Friday, April 27, 2007

CitiGroup Analyst Calls for GE Breakup

Last summer, I wrote this post regarding the reasons why GE should not exist in its current state as a conglomerate. As has happened with some other early predictions of mine, now others are coming late to this party.

Now a CitiGroup analyst has published a call for breaking up GE by spinning off its finance, real estate and media assets. He provided estimates of the value of each of the units apart from their current parent, such that the separated values sum to more than the current value of GE's stock.
Last August, I wrote,

"The days of Thomas Edison's end-to-end electrical system supply enterprise are long, long gone. I contend that each of these business units, and perhaps even more, at lower levels, could be spun off independently, to GE's investors' benefit. It's hard to believe that this collection of such different businesses can realistically derive value from being in a common corporate domicile, let alone generate excess returns because of that common home to pay for the lush compensation of the various senior executives.I can't see any downside to breaking up GE into its component businesses. Does anyone else?"

Clearly, I am no longer alone in this view, although I articulated it in detail eight months ago. Similarly to how Warren Buffett recently echoed my thoughts on Dell, discussed in this
post, and the business media took six months or more, last year, to echo my own views on GM and Ford, first posted in this blog in the fall of 2005, now there's the beginning of a drumbeat to dissolve GE into its more sensible, constituent parts.

For what it's worth, the CitiGroup piece merited an on-air acknowledgement and discussion by no less than David Faber, a CNBC reporter. CNBC, of course, is owned by GE, so Faber had to be, and was, very guarded in his remarks.

On the plus side, he explicitly acknowledged GE's dismal performance under Immelt. Then, he inexplicably, and with a straight face, intoned that 'some say' Immelt has actually performed even better than Welch at the helm of GE. I have absolutely no idea how Faber would justify this, and he didn't try.

However, he went on to essentially note that Immelt has said the company won't be split up, so, there. No matter what anyone else says, Jeff likes being paid tens of millions of dollars per year for not providing shareholders even as much as the better-diversified return that they could get in the S&P500, let alone a better actual return under his term as GE's CEO. However, Faber did end his piece by opining that, if the company's stock price doesn't begin to move, relative to the S&P, by year's end, Immelt's job and GE's structure could begin to be in danger. As I've noted in prior posts, I'd love to see a wolf pack of private equity groups do to GE what the European bank consortium is now attempting to do with ABN Ambro- buy it and break up the pieces to add more value among the hunting partners.

Earlier, on CNBC's Squawkbox program, Joe Kernen, one of the co-anchors, and typically very sensible, had read aloud the Citi analyst's estimated business unit values on an as-separated basis. He then asked, to paraphrase,

'well, if we know what the pieces should be worth alone, why is it necessary to split them off? why can't we just have GE's value reflect them?'

It's actually a fair question. Since the values are different, there must be reasons. Here are two that have occurred to me in the past.

First, astute observers realize that these units would behave differently, and probably more competitively and aggressively, if they had not corporate safety net, let alone had to vie internally for investment resources. Thus, on this basis, their different behavior and, probably, performance, would justify a different value.

Second, these units are currently saddled with a sort of corporate "tax" by Immelt and his royal court. Do you think Immelt actually adds value to any specific business unit personally? Doubtful. So, in essence, Immelt, his staff, headquarters operation, and all of the ponderous GE administrative overhead is paid by a tax on the operating earnings of the various GE units. Spin off a unit, and it instantly has more net income, and probably less meddling, time-wasting activities directed upward to the GE corporate staff.

For the record, here is a passage from Immelt's prepared remarks at GE's annual meeting this week, as reprinted in the Wall Street Journal,

"You can only believe one thing if you run GE or own GE stock: consistent earnings and cash flow growth, with expanding returns, increase shareowner value. This is a long-term investment. There are no short-term tricks.

The last few years have been frustrating for all of us. Your company has performed. Our five-year earnings growth rate of 11% matches our performance over the past 25 years. Our total shareholder return was 9% in 2006, 10% over the past three years and 2% over the past five years. But we have under performed the market.

Our challenge is one of historical valuation. GE's PE ratio was 31X in 2001, a 50% premium to the S&P 500. Today, our PE ratio is 17X, equal to the S&P 500. This is a function of a broader market sentiment away from "safer" mega-cap stocks and investors' desire to see GE perform consistently as we changed our portfolio.

