bizzXceleration: Performance, Value and Profit

 

Business Outlook: the Retail Industry

Our constantly harped on theme is that businesses need to adapt to the new normal, adopt new operational and innovation strategies and improve their performance mangement and governance. We've also argued that most businesses are lagging in their responses. Let's put that another way - every business is facing major structural changes at every level from the firm to the Industry to the global economy to geo-poitics and doesn't appear, on the best available evidence that we've seen, to be doing what needs to be done. Let's take the Retail Industry as the exemplarly case in point (exemplar in the sense of example not in the sense of ideal!). Bloomberg did us the favor of taking an outstanding look at the elephant in the room for the last decade - the fact that Retail is grossly over-stored. If you'll click on thru the graphic you'll be taken to another interactive graphic that will allow you to play with their model. Given the economic context of extended weakness PLUS the hidden anectoral evidence the outlook has to be judged as very poor.

Value-investing, the PFE Case and Investing Strategy

In the readings you'll find a bunch of other stories and cases from Harley's struggles with financing, to a slew of stuff on Toyota (wow, can you imagine - the poster child of well-managed company!), Hershey's continued struggles with dysfunctional executive leadership, a bunch of stuff on major shakeups and shakeouts in the Healthcare Industry and the really good story of the Fung brothers of Li and Fung who have managed to not only roll with the punch and more. How they've managed that is well worth studying - especially if you know that Li and Fung have been worldwide poster children for adaptive innovation for decades. You'll also find a link to the FT's "View From the Top" interview with Indra Nooyi of PepsiCo and a set of TechTicker interviews with a friend of our Vitality Katsenelsen, of Active Value Investing fame, discussing the market outlook, China and especially value investing in a range-bound market and taking PFE as his exemplar. We've seen Vitaliy's analysis and it's about as thoughtful and long-range a piece of fundamental analysis as we've ever read. The catch is that he argues that PFE is worth investing in because the PE's discount a total lack of effectiveness in drug development and they have great cash flow. So if anything pops on their huge R&D investments it's all gravy. Our problem - having looked at how badly broken the big pharma development methods are and knowing some folks in the Industry, we're not so sure that revenue is sustainable in the future. On the one hand you ought to look into both views, on another you ought to consider the tradeoffs and on the gripping hand we can split the difference. In the intermediate term Vitaliy's value-analysis probably has a lot of merit but in the long-term we think our breakage assessment will eventually triumph (the analogy that comes to mind is a few years back when we poopoohed Lamberts real estate-base financial engineering at Sears; a view since born out big time but one that took a few years to ripple on thru).

So let's consider PFE as investors via some longer-term stock charts. The 10Yr chart is here while the 5Yr chart is shown. You need to look at the 10Yr to see how bad the overall performance is while some mid-term distortions make the PEs hard to read so look at the 5yr here. And consider that each and every case study could/should be considered the same way. Now given volatile but flat earnings a PE of 10 is indeed still cheap but the question is, is it cheap enough? On the whole, once the market sorts out we'd have to say it might be well worth while putting PFE on your watch list for the next 18 months to 5 years. In the readings you'll find some other stuff on Healthcare, the Steel Industry and Oil. We've pointed out that Oil is going thru a major structural shakeup but, in the book of unintended consequences, the stillbirth of Healthcare Reform looks to provide a major and bigger shift in the HC Industry as well! We think that the Industry, and business in general, are going to bitterly regret not getting behind reform and really pushing.

A Final Word from Indra

And just to end on a slightly cheerful note we'll point you to Indra's interview where she discusses Pepsico's strategic outlook, globalization and corporate social responsibility as well as her impressions of Davos. We were delighted and relieved to hear that her views on Davos are nearly identical to our take and even more delighted that her views on how corporations should deal with the body public are entirely in line with our channeling of Drucker's Principles. On the operational, strategic, innovation and public/geo-political fronts we'd have to judge that Pepsi gets a 5 on our performance assessment ranking (that's another hint btw!).

