Friday, February 15, 2008

Auction-Rate Securities Troubles

Yesterday's article in the Wall Street Journal regarding the Maher family, Lehman Brothers, and auction-rate securities sheds new light on yet another corner of the troubled fixed-income markets.

The most interesting portions of the article, to me, were the relatively new information about this type of securities, and Lehman's suspect actions in putting a client in them.

According to the Journal article,

"The Mahers rank among the earliest victims of "auction rate" securities, a once-obscure type of bond now sending shock waves through broad swaths of the U.S. economy. Auction-rate securities -- an unusual type of long-term bond that behaves like a short-term bond -- have become a keystone of modern finance. They are routinely used to fund everything from college student-loan programs to municipal road-and-bridge projects.

These bonds became popular with investors looking for cashlike investments, because they offered better returns than traditional money-market investments but were just as easy to buy and sell.

Recently, however, that advantage has disappeared. The market for auction-rate securities has dried up amid fears about fallout from the subprime-mortgage crisis. This week, New York's Port Authority saw the interest rate on some of its debt jump to 20% from 4.2% amid disruptions in this market."

From what I can deduce from this, auction-rate securities have their interest rates reset by market-auctions, rather than, like a long-term bond, simply carry a fixed or variable, according to some index like LIBOR, rate.

Thus, the price of the securities which, of course, varies inversely with the yield, can plunge if, for some reason, the auction reset results in a very high interest rate being paid to new buyers of the debt. This is evidently what happened to the Maher's Lehman-based holdings.

The Journal article goes on to report,

"The brothers have filed a claim against Lehman, saying it mismanaged their money. The complaint, filed last month with the Financial Industry Regulatory Authority, which resolves disputes between investors and brokers, says Lehman ignored the Mahers' request to put the money in short-term, low-risk investments such as Treasurys and municipal bonds."

According to the Mahers, they didn't realize that Lehman was putting their money into these potentially volatile securities. As the fixed-income markets became increasingly unstable late last year, these securities fell victim to demand simply evaporating, necessitating very high rates of interest to result from the auctions. The Mahers had informal asset management advice from a banker, Mr. Liu, at the firm that sold their business, Greenhill & Co. So abstruse were the instruments that even Mr. Liu didn't fully understand them.

The article continues,

"Baffled by the codes, Mr. Liu says he phoned Lehman and learned that many were corporate auction-rate securities. Mr. Liu, who had only a vague understanding of the securities, asked Lehman for details.

Auction-rate securities usually are long-term bonds with interest rates that are reset periodically (usually once a month) at an auction. Because the auctions happen so often, the bonds traditionally were much easier to buy and sell than other forms of long-term debt. Auction-rate securities worked well for over 20 years and were regarded by Wall Street as cashlike investments, since they were highly liquid and highly rated.

But if buyers stop showing up for auctions, they become tough to sell, or even to value."

So we see yet another instance in which investors failed to completely understand that, for some instruments, there is no way a market can be guaranteed to exist continuously. In this case, rather than frequent auctions keeping yields competitive, but leaving the securities reasonably valuable, the lack of risk appetite by buyers has caused rates to skyrocket, correspondingly sending the bond values plummeting.

And, in a page right out of the CDO story, sometimes the bonds can't be valued at all, because the auctions draw no bidders.


Regarding Lehman, the article continues,

"Mr. Liu says he came away from his conversation with Lehman unsure of the quality of the bonds' underlying assets. He consulted with the Mahers, and they agreed the bonds should be sold as soon as possible. Mr. Liu told Lehman to "unwind the positions and give the Mahers their money back."

Lehman, however, had trouble selling. In early August, the market for auction-rate securities grew skittish as one auction for lower-grade securities failed.

Lehman had put the Mahers into most of their auction-rate securities a few weeks earlier, in July. It reinvested about $100 million of the Mahers' money in auction-rate securities in mid-August, the Mahers say."