We will continue to perform. We may have been over valued at 31X earnings, but we are not today. Our stock should reflect our double-digit earnings growth rate in the future. As we continue to execute, our valuation should improve as well. This is the best time to own GE stock.

I am compensated to meet with your expectations as long-term investors. Approximately 20% of my compensation is in base salary; 60% is at risk based on our financial performance; and 20% is at risk based on the stock price performance versus the S&P 500. I work without a contract. My objectives and compensation are set by our independent directors. My evaluation is transparent. You can read about it on page 41 of the annual report. I own 1.2 million shares of stock, including 100K shares I purchased in the open market over the past year. I will never sell a share of GE stock while I am CEO. Believe me, I am motivated."

Regarding Immelt's remarks, I would note the following.

His observation of GE's historic earnings growth rate being stable, while its stock price has stalled, simply points up Immelt's failure to understand that the game has changed in terms of investors' expectations. First, from my proprietary research, I would note that revenue growth, not earnings growth, is significantly related to concsistently superior total returns. Second, it's Immelt's job as CEO to figure out how to get total returns which exceed those of the market, not to excuse why earnings growth, and he, aren't getting the job done.

Second, Immelt is totally disingenuous in how he portrays his compensation. By expressing his compensation in percentage terms, he hides how much actual cash he has been paid by GE to date. I've covered this in various posts, most recently here, and the number is now at or north of $18MM. If Immelt explained this, than the '20%' figure, and his insistence that he is 'motivated' become pathetically hollow. Further the 80% of his compensation 'at risk' is, in reality, based upon terms he has proposed. The internal performance portion, 60%, is likely a sandbagged number. The 20% related to GE's stock price, in relation to the S&P, is, as I recall, rather complex, rather than simply requiring Immelt to consistently better the S&P's return over several years.

I'm left feeling a bit happier today, after hearing of the Citi analyst's call to begin dismembering GE. With time and continued lackluster leadership at GE, we might just see it be pursued and broken up within the next few years. Pity, though, that Immelt will get to keep what, by then, will be more than $20MM in cash, and probably more than $100MM in additional deferred compensation, all for doing basically nothing during his tenure to add value to GE for shareholders.

Thursday, April 26, 2007

AstraZeneca Acquires Medimmune: Is Big Pharma Finally Dead?

Over the last decade, we've seen, significant and, at times, rapid consolidation of the pharmaceuticals sector. I can't even begin to recall the various once-independent names from the 1980s anymore. I do recall the latter years of Roy Vagelos' reign at Merck, when it was a paragon of a well-managed company and pharma operation.

Does this week's acquisition of MedImmune by AstraZeneca (one of the big pharma giants that is the resulting combination of some of those firms whose names I can't recall) signal the final bankruptcy, from a total return perspective, of big pharma?

Is bio-pharma finally, legitimately replacing big pharma as the most efficient and effective means of discovering new medicines?

A look at the various Yahoo-sourced charts (please click on each to view a larger version) reveals some of the answer. The first chart depicts AstraZeneca's performance over the past five years, versus the S&P. Not only is AstraZeneca performing worse than the index, but it's inconsistent, as well.

Considering my latter question regarding big pharma vs. bio pharma, I charted several big pharma staples- AstraZeneca, Novartis, Merck and Glaxo, versus the S&P and Medimmune. With the exception of Novartis, the big pharma names lag both the S&P and Medimmune over the past five years.

Turning to the bio pharmas, we have this result. Gilead (one of my portfolio holdings) and Genentech lead the pack, with Genzyme and Medimmune also leading the S&P. Further, the graphic display demonstrates that Gilead and Genentech have continued to outperform recently, while the other two bio pharmas have coasted back down toward the S&P's return.

This would suggest that Carl Icahn has not lost his touch, and is focusing on one of the weaker-performing companies in a sector that is capable of far better performance.

Putting the two pharma sub-sectors together, you get this picture. Big pharma as a group clearly lags bio pharma in generating superior total returns for their shareholders. Thus, AstraZeneca is probably wise to turn to an undervalued bio pharma for help in re-igniting growth and, hopefully, the ability to generate consistently superior total returns.

Does this mean we might see additional consolidations of big pharmas chasing bio pharmas? The chart suggests it will continue to be a compelling consideration for the worst performing big pharma, Merck.

Wednesday, April 25, 2007

Trouble Hedging Oil Prices: West Texas Crude

Monday's Wall Street Journal contained a sleeper of an article about the behavior of West Texas crude as oil's benchmark pricing instrument.

