And it certainly doesn't address the oil crunch that consumers pay for every day at the pump.

A family affair The Rockefeller family confronts the board of Exxon Mobil. THE involvement of the Rockefeller family gives added piquancy to one of the two most significant shareholders- versus- board battles of this year's proxy season. Exxon strongly opposes the resolution and has tried to stem growing enthusiasm for it ahead of its annual meeting on May 28th by writing for a second time to shareholders urging them to vote no. Exxon says that its board is better placed than shareholders to determine its leadership structure, and that it wants Rex Tillerson to continue as both chairman and chief executive. The Rockefellers worry that Exxon does not spend enough time analysing risks to the business, such as climate change and the need to replace reserves as countries are becoming more nationalistic about their natural resources.

Posted by dblwyo at 10:47 AM | Permalink | Comments (0)

A major and critical part of the financial frenzies of the last several years have been the LBO buyout and somewhat related buyback booms. As most of us know by now there's been a relative freeze on LBO activity since last summer, at least among the very large/large PE funds. Talking to my friends in the mid-size business that began to show up abruptly around the holidays and, judging from various statistics on mid-size deals, has spread there as well, if not as seriously. Yet at the same time the various PE firms have continued, successfully, to raise enormous amounts of investment dollars. Despite the fact that, if anything, the freeze continues and, if you believe our analysis, is likely to face much worse.

Part of it of course is that buyout funds have, over the years provided unusually good returns and part of it is that there have been few alternatives in this era of low returns...so why not ? And another part, how much we don't know, is that LBO activity, or more correctly Private Equity investing is actually facing several interesting opportunities. Thought not as business as usual. But let's backtrack a bit and start with this chart, slightly dated, of the cycle in buyout fund investments.

You'll have to update it a bit in your minds eye with the '06 and '07 data which was even larger than the illustrated '05. The catch is that buyout investment kept on during YTD for this year as well. As you can see historically there were pronounced cycles in the business accompanied by a general upward trend in the amount of funds raised. A trend that was non-linear. It'll be interesting to see what updated versions of this chart look like when they become available because if the news headlines are right fund raising hasn't busted so far even if investing has.

There's another interesting aspect of this, which is what do you do with the money. With so much of it floating around there was not only an enormous increase in total funds but a lot of new firms and funds got started. Like the Hedge Fund industry though there are also enormous differences in performance. My suspicion is that these historical differences in fund performance and in performance over the years are about to get greatly exaggerated as we find out who's been swimming naked indeed. In the first sub-chart notice that the top firms enormously outperform the rest of the pack. And then bear in mind that all the newbies performance is not yet, and won't be for some time, reflected in those numbers. The second sub-chart suggests that there's also a big difference in performance over time that's worth looking at as well.

 Take a careful look at this chart and notice that the years of great performance are years of significant downturn - that is investments made during '91 and '01 did exceptionally well. Why ? Well largely because they weren't made at extraordinarily high multiples with unusual leverage built into them. All of which is not true this last few years. This time around there were three things that were generally true. 1) Prices (EBITDA multiples) were exceptionally high - most likely as a friend of mine has pointed out historically unique and never to be repeated. 2) Funding was easy and cheap so the levels of leverage in deals was also unusually large - which is about to come back and haunt folks a great deal. And 3) the terms of that borrowing were extraordinarily lenient - what're called "covenant lite" in terms of re-payment, default and other loan terms. Which means a lot of deals got done at too high a price, with too much leverage and assuming that prices would keep going up. Stop me when this all sounds familiar.

Yet in these potential disasters lurks at least a couple of key alternatives. Actually several. First off all that debt is going to generate a lot more distressed debt than in previous cycles and the PE firms are going to be able to pick it up for half price, or perhaps better. Though they'll then face some serious workout problems. Which leads to the second major opportunity for those who kept some dry powder and their heads - as Wilbur Ross has shown in his beginning to buy up mortgage servicing firms. There'll be a lot of companies across many industries who used capital to buyback their own stock, are now leveraged at the beginning of a major downturn AND didn't make the operational improvements they should have with those funds. Judging from the historical cycles illustrated above that suggests that as we move into and thru the downturn, whatever it's length and depth, PE companies who focus on returning to their roots and have the skills and acumen to do so will be doing well in the years ahead.