So Lehman, according to the Maher's and their informal advisor, Mr. Liu, failed to invest the Maher's money as directed. Apparently, the Maher's aren't the only investors displeased with Lehman's conduct involving auction-rate securities. The Journal article concludes with the passage,

"Many companies, including 3M and US Airways, are already writing down the value of their auction-rate securities. Bristol-Myers Squibb in January took an impairment charge of $275 million because of auction-rate securities it held.

Merrill Lynch & Co. recently bought back $13.9 million in debt securities that it sold to the city of Springfield, Mass. The Massachusetts secretary of state has since filed a civil lawsuit against Merrill charging the firm with fraud and misrepresentation.

In their claim, the Mahers are demanding their $286 million back from Lehman, along with interest, and are seeking punitive damages of up to an additional $857 million."

Just when you thought you had understood some of the more exotic credit market instruments, this story appears. It turns out that the Port Authority of New York and New Jersey saw its interest rate on auction-rate securities it issued jump to 20% this week, amidst weak investor demand for the notes.

How is it that with so many educated, intelligent investment bankers working in fixed-income departments throughout the industry, instruments such as CDOs and auction-rate debt fail to observe that there are times when demand for such exotic securities evaporates? And current 'values' cannot be easily determined?

If well-compensated, experienced sellers and investors continue to trade these instruments, without realizing all of the risks, can any regulator or government really have an impact on this business?

Or do investors and issuers simply need to experience the pain of loss with these securities, in order to learn not to participate in those markets anymore?

Thursday, February 14, 2008

Are We All (Liberal) Economists Now? CNBC's Aftermarket Debate

This afternoon, after the close of the market, CNBC featured a sort of on-air verbal brawl between three people- Steve Liesman, Ron Insana, and Larry Kudlow.

The topic was the overall health of financial markets as they affect the US economy.

It should be noted that only one of the "debate's" participants is a trained, recognized economist. That would be Larry Kudlow. Before going further, here are the relevant elements of the three persons' bios, from the CNBC website, regarding their educational background and economics credentials.

Liesman's CNBC bio,

Liesman joined CNBC from The Wall Street Journal where he served as a senior economics reporter covering monetary policy, international economics, academic research and productivity. At the Journal, Liesman previously worked as an energy reporter and, from 1996-98, as the Journal’s Moscow bureau chief. He was a member of the reporting team recognized with a Pulitzer Prize for stories chronicling the crash of the Russian financial markets.

Liesman holds a Masters of Science from Columbia University Graduate School of Journalism and a B.A. in English from the State University of New York, Buffalo.

Insana's CNBC bio,

Insana began his career in 1984 as an FNN production assistant, rising to managing editor and chief of FNN's Los Angeles bureau at the time the two networks combined. Insana graduated with honors from California State University at Northridge.

Kudlow's CNBC bio,

Kudlow is consistently ranked one of the nation’s premier and most accurate economic forecasters according to The Wall Street Journal’s semiannual forecasting survey.

He is a Distinguished Scholar of the Mercatus Center at George Mason University in Arlington, Virginia.

In 2005, New York Governor George Pataki appointed Kudlow the chairman of the New York State Tax Reform Commission.

For many years Kudlow served as chief economist for a number of Wall Street firms. Kudlow was a member of the Bush-Cheney Transition Advisory Committee. During President Reagan’s first term, Kudlow was the associate director for economics and planning, Office of Management and Budget, Executive Office of the President, where he was engaged in the development of the administration’s economic and budget policy.

He is a trusted advisor to many of our nation’s top decision-makers in Washington and has testified as an expert witness on economic matters before several congressional committees. He has also presented testimony at several Republican Governors Conferences.

Kudlow began his career as a staff economist at the Federal Reserve Bank of New York, working in the areas of domestic open market operations and bank supervision.

Kudlow was educated at the University of Rochester and Princeton University’s Woodrow Wilson School of Public and International Affairs.

It's clear from CNBC's own information that neither Liesman, their so-called 'senior economics reporter,' nor Insana, have any credible economics credentials, or, for that matter, much experience with financial markets, other than reporting on them.