 

Economic/Market Readings Updates

Chanos detailed presentation on China’s Strategic Outlook

AP analysis: US economic stress hit a peak in Dec. Weakness in Western energy-producing states helped raise the average U.S. county's economic stress in December to its highest point since the recession began in December 2007, according to The Associated Press' monthly analysis of conditions in more than 3,100 U.S. counties. States such as Alaska, Wyoming and Montana lost jobs related in part to a drop in energy and mining exploration. Those states in the past had generally defied the national economy's weakness. Economic strains in the final month of last year were evident throughout the nation. Foreclosure and bankruptcy rates rose even as the national unemployment rate held steady. The spillover to Western states was inevitable, some economists say. "It's hard to stay above water when much of the rest of the country is going down around you," Sean Snaith, an economist at the University of Central Florida, said of those states. The AP's Economic Stress Index found that the average county's score in December was 10.8. That's a sharp jump from the 10.2 reading in November. The previous worst reading since the recession began in December 2007 was 10.3 in March 2009. The index calculates a score from 1 to 100 based on a county's unemployment, foreclosure and bankruptcy rates. A higher score indicates more economic stress. Under a rough rule of thumb, a county is considered stressed when its score exceeds 11. Nearly 45 percent of the nation's 3,141 counties were deemed stressed in December. That compares with less than 39 percent in the previous month. AP Interactive Economic Stress Map

• 7 U.S. States That Are Worse Off Than Greece, Portugal, Ireland, and Spain
• Consumer credit down in Nov. for record 11th month

No Job Growth for Small Business Inspires Doubts Over Sustainable Recovery  Small businesses are becoming the Achilles heel of the U.S. recovery by limiting growth and job creation. Companies with fewer than 500 employees, such as Phoenix Technologies Ltd. and Sonic Corp., helped lead the economy out of the four recessions since 1980. This time, they continue to cut capital spending and dismiss workers, eliminating 3,000 jobs in January, according to Roseland, New Jersey-based Automatic Data Processing Inc., the world’s largest payroll processor. Improvement in the unemployment rate, which fell to 9.7 in January from 10 percent in December, may stall later this year if these firms aren’t hiring, and growth likely won’t meet the median 2.7 percent annual rate forecast for 2010 by 67 economists in a Jan. 14 Bloomberg News survey. “Will you have a sustainable recovery a few years down the road without getting some small-business spending? No,” Cary Leahey, senior managing director at Decision Economics Inc. in New York and a former White House economist, said in an interview. “Wall Street gets it.” Because few economic reports capture small-business statistics, some economists say investors are being misled about the strength of recovery from the longest, deepest recession since the Great Depression. Recent numbers suggest “the official data are too heavily weighted towards bigger companies, which are doing better than credit-constrained smaller firms,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd. in Valhalla, New York. “The latter employ half the workforce.”

Stock investors see threats from all directions Jittery stock traders react to each day's news as if it could be the start of Financial Crisis 2.0. On Thursday, the Standard & Poor's 500 index suffered its biggest one-day drop in more than nine months because of worries about debt problems in Greece, Portugal and Spain. Concerns about China's plans to limit economic growth and proposed regulatory bank changes from Washington also have pummeled the market.

• Weak Dollar Illusory as Correlated Trading Shows Gains Since Bretton Woods
• Corporate Bond Yield Spreads Widen the Most Since November: Credit Markets
• Reassuring talk isn’t ending the euro crisis
• End of the Bond Secular Bull Market?
• S&P 500 Equity Market Review

Is the Market ‘Priced for Perfection’? Yet in at least one important respect, there may be a significant parallel to the situation at the height of the tech bubble. Many market watchers say the late-January sell-off this year could be a sign that the market is again “priced for perfection,” said David C. Wright, managing director of Sierra Investment Management in Santa Monica, Calif.

• Get Used to Dow 10,000: Value Maven Predicts 10 More Years of Famine
• China Won't Crash But It's Time to Trim Exposure, Value Investor Says
• Vitaliy Katsenelson Reveals "The Perfect Stock for This Economy"
• How to build a global portfolio: What countries do you want to own?