By return to their roots we mean moving away from financial engineering, though not ignoring or neglecting the benefits of capital re-structuring. And moving toward what's been claimed as the major benefit, capability and strategy of PE firms. Putting in money, re-vamping operations, instilling good management and management practices and in general returing enterprises to high performance status. The firms that can do that in the next few years stand to do very well indeed and ought to be entering a new era. Not a golden one that turned out to be gilt. Rather an "Age of Iron". Look back at the second chart and the huge jump in performance between the top and restof the pack, especially during tough times.

As you go over the readings below you'll find a lot of these various aspects reflected from the section on the Strategic Outlook to indicators of current deals slowing and/or going bad. To my favorite section on the Mid-Markets. Now there's not a lot ever covered in the MSM on the mid-markets. So what you'll read there are the excerpts from various newsletters and seminar announcements which have come to my attention. Which aside from their intrinsic merits also are great indicators of the outlook - and they all are focused, one way or another, on the situation as we've sketched it. Life is about to get interesting indeed for the Private Equity industry. 

Strategic Outlook

Private equity: Year of the vulture While the days of the brainless megabuyout are over (at least for now), private equity has not gone away. It has just retreated. Veteran dealsters say they welcome the current separation of the men from the boys, of the serious players from those who merely surfed on waves of cheap debt but have now wiped out. What's different in private equity now from its last meltdown, in the late 1980s? Answer: It's become part of the landscape in a way that it wasn't 20 years ago. If you get coffee at Dunkin' Donuts, stay at a Hilton, or drive a Chrysler, private equity is part of your life. If your pension fund has money invested in buyouts, these guys' performance will have a say on whether your golden years are spent eating caviar or cat food. Many public-employee pension funds have a piece of buyout action (or soon will), and if they don't make their projected returns, governments will turn to taxpayers to make up the shortfall. So what do smart people do when they're confronted with violent change in the markets? For starters, they're engaging in what we'll call "double cropping," which we'll explain in a minute. Second, they're making grand plans to profit off the next boom by becoming publicly traded companies. That's the same transformation that a previous generation witnessed when a handful of brokerage houses began going public in the 1970s.

Following the Era of Large Buyouts, Private Equity Funds Find New Ways to Compete Now that credit has dried up, the future of large private equity buyouts has become uncertain. Today, buyout firms are looking to compete in middle-market and foreign deals and, in many cases, are teaming up with strategic buyers and corporations in new types of transactions. According to PE firm partners and other industry experts, the economic downturn has also paved the way for a resurgence in distressed investing, as lenders and investors alike begin to adjust to new pricing realities.

• Carlyle Group's David Rubenstein: 'The Greatest Period for Private Equity Is Probably Ahead of Us'

Carlyle Says Game Is Set to Restart Carlyle's David Rubenstein expects more $2 billion to $4 billion deals in coming months as companies begin to adapt to life beyond the era of megabuyouts. Early last year, private-equity firms struck deals that were as large as $45 billion, fueled by easy credit. Later in the year, as credit markets seized up, deal making ground to a halt and some of those buyouts collapsed. Now, as credit markets show signs of thawing, Mr. Rubenstein says, private-equity firms will cast their nets wider and close more deals ranging in value from $2 billion to $4 billion and that require less debt. One example is Carlyle's recent purchase of a majority stake in the U.S. government-consulting business of Booz Allen Hamilton Inc. for $2.54 billion