Insana is alternately described as a "CNBC contributor" and a "principal at Insana Capital Management," or some other similar title of a similarly-named, obviously self-started boutique. Before that, he was a regular CNBC employee who was moved about, unsuccessfully, in search of some sort of regular hour show on the cable network. Between his rather boring demeanor and lack of in-the-trenches experience, as, say, Rick Santelli, Insana never seemed to catch on with viewers. One gets the feeling he has the CNBC "contributor" gig as a sort of exit deal with the network, in order to help him get visibility for his new 'capital management' startup. Being seen on CNBC would obviously confer the image, perhaps incorrectly, that Insana is a well-regarded, sage, experienced capital markets veteran whom the network is fortunate to have as a guest commentator.

What began, ostensibly, as a discussion of the current interplay of the economy and capital markets quickly descended into a political scuffle, with Liesman and Insana declaring that the Fed and the Bush Administration, in the person of Hank Paulson, had failed miserably to mobilize governmental power to magically solve the current crisis. Both non-economists railed that the financial markets, and the economy, were damaged, and both Bush and Bernanke had failed the American people by being 'behind the curve' in somehow resolving both crises by now.

Kudlow weighed in on the economics of the current situation, pointing out that financial markets would be best-served by simply being allowed to sort out valuations and credit allocations themselves. In this, he echoed Rick Santelli's comments from this morning, wherein he opined that the more Washington interceded in financial markets, the longer it would take for them to eventually sort out valuations and capital flows.

What was incredible about the spectacle that developed between Liesman, Insana and Kudlow is that the two un-credentialed, non-economists behaved so condescendingly to a genuine economist, and one of note, Kudlow, on such fundamental issues as financial markets and macroeconomics, pointedly denying and ignoring Kudlow's simple and correct assertion that they just wanted government intervention.

It's a crucial point. Liesman went further to assert something like,

'Congress is fed up with Paulson's and Bernanke's excuses and late awareness of these problems,'

as if Congress' opinion matters. Translation: Liesman and Insana think that any lack of admission by the current Administration, or the Fed, that investors and bankers got themselves into this mess, and are more or less going to have to get themselves out of it, constitutes failure.

Kudlow steadfastly called their position what it is- interventionist governmental politics pandering to an incorrect populist belief that, somehow, the Federal government can and should cure all naturally-occurring market cycles that are temporarily more painful than people wish to experience.

To take Liesman's and Insana's arguments to their logical conclusions, the US economy should never experience economic slowdowns, recessions, or financial markets cycles.

We just won't have it. We'll demand that Washington simply stop them. Cycles- whether economic or financial market in nature- are inconvenient, and, henceforth, outlawed.

Sounds a lot like that song from the musical Camelot, where rain is forbidden until after sundown, doesn't it?

Of course, the real tragedy here is that CNBC employs Liesman and Insana and presents them as economically- and financially-savvy, without apology.

On Recent Consumer Spending Data

Yesterday's Wall Street Journal reported the better-than-expected consumer spending data released that morning. It was a major topic of discussion on CNBC, as well.

Despite December's -.4% reading on this measure, yesterday's January value was +.3%.

I confess to being puzzled by the resulting, if it was a result, or at least subsequent S&P500 rise of 1.36% yesterday.

If you think, as so many would-be and wannabe economists contend, that the US economy is either in, or entering, a period of recession, then how can this spending number be good?

Isn't this the sort of data point that has doomsayers wringing their hands about American consumers borrowing and spending China's and the Gulf's wealth?

Where are the harbingers of US economic decline, telling us that, once again, we are failing to save, and behaving in spendthrift ways?

If you believe that available wealth has diminished, due to last year's credit markets turmoil, which ultimately helped lead the S&P500 to 12 percentage points of decline in recent months, how can this spending be good for our economy?

I don't get it.

Mind you, personally, I don't buy the now decades-old worries about the American consumer being on his/her last few months of creditworthiness. That any time now, the economy will collapse under a mountain of unsustainable, unserviceable consumer debt.

And I am not concerned about the spending rise. I think it's a sign that the US economy is probably not in, nor actually going to experience, a recession. More likely, after a perhaps two more quarters, we will see that our economy simply underwent a decline in its positive growth rate from a higher level, to a lower, but still-positive level.