While the details of how and why this type of oil has become the instrument on which hedging instruments are built may be rather dull, it turns out that they are important. For, recently, the price of West Texas crude, and the hedging vehicles built upon it, have been moving in the opposite direction from the prices of the bulk of oil traded on world markets.

It goes to show, once again, that hedging is typically built on historical pricing behaviors, but is not always a lock. Right now, airlines and other major institutional consumers of energy hedges are seeing those financial insurance policies double down the wrong way. Instead of offsetting oil's price rise, the West Texas hedges are adding to the damage.

We saw this nine (has it been that long already?) years ago, when the wizards at John Merriwether's Long Term Capital Management, including two Nobel Laureates, misunderstood the behavioral assumptions they had made regarding various instruments used for hedging, and took them, instead, as tautological relationships. When a combination of market forces, including a Russian default, upset past relationships between the financial instruments, LTCM began its four month slide into bankruptcy and dissolution.

Now, we have a view of something similar, although simpler, occurring. The physical site chosen for delivery of West Texas crude-based derivatives is Cushing, Oklahoma. For a variety of reasons, the storage facilities in Cushing are full, thus depressing prices.

So, while attempts are being made to develop new benchmark oil instruments for other grades of crude, in other locations, let's not lose sight of the underlying lesson from this situation.

Relationships between financial instruments are observed behaviors within certain contexts. They are not laws, nor tautological truths. There can be occasions when conditions will be violated, relevant ranges of underlying or associated phenomena may be exceeded, and the relationships upon which hedges built with these financial instruments will fail to behave as expected.

It happened with "portfolio insurance" in the early 1990s. It happened again in 1998. It might be happening again now.

And it's almost certain to happen again, in some instruments, in the future.

Tuesday, April 24, 2007

Financial Academics as Wall Street Fund Managers

"Those who can't do, teach."

That's an old adage from my youth. However, Saturday's Wall Street Journal featured an article concerning academics who teach finance at our nation's universities, and also have developed and/or run asset strategies via hedge or mutual funds.

My initial question is, why would you think finance professors should necessarily know more about developing hedge or mutual funds that outperform the market than anyone else? If they did, and they knew it, wouldn't they be doing it already? Or, perhaps, have done it, become wealthy, and then retired to teach finance at a major university?

Unlike bygone eras before 1990 or so, when universities often had data, computational resources, and a collection of talent that was unmatched elsewhere, it's unclear what competitive edge would exist nowadays in the academic world. What is it that university finance professors have that is now unique? The days of University of Chicago's CRISP data base being unique, or Wharton's Rodney White Center having some edge, are gone. I can't imagine any leading trading or investing operation, let alone an exchange, releasing data in that manner anymore.

Would universities have better research resources, such as people? Probably not. Funds and investment banks with fund management shops are chockablock with young, eager twenty somethings on the make. In fact, my partner and I even pause when offered an opportunity to meet with some financial services concerns, because we don't see benefits to speaking to a room full of young, inexperienced analysts, all of whom are looking for some edge with which to make partner at their firm.

Computing power is cheap and plentiful now. That is not likely to be a source of advantage for a finance professor nowadays

How about innovative concepts? Perhaps the leading finance professors think better thoughts about investing strategies. The article mentions Wharton's Jeremy Siegel, Yale's Robert Shiller, and Princeton's Burton Malkiel. It neglects to name Robert Merton and Myron Scholes, co-recipients of the 1997 Nobel Prize in Economics, who assisted Long Term Capital Management in causing self-immolation, and the loss of $4.6B, back in 1998. Neither does it discuss Robert Haugen, a UCLA finance professor who applied the theories from his book, The New Finance, to mutual funds in the 1980s. As it happens, my colleagues at a hedge fund worked with Haugen in the late 1980s, using his data and models, and were unable to effect any significantly superior returns from the effort.

The article also omits any mention of Fisher Black's and Richard Roll's track records at Goldman Sachs, back in the 1980s and '90s. Black, of course, was hired for his part in the now-famous Black-Scholes options model (he died while at Goldman, so LTCM had to settle for his partner, Scholes), while Roll was instrumental in the application of a rather garden-variety statistical technique, factor analysis, to portfolio management, which was renamed Arbitrage Pricing Theory, or APT.

