Friday, January 11, 2008

BofA Buys Countrywide Financial Corp.

Today's news that BofA is buying crippled mortgage lender Countrywide Financial Corp. for some $4B is the big news in this sector.

Remember that Ken Lewis, BofA CEO, bought a big stake in CFC back in August for $18/share of the mortgage lender.

CFC closed below $8/share yesterday.

Is this an opportune deal for the money center bank?

As the nearby Yahoo-sourced, five-year price chart comparing BofA, CFC and the S&P500 shows, neither company has shown marked outperformance of the S&P in the past five years.

BofA has only matched the index for most of the past five years, recently underperforming. Countrywide stalled for much of the past five years, after an initial outperformance burst in 2003. After that, housing sector weakness began to affect investor confidence in the long-term position of CFC.

As this morning's Wall Street Journal article on the deal observed, BofA is protecting its own interest in the ailing mortgage company. If it were to go bankrupt, BofA's prior investment would become nearly worthless, and Lewis would look especially foolish.

So, basically, what we have is a very large money center bank using its 'cannot fail' position to buy a potentially dead mortgage lender, in which it already has a significant equity position. It is, in essence, borrowing from the Fed/economy, long, to buy an investment before that investment's value goes to nearly zero.

Of course Lewis casts this as a vote of confidence in the long term viability of CFC and mortgage markets. And he's right, given a very long time horizon.

The question is, were Lewis not already an owner of CFC, and at a much higher price, would he be rushing to buy it now? With his own loan losses potentially looming this quarter, and perhaps a need for more capital?

My own opinion is that two mediocre companies do not, generally, when combined, make a better resultant company. I think this is strictly a case of salvaging a soured investment. On that basis, it may make accounting and short-term capital sense for BofA.

But it begs the larger question of whether Lewis used, and will continue to employ, flawed judgment in both buying a stake in CFC at more than double today's price, and running the giant money center bank in the future.

By the way, I don't own any BofA. It doesn't look like I will be buying any for the forseeable future, either.

Thursday, January 10, 2008

Alan Schwartz' Big Challenge At Bear Stearns

Yesterday's Wall Street Journal's Money & Investing section featured Alan Schwartz and Bear Stearns in the article "Can New CEO Repair Bear?"

Coincidentally, I heard parts of Schwartz' interview on CNBC that morning, as well. In the interview, Schwartz was careful to avoid saying anything negative whatsoever about his longtime employer. The recent mortgage excesses are 'old news.' They are, according to the new CEO, well-balanced and focused on sustained growth businesses.

To hear Schwartz describe Bear Stearns, you'd think his ascendancy to the CEO position at Bear is business as usual.

However, the Journal asks,

"How would Mr. Schwartz turn around a company, which is now trading at a level below its stockholders' equity?"

How indeed? In a market already roiled by mortgage woes, partially of Bear's own making. Fueled by its chairman, Jim Cayne's, intemperate, self-serving comments last summer that it was the 'worst fixed-income market (he'd) ever seen,' or words to that effect.

Schwartz' initial comments on his plan to revive Bear, as reported in the Journal piece, include,

"exiting from unwanted positions in leverage loans and in mortgages; find new ways to make profits in the changing fixed-income business; and nurture Bear's healthier business units, like its growing international operations and energy unit."

Oh boy. Not one of these avenues out of Bear's mess involves unique strengths or any sort of competitive advantage for the ailing firm.

As I considered the article, the interview, and this post, it occurred to me to ask a simple question about the major, publicly-held US investment banks:

"What, if any, is the key source of competitive advantage for each one?"

What I came up with, off the top of my head, is:

Goldman Sachs: risk management and focused trading expertise

Merrill Lynch: ostensibly broad, valued retail distribution

Morgan Stanley: perhaps a one-time strength in old-line industrial investment banking contacts

Lehman: focused fixed income trading businesses

Bear Stearns: entrepreneurial zeal and nimbleness borne of small size

Given that Bear took mortal body blows to its capital and reputation in 2007, I think it no longer has a competitive advantage. Its prior strength has become its Achilles heel.

Too bad for Alan Schwartz. He seems to be a very competent M&A guy who has been handed an atrociously bad hand in a long-running card game, but without many chips.

Between the currently volatile financial markets, Bear's competitors, and its own badly damaged reputation, involving the two mutual funds from which Cayne tried to absolve any responsibility last year, I'd be disinclined to believe that Bear Stearns has any significant chance of earning consistently superior total returns for its shareholders for years.

It may get a temporary pop in its stock price at some point, if it simply survives for a while. But I don't see a long term basis for its ability to ever justify investment in it for total return performance.

Wednesday, January 09, 2008

Another Vote For Microsoft's Breakup

Today's Wall Street Journal contained an article by their minority-owned analyst firm,, echoing my own calls for breaking up Microsoft, entitled "A Microsoft Midlife Crisis?"

I wrote about Microsoft here, here and here, in some cases, quite some time ago, that it would be better for shareholders if it were split into logically consistent pieces: applications, operating systems, online, and gaming.

Now, Steve Rosenbush, Rob Cox and Martin Hutchinson write,

"Microsoft is spending freely because it has been unnerved by the rise of Google. Google has advertising revenue that Microsoft, despite the billions of dollars it has invested in search technology, has been unable to match. This potentially subsidizes Google's practically free offering of software that competes with Microsoft's core products.

So Microsoft is understandably nervous. But overpriced deals won't solve its problems. Microsoft is behind the curve on developing applications such as social networking and advanced search. Its over-engineered products are still too complex. The answer to Microsoft's problems must come from within. Breaking the company into more-manageable parts, instead of adding layers through overpriced shopping, would be a better way forward."

It's nice to have my analytically-based views reinforced by other observers, albeit much later. Granted, I don't typically give the folks at breakingviews much credit for original or controversial thinking. But in this case, I am pleased that somebody else sees the same irrational, inefficient behavior at the Redmond software giant, the same consequences and probably solution.

Tuesday, January 08, 2008

McDonalds vs. Starbucks- A Marketing Battle You Just Have To Love

Yesterday's Wall Street Journal featured an article on the marketing battle currently brewing (yes, I know- a bad pun) between McDonalds and Starbucks over upscale coffee.
The Journal article displayed a one-year stock price chart for the two companies. I prefer two other timeframes- two and five years.
The nearby two-year chart for McDonalds, Starbucks and the S&P500 Index clearly show Starbuck's recent decline. It was holding flat, even up a bit in mid-2006, then slumped monotonically beginning in October of that year, rising nearly without pause since then.
McDonalds' stock price over the same period is almost directly opposite. Its price was truly flat for mid-late 2006, then took off in September of that year.
The next, five-year price chart for the same entities reveals how Starbuck's decline is a serious departure from its prior, longterm trend. The red curve, depicting the coffee giant's price over time, enjoyed two years of growth which outstripped the S&P in 2003-4, then flattened in 2005-6, and began to fall.
McDonalds have been on a steady upward trajectory over the entire five year period.
With that backdrop, I found the article suggestive that McDonalds is about to take a major piece out of Starbucks' recently-earned volume growth. McDonalds' move into higher-end coffee is the next in a series of revitalizing moves that have turned around the formerly-ailing fast-food giant.
For Starbucks, however, as I've written in prior posts, here, here and here, their expansion strategy has brought new headaches, as they try to buck the natural limits to growth of their business model. To me, it seems a clear indication of Schumpeterian dynamics at work, signaling an end to Starbucks' salad days of growth and total return superiority.
Particularly worrisome, as was also voiced this morning on CNBC, is Howard Schultz' preoccupation with 'returning to the core' of Starbucks. For example, in this passage from his nearly year-ago internal memo, Schultz wrote,
"We desperately need to look into the mirror and realize it's time to get back to the core,"
Thus, this morning's announcement that Schultz forced out his CEO, Jim Donald, and is resuming that title and role at the coffee roasting titan.
However, McDonalds' push into coffee has more to do with raw market opportunity than simply competing with Starbucks. That is, as the Journal article notes,
"The confrontation between Starbucks Corp. and McDonald's Corp. once seemed improbable. Hailing from very different corners of the restaurant world, the two chains have gradually encroached on each other's turf. McDonald's upgraded its drip coffee and its interiors, while Starbucks added drive-through windows and hot breakfast sandwiches.
The growing overlap between the chains shows how convenience has become the dominant force shaping the food-service industry. Consumers who are unwilling to cross the street to get coffee or make a left turn to grab lunch have pushed all food purveyors to adapt the strategies of fast-food chains.

