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July 30, 2009

More Darkside Earnings Tales: Banks,Goldman und Unsinn

The last two posts tried to keep hammering what are the underlying realities behind the headlines - first on the economy and then on corporate earnings. Now it's time to go the dark side and talk about bank earnings, particularly Goldman-Sachs. The central message is that you have to look beneath the surface and make a real effort to understand what's going on - in a phrase, 'where's the beef?' !!! On the economic front, despite all the hoopla and hype, all we've done is stop cliff-diving not begin a recovery. Yesterday's Durable Goods Orders and the reporting are perfect illustrations but we aren't going to reproduce a chart that looks like everything else we've already talked about. (Realities vs Rhetorics: Economy, Policy, Real Data) For the record the latest YoY changes in DG and x-Aircraft, as well as Industrial Production, are here (click to view). Similarly the better than expected earnings were not the result of better performance but continued cost cutting and beating significantly "managed down" expectations. Earnings are terrible and revenue charts look like the economic data. (Earnings vs Growth: Cutting for Growth? Real Business Performance) Now it's time to talk about banks and their even more badly distorted earnings, particularly GS's. The bottomline is that everything we talked about in our previous assessment of the Industry was born out and the banks made money only on trading. The banks, i.e. GS, that traded more made more. The question is how did they make it besides that ? Other than the obvious strategic implications this matters because a market that was headed down all of sudden boomed on the back of those "amazing" bank earnings. You can see how the markets ran up over the last two weeks in this chart of the SPX.

Bank Earnings and Outlook

Another fairly recent post (Beyond the CRE "Bombshell": Real Stress Testing for Finance) tried to anticipate, partly and partially successfully, the reports by looking at the realities of the challenges that still face the Industry. When you look at either the Industry as a whole or any particular company you have to ask how they did in any line of business. We've applied our business performance framework to the functions that each bank needs to perform (click to view chart) and also to evaluating the strategic context, shown in this graphic.

With the economy still in terrible shape, with defaults, foreclosures and bad debt likely to continue to rise the traditional, "normal" lines of business will continue to be seriously challenged. That is consumer lending, business finance and credit cards will continue to see escalating pressures for the next several years. Wealth management will only hold its own as the markets perform and the industry re-thinks its products, services and customer relationship management. What brought down the house in the last 18 months and, literally, almost collapsed Western Civilization, was trading - either for own account or clients. One could argue that in a brilliant recovery banks turned the performance indicator green this time around. And as a result those that, like GS, were all about trading did well while those like C or BAC that are more about tradition did relatively poorly and face increased challenges. Just as a "minor" sidebar one contributing factor to alleged profits was reducing provisions for losses; if we're right that's going to come back to haunt them. So what did work and why ?

GS, the Gov't Put and Dancing with the Music

As you can see in this chart it was trading profits that drove GS's "exemplary" performance. One of the maneuvers that GS performed last fall as it was on the verge of implosion (bet you didn't know that, did you ? See the readings for proof.) was converting itself to a bank-holding company. That meant it had to start reporting and the UL corner tells us that they put more Value at Risk (VAR) than anybody else and even increased their own position. Furthermore GS is far and away the biggest player in derivatives.

Becoming a bank holding company was more than a maneuver - it meant GS had and has access to gov't subsidized low-interest funds. Now the purpose of all the bailouts and Fed special instruments is to get credit flowing again. If you check this chart you'll find out that the credit markets are self-repairing in the sense that interest rates are re-stabilizing and normalizing, which great news. But credit markets are still tight, i.e. that money is NOT flowing into the economy. What did happen is that the "Too Big to Fail" syndrome created the same kind of gov't put (an implicit guarantee) that FNM/FRE used to have, that failures reduced competition, that low interest money created subsidized funding and so on and so forth. All that means that essentially the nimble-feet made some brilliant tactical ploys to take advantage of unique circumstances on the taxpayers nickles without doing anything much to help out the rest of us. Those GS bonuses are being funded by you !

More than any other "bank" GS engages in proprietary trading - they are in effect, front-running their customers. By making markets and trading for so many clients they have more information than anybody on market trends and conditions and have actually been known to trade against the interests of their clients for their own advantage. So not only did GS make all its money on trading, not only did they double down or better using public resources but the can be said, arguably, to be acting against the fiduciary interests of their clients, the public and society. Tactical brilliance ? Surely. Strategic good sense - we don't think so. Just the opposite. Sustainable long-term ? Not in and off itself and l.t. profitability requires the assumption that as things continue to be in turmoil that GS will keep dancing with the new music, successfully every time. Given their track records it's possible but given they almost failed last Fall from getting off beat and missing some steps the question is, is it likely ?

What this pair of charts show us is that Mr. Market is not stupid in the long-run. He has figured out that GS is neither an investment bank or other standard financial firm. It is a giant risk-trading machine, otherwise known as a hedge fund.

Here the People Sing: the Simmering Backlash

The financial crisis made almost everybody from me to you to Bernanke tremendously angry. It was almost pitchforks and torches time; in fact we're sympathetic to the argument that it should have been. Now the firestorm that was is not going away. A few weeks ago we were at a conference for directors and consultants for medium sized business to talk about risk management, corporate governance and managing for performance. This was, in other words, a bunch of seasoned, experienced and mature adults. Nonetheless the second session got sidetracked and almost completely hi-jacked by a question on violations of the public trust which led to the whole audience jumping on the band wagon. Put another way a bunch of mature and responsible adults who are very informed about business and finance was and is so angry they're still stock-piling flammables. That potential firestorm hasn't gone away - it's just been temporarily banked.

A while back we started a whole series on performance, governance and social responsiblity and have since collected the entire set of postings in a single PDF files which we urge you to read (it's downloadable btw). Profit, Performance and Social Responsibility. Meanwhile Barney Frank made a recent major speech announcing that a) he anticipates completing a complete overhaul of the regulatory framework this Fall. At the same time Congress has charted a new "Pecora" commission. The original was the one charted to investigate the causes of the Great Depression and the shennanigans it documented led to the regulatory regimes we have now. We can anticipate something of equal or greater magnitude as the result of the new commission...and GS's malfeasant exploitation of public support for its own advantage just added fuel to the fire. Now be nimble in that guys because they're going to take away the punch bowl AND the party !


Bank Earnings in Context

Taylor Says Bernanke Gets Rate Rule Right While Goldman Doesn't Understand  Economists from Goldman Sachs Group Inc., Macroeconomic Advisers LLC, Deutsche Bank Securities Inc. and even the San Francisco Federal Reserve Bank argue the Taylor Rule, a pointer for finding the correct level for interest rates, suggests the Fed should be doing a lot more to stimulate the economy. Taylor said his measure shows just the opposite: that Fed policy is appropriate, that central bankers are right to be considering how to withdraw their unprecedented monetary stimulus and that critics who say otherwise are misinterpreting his rule. The formula is designed to show the best rate for spurring growth without stoking inflation. Those figures suggest the federal funds rate target should actually be negative 0.955 percent. Since the Fed can’t lower rates to less than zero, the Taylor rule means the central bank has to pump money into the economy through other methods, such as purchases of Treasuries, mortgage securities and agency bonds. That’s exactly what the Fed under Bernanke has been doing, more than doubling assets on its balance sheet to $2 trillion. The debate among economists is whether they’ve done enough to meet the Taylor formula. Macroeconomic Advisers said its growth and inflation forecasts for the coming year show the Fed should be aiming for the equivalent of a negative 4 percent federal funds rate under the Taylor rule. “What’s been done so far is not enough to get the economy back to any reasonable growth rate,” said Laurence Meyer, 65, a former Fed governor who is vice chairman of Macroeconomic Advisers. “You need to use your balance-sheet policies sufficiently aggressively to replicate the effect you would have had if you pushed the funds rate down to negative numbers.”

Bankers Bet Jobs on a Roaring V-Shaped Recovery The country’s biggest banks are doubling down on a bet that the economy will improve in the latter half of the year. If they’re wrong, and borrowers don’t pull out of a tailspin, bankers and their investors will take a beating. That’s because banks will have to rebuild diminishing reserves that they set aside for soured loans, which results in charges that lower profit. Signs that big banks are hoping to draw the equivalent of an inside straight on an economic rebound emerged in second- quarter results. Figures from the country’s seven largest commercial banks by assets, including banks like Wells Fargo & Co. and Bank of America Corp., show they went easy on increasing loan-loss reserves in the quarter. That followed a similarly light buildup in the first quarter. Such moves help bolster bank profits. If loan losses slow during the next six months because, say unemployment levels off and housing stabilizes, banks will win big with this bet. They will have pumped up profit today while allocating sufficient reserves for the rest of the year. At some point in every economic cycle, wagers like these pay off for banks as loan losses peak and provision charges ebb. Timing is everything, though, and there are reasons to worry banks are making their recovery play too early. Plus, commercial real estate loans are a growing threat. U.S. commercial property prices have declined 35 percent since their peak, Moody’s Investors Service said in a recent report, while Federal Reserve Chairman Ben Bernanke warned Congress this week that defaults in this sector may pose a “difficult” challenge for the economy. Meanwhile, banks’ credit losses aren’t showing signs of slowing. Wells isn’t alone in dragging its feet on bulking up reserves. Of the seven biggest banks by total assets, all but Citigroup Inc. saw the growth of nonperforming assets -- mostly loans likely to result in a loss -- grow at a quicker pace than the increase in the bank’s loan-loss reserve, according to my calculations. Additionally, all the banks except Citigroup saw reserves as a percentage of assets fall in the second quarter. Citigroup’s reserves increased to 128 percent of nonperforming assets compared with 119 percent in the first quarter.

Accountants Gain Courage to Stand Up to Bankers Turns out America’s accounting poobahs have some fight in them after all.Call them crazy, or maybe just brave. The Financial Accounting Standards Board is girding for another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out swinging. It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance companies could keep long-term losses from crummy debt securities off their income statements. Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month. The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan. This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values. The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.

Bank profits not as impressive as they seem The big banks are making big money again, but they won't be back to health as long as they have to deal with a recession and customers defaulting on mortgages and credit cards. The impressive numbers included a $3 billion second-quarter profit announced Friday by Citigroup and $2.4 billion for Bank of America. They followed similarly robust earnings for Goldman Sachs and JPMorgan Chase. That the banks managed to turn a profit at all is remarkable. Just 10 months ago, many of them looked to be on the verge of collapse. The stock market staged a huge rally this week, driven by the signs of health in banking. But Bank of America CEO Ken Lewis had some sobering words during a conference call with Wall Street analysts after his company's results were released Friday: "Profitability in the second half of the year will be much tougher than the first half." Bank of America Corp., JPMorgan Chase & Co. and Goldman Sachs Group Inc. earned profits this spring largely on investment banking and trading -- not traditional banking businesses, which still look shaky. Citi benefited from selling its majority stake in the Smith Barney brokerage. Strip away those money-makers, and the banks have to rely on customers who are losing their jobs or earning less money. The banks will suffer as long as their customers do.

GS as Exemplar

What Is Goldman Sachs? Recall that in Q4 2008 brokerage firms (Goldman Sachs, Morgan Stanley) and finance companies (CIT, GMAC) were given permission to convert into commercial banks. They did this to get access to better sources of funding during the dark days last fall. Now that Goldman Sachs is a commercial bank comes a new set of public reporting requirements. One of these public reports is linked above, and below is a series of charts and tables from this report. The first chart shows total credit exposure to risk-based capital for the five largest commercial banks. Below the chart is a table showing the the underlying data. Goldman Sachs is among the five largest commercial banks. Regarding their credit exposure to capital relative to their peers, we believe the technical term is “wow!” The next chart shows quarterly trading revenue at the top five banks. Notice the blue bar under Goldman Sachs, it is their Q1 2009 results. Trading revenue accounted for 69% of gross revenue. No other large bank is even close to having trading be this large a part of their gross revenue. Combined with the charts above and we can see that Goldman’s revenues primarily come from credit trading. What happened to investment banking? The charts note two different dates. The first is February 8, 2007, the date we believe the credit crisis began [11] (the date HSBC, or “patient zero”, restated 2006 earnings because of subprime losses). The second date is September 5, 2008. This was the day Fannie Mae and Freddie Mac were placed in conservatorship and a week before Lehman Brothers failed. Since February 7, 2008 both Goldman’s stock and the bank index has been highly correlated to credit. Neither was highly correlated before this date. Since September 5, 2008 Goldman’s relationship to credit held, but the bank index’ relationship has begun to diverge. So, in answering the question, “do stock traders understand that Goldman is essentially a large credit protfolio”, these charts suggest the answer is “yes.”

Shining Results Aren't Solid Gold Only months after the government rescued Wall Street, risk is back in fashion. Or at least it is on Broad Street, home to Goldman Sachs Group. As investors expected, the firm Tuesday reported blowout second-quarter profits. The secret? Putting risk capital to work as markets revived. Goldman reported net income of $2.7 billion on record net revenue of $13.8 billion. The stellar results raise two big questions: Are they sustainable for Goldman? And do they suggest the broader financial system is on the mend? On the first, Goldman recognized early that sentiment was changing. It didn't shrink from using its balance sheet to make markets for clients stampeding back into recovering markets. And Goldman appears to have booked solid proprietary-trading profits alongside increased client activity. Full marks for timing. More-cautious rivals may have lost out on a possibly fleeting period of hefty profits. But Goldman swung for the fences to post these second-quarter numbers, judging by its value-at-risk -- an industry risk measure that estimates the one-day loss on trading positions in certain adverse conditions. Granted, VaR is an imperfect and narrow measure. It gave no warning of the huge recent losses at banks. It is hard to reconcile across firms. And Goldman has higher capital buffers today to absorb potential losses. Even so, the big gap between Goldman's latest VaR and first-quarter numbers from other firms is raising eyebrows. In the second quarter, Goldman's VaR climbed to $245 million, its highest quarterly level since the firm went public in 1999. At Morgan Stanley, VaR was $142 million in the first quarter, while J.P. Morgan Chase's trading VaR was $190 million. Goldman's first-quarter figure also was higher at $240 million. Embracing risk could keep working for Goldman if market conditions continue to improve or, at least, stabilize. However, Goldman increased VaR the most in equities. And stock markets have weakened so far this quarter, notes Michael Hecht at JMP Securities. In addition, credit markets could easily swoon again, especially if massive government programs aimed at shoring up bond prices lose their impact.

A Tale of Two Bailouts Goldman will surely deny that its risk-taking is subsidized by the taxpayer -- but then so did Fannie Mae and Freddie Mac, right up to the bitter end. An implicit government guarantee is only free until it's not, and when the bill comes due it tends to be huge. So for the moment, Goldman Sachs -- or should we say Goldie Mac? -- enjoys the best of both worlds: outsize profits for its traders and shareholders and a taxpayer backstop should anything go wrong. We like profits as much as the next capitalist. But when those profits are supported by government guarantees or insured deposits, taxpayers have a special interest in how the companies conduct their business. Ideally we would shed those implicit guarantees altogether, along with the very notion of too big to fail. But that is all but impossible now and for the foreseeable future. Even if the Obama Administration and Fed were to declare with one voice that banks such as Goldman were on their own, no one would believe it.

Industry Futures

Two Giants Emerge From Wall Street Ruins A new order is emerging on Wall Street after the worst crisis since the Great Depression — one in which just a couple of victors are starting to tower over the handful of financial titans that used to dominate the industry. On Thursday, JPMorgan Chase became the latest big bank to announce stellar second-quarter earnings. Its $2.7 billion profit, after record gains for Goldman Sachs, underscores how the government’s effort to halt a collapse has also set the stage for a narrowing concentration of financial power. “One theme here is that Goldman Sachs and JPMorgan really have emerged as the winners, as the last of the survivors,” said Robert Reich, a professor at the University of California, Berkeley, who was secretary of labor in the Clinton administration. Both banks now stand astride post-bailout Wall Street, having benefited from billions of dollars in taxpayer support and cheap government financing to climb over banks that continue to struggle. They are capitalizing on the turmoil in financial markets and their rivals’ weakness to pull in billions in trading profits. For the most part, the worst of the financial crisis seems to be over. Yet other large banks, including Citigroup and Bank of America, are still struggling to return to health. Both are expected to report a more profitable quarter on Friday, but a spate of management changes and looming losses from credit cards and commercial real estate have thwarted a stronger recovery. And then there are the legions of regional and small banks that are falling in greater numbers across the country. While many have racked up large losses, they stand to bleed more red ink if the recession wears on. Fifty-three have failed this year, and the Federal Deposit Insurance Corporation is girding for scores to follow. Uncertainties over the economy mean that Goldman and JPMorgan may be enjoying a fragile dominance, industry experts said. JPMorgan reported big declines in its consumer business on Thursday, and it has set aside more than $30 billion to cover future losses from surging credit card charge-offs and mortgage and home equity losses. “Nobody is through this until unemployment turns around,” said Moshe Orenbuch, a Credit Suisse banking analyst. And if regulation being considered in Washington is passed, banks would face new limits on the amount of their own capital they may trade. That could limit the profits that banks like Goldman and JPMorgan make from their trading businesses, and level the playing field, experts say.

The real price of Goldman’s giganto-profits So what’s wrong with Goldman posting $3.44 billion in second-quarter profits, what’s wrong with the company so far earmarking $11.4 billion in compensation for its employees? What’s wrong is that this is not free-market earnings but an almost pure state subsidy. Last year, when Hank Paulson told us all that the planet would explode if we didn’t fork over a gazillion dollars to Wall Street immediately, the entire rationale not only for TARP but for the whole galaxy of lesser-known state crutches and safety nets quietly ushered in later on was that Wall Street, once rescued, would pump money back into the economy, create jobs, and initiate a widespread recovery. This, we were told, was the reason we needed to pilfer massive amounts of middle-class tax revenue and hand it over to the same guys who had just blown up the financial world. We’d save their asses, they’d save ours. That was the deal. It turned out not to happen that way. We constructed this massive bailout infrastructure, and instead of pumping that free money back into the economy, the banks instead simply hoarded it and ate it on the spot, converting it into bonuses. So what does this Goldman profit number mean? This is the final evidence that the bailouts were a political decision to use the power of the state to redirect society’s resources upward, on a grand scale. It was a selective rescue of a small group of chortling jerks who must be laughing all the way to the Hamptons every weekend about how they fleeced all of us at the very moment the game should have been up for all of them. Now, the counter to this charge is, well, hey, they made that money fair and square, legally, how can you blame them? They’re just really smart!Bullshit. One of the most hilarious lies that has been spread about Goldman of late is that, since it repaid its TARP money, it’s now free and clear of any obligation to the government - as if that was the only handout Goldman got in the last year. Goldman last year made your average AFDC mom on food stamps look like an entrepreneur. Here’s a brief list of all the state aid that is hiding behind that $3.44 billion number they announced the other day. In no particular order: Taken altogether, what all of this means is that Goldman’s profit announcement is a giant “fuck you” to the rest of the country. It is a statement of supreme privilege, an announcement that it feels no shame in taking subsidies and funneling them directly into their pockets, and moreover feels no fear of any public response. It knows that it’s untouchable and it’s not going to change its behavior for anyone. And it doesn’t matter who knows it. There are going to be some people who say that some of this stuff isn’t government subsidy so much as ordinary government contracting. After all, do we criticize Boeing for making airplanes or Electric Boat for making submarines during a war? If we don’t do that, then why should we be pissed about Goldman making a profit underwriting TARP repayment stock issuances, or Treasuries?The difference is that Boeing and Electric Boat didn’t start the war. But these guys on Wall Street causesd this crisis, and now they’re raking in money on the infrastructure their buddies in government have devised to bail them out. It’s a self-fulfilling cycle — beautiful, in a way, but at the same time sort of uniquely disgusting. That they’re going to get away with it is bad enough — that they’re getting praised for it, for being such smart guys, is damn near intolerable.

Tenacious G The interest of the Street, dominated by Goldman Sachs, has been to have markets that are opaque, inefficient, and unregulated,� says Peter Solomon, chairman and founder of the investment bank Peter J. Solomon Company. �And that’s been the policy for twenty years. That’s what the world is reacting to.� In the aftermath of AIG, the firm’s government connections have come to look like a conspiracy of outrageous self-interest�the ultimate hedge protecting their investments. As one Wall Street executive at a competing bank puts it, � �What about Goldman?’�that’s their natural default position. Lost in the haze of Goldman’s recent record profits is the fact that the firm nearly went under even after the AIG bailout last fall. As the market continued to plunge and Goldman’s stock price nose-dived, people inside the firm �were freaking out,� says a former Goldman executive who maintains close ties to the company. Many of the partners had borrowed against their Goldman stock in order to afford Park Avenue apartments, Hamptons vacation homes, and other accoutrements of the Goldman lifestyle. Margin calls were hitting staffers up and down the offices. The panic was so intense that when the stock dipped to $47 in intraday trading, Blankfein and Gary Cohn, the chief operating officer, came out of the executive suite to hover over traders on the floor, shocking people who’d rarely seen them there. They didn’t want staffers cashing out of their stock holdings and further destroying the share price. (Even so, many did, with $700 million in employee stock liquidated in the first nine months of the crisis.) Meanwhile, there were huge losses for Goldman’s clients in souring investments, many of which Goldman executives and their network of alumni were also vested in. Salvation came on November 25, a few days after Goldman’s stock price plunged to $52 a share, down from the year’s high of $200 and the lowest price the company had seen since it went public. Again, the white knight was the government. It turned out that Goldman’s conversion to a garden-variety bank-holding company offered an amazing advantage: Goldman now had access to incredibly cheap money. Exploiting its new status, Goldman became the first financial institution to sell $5 billion in government-backed bonds through the Federal Deposit Insurance Corporation, which allowed Goldman to start doing deals when the markets were at a near standstill. �Goldman was desperate for it,� says a prominent Goldman alumnus. �Everybody knows it. Those FDIC notes they got were lifesaving because they couldn’t issue any debt. If it had gone on another week or two, Goldman would have failed, they would have gone the way of Lehman, and you’d be talking about Lloyd the way you talk about [Lehman CEO] Dick Fuld.

  • The Man Who Crashed the World Almost a year after A.I.G.’s collapse, despite a tidal wave of outrage, there still has been no clear explanation of what toppled the insurance giant. The author decides to ask the people involved—the silent, shell-shocked traders of the A.I.G. Financial Products unit—and finds that the story may have a villain, whose reign of terror over 400 employees brought the company, the U.S. economy, and the global financial system to their knees.

Looking Back in Anger at the Crisis To the congressmen at the hearings, something nefarious must have taken place during those negotiations. But what exactly? Dennis Kucinich, a Democrat from Ohio, told me that Mr. Lewis’s failure to inform shareholders was a “potential violation of securities law.” He felt that Mr. Lewis had gamed the banks’ regulators to get more money. Mr. Towns, for his part, seemed to think that Mr. Paulson and Mr. Bernanke should have fired Mr. Lewis as a condition of more bailout money — that the government had been too nice to an incompetent management. Republicans, meanwhile, felt that Mr. Paulson and Mr. Bernanke had overreached, using intimidation and threats to force through a private transaction. And they all cited e-mail from the Fed that expressed skepticism at Mr. Lewis’s motives, and emphasized the need to keep things quiet for as long as possible. I had watched the first two hearings with a growing sense of bewilderment. It always seemed obvious to me that if the Bank of America-Merrill deal hadn’t gone through, Merrill Lynch would have been in a horrible position, akin to Lehman Brothers or the American International Group. The government very likely would have had to spend an awful lot more than $20 billion to save it. Surely, the end result was worth whatever arm-twisting and additional government aid was required. So why the anger? Why the suggestions of “cover-up” and “lies”? On Thursday, as I watched Mr. Paulson being castigated, it dawned on me. Seven months later, with the palpable fear of a financial collapse largely subsided, it really all boils down to how you view what happened last year. Was it, as Mr. Towns believes, a bailout of a handful of unworthy but too-big-to-fail institutions? Or was it, in the eyes of Mr. Paulson, a rescue of a teetering financial system? My vote is for the latter. We’ll never know what would have happened if Bank of America had canceled the Merrill deal. What we do know is that the system didn’t melt down last December, and it seems reasonable to assume that the decision by Mr. Paulson and Mr. Bernanke to hold Mr. Lewis’s feet to the fire was the right one. “They were making it up as they were going along last year,” said Ms. Bush. “There was no precedent.” By all rights, Congress ought to pat them on the back for saving the deal. Instead, it wants to pummel them. But there is also something else going on here. There was a point during Thursday’s hearing when the questions turned from the particulars of the Bank of America-Merrill deal to the larger questions surrounding the events of last year. The questioners seethed with anger. Hadn’t Mr. Paulson lied to Congress about the original purpose of the TARP money? Hadn’t his former company, Goldman Sachs, been the recipient of billions of dollars in government money that was funneled through A.I.G.? Why weren’t any of the heads of the financial firms — A.I.G. excepted — forced out of their jobs, given the calamity they helped create? One congresswoman practically accused Mr. Paulson of creating the crisis himself. In retrospect, Congress felt bullied by Mr. Paulson last year. Many of them fervently believed they should not prop up the banks that had led us to this crisis — yet they were pushed by Mr. Paulson and Mr. Bernanke into passing the $700 billion TARP, which was then used to bail out those very banks. Like Mr. Lewis, they took one for the team. Now that the crisis has subsided, it is payback time. As they watch Goldman Sachs and JPMorgan and — yes — Citigroup and Bank of America report billions in profits once again, they feel taken. Their constituents are out of work, home foreclosures are on the rise, yet Goldman, for instance, is planning to pay billions in bonuses for this year. The “investigation” into the Bank of America-Merrill deal is simply a convenient vehicle to express that fury. Maybe, if we’re lucky, the score is settled now. But I doubt it. If the Bank of America hearings show anything, it is that Congress is taking away all the wrong lessons from the crisis. In all likelihood, if the crisis erupts again, Congress won’t let itself be pushed around by Treasury, the way it was last time. Then we’ll really be in trouble.