French Boardrooms Are All Shook Up as Private-Equity Funds End `Beffa Era' Investor activism is shaking up French boardrooms as funds buy stakes in listed companies following a credit shortage that dried up financing for leveraged buyouts. The confrontations are breaking down links between executives and directors who attended the same schools and sat on each other's boards, making managers more accountable. The cozy relationship between companies and the state left France behind the U.S. and the U.K. in adopting shareholder- friendly policies, he said. In the 1980s, 12 of France's top 20 industrial groups and most banks were state-owned. Even after the government sold companies from Saint-Gobain to Renault SA, shareholder protests were rare. A new generation of executives is more receptive to investors, he said. Half the CEOs of companies in the CAC 40 Index, including Lafarge SA's Bruno Lafont, were appointed less than five years ago. Many, such as Schneider Electric SA's Jean- Pascal Tricoire, never held government jobs. Funds such as Los Angeles-based Colony Capital LLC and private-equity firm Eurazeo in Paris have built stakes in four CAC 40 companies, including hotelier Accor SA and retailer Carrefour SA, and are demanding better returns.

Deal Problems

M&A Deals in the Industrial Manufacturing Sector Drop A total of 39 deals (disclosed value at or above $50 million) were announced in the first quarter of 2008, a 17% decline from the 47 deals announced in the first quarter of 2007, according to PricewaterhouseCoopers. Total deal value for industrial manufacturing transactions totaled $7 billion, a 46% decline from the $13 billion announced in the first quarter of 2007 and a 78% decline from the $31 billion announced in the first quarter of 2006. At this rate, projected total deal value for 2008 is set to fall far short of the levels set in 2007 ($88 billion) and 2006 ($92 billion). "A shortage of large industrial manufacturing deals took a toll on deal values during the first quarter of 2008 and will likely impact deal values for the remainder of the year," said Barry Misthal, U.S. industrial manufacturing leader at PricewaterhouseCoopers. "Financial investors are playing a lesser role due to higher risk premiums and a decline in debt market liquidity, and it is unlikely that total and average deal values will rise to previous levels until the financing environment improves."

Bell Canada buyout in trouble Closing the biggest deal ever just got a little more complicated. According to Monday's The New York Times, the banks providing financing in the takeover of Bell Canada parent BCE, are seeking to renegotiate terms of that deal. Providence Equity Partners, Ontario Teachers' Pension Plan and Madison Dearborn are seeking to take BCE private for nearly $52 billion. The reason for the financing snafu? Banks are feeling squeezed because of losses from the subprime crisis, and their stomach for financing leveraged buyouts has diminished from even a year ago, when the Bell Canada sale was brokered. In interviews earlier this month, Providence Equity Partners CEO Jonathan Nelson told Fortune that he expects the banks and other partners to honor their commitments to the deal.Still, Providence has shown a willingness to sue its lenders: Earlier this year it countersued lender Wachovia (WB, Fortune 500) when that bank tried to extract itself from providing financing for a $1 billion buyout of Clear Channel's television group. That deal was separate from the acquisition of Clear Channel's radio stations, a deal that also found itself in litigation as lenders sought to renegotiate terms of the deal. In both Clear Channel (CCU, Fortune 500) cases, the deals ultimately got done. In March Clear Channel's television group and Providence agreed to a reduced price and announced the closing of the deal, and last week Clear Channel lowered its takeover price of its radio assets in order to get the $18 billion transaction financed. Indeed, three of the four lenders involved in the Clear Channel radio buyout are also involved in the BCE buyout, and the street had been speculating for months that those banks would "pull a Clear Channel" on BCE. BCE's buyers, though, seem eager to close on the transaction. It is a deal that is very much in Providence's wheelhouse: A big, national telephone company with strong cash flow. Providence likes these kinds of companies, adding to the likelihood that it is unlikely to let this one get away. ·  Inside a record-breaking $51 billion... More

Owner of Bill Blass Faces Cash Shortage After Acquisition The fast-growing buyout firm that owns the fashion house Bill Blass, the retailer Athlete’s Foot and the ice cream chain MaggieMoo’s appears to be on the verge of collapse.NexCen Brands, a little known firm that owns many high-profile brands, said on Monday that it faced a severe cash squeeze and warned that there is “substantial doubt” that it will remain in business. The company, which dismissed its chief financial officer two months ago, said that its 2007 financial statements could no longer be relied upon and that it was investigating its financial reporting practices. NexCen, which earns revenue from 1,900 franchised stores, said it might try to sell off some, if not all, of its brands. That could put eight chains — including Marble Slab Creamery, Pretzel Time, Pretzelmaker, Great American Cookies, Shoebox New York and Waverly home furnishings — up for grabs. And it could put the future of Bill Blass, an influential clothing label sold at high-end stores like Saks Fifth Avenue, in doubt.

