Friday, June 29, 2007

Applebee's & Schumpterian Dynamics

Today's Wall Street Journal features a textbook article about Schumpeterian dynamics and industrial structure.

In discussing the current troubles of Applebee's, the popular restaurant chain, it notes that the idea began as a single restaurant, loosely modeled on TGI Friday's, in 1980.

1980. Ronald Reagan was President, you didn't own a cell phone, and few of us had personal computers.

The article nicely observes three contributing factors to Applebee's demise. One is the growth in restaurants, from one for every 1,029 people thirty years ago, to one for every 664 people as of 2003. That's nearly a 100% increase in competition. So much for opportunities remaining fixed, and no change over time. This sector has become crowded, as barriers to entry remain, as always, fairly low.

A second factor is, not surprisingly, changes in American food preferences. Restaurants with meteoric growth due to style and cuisine are notoriously risky in terms of long term success. Applebee's menu formula originated almost thirty years ago.

Again, as the Journal article notes, today, your local supermarket competes with ready-to-eat delicatessen fare that is affordably priced and very acceptable. Plus, tastes have moved away from the bar-food and heavy, platter-like dishes at Applebee's. Fried and large are out, smaller and fresher are in.

Ruby Tuesday's is featuring ads touting fresher dishes in smaller portions, for lower prices, with a signature chef personally crafting their menu.

Finally, as this Yahoo-sourced chart shows (click on the chart to view a larger version), Applebee's stock price has barely outpaced the S&P500 Index over five years. And most of that has been a recent rise, at a faster rate than the Index, beginning late last year. For the early part of the period, the stock mirrored the S&P's rise, then flattened and fell as the index continued to rise, through mid-2006.

Former SEC Chairman Richard Breeden's investor group took a position in the stock, and has been agitating for changes. The restaurant chain's management is charged with essentially fiddling and compensating itself lavishly, while Rome burns. According to the Journal, the chain's management realized it had a strategic positioning problem as long ago as October, 2005.

Now, it is aping Ruby Tuesday's, by using chef Tyler Florence as its signature menu designer. Speaking personally, I have been to one of the chain's locations a few times in the last six months, as shopping with my daughters found me nearby at dinner time. I was not impressed.

The tab was higher than I expected for food that was not really all that good. "Steaks" that had gristle running throughout. Merely average salads. Somehow, for the atmosphere and menu, the total check size was somewhat shocking. A smaller, local steakhouse routinely does a much better job, for no more, and frequently less money.

I think that Applebee's is simply the latest example of the life cycle of distinctive style and menu restaurants. They catch a fashionable wave, grow like topsy, go public, and eventually mature. They add more stores, settle in as a popular favorite, and, therefore, dampen the opportunities for further, breakneck growth. Eventually, they saturate the potential markets, lure a reasonable number of patrons sufficiently frequently, and top out.

This can take a decade or more, during which consumer tastes change, early patrons' lifestyles are now radically different, and a new entry-level generation finds a new favorite restaurant chain.

Once again demonstrating that businesses which rely on capitalizing on fickle consumer behaviors simply don't have long term, consistently superior total returns. They are relatively shorter-lived, temporal plays on fortuitously hitting a sweet spot in consumer trends.

Thursday, June 28, 2007

Alan Murray's Interview with Carl Icahn

Yesterday, The Wall Street Journal/CNBC sponsored a conference, hosted by Alan Murray. The topic was, I believe, private equity.

Currently, CNBC has video clips of this interview in its free section, broken into four parts. Because it will soon move to their paid, premium area, I won't bother frustrating readers with a link. However, it is well worth your while to watch the 30 minutes or so of total air time.

As I have written here, back in December of 2005,

"However, what really made me sit up and take notice was Icahn’s pointed comment regarding the modern large-cap American CEO. He feels that, on average, and as a group, they are seriously disadvantaging US business relative to foreign businesses. This is a fascinating viewpoint. It echoes my own research, writing and feelings, some of which are found elsewhere on this blog.