But if you do believe those who warn of the end of creditworthy consumers as we knew them, as many pundits continue to, please explain how this +.3% rise in consumer spending is possible and/or desirable?

And why did it lead to, or is associated with, a hefty rise in the S&P500 that day?

Could it be that the investors are not as gloomy as many pundits. Could it be that, upon seeing the positive consumer spending number for last month, many investors concluded that economic woes are neither as severe as some would have us believe, nor likely to be as long-lived?

GM's Latest Setback- Updated For 2008

Is it a new model year yet? Does Detroit even have them anymore?

If they did, it would be a great time to showcase your new, updated, downgraded 2008 General Motors Company! Driven further into decline by that devil-may-care hotshot, Riiiiiiiick Waaaagoner!

Yesterday's Wall Street Journal featured an article in the Marketplace Section, headlined thusly,

"Huge Loss Dents GM's Hopes for a Turnaround"

Those newspaper guys. They have to go for the cutesy turn of a phrase. "Dents GM's hopes" indeed.

The real news, of course, is that this marks yet another big step down the road of mediocrity, toward bankruptcy, for the now-perennially-ailing US carmaker. Following on the bad news only last November, about which the Journal reported, and I posted, here, writing,

"The fact is that GM just lost $39B this past quarter. The face that I watched Rick Wagoner try to put on this appalling loss, in an early morning CNBC interview with correspondent Phil LeBeau, was that it is a non-cash charge that has no real meaning for investors. Skipping over the implicit acknowledgement that removing the asset from GM's balance sheet means the firm has no expectation of returning to profitability anytime soon, Wagoner attempted to paint a rosy picture of the firm's recent UAW contract, and longer term future."

The last six months have been another rollercoaster ride for GM shareholders, as the nearby Yahoo-sourced price chart of the company and the S&P500 Index illustrates.

About the time of GM's November travails, the brief uptick in the stock price ended, and it slid all the way through last month. It's almost become a timing vehicle.

Looking back two years, as this next chart does, shows that GM performed pretty much the same over that timeframe, too. It outpaced the index for much of the period, but the late-2007 downturn pulled it all the way back to parity with the S&P by year's end.

When we examine the five-year chart of GM and the S&P500 Index, the picture is quite different.

The recent 'recoveries' become just volatile investor reactions to GM's and Wagoner's attempts to halt the company's stock's long slide toward bankruptcy.

Yesterday's Journal article noted,

"In a fresh sign that its turnaround plan is sputtering, General Motors Corp. yesterday reported a $722 million fourth-quarter loss, to end the year a staggering $38.7 billion in the red -- believed to be the largest annual loss ever by an auto maker.

In the past three years the company has lost nearly $50 billion, more than all the profit it made in the preceding decade.

GM's latest quarterly loss came even though the company is showing signs of progress in certain areas. New models like the redesigned Chevrolet Malibu and growth overseas lifted the company's automotive revenue. Fixed costs in 2007 were $9 billion lower than in 2005.

But those improvements are being wiped out by other factors such as a softer U.S. car market and higher material costs."

So much for Wagoner's latest bid to turn the ailing auto giant around. The article goes on to observe,

"Meanwhile, GM's full-year 2007 loss of $38.7 billion in large part reflects a huge loss in the third quarter because it removed from its balance sheet certain tax credits it could only keep if it expected to become profitable soon."

This is what caused another sizable loss in November of last year, just one quarter ago. Failure to assure reasonably near-term profitability meant then, as now, the elimination of tax loss carry-forwards. This is a loss, make no mistake about it. It's not just some paper accounting entry. Had GM been able to forecast profits in the near future, that $39B credit would have shielded profits from tax.

With this as a backdrop, the Journal piece concludes,

"Chief Executive Rick Wagoner, 55 years old, now faces a monumental task in trying to turn GM around. After losses began piling up in 2005, Mr. Wagoner had to fight to keep his job when billionaire investor Kirk Kerkorian bought a stake in the company and placed a trusted adviser on GM's board. Mr. Kerkorian eventually gave up and sold his stake.

