Friday, January 05, 2007

Private Equity & Home Depot

Earlier this week, on Wednesday, the Wall Street Journal published an interview with Henry Kravis.

I've written posts about private equity before,
here, here, and here. Rather than restate all my thinking and points, you may read them there. Suffice to say, the last six months have not changed my findings regarding this topic.

Now, however, the media is all abuzz about Bob Nardelli, a reputed "operations guy," coming back for Home Depot as the CEO of a buyout group. Was Home Depot simply under leveraged? Would financial engineering have done the job? Certainly, one alternative was simply to dividend back to shareholders the cash that wasn't earning adequate returns at the firm.

What if all the mismanaged companies go private. What if all the good managers go private to run companies more simply? Would we not expect, if this happens, to see S&P average returns fall, as companies with promise leave the index? Or would they rise, because most private equity targets are actually performing below average. That's why they are targets.

Doesn't private equity get its big payday by taking these companies public again? So, isn't this private equity shift the on-shore effect of SarbOx, similar to the fewer IPOs on the American exchanges?

Is it not a sort of return to the 1890-1930s model of corporate chieftains who knew their boards, actually knew how to run companies? A few, wealthy, proficient owners who were largely unfettered by distractions like large numbers of small-scale shareholders? Then, when the juice is squeezed out of the company, the private equity groups will return their prize to the a premium, of course, to the price at which they took it private.

Let's suppose this does accelerate. Maybe that is the only way corporate boards will wake up and demand better performance, for appropriate compensation, from sitting CEOs. Might not CEOs, a la my post citing the example of VNU, demand higher buyout prices from the private equity groups, as they realize the 2x multiples the latter are reaping?

It should , in time, be self-correcting, should it not? Perhaps a new type of employee/group will arise: the "rental CEO & Co." Imagine a capable, smallish group of corporate troubleshooters willing to 'fix' a troubled company, letting shareholders remain in possession. Suppose they only ask for $20-40MM in fixed compensation for a 2-3 year period- enough to cover their operating risk. Then, they could agree to a fairly high valuation target which, if achieved, would compensate them lavishly, but still for far less opportunity cost than if shareholders had sold out to a private equity group at, effectively, the bottom.

In time, perhaps shareholders will demand that boards get the same performance out of their assets as private equity groups expect to realize after their overhaul of the same assets.

As for Nardelli, I'm not so sure, as I've read more pieces about his management style, that he's really going to fit into the collegial, results-oriented world of private equity. Many media pundits allege that Bob 'got the job done' at Home Depot, but simply failed to be recognized for it. I disagree. By several "operating" measures, such as sales and NIAT growth, he lagged his major competitor, Lowes. Plus, somebody has to be responsible for total return. Perhaps senior functional executives may be measured according to internal financials, or market share goals, but the CEO is paid lavishly to consistently earn superior total returns for the firm's investors. All else is superfluous.

Thursday, January 04, 2007

Dennis Kneale's Views on Nardelli, Fiorina, et al

Dennis Kneale, Forbes Magazine's managing editor, appeared as a guest host on CNBC this morning. He believes that Carly Fiorina and Bob Nardelli fixed, respectively, Hewlett-Packard and Home Depot, and then were fired, after which their successors have or will get the credit.

Don't you believe it.

Kneale's argument, taken to its extreme, is to return to allowing CEOs to escape accountability for their firms' total returns, unless, that is, the returns are healthy and rising. This will simply become another excuse for lack of board performance and vigilance.

My proprietary research shows that, when company performance is consistently superior, the market will contemporaneously reward the company and, thus, the CEO, with higher stock prices. Correspondingly, the market 'rewards' other performance patterns appropriately. Investors reward what they value, period.

If Fiorina and Nardelli chose the wrong strategies, and failed to deliver what the market wanted, then they failed their shareholders. Period.

It's not appropriate, nor consistent, to let CEOs pick and choose which investor behaviors to consider 'right.'

For instance, later this afternoon, CNBC replayed a tape of an interview Nardelli gave to one of its reporters, in which he admitted to having changed the bases on which he and his "leadership team" were compensated. Originally, upon being recruited to Home Depot, he was to be rewarded for increasing the stock price. After some three years as CEO, the basis was changed to various fundamental, internal operating measures, such as earnings, sales and margin growth, relative to other retail firms. He alleged that it was thought better to move to bases which were more 'controllable' by the "leadership team."

