Friday, August 31, 2007

Wendys' Fall: Another Case of Schumpterian Dynamics

Wednesday's Wall Street Journal featured a piece on the demise of Wendy's, the fast-food, hamburger chain built by Dave Thomas. It's a classic story of Schumpeterian dynamism, and the ability of otherwise apparently reasonable people to become deluded into thinking that companies last forever.

The real story begins with the absence of founder, builder and pitchman, Dave Thomas, in late 2001, when he focused on the final stages of a cancer that would take his life early the next year. According to the Journal article, Thomas was no longer "deeply involved" in the company's operations by late 2001. The fact is, nobody could convey the chain's quirky image and its food's comparative advantages like Thomas did. At this point, sane people would have begun to question if things could ever be the same.

Would Apple be Apple without Steve Jobs? It wasn't when he left years ago, replaced by John Scully. Some firms are, like it or not, iconic. Shareholders need to be sanguine about this.

After Thomas' death, the remaining management bought a Mexican food chain, Baja Fresh Mexican Grill, for $275MM. But the new unit never performed up to expectations.

Kerrii Anderson, hired as Wendy's CFO in 2000, became interim CEO after the departure of Jack Schuessler in 2006. Her compensation rose from $3.4MM as CFO, to $4.2MM as interim head of Wendy's.

The particulars of how Wendy's performance began to slide are almost immaterial. Take your pick- an accountant running a consumer food business, meddling in the kitchens, manipulating franchisees to push for her as permanent CEO, and her oversight of inept commercials using a male in a wig with red pigtails to replace Dave Thomas as the Wendy's image.

Between disgruntled institutional investors, including Nelson Pelz, and poor sales growth, the company was in trouble. It sold the Baja Fresh unit for only $31MM- a little over 10% of what it paid for the chain four years earlier.

The remaining Thomas family members- his wife and children- were appalled at how the company was faltering. Quotes in the article have them saying,

"You can't tear the company apart to satisfy shareholders," in answer to Pelz' demands to sell Tim Horton's, and that,

"Mr. Thomas's widow and several of his children say they were sick over the news (the sale of Wendy's to another owner) and couldn't understand how management had let the company become so vulnerable (my italics)."

The inept Ms. Anderson 'remained remarkably upbeat' about Wendy's growth prospects. However, as I have written in prior blogs about CEOs such as Jeff Immelt, of GE, when a CEO has earned upwards of $15MM in compensation, they no longer have the same goals as their shareholders. Ms. Anderson had, by this year, been paid at least $20MM (five years as CFO at at least $2.5MM, plus the $3.4MM in 2006, and $4.2MM as CEO). She no longer cares whether the company actually prospers. As my partner, a native of Ohio, noted,

"Do you know how far $4MM goes in Dublin, Ohio? You can't spend that kind of money out there."

The fact is, from a business history perspective, Wendy's had to slow at some point. It was Dave Thomas' passionate creation, and was inevitably destined to either grow too large, or miss some market trend. Companies don't grow forever. Changes in management, especially the loss of a gifted, passionate, insightful CEO, can cause irreparable damage.

If anyone should have had the sense to realize that Wendy's was finished as they once knew it, with Thomas' death, it should have been his family. Odds are, Nelson Pelz is more realistic about Wendy's than the family or its management. He realizes that it now is probably worth more in pieces.

A little perspective, and a lot less emotion, might have saved all the actors in this drama some grief, energy, time and money. Wendy's was destined to falter after the loss of Thomas, without some equally-passionate, experienced leader. Certainly, a relative newcomer, and an accountant, at that, wasn't going to be going toe to toe with McDonalds and winning. Or with Nelson Pelz, for that matter.

Sometimes, it's better to simply acknowledge change and get it over with.

Wednesday, August 29, 2007

Economies of Scale in Autos and Computers

Tuesday's Wall Street Journal's Marketplace Section featured two seemingly unrelated articles- Acer's purchase of Gateway, and Chinese auto manufacturers making inroads in Africa.

On closer examination, however, I believe the two share an important link and lesson. They both embody some elements of Schumpeterian dynamics.

In the case of Acer, this Asian computer maker has wisely taken the opportunity to buy market share and brands by scooping up the number three US computer manufacturer, Gateway. By combining supply chains and brands, Acer hopes to, and probably will, gain some margin room while obtaining new branding and price-point flexibility. Clearly, Acer understands that the computer manufacturing game is now largely a commodity one, with a few exceptions, such as HP's recent Pavillion line.

However, for large parts of the market, Acer's ability to provide competitive functionality at lower prices may help it drive Toshiba, Lenovo, and others into less tenable market and profitability positions.