Mid-Market Situation

The Big Picture: the Fate of Leveraged Deals (Capital Roundtable Seminar) Last summer, the credit market drama dealt private-equity mega-deals a losing hand.  But what the credit meltdown has in store for middle-market (LBOs) deals is still something of a mystery.  Even though leveraged deals in the middle-market seem to be holding off the downstream spread of credit upheaval for now, everybody, it seems, is watching for tell-tale cracks in the dam and asking:Is the credit infection spreading? If so, who’s more at risk – equity or debt investors? What new funding opportunities are emerging? Is there another shoe still left to drop? To answer these questions and learn what underlying factors will shape the murky credit markets and deal-making in all parts of the middle market for the remainder of the year and beyond, we invite you to an important new MasterForum -- and cocktail reception -- on Wednesday, July 16, called “the fate of leveraged deal financing,” featuring Ed Altman, Peter DeMaria, and James H.M. SprayregenTheir high-level discussion and lively Q&A session will be moderated by leveraged-finance investment banker John Miscione, himself a former commercial lender and current Managing Director at Duff & Phelps LLC. Come hear how these top minds view the erosion of confidence in the credit markets -- and what they predict will happen next for middle-market buyouts and the larger economy. They’ve given leveraged investing a lot of study -- and their well-considered recommendations for how best to proceed amid hemorrhaging valuations and liquidity demand our attention. And if you’re active in middle-market deals during these volatile times, then you need to hear what these three wise men are saying.

Checks and Balances (Merger Mogul Newsletter)This year, as the credit markets struggle to regain their feet, I imagine it can be pretty difficult for some to smile through the adversity. Nevertheless, I’m still a believer that a good soak can wash the toxins out. In our latest issue of Mergers & Acquisitions Journal, due out in June, Danielle Fugazy wrote the cover story on due diligence. The central theme of the article was that during the hysteria that engulfed the deal market from 2005 to the first half of 2007, buyers were giving short shrift to their homework. It’s not that they didn’t want to perform due diligence, it’s just that the pace of the market didn’t allow for it. The sell-side advisers pushed the PE firms, who pushed the lenders, who pushed someone else, until nobody knew even who was pushing whom. If anyone even thought to push back, someone else would step in to take their place in the daisy chain of “investors” unwilling to say no. Today, however, everyone seems to be pushing back – buyers, sellers, lenders, advisers, consultants, you name it. I’d argue that even us reporters are asking more of the right questions lately. On one hand, the collective pushback probably makes dealmakers feel even more squeezed in an already tight market. But these are the checks and balances that are necessary to truly thrive. Experienced buyers often tell me that their best deals were made during the last economic downturn at the beginning of the decade. While some of that success had to do with buying low and selling at the high end of a cycle, one has to believe that the increased focus on due diligence, and perhaps the fear of doing a bad transaction, played just as important a role.