Business Cases & Stories

Indra Nooyi explains why global institutions need to be rebuilt, why corporations need to give more to society, and why she’s not worried about PepsiCo’s share price on the FT View from the Top.

Retailers Likely to Close More U.S. Stores After Over-Expanding: Analysis Retailers are likely to close more U.S. stores to cut costs in the months ahead after expanding during the recession, an analysis shows. Retail Closings and Strategic Outlook (Interactive Graphics)

Harley's amazing downhill ride Today is an anniversary for motorcycle manufacturer Harley-Davidson that it would just as soon not remember. On February 3rd a year ago, with the stock market hurtling toward its March lows, Harley (HOG, Fortune 500) announced it had sold $600 million in five-year notes at a nosebleed interest rate of 15%. Yes, 15%, because the company needed the money to fund its finance company and had to pay what the market demanded. The market, in this case, included Warren Buffett, whose Berkshire-Hathaway (BRK.B) had been husbanding cash for years, and who was pleased to give $300 million of that money to Harley at 15%. The other $300 million was put up by Davis Advisors, a mutual fund company whose Chris Davis saw Harley notes as a fine investment for his funds (which, by the way, also own Harley stock). The annual $90 million of interest those notes carry certainly didn't help out Harley's 2009 results, though a recession that was killing sales of discretionary goods would have led to a financial wreck in any case. For the year, Harley reported shipments that were down 27% from 2008 and ended up with a $55 million loss -- its first red ink since 1993. Still, 2009 had its redeeming features for Harley, and these certainly began with its stock price. For the year, as investors anticipated the company regaining its zoom, its stock rose by 53%. Meanwhile, the great 2009 bull-market in junk-bond prices was producing an astounding turn in interest rates. In December, Harley sold still another block of 5-year notes -- $500 million -- at a 5¾% rate. For swings in what it costs to do business, and for a reminder of just how remarkable the securities markets were in 2009, a 15% rate down to 5¾% is an amazing ride.

Toyota’s Slow Awakening to a Deadly Problem At almost every step that led to its current predicament, Toyota underestimated the severity of the sudden-acceleration problem affecting its most popular cars. It went from discounting early reports of problems to overconfidently announcing diagnoses and insufficient fixes. As recently as the fall, Toyota was still saying it was confident that loose floor mats were the sole cause of any sudden acceleration, issuing an advisory to millions of Toyota owners to remove them. The company said on Nov. 2 that “there is no evidence to support” any other conclusion, and added that its claim was backed up by the federal traffic safety agency. But, in fact, the agency had not signed on to the explanation, and it issued a sharp rebuke. Toyota’s statement was “misleading and inaccurate,” the agency said. “This matter is not closed.” The effect on Toyota’s business is already being felt. Its sales in the United States in January are expected to drop 11 percent from a year earlier, and its market share in the United States is likely to fall to its lowest point since 2006, according to Edmunds.com, an automotive research Web site. The company has not yet projected the cost of its recalls and lost sales. But a prolonged slowdown in sales could substantially hurt a company that once minted profit. Toyota’s handling of the problem is a story of how a long-trusted carmaker lost sight of one of its bedrock principles. In Toyota lore, the ultimate symbol of the company’s attention to detail is the “andon cord,” a rope that workers on the assembly line can pull if something is wrong, immediately shutting down the entire line. The point is to fix a small problem before it becomes a larger one. But in the broadest sense, Toyota itself failed to pull the andon cord on this issue, and treated a growing safety issue as a minor glitch — a point the company’s executives are now acknowledging in a series of humbling apologies.

Where Toyota went wrong When Toyota gets around to doing one of its famous "root cause" analyses of the Great Accelerator Recall, it should start by looking in the mirror. As the company grew to become the world's largest automaker, it failed to adjust its corporate structure to accommodate its altered scale. And in its zeal to deliver profits as well as revenue, it may have overlooked fundamental principles that used to underpin its business. Toyota, in other words, forgot what the Toyota Way was all about.

