Friday, March 09, 2007

A Lesson In Schumpeterian Dynamics: ATT - Yahoo Pact Undergoing Change

The Wall Street Journal reported today on the imminent change in the 2001 joint venture agreement between ATT and Yahoo, which is due to expire next year.

Without substantially reciting the article, the essence is this. For the term of the arrangement, ATT has paid Yahoo $250MM/year to gain access to Yahoo's online information and services, hoping these would tip the scales to provide the original co-signatory, SBC, ATT's predecessor, in its quest to compete with high-speed cable delivery of online services.

However, in recent years, Yahoo's competitor, Google, has been paying its partners in similar situations- up to roughly the same $250MM level. For perspective, Yahoo's current annual revenues are roughly $6.43B, and its NIAC is $751MM. Thus, the ATT payment represents about 4% of Yahoo's current annual revenues, and a third of its net income.

Thus, Yahoo's Terry Semel and his managers must be contemplating not only losing this chunk fo high-margin revenue, but probably adding another $250MM of expenses to continue the relationship, resulting in a potential reduction of 66% of Yahoo's net income available to common.

How did Yahoo manage to wind up in this predicament?

Joseph Schumpeter wrote about this risk as long ago as 1926. His central tenet was that high-growth economies and business sectors made for constantly-changing competitive environments. Therefore, businesses were well-advised to innovate and change their competitive situations for themselves, rather than wait and be eviscerated by another company, or some uncontrolled, external influence.

In Yahoo's case, it looks like, since 2001, they've basically been sitting on their collective asses, counting the annual ATT payment, rather than taking a hard look at their unfocused, vulnerable business model.

As I discussed this with my business partner, it became clear what Yahoo's continuing vulnerability is. He described what he thinks Semel's vision of Yahoo is as 'a place to form groups,' or 'a place users go to find groups and information.' The trouble with this is that it is, for the most part, free. I have never paid a dime for any Yahoo service, although I use their portfolio tracking Finance page for my daily portfolio performance monitoring.

What I think Yahoo should have done, back in 2001, is to have immediately retained a few senior consulting partners from McKinsey and Bain to provide the Yahoo senior managers with anecdotal evidence of how other companies survived and prospered in highly-competitive, technologically-oriented business situations, when they had no clear, salient competitive advantage.

My own opinion is that Yahoo should have begun to take the things it is good at, such as information redistribution, presentation, and online groups management, and offered to private-label them to various companies which need these services, but can't get adequate results from their internal IT departments. Online brokerage services came to mind, as my partner and I discussed this. He and I both deplore Schwab's useless online portfolio performance reporting and "analysis," if you can call it that. Why didn't Yahoo provide them with a portal directly taking the Schwab customer to a Yahoo-provided, but Schwab-labeled customizable portfolio performance site/page? Or provide online retail companies with customer group-management facilities cloned from the very large, successful, but free Yahoo Groups offerings?

Such a strategy would cement Yahoo into corporate marketing and customer service functions, while, for once, actually getting paid by someone for what they do. I maintain that, with its largely free services for consumers, Yahoo continues to be the "used car" of internet information providers. It's got no software, hardware, superior search engine, or actual proprietary information for which to charge fees. Thus, I believe its hold on consumer loyalty is tenuous, at best.

Concerning the ATT-Yahoo pact, I don't actually think either company is destined for greatness, or, consistently superior total return performance in the near future. I think ATT is still going to be stuck vending commodity information distribution, while sinking ever more money into a pointless attempt to offer content, as well. As I've written in prior posts here, down that road has always lain failure.

Yahoo is unlikely to do much better, in my opinion. A la Schumpeter, the time for Yahoo to have begun a radical transformation was as soon as it cashed that first $250MM ATT payment back in 2001. By 2004, they could have been well on the way to forging new business directions and growing new fee-for-services offerings to businesses and consumers. Instead, they are now contemplating a new hole in their income statement, and even the potential loss of the ATT relationship, in its entirety.

Don't be surprised if this is the beginning of the end for Yahoo as a separate, publicly-held entity.

Video Link Replacement

If you read this recent post on Hillary Clinton's capital markets regulation remarks, you may not have been able to view the CNBC video link.

Here is a YouTube link to the same interview, at the end of my post. Sorry for the inconvenience.

Thursday, March 08, 2007

The Anatomy of A Shareholder's Response To A Proxy

A few days ago, I received, in one of my email accounts, a message from my broker, containing the electronic link for the proxy to one of the equities I hold, Chicago Mercantile Exchange.

It dawned on me, while discussing this with my partner over lunch today, to describe my reaction to this email. A sort of Proustian reflection on the chain of thoughts and feelings pouring forth from that single stimuli- my own personal Madeleine, as it were.