The focus of the other Journal article is the emerging market for new cars in West and Southern Africa. Whereas these areas historically were dumping grounds for used European models, the Chinese have arrived with new cars so affordably priced as to compete favorably with the used car stocks.

What's amazing is that all of the new entrants are Chinese, and no American, or even European names, are to be found. Nary a Ford, Chrysler or GM nameplate.

The article suggested that these auto makers can't really afford to aim so low in price as to compete with the Chinese in Africa. However, at least one Chinese manufacturer warned/promised that they would be moving upmarket, and into richer countries, on the back of the African experience and volumes.

I can't help but think that, a decade hence, we'll read various tomes from the likes of BCG, Bain or McKinsey consultants dissecting the final mistakes of the American auto makers. Can it really be so benign to allow the Chinese to gain a vehicle production foothold, uncontested, in an entire continent? Granted, it's Africa, but, still....

You can just see the Chinese lowering costs along expanding volume curves, gaining manufacturing experience and improving quality, as well as the ability to target small, profitable niches in Africa. Then turning these newly-acquired skills on the low end of the American market.

If you needed fresh reasons to explain the slow, inexorable death of US auto production, here's another one. Complete denial on the part of Detroit that a clutch of rising Chinese vehicle manufacturers can use Africa as a springboard to enter the US with small, efficient, low-priced cars and steal another potential market before American producers can respond.

It's been the way most prior Asian auto producers have entered. Plus, with fuel economy and environmentalism running rampant these days, it would be reasonable to expect the Chinese nameplates to be more than competitive on fuel consumption, weight, size, etc. They've got a large market with which to experiment, getting smaller, less expensive cars 'right' before shipping them to the US.

Alan (Mulally), Rick (Wagoner), Bob (Nardelli)? Anyone looking east to see the source of your next competitor?

Ironically, the three blind mice probably won't take note of Acer's recent move, and consider how scale and creativity, together, can both protect against further share erosion, as well as be the basis for new growth and profitability.

Second-Rate Economists & CNBC

They're at it again!

Yesterday, CNBC featured two little-known 'economists,' one from UBS, another from PNC, who agreed that the US economy is now in danger of a recession. Both solemnly lectured that Fed Chairman Ben Bernanke had better cut the Fed funds rate next month by a quarter-point, or he wouldn't be managing the economy effectively.

Honestly, this kind of thing just turns my stomach. Who do these guys think they are? They are so far from being credible it isn't even funny.

This morning, on CNBC, for the eighteen-thousandth time since the end of July, the anchors are holding a 'debate' among various guests and pundits, as to whether the Fed should cut rates next month. You're not going to hear much else for the next few weeks, until that magical afternoon when the Fed announces its rate action, or inaction.

It seems to always be this way now. If there's anything but blue sky and sunshine in the financial markets or on their horizons, then CNBC spends most of its air time on "Fedwatch," conducting unending discussions, day after day, week after week, as to what the Fed will and should do at its next meeting, and why. Nevermind that there's insufficient data released daily, let alone weekly, to justify this. It's merely 'entertainment.'

However, as Brian Wesbury, a better-known and credible economist, wrote of the business media's tendency to hold pro vs. con on camera "debates," these mistakenly give people the impression that, say, economists are evenly divided on the subject of the likelihood of a recession, when, in reality, they are not at all 'evenly divided.'

In his August 9th editorial in the Wall Street Journal, Wesbury wrote,

"Any reasonable sample of economists these days would include at least 80% optimists. So why all the bad news?"

And, again, this very morning, while listening to/watching CNBC in background, I heard Erin Burnett report that in phone calls she had (Yes! She actually talked to real people- not just regurgitated her own journalistic opinions.) with banking executives around the country, most of them saw no reason for a Fed rate cut.

For what it's worth, Wesbury believes that,

"...people gather knowledge about the rest of the economy, the part they cannot see, from watching news. As a result, it could be that the format behind most business journalism skews perceptions and creates pessimism.....But what seems clear is that in the name of producing an entertaining product, and in an attempt to provide contrasting views, the true consensus of experts is rarely reported."

As I discussed this with my partner the other day, we returned to a topic we've touched on before. That is, when Harry Markowitz developed efficient market theory and the concept of portfolios, he probably never imagined a world in which the white noise would crowd out true information.

Recall, if you will, the world of the late 1950s, in which Markowitz formed his theories. Markets were telephone order-driven, brokerage rates were astronomical, there was no cable television, nor on-going business news throughout the day. With trading so expensive at retail, investment was the order of the day. Computers were non-existent, so forget program trading, too. Most business "news" was just that, and the amount of commentary on it was a lot less than today. Magazines like Fortune, Forbes and Businessweek (if it existed then) held much more sway than they do today.