Whatever asset management vehicles other famous finance professors, such as Eugene Fama, and/or his research colleague, Ken French, have created, are also omitted.

If anything, finance professors may be more likely to be hidebound, since they must teach what has already been vetted. Or, if it's cutting-edge, what they teach becomes the market behavior. You'd expect to find the more successful asset management strategists out of the limelight, and certainly not prostyletizing their concepts to the masses in MBA and PhD programs.

As an example of this, several years ago, I worked with a wealthy private investor who desired to develop his own hedge fund complex. He told me that he and his colleague, Burton Malkiel, managed the money of some associates.

Did they employ some abstruse black-box econometrically-based model? No. Did they engage in esoteric hedging strategies across currencies, durations, and asset classes? They did not.

Their approach was almost comically simple. It used the yield on Treasuries, and a simply-derived proxy of yield for the S&P500 from its forecasted earnings and PE multiple. They then simply moved client funds between two publicly-available, pure index funds based upon the relative values of the two forward-looking yields.

Hardly rocket science.

However, my comments are hypotheses. Anecdotal, if you will.

What we really need to know, in order to determine whether ex- or current finance professors are uniquely talented asset managers, is whether, as a group, finance professors have outperformed their non-academic peers in the marketplace with their hedge, mutual fund, and/or private account strategies. Did they also outperform the average comparable fund or account? How about the S&P500 index, for equities, or other relevant indices for other asset classes?

This would be fascinating work for some financial media company, such as the Wall Street Journal, Barrons, Forbes, or CNBC to undertake or commission. Just using a few high-profile names and some anecdotes isn't sufficient to demonstrate or conclude anything.

For example, as noted above, Long Term Capital Management blew up, losing billions of investor dollars, with the help of two ex-academic, Nobel Laureates. Siegel's strategies, somewhat disingenuously called 'index funds,' have been off to a rocky start at Wisdom Tree, according to a recent Journal article.

There's no clear sense in the literature as to whether academics have done a better job consistently outperforming their respective market indices, or non-academic asset management peers. From that perspective, the Wall Street Journal article is an intriguing start on this topic, but by no means the final word.

Monday, April 23, 2007

Wall Street on Wal-Mart

Friday's Wall Street Journal ran a piece in their Money & Inveseting section on what ails wal-mart, and how to fix it. Trouble is, they mostly asked a group of money managers. Why they think those guys would have a lock on such knowledge is beyond me.

In my opinion, most of them are barking up the wrong tree. Wal-Mart isn't 'coming back' as they knew it. It's big, sluggish, and hard to manage with its saturated markets.
A look at the Yahoo-sourced chart above ( please click on it to view a larger version) displays the firm's stock price over the past five years. To call it 'stalled' would be kind. It's in deep trouble.

Among the suggestions from the analysts and portfolio managers were: improve customer service; focus on same-store sales, not new growth; exit Japan; enter another foreign market like Mexico, and; sell the Sam's Club operation.

It's quite a mix of advice, but I doubt most of it will result in consistently superior returns for Wal-Mart, like its heyday in the 1980s and '90s.

From what I've read of the firm's travails of the past few years, customer service, per se, is not the problem. Certainly not of the sort that matters to McDonalds. It's a totally different customer satisfaction model.

Rather, Wal-Mart is likely at a crossroads. If it desires to regain consistently superior total return performance via growth, then it needs to do a better job identifying those markets which will sustain its traditional, logistics-dependent strategy for dominating the low end of retail merchandising. Whether this means staying or leaving Japan, I don't know. But Wal-Mart's management should.

Similarly, selling or keeping Sam's Club is strictly a matter of whether it contributes to high-margin, high-revenue growth, or not.

However, what all of these observers miss is that real companies become senescent. Eventually, investor expectations become adjusted to their performance, their competitive environment brings the firm to parity, and, like Wal-Mart, it may even draw the focus and ire of public interest and governmental groups, further burdening the firm's efforts to outperform the market.

My own view is that it's unlikely that Wal-Mart will regain its former consistently superior outperformance record. Its size, need to be in multiple countries and exposed to radically varying cultures and logistics environments probably presents the firm's management with too many challenges to overcome simultaneously.

But, since I'm neither a broker, nor a current investor in Wal-Mart, I don't have a stake in convincing others to either buy, or sell the firm's stock based upon expectations. I'm just writing what I have observed, from both my proprietary research, track record of portfolio selections, and the recent media coverage of Wal-Mart's performance.