After a few seconds of consideration, with the email opened, viewing the link to the CME proxy voting site, I hit the 'delete' key.

It was a very assured, firm delete. And I have not gone back to my 'deleted emails' folder to rescue or revisit the email.

What occurred to me in that moment, in nanoseconds, actually, was this chain of reflections.

My disciplined, quantitative, non-subjective equities selection process chose CME, and its portfolio weight. That process is the disciplined implementation and expression of my experience, subjective hypotheses, and proprietary research findings with respect to the outperformance of the market, on a consistent basis, by large-cap equities.

I am buyer of equities like CME. I don't want to manage them. I see the causality of the relationshp between CME and me as one way. CME operates, and I reap the results. My process chose CME because it fits a set of criteria which I have found to have a good probability of outperforming the S&P500 for a six-month holding period. I bought CME in order to enjoy its performance results. As of today, I am. It is clearly and handsomely outperforming the S&P, +6.5% to the index's -.25% for the period.

Why would I want to attempt to reverse the direction of causality with respect to CME? What do I think I, personally, as a portfolio manager, can add to the value-creating capability of CME? My selection process chose CME for its behavior before I owned it. It may even be the case that my proxy vote, like the butterfly's flapping wings in the South American rainforest, will have an indirect, but notable, negative effect on CME's performance.

No, I would like the context of CME's operations to be as similar to the period over which my process analyzed it, as possible. I want to effect no change in CME, nor visit any significant influence on it.

Barney Frank, be damned. He has it wrong. So do the corporate governance and "shareholder democracy" crowd.

The only "democratic" thing this shareholder wants is to know that, when I want to sell my CME shares, I can. At the market. With little brokerage expense. Period.

That's it.

I have absolutely no interest in influencing CME myself. Why would I be so arrogant as to think I could buy shares of CME, and then improve its lot with my proxy vote?

Perhaps some investors, especially institutional investors, buy shares of companies which they believe they can improve. Such as private equity investors.

I am not a private equity mogul. I have no billions with which to assume control of CME.

I just want to share in their next few months of consistently superior total returns. To want more than that is to court disaster, and succumb to hubris. The last thing I would want is to have any effect whatsoever on CME's performance. Thus, I deleted that proxy link email as quickly as possible. Lest some unknown quantuum effect derive from my mere reading of the email, and depress CME's share price. I want no part of CME's operating or governance process. I simply want to make money by owning its shares, passively.

Is this such a hard concept to fathom?

Wednesday, March 07, 2007

BP's New Ad Campaign

I have been watching BP's ad campaign for a few months now. You've probably seen them- interviews with people on the street about what oil companies "should" be doing.

The various staged responses involve big oil firms needing to go green, and find new energy sources to power our world more cleanly.

Then the requisite solemn voice-over announces that BP is already doing all sorts of lovely green things for its customers and the world.

There's just one problem. Oil companies historically have gotten into trouble, and wasted money, when they try to be something besides an oil company.

For example, in the 1980s, Exxon tried to break into the information equipment business. Living near their operations in NJ, I had colleagues who had worked there, and witnessed the rise and fall of the division. It stemmed from the mistaken belief, in the late 1970s, that Exxon's oil business would diminish in a few decades. The Exxon Enterprises unit was created to house a large assortment of various non-oil businesses whose mission was to grow sufficiently to take up the eventual slack of a declining crude oil-driven business.

It didn't work out that way. Instead, Exxon Enterprises' units had their collective heads handed to them in their respective product/market niches. And it never had the full support of the dominant oil executives, either. If memory serves, a future CEO, Lee Raymond, shut the group down to stem the waste of hundreds of millions of expense dollars.

It seems that utility-like firms have a tendency to wander astray when their sector's outlook is bleak, typically racking up huge losses.

Anybody else recall a little thing called "Penn Central?" When the old railroad tried to become a "transportation" company, and eventually would up in Chapter 11?

So I view these BP commercials with great amusement. I think BP is still suffering from the culture with which outgoing chairman Brown suffused it. It's trying to stray from being a good, well-run oil company, and, instead, apologize for what it is, and try to change into something else.

On the other hand, Rex Tillerson, ExxonMobil's new CEO, was unabashed today on CNBC about being a growing, well-run, profitable oil company. No apologies from him.

Oil companies should seek, find, recover, refine, and distribute oil. That's where their core strengths are. When they try to do radically different things, their shareholders suffer.

Is this really such a difficult concept to grasp?

Tuesday, March 06, 2007

Portfolio Risks and The Mortgage Sector

It occurred to me this week, in the midst of the continuing meltdown of the sub-prime mortgage lending sector, that my portfolio selection process exited the homebuilding and (prime) mortgage sector over six months ago. Happily, we own no mortgage or homebuilding sector stocks anymore.