But as Mr. Wagoner heads into 2008, most analysts expect the company to lose money for a fourth year in a row. Most forecast U.S. auto sales this year at about 15.5 million to 16 million, which would be the lowest in a decade. GM may also have to take further Delphi-related charges."

Can it really be almost two years ago that Wagoner fought off Kerkorian and Toyota's Goshn? Thus, that two-year price chart reflects how bitter GM shareholders' disappointments must be with the ultimately flat performance of the stock since Wagoner fended off those potential saviors.

About the only good thing shareholders might celebrate was a relative rise in the stock price during the period, at which they could at least sell out before last year's bad news.

Wednesday, February 13, 2008

The Dow-Jones Industrials: Out With The Old....

The Wall Street Journal reported this week on the change in complexion of its major market index, the Dow-Jones 30 Industrials.

Out went Honeywell and Altria, in came BofA and Chevron.

I suppose there are various reasons for the changes. One is that Altria is effectively going away shortly, as the company's offshore tobacco businesses are being split from the old Phillip Morris.

As for Honeywell's ouster, apparently the folks at Dow-Jones feel that oil now represents a greater component of US economic activity than the diversified, high-value-added manufacturing and distribution of engineered material and systems produced by Honeywell.

Curiously, BofA was added, again, on the pretext that financial services is now underrepresented in the 30 company group.

Out of curiosity, I produced charts of all four companies on Yahoo, over 2-year and 'maximum' year timeframes.

The nearby two-year chart shows all four companies moving more or less in a band together until early last year. Then things got interesting.

Honeywell, one of the exiting companies, spurted ahead of two of the others, with Chevron slightly outperforming it, but with a similar pattern.

Altria, also exiting, also outperformed BofA, the worst of the lot. Of course, as the year wore on, and Ken Lewis had "about as much fun as (he could) take" in investment banking, BofA's performance slid sharply. In fact, so sharply that it nearly ended the two years back where it began.
The DJIA itself actually underperforms all the firms save BofA.

Turning to a much longer-term view of the four companies' stock prices, we see that all of them, except Altria, had remarkably similar paths for the past 38 years. There was a bit of untracking in the late '80s to mid '90s, and, as I noted above, in the last few years. And Honeywell declined noticeably from the path that Chevron and BofA shared for the early years of this decade.

Amazingly, the outperformer of the bunch has been the tobacco-and-sometime-packaged-goods giant, Altria, once a/k/a Phillip Morris..

What does all this mean for the Dow? I guess the rough parity of the three non-tobacco firms means you might expect similar Dow-Jones performance going forward. Maybe there's even a sort of central-tendency play going on, wherein the outliers over time, Honeywell and Altria, are dropped, in favor of two more attenuated stocks, BofA and Chevron.

Since the DJIA, over this long timeframe, nests right in among BofA and Chevron, this would seem to be true, even if it's not actually why Dow-Jones made these specific replacements.
Being focused more on the S&P, I really don't pay any serious attention to the Dow. If anything, this sort of shuffling merely points out how sensitive to membership is any market index composed of only 30 companies. Did the staff at Dow-Jones have to work exhaustively to choose a mix of outgoing and incoming companies, such that their effects upon at least the recent past of the Dow's performance would be minimal?
Choosing a bank and an oil company in an era of huge write-offs among commercial banks, including BofA, and dwindling opportunities for oil reserves acquisition by US majors worldwide, poses an intriguing question about the real reasons behind these choices.
As a few pundits opined, you can bet the folks at Dow-Jones want the index to do better, not worse, over time. Thus, they must be placing an implicit "call" on BofA and Chevron and, by extension, financials and oil in the US economy. And an implicit "put" on tobacco and diversified manufacturing onshore.
That's not a view I would have expected them to take, all other things equal. It should be interesting to see what sort of comments are made on these changes in the months and years ahead.

Tuesday, February 12, 2008

Esther Dyson On Microsoft-Yahoo Deal & Online Advertising

Yesterday's Wall Street Journal featured an excellent editorial by Esther Dyson, a longtime, well-regarded observer of technological trends and developments for nearly 30 years.