• With Eye on Its Reputation, Toyota Issues Repair for Pedal, Toyota’s Sales Fall as G.M. and Ford Gain
• Toyota Says Prius Brakes Had Design Problems, Toyota Has Pattern of Slow Response on Safety Issues
• Week in Review: Watching Toyota Flunk for Once
• The Dozens of Computers That Make Modern Cars Go (and Stop)
• Auto Sales BNN speaks to George Magliano, director, automotive research for the Americas, IHS Global Insight.

News Wrap: Toyota President Apologizes for Recall In other news Friday, Toyota's president Akio Toyoda apologized for the brake problems that triggered a worldwide recall, and at least 40 people are dead in Iraq from two bomb blasts targeting Shi-ite pilgrim

Hershey Meltdown Looms With Reese Shadowing West in Failed Cadbury Merger  Hershey’s failure to find a way to combine with Cadbury -- a traditional British company with a compatible culture -- is the story of two men who stood in each other’s way on the same side of the $19 billion takeover lost to Northfield, Illinois- based Kraft Foods Inc. Their rift, as recounted in interviews with more than a dozen executives, board members, and advisers who spoke on the condition of anonymity, shows how Hershey missed its last chance to attain Cadbury’s global scale, especially in the faster-growing emerging markets of Latin America and India.

• Cocoa Peaking Means Kraft Gets Cadbury as Chocolatier Profit Margins Widen

Overhaul Failure Will Spur Mergers as U.S. Health Industry Pursues Savings Insurers, drugmakers and hospitals will likely slash costs and merge companies to maneuver through a U.S. health-care landscape marked by rising medical expenses and the loss of millions of potential paying customers. With Congress’ sweeping overhaul of the health system stalled, industry will seek its own answers to a push by government and the private sector to rein in costs, said Curtis Lane, senior managing director at MTS Health Partners, a New York-based equity fund. An aging U.S. population will spur demand for services and, at the same time, boost pressure to control spending, he said. One solution will be increased consolidation, with companies led by WellPoint Inc., the biggest U.S. insurer by enrollment, and Community Health Systems Inc., the largest publicly traded hospital chain, scooping up rivals unable to “spread rising costs across fewer customers,” said Paul Keckley, of the Deloitte Center for Health Solutions. The health-care market “certainly seems to favor bigger, innovative, scalable companies,” said Keckley, executive director of the Washington-based center, in a phone interview. Drugmakers facing the loss of patent protection on top-selling medicines “were looking at decelerating revenues, with or without reform,” he said.

• Health Care Spending Continued Climb in 2009 Health care spending grew to 17 percent of the U.S. economy last year. Betty Ann Bowser examines the impact of the figures amid questions on the future of a legislative reform push.
• Health Spending Projections Through 2019: The Recession’s Impact Continues
• If Colleges Worked Like Health Care, If Air Travel Worked Like Health Care

• Bill Would Apply Antitrust Laws To Insurance

The unstoppable Fung brothers Just as this skein of good karma threads through the Fung family, so too has Li & Fung built its business around an invisible chain. The company quietly has become one of the world's largest producers of consumer goods -- including Cannon sheets, Tommy Hilfiger polo shirts, Restoration Hardware bathroom faucets, L'Oreal cosmetics and Hello Kitty stuffed animals -- all without owning a single factory or fabric mill. Sales, which grew sevenfold over the past decade, totaled $14.3 billion in 2008. One third is hard goods; the rest is apparel. All told, Li & Fung produced more clothing last year than the apparel exported by Thailand, South Korea, and Malaysia combined. "Their size is their competitive advantage," says J.P. Morgan analyst Vineet Sharma. "They are just so much bigger than any of their competitors." And Li & Fung is growing -- fast. Like a giant squid, the company has been gobbling direct rivals and ancillary businesses in an attempt to reach its goal of $20 billion in sales by 2010. To keep growing, Li & Fung is expanding into new businesses, including LF USA, a division formed in 2004 to buy and license brands, including Royal Velvet, Cannon and a company that makes Vera Wang clothes for Kohl's (KSS, Fortune 500). The New York-based division now has $1.4 billion in sales, making it a rival to large Seventh Avenue manufacturers. "The idea was to layer the front end of design over the back end of sourcing," says Rick Darling, the division's president. It's as if Intel, in addition to supplying Dell and HP with chips, started making computers. Li & Fung says it keeps the various business lines straight by creating separate divisions for each large customer. At last count, there were 180 such divisions, each headed by a manager, known internally as a "Little John Wayne." Victor coined the phrase to convey a sense of cowboy-like freedom. These managers have wide ranging authority; they can authorize the use of a new factory in Tunisia or open alternative shipping routes -- all without corporate approval. "What they orchestrate is incredibly complex," says Marshall Fisher, a logistics expert at the University of Pennsylvania's Wharton School. "But that complexity has costs."