That Home Depot's board consented to this seems, to me, to be outrageous and pathetic. For the compensation Nardelli earned as CEO of Home Depot, he certainly should have been responsible for knowing what performance to effect in order to improve shareholders' wealth. Whether every member of his team was also responsible may be another matter. But someone in the firm has to take responsibility for operating the firm in a manner calculated to increase shareholder wealth, not to mention at a rate which makes owning the shares of the firm preferable to those of an S&P500 index fund.

Otherwise, the firm's senior management will happily focus on internal financial or market share performance, oblivious to whether or not any of these affect the total returns to shareholders.

It reminds me of something I saw years ago, in my managerial youth, at the Chase Manhattan Bank. My partner and I were conducting an assessment of the productivity and profitability of the various functions which composed the firm's Securities Trading group. The business head of the unit took credit for the profitable years' performance, but lamented that 'unavoidable market conditions' had led to some years of losses.

How convenient. The SVP in question got a bonus for the profitable years, but he didn't have to return any of it in the losing years. I suggested that we could replace him with a monkey and save the then-average compensation of a bank SVP, about $350K. With a monkey, his subordinates would probably still perform in a manner correlated with the market, but we'd only have to buy bananas for the 'new' SVP of Securities Trading.

Nardelli and his ilk need to take care that they do not become eligible for replacement by lower primates. Shirking responsibility for producing consistently superior total returns for shareholders essentially relegates a CEO to the status of chief apologist, rather than Chief Executive. Someone has to be responsible for steering the corporation in the direction of presumably higher total returns.

In exchange for several million dollars of annual compensation and a hefty severance package in excess of $200MM at Home Depot, it had better have been Bob Nardelli.

Wednesday, January 03, 2007

Bob Nardelli's Resignation as CEO at Home Depot

This morning's breaking news regarding Bob Nardelli's resignation as CEO of Home Depot, effectively immediately, is welcome news to me. Hopefully, it will be, as well, for investors at large.

As I have written recently
here, and this summer, here, and here, I think it is past due.

Nardelli's poor performance and imperial attitude, most explicitly apparent in the 'boardless' May, 2006 annual meeting in Delaware, finally outlasted their welcome with Home Depot's overly-patient board.

I am gratified for several reasons. First, it is good to see a board finally wake up and discipline its CEO for failure. Second, it reinforces my belief in my proprietary research-based view of business dynamics. Where others purportedly saw opportunity and "powerful numbers...powerful performance," I saw inadequate operational performance, and appropriate lackluster market price performance, as well.

As various analysts and pundits on CNBC babbled about Nardelli's arrogance as CEO and Chairman of Home Depot, they also tended to assert that this was not the major cause of his departure. I would agree. To me, style doesn't count anywhere near as much as performance. And Nardelli's performance during his tenure at the company was miserable.

Similarly to my recent post concerning CitiGroup CEO Chuck Prince's extraordinary good fortune,
here, I think Nardelli received several years' grace time from his board, as well. Would any of his subordinates receive such forgiving treatment?

Perhaps it's a fitting start to the new year, that an atrociously underperforming CEO gets the boot.

Happy New Year!

Tuesday, January 02, 2007

ATT: Forbes "Company of the Year" for 2006?

Forbes has chosen AT&T "company of the year" for 2006. The firm's chairman, Ed Whitacre, stares out from the magazines current cover edition.

Perhaps I'm in the minority here, but I don't see it. Posted on the left is the company's five-year stock price chart, courtesy of Yahoo, along with the S&P500 (please click on the chart to see a larger version).

It's probably a moot point to attempt to interpret revenue growth for the firm now, since it been affected by acquisitions. The annual sales growth rates are, for 2004-6, 0%, 1%, and 37%. There is by no means, yet, a clear record of sustained revenue growth in the combined firm.

NIAT is also a giant hockey stick, still negative in 2005, at -23%.