Icahn specifically voiced concern that today’s CEOs are so over-compensated that they simply do not pay sufficient attention to maximizing ongoing shareholder wealth. In this, I totally agree ( see my recent post regarding pay-for-performance for large-cap CEOs). He feels that if this trend continues, American business will lose its competitive edge and, over time, fall victim to hungrier, more attentive foreign competitors."

In his CNBC interview, Icahn explained in much more detail how he thinks this has occurred. I must say, I am in total agreement with him. I actually watched it happen at Chase Manhattan Bank in the late 1980s. Essentially, Icahn contends that today's CEOs are the guys who simply socialized well, didn't do anything notably innovative, nor stupid, and kissed ass. Being no threat to their managers, they were moved up in concert with said managers, resulting in senior executive ranks full of yes-men and average, mediocre "talent." Since a CEO of this type does not want a second smarter than him, the capabilities of the firm's CEOs decline with each generation. A business version of Aristotle's theory on the decline of leadership in society, beginning with the wise, benevolent philosopher-king.

Icahn is really funny, but very insightful and shrewd. He explains, without naming names, why CEOs like Jeff Immelt exist and prosper. He goes so far as to lay the blame not with the boards of these firms, but publicly-held mutual funds. Because those funds are so often desirous of pension money to manage, they will often judiciously withhold criticism of a company, in hopes of getting some business.

Too, although Icahn didn't single this out in the parts of the interview I watched (for some reason, each segment cut out at about the halfway point), once a CEO has made something north of $2-3MM, he really isn't all that motivated to make his shareholders wealthier, if he ever was. His major orientation is to just not lose his lucrative, relatively easy job.

I also found it both funny, and chilling, that Icahn explained that, when he actually gets inside of some of these firms, the managements, including the middle layers, are much worse than imagined.

His comments and insights echoed and supported my own proprietary research findings, which is that very few companies are capable of consistently outperforming the market on the basis of total returns. There just are not that many smart CEOs who are motivated to really take risks in order to enrich their shareholders at a rate better than those owners can realize by simply holding the S&P500 Index.

I think it's a mark of how right Icahn is, that so many corporations attempt to smear his motives and ideas when he arrives on their doorstep, holding a significant position in their company, and wanting a board seat.

Wednesday, June 27, 2007

What's In The News?

As I read the Wall Street Journal, one of my three major news sources (along with The Economist and CNBC) this morning, I found myself strangely unmoved.

The headlines read,

"How Wall Street Stoked The Mortgage Meltdown," "Exxon, Conoco Exit Venezuela Under Pressure, and "As Competition Rebounds, Southwest Faces Squeeze."

None of them seemed all that interesting, relevant, or surprising to me.

We own Goldman Sachs in our equity portfolio. It's up more than 9% year-to-date, and has recovered some of its recent losses, which were only about 4% in total. I honestly don't think the sub-prime mortgage mess is either going to seriously harm Goldman, the financial services sector as a whole, or the economy.

Will some less stable, diversified funds suffer large losses as lots of that paper is truly "marked to market?" Yes. But it's unlikely to cause some sort of panic, much less a recession or "market meltdown." Last week and a few days this week saw equity investors worrying over this potential outcome. However, as time passes and nobody goes bankrupt, investors seem to be settling down.

How about Exxon and Conoco? Well, we don't own them. Instead, we own OxyPete, Allegheny Energy, and El Paso gas. They're all doing very well, thank you for asking. Occidental is up 24% this year, while the other two have returns of roughly 17% year-to-date. Evidently, none are affected by the Venezuelan mess.

I'm curious to read the article, of course. But I think it's rather obvious what the script is going to be. Does anyone else recall Libya in the late 1960s, when US oil firms were summarily ejected via nationalization?

Lastly, there is Southwest Airlines. Some years ago, our portfolio selection process actually picked Southwest. It was a rarity, as I have commented on the low barriers to entry in this sector. The first paragraphs of the Journal's piece tell you all you need to know,

"For years, Southwest Airlines managed to fly above the industry's storm clouds, trouncing rivals with a hard-to-match formula of low costs and low fares. Now it's facing a painful role reversal.

Its revenue growth has slowed, its costs are mounting, and its resurgent rivals have torn key pages out of its playbook.

"The threat to our future is real," says CEO Gary Kelly.

Don't say I didn't warn you- here, here and here, in these prior posts, in fact. In the last post, I observed,

"What seems to sound the death knell for these regional carriers is their eventual desire for passenger and revenue growth which requires them to outgrow their original, self-contained market segment of travelers. Just because an airline wishes to profitably continue its growth does not mean it should, or will, happen. Thus, Southwest’s dilemma.

It is pushing for growth while its total returns over the last five years are already penalizing its shareholders.

Hard as it may be to accept, many companies simply run out of profitable market segments in which to grow, and then their days of consistently superior returns are over. Airline total return performances seem to reinforce this conclusion with stunning regularity. So much for learning by example, or even from their own mistakes."

It would appear that I have, once again, predicted the outcome of another firm's strategic moves.

The airline industry is so beset with low barriers to entry and shared facilities that it does not take a genius to realize that long term, consistently superior total returns are very unlikely. Southwest had its run some years ago, in terms of consistently superior total return performance. Now, however, that is over.
As the Yahoo-sourced chart on the right demonstrates (click on it to see a larger version), Southwest Airlines has been flat for five years, and plunging recently. My rationale for this, as expressed in the post which I quoted above, seems to have been dead on.
I guess it's a good thing I am not an editor for a media publication, because my sense of "news" is probably very different than the average persons. I didn't find any of the three Journal pieces all that compelling. Yet, clearly, it's important and useful that the stories are reported.
Perhaps I would add a considerably greater amount of analysis. But, then, it would resemble some sort of, well, real analysis. Then again, maybe it's better to get in-depth analysis from a more objective source, such as a media publication, than a sell-side brokerage firm which you know is biased.

Tuesday, June 26, 2007

Bear Stearns' Miscalulations

The Wall Street Journal has, understandably, featured several recent articles regarding the Bear Stearns hedge-fund debacles. A piece in the Weekend Journal focused on whether or not Bear would stand behind its one failing fund. Another, yesterday, discussed the mechanics of marking sub-prime-backed CDOs to market. Today's Journal returned its focus to Bear Stearns' corporate situation, as it manages the two hedge funds which have racked up such appalling losses so suddenly

I've spoken with several friends about the developing situation at Bear Stearns. We all agree that this is yet another instance of financial service CEOs on the non-commercial bank side of the sector seemingly ignoring obvious signs of public discontent with their behavior.

To understand some of what is occurring with Bear Stearns, you need to recall that James Cayne, the company's CEO, refused to join the rest of Wall Street in bailing out Long Term Capital Management in 1998. I have been told that he personally rebuffed Merrill Lynch's then-CEO, David Komansky's request that Bear join the party in working out a rescue.

Instead, Bear stood on its legal claims, and refused to reset terms of its loans to LTCM.

Now, of course, the shoe is on the other foot. This probably explains, in large part, why Merrill recently moved quickly to seize and auction collateral it held for margin loans to Bear's troubled hedge fund.

Yes, what goes around, comes around. Even if it takes a decade or so to do so.

This weekend's piece in the Journal was eye-opening, as Bear's fund manager, Ralph Cioffi gathered his fund's creditors in a meeting and demanded, among other concessions, a 12-month moratorium on margin calls against the fund by its lenders. While doing so, however, he acknowledged, to an inquiring creditor, that the fund's notional parent, Bear Stearns, did not anticipate providing any capital to shore up the fund's losses during this period.

This is the sort of attitude that not only irks other Wall Street firms, but is seen by the less-well informed public as simply walking away from responsibility.

It's likely that, as with most funds, the two troubled Bear Stearns funds are technically separate corporations, 'owned' by their shareholders, with a separate 'board,' and a contract given to Bear Stearns to manage the fund. Thus, Cayne's attitude that Bear has no technical obligation to assume, or make good on, or even simply provide capital for, the egregious losses in these funds.