Her topic was the proposed combination of Microsoft and Yahoo, and its effect on Google's advertising business. She began her piece with,

"While the big news in the online world focuses on Google, Yahoo and Microsoft, a more profound revolution is taking place on the online social networks: The discussion about privacy is changing as users take control over their own online data. While they spread their Web presence, these users are not looking for privacy, but for recognition as individuals -- whether by friends or vendors. This will eventually change the whole world of advertising."

I've always liked Ms. Dyson for her ability to objectively and clearly explain evolving trends in technology, stretching all the way back to when I worked on digital PBXs and business strategy at AT&T in the 1970s and '80s.

As I no longer specialize in telecommunications, computing or online business, per se, Ms. Dyson provides an easy way for me to catch up on these sectors. Her identification of the differently-developing and increasingly-important social networking area is of interest to me.

She continues in this vein in her editorial,

"The current online-advertising model will become less effective, even as it gets increasingly sophisticated. New players are emerging to devalue the spaces that the ad giants are currently fighting over. Companies you've never heard of called NebuAd, Project Rialto, Phorm, Frontporch and Adzilla are pitching tools to Internet service providers that will enable them to track users and show them relevant ads. This approach (called behavioral targeting and already in service by ad networks that track users through so-called tracking cookies) undercuts traditional online publishers, who employ content to lure users and to sell adjacent ads. Now, the ISPs can sell advertisers direct access to the same users.

Take user number 12345, who was searching for cars yesterday, and show him a Porsche ad. It doesn't matter if he's on Yahoo or MySpace today -- he's the same number as yesterday. As an advertiser, would you prefer to reach someone reading a car review featured on Yahoo or someone who visited two car-dealer sites yesterday? His identity is still private: The ISP and behavioral-targeting networks don't know 12345's name and don't care. They just know what they think he wants.

This market will get more competitive, and users will be barraged by ads to which they will pay less and less attention. Call that public space, a world of billboards and cacophony. Even though the ads will be more "relevant" than ever, users will increasingly tune them out.

Now consider the new world of social networks. Facebook, unwittingly or on purpose, has been teaching people to manage their own data about themselves. Facebook's launch of the Beacon service -- which informs Facebook of members' activities (i.e., purchases) on other sites -- was a PR fiasco. But it still familiarized millions of users with the notion that they can control information about themselves online -- and determine to whom it is visible."

Ms. Dyson provides a clear illustration of why the very prize for which Microsoft is begging to pay a hefty premium is, even now, gradually losing value.

Leave it to Gates and Ballmer to ignore Schumpeterian dynamics and buy the last online trend, while another slowly builds elsewhere.

Ms. Dyson then gets to the heart of the matter- the economic value proposition these social networks offer. That's important because, as Dennis Berman wrote in the Journal a few months ago, about which I posted here, these online sites have traditionally had difficulty making money for anyone but the founder, after he sold out to a deeper-pocketed media or technology firm. In that post, I wrote,

"Aside from the marvelous business strategy expose, Mr. Berman makes it hard for the reader to avoid asking the question,

"If no other, larger firm, had bought, or bought stakes in, GeoCities, or was trying to buy or invest in Facebook, would Bohnett and Zuckerberger realize millions in wealth simply from the profitability of their businesses and business model? Or would they become, like Amazon, long on initial market value gains, but short on realized profits?"

Thus, leading to the ultimate question,"Were/are the acquiring giants of these online social networking businesses the greater fools?""

With this as background, Ms. Dyson, with her wealth of technology sector background as an observer over many decades, writes,

"So what's the business model? I'll "friend" British Airways, which will say, "We see you're going to Moscow next month. Why not fly through London and we'll give you 10,000 extra miles?" I'm no longer in a bucket of frequent travelers, my privacy protected. I'm an individual with specific travel plans, which I intentionally make visible to preferred vendors. British Airways, of course, will pay Dopplr a handsome sponsorship fee to be eligible to be my "friend" (just as a Nike rep might pay to sponsor a basketball game and be part of the community). Someday NetJets may show up, offering to ferry me and my friends to a conference we'll be attending together.