It's hard to set a hard and fast rule among today's surfeit of business 'information,' but, surely, the babbling of some third-rate economist at a third-tier financial institution hardly qualifies as similar in quality, or, probably, 'information,' next to, say, a Fed president's remarks, or those of a Nobel Laureate in economics. Or the CEO of a well-performing, large hedge fund or private equity group. Not all the utterances we hear on CNBC, booked to fill up air time, are deserving of the description 'information.'

Most of it is, in reality, just noise. Recycled worries and warnings, and hand-wringing by people who, otherwise, would never be exposed to the wide world of business media viewers. Nobody said these guests and commentators are actually credible, or competent.

Yesterday, I actually heard one of the less intelligent CNBC morning anchors say something like,

'well, if bank CEOs aren't believable, don't you have to listen to large company CEOs, who have their ears to the ground?'

My laughter was immediate. CEOs with ears to the ground? You've got to be kidding!

When you hear drivel like that from a CNBC on-air anchor, you know you should heavily discount most of what you hear on the network that is not breaking news, and carefully choose which of their guest pundits to believe.

Tuesday, August 28, 2007

Confirmation of My Views on CDOs and Securitization

Yesterday's Wall Street Journal featured an editorial by Ethan Penner, one time Nomura employee in the mortgage banking group. Penner replaced my friend B, who had built the group some years ago.

It was very satisfying to read Penner echoing my own comments from this post, two weeks ago. Specifically, he confirms two of my contentions. First, that the manner in which differing asset types have been combined into CDOs, is far different in purpose, and effect, than the original uses of the securitization vehicles. Second, the ratings agencies played important parts in the debacle, highlighting their conflict of interest.

In one of my posts, I wrote,

"Second, to paraphrase Wilbur Ross, a self-made tycoon via conventional buying, improving and selling mundane businesses, and CNBC's guest host this morning,'when someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.'

I could not say it any better. Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used."

In his piece, Penner phrased it this way,

"Of course, it is very important here to distinguish between CDOs that make sense and are a healthy part of the market, and ticking time bombs that should never have been created. As an example of the former, there are those issuers, the NYSE-listed REIT Capital Trust, who utilized the CDO structure to pool their homogeneous real estate credit assets and create a financing that matched up ideally. This sort of CDO is not only sensible but an example of how securitization can help foster a healthy financial system -- creating a liability for the issuer, Capital Trust, that matches exactly the term of the assets.

On the other hand, many CDO issuers bought all sorts of assets and combined them into proverbial "witches brews" that they foisted onto the bond market, sucking out profits and fees at issuance in a game that was ongoing as long as the deals held up. The buyers of these concoctions, reliant upon the rating agencies' models, were unlikely to ever get their arms around the risks that they were asked to underwrite. How a trader would be able to traverse the various markets represented by the diverse collateral underlying these bonds to provide a suitable secondary market bid is beyond me.

My guess is that a healthy CDO market will return, but it will only be available as a source of financing to those few professional risk managers with real expertise and only for homogeneous asset pools. I have pity for bond buyers with the other type of CDOs, as it is difficult to imagine how liquidity will ever return to their holdings."

Penner also reinforces points I made in this post, the following day, regarding how the ratings agencies abetted the mortgage originators/CDO packagers. In my post of a few weeks ago, I wrote,

"Yesterday's Wall Street Journal carried a fascinating article concerning how S&P's and Moodys' rating of so-called 'piggybacked' sub-prime mortgages, in 2000, led to today's credit turmoil.

Amazingly, the ratings agencies first allowed the CDOs backed by these mortgages to be investment grade, then changed their minds last year. It evidently took five or six years for S&P and Moodys to sample and test the payment history of such mortgages, leading them to downgrade them to junk status.

Now, as Wilbur Ross said on CNBC yesterday morning, nobody should simply blame a rating agency for their own bad investment decision. And I agree with that.However, when buyers included institutions which could not buy those CDOs with today's ratings, but could earlier, you have to wonder how much the agencies' appetites for fees led them to inappropriately collaborate with the issuers, and look the other way over an obviously riskier type of home loan."

Penner seconds this by noting in his article,

"However, it's become apparent in these last months that the free market, combined with a complete dependence upon the three main bond rating agencies, may not, in its current format, be the perfect answer either.

Securitization may be the only business in the world where the appraiser is hired by, paid by, and thus works for, the seller rather than the buyer. It would be unthinkable, for example, in a real estate transaction for the seller of a property to expect that the buyer would accept a seller-provided appraisal as the basis of their valuation.