Regarding total returns, the company now known as "AT&T" has a total return which has only exceeded that of the S&P500 index twice in the past seven years: 2000, and 2006.

None of this indicates to me that AT&T is now a smoothly-functioning, world-class firm. In fact, unless I am mistaken, I am now, once again, a customer of their wireless business. I've had AT&T, then Cingular, and now, evidently, AT&T once again. So much for brand building. My usage of their long distance is now de minimis. The wireless business is apparently hoping for ad revenues to save them.

I confess to being a sceptic on this one. More power to Forbes if this is the "company of the year" for 2006- or any future year.

Monday, January 01, 2007

"Five Macroeconomic Myths"

This being New Year's day, and a slow last few business days, I want to discuss a "filler" topic which I've hung onto since mid-December.

In the December 11th Wall Street Journal, Edward C. Prescott, 2004 Nobel Prize-winner for economics, senior monetary advisor at the Minneapolis Fed, and professor of economics at University of Arizona Cary School of Business, wrote a piece thusly entitled.

The first thing I'd like to note is that I don't think I had heard of Mr. Prescott, or could identify him in unaided recall, prior to reading this incredibly lucid and important piece. I see a constant parade of lesser economic lights troop through the CNBC studios each day, but not Mr. Prescott. As I wrote in this post,
here, on June 11th of last year, there are a lot of economists who think they know more than, or as much as, Ben Bernanke. I begged to differ. However, Mr. Prescott is precisely the sort of economist to which I referred when I noted that the Fed staffs would probably be a better source of economic thought than some 'chief economist' of a second-rate US bank or brokerage firm.

Having established Mr. Prescott's credentials, let me summarize his five 'myths:'

1. Monetary policy causes booms and busts.
2. GDP growth was extraordinary in the 1990s.
3. Americans don't save.
4. The U.S. government debt is big.
5. Government debt is a burden on our grandchildren.

Suffice to say, Mr. Prescott provides some very illuminating evidence to eviscerate all of these myths.

My favorites are numbers 3-5. First, he assails national income accounting, writing,

"Our traditional measures of savings and investment, the national accounts, do not include savings associated with tangible investments made by businesses and funded by retained earning, government investments (like roads and schools) and business intangible investments."

He focuses on the relationship of wealth to income, and judges the US savings rate to be "the right amount."

Mr. Prescott observes that "privately held interest-bearing debt relative to income" is at levels comparable to those of the 1960s. So he also judges our governmental debt level to not be "too big."

Perhaps the most interesting myth is the fifth one. It's a sort of product of the third and fourth myths, with a little emotional zing tossed in about the next generation's inherited liabilities.

Here, Mr. Prescott refers to some prior research, stating,

"Theory and practice tell us that the optimal amount of public debt that maximizes the welfare of new generations of entrants into the workforce is two times gross national income, or GDP. This assumes 1% population growth, 2% productivity growth, 4% real after-tax return on investments, and that people work to age 63 and live to age 85. Currently, privately held public debt is about .3 times GDP, and if we include our Social Security obligations, it is 1.6 times GDP. In either case, we could argue that we have too little debt."

Mr. Prescott actually make the point, subsequently, that government debt is a necessity if one has a long-lived population that is not growing rapidly. In effect, the more older, non-working people a society has, the more productive assets it needs with which to generate wealth in order to pay for those retired people. It's the reverse of how most economists present this situation.

Rather than hand-wring about debt and retirement, Mr. Prescott implicitly assumes a preference for creating wealth, then assess whether the right debt levels are in place to most efficiently do that in the given context.

What I liked most about his piece is how, at a stroke, he removes most of the bases for those who assert we have a government debt problem, a savings problem, and a looming retirement-affordability problem.

Similarly to other economics topics upon which I have touched recently, he focuses on two things. First, he 'rehabilitates' national income accounting to bring it a point of usefulness in the debate. Second, he provides insightful measures and research in order to effectively debunk myths regarding the allegedly-perilous US economic condition.

After reading Mr. Prescott's article, I feel much better about our current economic productivity, debt and savings levels. Far better than I typically feel after listening, on CNBC, to some third-rate economic "chief" of some little-known financial institution.

Quality matters, and Mr. Prescott is the genuine article.