I'm far more likely to respond to BA or NetJets within a trusted site, and for a specific offer, than I am to heed their ad while reading a newspaper article on the troubles in Russia. (As for Orbitz, my old standby: After five years, it still doesn't acknowledge my preferred airlines.)

The new model creates a more trusted environment for reaching high-value, frequent purchasers, whether of airline tickets, electronics, clothes or other items. Where does that leave the less-frequent purchasers? Probably looking to their friends rather than to advertising for advice. I'm an expert on travel; my friends may look to me for hotel choices. When I'm in the mood to buy a book or a new computer, I'll check out what my friends on Facebook are doing.

This does not mean that traditional online advertising will go away, just that it will become less effective. Value is being created in users' own walled gardens, which they will cultivate for themselves in real estate owned by the social networks. The new value creators are companies -- like Facebook and Dopplr -- that know how to build and support online communities."

Thus, Ms. Dyson not only identifies the upcoming competitive forces which will eventually diminish the value of current online advertising models dominated by Google and Yaoo, but explains how and why the new approaches will displace the older ones.

Ironic, isn't it? It's not enough that Microsoft is now several generations old in terms of its basic, profitable technology- single-computer or network operating systems and applications software. Its leaders have now decided to risk a sizable amount of their retained earnings to buy into a fading online technology/firm.

Evidently not content to dividend their earnings to shareholders, Gates and Ballmer, already wealthy in their own rights, are determined to squander Microsoft's legacy cash horde on a business to which they really own bring money. Just as that business model's probably successor is appearing on the scene.

Truly, you can't make this sort of thing up.

Monday, February 11, 2008

Product Development Fiascos

Wednesday's Wall Street Journal contained a review of "Why Smart Companies Do Dumb Things," by Calvin Hodock. Daniel Akst wrote the review.

The article is a great read about some really inept and stupid corporate mistakes. It's hysterical to read about these marketing snafus. Specifically product development mistakes.

For instance, Mr. Akst writes, of Mr. Hodock's book,

"Coca-Cola executives were traumatized in the early 1980s by "Pepsi Challenge" commercials that showed real people, in blind taste tests, repeatedly choosing Pepsi over Coke. The folks in the taste tests really did prefer Pepsi, and in response Coca-Cola decided to reformulate its flagship product. The problem, Mr. Hodock says, is that a sweeter beverage -- in this case, Pepsi -- will always win in a "sip test." But real people, in the real world, don't take just one sip. They drink perhaps 16 ounces, and that's a different story. Millions of consumers had long ago decided that they preferred a less sweet cola -- as they loudly let Coca-Cola know when their favorite drink was supplanted by a sugary replacement."

I vividly recall this particular story. It was a major business headline for months, and called Coke's entire franchise, and its management, into question. Ironically, though, it also unleashed both Coke and Pepsi to realize something about shelf facings.

When Coke brought back the original formula as "Coke Classic," retailers were obliged to assign it substantial shelf space, as well. The result was that Coke's initial blunder actually increased its shelf space at the expense of smaller bottlers' products.

Still, it's quite revealing that the Coke executives failed to distinguish the differences between sipping tests, and satisfaction with full bottles of the soft drinks.

Says about all you need to know regarding creativity and confidence in senior management ranks at Coke in that era, doesn't it? Pepsi's Roger Enrico managed to put the entire senior management of his major, larger rival off balance with one simple marketing trick.

Another great story highlighted in the review is this one,

"One of the most interesting case studies in the book concerns a failed effort in the late 1980s by Campbell Soup Co. to launch a line of frozen soup-and-sandwich products called Souper Combos. Early tests indicated that consumers liked the concept, and Campbell projected $68 million in annual sales, just about hitting the company's target for new products. But as more data became available, the forecast was cut to about $40 million. "The innovation team didn't want to hear talk about a revised forecast," Mr. Hodock reports. "It was too far off the mark from the $70 million threshold level."

Nor did anyone at Campbell seem to want to take aboard the idea that, as Mr. Hodock says, "the product was a nightmare to work with." The frozen soup took twice as long to microwave as anticipated, and the directions required consumers to repeatedly insert and remove the soup and the sandwich. