Wednesday, November 29, 2006

The Tyranny of a Monopoly

Anybody else out there finding it interesting how people—even really smart people—can be cowed into not asking an obvious question for fear of looking stupid?

Generally speaking, the larger the room and the bigger the crowd, the less inclined people are to ask a question, particularly an obvious question that begs to be asked.

(Smaller rooms packed with people tend to avoid this syndrome, probably because by definition there is greater interest in the subject matter, which means there is a controversy that those in attendance want to address; hence, lots of questions on people's minds and no standing on ceremony to ask them.)

As to the reason why the more obvious the question, the less inclined people are to ask it, I suppose it goes back to First Grade: everybody thinks everybody else in the room already knows the answer, and nobody wants to look stupid in a room full of their peers.

This is a shame because the more obvious the question, the more likely it is everybody else is itching to ask it.

I’ve witnessed this syndrome at “back-to-school night” and at church board meetings, and I’ve seen it in a room full of high-testosterone Wall Street types who are not usually cowed by anybody.

And now I’ve witnessed it in the Wall Street Journal—specifically a recent interview with Microsoft CEO Steve Ballmer.

Here’s the first question of the interview:

WSJ: As more storage and other PC functions are offered on the Web, it raises questions over the value full-blown Windows software will continue to have in the future. How do you factor that in with future Windows development?

That’s a pretty good question.

After all, the heart of Microsoft’s dilemma, as I see it, is and always has been that every product Microsoft has ever made, with the single exception of Xbox, has been designed to further the use of the Microsoft operating system.

This is not a criticism, but a statement of fact. Hey, if I had a monopoly like Microsoft has a monopoly, I’d want to push it onto every device possible, too.

Problem is, this kind of product development doesn't work. It is, I think, no coincidence that Xbox has been Microsoft’s only non-desktop-monopoly related success, for reasons the Wall Street Journal reporter was getting at in that question, which is why it's a good one.

And this is Mr. Ballmer’s response, which I include from start to finish:

Mr. Ballmer: The best chapter in "Good to Great" by Jim Collins should be reread, and it will help explain a little bit of what I'm about to say. The chapter called "The Tyranny of Or" talks about how in great organizations, things don't always come down to A or B. People innovate because they see the value in A and B.

The innovations that will continue to come forward are the innovations that bring together [PC] client and [online] service as opposed to the sort of people who want to be provocative with a "Tyranny of Or" kind of discussion about it being A or B.

Basically everybody in the industry agrees that you've got to have rich clients and rich servers. There's nobody who actually, by their actions, disagrees with that.

How can I say that? Let me give you some evidence. Cell phones are going through a very distinct transformation where you're getting more and more intelligence built into phones, despite the fact that the phones are backed up by rich services coming off the Internet. That's an interesting data point because you can deliver a better experience with rich intelligence at the client talking to rich servers and service infrastructure on the backend.

How that answered the question is beyond me.

Ballmer’s long-winded response is, however, quite instructive. For one thing, he quotes a book, “Good to Great,” which upon publication in 2001 highlighted a bunch of so-called “Great” companies based on a complicated analysis of many factors, including such vapid notions as the “Tyranny of Or” quoted by Ballmer.

One of those “Greats” so highlighted was a mortgage buyer named Fannie Mae.

Fannie Mae, as we now know, actually achieved greatness not by avoiding the “Tyranny of Or,” but mainly by avoiding the “Tyranny of Reporting Disappointing Earnings” via the “Wonder of Accounting Fraud.”

Those “great” numbers from Fannie Mae have been restated, as has the management team lauded by Collins.

Secondly, I seriously doubt anybody at Google or any of the thousands of companies working on ways to move desktop functions onto the Web—which was the heart of the Wall Street Journal reporter’s question—is wasting time reading hoary old business casebooks.

They are, rather, working on undermining everything Microsoft holds dear, most especially its monopoly on a desktop computing model fast becoming irrelevant. You might say Microsoft is subject to its own kind of tyranny: the Tyranny of a Monopoly.

So if there is a person in the world—including the reporter conducting that interview—who understands a) what Ballmer was saying in his response, b) how it addressed the question that had been asked, and c) how it helps Microsoft deal with the tyranny of a monopoly that keeps them from making truly great, useful, uncomplicated and popular products, I’d like to hear it.