Yet, this is exactly what transpires in the bond market, where the sellers, Wall Street firms that aggregate assets and pool them into carefully "sliced and diced" securities, hires and works carefully with the appraiser, the rating agencies, to maximize their arbitrage. Importantly, appraisers at the rating agencies are paid a small fraction of the pay of the investment bankers they work with, and many aspire to work at one of the firms that they are representing, thereby creating a heightened conflict.

The potential for conflicts and misaligned incentives are more potent over time than even the best of intentions.

So, the first place one may look when tweaking the securitization model would be to re-align the interests of the governing bodies, that is, the rating agencies, more precisely with those they truly represent -- the bond buyers. There are numerous ways that this might be accomplished; suffice it to say here that a change is probably healthy and long overdue."

So true. Finally, we have confirmation from an ex-senior manager of a securitization manufacturer that the process finally went overboard. Rather than allowing the marketing of loans, suitably repackaged, to clarify risks, with concommitant returns, the process became a method for creating opaque securities with respect to risk.

Meanwhile, the ratings agencies- S&P, Moodys, Fitch- stood by and kept quiet, while accepting payment for blessing the evolving practices.

Still, as Wilbur Ross noted, shame on any investor, especially institutional investors, who try to blame the agencies and securitizers, when, as buyers, they bore the ultimate responsibility for knowing what they bought and elected to hold. Some investors will continue to find ways to make bad investment decisions, and blame the markets, regulators, rating agencies, etc. We can't really stop that. But we can at least identify the need for buyers of securities to be intimately knowledgeable about that which they are buying.

Monday, August 27, 2007

More on Mortgage Lending and Lower-Income Homeowners

Last Wednesday's Wall Street Journal carried Holman Jenkins' weekly editorial, which dealt with homeowners on the low end of the income distribution.

Citing the work of Carolina Katz Reid, then a graduate student at the University of Washington, Jenkins wrote,

"But a home financed by a mortgage is not just an asset. It's also a liability. We owe thanks to Carolina Katz Reid, then a graduate student at University of Washington, for a 2004 study of what she dubbed the "low income homeownership boom." She considered a simple question -- "whether or not low-income households benefit from owning a home." Her discoveries are bracing:

Of low-income households from a nationally representative sample who became homeowners between 1977 and 1993, fully 36% returned to renting in two years, and 53% in five years. Suggesting their sojourn among the homeowning was not a happy one, few returned to homeownership in later years.

Even among those who held on to their homes for 10 years, the average price-appreciation gain was 30% -- less than if their money had been invested in Treasury bills. This meager capital gain was about half that enjoyed by middle-income homeowners.

A typical low-income household might spend half the family income on mortgage costs, leaving less money for a rainy day or investing in education. Their less-marketable homes apparently also tended to tie them down, making them less likely to relocate for a job. Ms. Reid's counterintuitive discovery was that higher-income households were "twice as likely to move long distance if they're unemployed." "

I have to admit, I was stunned by this research. So much for the 'ownership society,' at least at the really low end of the incomes distribution curve. However, when you think about it, it's very sensible.

As a sometime homeowner, I can vouch for a home being a lumpy, often-illiquid investment which requires substantial cash for for maintenance. And it certainly can restrict mobility.

It's eminently reasonable to conclude that lower-income people are better off spending their assets on education and the ability to remain mobile, for employment purposes. Saddling them with a large, illiquid fixed asset does not actually make much sense.

Jenkins goes on to note,

"The irony is, were the owners of the subprime paper inclined to make themselves known and realize their losses, the majority of these loans would likely end up paying off. Buyers of the severely discounted paper would make a killing and the market's dispersed decision-making, which recently became its weakness, would return to its normal role as a strength. In any case, subprime lending accounts only for about 15% of outstanding mortgages, with an uncataclysmic $90 billion worth facing foreclosure.

Fluctuations in the S&P 500 wipe out as much wealth every ho-hum day without drying up credit globally. But today's caginess problem is partly a regulatory and legal problem, because something is clearly stopping holders of temporarily unmarketable mortgage paper from sidling up to their bankers and asking forbearance on the loans financing these positions.

His comment about a corresponding loss in equities from an S&P Index decline is a point I've made in a prior post. The current market turmoil is overblown, in that too much is made of the source of the losses, rather than the rather modest likely net losses when the dust settles. Capital markets is all about taking risks, and sub-prime-based paper is just another example of how that can result in losses. It's part of investing.

The Democratic presidential contenders are currently outbidding each other in ways to help "homeowners" (a dubious term in the present instance) avoid foreclosure. What might really benefit these citizens is being freed to return to renting, where some real bargains will likely be had in the months and years ahead."

Now there's a good point. With a swollen residential housing supply, rents will probably be on the softer side for years. Good news for lower-income citizens seeking to save money for investment in assets such as their children's, and their own, educations.