Posted by dblwyo at 06:13 AM | | Comments (0)

July 27, 2009

Earnings vs Growth: Cutting for Growth? Real Business Performance

From a market that appeared to be running out of steam after the Mar/Apr runup we suddenly shifted to one roaring ahead at a fantastic rate. In fact the last two weeks have seen the SPX roar ahead almost 11%! That relatively huge uptick has been based on the widespread earnings upside surprises. Which then lead to the question of whether or not that reaction is well-based on realities or is simply another example of people not looking below the headlines, much as it was the problem we highlighted in our last post on the state of the economy. That becomes especially acute when you remember that this whole runup began with Meredith Whitney's comments about GS's earnings. What she really said when you listen to it was that GS earnings were based on one-time factors, driven by trading profits and based on taking more risk (essentially with public money !). We hope to show that those caveats apply to all the other companies that reported. Here's the rub - earnings got better but revenue didn't and the upside earnings surprises were a function of continued severe cost cutting combined with strenuous efforts to manage expectations down. You can see the surface symptoms in this graphic. Despite CAT's "surprise" revenue growth was abysmal. Similarly MSFT revenue dropped almost $2B and the damage was across all its divisions. One of the things that fascinates us is the topline revenue curves for the various companies look exactly like all the economic data - the YoY growth has stopped dropping at such painful rates but is also flattening off at terrible levels. Which is NOT what you're hearing reported. Which also means that what we're seeing is a bear market rally continued.

A Little Reality Refresh: Earnings vs Economy

When we try and face up to the realities of earnings we're looking at now, next week and beyond - that is what are earnings going to look like in the future and how are companies setting themselves up to get them. Which naturally leads, or should lead, to what's the economic climate going to be (if you want to consider this bit a continuation of the last post please do). (Realities vs Rhetorics: Economy, Policy, Real Data (Updates))

Business Week had an interesting story about what the changes in consumer behavior are going to mean (excerpted in the readings) captured in the l.h. side of this graphic. An increase of savings rates to 5% will pull $400B/year out of consumption. If, as the chart in the l.r. shows, savings returns to 10%, well... Even at the lower figure that tells us the long-term outlook for GDP growth is 2.4%/yr. That's just about breakeven for creating enough new jobs to keep up with labor force growth. Which in turn means that what we already new was going to be a long, drawn-out and very weak recovery with poor job creation is in fact THE outlook for the next three decades ! You don't have to buy all that bad news to know that companies are not going to be able to cut their way to earnings growth.

Company Performance Outlook

The accompanying graphic is Part 1/2 of a BNN interview the ex-Chief Science Officer at Cisco who joined Nortel in 2005 to try and save the company. He didn't last long because a company trapped in the worst of a 20thC set of business practices refused to change to the ones required for the 21stC. Listening to both parts of the interview dysfunctional and self-inflicted are the kindest words that occur to us. The sad part is that Nortel had both some good technologies as well as some good people; in other words it didn't have to result in a BK filing and the last two weeks of auctioning off the piece parts.

We've been hammering on the fact that for months now many companies were caught flat-footed by the severity of the downturn and reacted like deer in the headlights. (Beyond Specifics to Principles: Business Performance Principles & Outlooks, Cutting to the Heart of It: Capitalism's Death, Values, Performance (Ads)) What the earnings reports tell us is that instead of thinking about what they need to do for what's likely to be a sustained period of crisis they are instead hunkering down and doing what they know how to do. Reacting with thought and discipline in a crisis where the answers are not clear is one of, if not the single most, difficult things that leadership needs to do. Sadly it's also not something they appear to be doing and the damage will get worse, except for those apparently few leadership teams that are adapting intelligently instead of reacting blindly. Both parts of the interview are listed in the readings section, which strongly suggest you listen to 'em, take notes and think about your investments, employment and opportunities with these lessons in mind.

Better yet read the HBR article, excerpted below but available for a fee or subscription, Leadership in a (Permanent) Crisis.

"The immediate crisis—which we will get through, with the help of policy makers’ expert technical adjustments—merely sets the stage for a sustained or even permanent crisis of serious and unfamiliar challenges."

There's a whole slew of other readings on various companies in traditional and technomedia companies about which companies are adapting well and which are not. For many of the major excerpts you'll also find a bunch of related URLs so, for example, the poor adaptation rates that are likely for WIN7 are coupled with a bunch of other Technology earnings reports.

Earnings, Revenue, Economy

Sales Fail to Keep Pace With Profits, a Sign U.S. Economy Remains Sluggish  Sales growth lagged behind profits as companies in the Standard & Poors’ 500 Index beat analysts’ estimates this week, a signal that economic recovery may be slow. Second-quarter revenue at Caterpillar Inc. and Freeport- McMoRan Copper & Gold Inc. tumbled more than 30 percent from a year earlier, though earnings topped the average of analysts’ predictions. Amazon.com Inc.’s profit skidded and sales missed estimates. United Parcel Service Inc.’s sales slid 17 percent. Microsoft Corp. saw annual sales drop for the first time in 23 years as a public company. “The economy is coming back but it is not going to come roaring back,” said Mark Zandi, chief economist at Moody’s Economy.com. Companies “are going to be reluctant to add investment and jobs until they get better sales.” Revenue at 143 companies in the S&P 500 reporting this week, many of them bellwethers for the American economy, fell on average 10 percent from a year ago, according to Bloomberg data. Seventy managed to top the analysts’ consensus for sales, while 107 did so for earnings per share. The economy probably declined 1.5 percent in the three months ended June 30, marking the fourth straight drop and the longest such streak since quarterly records started in 1947, according to the median of 66 economists in a Bloomberg survey. “The real theme is the divergence between earnings and revenues,” said Steven Ricchiuto, chief economist at Mizuho Securities USA Inc. in New York. “We know companies are cutting costs at a record pace, and that is helping earnings. But you can’t keep on shrinking your way to profitability. Eventually, you do damage to your end users. You have to get revenues up to have a sustainable upturn.” Some economists fear a second economic contraction, what they call a “double dip.” “Expectations of corporate earnings will have to be downgraded again,” Nouriel Roubini, the New York University economist who predicted the credit crisis, said in a July 23 research note. “Demand will be weak, most prices will be falling, and companies will therefore have little pricing power and their profit margins will remain squeezed. The expectation that in these conditions profits will rebound strongly is quite far-fetched.”

  • The Charade Of Quarterly “Earnings Surprises”  A critical aspect to analyzing earnings surprises is the fact that there has been a secular increase in the proportion of companies reporting positive surprises which dates back more than 15 years.  This clearly can’t be attributable to a secular improvement in earnings because the volatility of reported earnings has been historically high for many years.In the mid-1990s, the proportion of positive and negative surprises was roughly equal.  In other words, it was roughly a 50/50 chance that an earnings report would produce a positive or negative surprise.  Although the proportion of positive surprises decreased during the current recession, it hardly fell below 60% let alone reverted back to the old 50%/50%.  This has been the worst profits recession on record, but still more than 60% of the S&P 500 companies produced positive surprises.  Something certainly seems odd.The primary catalyst behind the secular increase in positive earnings surprises has been the on-going development of more sophisticated investor relations techniques.

U.S. Job Cuts Outpace GDP Fall  The job market is doing even worse than the overall economy, prompting concern inside and outside the government that deeper-than-expected joblessness could persist once the recession ends. Breaking from historical patterns, the unemployment rate -- currently at 9.5% -- is one to 1.5 percentage points higher than would be expected under one economic rule of thumb, says Lawrence Summers, President Barack Obama's top economic adviser. Since the recession began in December 2007, the economy has lost 6.5 million jobs, 4.7% of total employment. The unemployment rate has jumped five percentage points, while the economy has contracted by roughly 2.5%. In recent days, Mr. Summers, White House budget director Peter Orszag and Fed Chairman Ben Bernanke have all talked publicly about the unusual disconnect between growth and employment. Some companies are reaping gains as they clamp down on labor costs. While corporate profits are down from a year ago, many of the biggest companies reporting income figures for the second quarter are ahead of expectations because they have cut costs so aggressively.

The Leaner Baby Boomer Economy When 79 million people—nearly a third of Americans—start spending less and saving more, you know it won't be pretty. According to consulting firm McKinsey, boomers' conversion to thrift could stifle the economy's hoped-for rebound and knock U.S. growth down from the 3.2% it has averaged since 1965 to 2.4% over the next 30 years. "We would have gotten here in 5 or 10 years as boomers retire, but we pushed it up," says Michael Sinoway, managing director of consulting firm AlixPartners. "Now [companies] are scared things won't come back." And that's why everyone from Mercedes to Nordstrom (JWN) to designer Vera Wang are scrambling to remake themselves for the Incredible Shrinking Boomer Economy. With boomers, however, many companies became complacent. It wasn't that they ignored younger consumers but that they counted on boomers to keep spending longer. And why not? Until recently boomers typically reached their spending peak at age 54, according to McKinsey. Contrast that with the previous generation—a thriftier bunch whose consumption typically peaked at 47. Now many companies are scrambling to appeal to Generations X and Y. You can already see this thrust in the stores. Clothing designer Vera Wang is selling a casual line called Lavender aimed at twenty- and thirtysomethings. It's fashion, but not the pricey garments the company typically has sold. Meanwhile, says Wang, her namesake brand needs to get a lot less expensive. In one instance, Wang made a high-end dress using fabric that costs $5 a yard instead of $12 but used the fabric in several layers to give the garment a richer look. As a boomer herself, Wang, 60, feels her generation's pain. You don't have 30 years to reinvent yourself," she says. That's why some companies are coalescing around "cheap chic," a marketing conceit that has become synonymous with Target (TGT) but also has been tried by the likes of JetBlue, Ikea, and Mini. The latter is owned by BMW, another classic boomer brand. BMW didn't plan it this way, but the Mini is one solution for a company whose cars are becoming too pricey for many boomers

Global Deflation Pandemic Begins to Brew In congressional testimony this week, Federal Reserve Chairman Ben Bernanke gave no indication that he planned to turn off the central bank's liquidity spigots anytime soon. Critics howled that the Fed is risking runaway inflation. More immediately, however, the threat of deflation seems a bigger concern -- not just in the U.S., but also in economies around the world. Last week, World Bank Chief Economist Justin Lin warned in a speech that a surge in excess capacity world-wide could lead to a global "deflationary downward spiral." The Bank of Japan and the International Monetary Fund are forecasting two years of price declines in Japan, which suffered a serious bout of deflation in the 1990s because of a blowup in its banking sector and collapse in the real-estate market. Recent data show that prices still are falling in fast-growing economies such as India and China. In the first half of the year, China's consumer-price index was down 1.1% from a year ago, and its producer-price index fell 5.9%, according to China's National Bureau of Statistics from last week. In India, prices have been slipping into negative territory for more than a month. Broadly, prices in Europe are tipping into a deflationary dead zone. In the 16-nation euro region, prices fell 0.1% in June from last year, the first such drop on record. Prices have been flat or down in Finland, Portugal, France, Germany, Ireland, Spain and Switzerland, according to Moody's Economy.com. There are a few caveats. Recent deflation data in part reflect the comparison with sky-high energy prices last year. And oil prices could spike again. Ironically, that could potentially hurt companies' pricing power by taking spare cash out of struggling consumers' pockets. But if deflation does take root, it could prove devastating for investors. Deflation can cause stock prices to decline as companies are unable to boost prices; corporate bonds also suffer from rising bankruptcies.Behind a global deflation virus is a collapse of demand in the U.S. Unless the economic engine in the U.S. can get cranking again, deflation could keep spreading.

Business Performance: Nortel to Autos to Mfg to Retail

Leadership in a (Permanent) Crisis It would be profoundly reassuring to view the current economic crisis as simply another rough spell that we need to get through. Unfortunately, though, today’s mix of urgency, high stakes, and uncertainty will continue as the norm even after the recession ends. Economies cannot erect a firewall against intensifying global competition, energy constraints, climate change, and political instability. The immediate crisis—which we will get through, with the help of policy makers’ expert technical adjustments—merely sets the stage for a sustained or even permanent crisis of serious and unfamiliar challenges.Consider the heart attack that strikes in the middle of the night. EMTs rush the victim to the hospital, where expert trauma and surgical teams—executing established procedures because there is little time for creative improvisation—stabilize the patient and then provide new vessels for the heart. The emergency has passed, but a high-stakes, if somewhat less urgent, set of challenges remains. Having recovered from the surgery, how does the patient prevent another attack? Having survived, how does he adapt to the uncertainties of a new reality in order to thrive? The crisis is far from over.

GM’s Whitacre Promises to Repay Carmaker’s U.S. Taxpayer Loan  The fates of General Motors Co. and Chrysler Group LLC, hobbled by their histories, now rest with two outsiders with no auto experience. They may be the perfect guys for the job. Ed Whitacre, 67, who as chairman and chief executive officer of AT&T Inc. assembled the world’s largest telecom company, became GM’s chairman on July 10. His counterpart is former Borden Chemical Inc. CEO and chairman Robert Kidder, 64, a turnaround specialist who assumed the chairmanship at Chrysler when it left court protection last month. The most important challenge facing Whitaker and Kidder will be undoing the worst tendencies of GM and Chrysler, said Warren Bennis, founder of the Leadership Institute at the University of Southern California in Los Angeles. “Changing the culture of these companies has got to start at the top,” Bennis said. “They’ve got to drive a culture of innovation where people can come up with crazy ideas and not be laughed at.”  At Detroit-based GM, Whitacre confronts a change-averse organization where poor performance could hide in the bureaucracy, said Joseph Phillippi, auto analyst at AutoTrends Consulting in Short Hills, New Jersey. “There was an incredible, ongoing lack of accountability at GM,” said Phillippi. “And if there ever was a desire to change, it got subsumed by the idea that, ‘We’re big GM, we’re omnipotent and we’re too big too fail.” At Chrysler, Kidder, a former McKinsey & Co. consultant, must reconstitute a company once known for stylish cars that lost engineers and designers during 11 years of ownership by Germany’s Daimler AG and then by Cerberus Capital Management LP of New York, Phillippi said. Kidder will oversee CEO Sergio Marchionne, 57, also CEO of Fiat SpA, which aligned with Chrysler after the Auburn Hills, Michigan-based automaker finished its restructuring in bankruptcy court last month.

Caterpillar Chews on Green Shoots If you want an image summing up Caterpillar's latest set of quarterly results, it is this: a big, half-empty, lightly manned depot. As a spectacular construction- and commodities-fueled boom has turned to bust, Caterpillar is doing the sensible thing: cutting excess capacity and inventories. Indeed, without cost reductions and currency gains, its operating profit before items would have fallen 97% year on year, rather than two-thirds. End-user demand has collapsed. Caterpillar's revenue fell 41%, with some product lines suffering declines of between 60% and 80% for new equipment sales. Faced with this, cutting costs is one of the few levers management can pull. It also is why they are idling factories and letting warehouses empty out inventories, just as the dealers to which they sell do the same. The ultimate buyers of Caterpillar's equipment and services have closed the gate. That leaves product backing up in the supply chain. On the surface, Caterpillar beat the 22-cents-a-share consensus earnings estimate by 50 cents. But accounting gains on shrinking inventories, a two-thirds drop in the effective tax rate to just 10% and currency gains accounted for four-fifths of the outperformance, reckons analyst Larry De Maria at Sterne Agee & Co. Caterpillar still deserves plaudits for beating expectations in such a weak environment. But these results hardly herald a sustainable rebound. And while the company raised its earnings projections for the year, it trimmed the upper limit of its revenue range, which remains wide at between $32 billion and $36 billion. A third-quarter loss can't be ruled out. As for 2010, if Caterpillar knows what is coming, it isn't telling. More likely, it is just too difficult to say. Before Tuesday's release, the highest estimate for the company's 2010 earnings was 19 times the lowest, according to data from Thomson Reuters. As with Caterpillar's sales projections, that is a gap big enough for a bright-yellow hydraulic excavator to drive through. The big uncertainty concerns the top line, a worry for many other companies and not just Caterpillar. Cost cuts, idled capacity and inventory liquidation can't offset slumping revenue indefinitely. And while they are perfectly legitimate corporate responses to a slack economy, they don't do much for jobs, incomes and, ultimately, a recovery in demand. This continuing uncertainty over the timing and strength of an upturn in Caterpillar's fortunes puts Tuesday's initial market enthusiasm about its results in perspective. Even though the stock's initial pop of 11% faded somewhat by midafternoon, it still commands a multiple of 26 times 2010 estimated earnings. If only Caterpillar's products could count on pricing power of that magnitude next year.

In Strategy Shift, Exxon Plans $600 Million Biofuels Venture After years of snubbing alternative fuels as a bad investment, global energy giant Exxon Mobil Corp. said Tuesday it will sink $600 million into researching how to turn algae into a biofuel that would also help fight global warming. Exxon's partner in the biofuels effort will be groundbreaking genomics scientist J. Craig Venter and his company Synthetic Genomics Inc. The companies will attempt to develop algae strains that excel at both sucking up greenhouse gases and secreting oil that can be fed into refineries alongside conventional crude oil. If the companies are successful in developing cost-competitive barrels of algae-based oil on a large scale, the Texas energy company said it could invest billions of additional dollars to build production facilities in the future. Exxon's embrace of biofuels represents a strategic turnaround for one of the world's biggest refiners of transportation fuel. Exxon grew into the world's largest publicly traded company by extracting fossil fuels from the earth and converting them into gasoline, diesel and chemicals. But as global supplies of oil become harder to find and growing concerns about greenhouse-gas emissions inspire new attempts at government regulation, the concept of domestically produced oil derived from algae has become an alluring enough prospect to catch Exxon's interest. Mr. Venter, a well-known biologist who led an effort to map the human genome, said the leap into algae-based fuels wasn't going to be easy: "The challenges are not minor for any of us, but I think we have the combined teams, scientific and engineering talents, to give this the best chance of success." The two companies said they would like to use genetic engineering to develop algae strains that consume significant amounts of carbon dioxide, a gas produced by fossil-fuel use that is contributing to climate change. Exxon's head of research, Emil Jacobs, said it was possible the algae farms would be located near power plants and other industrial complexes to use the carbon dioxide generated in those places as feedstocks for the algae. Algae farms could produce two streams of income for the venture: one from selling barrels of algae oil to refineries and the other from capturing and reusing carbon dioxide. "It is reasonable to say you have to look at all commercial elements," said Exxon spokesman Rob Young.

7-Eleven Sees an Opportunity to Open Doors Already seemingly ubiquitous, 7-Eleven, the convenience store chain, is taking advantage of the weak commercial real estate market to carry out a major expansion plan. The company — which now operates or franchises approximately 5,700 stores across the United States — announced its growth strategy in May, saying it would add more than 200 new outlets this year. Company officials said the two regions where growth would be strongest were California, which had almost 1,300 stores at the end of 2008, and the New York metropolitan area, which had 431 stores at the end of 2008. At least 44 stores will open this year in metropolitan New York, more than twice the number that opened last year. In the longer term, Dan Porter, vice president for real estate and new store development at 7-Eleven, said that the company saw the possibility of adding 350 stores in the metropolitan area in five to seven years. The growth plan of 7-Eleven, officials said, reflects relatively strong demand for its products. In addition, they said, the retailer is getting access to desirable retail space that it was not previously offered or that was too expensive.   Johnson & Johnson Profit Fell 3.5% in 2nd Quarter

Technomedia: Search for Business Models

Six in 10 companies plan to skip Windows 7: survey Six in 10 companies in a survey plan to skip the purchase of Microsoft Corp's Windows 7 computer operating system, many of them to pinch pennies and others over concern about compatibility with their existing applications. Windows 7 will be released October 22, but has already garnered good reviews, in contrast to its disappointing current version, Windows Vista. Many of the more than 1,000 companies that responded to a survey by ScriptLogic Corp say they have economized by cutting back on software updates and lack the resources to deploy Microsoft's latest offering. ScriptLogic Corp, which provides help to companies in managing their Microsoft Windows-based networks, sent out 20,000 surveys to information technology administrators to learn the state of the market. Many companies have rejected Windows Vista as unstable. For example, the chip maker Intel Corp, Microsoft's long- time partner in producing personal computers, has stayed with the older XP system. The survey found about 60 percent of those surveyed have no plans to deploy Windows 7, 34 percent will deploy it by the end of 2010 and only 5.4 percent will deploy by year's end. Forty-two percent said their biggest reason for avoiding Windows 7 was a "lack of time and resources." That dovetailed with another part of the survey, which found that 35 percent had already skipped upgrades or delayed purchases to save money. But there were reasons other than money for staying away from Windows 7. Another 39 percent of those surveyed said they had concern about the compatibility of Windows 7 with existing applications.

Tech Rebound? [07-14-09] BNN speaks with Ed Snyder, Charter Equity Research, Duncan Stewart, president, DSAM Consulting; and Naser Iqbal, technology analyst, Salman Partners.

Texas Instruments Shifts Focus Texas Instruments Inc. is attempting a tough calculation: subtracting the revenue of one of its largest businesses without adding stock declines. TI decided last year to wind down its wireless baseband unit, which makes chips that connect phones to cellular networks, to focus instead on higher-growth markets for analog and embedded chips. Over the next three years, TI expects revenue from its business selling baseband chips will drop to zero. TI thinks it can offset the loss of baseband revenue and generate better returns by investing in the chips used in products ranging from smart phones to heavy machinery. Over the long-term it's a sound strategy, say analysts, but strong revenue growth may not arrive in time to make up for the loss of baseband. "I think people, investors, don't understand how rapidly the baseband business is going to go away," said Auriga analyst Daniel Berenbaum, adding that TI shares are too expensive for the slowdown in growth ahead. Baseband represented the vast majority of TI's wireless unit sales and roughly 20% of TI's $12.5 billion in overall 2008 revenue, but the chips are becoming a commodity and TI doesn't want to stay in what could end up being a less profitable business. "You can't be afraid, no matter how big or how much you enjoyed the business in the past to say, 'That world of baseband is going to change,' " said Texas Instruments Chief Executive Rich Templeton at a May investor conference. "Therefore, you ought to be centering up your investments in new areas." Shares of the Dallas-based chip maker are up more than 50% -- well above the returns of broader indexes over the same period -- since hitting multiyear lows late last year. TI successfully managed chip inventories and slowed factories as customers virtually stopped buying chips in the fourth quarter of 2008 and first quarter of 2009. But investors could suffer from what Goldman Sachs analyst James Covello called, during TI's last midquarter update, a potential "landmine" when the next chunk of baseband revenue disappears from TI's balance sheet. The stock currently trades at almost 28 times estimates for fiscal 2009 earnings, up from a range of 10 times to 20 times estimates for most of the past three years -- a steep price if top-line growth will continue to be muted even as TI exits the downturn.

Korea's LG Dials Up Cellphone Growth, Gaining Market Share on Rivals While the recession forces a sharp decline in global sales of mobile phones, LG Electronics Co. is posting some of its strongest growth ever and taking market share from cellphone rivals. LG last year passed Motorola Inc. and Sony Ericsson to become the world's third-largest seller of cellphones, shipping just over 100 million units, or about 8.6% of the global 1.17 billion. This year, with the overall cellphone market expected to fall more than 10%, some analysts predict LG's cellphone shipments will rise between 10% to 20%. The division's growth is expected to help LG post a profit when it reports quarterly results Wednesday at a time that many consumer-electronics companies are struggling with deep losses. One of the South Korean firm's strategies is a business process in which each product has an individual responsible for it from the moment it moves out of the research lab until its last day on a store shelf. "In the past, we didn't have people who owned the performance of a product," says Kim Myung-ho, a vice president in LG's cellphone division. "Now that we do, the number of hit phones we have is increasing." The system allows LG, which introduces about 50 phones a year, to quickly recognize when a model is performing poorly and shorten its product life, something that happened with several camera phones over the past two years. "If we have 10 phones, perhaps one or two will be hits that sell millions of units, two or three more will make targets and the rest will fail," Mr. Kim says. "If a certain product is not going to be successful, we want to move on." The system also allows product managers to quickly boost supplies and marketing in areas where a particular phone is selling well. On Monday, LG said a new phone called Cookie -- touch-screen models with colorful cases for younger buyers -- has shipped five million units since its release in November. LG has also been boosted by new versions of its popular Chocolate and Vu phones. LG laid the groundwork for its performance about two years ago when then-new Chief Executive Nam Yong restructured the electronics maker so that each item had a product business leader, a position known as a PBL within LG, responsible for it. The position is now common in all of LG's divisions, including home appliances and consumer electronics, but the work involved in it has been refined in the cellphone business, which introduces the highest volume of products and copes with the widest mix of targets for profitability and time in the market.

Big media seek 21st century business models Media moguls at this week's Sun Valley conference have spent as much time discussing how to reconfigure business models disrupted by the Web as they have worrying about the weak economy. With difficult credit markets and an unclear future, talk of dealmaking has been at a minimum this year. Yet there has never been a more important time for media conglomerates and their financiers to act and adapt to the Internet age. The mood at the conference was described as "somber" and "very bearish" by executives. While the recession was a key reason, the other was the uncertainty over how future profits can be made from distributing news and entertainment online and across devices like smartphones. "We're not using long-form content on the Web because it's not clear to us that's the way people want to consume content, said David Zaslav, chief executive of Discovery Communications Inc, which owns the Discovery Channel. "But also the business model isn't there yet, so we're taking it slow," he said in an interview on the sidelines of the event organized by boutique investment bank Allen & Co. In the late-night bar at the Sun Valley Lodge, from which the press was banned, most of the discussions were around the issue of free versus paid content, said one senior executive who asked not to be named as his conversations with other executives were private. The challenge is how media companies can keep alive the lucrative cable business model at a time when consumers are increasingly used to getting content for free online. Cable operators pay affiliate fees to cable networks for their programing, and both share advertising revenue. Plans such as Time Warner Inc's "TV Everywhere" and Comcast Corp's "On Demand Online" seek to preserve that business model by offering cable shows on the Web to authenticated, paying cable TV subscribers.