I suspect, however, at least in this case, everybody already really does know the answer.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

Friday, November 24, 2006

More, Less Cute, Stories about Inflation

A reader once suggested this blog should be called “Cute Stories about Inflation.”

That was his response to multiple pieces over an extended period of time in which I had pointed out the decoupling of government-reported inflation statistics from the actual rising cost of gasoline, heating oil, natural gas, steel, copper, concrete, glass, plastic resin, zinc and other industrial inputs, not to mention health insurance, car insurance, flood insurance, homeowner’s insurance and medical malpractice insurance, plus housing related items such as homes, lumber, appliances, asphalt shingles, cable television—well, you get the idea.

My point was not unique or particularly insightful—after all, many observers had discussed the same thing for some time.

Indeed, some of the more grumpy, perma-bear, gold-bugs I know took it all as yet one more dark sign that the entire system is rigged; that the government puts out whatever statistics it wants to put out in order to make the maximum number of market participants wealthy; and that Alan Greenspan and his successor are nothing more than pawns in a giant game of Squeeze-the-Shorts.

And for a while it looked like the Conspiracy Theorists might be right, because despite the persistent rise in the cost of all those aforementioned items, the various price indices—particularly when “adjusted” to exclude food and energy, which the government as well as bond buyers deem too volatile to pay attention to—stayed at or near historic lows for longer than it seemed possible

All the while, the consensus in The Market held that as long as America’s 100 Million Dollar CEOs could keep outsourcing not only manufacturing but also, as in recent years, telemarketing, contract research and anything else that didn’t threaten their own bloated pay structure, then the wage growth of working stiffs in the U.S. would remain close to zero, and the “core” inflation rate—unlike the South—would never rise again.

Now, for the record (and for those who grew weary of my “cute stories about inflation”), I actually posted the last of my inflation updates in May—six months ago.

It was called “Don’s CPI,” and it reported on the fact that Don, my car guy, had raised his prices by 6%. This meant two things: it meant that instead of costing us $700 every time we take in a car to Don's, it was now going to cost us $742; and it told me that inflation was real, it was happening, and it was here to stay.

(It’s true: no matter what we take a car in for—oil change, wiper blade, tune-up—it used to cost $700, which is now $742. But Don does great work, and the way I see it, cars are life-or-death conveniences, not toaster-ovens. So I don’t screw around when it comes to keeping them in shape, nor do I begrudge Don sending his several fine children to college on us.)

Around the time of that piece there was a coincidental awakening of the bond market and the Fed to higher inflation rates creeping into government statistics, adjustments or no adjustments. This spooked the markets and led to an extended and hopeful debate as to when the bursting of the U.S. Housing Bubble might ease the upward price pressure.

Since everybody else was talking about inflation, I decided to let sleeping dogs and “cute inflation stories” lie.

But now that the Housing Bubble has been burst in a far more spectacular manner than generally expected, markets appear convinced all is well and inflation is contained, and I feel the time is right to pass on another, not-so-cute inflation story.

It comes from a private equity guy whose firm owns several companies in the heartland of the American industrial supply chain.

And one of his companies with operations in the still-hurricane-rebuilding Gulf Coast recently raised wages 12% in order to retain workers it was not otherwise able to retain, owing to the many better offers they were receiving.

This was not, I should make clear, a 12% wage increase for a CEO or a CFO, which nobody at the Fed or in the bond market or at the White House would blink an eye at.

This was a 12% wage increase for hourly American workers whose jobs can not be outsourced, no matter how fast the T-1 line between Bangalore and Chicago.

I should also note that according to my contact, the company in question was able to raise prices to cover that wage increase, “no problem.” Lest you think this data point should be dismissed because it covers just one company in one region of the country, my private equity contact tells me all his portfolio companies have likewise been able to put through price increases with no resistance.

For the record, the current 10 year rate is 4.6%.

A year ago August—in response to a snide question about when I was going to put my negative views on the U.S. Housing Bubble into the form of a market call on homebuilding stocks, which is something I am not in the business of doing here—I wrote that ‘anybody who buys a house they don’t need is an idiot.’

I don’t think that was bad advice.