I recall, however, back in 2005, that the business media was screaming about the sector's imminent collapse. At the time, a prominent fund allocator, with whom I had discussions, in hopes of attracting investments, complained that my strategy was overconcentrated in the homebuilding and mortgage sector. My response was that, to earn returns, you had to choose what was going to do well, and devote resources to those areas, rather than to mindlessly diversify. Rather like Kirk Kerkorian's own philosophy, mentioned in this

"Diversification is for people who aren't sure about what they are doing."

Over the time period stretching from mid-2003 to mid-2006, my selection process had selected companies in these sectors which returned a total of 4.8%. By July of last year, however, the process had rinsed mortgage lending and homebuilding out of the portfolio.

Now, everyone is worried about the sub-prime lending sector and, by extension, the homebuilders. The market's damage to the former group is making the pain felt by the conventional home building and lending equities in late 2005 and 2006 look tame by comparison.

This is a fine example of how our equity portfolio strategy and selection process' risk management has performed. As the sector's constituent companies began to underperform, both fundamentally and technically, our process had us exit the sector way before real damage occurred, and we made money on the sector over the time in which we were invested.

I wish I could speak with the analysts from that fund allocator again, now. As it happens, I heard from a friend that they sustained some heavy losses in the past year. I guess their own risk management wasn't quite up to snuff, after all.

Warren Buffett Seconds My Views on Dell, et. al.

Yesterday, I wrote about Michael Dell's return to lead the company he founded, and the likelihood that he will return it to consistently superior total return performance.

I wrote,

"Both H-P and Dell are, for the most part, engaged in the production and marketing of commodity electronic products- desktop and laptop computers, and printers. These types of firms haven't been on my equity strategy's selection lists since 1998. In the interim, the market for consumer computers has evolved to the point that most buyers can select and take home a perfectly adequate machine from a store at any one of as many as four chains (e.g., BestBuy, CircuitCity, Staples, Costco), with competitive pricing pressure providing similar values across the vendors and products.

In such a market, can we really expect either vendor, H-P or Dell, to somehow add sufficient extra value, and be paid for it, to drive its performance to a level of consistently superior total returns over several years? We're talking about producing some of the most common, nearly-disposable electronic devices you can imagine- personal computers and printers.

The competitive environment for its products, and the behavior of its target consumers, have changed to the extent that I don't think the product/market positioning of the firm will sustain consistently superior total return performance anymore.

Instead, the action seems to have moved on to online information and advertising purveyors- notable Google. This is not really a surprise. Over the years, consistent superiority of performance among technology firms has moved up the "food chain," from Intel and Microsoft, to the box makers, then the specialty applications software firms, to the online access and content providers. Now, it's moved beyond the last group, to simply providing tools to find information.

Although Michael Dell may return his firm to profitability and some revenue growth, relative to recent years, I don't think Dell has much potential to reward shareholders anymore."

Today, my partner emailed me a piece containing excerpts from Warren Buffett's annual shareholder letter. It would seem he and I share the viewpoint which I expressed above.

Here is, in part, what Buffett wrote:

"Not all of our businesses are destined to increase profits. When an industry's underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. (As a wise friend told me long ago, "If you want to get a reputation as a good businessman, be sure to get into a good business.") And fundamentals are definitely eroding in the newspaper industry, a trend that has caused the profits of our Buffalo News to decline. The skid will almost certainly continue.

Now, however, almost all newspaper owners realize that they are constantly losing ground in the battle for eyeballs. Simply put, if cable and satellite broadcasting, as well as the internet, had come along first, newspapers as we know them probably would never have existed."

In this post, last November, I discussed the odds that Maurice Greenberg or Jack Welch can turn around the daily newspapers they are interested in buying and running. Again, Buffett has come to the same conclusion I did, by writing,

"For a local resident, ownership of a city's paper, like ownership of a sports team, still produces instant prominence. With it typically comes power and influence. These are ruboffs that appeal to many people with money. Beyond that, civic-minded, wealthy individuals may feel that local ownership will serve their community well. That's why Peter Kiewit bought the Omaha paper more than 40 years ago.

We are likely therefore to see non-economic individual buyers of newspapers emerge, just as we have seen such buyers acquire major sports franchises. Aspiring press lords should be careful, however: There's no rule that says a newspaper's revenues can't fall below its expenses and that losses can't mushroom. Fixed costs are high in the newspaper business, and that's bad news when unit volume heads south. As the importance of newspapers diminishes, moreover, the "psychic value" of possessing one will wane, whereas owning a sports franchise will likely retain its cachet."

It's nice to be in the philosophical and intuitive company of someone so well-regarded as Warren Buffett.