Bonnie Hammer’s Hit Factory The process of greenlighting TV shows is extraordinarily subjective; often the genius who champions a hot show like ABC's Private Practice is the same person who subsequently greenlights dreck like The Unusuals on the same network. But Hammer, 58, is working to change that law of averages by systematizing the way her team looks at potential shows, by moving beyond the "golden gut" decision making that drives Hollywood to rely instead on formal checklists and scorecards. Today when considering scripts, Hammer and her team ask a routinized series of questions: Does the show have a fun sensibility? Does it have a "blue sky" tone of hopefulness? Does it revolve around an "aspirational," if quirky, lead character with a moral and ethical center? Potential shows are scored based on how closely they match these dictates; only high scorers make it on air. Before Hammer's arrival, USA was the television equivalent of a potluck supper, a hodgepodge of reruns and castoffs. Driven by her unique show-selection technique—a process she refers to as the "brand filter"—USA has been transformed into a cohesive collection of character-driven shows that are resonating with viewers, and advertisers are in hot pursuit. "The goal was to take a large, broad-based network and make it an exclusive club by creating connective tissue," Hammer says, describing the bond between characters on the screen and an audience of individual characters watching at home. The USA tag line describes its strategy: "Characters Welcome." Hammer's approach also relies on a culture shift within USA. She is insisting that her top executives—including those in the marketing and promotion departments—not just have a vote in selecting shows, but also a voice in each other's plans for molding, rolling out, and supporting them. She calls it breaking down the "silos" that widely exist in Hollywood's TV-show factories and lead to inconsistencies in the look and feel of network brands. On the set of Royal Pains this past spring, Hammer seemed to be working to avoid the royal treatment: when underlings worried about her walking without an umbrella through a cool drizzle to the lunch tent, she waved them off. Around the creative types upon whose work she renders judgment, Hammer projects authority but not self--importance: a mix that's in contrast with a lot of Hollywood bosses.

Posted by dblwyo at 03:58 AM | | Comments (0)

July 22, 2009

Realities vs Rhetorics: Economy, Policy, Real Data (Updates)

Long past time for another post and, as things cycle around, it probably should be on the state of the economy. But we've hammered that a whole bunch and nothing has changed our conclusions (The Vast, Ignored Difference: Economic Bottoming vs Recovery, Drugged Wallabies, Crop Circles and World Economies (Refreshes). We did keep repeating that the slowing of decline was not either green shoots or a harbinger of recovery (our constant theme for months now !) so the good news is that we're hearing that reflected all over now. Alleluia ! So we're going to spend less time on pure economics and focus more on the conundrums and policy dilemmas we find ourselves in. The level of mis-understanding about the state of the economy, the outlook and the role of government policy is just astounding; and it rests on a fundamental mis-understanding of how cycles and stimulus work. That will be our focus. But just to hattip last week's economic data take a look at the chart set, which shows monthly data back to Jan00 and Jan93 and quarterly back to Q160 on a YoY% basis. Despite the "it's better, it's better" meme running around in fact it's flattened off around approx. -10% ! The real thing to note is this: every single data series in the last few weeks has looked exactly like this (including revenues being reported in the earnings announcements !). Like we said the only ray of light is that the fact that things are NOT good and this is going to be a very weak and drawn out recovery has dawned among a wide group of observers.

Current Cycle and Strategic Outlook

When consumer demand drops as badly as this businesses will also cut their spending. In fact increases in hiring and investing happen ONLY after a recovery begins as companies don't need to add to capacity until demand uses up existing capacity. That's why employment and capex are lagging indicators. In normal times the economy naturally follows a cycle where rising consumer demand leads to more business spending which generates new hiring which in turn leads to more spending. The Fed can help mitigate the worst extremes of this as long as we're in a normal environment thru interest rate management. But we're in a once in multiple generation state where things are anything but normal. THE ONLY SOURCE OF DEMAND IS GOVERNMENT SPENDING. Without it we'd be in much worse circumstances, with some serious risk of Depression 2.0. If the Fed and Treasury had screwed up last Fall we'd have had one anyway. This 4-panel composite tries to convey all that and link it to our strategic alternatives. We've likely avoided GD 2.0 but are now trying for a weak recovery instead of a long L-shaped malaise. There are a bunch of "abort" points we need to navigate until we get back to the self-priming normal cycle of organic growth. But even if that works everybody from the Fed to Roubini is seeing poor long-term growth prospects (2% or so), far below potential, for years. To restore long-term growth we've got to invest in things like infrastructure, energy, healthcare and education to re-base the economy.

Stimulus Package Structure

A couple of weeks ago I sat thru an online presentation by GE Healthcare discussing it's electronic medical records and physicians practice software solutions. As the result of a sliver of a sliver of a sliver in the stimulus package they are offerring low-cost financing to the 95% of doctors who haven't yet even begun to think about the problem. That sliver was pretty well-crafted. When you look at the breakdown of the stimulus package it was pretty well constructed. There was a big chunk that was in tax cuts and transfer payments, e.g. extending unemployment benefits. That was and is a big help in mitigating some of the downturn and employment impacts. But 2/3 of the package will hit later on this year and thru next. The other thing that the package does is start laying the groundwork for not only getting us past the abort point but also in jump-starting a structural evolution to a re-based economy.

Now there's no denying that the process of rushing thru the package saw some pork loaded in but the extent has been enormously exaggerated. Some reasonable and responsible estimates put it somewhere between infinitesimal and ~3%, a minor political price to pay for getting something that large out that fast and that reasonably well-crafted. When people criticize the package they have no clue as the real challenges. First off the package was about as large as could have been passed given the political situation. Second, when you examine the graphic and think about my anecdote, it's well-crafted. It's not like folks haven't been examining much of this for decades, e.g. infrastructure spending requirements. ANOTHER key thing to keep in mind is that the package is the down payment and tabs into follow-on legislation on the budget, education,  energy and healthcare. Taken all together and in conjunction with what the Fed and Treasury are doing to restore the credit markets and re-regulate the Finance Industry this is comprehensive and integrated a system of initiatives as we've seen in almost four decades. Finally, and this speaks to the call for a 2nd stimulus, what's authorized is about as much or more as the current mechanisms of the various Federal departments can handle. Or beyond. To make this work we're going to need a revolution in government operations that's one of the major hidden challenges. And if we end up needing a second stimulus we'll need it on the state and local levels, as the CA. nightmare tells us. The bottomline here is that people are doing the best they know how, it all hangs together and it's all at the limits of what we can manage. In many senses !

The Deficit Bogeyman

A really key thing, setting aside the partisan political posturing that's done to try and exploit old shibboleths that are unworkable and discredited, is that most folks are judging things thru ideological blinders. If we've learned anything in the last couple of years is that the simple common wisdom is no substitute for actually knowing what you're doing. Faced with a problem of this scope and magnitude and complexity what you want is a set of approaches that are as complex as necessary and understand the feedback loops built into a system. Simple answers just won't do it. One of the key bogeymen is the fear of excess deficits so let's take a look at that and try to make it a little clearer. If you're with us this far we hope it's crystal clear that we have NO choice but to spend or face a decade+ long period of 1% growth or less; and hope it doesn't turn over into a depression which is still a possibility. This little composite collection we've accumulated over several years might help.

Despite supply-side idolatry what Reagan actually did to restore the economy was create the most massive deficits in post-WW2 history. In other words he pursued as Democratic like a policy as anybody had in decades. The good news is that it worked and got the economy back on a growth path. The bad news is that the resulting deficits were massive. Clinton, bless his pointy little head(s), not only eliminated the deficit but briefly put us in surplus thru a combination of fiscal discipline and taking advantage of reduced military spending. Unfortunately BushII, returning to idolatrous worship, chose to both cut taxes AND enormously expand spending. Some of which was unavoidable. But the net result is that we came to the end of a mini-boom and entered the worst recession extremely far in the hole. When you look at the sources of the current and projected deficit about $200B of $1.3T is due to the current administration. The other thing to keep in mind is the odd thing that if we get back on a higher growth path tax collections will increase and we'll have less of a deficit burden and pay it down faster. In the long-run it really matters what you spend your money on - invest it for future growth or chew it up in frivolous short-term spending. So far we're more on the former path than the latter. When you combine that with the even deeper structural shift of the public from over-borrowing consumers to folks who will be forced to be savers this isn't going to be hard to finance; nor will it crowd out private investment. Initially because there's no demand for private investment and then because a growing economy where Savings > Investment throws off lots of cash. In fact if we can keep this all together for the next decade we're going to be in a far...far better place then we're in now or would have been otherwise.

BtW - there's a whole slew of readings and some more charts after the break that span current economic data, the long term outlook, oil/commodities, the mounting problems in China with Rio Tinto that will make sustaining their growth more difficult, a bunch on the policy issues and some more on re-thinking the relationship between markets, policy and institutions.You might want to pay particular attention to the collection to the second China collection if you want to understand a) the long-term problems they ARE creating, b) what a dangerous stimulus program looks like and c) whether we can count on them to pull us out of this (otherwise HA !).

Bon Appetit' !

UPDATEs:

We added a Bloomberg clip on the failure of a recent Chinese bond market auction that discusses the general Asian economic and financial outlook along with a chart on worldwide monetary aggregates from Macro Man. The conjoint point here is that China has pumped monetary stimulus unlike any other player yet, unlike the US, China's money is flowing into consumer spending and more highly questionable loans. In the US the increases in the monetary base has NOT entered the credit markets because of reduced velocity; i.e. the money is sitting on bank balance sheets and credit is tightly constrained. Not good for the US and terrible for China and the worldwide impact ! Be warned.

Current Economic Situation

When We Get “There”, Will We Know It? Back in April, our forecast update commentary was entitled, “Are We There Yet?” The “there” referred to a resumption of real growth in the overall economy. Our answer in April was “no,” which also happens to be our answer in July. When will we get there? Our answer in April was the fourth quarter of this year, which also happens to be our answer now. Assuming we get there in the fourth quarter, would most households and businesses in America know it if they were not so informed by the media? Probably not. We anticipate another “jobless recovery,” which implies a relatively feeble one. We would not be surprised to hear terms early in 2010 such as “double dip.” Why do we anticipate a feeble recovery? Firstly, we believe that although the private financial sector has stabilized, it still is a long way from functioning in a normal fashion. Net lending by the private financial sector contracted in the first quarter of this year at an annualized rate of $1.6 trillion (see Chart 1) – the first quarterly contraction on record since the 1952 inception of this series. The combination of inadequate capital to increase net lending along with deteriorating credit quality on the part of potential borrowers led to the most severe credit crunch in the post-WWII era. Although a number of financial institutions have bolstered their capital positions in the first half of this year, some of that newly-raised capital is likely to “depreciate” significantly in the second half of this year and into 2010 as losses are incurred in connection with commercial mortgages and household debt – residential mortgages along with credit card and auto-loan debt. So, anything like normal net lending by the private financial system is unlikely to commence until 2011, at the earliest. History suggests that although economic recoveries can occur with a crippled financial system, those recoveries tend to be muted – witness the 1991 recovery.

Retail Sales in June On a monthly basis, retail sales increased 0.6% from May to June (seasonally adjusted), and sales are off 9.6% from June 2008 (retail ex food services decreased 10.3%). Excluding autos and gas, retail sales fell again in June. The following graph shows the year-over-year change in nominal and real retail sales since 1993. The Census Bureau reported that nominal retail sales decreased 10.3% year-over-year (retail and food services decreased 9.6%), and real retail sales declined by 9.7% on a YoY basis. The second graph shows real retail sales (adjusted with PCE) since 1992. This is monthly retail sales, seasonally adjusted.This shows that retail sales fell off a cliff in late 2008, and may have bottomed - but at a much lower level. Maybe the cliff diving is over, but retail sales are still at the bottom of the cliff ...

More Inventory Correction The Manufacturing and Trade Inventories and Sales report from the Census Bureau today showed more evidence of declining inventories. The above graph shows the 3 month change (annualized) in manufacturers’ and trade inventories. The inventory correction was slow to start in this recession, but inventories are now declining sharply. However, even with the sharp decline in inventories, the inventory to sales ratio has only declined to 1.42 in May - since sales have fallen sharply too. There has been a race between declining sales and declining inventory. Even as sales start to stabilize (appears to be happening), inventory levels are still too high compared to the lower sales levels, and further inventory reductions are probably coming. Inventory:Sales Ratio

Industrial Production Declines, Capacity Utilization at Record Low in June This graph shows Capacity Utilization. This series is at another record low (the series starts in 1967). In addition to the weakness in industrial production, there is little reason for investment in new production facilities until capacity utilization recovers.

Housing Starts Fall 46% Yet another set of odd and misleading coverage on Housing Starts. BUILDING PERMITS: Privately-owned housing units authorized by building permits in June were at a seasonally adjusted annual rate of 563,000. This is 8.7% (±3.0%) above (revised) May rate, but is 52.0% (±3.6%) below the June 2008. HOUSING STARTS: Privately-owned housing starts in June were at a seasonally adjusted annual rate of 582,000. This is 3.6% (±11.3%)* above the revised May estimate but is 46.0% (±4.3%) below the June 2008. What can we tell from this data? Nothing about monthly change in Starts (data points less than the margin of error are not statistically significant); We can say that permits were up month to month, although how much of that is seasonal is hard to decipher. The year-over-year data is much clearer: New Starts down 46%, Permits down 52%. Not exactly green shoot materials here — but given the enormous inventory overhang, less new building is better. And since year-over-year compares the same month, seasonality is not a factor. Incidentally, much of the media reportage on this was simply innumerate — the numerical equivalent of illiteracy. Not just a little wrong, but totally, embarrassingly incorrect.

Mortimer Zuckerman: The Economy Is Even Worse Than You Think The recent unemployment numbers have undermined confidence that we might be nearing the bottom of the recession. What we can see on the surface is disconcerting enough, but the inside numbers are just as bad. The Bureau of Labor Statistics preliminary estimate for job losses for June is 467,000, which means 7.2 million people have lost their jobs since the start of the recession. The cumulative job losses over the last six months have been greater than for any other half year period since World War II, including the military demobilization after the war. The job losses are also now equal to the net job gains over the previous nine years, making this the only recession since the Great Depression to wipe out all job growth from the previous expansion. Here are 10 reasons we are in even more trouble than the 9.5% unemployment rate indicates: - June's total assumed 185,000 people at work who probably were not. The government could not identify them; it made an assumption about trends. But many of the mythical jobs are in industries that have absolutely no job creation, e.g., finance. When the official numbers are adjusted over the next several months, June will look worse. - The number of workers taking part-time jobs due to the slack economy, a kind of stealth underemployment, has doubled in this recession to about nine million, or 5.8% of the work force. Add those whose hours have been cut to those who cannot find a full-time job and the total unemployed rises to 16.5%, putting the number of involuntarily idle in the range of 25 million. Since consumer spending is the economy's main driver, we are going to have a weak consumer sector and many businesses simply won't have the means or the need to hire employees. After the 1990-91 recessions, consumers went out and bought houses, cars and other expensive goods. This time, the combination of a weak job picture and a severe credit crunch means that people won't be able to get the financing for big expenditures, and those who can borrow will be reluctant to do so. The paycheck has returned as the primary source of spending. This process is nowhere near complete and, until it is, the economy will barely grow if it does at all, and it may well oscillate between sluggish growth and modest decline for the next several years until the rebalancing of excessive debt has been completed. Until then, the economy will be deprived of adequate profits and cash flow, and businesses will not start to hire nor race to make capital expenditures when they have vast idle capacity.

Energy ==> Commodities

Oil Falls to Eight-Week Low on Concern for Economy, Fuel Demand Crude oil fell to an eight-week low in New York on concern that the economy and fuel consumption won’t recover this year. Oil futures retreated after Treasury Secretary Timothy Geithner warned that the American economy faces “enormous challenges.” Prices on July 10 capped their biggest weekly decline since January as U.S. consumer confidence fell and fuel stockpiles increased for a fourth week. “Prices are probably going to go lower this week because of worries about the economy,” said Phil Flynn, vice president of research at PFGBest, a Chicago-based brokerage. “We have several big economic reports this week and they better come out better than expected. Otherwise, there will be further pressure on oil prices.”

China: Governance vs Business

China Accuses Rio Workers of Stealing Price Data Four employees of miner Rio Tinto Ltd. detained on spying charges are accused of bribing Chinese steel company managers to obtain secret information on China's position in talks on iron ore prices, state media said Friday. The four employees were detained Sunday while Rio was negotiating on behalf of global iron ore suppliers with Chinese steel mills. The government said Thursday they are accused of stealing state secrets. They include an Australian citizen, Stern Hu, the Shanghai-based manager of Rio's Chinese iron ore business. Australian diplomats met Friday with Hu for the first time since his detention, Foreign Minister Stephen Smith said. He said details of the meeting would be released later. "In 2009 during negotiations between Chinese and foreign companies on iron imports, Hu and his people used illegal methods by bribing personnel of Chinese steel production units to steal Chinese national secrets, which caused damage to China's national economic safety and interests," newspapers said, citing a statement from the Ministry of State Security, China's main internal intelligence agency. The material included summaries of meetings of Chinese negotiators, the newspaper 21st Century Business Herald said, citing unidentified sources. It said that would allow Rio to know "the Chinese iron ore negotiating team's bottom line." Rio, the world's third-largest mining company, is acting as lead negotiator for global iron ore producers in price talks with Chinese steel mills. China is pushing for sharp price cuts following years of repeated increases. The other major suppliers are Australia's BHP Billiton Ltd. (NYSE:BHP) and Brazil's Vale SA.China's communist government regards steel production as a strategic industry and treats a wide range of economic data as secret. Information on steel company ore costs, profits and spending on technology all are considered secrets, according to news reports.The maximum penalty for an espionage conviction is life in prison.

China Ignites Rebound China's government has turned its economy around far faster than most thought possible, driving share prices up Wednesday to close at a 13-month high on some of the heaviest trading since 2007. Economists estimate that China's economy likely expanded by close to 8% from a year earlier in the second quarter, up from 6.1% in the first quarter. The official figure was scheduled to be announced early Thursday in Beijing. When measured in the same terms as other major economies -- an annualized quarter-on-quarter comparison -- China's growth in the second quarter could be on the order of 15%, some private economists estimate. Even if the surge moderates in coming quarters, many analysts say China will very nearly meet its target of 8% growth for all of 2009. The Shanghai stock market's benchmark index has gained 75% this year as the Chinese outlook has improved, with factory output, bank lending and commodity imports all continuing to accelerate in the past few months. Now, authorities face increasing questions about how long this growth can last, and how quickly the world's third-largest economy can be weaned off its massive stimulus before longer-term problems take root. The sustainability of this state-driven growth spurt is a critical issue for the global economy. The success so far of China's stimulus has been one of the few bright spots in the worst global downturn in a generation, with all advanced economies expected to contract this year.

For all the talk this year about the Chinese refusing to buy U.S. bonds, the real story is about the People’s Republic of China’s failure to find buyers for the equivalent of $1.7 billion of its debt because too many investors showed no interest at auctions that would be considered disastrous if their outcomes were repeated on Wall Street.

Failing China Bond Sales Show Asia Debt Auctions No Competition With U.S. Other Asian countries face similar difficulties. India’s underwriters had to purchase 3.1 billion rupees ($64 million) of 25-year securities they were unable to sell at a July 10 auction. Vietnam and the Philippines abandoned offerings because investors demanded higher yields than the governments were willing to pay. China’s 11.9 billion yuan in unsold short-term debt represented 14.3 percent of the 83 billion yuan it offered in three sales this month.While Asian local currency debt returned 94 percent from 2001 through 2008, the lack of demand signals that the rally is coming to an end, according to Allianz SE, Aviva Investors Ltd. and UOB Asset Management Ltd. Central banks in India, Thailand and Malaysia have stopped reducing interest rates to keep inflation from accelerating. China has started pushing money- market costs higher to slow record lending.

US Economic Policy: Stimulus vs Headlines

Obama Stimulus Fails to Reboot Economy as Multiplier Effect Shows No Life  The debate over whether the $787 billion stimulus package is sufficiently large or efficiently designed obscures a broader question, some economists say: Can any fiscal measure pull the economy out of the recession? With credit still crimped and the outlook for consumer demand gloomy due to rising unemployment and increased personal saving, no amount of government intervention will be able to stanch the hemorrhaging of jobs and quickly ease the U.S. out of its deepest recession in a half-century, they said. Even though a second stimulus package is unlikely at this point, those advocating such a measure said it may be needed precisely because the effects of the first have been so modest. The combination of rising unemployment and thrifty consumers “definitely lowers the multiplier effect” of every stimulus dollar spent, said Dean Baker, a co-director of the Center for Economic and Policy Research in Washington. “That just means you need more stimulus. There’s really no alternative.” Obama administration officials such as Treasury Secretary Timothy Geithner said the measure needs time to work and are appealing for patience. For the moment, the initial measure has shown little impact. The net worth of households has fallen almost 22 percent, by almost $14 trillion, since 2007, to the lowest level in five years. House prices have fallen more than 32 percent from their 2006 peak, according to the S&P/Case-Shiller national index, while the Standard & Poor’s index of 500 stocks is 40 percent below its October 2007 level. The crisis reminded Americans that home values can fall as well as rise and that bull markets don’t last forever, causing consumers to stash away a much larger portion of their incomes. Government data showed that the household savings rate rose to 6.9 percent in May, from zero in April 2008. The May figure is the highest in almost 16 years.

Stimulus Said to Be Moving Faster The Obama administration says it has been on a "learning curve" with the economic-stimulus package but has now figured out how to spend some of the available billions more quickly. Many tax cuts, which account for a third of the $787 billion package, have already taken effect. But only $60.4 billion of the remaining $499 billion has been spent. Most of the money was always likely to be spent this summer at the earliest as departments wrestled with the increased workload and new requirements imposed by the bill. The White House isn't changing its goal of spending 70% of the funds by September 2010. But amid worries about steep unemployment, the White House has been pressuring agencies to get some money out the door more quickly. "It was a learning curve and as we learned more we were able to accelerate more," said Ed DeSeve, a senior White House adviser. The Department of Education, for example, scrapped the idea of giving $8.8 billion of general aid to states in two phases and decided to send them all the money after their application was approved. The Department of Labor said it had distributed the bulk of its $38.5 billion in stimulus money within 30 days of the law's enactment, but that "it takes time" for states, in turn, to move the money. The White House told agencies to find ways to cut red tape, both for making large transfer payments to states and running big competitions for grants. Agencies were also instructed to work more closely with states to help them spend the money once they received it. Some agencies have indicated there isn't much more they can do. At the Commerce Department, a senior official said the time frame for a competition to give out about $4.7 billion in grants to build broadband networks had been condensed. But in an effort to make the money widely available, the department is deliberately staggering the pace at which it gives out the grants, giving more groups chances to apply. Another $1 billion of the agency's $7.9 billion will be spent next year for the 2010 Census.

America’s Sea of Red Ink Was Years in the Making There are two basic truths about the enormous deficits that the federal government will run in the coming years. The first is that President Obama’s agenda, ambitious as it may be, is responsible for only a sliver of the deficits, despite what many of his Republican critics are saying. The second is that Mr. Obama does not have a realistic plan for eliminating the deficit, despite what his advisers have suggested. The New York Times analyzed Congressional Budget Office reports going back almost a decade, with the aim of understanding how the federal government came to be far deeper in debt than it has been since the years just after World War II. This debt will constrain the country’s choices for years and could end up doing serious economic damage if foreign lenders become unwilling to finance it. Mr. Obama — responding to recent signs of skittishness among those lenders — met with 40 members of Congress at the White House on Tuesday and called for the re-enactment of pay-as-you-go rules, requiring Congress to pay for any new programs it passes. The story of today’s deficits starts in January 2001, as President Bill Clinton was leaving office. The Congressional Budget Office estimated then that the government would run an average annual surplus of more than $800 billion a year from 2009 to 2012. Today, the government is expected to run a $1.2 trillion annual deficit in those years. You can think of that roughly $2 trillion swing as coming from four broad categories: the business cycle, President George W. Bush’s policies, policies from the Bush years that are scheduled to expire but that Mr. Obama has chosen to extend, and new policies proposed by Mr. Obama.  The first category — the business cycle — accounts for 37 percent of the $2 trillion swing. About 33 percent of the swing stems from new legislation signed by Mr. Bush. That legislation, like his tax cuts and the Medicare prescription drug benefit, not only continue to cost the government but have also increased interest payments on the national debt. Mr. Obama’s main contribution to the deficit is his extension of several Bush policies, like the Iraq war and tax cuts for households making less than $250,000. Such policies — together with the Wall Street bailout, which was signed by Mr. Bush and supported by Mr. Obama — account for 20 percent of the swing. About 7 percent comes from the stimulus bill that Mr. Obama signed in February. And only 3 percent comes from Mr. Obama’s agenda on health care, education, energy and other areas. If the analysis is extended further into the future, well beyond 2012, the Obama agenda accounts for only a slightly higher share of the projected deficits.