And while I am no more inclined to make a bond market call today as I was making a homebuilder call back then, I'll say this: given the accelerating rate of wage increases in the U.S., the rising cost of products sourced from Asia, and the global call on natural resources that's keeping prices high despite the collapse in spec housing in Reno Nevada and condos in Miami Beach, I have now come to think—for what it’s worth—that anybody who buys a bond they don’t need is, down the road, going to regret it.

Perhaps, some day, those grumpy, perma-bear gold-bug friends of mine are going to be right.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

Monday, November 20, 2006

Goldilocks Napping

Core inflation is spreading slower than we expected (core CPI up 0.1% in October), while the correction in housing and autos came more abruptly (Q3 GDP increased 1.6%). The result may be a smoother path for the overall economy. Growth in the second half of 2006 may be 2.3% or less, leaving room for a reacceleration in 2007. the [sic] risk of the Fed having to overshoot to regain confidence has declined markedly.

So reads the summary of one Wall Street economist’s early morning comments today, summarizing the “Goldilocks” economic scenario prevailing on Wall Street these days—at least, if stock and bond prices are any indication.

This is all quite a turnaround from just three months ago, when markets were depressed by fears the Fed had tarried too long in switching from deflation-fighting mode to inflation-fighting mode. Back then, both stocks and bonds feared the resurgent “core” CPI would not be tamed until several more Fed rate hikes had done their worst on the U.S. Housing Bubble, not to mention the U.S. Consumer.

But gasoline prices began dropping a week or two before Labor Day, and two things happened in response: the U.S. Consumer began to spend like drunken sailors, boosting third quarter earnings reports and helping the stock market recover; while whatever inflation measure economists chose to follow began decelerating, lifting bonds.

Lost in the current Goldilocks euphoria—as strong today as was the bearish gloom of late summer—is what companies are seeing coming down the pike in the way of costs.

And what they are seeing is, generally speaking, cost increases. Significant ones.

From a big ore mining supplier expecting steel price increases for next year no matter what the current spot price says, to a well-known branded apparel makers whose Asian suppliers have jacked up the landed cost of next fall’s product line by 5%—the first general all-purpose increase this company has seen out of its formerly deflation-inducing Asian supply base, ever—I am hearing a consistent message: the cost of doing business around the world has stopped going down.

It is, rather, going higher, not matter how many houses remain unsold in Stuart, Florida or Sacramento, California or Reno, Nevada.

Now, along these lines, it is no new news to anybody that UPS last week announced a 4.9% rate hike for its all-important services in 2007.

But what the bond market may not have noticed—so eager is it to see Goldilocks out frolicking in the woods as opposed to something that might interrupt the current picnic—was that 4.9% represents the net rate increase, after a 2% decline in the fuel surcharge to match the recent drop in oil prices.

Which means that the UPS “core” rate increase (have we not been trained by the Fed to look at the “core” rate?) is actually 6.9%.

So not only is the cost of stuff coming out of Asia going to rise in 2007, but the cost of getting it from the docks in Long Beach and Charleston to your house in Menlo Park or Newton Massachusetts will rise as well.

The bond market, as I understand it, suspects that we are on the verge of a significant cooling down of inflationary pressures.

But unless China and the rest of the world is about to hit the wall like a Sacramento tract house, I don't see that what the Fed does or does not do next month or next year will be relevant.

It's not "the economy, stupid." It's the "world-wide economy, stupid."

And that ain't slowing down.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

Thursday, November 16, 2006

De-Layering and De-Customering at The Home Depot

I’ve walked stores with Bernie Marcus, and it’s an experience.

If you don’t know who Bernie Marcus is, he’s one of the two geniuses (the other being Arthur Blank) who invented The Home Depot.

Bernie was a whirlwind: loud, brash, and eager to help any potential customer who walked in the door, even if it meant turning his back on whatever number of Wall Street's Finest were getting the store tour at that moment.

Just to help the guy find what he was looking for.

Bernie seemed to know every sales associate who ever walked the floor—and for good reason, because he'd hired them and trained them. And it was within the sales associates that he'd also imparted his passion for helping the customer so well that it made his company what it became: a place where people who don’t necessarily know how to use a hammer could come in and get help and advice so that they could actually install a door or fix a faucet or add a deck—meanwhile spending oodles of dollars in the process.