Post-Crunch M&A (Merger Mogul Newsletter) No matter how challenging the deal market becomes, it’s a sure bet there will be folks, funds and firms who find ways to benefit from the down cycle. (In fact, you can hear from some of them at our June event on Post-Crunch M&A.) Restructuring firms are chief on the list of beneficiaries, since economic slowdowns tend to expand their pool of potential clients. Talk to firms like Alvarez & Marsal and FTI Consulting, and they’ll tell you they have more clients than they can handle these days, which is a problem most of us would love to have. Among the list of not-so obvious beneficiaries—at least within the mid-market—are private equity firms willing to increase their equity contributions. History has shown, and conventional wisdom would support that firms who are willing to invest in down cycles generally come out of those cycles in better shape than counterparts who sit on the sidelines. Of course, it’s tough to know how long the current downturn will last, but a financial buyer who buys now and can afford to be patient has a good shot at turning a big profit a few years down the road. Small companies who price their assets to sell should also do well in the current market. My numerous talks with small market participants at the recent ACG InterGrowth conference only confirmed what most people had been telling me leading up to the event: The smaller the deal, the less impacted it is by Scrooge-like lenders. Another thing helping small deals is the creep down market by mid-market buyers who can’t get bigger deals done as easily anymore but still need to put money to work.But without question, getting deals done post-credit crunch is no easy task. Due diligence is going the way of the tortoise, limited partners are asking more questions of their GPs, and even some strategic buyers are more gun-shy, wondering how long the current downturn with last. Meanwhile, anyone who bought a company before Fall 2007 is now dealing with a new set of rules, forecasts and expectations. PE buyers have to determine whether to invest in their companies, stay ultra-lean until the downturn is over or, despite the blow to ego, cut their losses. More than deal sourcing, portfolio management is arguably the most important skill of any M&A buyer. Only those who can manage effectively through the current storm will circumvent the crunch.

Creating Value in PE Portfolio Companies – Strategies for Catalyzing Operational Success (Capital Roundtable) Facing greater competition and limited financing, private equity investors recognize that gone are the days when they could achieve good returns just by buying low, leveraging up, and selling high. Busy GPs who used to “pinch hit” between deals by helping improve portfolio company performance are seeing that this work takes a specialized skill set, quite different from what it takes to source and finance a deal. So today, some GPs are themselves becoming deeply enmeshed in portfolio company operations, while others are relying  on the services of “hired gun” consultants – or increasingly are developing in-house operations teams.  As a result, to differentiate their firms in today’s competitive and recessionary markets, many GPs have entered an operational “arms race,” struggling to develop or access capabilities to enhance the performance of their investments.  If you’re interested in comparing notes on these trends with 20 of your peers who are testing out different operational strategies, then please join us for The Capital Roundtable’s first MasterClass on “Creating Value in P.E. Portfolio Companies,” being held Wednesday, May 21, in midtown Manhattan. Come see how some of the best-managed private equity firms are -- …conducting rigorous pre-investment operational assessment and planning… achieving 360° company and sector awareness…analyzing executive talents needed to manage and coach portfolio companies …pushing their companies’ management outside of their comfort zones to boost returns

Posted by dblwyo at 01:06 PM | Permalink | Comments (0)

Let's keep cranking on trying to take apart the current situation and strategic outlook for the Finance Industry. But first we should note that BM stands for "Business Model". Not what you thought it stood for but, nontheless, the pun was intended. And gets to the heart of our argument - which is that the business models of key sectors of the Finance Industry are flawed to badly broken, and we believe that many of the readings support that. The extent of the breakage depends on the sector but those which depended on leveraged trading and investment are most exposed for multiple reasons which are discussed below. Those closer to traditional banking and finance practices have lots of room to improve but equally a good dose of sound business practice, a little innovation and an increased focus on marketing and customer service would go a long way. If you are a stakeholder in any of these you need to walk thru the blueprint and use it as a checklist for assessing their statii and outlook.

The chart at right will be no surprise of course. It shows the Industry as a whole (XLF), the Broker-Dealers (IAI), the Insurance sub-industry (IAK) and Regional Banks (IAT). If you buy the arguments of the last three posts (Market, Economy, Finance I) we've had a bull rally with terrible misjudgments on valuations and earnings outlooks with a weakening economy which has yet to tip over into a real downturn. Consumer demand has been weakening in any case, and that was before factoring in the implicit tax of energy and food costs surges, which would feedback destructively to hiring and investment spending (per the normal causal linkages). And as a result we were about to see many more boulders topple into the credit pond with a series of feedback loops between deteriorating economics and worsening delinquencies. Net net the question would therefore be how much farther on that chart - over and above where we think the markets are going ?