Keynes Arouses Fed as ECB Looks for Monetary Exit: Mark Gilbert The worst crisis in modern financial history is set to culminate in an ideological clash, pitting the Federal Reserve against the European Central Bank in a debate that will shape the global economy for at least the next decade. The catchphrase that will dominate central bank meetings for the rest of the year is “exit strategies;” now that the markets are showing some semblance of normality, how quickly should they be unhooked from the life-support systems that have transfused the banking system with government funds?  Act too quickly in raising official interest rates and reversing the flow of liquidity, and economies might slump back into recession, bringing Federal Reserve Chairman Ben Bernanke’s well-documented nightmare about deflation to life. Wait too long, though, and the seeds of the next crisis may be sown as policy remains lax and encourages yet more financial bubbles that will inevitably burst. The outcome seems binary; our unelected guardians of stability will either awaken the ghost of inflation past, or condemn us to a deflationary spiral. Unfortunately, the most unlikely result seems to be a return to the Goldilocks economy of not too hot, not too cold that endured for a decade. Ideally, policy makers will act simultaneously around the world, with concurrent elimination of emergency measures. Moreover, ending the different kinds of local therapy being applied, via taxes, interest rates, distressed-debt purchases or whatever, should keep a balance, with some medications maintained while others are withdrawn. Finally, the cessation of crisis policies must not leave business short of credit; the liquidity can’t just end up in the hands of the banks, it must flow into the economy -- otherwise, what was the point? None of this will be easy. Russell Jones, the head of fixed-income strategy at RBC Capital Markets in London, summed up the quandary in a research note this month. “History suggests that after severe financial traumas and the painful recessions that follow them, macroeconomic policy support should not be removed too soon and tightening monetary and fiscal policy simultaneously can be particularly hazardous,” he wrote. The battle lines are being drawn. On the Keynesian side of the equation is the Fed (with an acknowledgment that these are strange days indeed when the U.S. seems more left-leaning than mainland Europe), under a new president who has no qualms about spending public money to either prop up or appropriate private companies, much as John Maynard Keynes might have advocated.

What the Future Holds: Re-thinkings and Structural Change

What If? The whole world, it seems, is wrapped around the axle about exit strategies from putatively unsustainable policies: (1) the Fed’s bloated balance sheet, with some $800 billion of excess reserves sloshing ‘round the banking system, in the context of an effective zero Fed funds rate; and (2) the Treasury’s huge budget deficit, unprecedented in peace time and set to stay huge, implying a Treasury debt/GDP ratio approaching 100% within a decade’s time. In any event, there does not seem to be any serious consensus as to how the policy mix should be adjusted, if at all, despite clear and present evidence of massive unemployment and underemployment, which is putting downward pressure on nominal personal income (the product of fewer jobs, fewer hours and decelerating wages, almost to the zero line). This is not the stuff of a self-sustaining revival in aggregate demand. Thus, my tentative conclusion is that maybe the consensus professional economist view is that America should simply accept that it’s going to have its version of Japan’s lost decade, the Calvinist aftermath of the preceding sin of booming growth on the back of ever-increasing leverage and mal-investment. In a follow-up (similarly wonkish) paper2 in 1999, Professor Krugman refined his argument, stressing that the core of his thesis could be implemented through a credible inflation target that was appreciably higher than the prevailing negative inflation rate in Japan. Thus, he was not so much arguing that the Bank of Japan should act irresponsibly, but rather act irresponsibly relative to orthodox, conventional thinking, which itself was irresponsible, in that it emphasized the need for an eventual exit strategy from liquidity trap-motivated money printing. To get out of the trap, he emphasized, the central bank needed to radically change expectations to the notion that there was no exit strategy, at least until inflation was appreciably higher – not just inflation expectations, but inflation itself. Only then would the commitment to higher inflation be credible, with the central bank not just talking the reflationary talk, but walking the reflationary walk, turning deflationary swamp water into reflationary wine. Naturally, the Bank of Japan didn’t listen to Krugman at the time; orthodoxy is as orthodoxy does.

In Slumping Economy, a Shift in Shopping Habits Economics correspondent Paul Solman speaks with author Paco Underhill about how consumer habits have changed during this recession

The Invisible Hand, Trumped by Darwin? IF asked to identify the intellectual founder of their discipline, most economists today would probably cite Adam Smith. But that will change. Economists’ forecasts generally aren’t worth much, but I’ll offer one that even my youngest colleagues won’t survive to refute: If we posed the same question 100 years from now, most economists would instead cite Charles Darwin.  Darwin, renowned for the theory of evolution, was a naturalist, not an economist, and his view of the competitive struggle was different from Smith’s in subtle but profound ways. Growing evidence suggests that Darwin’s view tracks economic reality much more closely. Smith is celebrated for his “invisible hand” theory, which holds that when greedy people trade for their own advantage in unfettered private markets, they will often be led, as if by an invisible hand, to produce the greatest good for all. The invisible hand remains a powerful narrative, but after the recent economic wreckage, skepticism about it has grown. My prediction is that it will eventually be supplanted by a version of Darwin’s more general narrative — one that grants the invisible hand its due, but also strips it of the sweeping powers that many now ascribe to it. The central theme of Darwin’s narrative was that competition favors traits and behavior according to how they affect the success of individuals, not species or other groups. As in Smith’s account, traits that enhance individual fitness sometimes promote group interests. For example, a mutation for keener eyesight in hawks benefits not only any individual hawk that bears it, but also makes hawks more likely to prosper as a species. In other cases, however, traits that help individuals are harmful to larger groups. For instance, a mutation for larger antlers served the reproductive interests of an individual male elk, because it helped him prevail in battles with other males for access to mates. But as this mutation spread, it started an arms race that made life more hazardous for male elk over all. The antlers of male elk can now span five feet or more. And despite their utility in battle, they often become a fatal handicap when predators pursue males into dense woods. In Darwin’s framework, then, Adam Smith’s invisible hand survives as an interesting special case. Competition, to be sure, sometimes guides individual behavior in ways that benefit society as a whole. But not always.  Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance, as in the antlers arms race. In the marketplace, such reward structures are the rule, not the exception. The income of investment managers, for example, depends mainly on the amount of money they manage, which in turn depends largely on their funds’ relative performance.

Posted by dblwyo at 04:56 PM | | Comments (0)

July 13, 2009

Wilting Flower, Perfect Storms: PE Outlook and the Return of Reality

One of the things we've all learned, very painfully, over the last couple of years is that the performance of our investments and the activities of the Finance Industry cannot be taken for granted. Instead we must pay careful attention to both for obvious reasons (or so we hope). Like learning to play poker the tuition has been steep. As part of our own learning experiences, insurance program and to help out we've ended up writing so much about the Industry, Credit Markets, valuations, etc. that they've grown to have their own archives.

Our interest reflects a broader concern of course and one of the things that is going on is that the old, tried, tired and busted shibboleths that people went along with for the last ~30 years are being re-tested. Buy-n-hold for example or asset allocation; both of which have gotten increasing coverage in, for example, the WSJ and other publications. A major meta-class that grew enormously these last two decades are the alternative asset classes: Venture Capital, Hedge Funds and Private Equity. Now we've been regularly dissecting the status, outlook and performance characteristics of the Industry with forays into specific sectors (Hedge Funds) or firms (Citi). In this post we're going to focus on Private Equity, though we've pinged it before. Last week's Economist captured the situation nicely by showing wilted flowers dying in a devasted economic landscape. In this post we'll dig a little deeper into what that means.

A Little Background: Market Anomalies

David Swensen of Yale is probably the best-known and well-reputed endowment manager in the country and deservedly so as his re-thinking of portfolio and investing strategies led to fabulous returns for Yale and fundamental changes in the way endowment investments are managed. As well as what the world's asset managers do to manage their clients money as well. With all that he got badly hurt this last year because of the way the markets behaved but has since argued that once the storms are over and recovery begins he'll be able to return to business as was. To some extent we agree with several critical and important caveats that bear on this discussion. We borrow this chart from today's Bloomberg to make the point. When Steinhardt, Soros, et.al. got the Hedge Fund business going there were few in existence and they had their pick of talent. Recently the Hedge sub-sector was flooded with money, people and investors and the result was poor performance, a massive shakeout and poor prospects. In this last decade there were other major anomalous situations: Real Estate, Energy and Commodities and Emerging Markets. EM offered unusual returns because for years they had been heavily discounted but with globalization, widespread global growth AND the establishment of safer, more secure and more predictable environments they became better investments that were mispriced. In other words, in true Graham-Dodd fashion, there was a market anomaly where assets with real values were priced under what they would be worth as the result of these structural changes. Something similar happened with the alternative asset class. Yet consider what's happened to the VC Industry after the Tech Bubble burst, following it's own decade of bubbliciousness and bad business practice. In the last few months (18 ?) Hedge Funds have been taking a big hit. The question then becomes what's going to happen to the PE Industry ?

PE Industry: the Perfect Storm and the Coming Shakeout

Having beat our heads against the wall trying to explain business and economic realities to the Industry for several years and making little headway in the face of vast liquidity, leverage, out-of-control multiples and covenant-lite debt financing what we see, and hear from many sources, is that the Industry is just beginning its own major shakeout. At the end of '07 we were chatting with a delightful young lady who was an associate with one of the local firms who told us she'd never had a better year. A couple of months later we had the same conversation and found her looking and acting like the shell-shocked survivor of a bombing attack or a major natural disaster. The bubble this decade in PE investing was built on easy debt, massive leverage, outsize multiples and, dare we say, a "buff it, fluff it and flip" it mentality. The chart shows the massive collapse in the debt markets. It also shows the massive bubble over historical norms and trends that preceded the startling bubble. It wasn't just Housing that ran away with itself !

Excess debt, out-of-control leverage and inattention to business fundamentals are just beginning to reverberate thru the PE investment portfolios. Any time debt instruments trade at or over a 1,000 basis points above safe instruments that debt is badly distressed. That 10% difference (or more as you can see) holds for 60% of the LBO portfolio companies. Which means defaults, bankruptcies, major valuation write-downs and outright losses for the lending banks, the PE firms and their investors.

In other words the PE Industry is well into, but a long from the end or even the beginning of the end, of a perfect storm where all the excesses of this decade are coming home to roost. The bottomline impact is projected to be that somewhere between 20-40% of the firms in the industry will go out of business. On the other hand it's estimated that the firms that were both prudent and followed the traditional emphasis on good operating practices will survive and be well-positioned for the future; about 30% of them. The remaining 30-50% of the firms will be on the bubble and their survival will depend on re-thinking and re-structuring the way they do business.

PE Industry Challenges and Outlook

Now the industry, like hedge funds and VCs, is NOT going away. But it will move from having a free ride to having less access to debt financing, paying lower multiples, probably lower returns (certainly on recent vintages of investments) and having to make operational engineering, as opposed to financial engineering, a major component in their strategies and toolkits. It's going to be a brave new world, sort of a "back to the future" one if you would, as a result of all this. Now the Industry has in fact been able to continue to raise major funds but, as the result of huge writedowns, assets under management has shrunk significantly.

In the readings we start with some excerpts and URL pointers to the Economist article as well as some recent BCG studies (which we can't excerpt but are available in downloadable PDF format online at thos addresses and everyone interested should consult !). That's followed by a sampling of stories and cases collected over the last several months reinforcing and illustrating our themes and an even bigger collection talking about institutional investor reactions, firms outlooks and attitudes, fund-raising, debt and portfolio company impacts, deal flow, M&A trends, layoffs, investors pullback from the industry as they re-balance their portfolios and fundamentally re-think their allocation strategies and attitudinal changes.

Tough times all around - it's going to be more than interesting to see who survives and who doesn't. Our bet is on the firms that have traditionally been the top performers who stuck to sound financial practices, focused on operational improvements and passed the debt-driven quick flips. We suspect we're not alone and the turmoil will be massive and continue for a long while.

Strategic Situation

Private equity faces a more hostile world THE private-equity industry faces a critical test. It prospered in an era when asset markets were generally rising, debt was plentiful and cheap, and recessions were rare and relatively mild. Now private-equity firms have to manage their portfolios through a recession. They cannot buy companies, strip out costs and “flip” them back to the market or to a trade buyer; there are too few purchasers around. They cannot use as much debt to finance their deals because banks and institutional investors are less willing to finance them. The regulatory climate has also changed. European politicians have seized the chance provided by the financial crisis to propose new rules for the industry, despite the lack of evidence that it had much to do with the credit crunch. All these changes should provide an answer to a long-running debate about the industry. Is it, as its supporters claim, a superior business model in which the interests of managers and investors are better aligned? Or is it, as its detractors claim, a simple financing ruse designed to allow rich people to take advantage of various tax breaks while simultaneously stripping assets and sacking workers? Investors may also get answers to some big questions. Is private equity simply a geared bet on equities, offering higher returns but also higher risks? Does an investment in private equity genuinely diversify a portfolio or simply make it less liquid? And does the skill of private-equity managers lie in company selection or in the management expertise they bring to the companies they fund? There is a potential historical parallel. In the 1960s investors were lured by the appeal of the conglomerate. Smart executives would assemble a portfolio of companies, save costs by sharing group services and use their expertise to allocate capital from head office. But with the admittedly large exception of GE, the dream died. The key driver of conglomerate growth turned out to be a financing trick, in which highly rated shares were used to acquire lowly rated ones, thereby enhancing earnings per share.

Companies, Deals and Cases

PE Vets Launch Commercial Lender In a sign that the lending markets could begin to squeeze open, Thomas H. Lee Equity Partners, Genstar Capital and Moelis Capital Partners--the private equity arm of Moelis & Co.--committed over $500 million to fund the launch of MidCap Financial, a commercial finance company targeting the middle-market healthcare space. Wells Fargo Foothill also committed a long-term debt facility to help fund MidCap. The deal marks the latest effort from private equity firms to help fill a hole in the battered lending market. In September, for instance, Merrill Lynch Capital vet Robert Radway raised capital from the likes of Stone Point Capital and J.C. Flowers & Co. to launch mid-market lender Next Capital. That effort followed the May launch of Tygris Commercial Finance Group, which pulled down $1.7 billion from Diamond Castle Holdings, Hamilton Lane, TPG Capital and others. While the middle-market lending space has been wracked by the broader market dislocation, investors are selectively targeting areas that should be more protected in the case of a protracted economic downturn. MidCap, for instance, will target four specific areas within healthcare, including real estate loans for senior housing and medical office buildings; working capital loans collateralized by third-party accounts receivable; leveraged loans to healthcare companies backed by PE; and life sciences loans, specifically focusing on pharmaceutical, biotech and medical device companies. “Healthcare continues to be one of the largest and most rapidly growing segments of the economy,” Widra said in a statement, adding that the liquidity crisis has only created “significant demand” for MidCap’s services.

In Private Equity, the Limits of Apollo’s Power “Traditional private equity is dead and has been for a year,” says Mr. Black, seated at a round conference table in an office once occupied by L. Dennis Kozlowski, who was ousted as chief executive of Tyco International. “It will probably remain so for a couple of years.”  Part of the allure of private-equity honchos like Mr. Black is that they made an art out of making money during the boom years. Their fist-pounding negotiations were legendary. Their corporate turnarounds became Harvard Business School case studies. Their multiple homes, black-tie parties, sports cars and yachts were alternately envied and vilified. Today, with Wall Street in tatters and the easy money long gone, the question now for Mr. Black and his peers is whether they have enough moves left to turn the bleak outlook for private equity into something rosier for themselves, their companies, their investors and the legions of workers they employ. Achieving that will hinge on whether Mr. Black and his peers can persuade banks and investors to give their companies more time to make good on their debts, something that Mr. Icahn’s lawsuit suggests is not always easy. The other parts of the equation — how long the economic malaise lasts and how deep it becomes, as well as its ultimate impact on the companies they own — are something that even the Wall Street power brokers can’t control. MR. BLACK says the big money over the next few years will be made in vast restructurings — the financial, operational and structural changes that companies will need to make if they hope to survive the economic malaise. Of course, the question is how many of these overhauls will involve Mr. Black’s own companies. The Boom Went Bust

$35B buyout of Canadian telecom company dead The largest leveraged buyout in history is dead after a group of buyers of the Canadian telecom company BCE Inc. said an audit found the proposed $35 billion deal to take the company private did not meet solvency requirements. An investment group led by the Ontario Teachers Pension Plan Board and several U.S. partners had expected to complete its deal for BCE, the parent of Bell Canada, on Dec. 11. It also would have been the biggest takeover in Canadian history. But a review by accounting firm KPMG found that BCE would not meet the solvency tests of the privatization agreement, partly due to the amount of debt involved in the transaction and current market conditions. The company had to meet the solvency requirements for the acquisition to be completed. The buyers announced the decision early Thursday. The banks that agreed to finance the deal will now be off the hook for billions of loans. Citigroup was directly on the hook for at least $11 billion of the $35 billion in loans backing the deal. The Royal Bank of Scotland, Toronto-Dominion Bank and Deutsche Bank were to provide the rest. It could have meant billions of losses for the banks. Some analysts speculated the banks would try to get out of the deal. New Chief Executive George Cope took over on July 11 despite the deal not closing yet. Cope has refocused the Montreal telecom operator as it faces more intense competition in its wireless and Internet data businesses. The deal has been in some doubt for a year for a variety of reasons, including the credit crisis and because a court ruling temporally put it in jeopardy. Earlier this year, Canada's Supreme Court overturned a lower court ruling that said the sale of BCE didn't adequately consider bondholders' interests.

Blackstone Plans To Prune Staff The Blackstone Group is planning to lay off roughly 70 staffers amidst the credit crunch, a source told IDD. A New York private equity firm that employed 93 senior managing directors and more than 780 other investment and advisory professionals through September, Blackstone is said to be making a wide range of job cuts. Officials from Blackstone declined to comment on the matter. The layoffs, initially reported by Bloomberg, come on the heels of disappointing results for Blackstone's various business segments in the third quarter. It reported negative revenues for its private equity business of $68.3 million, negative $273.7 million of revenues for its real estate business, and negative revenues of $48 million for its alternative asset management business. Like other buyout groups, Blackstone has been hard hit by the credit crunch and whipsawed equity markets. Shares of the $1.7 billion market-capitalized business declined from a high of $23.99 a share over the past year to $6.49 on Friday.  That Blackstone is reducing its head count, however, is hardly surprising. A number of other global private equity houses have moved to eliminate jobs including The Carlyle Group, Investcorp (which owns SourceMedia, the parent company of IDD) and 3i Group, as well as a spate of middle-market shops (see related story). The cuts at the largest buyout firms might be counter-productive considering the changes facing the industry, according to some industry participants. One managing director at a rival firm says: “A $30 billion deal, generally speaking, doesn’t require more manpower than a $1 billion deal.”

Pine Brook: Back To The Future While most private equity firms have found the credit crunch is making it harder for them to raise money, Pine Brook Road Partners LLC says the opposite is true. The firm just closed its debut fund at $1.43 billion, a bit south of its $1.5 billion target. Raising the fund took it some two years, but Pine Brook says that things actually got easier for it once the credit crunch hit. The firm attributes that to its old-school mentality. Pine Brook practices a “line of equity” approach to companies, founding them itself and contributing equity to them as they expand. There’s very little debt involved, at least in the early stages. While that approach didn’t serve it too well when mega funds and mega leverage was all the rage, in today’s environment, it’s looking a lot more attractive. “In fact it resembles the model around which private equity was based 20 years ago,” President and Chief Executive Howard Newman, who comes from a long career at Warburg Pincus LLC, said. “It was back to the future, in many ways.” The firm has done nine investments out of the fund, deploying around $250 million of capital thus far. Newman expects that figure to reach $500 million or $750 million by the time the firm is done deploying its line of capital to those nine companies. He said the model allows the firm to assess how its investments are doing as time passes, making sure its investment hypothesis is still accurate before it injects additional capital.

‘I Feel Like I’m In Michael Jackson’s Thriller Video’ As Michael Jackson might say about the current distressed debt environment, it’s close to midnight, and something evil’s lurking in the dark. But in this case, there may be someone there to save you from the beast about to strike. That would be Siguler Guff & Co., which recently closed on $2.4 billion for its latest private equity fund of funds dedicated to investing in distressed funds, as reported earlier by Reuters. That makes it the largest such dedicated fund of funds yet raised. Deal flow has never been better, according to Managing Director Maria Boyazny, who manages the portfolio. “Everything is measured in trillions of dollars,” said Boyazny, adding that both the size and scope of the current distressed cycle are much broader than in past downturns. “If you look at prior cycles, they centered around one or two types of opportunities,” she said. “In 2001 to 2003, you had more corporate debt, the fallen angels like Adelphia. But the residential mortgage market wasn’t in distress and the consumer wasn’t in distress…This time around, everything is distressed.” Besides backing distressed debt funds, Siguler Guff can also invest up to 30% of the fund of funds’ capital directly into debt or equity positions alongside its fund managers. Boyazny mentioned that her firm is seeing an unprecedented amount of co-investment deal flow at increasingly attractive pricing. “I feel like I’m in Michael Jackson’s Thriller video,” said Boyazny. “I have a running list of co-investment deals that we passed on in the past two years and they are coming back from underground. I feel like I’m dancing with all of these dead deals. They’re 50% to 75% cheaper and in some cases they make more sense, but in some cases they don’t even make sense now.”

PE Industry Reactions and Problems

Private Equity Draws the Cold Shoulder Large institutional investors are turning down requests for private-equity investments and seeking to ease prior commitments. Large institutional investors that provided much of the capital that put some of America's best-known companies into private hands are starting to cool on the investment strategy, suggesting that the lifeline for private equity is eroding. Public pension funds and endowments are turning down invitations to make private-equity investments. The nation's largest public pension fund, the California Public Employees' Retirement System, or Calpers, is asking private-equity firms to ease off on requests for additional capital it had previously committed to deliver. Calpers has $189.6 billion of assets under management.Harvard University, with an endowment of $36.9 billion under Jane Mendillo, is seeking to offload about $1.5 billion in investments with private-equity firms such as Bain Capital LLC, according to people familiar with the situation. If the Harvard portfolio trades, the transaction would be one of the largest-ever sales of a private-equity stake. Bids are due this week. Meanwhile, private-equity firms, some of which earned hundreds of millions of dollars for their founders less than two years ago by taking their firms public, continue to struggle amid the financial crisis.

Get a grip The hollow bullishness of buy-out firms’ bosses. LIKE professional wrestling, private equity has a butch subculture that is hard to take entirely seriously. One of its defining characteristics is never, ever, to admit to a mistake in public. By convention, most buy-out bosses maintain that they anticipated a recession and acted cautiously. In reality, the buy-out industry had its biggest-ever binge just before the bust began. Most big firms paid silly prices for companies using sillier levels of debt. A reminder of just how reckless some deals were was provided on November 26th by BCE, a Canadian telecoms firm and the target of the second-largest buy-out bid on record. Its auditors judged that if the transaction went ahead the company would become technically insolvent. As more companies owned by private-equity firms go bust, the industry will have to admit its sins. Until then executives can enjoy the latitude created by the valuation conventions that govern their portfolios. Accounting rules require that investments are held at “fair value”—the price at which they can be sold to a third party in an orderly transaction. Valiant efforts to interpret these rules are being made by the International Private Equity Valuations Board, an industry body that some buy-out firms support. But the calculations involve inevitably subjective comparisons with quoted companies. Conflicts of interest are possible: some buy-out firms’ in-house dealmakers conduct valuations, which are reviewed by consultants and auditors and approved by senior executives. Just how optimistic are these valuations? In the nine months to the end of September, developed-world shares dropped by about a quarter in dollar terms. Given their extra leverage, that is consistent with a fall in the value of companies owned by private equity of well over 50%. Yet Blackstone has said that its private-equity portfolio fell by just 13%.

PE Fundraising Declines To Six-Year Low Private equity fundraising has declined to a six-year low because of lackluster institutional investor demand, according to London data provider Preqin. There were 73 global funds that raised $45.9 billion in the first three months of the year, and 39 U.S.-centric funds that secured $23 billion in commitments. The second-lowest amount of capital raised by private investors occurred in the fourth quarter of 2003, when 131 investment funds secured $34 billion. “The slowdown in fundraising in Q1 2009 has been dramatic, but not unexpected," said Tim Friedman, a spokesman for Preqin.  An imbalance in asset allocations on the part of institutions ranging from endowments to pension funds has diminished investor appetite for new fund commitments. Friedman, though, expects that institutional investors that have delayed making commitments to new funds will return to the market this year. "We predict that fundraising levels will increase throughout the year as a result." Even so, he said that many investors may not fully commit capital for new funds until 2010. In the meantime, private equity managers don't appear to be paying attention to reticence on the part of their limited partner investors. Through March, 1,673 private equity funds were aiming to raise new capital. Global buyout funds accounted for the most capital raised in the first quarter, or $22.7 billion from 15 funds, followed by $13 billion garnered by 22 real estate investment vehicles.

COSTLY DARK SIDE OF M&AS If the fear stalking Wall Street has you nostalgic for the days of confident dealmaking, do not worry - a trip down memory lane is on its way. Over the next few quarters, experts say investors are likely to get plenty of reminders of those headier, happier days as dozens of companies that participated in the greatest M&A wave in history revisit those deals with their auditors - and admit how much they overpaid. It won't be pretty. "We're going to see an avalanche of these things," says James Cox, a corporate securities and accounting expert at the Duke University School of Law. "In the euphoria of the times they overpaid and they overpaid because money was cheap." With the credit markets frozen, asset prices falling and regulators pushing auditors to do their jobs, it's time for executives to admit they made some pretty dumb decisions, Cox said. The corporate confessions, in fact, have already begun as the downturn in stock prices compels companies to reassess deals inked when their shares were much higher. Last Monday, Sirius XM Radio took a $4.8 billion writedown related to Sirius' acquisition of XM. The company blamed the writedown on the significant decline in its share price from February 2007, when the merger was first announced. At that time, Sirius traded at about $3.79, compared with 26 cents at the close Friday. In an SEC filing last week, Google said it believed its 2005 investment in AOL was impaired. And although it said it would continue to carry the $1 billion investment on its books at its original cost in hopes the situation might right itself, Google warned it might need to take a future charge that "could be material." And Sun Microsystems took a $1.44 billion charge related to its 2005 acquisition of Storagetek for $4.1 billion, citing a "sustained decline in Sun's market capitalization."