Not for nothing the motto was “You Can Do It, We Can Help.”

Now, it is ancient history to point out that the Home Depot under Bernie and Art developed growing pains, and that the founders stepped aside for a new breed of operations-based management under ex-GE big Bob Nardelli.

And it is old news that today's customers may have less free time and be less inclined to do it themselves, and are, therefore, more apt to want somebody to do-it-for-me, requiring an updating to the original Home Depot motto.

And in any event it may soon be ancient history to talk about the Home Depot as a public company, what with rumors sweeping Wall Street that Sears Holding’s Eddie Lampert has been looking at adding Home Depot to his real-estate rich retailing empire, plus all the private equity money desperate to buy anything with cash flow, which Home Depot has in spades.

But it is, nonetheless, worth keeping up with how Home Depot has been doing under the Nardelli regime, and if this week’s earnings call proves anything, it proves that Nardelli is masterful at spinning his story to Wall Street’s Finest.

He begins right away, in his opening remarks:

Thanks, Diane. In August, we predicted that the third quarter was going to be soft, and it was actually more challenging than we anticipated. We felt the impact of the U.S. retail home improvement market slowing significantly.

Note how Nardelli manages to paint himself and his company as both prescient (“we predicted”) and a victim (“we felt the impact…”). This is masterful spin-doctoring: it’s as if nothing bad happening at Home Depot is the fault of management.

But that’s not the whopper.

The whopper comes in the very next sentence:

However, during the quarter, we did stay on strategy by accelerating our investment in our core retail business and growing our supply businesses.

Right now I’ll bet there’s a would-be customer—I’m one myself, so I know how this works—trying to figure out which size floodlight to buy for his stupid kitchen ceiling lights, who is walking around the cement floor of a huge cavernous Home Depot looking for anybody wearing an orange apron with a “You Can Do It, We Can Help” button that isn't already being trailed through the store by four or five desperate fellow potential-customers with hollow eyes looking like those émigrés in “Casablanca” following around somebody who has their visa papers.

And I seriously doubt that would-be customer is thinking,

“Well, I may not be able to find somebody in an orange apron who can help me figure out which size floodlight to buy for my stupid kitchen ceiling because apparently this is a store run by self-service checkout robots, but at least they’re staying on strategy.”

Yet even Nardelli could not spin away the fact that staying “on strategy” didn’t prevent Home Depot from earning less money this year than last:

In the third quarter, consolidated sales were $23 billion. That is up 11% from last year, and our diluted earnings per share were $0.73. That is up 1%, while consolidated net income earnings were $1.5 billion, down 3%.

Now, it is a fact that Bob Nardelli runs a company called The Home Depot.

And it is a fact that the home-building industry has, of late, smacked head-first into a brick wall after several years of increasingly testosterone-charged home-building CEOs telling doubters on Wall Street that, like the Internet skeptics of the late 1990s, “you just don’t get it” when it came to understanding why the Housing Bubble wasn’t a Bubble.

And it is a fact that recent results at vendors such as Masco (faucets and kitchen cabinets) and Mohawk (carpets and tiles) demonstrate the difficulty facing anybody selling anything that goes into one of those D.H. Horton or Toll Brothers or Ryland spec homes now sitting empty out in the scorching Las Vegas desert (sales brochure slogan: “It’s the desert so why would you need a yard?”).

So the fact that numbers at The Home Depot are a bit light is not reason alone to pick nits with the sort of spin-doctoring conference call you’d expect from a guy who very nearly made it to the top of one of America’s most ferociously management-by-numbers companies, GE.

(True story: I was at the Greek diner one morning recently when two GE-ers, who clearly worked together several job assignments ago but hadn’t seen each other in some time, began talking, and I am not making this up:

“So how are things?”
“Good. We made our numbers.”
“Good! You made your numbers?”
“Yep, we made our numbers—how about you?”
“Oh, yeah. We made our numbers.”

It wasn't until then that they got into family, kids and other apparently less important stuff. That is the DNA of the guy in charge of Home Depot.)

And while Home Depot had outgrown its systems and needed serious work behind the scenes to support what Bernie Marcus and Art Blank had created from not much more than a passion for their customer, the GE Culture is not necessarily the kind of culture that’s going to keep retail customers happy.