Well we could let you just skim the readings excerpts and reach your own interpretations. Which we urge you to do. BUT...we'd also like to testfly the framework we deployed against our strategic evaluation of Citi as a way of thinking about the industry as a whole. Both because we think the general enterprise framework works and because the work that Pandit and his team have done strikes us as capturing 80-90% of the total industry situation (excluding the Insurance industry of course). (Poster-child II: Citi's Potential Turn-around as Performance Examplar) You'll find the readings below collected in various takes on the Strategic Outlook, specific companies (including one that shows AIG's writeoffs and capital raising changing radically in a week as well as UBS's huge discounted rights offering...shocking though nobody appeared shocked...numbness setting in all over ?). The final section gets to the heart of the matter by providing various readings on thinking about the futures of the industry...that is does their business model and strategies still work, if they ever did ? 

Based on those readings, all the prior posts which basically dealth with the same question and the strategic assessments in Citi's presentation we end up with the graphic at right. After two decades of innovation in the '70s and '80s which provided tremendous value-add and new services for consumers and business the industry shifted its' emphasis to leverage, complex products and trading on its' own account. That worked, apparently, since the mid-90s til last year. And then broke badly despite bringing us an unprecedented series of booms and busts for the same underlying structural reasons.

Now we're in a regime where de-leveraging will be the dominant macro-environmental theme and as a result capital requirements will be raised, explicitly by regulation or implicitly by investment returns. So instead of being able to reap the profits from being leveraged 30x, or 40x or 70x the banks, brokers/dealers are entering an era where they'll have to return to fundamentals. Hence our judgements in the various shade of warning indicators as to whether the business models of the last decade are sustainable going forward.

We could argue thru each sector individually and then discuss each of the major players but won't - though we do think this is the kind of evaluation any employee, investor or stakeholder needs to do for each and every one of them. What we will assert though is that these fundamental re-thinkings aren't widely recognized, acknowledged or accepted though several key commentators have made similar observations. And this kind of re-thinking is clearly implicit in Citi's new strategic framework. So apply the Buffett test - which of these are businesses you'd want to own a piece of as businessess ? Our answer - not many until these re-structurings are begun. On the other hand as Rubenstein, Buffett, Jubak, et.al. are pointing out there will be lots of gems to be sorted from the rubble. Once the rubble all falls down...which point we are IOHO a long way from. 

Strategic Outlook

De-leveraging dilemma Investment banks like Goldman, Lehman Brothers and Morgan borrowed more and more money in recent years and used that to accumulate assets. That left the firms leveraged more than 30 times at the end of 2007, a record, analyst Michael Hecht noted. But the mortgage-fueled credit crunch is now forcing investment banks to sell assets and cut borrowing, in a de-leveraging process that Hecht thinks has only just begun. If investment banks cut leverage to 20 times, down from 30, that would slash return on equity in the industry by 24%. Return on equity, or ROE, is a closely watched measure of how efficiently companies use the money they get from shareholders. Lehman could be the worst hit, suffering a 55% slump in ROE in Hecht's de-leveraging scenario. Goldman and Merrill would see the smallest declines in ROE, the analyst added. Reducing leveraged to 20 times from 30 may also slash net income in the industry by 27% and imply an 11% reduction in total assets. That's a reduction of more than $370 billion in assets across Wall Street, something that "would undoubtedly put some pressure on asset prices," Hecht warned.

• Wall St. Compensation Disaster? All of Wall Street has to prepare for a compensation disaster that will make Citis layoffs and pay cuts look like small change, according to CNBCs Charlie Gasparino.
• Brokerages Under Fire  Cutting rates on a few financials, with Dick Bove, Ladenburg Thalmann and Co analyst and CNBCs Carl Quintanilla

 Plastic's Uncertain Future A growing feeling that stand-alone credit-card lenders will weather the economic slowdown has started to lift shares in firms like American Express Co., Discover Financial Services and Capital One Financial Corp. But recent credit-card data indicate that none of the big card companies -- including the large card units at banks like Bank of America Corp., Citigroup Inc. and J.P. Morgan Chase & Co. -- are in the clear. Rising defaults could weigh on earnings for longer than expected. But two key data points indicate defaults climbing higher, not falling fast. First, card borrowers are starting to pay back less of their outstanding balances each month. Analysts at Oppenheimer & Co. say that a sustained decline in the amount borrowers repay each month, compared with a year-earlier, can be a leading indicator that borrowers will start to fall behind on payments. Also worrisome are data from Moody's suggesting that borrowers are finding it harder to become current on credit-card loans once they fall behind. The ratings firm notes that the amount of loans on which borrowers have skipped three or more payments has started to rise more quickly than loans that have missed one or two. Once borrowers are three payments behind, fewer of them ever catch up.