Buyout Firm Could Call In Their IOUs Some investors may soon be faced with offers they can't refuse. No matter how dire their financial straits, those who have committed to invest in private-equity funds could be forced to follow through. That prospect could throw up yet another hurdle to a return to the go-go days for the buyout business. The issue is that private equity generally entails a long-term, roughly 10-year, investment. Investors, who don't plunk down all their cash at once, have to provide money to a fund as needed. This can lead to cash drains at the worst possible time. Also, many private-equity firms, unable to exit from investments, are unlikely to return much money to investors anytime soon. Blackstone Group stressed on its earnings call Thursday that investors have a legal obligation to meet capital calls. The firm emphasized that investors can otherwise lose 50% of their existing investment. In fairness, Blackstone has to take a hard line. The firm has a fiduciary duty to its shareholders and all the investors in its funds, so it can't go easy on a single investor. But it still may jar investors who never fully realized that, once in, there are no easy exits from private equity. One outcome could be investor demands for shorter lockup periods, or ways to redeem some money in a pinch. That would wreak havoc with the private-equity model, which is designed to give firms time to re-engineer purchased companies without having to worry about redemptions. An alternative is that chagrined investors may allocate less money to illiquid holdings such as private equity. At the least, they may demand lower fees. Blackstone and others have to play tough. But they themselves might end up taking a hit down the road.

Writedowns Extend Beyond Mega Firms It’s not just the mega buyout firms that gorged on debt that are marking down the value of their funds to account for the downturn in the economic environment. As reported this morning in LBO Wire, mid-market buyout firm Arsenal Capital Partners valued its $500 million second fund, raised in 2006, at 75% of cost at the end of last year. Most of that writedown came in the fourth quarter. Fund II has thus far invested in six companies, and its deals on average consist of about 50% equity and 50% debt, said a person familiar with the firm. Arsenal’s investors aren’t particularly concerned by the writedown. In fact, they think the firm is, if anything, being too scrupulous about valuing its investments to reflect the current environment. “Their valuation methodology is draconian,” said one limited partner. “They are using distressed multiples on all their companies, some of which were up year over year in 2008.”

PE Industry Trends, Outlooks and Consequences

Slow Deal Making Leads To Bigger Problems For The MM Middle market transactions may be easier to finance as a rule of thumb. Yet, the firms behind mid-sized deals aren’t immune from the problems faced by the mega-market buyout community. Private equity executives and investment bankers foresee a wave of bankruptcies and restructurings for over-leveraged portfolio companies that financial sponsors, large and small alike, acquired during the M&A-industry’s latest boom. And, if the value of an operations-focused private equity business model wasn’t clear before, it certainly is now. I believe, however, there is a bigger worry facing many middle market investment banking and buyout executives this holiday season: a job. Long known for paring the corporate ranks of portfolio companies, buyout firm partners have started thinning the ranks of their own. American Capital and Behrman Capital, two well-established East Coast private equity firms, have reduced the head count at their respective firms, mirroring the actions being taken by global behemoths such as The Blackstone Group, Carlyle Group and 3i, among others. It turns out that investment professionals once thought vital to a firm’s operations are as vulnerable to cost-cutting measures as administrative personnel. The immediate savings might make sense in the world of corporate rightsizing, though I’m afraid the damage may ripple beyond the livelihoods of the buyout industry professionals affected. By having fewer managing director and principal-level dealmakers, private equity firms will have less support to re-jigger troubled portfolio companies, source transactions and handle due diligence on prospective acquisitions. Of course, these challenges can and likely will be absorbed by a firm’s remaining staffers, many of whom may experience a return of sorts to their investment banking roots by putting in longer hours. Even so, it makes one wonder what kind of long-term “value creation” will be generated by this short-term measure. If the managing partners of buyout firms are truly concerned about that oft-talked about concept, they might want to think carefully about the managing of their own firms. After all, it takes people to create value.

PE Deal Flow Tanked In 2008 Private equity firms executed a record $21.2 billion of growth capital investments last year, or 252 transactions involving public and privately held businesses, according to research from data provider PitchBook Data. The credit market retraction and economic downturn sliced the number of leveraged buyout deals arranged last year to 1,241, marking a 40% decline from the 2,097 LBO deals generated in 2007. In addition, the amount of equity and debt invested via leveraged buyouts declined to $116.5 billion in 2008, compared with $489.5 billion for the prior year. Not surprisingly, the number of large private deals, or those valued at more than $2.5 billion, declined 75% to $86.5 billion. In 2007, mega transactions commanded $347.6 billion of capital; even so, large transactions made up close to 50% of the equity invested in deals last year. Despite the decline in large private equity transactions, the $186.6 billion invested in 2008 represented the third-highest amount of capital ever put to work, according to Seattle-based PitchBook. The fourth quarter of 2008 illustrates the toll that the volatile financial markets have had on private equity. For example, capital invested in the fourth quarter fell more than 85% to $24.6 billion, or 251 deals, as compared with the $184.7 billion deployed the fourth quarter of 2007.

  • PE Deal Flow Depressed In 2Q The private equity business was in the doldrums during the second quarter, according to new data from PitchBook. Buyout groups completed 407 investments in the first half of the year and 174 deals in the second quarter. Much of the transaction activity centered on add-on acquisitions, which are purchases made by private equity-owned companies. Despite the lower amount of leveraged buyout activity in the second quarter compared to prior years, however, there are indications that the deal business is on the uptick. "It seems a lot better than the fourth and first quarters. Even though deals haven't really come back, people are getting back to dealmaking," said John Gabbert, chief executive of PitchBook, a Seattle-based private equity data provider. Most activity was in the middle market, which Pitchbook defines as transactions with an enterprise value of $250 million or less. Small and mid-sized businesses accounted for 70% of deal activity in the first half of the year, according to the data provider.

MacFadyen: Cleaning out the Inbox So what does this have to do with deals? Nothing really, but those seven seconds reminded me of the onslaught of M&A data that has been filling my inbox since July -- data, coming from every direction, that seems just as nocuous.From Thomson Reuters, global M&A is down more than 40% in the first half, with more than half of that activity coming from just three sectors. From Dealogic, the private equity space saw an 82% drop in global buyout volume for the first half. From Robert W. Baird, middle-market M&A fell by a quarter. Various boutiques sent along updates as well, covering specific segments. Peachtree Media Advisors recorded a 61% decline in reported deal volume in the digital media space; Freeman & Co. noted that PE investments in financial services were off by 78%; and The Jordan Edmiston Group documented a 76% decline in media and marketing deals.Maybe Standard & Poor’s could provide some cheer? The corporate default rate climbed to 9.2% in June. How about the economic picture? Forward Capital’s Richard Moody reports that unemployment rose to 9.5 percent. That’s not good. What about this Rolling Stone link? More bad news.

From a PE Recruiter’s Eyes: “Layoffs Are A Function Of Fund Size”  With murmurs that PE firms may not be immune to layoffs (and proof of that rumor trickling in), what’s a private equity recruiter to do? I asked Todd Monti, head of the PE practice at global executive search firm Heidrick & Struggles, what’s going on with the private equity job market. Your firm recruits upper level private equity pros. That must be tough if there aren’t any openings to fill. What are you seeing there? It really depends on the amount of assets under management and how much of it is deployed versus dry powder. Firms that have access to capital are being opportunistic in hiring. For those that don’t, it’s a wait-and-see approach with a lot of questions. The main hiring I’ve been doing is when a fund has just been raised and the firm feels a need to supplement the team. The second category of firms hiring is the firms that are starting to view distressed as an opportunity. A number of firms are bringing in turnaround pros. What about layoffs? It’s a function of fund size and what a sponsor’s commitment is to raising a pool of capital. If one feels it may be difficult, or they’ve decided to scale back fundraising efforts, there’s a direct correlation to layoffs. It would be case specific but wouldn’t be surprising if a firm that decided to scale back its efforts on the fund side also did so on the personnel side. There are two variables really. One is performance and two is the ability to raise capital. If there’s a team with a strategy that can’t get off the ground, then typically those (people) are reallocated. If there’s no immediate need for them elsewhere, they’ll get caught up in the layoffs.

Survey Paints Grim Picture For PE The denominator effect is taking its toll on limited partners, according to Coller Capital’s most recent global survey of institutional investors, as over a quarter of North American institutional investors expect to be over-allocated to private equity next year--a result, largely, of weakness being experienced in other asset classes. Jeremy Coller, in a statement discussing the survey, mentioned both a “distributions drought” from private equity firms as well as the oft-cited denominator effect, which describes the inverse climb of private equity allocations as competing, more liquid, asset classes sink--such as equities, fixed income and real estate. The results of the Coller Capital study do not bode well for PE firms intent on raising funds in the next 12 months. The survey, which polled 107 investors in private equity worldwide, revealed that 66% anticipate being “at or above” their target allocations for the asset class. Moreover, investors that still have room for additional commitments are scrutinizing their general partner relationships more closely. Four out of five, for example, have cut ties with existing GPs during the past year, with performance, style drift and staff turnover representing the top three reasons for refusing follow-up investments. The majority of those polled also anticipate that mega buyout funds will not fare well in the current environment. Over 60% are expecting the most recent vintage of mega funds will return less than 1.5 times committed capital, and 7% believe returns could gravitate into negative territory. Alternatively, the small and lower mid-market players are seen as outperformers over the next 12 months, both in terms of returns and activity. More than 40% anticipate returns over two times or higher from buyout firms targeting deals below $200 million in size, and in the lower middle market, for deals under $500 million, roughly a third of LPs anticipate draw downs will exceed 2008 numbers.

Buyout-firm failure rate will top 20%, study says Between 20% to 40% of private-equity firms are expected to fail due to the current financial turmoil, according one of the most pessimistic reports about the industry's future so far. Heinrich Liechtenstein, a professor at Spain's IESE Business School, and Heino Meerkatt, a Munich-based senior partner and private-equity expert at Boston Consulting Group, predict in their report that about a third of private-equity firms should survive. In a research paper, they say 30% of firms should survive, but 20% to 40% will go under. The remaining companies will "hang in the balance" with a slim chance of survival. The study looked at publicly available data for private-equity firms, portfolio companies, banks and credit-default-swap rates. It also relied on the authors' own analysis of loan trading levels and default probabilities. From 2003 to 2007, "nearly all private-equity firms were able to grow exponentially thanks to an unusually favorable financial and economic climate and, in particular, four major drivers of growth: massive amounts of cheap debt, rising profitability across all industries, escalating asset prices and the allocation of significant assets from institutional investors to private-equity funds," the authors said. "The recent financial and economic crisis has sent all these drivers racing rapidly in the opposite direction." In October, Walid Sarkis, managing partner at the London office of U.S. buyout firm Bain Capital, publicly said that there could be a 30% to 40% reduction in fundraising over the next five years. Eariler this month, preliminary findings of Private Equity News' annual survey of more than 200 financial sponsors, firms and advisers revealed that 75% of people surveyed said they expected consolidation of the private-equity industry. The survey will close early next month. Three-quarters of respondents said consolidation would occur because firms were unable to raise funds and a quarter said it would happen through mergers.

Private-Equity Fallout: Lost Jobs Wall Street might remember the private-equity boom for the billions in fees it collected along the way. The rest of the country might remember it for a different kind of cleanup: job losses created, in part, by unsustainable debt loads hoisted on thousands of companies across the economy. So far, the private-equity industry hasn't come to terms with this inevitable bloodletting. That is largely because it has been spending the last two decades trying to reform its image from the 1980s, when buyout artists were branded unrepentant "flippers and strippers." The makeover can't hide the basic facts: Otherwise-decent companies are being subsumed by debts that simply can't be paid in this brutal recession. There is a certain irony that the Web site of the industry's trade group, the Private Equity Council, highlights three investments -- MGM Studios, Univision and Hilton Hotels -- that are already struggling mightily. There are more than reputations at stake. There are big portions of the economy, too. Private-equity research firm Pitchbook Data estimates 7.8 million people are employed by companies owned by private-equity firms. "Things are bad, and because of the capital structure, it's even more challenging," says Pitchbook's John Gabbert. Private-equity owners are "going to do everything they can to make these companies lean to service that debt." Buyout bosses have for years said they had properly "stress-tested" their numbers, leaving room for a downturn. But they couldn't anticipate a near depression. Just look at Moody's latest Bottom Rung list, which features the companies it views as most likely to default on debts. The buyout gang's all there: Univision, Harrah's Entertainment, Realogy Corp. and Jacuzzi Brands Corp. among others. The question for the private-equity industry is just how many incremental jobs were cut because of that incremental debt. In other words, how many jobs were destroyed that didn't have to be? Harvard Business School's Joshua Lerner has done a lot of research on these questions, some of it commissioned by the World Economic Forum. He says that such layoffs "would be less severe than what we might initially anticipate," but added that they were likely to be "more severe than what we saw during the early 1990s." One difference is that credit market turmoil is starving troubled companies of the capital they need to emerge from bankruptcy protection. That means that many private-equity backed companies may simply disappear in liquidation. The margin of error is, indeed, shrinking. And who will get caught in the middle?

Chrysler Bankruptcy: End of "Dumb Money" Era for Private Equity Chrysler's bankruptcy filing is a watershed moment for the U.S. auto industry but also harkens the end of an era for private equity too, says Daniel Gross, columnist at Slate and Newsweek and author of Dumb Money. Cerberus, which acquired 80.1% of Chrysler and its finance arm for $7.4 billion in May 2007, is just one of several high-profile private equity firms facing big losses on deal done in 2007-08. Others include: Thomas Lee Partners and Bain Capital, which paid $18 billion and assumed $5 billion of Clear Channel Communications debt - and sued bankers to complete the deal - when it took the radio giant private last July. Clear Channel is now in danger of defaulting on its loans, The NY Times reports. Sam Zell, who paid $8.2 billion and assumed $5 billion of debt in Dec. 2007 when his firm acquired Tribune Co., which filed for bankruptcy in Dec. 2008. Kohlberg Kravis Roberts (KKR) and the Texas Pacific Group, which spent $45 billion to acquire TXU in Feb. 2007, including $24 billion of debt.  A consortium of firms, including Bain, KKR and Merrill Lynch Global Private Equity, which acquired hospital owner HCA in July 2006 for $21 billion, plus the assumption of $11.7 billion of debt. "Nine of the 10 biggest leveraged buyouts were done between 2006-2007," Gross notes. "They bought into cyclical industries right at the peak and loaded a ton of debt on them, which is not a winning proposition. " Gross compares these corporate financiers, who issued debt to pay themselves a dividend they considered income, to individuals who took out home equity loans and thought of it as income vs. a liability to be repaid. While none of the private equity moguls are going to go hungry, neither should you think this is just a case of a bunch of rich guys who bet wrong. Investing in private equity has been in vogue for pension funds and endowments in recent years, meaning a lot of "average" Americans are directly exposed to the industry's fate. Furthermore, private equity had been a major source of capital for distressed industries and is now going to be far less eager to come rescue some floundering firm. That means less private equity deals - which often reward common stockholders - more potential bankruptcies, and yet more potential candidates for bailouts by (you guessed it) the Federal government.

Granahan: 'Mid'dling Market Wall Street celebrated a much-needed boost in confidence last week, a barometer that not only ignited a stock market rally but also prompted many to call the unofficial end of the recession. Someone should let the M&A market know about this. At about the same time we were told that consumers felt better than at any time since Lehman Brothers fell last year, Baird was offering a dramatically different view of the world, one in which dealmaking between companies was ... well, less than confidence-building. Some numbers: The number of global transactions fell 39.1% in April, the largest percentage drop in a single month this decade. Dollar volume was off 43.3% from the year earlier period. The middle market saw deal activity drop 33.1%, and dollar volume declined 54.8 percent. For the very few remaining holdouts who argue that middle-market activity is hanging in better than among the bigger names, maybe that last stat will be the conclusive evidence needed to prompt a reconsideration. Indeed, it turns out so far this year that the overall number of announced deals has fallen 32.2%, with dollar volume down 38.8%. Alas, for the middle market the numbers look even more depressing; deal count is down 35.7% and transaction value off 53% from the year earlier. Of course, consumer confidence and M&A are two different beasts; a willingness to buy a pair of Nikes is not the same as agreeing to buy a shoe company. But the middle market has its own version of an M&A confidence report in the form of a twice-a-year survey done by the Association for Corporate Growth. In the most recent survey, 45% said the current M&A environment is poor, and half said the recession and tight credit are the biggest impediments to growth. That part makes sense, much more so than the 12% of the 700-plus respondents who called the current dealmaking backdrop "good or excellent." (They must be distressed investors.) But it is an optimistic crowd; 56% foresaw an increase in the number of transactions in the next six months; just 10% saw a falloff. The main catalyst in this turnaround would be healthier debt markets.

Posted by dblwyo at 10:46 AM | | Comments (0)

July 10, 2009

Beyond the CRE "Bombshell": Real Stress Testing for Finance (Updates)

One of the big announcements today was a member of Congress telling us that Commercial Real Estate was a major bombshell about to burst. This was actually kind of funny since CalculatedRisk has been laying down the law, graphically, on the CRE bust for almost two years now and calling it exactly. And he's done it by simple informed and competent analysis. Of course he also prognosticated the real estate bust early (very) in 2005 (which was just about the time that Merrill, et.al were piling on, taking more risk and creating special business units to get into the business !). There are NO surprises here - the good news is that this will be bad but not as bad as residential real estate and there's not as much leverage involved. We ourselves introduced this simple conceptual graphic well over a year ago to try and illustrate the various feedback loops that were at play (the immediately preceeding version is here - click on thru to note the changes). Credit markets are repairing but not in great shape and credit is still restricted. In the meantime the economy turned bright red but has since stabilized, as we've been saying, at a terrible level. Ditto on the stock market. Despite the headlines and talking heads the International Economy is worse - you think it's an accident that Iran and China have been beset by riots ? Despite China's headline growth they need 8% to stay ahead of the alligator of population and at 6% are in deep, deep trouble. Unfortuantely they're really storing up worse problems in the future when they have to deal with this credit bubble they are creating.

Credit Contagions

Even earlier in the game when we were all trying to decode the alphabet soup of CDS, CDOs, MBS, etc. etc. we came up with this little gem to illustrate the basic problem on of leverage, balance sheet blowups and cross-linked markets. This chart is close to two years old now (to the best of our recollection, anyway). We think it's fair to assert that, conceptual as it is and naive to boot, that it's held up pretty well. Even very well. The contagion that started in sub-prime saw boulder after boulder crash into the various debt and credit markets and sequentially take them all down. If you think it's an accident that nobody can get a mortgage or that the PE guys can't get financing or that the credit card companies are screwing us all...well look at this chart. Thougth admittedly we didn't spell out all the ramifications at the time since we didn't see them.

The Next Set of Credit Tsunami's

What we did suggest however is that Housing and the related financial markets were just the beginning. As credit problems metastasized into the real economy a vicious feedback loop was set up between a weakening economy, growing joblessness and increasing bad debt across the reach and range of debt. Including consumer, business and financial. Which led to this much more analytical chart. This one in particular we really meant, and mean, for you to trace the paths and think about them. The ONLY linkage path that's pretty well worked its way thru its doomsday scenario is Housing. Yet banks still haven't cleaned up their balance sheets and are both figting the government repair programs and refusing to come clean. Now as we continue in weak economic circumstances leveraged debt, for example for buyouts (CLOs) are headed say with rising corporate bankruptcies while credit card and consumer bad debt is growing exponentially. Similarly business defaults are growing rapidly. The level of balance sheet exposure and synthetic, leveraged debt instruments is somewhat less in these markets but they've got a long way to.

Repair My Sainted Aunt's Left Butt...

You figure out the rest. We've been harping in every market and financial post that the market was being driven by a surge in expectations built on the shaky finance repair and recovery. Courtesey of BigPicture we get this top chart which shows how the various sectors did from the Mar trough to the Jun peak and since then. Guess what - the unrealist of the unreal did the best far and away. Starting with the Pandit put and the "managed" earnings reports for Q1 we got this surge. yet all the bad news is hardly factored in. (NB: stay away from finance stocks unless you're a trader !)

 So what did that mean for the market as a whole ? Well the bottom sub-chart compares the SP500 to the Finance Sector ETF along with the the one for Industrials (XLI) and Consumer Discretionary (XLP). Take a careful look and the best performer by far was XLF closely followed by SPX; in other words Finance drove the market as we've been saying. Meanwhile Industrials didn't do anywhere near as well and Consumer stocks ran up with the trend but are since deteriorating badly. If this was a real recovery in sight just the opposite would be try, to some extent anyway.

Pound Away At Finance

Off and on we've been devoting major posts to the status of the Finance industry or key players within it. So much so that we found ourselves having to create a whole separte Finance Archive to collect the various posts where you could see them. Skimming back over the last two years it makes for interesting reading. The bottomline here is that we couldn't find any line of business in the Industry that was even in fair to so-so shape. Most are bad or worse. Now we're facing a world where: 1) things are going to keep getting worse for the banks but 2) they need to start do some fundamental re-thinking.

The result ? They're still in denial. In fact the whole thesis of the Industry being capable of self-supervision has proven false to fact; nobody else has come so close to bringing down Western Civilization all by themselves. Yet not only are they in denail but they are fighting reform of the regulatory regime tooth and toe nail while also insisting that just as soon as things "get a little better" it'll be back to busines as it was.

If you'll recall our discussions of the aberrational profit pictures that metastasized in the '80s, '90s and oughts for Finance that these is dead as a doornail. The real bottomline is that the Industry is facing a major structural shift that will be as momentus as the impact of de-regulation initially was. And that's going to eventually provoke a backlash of monumental proportions.

In the readings section you'll find a sampling of stories from the last couple of months or more that illustrate, as a whole and sector by sector, how the industry is fairing. We suggest you skim them for their own sake but keep all these points in mind ! And then think about the sector both as an investor, as a customer and as a participant in the larger economic picture.

UPDATES: the Latest Takes

Reviewing some recent WSJ coverage and other news we'd have to say that our take on storms yet to come along with the need for fundamental res-structurings and re-thinkings is beginning to be more widely reflected. Which is both good news and bad news. As evidence, which we think you really need to consider, we offer up some recent "Heard on the Street" comment along with some other stories.

Heard on the Street: Payback Time for Banks  After giving banks everything they could want in a financial storm, the U.S. is now demanding something in return. Assessing what the regulators, Congress and the Treasury actually want is a high priority for bank investors.Citigroup's management changes, announced Thursday, are likely the latest example of government intervention. The Federal Deposit Insurance Corp., one of Citi's regulators, has been keen on an executive shake-up.However, changing executives won't quickly fix Citi. The bank could face further pressure from the government, soon to be its largest shareholder. And Citi may find it harder than peers to generate sympathy in Washington by claiming it is a critical cog within the U.S. economy. Its domestic banking operations aren't huge and 60% of its deposits are foreign.Not just the weaker banks face change. Elements of the Treasury's financial-sector reform proposals could end up being quite stringent. The banks are pushing back against the government on many fronts, with a few willing this week to battle over the cost of buying back Troubled Asset Relief Program warrants.But bank executives need to realize that Washington might not be as receptive as in the past. Congress's desire for reform has remained strong -- witness the support for a recent credit-card bill -- and could even strengthen if some bank profits and bonuses balloon at a time when voters face hardships. It is consumer banking that politicians seem to care most about. A lender like Bank of America, with its large home-loan and credit-card portfolios, looks particularly exposed. Government support helped propel financial stocks higher in the spring. The summer political heat may cause them to wilt.


Finance Sector Trends

Bankers' Worry: Worst Is Yet To Come still worrying about whether they’ll get paid back on old loans. The latest Federal Reserve survey of senior loan officers finds very few shoots of green in that garden. The Fed asked senior loan officers: What is your bank’s outlook for delinquencies and charge-offs on existing loans of various sorts in 2009, assuming that “economic activity progresses in line with consensus forecasts?” Short answer: Gloomy. Or as the Fed put it: “A significant majority of banks reported that credit quality for all types of loans is likely to deteriorate over the year” — and that’s assuming the economy doesn’t take another turn for the worse.The specifics: Commercial and industrial loans: Of 52 banks responding, none said they expect improving quality, but seven said they expect delinquencies and charge offs to stabilize at current levels. Commercial real-estate loans: Only 1 of 51 banks (the other doesn’t make such loans) sees improving quality, and three see quality stabilizing at current levels. Of the 47 who see a worsening picture, 13 expected a substantial deterioration in 2009. Prime residential mortgages: Only 1 of 50 banks sees improving quality, and seven see quality stabilizing at current levels. Subprime mortgages: No bank sees improving quality, and only two see quality stabilizing at current levels. Home equity lines: No bank sees improving quality, though nine expect quality to stabilize around current levels. Credit card loans: None of the 31 banks who make such loans expects improvement, and three expect stabilization. Other consumer loans: Only one of 50 banks expects improvement, though 12 see loan quality stabilizing around current levels.