So it should be no surprise that, unless all the former Home Depot store managers I run into are making up stories about reduced money for staffing labor at stores—what they call “earn hours”—as well as a Sears-like bureaucracy taking over the Atlanta headquarters (which, as far as Marcus and Blank were concerned, took its orders from the stores, not vice-versa), there’s no arguing the Home Depot has changed, for the worse, from a customer-driven operation to a numbers-driven operation.

But don’t take my word for it. Ask anybody who used to shop there. Anybody. I’ll bet we come up with more horror stores than Dell (see “Dell Screws Up a Good Thing” from this site).

Nevertheless, the numbers-agile crew now in charge at Home Depot didn’t get to where they are by not having whatever data could support the upbeat “message” handy in their PowerPoint presentation, and Nardelli did indeed offer up customer satisfaction numbers that seem completely at odds with every anecdote I’ve heard recently:

I want to thank our associates for their hard work and focus on taking care of our customers. Every week, we hear from 250,000 customers through our voice of customer survey. We have seen significant improvements in our survey results. Key customer service attributes, including customer engagement, waiting to check out, find and buy, likelihood to recommend, and associate availability were up over last year and showed sequential improvement this quarter. Overall satisfaction with our company, as measured by scores of 9s and 10s, is up over 2004 and 2005 levels.

Lest anyone think this “voice of customer” might be something he is hearing inside his own head, Nardelli delved into these numbers later in the Q&A with just enough color to make you wonder about how much they reflect reality, or not:

Mark, I think two points, just to be real clear. What we talked about is that overall customer satisfaction, or voice of customer, as we call it, is up across the entire network of stores, and that is the 250,000 customer shopping experiences, that they go online and call and score us on associate availability, ability to find and buy, et cetera. We have seen a sequential improvement month over month in the third quarter for sure, and we would expect the same thing to continue in the fourth quarter. In other words, the customers that are scoring us 9s and 10s.

I may be wrong, but customer surveys—especially online customer surveys—might not be the best way to find the customer who went into a store, couldn’t find anybody to help who wasn't already under siege from four or five other desperate individuals, picked up the wrong-sized floodlights for his stupid kitchen ceiling, spent ten minutes in line because there weren’t enough live human beings at the registers…and then vowed never to come back again.

Still, Nardelli appears to have great faith in management-by-numbers. He even boasts about a new “organizational structure” that has been in place all of thirty days.

I am not making that up, either:

Before I turn it over to Craig, I just want to comment on our new organizational structure. It has only been in place 30 days, but I could not be happier with the focus, alignment and speed of decision-making we have gained as a result of de-layering. I have a great and experienced team.

What on earth this might have to do with making customers happy is beyond me…yet so it is that “de-layering,” “voice-of-customer,” and “staying on-strategy” are the new buzz-words at The Home Depot.

But it’s the “de-customering” that should have them worried.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

Monday, November 13, 2006

Old Media in the Bizarro World

Time magazine, the flagship publication of Time Warner's Time Inc., is cutting its rate base, or the circulation it guarantees advertisers, according to Ed McCarrick, world-wide publisher of Time magazine. He says Time will cut the rate base by 750,000 to 3.25 million, a reduction of about 19%.

—The Wall Street Journal

It’s hard to know where to begin on this report of Time magazine’s desperate measures to keep publishing, printing, stacking, trucking, and delivering an increasingly irrelevant weekly news magazine to a world now getting its news immediately and effortlessly the same way these words are brought to you: online.

No printing, stacking, trucking, delivering or recycling required.

Time had kept circulation artificially high by offering cut-rate subscriptions, the account went on, noting, Time's ad pages are up 2% for the first 10 months of the year, according to Publishers Information Bureau, but were down 12.2% in 2005.

Now, for starters, you would think the fact that Time needed “cut-rate” subscriptions to keep up the magazine’s circulation would have clued in management to the fact that in order to keep readers interested, something needed to change—i.e. the price of the magazine.

And you would be right, except you would be wrong.

Let me explain.

You would be right in thinking that the Time elders would realize the need to change their magazine’s price in order to maintain circulation in the face of compelling alternatives to a high-priced, once-a-week bound copy of old information headed straight for the recycling bin.