Let's be clear on the sort of funds these are. They were developed within the past year or so, explicitly to bottom-fish the sub-prime loan market. They constitute organized efforts to take advantage of the sector's problems, buying low and, so the funds' managers hoped, holding and selling as the sector turned around. Only it hasn't turned around.

Basically, Cioffi and his colleagues made a naked bet on the direction of yields and prices of sub-prime mortgage loans, and got it wrong. By leveraging something like 10:1, they blew through the equity behind their fund with recent losses.

If the two funds were actually just standalone entities, that would be the end of the story. Their creditors would seize the collateral, organize asset sales, satisfy what obligations they could, and the funds would be closed.

However, since the notional parent is a large, stable, well-capitalized Wall Street investment bank, the picture looks somewhat different. Even though the funds' customers are 'sophisticated investors,' the public and, perhaps more importantly, the Democratically-controlled House of Representatives, will view the situation as a wealthy investment bank sticking its customers with losses, while it reaps management fees from the funds, and declines to share the losses.

Sometimes, businesses hurt themselves by ignoring the effect of their actions on the larger society in which they operate. I suspect this is one of those times. I think James Cayne is making a serious mistake vis a vis his company's troubled sub-prime mortgage hedge funds. After shuffling his feet and first refusing to help the funds with loans, to allow them to make margin calls without selling assets, he has already sent a message to the markets, other Wall Street firms, Congress, and the public. His reversal on this issue, and decision to lend to the funds, now comes a day late, if not a dollar short.

Who would now want to invest in a Bear hedge fund? What other firms will extend loans to Bear funds now, without extra protection for the value of those loans? Perhaps they will restrict the leverage that a Bear Stearns-backed fund may use.

And surely, Barney Frank will be using this example to drive new hedge fund regulation through Congress.

It's a shame that James Cayne is repeating such callous, ill-considered and naive behavior in this matter. By attempting to take refuge in the legalities of the situation, he may win the battle, but will almost certainly help lose the war for all of the capital markets, and other Wall Street firms.

Monday, June 25, 2007

Corporations & Remote Collaboration

The Wall Street Journal's Weekend section, two weeks ago, featured a section, in concert with MIT, concerning how corporations work in the modern era from many, remote locations.

In her article, "Working Together...When Apart," Lynda Gratton proposed 10 rules for making global, virtual teamwork successful. It's worth reading the entire piece, to get the full impact of the findings. She provides details about the origin of her information. In brief, it is the product of case studies at companies judged to have had successful virtual teams, followed by a London Business School survey of over 1,500 virtual team members at 15 US and multinational companies. From this information, the 10 rules common to successful virtual teams were distilled.

When I first read the list, my reaction was one of doubt that this sort of thing was going to be very replicable. I recall being at Accenture (then Andersen Consulting) in the 1990s, when we began using LotusNotes on project teams and in industry practices across the globe. Suffice to say, it wasn't pretty, and it wasn't all that effective, either.

However, as I returned to Ms. Gratton's piece to write about it, I am struck by another thought. Much of it is just common sense. For example,

2. Choose a few team members who already know each other.
5. Break the team's work up into modules so that progress in one location is not overly dependent on progress in another.
9. Ensure the task is meaningful to the team and the company.

Some of the other 'rules' make sense as well, but don't exactly seem like rocket science.

On one hand, one is tempted to give credit to the author(s) for distilling the 10 things that make the most difference. On the other hand, they aren't all that surprising.

As I wrote this, it occurred to me that there are some fairly older examples, before the internet age, which must have also produced rules lists like this, e.g., Boeing jet design, IBM mainframe computers, McDonnell Douglas jet and bomber design, intel chip design.

Surely some of these earlier projects learned similar lessons?

In the end, I found this article a bit disappointing. And reinforcing of something my proprietary research on equity performance discovered. Over time, surprisingly few companies can operate so effectively as to consistently outperform the S&P500. Getting things right, growing, and continuing to perform well, seems to remain a sort of 'catching lightning in a bottle' trick, even to this day.