It also shows how the chains' efforts to adapt to a changing market have had drastically different results on their bottom lines. McDonald's is entering the sixth year of a successful turnaround, while Starbucks has begun struggling after years of strong earnings and stock growth.
McDonald's executives watching the growth of Starbucks at the beginning of this decade realized that they were missing out on the fastest-growing parts of the beverage business. Data showed that soda sales had flattened while sales of specialty coffee and smoothies were growing at a double-digit rate outside McDonald's. Customers were buying food at McDonald's, then going to convenience stores to get bottled energy drinks, sports drinks and tea, as well as sodas by Coke competitors."
The fact that McDonalds wasn't originally remotely considered a competitor of Starbucks makes this a fascinating marketing battle. It's like watching a football wide receiver and his defender both leap for a pass, each having an equal 'right' to catch the ball, neither having especially wanted to collide with the other. But the ball is in only one place, so there they all are- the receiver, defender, and the ball.
In this case, it's the fast food and drink consumer, McDonalds and Starbucks. If McDonalds had identified something else, such as upscale desserts, or pizze, or what have you, somebody else might be in their way. Or perhaps nobody.
But as it is, Starbucks moved so far downscale, and reprogrammed so much of America to drink better coffee, that they created a market too tempting for McDonalds to avoid. And Starbucks developed its business model to be perilously close to that of McDonalds, in terms of satisfying instant consumer demands for food and/or drink, but being less efficient in its provision.
Chance are good you can learn to make better coffee more easily than you can instill a new, faster service ethic in your sprawling employee base. For what its worth, I happened to have sampled McDonalds' upscale coffee salons in New Zealand several years ago, and found it every bit as acceptable as Starbucks or, for that matter, Dunkin' Donuts.
In this passage, the Journal piece provides a wonderful insight into how McDonalds used classic, grass roots market research to unearth the opportunity they are developing,
"McDonald's researchers contacted customers of Starbucks and other coffee purveyors and conducted three-hour interviews where they videotaped the customers talking about their coffee-buying habits. The researchers got in the cars of the customers and drove with them to their favorite coffee place, then took them to McDonald's and had them try the espresso drinks.
"There was a surprise factor," says Patrick Roney, a director of U.S. consumer and business insights at McDonald's. "The people who were on the fence...there was an opportunity to get those." "
And McDonalds is using some of its classic strengths- ubiquity and reasonable prices, to move into the upscale coffee product/market, as seen from this passage,
"Heather Pelis, a 19-year-old babysitter from Rayville, Mo., says she didn't like the McDonald's vanilla latte when she tried it. "It was a little syrupy tasting," Ms. Pelis said recently while drinking a drip coffee at a McDonald's in Liberty, Mo. But she says she'd be willing to try another espresso drink because they are cheaper than the caramel macchiatos she buys at Starbucks, and because McDonald's is more conveniently located. The nearest Starbucks is a 30-minute drive from her, she says.

McDonald's franchisees say they think the new coffee drinks will be particularly helpful in drawing young consumers who prefer them to drip coffee. Gary Granader, a Detroit-area McDonald's franchisee, has started seeing groups of teenagers at some of his restaurants after school since he added espresso drinks a year ago. Mr. Thompson says McDonald's also is considering adding some type of music-downloading service at its locations."
Toward the end of the Journal article, it discusses Starbucks' reaction to its current dilemma,
"Starbucks executives have attributed the slowdown in sales growth and store traffic in the U.S. to the weak economy.

Mr. Schultz has said that new competition actually helps Starbucks by expanding the specialty-coffee category. "Those consumers over time are going to trade up," he told investors in November. "They're going to trade up because they are not going to be satisfied with the commoditized experience or the flavor." He has emphasized that Starbucks's baristas, who are instructed to memorize customers' drink orders and make genuine conversation with patrons, will continue to set the chain apart.

But some Starbucks baristas say that the chain's push into food and drive-through service has made that a lot more difficult. Some workers say their managers instruct them to ask customers whether they want a breakfast sandwich with their coffee -- a selling technique that feels unnatural when they know the customer doesn't want one.

"The more and more business they get in the store, the more it seems like another fast-food job," says Joe Tessone, a Chicago barista who has worked at Starbucks for three years."
To me, having followed this building story for nearly a year, Schultz' and Starbucks' logic and expectations are wrong. They expanded into more price-sensitive, lower-income segments, and are now struggling to make that business more constant. But it will be precisely those customers who are vulnerable to McDonalds and Dunkin' Donuts. Further, the changes in its product strategies is causing confusion and morale problems among Starbucks' workforce.
In today's article on Schultz takeover of the CEO spot, they write,
"Mr. Schultz wouldn't specifically address the coming competition from McDonald's but said he will work to make the experience at Starbucks more distinctive. "We have to be able to restore that in a way that significantly differentiates us from everyone else," he said."
Clearly, this makes sense. It's simple, basic marketing- provide a clearly differentiated offering if you have different price points than your competitors. Doing that, however, after having lost the magic, is a pretty tall, or is that venti or grande, order. However, they also quoted from Schultz' recent internal letter to employees,
"Some of Mr. Schultz's objectives stated in the letter, such as "re-igniting the emotional attachment with customers," are so difficult to measure that it may be hard for investors to know whether they are happening."
Maybe it's me, but I don't really want an emotional attachment to my coffee purveyor, when I do buy coffee from a retailer. I guess that's why I've been a Dunkin' Donuts guy up until now. I only buy whole espresso beans from Starbucks, although my children will sometimes ask to buy a drink when I stop to do that.
Of course, I'm only one coffee drinker, albeit a fussy one. The outcome of this battle royale between two retail food giants, Starbucks and McDonalds, with Dunkin' Donuts also roaming the same terrain, will be fun to watch. If you ever wanted to view a classic marketing struggle between two fairly well-matched firms in a clearly-defined market, this is your chance.

Employment Numbers Revisions & Friday's Selloff

Yesterday morning on CNBC, economist Brian Wesbury shed some light on the employment numbers which caused Friday's sharp equity markets selloff.

When discussing the economy for 2008, Wesbury contended that it is in solid shape, with basic employment and incomes growth intact. He cited the Friday number of 18,000 newly employed and agreed that 'we'd all like that to be higher.'

Then he went on to recall that, in August, the same report caused another market selloff when it registered -4,000 new jobs.

However, Wesbury explained, that -4,000 subsequently became adjusted to a positive 90,000. That's some difference.

Wesbury then remarked that low or negative numbers, in the context of this still-growing economy, typically get revised upward at a later date. But we don't hear about these revisions as front page news.

If you recall, after a lackluster, but positive August, the S&P500 Index registered a gain of almost 4%.

Makes you wonder how equities will fare in February, if the January employments numbers are also revised upwards at a later date.

Monday, January 07, 2008

Cable vs. Telephony Valuations

Friday's Wall Street Journal carried a piece by its minority-owned analyst's shop, This particular piece involved the assessment of market valuations of cable companies versus those of ATT and Verizon.

Specifically, Robert Cyran and Lauren Silva argued that,

"The phone companies furthest along in their rollouts are pummeling cable groups. Shares of Verizon and AT&T both rose more than 15% in 2007, while shares in Comcast and Charter Communications have fallen 35% and 62%, respectively. This trend isn't over.

Cablevision and Comcast increased their capital-spending plans last quarter. However, the average cable company has a prodigious amount of debt. In the short term, it could be difficult for them to take on much more in order to build better networks. Despite all this, the average cable stock trades at a 30% premium to the big telephone companies, based on estimated 2008 earnings before interest, taxes, depreciation and amortization. This doesn't look right. Cable companies may be overvalued or phone companies undervalued -- either way they should converge over time. Playing that trend again in 2008 is likely to reward investors."

Whenever I read people quibbling or arguing over valuations, a red flag goes up. In this case, note the use of the word 'estimated 2008 earnings.'

Whose estimates?

Essentially, Cyran and Silva complain that cable stocks are probably 30% overvalued (from their prose earlier in the piece), but that, either way, they should converge to a similar multiple as that of ATT and Verizon. Oh, and, by the way, according to the article's numbers, cable is still 'overvalued,' despite a 2007 decline of as much as 60% or 30% in value among selected cable equities.

Maybe I'm wrong, but didn't I read articles in the Journal over the last year concerning Verizon's difficulties in stringing fiber through every town and hamlet? That local regulatory fiefdoms were holding it up for special deals and payments? That it's not the cost or technical aspect of running fiber, per se, that dogs Verizon, but, to put it bluntly, the extortion money the company must pay to every little 'burb that it wants to serve with fiber-optic.

Perhaps, as the piece alleges,

"Installing fiber may be costly, but it enables the phone companies to leapfrog their cable rivals. While expensive to install, fiber is cheaper to operate because many repairs can be done off-site. Verizon claims a saving of around $900 a customer a year. More important, a fiber connection to the home offers a faster Internet service than the cable companies serve up."

But if the local regulatory/payoff issue hasn't been resolved for the long term, I think that could go a long way toward explaining the valuation differences. Cable has been a community staple for decades. It doesn't have to negotiate for access anymore, if it ever did. Maybe that's why the article stated,

"Verizon and AT&T both offer the so-called triple play: phone, television and Internet service. While the big cable guys have about 10 million customers for their phone service, the phone companies are just getting started in video. AT&T has around 250,000 customers and Verizon about one million."

Clearly, the phone companies have a long way to go to reach the same numbers in high-speed access as cable currently has in telephone. Even my father recently switched his telephone to his cable provider.

Additionally, as I recall, DSL is more susceptible to local traffic congestion, by virtue of its loop technology, than is high-speed cable.

It just seems to me that Cyran and Silva paint an incomplete picture of the various bases of competition and consumer choice for high-speed access. The fundamental regulatory and technical aspects of cable and telephony are still quite different.

Might not that, alone, account for valuation differences?