But you would be wrong in thinking they are reducing the price.

It seems Time (and perhaps other Old Media companies, but we only have one sample in this case) hires only people from Superman’s Bizarro World (frequently invoked by Jerry Seinfeld)—where things are the opposite of what they should be.

For instead of lowering their costs and passing on the savings to induce readers to continue buying, the Time magazine elders from the Bizarro World decided to raise prices.

I am not making that up:

Time is also raising its newsstand cover price to $4.95 from $3.95, Mr. McCarrick says, and offering advertisers the option to purchase space in the magazine based on a guaranteed audience measure.

So what we have here is a business facing declining demand, that is raising prices to meet the challenge.

Perhaps this is merely a knee-jerk reaction by the elders at Time to changes in their external environment, and they are simply reacting as all Old Media types grew accustomed to reacting whenever costs rose or circulation declined.

In that case, I would suggest they take a lesson from Seinfeld himself, by doing precisely the opposite of these apparently deeply held instincts:

George: Elaine, bald men, with no jobs, and no money, who live with their parents, don’t approach strange women.

Jerry: Well here’s your chance to try the opposite. Instead of tuna salad and being intimidated by women, chicken salad and going right up to them.

George: Yeah, I should do the opposite, I should.

Jerry: If every instinct you have is wrong, then the opposite would have to be right.

After all, weekly news magazines with declining circulation, terrible demographics, and a high fixed-cost structure don’t raise prices.

Except, perhaps, in the Bizarro World.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

Thursday, November 09, 2006

The First YouTube Election, and Not the Last


You gotta love the New York Post.

Thus today’s headline reports Rummy's demise, encapsulating in two words the entire changing of the guard now under way in Washington after Tuesday’s game-changer elections.

And we owe it all not to the mainstream press, which, as far as I can recall did not break a single investigative piece of news that mattered to the voters on Tuesday.

It was, rather, thanks to YouTube.

For it was on YouTube that Virginia Senator George Allen was shown to the world, his shirtsleeves rolled up, microphone in hand, clearly unnerved by the presence of an observer with a video camera recording his off-the-cuff remarks, attempting to turn the tables by pointing to the cameraman and saying,

“Let’s give a welcome to macaca here, welcome to America…”

And it was on YouTube that Montana Senator Conrad Burns was shown to the world, eyelids flickering, elbows slipping, as he tried to stop himself from dozing off in the middle of an agricultural hearing.

His campaign slogan? "Delivering for Montana."

Democrats complained last time around when bloggers discredited pieces of John Kerry’s self-styled Vietnam heroics and flat-out dismantled the forged document Dan Rather somberly presented as fact on National Television.

So too Republicans will complain this time around that their precious Senate majority was lost thanks to wise-guy video-tapers looking for “gotcha” moments.

But if the mainstream press isn’t going to keep things honest—and they have proven they can’t, or won’t—then why not give that power to individuals?

Which is exactly what the internet has done.

Pretty cool, I think.

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

Tuesday, November 07, 2006

It Took Apollo Group How Long to Figure This Out?

I’m holding in my hands a report on the potential for backdated options grants at Apollo Group, Inc.—the company whose stock collapsed following the November 3 announcement of suspicious option grants:

Apollo Group today announced that its ongoing internal investigation into the issuance of certain stock option grants has discovered various deficiencies.

After discussing earnings restatements and other details, the company said:

Apollo Group also announced that Chief Financial Officer and Treasurer Kenda B. Gonzales resigned on November 1st, citing personal reasons. In addition, Chief Accounting Officer Dan Bachus is currently on administrative leave.

Now, the report I’m holding in my hands (actually, I’m looking at it on my computer screen, but “holding in my hands” is more dramatic) is titled:

Did Apollo Backdate Options?

Its front page summary begins as follows:

While it is impossible to tell definitively from a company’s proxy and other SEC filings whether or not it is guilty of backdating, Apollo Group’s option grant history looks highly questionable, in our opinion, and we believe that scrutiny by the SEC or other gov’t bodies is a real risk to consider.

The report then goes into chapter and verse—actually three devastating tables—about how Apollo Group’s option grant prices occurred almost miraculously at the lowest price of the year in 2000, 2001, 20002 and 2004.