U.S. Mortgage Mess Worsens Delinquencies of U.S. mortgages in the first quarter shot up to levels not seen in nearly four decades, snaring a wider range of borrowers and suggesting that the U.S. housing market remains under severe stress.News of the record amount of mortgage loan delinquencies and foreclosures unsettled equity investors, sending share prices lower. The Dow Jones Industrial Average was off 33.53 points at 8,266.49 soon after release of an industry report mid-morning Thursday.The Mortgage Bankers Association said foreclosure actions were initiated on 1.37% of first-lien mortgages in the first quarter and 9.12% of all loans outstanding were delinquent. The MBA said the 9.12% rate is the highest in its records going back to 1972. Delinquencies are up 124 basis points from the fourth quarter of 2008 and they are up 277 basis points from year-ago levels.The MBA's delinquency rate includes loans at least one payment past due, but does not include loans in the process of foreclosure. Loans in the foreclosure process at the end of the fourth quarter made up 3.85% of all loans outstanding. That is up 55 basis points from the fourth quarter of 2008 and up 138 basis points from a year ago. The foreclosure inventory percentage and the quarter-to-quarter increase are record highs. The MBA said problems with mortgages now include loans to credit-worthy consumers and they are not relegated to just subprime home loans. “What has changed is the shifting of the problem somewhat away from the subprime and option ARM/Alt-A loans to the prime fixed rate loans,” MBA chief economist Jay Brinkmann said in a press release. “The foreclosure rate on prime fixed-rate loans has doubled in the last year, and, for the first time since the rapid growth of subprime lending, prime fixed-rate loans now represent the largest share of new foreclosures.”  Most of the problem mortgages are concentrated in California, Florida, Arizona and Nevada, according to the industry trade group, which examined 45 million loans for one- to four-unit residential properties.

Fitch: tough times ahead for credit card companies Credit card companies are facing a difficult second quarter as card losses increase and cardholders fall further behind on payments, said a report released Monday by Fitch Ratings. Consistently high unemployment figures and a decline in business in the first quarter point to hard times for credit card companies for this year and into 2010, said Meghan Crowe, senior director at Fitch. "Furthermore, net charge-off levels will be hurt by industry portfolio contraction, which will make trends in absolute dollar losses more useful in coming quarters," she said. The news did not dampen investor interest in credit card stocks, however, on a day major indexes climbed about 2 percent. Higher losses in investment portfolios combined with lower consumer spending volume and smaller loan portfolios will combine to challenge profitability this year and next, Crowe said.Purchase volume dropped an average of 5 percent at the top six card issuers in the fourth quarter of 2008 from the previous quarter and fell another 14.2 in the first quarter of 2009. These spending trends are expected to continue over the balance of the year, Crowe said. Companies relying less on interest spread income, such as American Express Co., will fare relatively better from an earnings standpoint, she said. She noted that few credit card companies have signed on to the Federal Reserve Board's Term Asset-Backed Securities Loan Facility program, known as TALF, which launched on March 3. The program was designed to expand credit availability. Citibank became the first credit card issuer to issue notes eligible for the TALF program in March, but other large credit card issuers have been noticeably absent from the program, as historically low interest rates continue to make deposits a more attractive funding source. Fitch believes a new accounting regulation that requires all off-balance sheet assets to be recorded on balance sheet may make asset-backed securities issuance less attractive for some card issuers.

U.S. Banks Risk Losing Trump Card The golden age of credit-card profitability isn't on hold. It could be gone forever. As investors weigh the potential impact of new legislation on credit-card profits, it pays to remember that this sector is also being hit by other factors. As a result, credit cards could go from being a high-return business for banks to one where lenders struggle to achieve average returns, even in good times. The margins were always unsustainable. First, consumer impatience with the high cost of running a credit-card balance was always going to come to a head one day. Now, a tough Senate bill, to improve customer disclosure and restrict flexibility to levy fees and raise interest rates, looks set to become law. Card companies typically don't disclose the exact contribution of penalty fees to earnings. But the impact could be larger than expected, as one route to outsize returns was to target borrowers who rarely defaulted but often paid penalty fees. Off-balance-sheet funding was another once-advantageous practice. But planned changes to accounting rules could soon force card lenders to bring large amounts of loans back onto their books. In turn, they would have to hold more capital and reserves against their loans, damping returns on equity. Also, high credit losses in this recession has disproved a common boast from card lenders that they were uniquely skilled at setting appropriate interest rates to reflect the risk of each borrower. A final negative: Many consumers burned in the bust are going to be more cautious with their cards for several years. Credit cards obviously aren't going anywhere, but the industry's easy profits are over.

Small Banks Face Hits on Commercial Real Estate Thursday's "stress-test" results will bring fresh scrutiny to the nation's biggest banks. They also are likely to highlight the woes from commercial real-estate loans that are piling up at large and small banks alike. In the worst-case scenario, federal regulators examining the 19 largest U.S. banks are projecting losses of up to 12% on commercial real-estate loans over two years, according to a document viewed by The Wall Street Journal. The regulators are likely to cite commercial-property debt problems as a major reason why at least some of the large banks need additional capital. Such losses likely would cause even deeper misery, and risk of failure, at small and medium banks because they tend to have disproportionally more exposure to commercial real-estate loans than giant institutions. While regulators have indicated they won't allow the 19 stress-tested banks to fail, that group doesn't include more than 500 banks with assets of less than $1 billion that have too much exposure to commercial real estate and are at the most risk of failing, according to an analysis by Foresight Analytics LLC. During the housing boom, small and regional banks doubled down on lending to home builders and commercial-property developers and investors as they were largely squeezed out of the home mortgage market by large banks and Wall Street firms. Now many of those loans are going bad as vacancies rise, rents fall and developments open to anemic demand. Analysts already had been forecasting hundreds of bank closures in the next five years. The stress-test assumptions, including a 10.3% jobless rate at the end of 2010, raise the specter that some of the failures could occur sooner. The 12% loss rate being used by regulators to scrutinize commercial real-estate loans surprised some analysts because default rates on such debt remain lower than those on home mortgages. The loss rate implies that the nation's banks and thrifts, which hold $1.8 trillion of commercial real-estate debt on their books, would incur $216 billion in losses by the end of 2010.

Banks' Credit Problems Persist  U.S. banks were able to report a first quarter profit, buoyed by revenues at a few larger firms, but overall the credit picture remained grim as the number of banks on the brink continued to rise and consumers and businesses increasingly fell behind on their loans. The Federal Deposit Insurance Corp. said Wednesday that U.S. banks reported a net profit of $7.6 billion for the quarter ended March 31, down from the same quarter in 2008, but a sizable improvement from the $36.9 billion loss recorded by the industry in the fourth quarter of 2008. Though banks were profitable, there were signs that the credit crisis continues to take its toll. The number of banks on the FDIC's "problem" list climbed to 305, the highest level since 1994, and the number of loans more than 90 days past due climbed across all major loan categories. "The first quarter results are telling us that the banking industry still faces tremendous challenges," FDIC Chairman Sheila Bair said in prepared remarks. "And that going forward, asset quality remains a major concern." Separately, Ms. Bair said U.S. banks will not be able to bid on their own troubled assets under the U.S. government's plan to help rid banks of those assets. "There will be no structure that would allow banks to bid on their own assets," Ms. Bair said during a briefing with reporters on the banking industry's first-quarter results.

The Hedge Fund Collapse The hedge fund mystique died with the crash of 2008. Youthful traders and big shots from investment banks won’t soon be given billions to invest based on their résumés. Mystery and opacity will be a negative, not cause for reward. Regulators, one hopes, are unlikely to again ignore an industry that, under their noses, grabbed at its peak nearly $2 trillion to manage. As many as half the funds that existed earlier this year, when the industry topped out at 10,000 funds in business, could fail or be wound up in a year’s time, industry watchers estimate. Assets under management at hedge funds are falling as investors rush to pull money out of good funds and bad. In September, investors took out an estimated $41 billion from the sector, the largest monthly outflow of money since experts began tracking numbers. October looked even worse. Smart investors will always be with us. They will continue to invest both long and (assuming that it remains legal) short. They will call themselves hedge funds unless they get smart and rebrand. But the hedge fund business itself will not look anything like it did during its heyday. Washington clearly intends to declaw the industry. That will probably mean, among other things, that hedge funds (and private equity firms) will finally lose the argument about taxation. No longer will their income be taxed as capital gains but as regular income. The additional tax dodge of keeping money offshore to defer taxes for years should, and probably will, be closed. After having looked obviously unsustainable for years, the egregious hedge fund fees will come down.

Public Markets Lock Down Private Equity If the latest rally turns out to be bear flavored, that is bad for investors in listed stocks, but possibly just as bad for private-equity firms. Public-market multiples are an important benchmark for putting a value on private-equity portfolios. When private-equity managers were giving 2008 year-end updates to investors, they had to contend with the drop in listed asset values. These would have implied lower multiples on the cash flows of businesses in the funds, cutting values and irking investors. At least then, however, profits hadn't been too badly savaged. That changed in the fourth quarter, when S&P 500 earnings dropped 25% from a year earlier. Analysts expect a 38% drop for the quarter just gone. When private-equity managers update their investors in the summer, therefore, they could face pressure on two fronts. Imagine a hypothetical buyout in early 2008. Back then, the company's earnings before interest, taxes, depreciation and amortization for the prior 12 months was $100 million. The buyer paid 10 times that, funding 60% with debt. Come June, say trailing Ebitda is now just $70 million. Public markets, spooked by predictions of a long recession and slow recovery, now posit a multiple of eight times. Assuming debt is still $600 million, the equity would appear to be worthless. At least on paper, that is. A strength of private equity is that its investments are held for years, so the valuations indicated by public markets on any given day are useful only up to a point. Actual returns are realized only when assets in the portfolio are sold or go bust. Therein lays the problem if markets don't rebound quickly. Almost 1,700 funds are trying to raise $887 billion, almost certainly chasing rainbows. Even anchor investors who participated in previous funds will likely be constrained in their ability to pony up. True, the private-equity industry sits on $1.3 trillion of committed capital from investors, waiting to be used, according to Preqin. More than half of that amount dates from before 2008. Yet deal activity has slowed to a crawl as credit has vanished. And given market conditions, funds face the threat of investors selling existing investments in the secondary market or trying to claw back commitments.

Goldman Sachs Increases Risk-Taking at Fastest Pace in Wall Street Trading  Goldman Sachs Group Inc., unbowed by the securities industry’s worst year since the Great Depression, increased its trading bets at the fastest rate on Wall Street. Goldman Sachs’s so-called value-at-risk, the amount the New York-based bank estimates it could lose from trading in a day, jumped 22 percent to $240 million in the first quarter, twice what Morgan Stanley stands to lose, company reports show. VaR climbed 2.8 percent in the same period at JPMorgan Chase & Co. and dropped 14 percent at Credit Suisse Group AG. Offense beat defense in the first three months of 2009 as Goldman Sachs reported record revenue of $9.4 billion, dwarfing Morgan Stanley’s $3.04 billion. Since Goldman Sachs and Morgan Stanley, the two biggest U.S. securities firms, converted into banks in September, Morgan Stanley Chief Executive Officer John J. Mack has reduced proprietary trading and principal investing to focus on the firm’s role as a financial adviser and broker. “What stands out to me isn’t so much that Goldman had a blow-out quarter, it’s that Morgan Stanley had a disappointing quarter,” said Jeffery Harte, an analyst at Sandler O’Neill & Partners LP in Chicago, who has a “hold” rating on both firms. Morgan Stanley posted a $177 million loss in the first quarter and slashed its dividend by 81 percent after real estate and debt-related writedowns. By contrast, Goldman Sachs, led by Chief Executive Officer Lloyd C. Blankfein, reported better- than-estimated earnings of $1.81 billion in the same period. “Morgan may have it right for 2010, but for the first quarter of 2009 that wasn’t the right answer,” said Peter Sorrentino, a senior fund manager at Cincinnati-based Huntington Asset Advisors Inc., which oversees about $13.3 billion and owns Goldman Sachs shares. “Goldman saw the moment completely differently. They saw the opportunity, saw the pricing and realized this isn’t going to last forever.”  Goldman Sachs wasn’t alone. New York-based JPMorgan generated a record $4.9 billion of fixed-income revenue, and profits at Citigroup Inc. and Credit Suisse, based in Zurich, were helped by trading revenue that exceeded analysts’ estimates. Deutsche Bank AG, Germany’s biggest bank, may report record trading when it discloses first-quarter earnings tomorrow, people with knowledge of the situation said last week. VaR is just one measure banks use to try to gauge losses. It isn’t designed to capture the risk of rare and extreme losses. For that reason, some critics such as Nassim Taleb, author of the “The Black Swan,” say the metric is inadequate. Wall Street made money in the first quarter from traditionally unprofitable corporate loans and trades for their customers, as the gap between what banks pay to buy fixed-income securities and what they sell them for, the so-called bid-ask spread, almost doubled.

Active Managers Get the Cold Shoulder A growing number of big investors are concluding that stock and bond pickers failed to add any value during the market turmoil and are shifting to index funds, a move that threatens to cut profits for asset managers. "Active managers have not given us the added performance in a down market that we hoped for," says Bill Atwood, executive director of the $9 billion Illinois State Board of Investment. Disappointing returns by some large- and small-stock managers led his fund to move about $400 million to index funds. "Now that we think we're close to the bottom, we feel we can access the upside just as well with index managers," Mr. Atwood says. The move toward more-passive investments is part of a broader reconsideration by many investors about what went wrong in 2008 and how they can reposition their portfolios to avoid a rerun of that dismal performance. Active managers promise to beat, rather than match, the market's overall returns and charge fees that can be at least 10 times higher than those of index funds. In a recent survey by Greenwich Associates, a Greenwich, Conn., consulting firm, about one in five institutional investors said they have recently shifted money away from active managers and into passive index strategies. That is up from just 4% who expected to make that shift when asked from July to October 2008. The active-versus-passive debate is shaping up as a driving force behind industry consolidation. When BlackRock Inc. agreed this month to acquire Barclays PLC's Barclays Global Investors, the giant index and exchange-traded-fund business, BlackRock CEO Laurence Fink cited investor efforts to cut costs through passive strategies as an impetus for the deal. Thanks in large part to a growing preference for index funds, the Bank of New York Mellon Corp. unit is forecasting a record number of asset managers will be replaced in the second half of this year. Mr. Keleher says the moves primarily involve switching from traditional "long-only" active asset managers who invest in stocks and bonds but generally don't hedge or use derivatives, rather than from hedge funds or private-equity firms. A change of heart in the $2.3 trillion public pension industry could quickly slice profits for the large asset managers that serve them. Stock index funds may charge annual fees of less than 0.1% of the money they manage, rarely topping 0.5%; stock pickers charge fees that can range from roughly 0.3% up to 2% of assets. Fees for bond managers are generally lower.

Ten Ways Banks Take Your Money Consumers need to keep their guard up as financial institutions increasingly impose new fees and charges. Banks and credit-card companies have gone on the offensive in advance of new consumer protections the Obama administration is asking Congress to enact. For many consumers, that could mean an unexpected financial sting. "The fee income is becoming increasingly more important as interest income is falling as a percentage of total revenues," says Bob Hammer, chief executive of bank-card advisory firm R.K. Hammer. Late fees, loan-origination fees, over-the-limit and overdraft charges helped generate 53% of banking-industry income in 2008, according to R.K. Hammer, up from 35% of income in 1995. The average bounced-check fee is $28.95, up about $1 from last year, says Greg McBride, senior analyst at Bankrate.com. And it's a charge that rises every year. At $19 billion, credit-card penalties for late payments and over-limit charges were up 80% between 2003 and 2008. Fees aren't necessarily bad, consumer advocates say, as long as they are reasonable. There's a lot more involved in a loan origination, for example, than there is in using an ATM. But Adam Levine, chairman of Credit.com, says banks are drawing wide margins around what's considered "reasonable." One thing to keep in mind: It's worth the time to ask for a pass on fees. No bank is going to advertise that it waives fees on a regular basis, but many will do so when asked.

Posted by dblwyo at 09:19 PM | | Comments (0)

July 08, 2009

Brown Shoots, Weak Markets, Resilient Business ?

We're going to take a quick pass thru the economic situation, markets and - picking up on last post's theme's - talk a bit about business resilience or not, as the cases may be, with examples. Last week's payroll employment data seems to have convinced folks that what we've been saying for months about non-existent green shoots, a weak outlook, a drawn-out recovery and a de-leveraged jobless future is in fact what's the outlook. Interestingly you need to tear yourself away from the US and major foreign business and financial news and listen to BNN; in the readings you'll find some selected vidclip URL's that are NOT there by accident and we highly recommend them all but especially the two *** ones. The market has bounced on PEs not on earnings and that's the story of the moment with the longer-term implications of all this still being struggled with. As we've tried to make clear this is a matter of responsive adaptation in the shorter run and adoptive innovation in the long. Also in the readings you'll find some specific cases on how well that's working and the brave new world we're all facing. The NYT did provide a superb graphic slideshow illustrating how a business cycle works which, if you'll click thru on the graphic, you'll be taken to. Watch it and think about it. We've talked about business cycles a lot and even provided a tutorial earlier so were particularly happy to see this; a superb use of new technology that gets the story right (NB: we've also notice that the YoY meme is really getting much wider spread use as well !).

Back to the Future: Employment & Consequences

This little gem of three composited charts tells multiple inter-locking stories with the top part showing the YoY% changes in Employment and Unemployment since 1998 monthly. Like we've been saying, a leveling off in the rate of decline is NOT a recovery, and you can see both the steepness and depth of the decline as well as the slight leveling - though Unemployment continues to worsen. Folks are starting to pick up on the differences between unemployment in folks actively looking for work and those pushed out of the labor force (Many Left Uncounted in Nation's Official Jobless Rate). That rate of unemployment is 16.3%. Those points are reinforced in a longer-term context in the 2nd sub-chart which shows Employment dropping -4%, Hours Worked -6% and Unemployment increasing by 70% !!! If you think the consumer is coming back any time soon think again. Worse yet the 3rd sub-chart gets back to our long-running theme about how weak job creation was during the recent "recovery" (reaching almost -4 million jobs in the hole) and how disastrous it's become. We're now about -12 million jobs in the hole. REALLY think about that - how long will it take to even get back to breakeven ? Bearing mind that unemployment will keep increasing for some time - perhaps thru all of next year ? What can we say except OMG X 2. First time for the numbers and second because almost nobody gets it.

Market Realities Return

The green shoots and China will save us theories led to a major bear rally between March and May though we've gone nowhere since then. In the last few days (largely on BNN again admittedly) we've heard pundit after pundit talk about the same things we've been jabbering away at. And in the last week we've seen a bunch of market analysis on the likely breakdowns in the market, for which you'll find another bunch of URL addresses to reinforce that point. If there's one must watch please watch the online vidclip presentation of MarketClub's tool demo assessing the SP500. Wonderful. Here's two SPX charts compounded to make our points, which are nearly identical. As you can in the top chart the critical level is about 880, which we busted yesterday on weak volume. If that keeps up, depending on how earnings run, then we can expect things to run down. But where ? In the lower sub-chart we look for some natural limits using Fibonacci limits. A first bottomline here is that you should be on the sidelines - as we said last major market post - take your money off the table ! The next stopping point is ~840, which we consider likely. If that's breeched the downward momentum will build and running down to 780-790 is highly likely. Depending on how things look, the news is running and what the sentiment is that might be breech as well. If that happens then we're back in the where's the bottom in a long-run sense. A question extensively previously considered but if you want to look at an updated long-term chart click thru. Which we recommend and you can't say you haven't been warned ! :)

Business Reactions and Performance

 Recent earnings estimates have been extensively revised downward, which you can see by consulting the S&P Earnings Estimates. They're calling for earnings of $55.54 and $74.02 in '09 and '10 with PEs of 16.55 and 12.42, which leads to estimates for the SP500 of 919. In other words a flat market at best, though if you use our Graham-Dodd approach lower PEs, like 10 or less, are appropriate. But even so that's telling us two major strategic things, actually three. 1) There's a lot of risk in valuations, 2) the recent runup was the limit for two years (and possibly more if you go with our pessimistic outlook) and 3) real earnings in a terrible economy are going to be the critical determing factor.

Gee, somehow or another we've circled back to business performance, short- and long-run. Our recurrant mantra is understand the strategic context (Economy and Geo-Politics), understand how each Industry is trending and then understand how each company is dealing with the things it cannot control and the things it can, now and for the future. There's a vidclip in the readings of Ivan Seidenberg being interviewed on Rose which is as perfect an exemplar of this sort of balanced thinking. The take on the current secular trends and how Verizon is being positioned is outstanding but the look ahead to the worldwide future of the Telecom Industry is worth the time.

In the readings there are some specific examples for your skimming pleasure. The section starts with some examples like a Greek Shipping company as well as Apple, talks about the Finance Industry which is the exact opposite of an industry adapting well. They're still locked into the way things were, not the way they are or will be. The lack of effective response and thining ahead can only be described as stunning. Then we have Rio Tinto, the Australian mining company who road the commodity boom into worldwide acquisitions sprees starting to spin off pieces as the result of the downturn. Talk about foresight and mis-readings ! NOT !! We spent a whole long post taking apart the Auto Industry but the outlook for sales is abysmal but the triple tsunami is the growing capabilities of the rapidly developing world, e.g. China's acquisition of Opel and the fact that India has turned out a great car in the Nano. Sadly it would appear that the kind of innovative adoptiveness required is more on display outside the developed world than in it. A theme enormously reinforce by Saab's moving to migrate production of the Grippen to Brazil - really.....really....really think about what that says not just about opportunity but about capabilities. Aircraft are among the most complex and demanding products in the world - advanced fighter aircraft are another order of magnitude. Meanwhile pharma sales are going to decline in the developed world so Big Pharma is looking outside the US, which has been its development base since it's founding. Now the Rapidly Developing Economies are very exposed because they are so export oriented to the downturn and future weakness. But in the long run.... ? Well...we'll leave it at that because we think the implications are both obvious and taken apart in depth and detail in the last post.

 

Economic Situation

Crisis far from over: World Bank chief  World Bank President Robert Zoellick said on Tuesday that financial markets are showing signs of stabilization, but warned that the global crisis was far from over in developing countries. Speaking to reporters ahead of a meeting of finance ministers from Latin America, Zoellick said developing countries were only now feeling the full force of the global economic and financial crisis, which could quickly return to advanced economies where it began. He said demand for World Bank financing was high and growing as credit markets remained shut to many developing market clients. "There seems some opportunities for improvement on the financial market side, but there is still great uncertainty about the scope and timing of recovery," Zoellick told reporters on a conference call. "There are risks that could threaten the turnaround and I have emphasized the world needs to recognize that dangers will come in waves," he said. Zoellick was speaking ahead of a meeting of finance ministers from Latin America in Chile on July 2.

A second half recovery is suddenly not a sure thing For months, policymakers from Federal Reserve Chairman Ben Bernanke on down told investors that a second-half recovery was a safe bet. Investors, optimists by nature, eventually bought in. But now, even though the second half has actually arrived, the curtain on the recovery has so far remained down and questions are being raised on whether it will go up at all. Suddenly notable economists say the whole thing might not happen. Others, including Harvard economist Martin Feldstein, predict the curtain may go up for a brief period but then go crashing back down. What gives? It turns out the "consensus" of a second half recovery was never very solid. This is how economists put it. "It is worth noting that there remains a wider-than-usual variance among our panelists about the prospects for economic growth over the forecast horizon," the Blue Chip Financial Forecasts said. What that means is that, while the consensus of a 2.8% growth rate by the second half of the year looks pretty good, it turns out that that this estimate just masks a dog-fight between economists. One camp of optimistic economists sees growth averaging 3.8% from June through December. A pessimistic camp sees growth closer to an anemic 1.8%. Pessimists believe that the financial crisis is re-writing the history books.

Feldstein Sees Renewed US Slump After ‘Improvement’  The U.S. economy will grow for a few quarters and then contract again, said Martin Feldstein, a professor of economics at Harvard University. “I think we’re going to see a temporary substantial improvement,” Feldstein, the former head of the National Bureau of Economic Research and a Reagan administration adviser, said today in an interview on Bloomberg Radio. “I emphasize the words temporary and substantial.”  Feldstein -- a member of the private panel that dates the start of recessions and recoveries -- suggested the economy will contract into next year, and that the pattern of economic turnaround will be more of a seesaw than what he called “a beautiful symmetrical W.” The National Bureau of Economic Research Business Cycle Dating Committee said the current recession, the worst in half a century, started in December 2007. Since then the economy has lost about 6 million jobs, and gross domestic product contracted in the final quarter of 2007, the third and fourth quarters of last year and the first quarter of this year. After the economy shrank at a 5.5 percent annual pace in the first quarter of the year, the change in GDP will be “closer to zero” or “even a small plus” for the April-to- June period, Feldstein said.

American jobs data are worse than we think  What if the US unemployment rate rises above 10 per cent and stays there for an extended period? This is a question that is not being asked enough, even though it entails yet another historical anomaly that will further complicate policy formulation and open it up to greater political interference. The unemployment rate is traditionally characterised as a lagging indicator and, as such, is viewed as having limited predictive power. After all, unemployment is a reflection of decisions taken earlier in the cycle so the rate always lags behind the realities on the ground – or so says conventional wisdom. This conventional wisdom is valid most, but not all of the time. There are rare occasions, such as today, when we should think of the unemployment rate as much more than a lagging indicator; it has the potential to influence future economic behaviours and outlooks. Today’s broader interpretation is warranted by two factors: the speed and extent of the recent rise in the unemployment rate; and, the likelihood that it will persist at high levels for a prolonged period of time. As a result, the unemployment rate will increasingly disrupt an economy that, hitherto, has been influenced mainly by large-scale dislocations in the financial system. Notwithstanding its recent surge, the unemployment rate is likely to rise even further, reaching 10 per cent by the end of this year and potentially going beyond that. Indeed, the rate may not peak until 2010, in the 10.5-11 per cent range; and it will likely stay there for a while given the lacklustre shift from inventory rebuilding to consumption, investment and exports. Beyond the public sector hiring spree fuelled by the fiscal stimulus package, the post-bubble US economy faces considerable headwinds to sustainable job creation. It takes time to restructure an economy that became over-dependent on finance and leverage. Meanwhile, companies will use this period to shed less productive workers. This will disrupt consumption already reeling from a large negative wealth shock due to the precipitous decline in house prices. Consumption will be further undermined by uncertainties about wages. This possibility of a very high and persistent unemployment rate is not, as yet, part of the mainstream deliberations. Instead, the persistent domination of a “mean reversion” mindset leads to excessive optimism regarding how quickly the rate will max out, and how fast it converges back to the 5 per cent level for the Nairu (non-accelerating inflation rate of unemployment). The US faces a material probability of both a higher Nairu (in the 7 per cent range) and, relative to recent history, a much slower convergence of the actual unemployment rate to this new level.