Beyond the black stuff In the long term, however, the firms’ success depends on sustaining reserves. The big western oil companies are trying to expand through acquisitions and investment, but the opportunities do so are becoming scarcer. The firms are spending where they can. Exxon Mobil, the biggest listed oil company, says that exploration and capital spending hit $27.1 billion in 2009, 4% higher than in 2008. The company expects to spend $25 billion to $30 billion annually to the same end over the next five years. BP intends to spend some $20 billion this year on investment in new projects and drilling, roughly the same level as last year. But there are limits to what money can buy. State-controlled rivals—in the Middle East, Russia and beyond—jealously guard oil reserves on their home patches. Few new big fields of oil, at least those that are easy to reach and cheap to exploit, have been discovered in recent years. And where new opportunities emerge, such as in Iraq, Western oil giants are scrambling to pay big sums at auctions for drilling rights in territory where the local government tightly limits their returns. Even then, competition from Chinese, Russian and other state-run oil firms can be severe. National oil companies will often pay prices that would alarm shareholders in the big listed oil companies.Thus Western firms are increasingly looking for different sorts of growth. One option is to deploy their expertise in the hunt for oil that is harder to reach, for example deep offshore, or to go for reserves such as tar sands that are trickier, and so much pricier, to refine.

Another route is to speed up the quest for other energy reserves. France’s Total has branched out into nuclear-power generation. This week Shell announced a $12 billion joint-venture with Cosan, a Brazilian producer of ethanol from sugar cane. This is something of a change of tack. Exxon and Shell are both spending money on “second generation” biofuels made from algae or waste materials, but these could take years to develop. Now Shell can sell Cosan’s “first generation” wares through it global distribution network. By far the biggest bet laid, however, has been on natural gas. Around 40% of Shell’s daily production is now in the form of gas. Total and BP are not far behind. Gas is increasingly important for power generation and heating and the global market is expected to grow by half by 2030. Big oil companies are keen to expand, calculating that their skills at managing huge capital projects will be useful when building gas-liquefaction plants that make the stuff readily transportable. Late last year Chevron, Shell and Exxon agreed to spend $37 billion to develop the Gorgon field off Australia, another potentially huge source of gas.

• Shell and Cosan team up on biofuels in Brazil
• The handful of firms that build nuclear reactors face new competition
• Why hasn't the carbon price fallen further?

A Globe Still in Need of Steel The steel industry, though buffeted by crises in past decades, remains a core part of the economy. We may now be in the information age rather than the industrial age, but people still need steel for things like cars, buildings, pipelines, machinery and appliances. Data from the World Steel Association shows an industry that, like many others, took a hit from the recession: crude output declined 8 percent in 2009 compared with 2008. But there were some geographical variations. While production plummeted in the United States and dropped in many other countries, it climbed in China. India eked out a gain, and the Middle East also showed an increase. In the United States, the biggest steel-producing states include Indiana, Ohio, Arkansas, Alabama, North Carolina, South Carolina and Texas, according to the United States Steel Manufacturers Association. And Pennsylvania remains a maker of steel, though at nothing near the level it was in Andrew Carnegie’s day.

• Steel-producing Countries Graphic
• Reality curbs China's reform of steel sector