(Something went screwy in 2003—the option grants were 10% above the low.)

Furthermore, no other company in the educational services group included in the tables came close to Apollo. Only one company had even one year when options were granted at the lowest price possible.

The date of this report?

June 8, 2006. Almost half a year ago.

The author?

Gary Bisbee of Lehman Brothers.

His methodology?

Publicly available information from Apollo Group filings.

So it took the educational geniuses at Apollo Group how long to figure this out and hold somebody accountable?

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

Wednesday, November 01, 2006

Well Excuse Me

It isn’t easy being skeptical, at least in public.

A few weeks back, I made the mistake of asking what was perceived as a not-friendly question at a company breakout session during one of the many healthcare conferences we attend each year.

Conferences are a great way to hear from a lot of companies in a short period of time, swap ideas with friends and maybe find something new. I spend most of my time in the breakout sessions, because that’s where you can take the measure of management and also hear what other people are worried about or interested in.

It was in that frame of open-mindedness that in late September I stood in the back of a packed breakout session and listened to a management team explain its recent earnings stumble to the disappointed-but-hopeful shareholders in the crowd.

The company in question is a formerly high-flying consolidator in the field of drug discovery tools and cell culture material for biotech and pharmaceutical companies—and until late last year management could do no wrong , snapping up $1.5 billion worth of other players in the field, reporting quarter after quarter of positive earnings surprises, and watching its stock triple in the process.

The good times, and the stock, peaked last year, prior to several inconsistent earnings reports, and was well below its $88 peak when the company reported a bona fide earnings miss this August—a miss that caused one of Wall Street’s Finest to ask, during the ensuing conference call,“What the hell happened?”

I am not making that up.

Here’s the full quote:

The first question, I'm just curious at what dramatically changed from the time that you had your analyst day in June…. Certainly when we were at the analyst day, I think we spent a lot of time drilling down onto your visibility into the back half of the year, and I think I will speak for a lot of the people on the phone that want to know what the hell happened?

Now, the company in question didn’t get to be a Wall Street Fave by fumbling conference calls. And sure enough management spent a good portion of the call talking up a $500 million share buyback the company had announced simultaneously with the earnings miss.

Such share buybacks are an old technique by which companies take the sting out of what we on the Street call a stock that is—in the precise, technical jargon of the professionals that we are—“blowing-up” as a result of the company “puking the quarter.” And a half-billion dollar share buyback is, at least for this company, pretty big.

But what made it stand out, at least for me, was the eagerness with which management shared the details of when and at what price the buy-back would take place.

See if you can spot what appears to be—and I do not believe I overstate the case—an implied guarantee that the stock would go up some time in the future following the buyback:

Now I would like to briefly cover the share repurchase program that we announced today. We see the buyback as a means of returning excess cash to our shareholders and enhancing our return on invested capital. The current stock price is an additional factor in our decision since we're confident in the future of the Company and therefore know that we will get an attractive return for purchasing the stock at this price [emphasis added].

And to make it seem even more like a no-lose proposition, the CFO more or less said the company would begin buying its stock at once:

We have a significant amount of funds currently available to do this buyback as well as acquisitions. With our cash balance of over 700 million plus the current revolver and the addition of the second half free cash flow, we have plenty of funds at our disposal to execute a significant portion of the buyback immediately as well as move quickly on acquisitions as opportunities arise. [Emphasis added.]

Whether all this was a bald attempt to prop up the stock or not, I have no idea and take no side, but the implication was clear: the company would spend a “significant” portion of $500 million buying stock real quick.

This seemed to me roughly equivalent of an over-excited Grad Student hell bent on making his name at Binion's Texas Hold ‘Em table flashing his paired aces to the other players and going "all in" before the Flop, the Turn or the River. Anybody at the table with half a brain would immediately fold, leaving Mr. Paired Aces nothing to collect for his great hand but the lousy blinds.

After all, the very act of announcing the company’s intent to buy several hundred million dollars worth of stock ASAP would likely hold up the stock price higher than where it otherwise would trade, thereby unnecessarily raising the cost of the share repurchase and lowering the return to shareholders.