Turning a Corner? Industrial production suggests that the economy is poised to turn around, but that the climb out of the current downturn will be a long one.

Ivan Seidenberg, Verizon CEO on Charlie Rose Current state of telecom industry and plans, the role of application futures and bandwidth, corporate failures, public policy on telecommunications and healthcare AND economic outlook (no change in 2nd quarter).

  • Business Roundtable Releases Second Quarter 2009 CEO Economic Outlook Survey The CEOs of America’s leading companies continue to see the strains of an international economic downturn, according to the results of Business Roundtable’s second quarter 2009 CEO Economic Outlook Survey. “This quarter’s results reflect a continuing weak set of economic conditions,” said Ivan G. Seidenberg, Chairman of Business Roundtable and Chairman and CEO of Verizon Communications. “Conditions – while still negative – appear to have begun to stabilize.” The CEOs of America’s leading companies continue to see the strains of an international economic downturn, according to the results of Business Roundtable’s second quarter 2009 CEO Economic Outlook Survey. “This quarter’s results reflect a continuing weak set of economic conditions,” said Ivan G. Seidenberg, Chairman of Business Roundtable and Chairman and CEO of Verizon Communications. “Conditions – while still negative – appear to have begun to stabilize.”

Glut of $4.5 Trillion Will Haunt Obama's Dollar: William Pesek  It’s time to begin picturing Obama shilling bonds few may soon want. His best customers? Asians, of course. Asia already holds about $4.5 trillion of currency reserves, most of them denominated in U.S. dollars. It’s a product of Asia’s “savings glut,” of which the cash-strapped U.S. remains a major beneficiary. That is, if Asians don’t pull the plug. The trouble is that the U.S. seems to be taking Asia’s money for granted. That’s a grave mistake for a White House that needs to offload record amounts of debt to fund a $787 billion stimulus package -- not to mention spending plans yet to be announced. Assuming Asia’s perpetual devotion is a mistake. It’s no coincidence that China is pushing for a new international currency at a time when it wants to diversify its almost $2 trillion of reserves. Such mutterings from Venezuela are one thing. They’re quite another coming from the biggest foreign holder of Treasuries, with about $764 billion. “It would be important for the U.S. not to take its position for granted,” World Bank President Robert Zoellick said last week. “My guess is what you will see over time, just as the euro has developed over time, you may have some other currencies develop as an alternative.”  Not that the yuan is ready for prime time. Besides, say analysts like Marc Chandler of Brown Brothers Harriman & Co. in New York, China’s desire for the yuan to become a global invoicing currency doesn’t outweigh its need to maintain control and help exporters. Ultimately, China’s ambitions are hemmed in by the realities of a currency that still isn’t convertible. China speaks out of both sides of its mouth on the issue. One day, a top official says China wants an alternative to the dollar. The next, someone like Vice Foreign Minister He Yafei tells reporters that “we hope that as the main reserve currency the U.S. dollar will be stable” and that he’s “not aware” of China pushing to put the subject on the agenda of the Group of Eight’s agenda this week. The other BRICs nations -- the acronym refers to Brazil, Russia, India and China -- all have made noises about the dollar’s stability. Some more than others, of course, yet their concerns have been well reported.

Market Situation to Earnings Issues

FusionIQ S&P 500 Equity Market Review As seen below in the S&P 500 has been capped by resistance at the 950 level (red lines and arrows). As we had said in earlier S&P 500 notes we expect this level to mark a high water mark for a good period of time as we enter the seasonally weak period of the mid to latter summer. How deep of a correction we get will depend on the ability of the S&P 500 to hold support near the 875 level (purple line). The best case scenario is we stay locked in a trading range between 950 and 875, while the more alarming scenario is we break back below the 875 region and we have a deeper sell-off as part of a retest of the lows. So far the rally has been aligned with the reality that the economy was not nearly as weak as many had anticipated. However going forward the market won’t get such an easy pass and just being not as bad as expected won’t fly. So from an investment standpoint this new technical picture in the S&P 500 means curtailing trading activity on the long side, building cash (until the picture becomes more clear), tightening stops and possibly introducing some short exposure. Clearly the easy money has been made off this rally and now the market is taking back some of that easy money so investors need to step back and reassess and not get sloppy.

Biggest VIX Slump Obscures Options Market Betting S&P 500 Rally to Falter  The biggest drop in U.S. options prices since 1998 masks growing anxiety over the stock market’s rebound, as traders pay more for bearish contracts than any time since before the failure of Lehman Brothers Holdings Inc. Investors are spending the most since August 2008 to protect against a 10 percent decline in the Standard & Poor’s 500 Index versus wagers on an advance, according to data compiled by Bloomberg. That’s one month prior to New York-based Lehman’s bankruptcy. The premium on so-called put contracts increased even after the Chicago Board Options Exchange Volatility Index, a gauge of U.S. options prices known as the VIX, fell 40 percent last quarter. Traders are locking in gains on the S&P 500, which rose as much as 40 percent since March, on concern the worst U.S. recession in a half century isn’t abating, according to Huntington Asset Management, BlackRock Inc. and Fiduciary Trust Co. The widening gap between bullish and bearish options belies the VIX’s retreat to below its level when Lehman collapsed and comes as U.S. companies prepare to report second-quarter earnings this week. “Too many people are thinking the worst is over, life gets better from here,” said Peter Sorrentino, who helps manage $13.8 billion at Huntington Asset in Cincinnati. “We’re scratching our heads, going, ‘Something doesn’t feel right here.’ It’s probably better to have some insurance on the books.” Sorrentino, who expects the S&P 500 to retreat more than 10 percent from last week’s closing price of 896.42, said he bought options that pay off if the index declines to 775 in December. The “strike price,” or the level at which Sorrentino can exercise the contract, implies a 14 percent slump.

Wary Banks Hobble Toxic-Asset Program  The government's plan to enable banks to dump troubled assets is facing troubles of its own. Markets initially rallied when Treasury Secretary Timothy Geithner announced in March a two-pronged plan to offer favorable government financing to entice investors to buy bad loans and toxic securities from banks. But that initiative -- called the Public-Private Investment Program, or PPIP -- has lost momentum. Big banks worried about having to sell at fire-sale prices while small banks feared they would be shut out. Potential buyers balked at the risk of doing business with the government, concerned that politicians might demonize them for making big profits. The program's problems threaten to stymie efforts by struggling smaller banks, in particular, to clean up their balance sheets. That in turn could hinder efforts to revive the nation's economy. A look at why the program has stumbled underscores how difficult it has been to solve one of the economy's biggest problems: Mountains of bad debt sitting on the books of the nation's banks. As those loans and securities lose value, they are saddling the banks with losses and constricting their ability to lend.

Market Awaits the Earnings Turnaround  The current bull market has been fueled largely by wishful thinking. To go much further, some wishes need to start coming true. Corporate earnings, for example, should recover one of these days. That day was likely not the second quarter, which ends on Tuesday. The season for reporting second-quarter profits starts next week , but companies might start preannouncing results soon. Wall Street analysts, on average, think earnings fell 34.9% year-over-year in the quarter, according to Thomson Financial. First-quarter earnings beat expectations, but were still far down from a year earlier. Analysts don't expect earnings to rebound until the fourth quarter. But stocks have risen in advance, which is not unusual. Since March 9, the S&P's price-to-earnings ratio, based on consensus forecasts for operating earnings for the next four quarters, has risen to 14.7 from 10.8, due mainly to the sharp increase in the "price" component. The "earnings" side has shrunk as analysts have trimmed their earnings forecasts. Eventually pricier stocks need to be justified with earnings, and the rally has cooled in recent weeks. Mr. Grigoli thinks stocks have entered a "Twilight Zone" of uncertainty that leaves them vulnerable to earnings disappointments as they wait for earnings to recover. The earliest quarters of the profit rebound, when it comes, could generate easy comparisons to recent disastrous results. After that, cautious consumers and a humbled financial sector on a leverage diet might keep profits from rising very far.

Earnings Dropped Worldwide in Second Quarter as Job Losses Hurt Consumers Earnings at such companies as Ford Motor Co. and ArcelorMittal may continue to decline in the next three months as the highest unemployment in a quarter-century keeps consumers from spending. The year-over-year profit slide for Standard & Poor’s 500 Index members may narrow to 21 percent from July through September, after declines of an estimated 34 percent in the second quarter and about 60 percent in the year’s first three months, according to data compiled by S&P and Bloomberg. Earnings may rise by year-end based on comparisons to late 2008, which was roiled by the meltdown in financial markets. Consumers in the U.S., the world’s largest economy, remain concerned about jobs after unemployment reached a 26-year high in June, analysts and investors said. Until Americans start spending again on cars, cell phones and clothes, most U.S., Asian and European companies may keep squeezing out costs.

Microsoft Prepares for Worst as New U.S. Company Bonds Show No End to Fear  During the last week of May, treasurers representing America’s bluest chip companies gathered at the Park Hyatt hotel in Philadelphia for a conference dubbed “Survival Skills.” Instead of discussing ways to take advantage of the drop in borrowing costs to expand their businesses after the Federal Reserve cut interest rates to near zero, representatives of New York-based Colgate-Palmolive Co., International Business Machines Corp. in Armonk, New York, and dozens of other companies had other plans. After watching credit dry up almost overnight as the subprime mortgage contagion spread in 2007 and 2008 and Lehman Brothers Holdings Inc. collapsed in September, companies were more preoccupied with stockpiling cash and extending debt maturities by selling a record $301 billion of investment-grade bonds in the first half. Those events were “fresh in everyone’s memory,” said Brad Fox, chairman of the National Association of Corporate Treasurers and treasurer of Pleasanton, California-based grocery chain Safeway Inc. “We spent a lot of time talking about the aftermath of the fourth quarter.” Microsoft Corp., the world’s largest software maker, and Pfizer Inc., the maker of the cholesterol fighting drug Lipitor, led at least 262 non-financial borrowers in the first half, the most since at least 2001, according to data compiled by Bloomberg. Bond sales are rising even as the economy struggles to pull itself out of the deepest recession since the 1930s.

Business

Cheer up -- and start thinking 2010 Multiply the cunning of Navios management by smart companies around the world, and you'll see that managers are not standing still even as business looks bleak. They are thinking 2010 by trying to feast on the carrion of their fallen rivals, turning job cuts into profit-margin gains, buying real estate on the cheap and, most importantly, pouring money into research and development. The last is critical because if they can't persuade customers to buy more things this year, at least they can buy loyalty cheaply for '10 -- and obtain inexpensive marketing via the media -- by persuading customers to purchase new and improved versions of their favorite old things. For a great example, look no further than the sales geniuses at Apple (AAPL, news, msgs). They know everyone who really wants an iPhone already has one. So to ramp up business in these difficult times and wrest market share from BlackBerry maker Research In Motion (RIMM, news, msgs), they have had to look past 2009 parsimony and find an inexpensive way to provide an improved wireless device that has a better screen, more memory, a video camera and more speed. Voilà, the kinda-new iPhone 3G S, released last week. Retaining old customers and obtaining customers at a low cost in trying times are just another reason Apple continues to be a buy on any dip to the $110- to $120-a-share area -- yep, a good location -- that may surface over summer. Now, to lock arms with Navios and Apple in optimism over the potential to make next year a real 10 requires some hopefulness about employment. Jobs, after all, are the bedrock of the economy. People who work buy things, and that allows manufacturers the opportunity to make things, retailers to sell things and banks to finance things.

Banks’ Bogus Bonuses But at a time when other industries are suffering, the economy continues to languish, and today's job report was dismal, record bonuses on Wall Street seem shameful, if not laughable. And they are. Indeed, any insistence that record bonuses are on the way should be met with considerable skepticism, particularly if the implication is that Wall Street banks are now healthy and creating sustainable profits. There are some reasons bonuses may modestly grow this year. Revenues are up, and headcount has fallen 10 percent to 15 percent as banks laid off large chunks of their staffs. Banks are also making money because three large competitors were taken out of the business or merged: Lehman Bros., Bear Stearns, and Merrill Lynch. More money split among fewer people means bigger bonuses. But if bank profits are up significantly—particularly in the second quarter—that may not be good news. Instead, it may well be that banks are falling back on a risky old standby: mortgage-backed securities.

Reducing LBO Fees Means 2% Becomes Defunct as Pensions Lament Their Losses The 2 percent management fee that has been the industry benchmark for leveraged buyout funds since the 1970s is headed for extinction. The California Public Employees’ Retirement System, the biggest U.S. public pension plan, AlpInvest Partners NV, Europe’s largest backer of private equity funds, and HarbourVest Partners LLC, which has more than $10 billion in LBO funds, are pressing firms to cut their rates. “We should be able to get a better deal from private- equity firms in this market,” said George R. Anson, managing director at Boston-based HarbourVest. Buyout firms recorded a 31 percent decline in the value of their holdings last year, the biggest drop since London-based research firm Preqin Ltd. started collecting the data in the 1980s. The market slump has led to a 75 percent reduction in LBOs in 2009 and prompted investors to challenge a pay structure that rewards managers without requiring them to turn a profit. “We would like lower fees, especially those not related to performance,” AlpInvest Chief Economist Peter Cornelius said in an interview at an industry conference last week in Geneva. Investors would have been better-off last year owning shares of Pacific Investment Management Co.’s $156.9 billion Total Return Fund. The world’s biggest bond mutual fund gained 4.8 percent and levied a management charge of just 0.25 percent. LBOs plummeted to $37 billion in the first half of this year from a record $482 billion in the same period of 2007, data compiled by Bloomberg show. Stock market declines are forcing firms to write down the value of their investments, leaving investors with their first paper losses in at least five years. Even before the LBO boom ended, firms earned almost twice as much from what they charged clients than from the gains they received from selling companies, according to a 2007 study by the Wharton School at the University of Pennsylvania. LBO funds collect $10.35 of management compensation for every $100 they oversee, compared with the $5.41 they get from selling companies at a profit, according to the Wharton report. “The whole budget of private-equity firms is going to change with no transaction fees, smaller management fees and smaller funds raised,” said Mounir Guen, chief executive officer of London-based MVision Private Equity Advisers Ltd., which helps buyout firms raise funds. “It will be like being on a diet and going to the gym regularly all of a sudden.”

Rio Tinto offloads Alcan division for $1.2 billion Rio Tinto has sold a division of its Alcan unit for $1.2 billion as it continues to reduce debt, the Anglo-Australian miner said in a statement Monday. The deal to sell its Alcan Packaging Food Americas division to U.S.-based Bemis Company Inc. is subject to regulatory approvals and $200 million of the total price may be in the form of Bemis shares. The move is the latest by Rio to reduce its debt, which is about $23.9 billion after raising fresh capital last week through a share issue. Rio incurred significant debt in its 2007 purchase of Canadian aluminum giant Alcan Inc. for $38 billion. "The sale of the Food Americas division is the first significant step in reducing the asset portfolio acquired with Alcan," said Guy Elliott, Rio Tinto's chief financial officer. "The transaction represents solid value given the challenging financial environment." So far in 2009, Rio Tinto has announced a total of $3.7 billion of asset sales, including its interest in an aluminum smelter in China, Brazilian iron ore operations and a coal mine in the United States. Monday's statement said the company has identified Alcan's packaging and engineered products divisions as candidates for sale.

How Bad Are Auto Sales? 10 Questions and Answers 1) How bad are sales, really? After edging up in May, sales again in June dropped below the 10 million—unit annual sales pace again in June, which puts new vehicles sales at the slowest pace since the recession in 1958—a downturn that forced some carmakers, notably Packard, to shut their doors for good. Meanwhile each of the "Big Six," (the three domestic carmakers plus Toyota, Honda, Nissan, which together account for 75% of all vehicle sales in the United States) all reported double digit declines in sales. The declines ranged from 11% at Ford to nearly 42% at Chrysler. German automakers such as Volkswagen, BMW, Porsche and Mercedes-Benz also reported double digit declines.

Saab Ready to Move Gripen Manufacturing to Brazil, Marketing Chief Says Saab AB, the Swedish maker of the Gripen jet fighter, is ready to make Brazil the manufacturing center for the aircraft to increase its chances of winning a $1.8 billion order and safeguard the model’s future. Saab is prepared to shift as much as 50 percent of future Gripen production to the South American country, where the main competition to provide 36 warplanes is from Boeing Co.’s F/A-18, Bob Kemp, marketing chief for the $50 million plane, said in an interview. Final assembly work has already been offered to Empresa Brasileira de Aeronautica SA, or Embraer, he said. Saab is betting on the Brazilian order to rescue the flagship Gripen as the production backlog shrinks. Winning the contract, which may be awarded as early as next month, is crucial to establishing the model as the warplane of choice in markets not already dominated by Boeing and Lockheed Martin Corp., which is grabbing market share with its F-35. “Maybe in the future Brazil will become the leading exporter of the next-generation Gripen,” Kemp said yesterday by telephone from Linkoeping, Sweden, where Saab is based. “This fits perfectly with their strategic ambitions. We are looking at six or seven major defense companies that have the potential of offering equipment for our aircraft.”  Saab may be able to fend off Boeing because it’s able to transfer more technology to Brazil than the Chicago-based company, Kemp said, adding that the Gripen costs about 20 percent less than the more-sophisticated F/A-18 and is better matched to Brazil’s need for a low-maintenance fighter able to operate in small numbers from widely dispersed airfields. Spare parts and maintenance may also cost one-third less, he said. While Brazil’s initial requirement is to replace a batch of aging Mirage jets made by Paris-based Dassault, the country may need as many as 120 planes, Kemp said, each with a life of as many as 40 years. “In terms of value for money the Gripen is a superb aircraft, but Saab is at a terrible disadvantage in not having a strong home market,” said Richard Aboulafia, vice president at Teal Group, a Fairfax, Virginia-based consultancy. While the model has so far won 250 orders, 204 of them are from Sweden, where some planes have been leased out as the government reins in defense spending.

Drug Firms Seek Sales in Poor Nations  For the first time in a half-century, sales of prescription drugs are forecast to decline this year in the U.S., historically the industry's biggest and most profitable market. The Obama administration and Congress's attempt to pass legislation overhauling the health-care system, including provisions that could lower the cost of medicine, could put drug makers' U.S. businesses under further pressure. As a result, developing countries like Venezuela have begun to look more attractive to the industry. Sales of prescription drugs in emerging markets reached $152.7 billion in 2008, up from $67.2 billion in 2003, according to IMS Health, which tracks the industry. IMS forecasts sales will nearly double by 2013 to $265 billion. With a handful of other drug makers, including the U.K.'s GlaxoSmithKline PLC, Switzerland's Novartis AG and France's Sanofi-Aventis SA, Pfizer is making a big push into the developing world. In addition to Venezuela, the company is expanding in China, India, Brazil, Russia and Turkey. Pfizer brought in $1.4 billion in sales from emerging markets in the first quarter of this year. That's a fraction of its $10.8 billion in overall sales in the same quarter, but a slice Pfizer says it's determined to expand. Until recently, drug companies doing business in emerging economies have catered mostly to the wealthy and middle class. Now, Pfizer is turning to what it calls, in internal marketing discussions, the "bottom of the pyramid." Its program in Venezuela is an exercise in how to reduce prices enough to attract poorer customers while still turning a profit.

Posted by dblwyo at 11:41 AM | | Comments (0)

July 05, 2009

Run For Daylight: Innovation, Innovation, Innovation (Adds)

We're going to focus on innovation - what it is, how it works, it's role in business performance and broader trends and implications for the economy and society. Including the notion of how to judge it as a stakeholder. As it happens this is a theme we've been striking for some time and we'll review the previous discussions later on. The gist of our hammerings are threefold:

1) Innovation is widely and broadly mispercieved - all to often being viewed as an isolated pocket of activity and not as the broad multi-function, multi-process and cross-enterprise set of inter-linked activities it needs to be.

2) Innovation is generally not well handled - most businesses will give lip service to the need for innovation but when push comes to shove they'll cut the resources devoted to it. Given that they've already been doing it badly that may not be such a bad short-term idea but it's going to leave them terribly positioned for the foreseeable future.

3) Performance and competitive pressures are going to see an accelerating macro-scale series of on-going disruptions from the functional to the company to the industry to the economy-wide scales for decades to come. Failures to grasp the widespread disruptions that are entrain will lead to the kind of "penalties" that the Auto Industry is paying, the Finance Industry paid and will keep on paying and will hit every other single industry in the developed world. The times they are indeed a'changing.

Needless to say, with these recurrent themes in mind, we were absolutely tickled to see Business Week (long a loud and informed champion of good design and innovation) publishing a story a couple of weeks ago on the failures of innovation over the last decade. The graphic is borrowed from that story and nicely illustrates the point; and if you have trouble believing it then ask youself why 'ol Larry-boy at Oracle has been feverishly consolidating things, why MSFT hasn't made any major breakthrus or why the pharmaceutical industry suddenly tipped over into hard times about 6+ years ago (again something we've been arm-waving about for a long time).

Re-Imaging the Airstream: Imagination in Action

While we were contemplating this post we ran across another TED Talk on the designer who helped to re-imagine the Airstream Trailer for this century instead of the last one. His engagement started out as an exercise to showcase how laminates could be re-thought for the interior. What he found was that the Airstream, originally conceived as a forward-looking icon of the open-road, freedom and innovation had received the interior of a '50s mountain-cabin. Not bad in and of itself but not consistent with the supposed strategic theme; and not likely to appeal to new markets, like active sports enthusiasts. Thereby locking Airstream into its old and dying marketspace. By (literally) taking the trailer down to bedrock they were able to build a prototype that reimagined the interior and then use to that to re-imagine a whole new and modern trailer with a completely re-thought interior that was consistent, appealing and which created new value for new markets. There are some real lessons here that everybody who buys into our basis thesis needs to pay attention....or join the roadkill. (Chris Deam Re-imagines the Airstream)

Innovation As-Is vs Should-Be: Going to the Movies

 One of the interesting things the movie industry has started doing is loading up the DVDs they sell with all sorts of special features giving you the back-story on how the thing was conceived, developed and delivered. The first time we really paid deep attention was listening to all this was for Sky Captain and the World of Tomorrow but since then we've made a special effort for every major movie that interests us. The preeminent example is Pixar and it's string of hits. Two things we'd point out about all that, perhaps three. First, they've proven that they can keep it up time after time. Second, do you think it was an accident that (maturity aside) that after Jobs went back to Apple his long-standing interest in good design and innovation took a couple of quantum leaps ? And third (something we gleaned from listening to the 2nd disc of the Ratatouille DVD set) the recent string from the Incredible to Cars to Up was conceived years ago at a restaurant lunch meeting and sketched on napkins. A familiar process for anybody who's ever had the joy and terror of playing on the bleeding edge. Of course from napkin to delivery to sales is a long....long way.

The graphic compresses the long discussions in a couple of prior posts and also captures 25+ years of sustained experience in trying to move from how it's typically done poorly to how it should be done well. Based on that experience we guarantee that anybody who manages to get this blueprint in place will start having some real impacts and will, in fact, be able to create a sustainable habit of innovation. Contrawise you can use the blueprint as a diagnostic of failures. If you were to go back and re-visit the various movies that have been wildly successful you'll find these arguments supported. You might, for example, compare and contrast Lord of the Rings with King Kong with typical run-of-the-mill summer thriller. Or consider Pixar or the Harry Potter series as other examples.

All too often what you find in companies doing the lip service thing is that at some point in their history somebody had a bright idea that's thrown over the wall to Development and if it sticks (in the marketplace) all well and good. After the original idea is turned into a product more or less then Marketing is called in to put lipstick and ribbons on a pig and it's handed over to Sales to push into the customer base. Over a period of time this becomes embedded in the corporate culture and feature after feature that creates no appreciable new value from the customer's view is stuffed out there. Two major problems exist on this level. First, invention is NOT innovation. Innovation turns invention into new products and services that create incremental new value, not move beyond the 80/20 cutoff point of death. Second, the transom-throwing is a Vegas crapshoot that's playing a numbers game. There's always going to be elements of uncertainty but you can change the odds in your favor dramatically by doing it right.

Doing it right starts with understanding customer and market needs, wants, desires, values and characteristics. Stop me when the failures of Detroit come to mind. Let me stop  you if they don't but pick your industry. THEN the original problem identification goes thru a Design phase where the market-based, problem-solving goals are translated into product characteristics. Think about the LofR - Tolkien had a magnificent concept based on his life experiences and a lifetime of work in mythology and languages. That got us into the Design stage with the books if you would. Then the script-writing team spent years, literally, taking the books down to the next level of developmental detail. The extended edition DVD discussions on the subject are, IOHO, worth the price of the set for this alone. They're also worth it for the discussion of how special effects, weapons and fighting, horsemanship, filming, production design, etc., etc. etc. were all brought together in a synergistic blend of functions into a cohesive cross-functional development and delivery team. And serve as a model for how real, deliverable innovation should be being done by business or any other organization that needs to create new value.

Innovation Is A Team Sport

That highlights another major facet and the review of the LofR DVD will flesh it out if you pay attention and really think about what you're hearing. Innovation is not the result of any single innovater or even a small core. It's the result of a team scaled to the size of the problem with a wide and appropriate range of skills all working together.