Investors see one Wall St., while bankers and brokers see another Investors see sunshine; bankers, rain. No one seems to be on the same page. Or are they? In this case, the diverging opinions of the industry and the investors who stake their fortunes on it aren't mutually exclusive. The idea that Wall Street -- or any industry, for that matter -- can get leaner and meaner when business slows isn't radical thinking. Banks and brokerages operate in a cyclical business. Things will turn around. Investors may be wise to buy when prices are relatively low. The issue, then, isn't if profits will return to the industry, but when. And here's where the two sides diverge. Wall Street is bracing for a long slumber, and investors think a rebound is already here. Unfortunately, there's ample evidence that the Street has this one right. Since first-quarter earnings hit in March, there's been little to suggest a turnaround is imminent. Jamie Dimon, J.P. Morgan's chief executive and the last banker standing without foreign ownership or diluted shareholders, has been among the most pessimistic when it comes to forecasts.

UBS's Magnus Sees `Long Way to Go' for Recovery of Banks May 23 (Bloomberg) -- George Magnus, senior economic advisor at UBS, talks with Bloomberg's Naga Munchetty in London about inflation risks in the global economy, interest rates in the U.S., U.K. and Europe and the outlook for banks recovering from the credit crisis. The world's biggest financial companies have posted at least $383 billion in writedowns and credit losses since the start of last year after the subprime mortgage market collapsed. The resulting economic slowdown has prompted the Fed to lower its benchmark rate 3.25 percentage points since September to 2 percent.

Posted by dblwyo at 10:04 AM | Permalink | Comments (0)

The prior two posts were our weekly surveys of Market and Economic information. We'll grant that typical blog practice is one/two clip(s) per post but we think something is served by collecting and categorizing them so that the patterns and implications are clearer. At least it works for us. We mention that by way of pro forma apologia for the infodensity, there and now. Because that econ/mkt information is only mildly interesting to us for its' own sake. What we think is even more important is the implications for business performance...industries...companies and you. Which is also by way of suggesting that with those two in mind it's really time to roll it forward and look at the consequences....which are, IOHO, pretty dire. Before rolling on we'd like to suggest a few minutes spent listening to Dave Wessel on CNBC will help set the table:Econ-Recon Mission  Perspectives on the economy, with David Wessel, The Wall Street Journal economics editor.

Here we'll focus on the implications for the Finance Industry...at least in part. Consider the graphic at right where we've down our best to capture what we think is going on. Though admittedly I'm not a finance industry expert we've all had to learn more about that arcane and mysterious industry in the last year than we ever wanted (btw do you realize we're over a year on the first small canary the Shanghai Surprise and the big one - the first BSC disasters ? Think about those as warning sigils in light of this arm-waving).

What we've tried to capture is the impact of the credit crisis so-called and how it's rippled thru the system and what's likely to still happen. So what we've seen so far is bad loans (1) moving up the chain of leveraged links to create ripples (2) and breakdowns across many different credit markets. That almost brought the whole house of cards down. Those losses led to massive writedowns and P&L losses (3) which severely damaged almost all the players in the Finance Industry. The catch on that set of loops is that sub-prime problems aren't thru and we have a whole host of other sources, e.g. ARM resets, HELOCs, etc. which are also turning bad; which'll keep that loop going. It's that metastasis of the credit contagion that folks like Whitney are warning about. Consider this the revenge of the "Rocks-in-the-Ponds" model.