Nevertheless, the company did show its cards. And in case anybody had missed them, the CFO flashed them again, during the Q&A session, repeating the company’s eagerness to begin buying stock:

It was authorized at our most recent Board meeting last week, and we're in the blackout period. We'll be in the blackout period until Sunday, and at which point we would be free to start executing buyback. As we've said before, we're running through the mechanics right now, but we would do a substantial portion of the $500 million authorization relatively soon [emphasis added].

Now, I admit to being a little wary of managements that try to keep Wall Street’s Finest on their side with happy talk and spin control.

But, hey, if I'd been long a stock that was no doubt being referred to by disgruntled portfolio managers as—using, once again, the precise technical term—“a pig,” I’d be rooting for the company to buy every share it could get its hands on, price be damned, if only to give me a chance to get out.

(It may surprise people to read this, especially those who put their life and heart and soul into a company for the better part of their natural lives on this planet, but most institutional investors—hedge funds especially—could not care less what a company actually does for a living and how it provides for its employees and their families and their children: most of 'em just want the stock to go up. And if it doesn’t, they get rid of it like an old bag of lettuce turning brown and wet in the back of the frig.)

And so it was that two months after the Paired Aces conference call, I decided to attend the Q&A session of management’s appearance at a healthcare conference, just to listen.

And it was during the course of a discussion about the $500 million share repurchase that management allowed as how the company could buy stock up to a price as high as $80 a share.

I looked at my Blackberry: the stock was trading hundreds of thousands of shares, at a price near $63.

This boggled the mind.

Why on earth would a company authorize a repurchase “up to” eighty bucks a share when it could have all it wanted in the low $60s?

Aside from making the poor shmucks who’d owned the stock at $80 feel like they had some shot at getting their money back, I could see no reason to slap a silly number on something as serious as the allocation of half a billion dollars' worth of shareholder’s capital.

What, I wondered, were they smoking?

So I asked them that, in a slightly different way:

“How’d you come up with $80?”

Management smiled tightly and more or less shrugged, saying something to the effect of this:

"That’s what we decided."

So I asked it again:

“But how did you get $80? Were you looking at return on capital? Earnings dilution? What was the analysis?”

Now, anybody with six months in this business could have answered that question. My dog Lucy could have answered it, if she could talk.

After all, most public companies at some time or other buy back stock—some to offset option dilution; some to take advantage of market weakness; some to shrink their capital base; some to prop up the stock; some to re-allocate capital in the absence of better reinvestment opportunities; some for all the above.

And when they buy stock, they usually consider two things in determining what price to pay: they look at the point at which a repurchase becomes dilutive to earnings (based on the implied cash on cash return of a repurchase as compared with keeping the money in T-Bills) or the alternative returns from making an acquisition with the dough.

Something, in other words, that is rational and easily defined.

But you would have thought I had asked these guys for their opinion on the Combined Uniform Theory of Relativity, or whether they were, in fact, the bright boys responsible for the “intelligence” that Saddam had WMD. Or the ones who thought of giving the CBS anchor job to Katie Couric.

They sort of shrugged and cleared their throats while a kind of embarrassed silence descended on the room, keeping anybody else from following up on the topic.

Finally, a fellow sitting near me in the back turned and said in an angry, sharp voice:

“The stock traded at $80 not too long ago, you know.”

Since he was clearly one of the poor schmucks who had owned the stock at $80 and was rooting for the stock to get back there, I didn’t say what I was thinking, which was:

“So let me get this straight: the company should pay $80 just because that’s what some idiot thought it was worth last year?”

Instead I let it go.

You can’t win asking a perceived-unfriendly question in a room full of investors who know they’re stuck in a pig but don’t want to admit it.

Which is why it wasn’t all that surprising when the company "puked" another quarter just last week and the stock "blew up"…at the same time management announced it had spent almost $300 million of that half-a-billion authorization to buy stock at $61.

Now, you might think that with the stock dropping below that price on Friday, the company would be delighted to have the opportunity to spend the rest of the $500 million at a lower price.

After all, if they liked it up to $80 and paid $61, they must love it below $60, right?

Well, not exactly.

“We expect to continue to be buyers of our stock, although the level of the buyback will depend on several factors, including share price, other cash requirements, and expected cash generation.”

In other words, this time they aren’t showing their cards yet.

And they want to see the Flop—and maybe the Turn and the River—before they go “all-in.”

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.