Before we run on we suggest you run out and read Car: A Drama of the American Workplace by Mary Walton which discusses the design and development of the Taurus that save Ford when it first came out. A book that Ford tried to kill eventually after providing unprecedented access but perfectly illustrating our points - large and small. As well as Twenty-First-Century Jet: The Making and Marketing of the Boeing 777 by Karl Sabbagh about Boeing's creation of the 777. Guess who the Program Manager was for that and what he's doing now ? Now the graphic is adapted from the Technology business and it's worked for us for a long time; and contrawise killed us when we couldn't get the required executive support. But if you check out those books you can map what Ford did and doesn't and what Boeing did and still does (consider the Dreamliner) to the framework.

A Closing Thought: Tsunami's of Disruption

 Just a brief closing thought, having run on at great length longer than intended. As the world continuse to go thru massive re-alignments, new countries enter the mainstream of the developed world and make their own moves up the value-add ladder of innovation we're all going to face continuous disruptions. We can no longer count on the occasional miracle to save us, our jobs, our companies or our socieities. On the other hand we've coasted for almost sixty years on the innovations that came out of WW2. Isn't it about time to do it again ? In any case the choices are not to avoid the problem - only how we deal with it. The graphic is from an earlier post that walks thru all this in some detail AND provides the evidence to back it up.

In the readings below you'll find some are on general principles and practices while others are on specific cases. We recommend, highly, at least skimmin them ! We don't have the space to walk thru each reading and map it to this discussion but that'll be an interesting exercise for the reader, right ? :) More to the point we've collected ALL the prior posts in a single downloadable PDF file and included this one as well. In that file you'll find extended discussions on each of the major components as well as discussions of P&G, examples from Apple to Yahoo to MSFT to the Auto, Energy and other industries and lots of tools you can "borrow". The various posts also give you the URLs for the on-line posts which we recommend if you want the background details. Our estimate is that there's a collection of 20-30 pp. of short paragraph excerpts you might be interested in: Innovation: From Aha to Development to Delivery

Two Cases of Innovation Thinking

Just ran across two outstanding interviews on Charlie Rose that bear on the topics at hand. The first with Ivan Seidenberg of Verizon and the second with Jeff Immelt of GE. Why should you watch - well we started talking about something we called the Theory of the Case (Beyond Specifics to Principles: Business Performance Principles & Outlooks) where you had to think about balancing today and the future as well as operations and strategy. Both are exemplars of that. Seidenberg not just for Verizon's strategic move after FIOs, it's fibre-optic network, but for what he has to say about the future of telecommunications. Immelt for his assessment of the industries and regions that one has to be positioned in for today and tomorrow. Both also come down heavily on corporate social involvement and responsiblity, another of our "pounded" themes. The graphic is taken from our recent dissection of the Automotive Industry while the embedded title is from an earlier discussion of business performance, though not the first introduction of the idea. In any case we really recommend, and hope, you listen to these interviews careful. And then apply some notions like these to diagnosing what you're hearing. It'll be worth your while IOHO ! :)


Innovation: Practices, Status and Concepts

Cuts Are Here to Stay, Companies Say Many companies that have cut jobs, pay and benefits during the recession may not be quick to restore them. According to a new survey, 52% of companies expect to employ fewer people in three to five years than they did before the recession began. The survey of 179 companies was conducted this month by consulting firm Watson Wyatt Worldwide Inc. Among employers who have cut salaries, 55% expect to restore the cuts in the next year. But 20% expect the cuts to be permanent. Of employers who have increased employee contributions to health-care premiums, 46% don't plan to reverse the increases. Of all survey respondents, 73% said they expect employees to shoulder more of the cost of health care than before the recession began. Nearly half of the employers who have cut their contributions to retirement plans expect to reinstate them in the next year. The remainder plan to restore the contributions after that, expect the cut to be permanent, or aren't sure. "We're not going to go back to the status quo," says Laurie Bienstock, national director of Watson Wyatt's strategic-rewards practice.

Why Business Plans Don’t Deliver Truth be told, most business plans fail to make much impression on potential investors. Most aren’t even read in full. Their shortcomings tend to be obvious even in a two-page executive summary, largely because they are written before enough real work has been done to create a solid foundation. Five oh-so-common varieties of plans that go quickly into the trash without further consideration. To help budding entrepreneurs avoid these traps, I also identified the three key elements that go into a successful business plan: a logical statement of a problem and its solution; a battery of cold, hard evidence; and candor about the risks, gaps and other assumptions that might be proved wrong. 1) In this kind of plan, the writer is smitten with the elegance of his or her technology. The plan begins not with the identification of a customer problem to resolve, but with a detailed explanation of how the technology works, why it is cutting-edge or state-of-the-art, and how it is better, faster and cheaper than current solutions. 2) This gambit rests its case on a plethora of secondary data to show how large and fast-growing a market is. The plan then makes a heroic leap and assumes that the new venture will grab X percent of that market—it could be 1%, 10%, 30% or whatever. 3) Of our five fundamentally flawed business plans, this one is perhaps the most difficult to spot. Such business plans often contain detailed spreadsheets showing why the numbers would work. That’s why these kinds of plans are difficult to spot—the numbers look like they work. 4) Investors won’t be snowed by top-tier diplomas or past employment with a leading company. Investors care first about the main challenges of the industry in question, and whether the proposed team has hands-on experience tackling those challenges. 5) The most common type of business plan, and the one that goes most quickly into the trash, is the one in which the writer can’t find anything but good things to say about the opportunity and plans to pursue it. Investors know that in the real world most opportunities, even good ones, have some weaknesses. 

Is Innovation Too Costly in Hard Times? Not that long ago, innovation was a must-do priority for business. Now research and development might seem more like vacation homes and new cars—luxuries that will have to wait for better times. "Innovation is an easy target," says Vijay Govindarajan, a professor at Dartmouth's Tuck School of Business. "R&D dollars by definition lead to uncertain outcomes. Companies don't want failure during difficult times." In an annual survey of top executives by Boston Consulting Group (BCG), which provides the foundation of BusinessWeek's 25 Most Innovative Companies list, more respondents said that innovation spending will be flat or down than since the ranking began in 2005. On the other hand, after focusing on shorter-term, lower-risk projects, a majority said they're satisfied with their returns on innovation investments. But recession and market meltdown aside, many of the corporations on the 2009 ranking are finding ways to forge ahead. Perennial top vote-getters shouldn't take their positions for granted either. Apple (AAPL), which has always held the survey's top position, had 33% fewer votes this year than in 2008, while Google (GOOG), consistently the list's No. 2, had 31% fewer. Why? Wrote one respondent of Apple: "Their products are improvements on previous technology. Their execution is flawless, but they are not necessarily innovative." Another respondent had the same criticism of Google: "Resting on past glory (search). Spending a lot on new things but no new breakthroughs." In contrast, Jeffrey R. Immelt, CEO of recently battered General Electric (GE) (No. 17), nominates Southwest Airlines (LUV) (No. 45) as the most innovative company in the world. "They are always trying new ideas," he says. Risky? Of course. But success doesn't come any other way.

The Failed Promise of Innovation in the U.S. "We live in an era of rapid innovation." I'm sure you've heard that phrase, or some variant, over and over again. The evidence appears to be all around us: Google (GOOG), Facebook, Twitter, smartphones, flat-screen televisions, the Internet itself. But what if the conventional wisdom is wrong? What if outside of a few high-profile areas, the past decade has seen far too few commercial innovations that can transform lives and move the economy forward? What if, rather than being an era of rapid innovation, this has been an era of innovation interrupted? And if that's true, is there any reason to expect the next decade to be any better? These are not comfortable questions in the U.S. Pride in America's innovative spirit is one of the few things that both Democrats and Republicans—from Bill Clinton to George W. Bush to Barack Obama—share. But there's growing evidence that the innovation shortfall of the past decade is not only real but may also have contributed to today's financial crisis. With the hindsight of a decade, one thing is abundantly clear: The commercial impact of most of those breakthroughs fell far short of expectations—not just in the U.S. but around the world. No gene therapy has yet been approved for sale in the U.S. Rural dwellers can get satellite Internet, but it's far slower, with longer lag times, than the ambitious satellite services that were being developed a decade ago. The economics of alternative energy haven't changed much. And while the biotech industry has continued to grow and produce important drugs—such as Avastin and Gleevec, which are used to fight cancer—the gains in health as a whole have been disappointing, given the enormous sums invested in research. As Gary P. Pisano, a Harvard Business School expert on the biotech business, observes: "It was a much harder road commercially than anyone believed." If the reality of innovation was less than the perception, that helps explain why America's apparent boom was built on borrowing. The information technology revolution is worth cheering about, but it isn't sufficient by itself to sustain strong growth—especially since much of the actual production of tech gear shifted to Asia. With far fewer breakthrough products than expected, Americans had little new to sell to the rest of the world.

Preparing for the Recovery  In Dr. Govindarajan’s three-box framework, Box One involves managing the present—for example, improving the efficiency of today’s businesses. Box Two involves selectively forgetting the past. And Box Three? That’s about creating the future. Often, Dr. Govindarajan maintains, companies spend too much of their time managing Box One—the present—and think that’s strategy. Instead, he argues, companies need to spend more time and energy on thinking about Box Two and Box Three. In the current environment, the tendency for companies is to focus on efficiency and cost control—what I call “Box One” thinking, which is about managing the present. That’s inevitable because, for many companies, sales revenue has dropped by 50%, 60% or 70%. When your sales drop by 70% and you’ve got to maintain margins, you’ve got to cut costs. However, as a response to the economic crisis, many companies focus almost exclusively on Box One. I think this is wrong. Box Two and Box Three are critical despite these tough times. You see, there are three things that stand out about recessions. One is: Expansion always follows recession—and the expansion lasts longer and is more robust than the recession. The second point is that a recession fundamentally changes the competitive landscape in most industries. There are new winners and new losers. That leads to the third point, which is: Focus on the future and play offense while also trying to control costs and play defense. The best time to prepare for expansion is during a recession, because during a recession, assets are cheaper and talent is cheaper and more available. So you cannot lose sight of what you have to do in the long term.

Playing Well With Others Why can’t marketing and research and development play nice? Both functions are essential to developing successful new products. But the two departments don’t get along nearly as well as senior management thinks. How big is the gap? Huge. According to a survey we conducted, some 69% of senior managers described relations between marketing and R&D as collegial, but only 34% of mid-level managers saw the relationship that way. When we asked staff in each department what they thought about the staff in the other, the comments were even more revealing. R&D employees complained that marketers give them poor data, that the marketing department is too insistent about certain product features or benefits, and that marketers are mainly useful in developing launch plans rather than in actually coming up with new products. Marketing, meanwhile, had its own beefs: R&D doesn’t include marketers early enough in the product-development process; R&D doesn’t understand marketing, or what it brings to the process; R&D takes the credit when a product succeeds, and blames marketing if a product doesn’t sell. Such complaints are hallmarks of a dysfunctional product-development process. Both marketing and R&D have indispensable roles to play, but neither can reach its full potential without the other. Companies where such divides exist are more likely to miss out on the kinds of breakthrough products and market-research discoveries that can drive growth and profits for years.

Debunking Innovation`s Buzz The buzz around innovation is inescapable. It’s impossible today to open a trade journal or attend a conference without hearing about innovation’s importance. The problem is that too many CIOs view innovation as a kind of standalone activity that happens in the dark recesses of some R&D laboratory, while too many others view it as some type of technology to be deployed. You can almost hear a CIO calling his or her local services company and placing an order for innovation as if it were some shrink-wrapped product sitting on a shelf. Innovation isn’t some sort of mystical silver bullet that will solve all of our problems. Nor is it some new technology that we can buy and implement. Innovation is about creatively leveraging the tools and processes at your disposal to drive business value. Another concern is that people don’t understand that there is a certain culture required to successfully innovate. How many organizations in the current economic climate are open to trying things that may “fail”? To drive innovation, you must be open to the reality that a percentage of the things you try will not work out as hoped. As Edison quipped when asked about the creation of the light bulb, “I hadn’t failed. I just found 10,000 ways that won’t work.” Is your organization willing to stub its toe, or will it punish people who take educated risks that don’t pan out? A last issue in the current innovation rage is that people are struggling to figure out how they can innovate when they have to focus on other important initiatives, such as enabling process change and cutting budgets. This shows a limited view of innovation as something that requires additional funding and happens in a vacuum. Granted, some innovations do need seed capital. If so, work on reducing your operating costs to shake free a few dollars. In most cases, innovation requires less in financial capital and more in human thought equity. Don’t dedicate a team to driving innovation—make it the responsibility of everyone who works with you. Turn your people loose and let them come up with creative ideas. That is the true essence of innovation.

5 Ways Big Business Weathers the Economic Storm  Surviving this economic crisis is like going to see the latest Vin Diesel movie: Sure, it's bad, but believe it or not, others have seen worse. How do the grizzled vets get through the ordeal? They don't just sit there. Major companies such as Charles Schwab, Cisco, Corning, IBM, and Intel have all experienced crises more severe and life-threatening than our current one, making today's maelstrom for them more akin to Fast & Furious than, say, The Pacifier. Nothing creates fresh perspective like having stared into the abyss and living to tell the tale. No wonder, then, that each of these companies is approaching today's meltdown with distinctive strategies for not only surviving but also thriving. Intel and Corning are protecting their core advantages at all costs. Cisco, Intel, and Schwab view customer interaction and community as essential. IBM and Schwab are exhibiting a refreshing aggressiveness in chasing new business. Together, these five companies display a range of creative solutions that any business, fire-tested or not, should be applying right now. And unlike the Diesel, that's no joke.

Cases and Examples

Boeing and the 787: Not so dreamy ONLY a few days ago staff at Boeing were opening a ceremonial barrel of sake at the factory in Seattle where assembly was starting of the first 787 Dreamliner aircraft to be delivered to All Nippon Airways (ANA), the launch customer. At the ceremony Boeing affirmed that the virgin test flight of the world’s first big airliner to be made largely of composite materials, rather than aluminium, would take place by the end of June. But on Tuesday June 23rd Boeing’s share price fell by almost 9% when the company announced that because of structural flaws the test flight would be delayed. Boeing said it would take weeks before a further date could be set.The worrying things about the latest delay are that it comes so late in the process of development and that it relates to stresses where the wings join the fuselage. The stresses appeared in routine testing of wing flexibility. The wings are made in Japan and the fuselage comes mostly from Italy, to be pinned together in Seattle, thus the scope for confusion is immense. All new aircraft face delays as they become technically more complex and as manufacturing methods change in search of greater efficiency. Airbus's A380 super-jumbo was severely delayed mainly because of wiring problems. At first Boeing seemed to think that it had a quick fix for its latest problem—which would have limited the aircraft’s ability to manoeuvre—but subsequently the firm decided to postpone test flying until a more comprehensive solution is found. Boeing has pushed innovation in both technology and manufacturing to the limit, with its choice of a structure made of carbon fibre reinforced with resin and its decision to outsource much of the aircraft’s construction to distant partners. Earlier delays to the 787 were already turning the production of the Dreamliner into an anxious experience. Now it is becoming a nightmare. Getting the global chain of various suppliers to run smoothly has been a difficult task, as parts failed to arrive in a fit state in Seattle for final assembly.

Pressure Mounts From Boeing Buyers

 

Sony: Lost in transformation Sony's woes, especially since the global economic crisis rattled Japan, have led to his staying here 11 of the year's first 14 weeks -- a situation compounded by his hospitalization over the Christmas holidays with an intestinal malady. But he's here because, he says, he finally has his arms wrapped around the Japanese leviathan, and he thinks he has a clear shot -- perhaps his final one -- at remaking Sony (SNE) by transforming its culture, elevating new leadership, and finding new ways to exploit its technology and content. Says William Drewry, a longtime Sony follower who now heads media investments for Diamond Castle, a private equity firm: "This probably is going to be his last chance to run this company back to the top of the mountain." It's a daunting task. Sony's stumbles in sectors it once dominated (Apple (AAPL, Fortune 500) is No. 1 by a large margin in portable music players, and Microsoft (MSFT, Fortune 500) and Nintendo have taken swaths of share in gaming consoles) are old news by now, but upstart competitors continue to gnaw away at the Japanese giant. In just two years a startup called Pure Digital (now owned by Cisco (CSCO, Fortune 500)) has grabbed some 17% of the video recorder market with its easy-to-use, pocket-size Flip. Sony debuted an e-reader in 2006, but bookseller Amazon (AMZN, Fortune 500) swooped in two years later with its Kindle and has won consumers and acclaim largely because it boasted a feature the Sony Reader lacked: a wireless connection for downloading books, newspapers, and magazines. The culprit in nearly every case has been Sony's tradition-bound mentality, one that remained too focused on building excellent analog machines in an increasingly digital world. And though Stringer has been pushing for transformation since his first days in the top job, by his own admission he has been hamstrung by the management culture in Sony's home market and the repercussions of bad decisions made years ago that still haunt the company. It took the global financial meltdown for the notably cheery Sir Howard to finally decide there would be no more -- or at least a little less -- Mr. Nice Guy. In its last fiscal year Sony swung from a record profit to a loss of $1 billion on revenue of $79 billion, while cash flow in its main businesses whipsawed from $5 billion to minus $3 billion. Some of the blame for Sony's annual loss, its first in a decade, can be attributed to the economy and the rising Japanese yen. But huge Sony businesses like TVs -- where new Bravia models have sold well against those of rivals like Samsung -- have also bled red ink because of high manufacturing costs and commoditizing retail prices. (One of the bad decisions was to bet against the LCD display format for flat panels -- whoops!)

 

P&G Looks Beyond Premium Goods At an investors conference Thursday, P&G Chief Executive A.G. Lafley issued a sharply lower-than-expected earnings forecast for the Cincinnati company's 2010 fiscal year, which begins July 1. Outlining P&G's strategies to bolster sales in a difficult economic climate, Mr. Lafley said that every business at P&G is working to reach more consumers by widening the price range of its products. He cited the recent success of the company's bargain-priced Gain detergent and Luvs diapers. In recent quarters, both products have outpaced the sales gains of their premium-priced sister brands, Tide and Pampers.

As the recession wears on, cash-strapped shoppers are opting for more-affordable household goods, including store brands. P&G's new willingness to invest in developing more lower-priced products suggests it expects this price sensitivity to outlive the current downturn. "You have to see reality as it is," Mr. Lafley told investors. "In every recession there are hosts of compensating consumer behaviors as they manage a more modest budget. We have to expand our portfolios to serve the needs of those consumers. I think a lot of that is going to last."

 

Wal-Mart Moves Upmarket  Rivals are struggling to stanch losses while Wal-Mart's U.S. same-store sales grew 5% in April. More than a quarter of Wal-Mart's sales increase has come from new shoppers, more than half of whom have household incomes of at least $50,000. Wal-Mart execs say that higher-income group spends an average of 40% more per visit than the typical shopper. "Wal-Mart is becoming increasingly relevant to a growing proportion of households," says William Blair analyst Mark Miller. As Wal-Mart's U.S. marketing chief Stephen F. Quinn puts it: "We are being reassessed." The question is whether Duke can hold on to that more affluent demographic once the economy improves. Wal-Mart's reputation for humdrum goods and aggressive labor tactics has made it tough for the chain to gain a following among wealthier customers. To help keep them, Duke is expanding the presence of brands such as Dell (DELL) and Apple, putting pressure on manufacturers to advertise more in stores, and aggressively ramping up an initiative called Project Impact. The effort's goal: to remodel most of the chain's 3,600 U.S. stores (it has 7,900 worldwide) and make them more inviting. Duke is spending $1.6 billion to upgrade 600 stores this year, on top of 300 that were recently redone. He is also continuing a push to reduce the number of items in stores, which means less clutter but less variety for customers. And despite Wal-Mart's growth, he has laid off 800 staff at the Bentonville (Ark.) headquarters and slashed other costs to keep the chain lean. Such moves suggest Duke is taking a bolder role than expected by industry experts, who paint him as a caretaker CEO.

Slide Show: Wal-Mart's World

Wal-Mart looks for expansion overseas

Wal-Mart Exports Big-Box Concept to India

Wal-Mart Moving Upscale (2005)

Retailers emulate Wal-Mart's focus on necessities

No Need to Shop Around

 

In Recession, Strategy Shifts for Big Chains Shopping as we know it is on the brink of major change. Hammered by the recession, some of the nation’s biggest retailers are seizing the moment to reinvent their business strategies. And the impact will mean both sweeping changes in the merchandise on their shelves and subtler alterations, like how many pantyhose to keep in stock. High-end stores like Neiman Marcus, Saks and Coach will offer more midpriced merchandise. Many chains, including Wal-Mart, will carry less inventory and fewer brands. The likes of Sears and J. C. Penney will put self-service computers in stores so customers can browse collections or buy out-of-stock items. And retailers of all stripes will offer more exclusive merchandise and more attentive customer service. One of the biggest changes consumers are likely to see is greater personalization and regionalization of merchandise. An initiative known as “My Macy’s” requires the retailer’s merchandisers and other planners to go into stores each week to learn from the sales staff — who keep logs at the cash registers — what shoppers are requesting, snapping up or complaining about. For instance, when strapless and bare-shouldered dresses were selling well everywhere except Salt Lake City and Pittsburgh, Macy’s employees in those stores knew the problem was that their customers wanted more modest dresses. So they passed that information on to the merchandisers. Out went the strapless dresses; in came dresses with cap sleeves. And sales went from lackluster to robust. Under the new system it will not be unusual for a local Macy’s to stock the merchandise customers request, be it wide-width shoes or Sean John suits, and for those offerings to be different from the ones in a Macy’s store 100 miles away. “I think what Macy’s is embarking on is perhaps the largest transformation in our company in a couple of decades,” said Terry J. Lundgren, president and chief executive. The Macy’s change is just one example of a wide range of initiatives retailers are pursuing as they struggle to cope with an economy where sales are lower than they were just a few years ago. Despite all the new technology, consumers will be getting more attention from sales staff. During the last few years, retailers did not have to work hard to separate consumers from their dollars. But those days are over. More middle-market chains are striving for Nordstrom-quality service to win customers. Even Home Depot has adopted its “most extensive customer service training ever,” its chairman and chief executive, Frank Blake, told investors and retailing analysts last week.

 

Pixar's Small Wonder There's a brief scene in the back half of Pixar's Up in which 8-year-old Russell recalls how, years before, his estranged father used to take him out for ice cream. Butter Brickle was Dad's favorite flavor, Russell's was chocolate, and the pair would sit together, slurping their melting treats and counting passing red and blue cars. "That might sound boring," says Russell, pink-cheeked with embarrassment. "But I think the boring stuff is the stuff I remember most." If anything sums Pixar's modus operandi, it's loving the boring stuff. Finding salvation rather than the Devil in the details is one of the main reasons for the studio's artistic (53 combined Oscar nominations and wins) and commercial (nearly $5 billion in worldwide box-office gross) successes. Up, the studio's 10th full-length film, clocks in at a zippy 86 minutes and, like the nine before it, will rise or fall on the strength of its smallest moments. The guiding principle is the same across all Pixar films: "Wonder and interest doesn't have to come out of pizzazz and spectacle and huge idea. … I always knew that the power came from the small, and not from the big," Wall-E director Andrew Stanton said earlier this year. "[Making Wall-E] got me thinking about, and this may sound commercial, but how good Spielberg was at making moments of the littlest things." That minor details drive major plot points doesn't happen without meticulous curation, especially in the opening, silent montages of both Wall-E and Up. "It's not letting any stone be unturned," Stanton said about Wall-E. "It wasn't a random choice to just pick this. It's a conversation, like, 'Why are we picking this, why are we using this object, why are we in this set?'

·          Pixar, the Anti-Disney

·          Q&A: 'Up' Producer Jonas Rivera

·          An Interview With Andrew Stanton

 

Acer’s Everywhere. How Did That Happen? To reach the No. 3 spot in the global computer business, Acer went through a corporate reinvention that offers fodder for business-school case studies. For close to 15 years, Acer suffered from a split personality. One part of the company built computers for other PC sellers that would then put their labels on the machines. Another part of Acer sold very similar computers under the company’s own brand. The arrangement created obvious conflicts, Acer executives say, with the group responsible for the Acer-branded products competing against the customers of the manufacturing arm. In 2000, Acer began cleaving off its manufacturing division. A year later it formed an independent company called Wistron to handle these operations. A smaller, nimbler Acer emerged, outfitted with a new logo and lofty, global aspirations. With a clean slate, Acer made what looked like counterintuitive decisions. It decided to focus on laptops for consumers, and to sell them through partners and retailers, avoiding any kind of direct sales. This approach placed Acer on a distinctly opposite path from Dell, which was the PC industry’s major success story in 2000. Dell had surged past rivals like Compaq, I.B.M. and H.P. through an ultra-lean direct sales model that hinged to a large degree on shipping desktop computers to big businesses. In the subsequent years, however, computer retailing shifted in favor of Acer. Consumers now buy more computers than businesses do, and these buyers tend to prefer laptops to desktops. The advantages that Dell once gained by mixing and matching components for customers at its factories have faded as consumers have flocked to stores to buy preconfigured computers. In the meantime, Acer has snatched the mantle of quick-moving, lean operator from Dell. Be it wireless technology or super-thin laptops with a long battery life, Acer often ships computers with new features before any other large PC maker. And when it spots a hot trend started by another company — netbooks, for instance, were the brainchild of Asustek, a fellow Taiwanese company — Acer follows in force, bombarding the market with low-cost products. Paul S. Otellini, the chief executive of Intel, credits Acer with embracing its underdog role and taking big risks to disrupt the status quo. “They have done a spectacular job,” he says.

The Challenger from Taiwan

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