The real on-going problem likes in the deteriorating general economic conditions which will lead to to additional credit tightening (4) and asset deteroriorations (5). In fact as we enter a "normal" cyclic downturn all the host of standard consumer and business loans (6) are now qued up to go thru a similar decline. And there impacts on things are not even factored in because everybody knows "the worst is over", right ? So as you skim the readings below please keep in mind that the real reason to make you wade thru the Market and Economy readings was to frame the context of what's going to happen to the Finance Industry as these cycles kick into high-gear. 

UPDATES (5/22): Two other major data points on rising delinquencies and on leveraged loans have been added to the readings. 

Barbarians at the vault BANKS have endured a brutal nine months since credit markets froze in August. Losses and write-downs already total $335 billion; many of their best businesses have disappeared. In developed economies, almost all banks are facing economic and regulatory headwinds that will cut revenues and jobs. Yet the biggest danger facing Western finance is not a fall in its earning power but a loss of faith in how it works. Two criticisms assail the industry, one based on fairness and the other on efficiency. The first argues that finance is rigged to enrich bankers, rather than their customers, shareholders or the economy at large. Some worry about the way bonuses are calculated; others about moral hazard. Bankers will take wild bets because they know they will be bailed out by the taxpayer. Look at Bear Stearns or Northern Rock. The second, deeper question is whether a market-based approach to finance is efficient. Some Chinese officials claim the Western system has been shown up by the crisis (see article). This week Germany's president demanded that the “monster” of financial markets “be put back in its place”: bankers had caused a “massive destruction of assets”. The critics do not lack ammunition. The lapses in credit-underwriting in the subprime-mortgage market hardly reflect a wise allocation of capital. The opacity of the shadow banking system and the mind-boggling complexity of those toxic asset-backed products have raised doubts about the discipline of the market. Economist Special Report on International Banking…breakdowns, problems, regulation and futures. (***)

Ken Griffin, and Thoughts on Fixing Wall Street Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.” The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price. But the answer is simple, in his view. The entire industry needs to overhaul its thinking and, believe it or not, perhaps even accept greater regulation. He is upset that the investment bank Bear Stearns ran aground. He is annoyed at the big-name chief executives who took too much risk and then watched as billions of dollars of value vanished from balance sheets. He is anxious about high-priced finance jobs moving abroad. And he is particularly galled with regulators in Washington who have overseen what he calls “the great depression on Wall Street.” But Mr. Griffin isn’t just a serial complainer. He has thought about solutions. First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said. It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.

• Hedge Fund Headwinds Hedge funds are hurt by the credit crunch and under pressure in Washington, with Richard Baker, Managed Funds Association president/CEO and CNBCs Carl Quintanilla

Rubenstein Says `Enormous' Bank Losses Unrecognized U.S. and European banks and financial institutions have ``enormous losses'' from bad loans they haven't yet recognized and may have a harder time wooing sovereign-fund rescuers, Carlyle Group Chairman David Rubenstein said. ``Based on information I see,'' it will take at least a year before all losses are realized, and some financial institutions may fail, Rubenstein said at a breakfast meeting of the Institute for Education Public Policy Roundtable in Washington. He didn't name any companies. Rubenstein said sovereign wealth funds are becoming wary after losing $25 billion on their investments in struggling banks and securities firms worldwide. Financial institutions worldwide have recorded $329.2 billion in credit losses and writedowns and raised $246.6 billion in capital since the beginning of 2007. Rubenstein said about $60 billion of that capital was provided by sovereign funds last fall, and their investments today are worth about $35 billion. On April 28 at a conference in Baltimore, Rubenstein said financial institutions and financial assets are ``the single greatest investment opportunities'' in the U.S. and ``a lot of private-equity firms like ours are going to try to make investments in these firms.'' Sovereign wealth funds and private-equity firms typically have different investment goals. Sovereign funds usually buy a minority stake in a quest for share-price appreciation, while private-equity firms often assume an ownership role and try to rebuild distressed companies. Rubenstein said today that the industry and broader economy aren't likely to turn around until early next year. The economy's troubles, compounded with tighter lending standards, have brought the leveraged-buyout industry to a standstill, he said. There are fewer buying opportunities because many owners of companies have an inflated and irrational sense of their property's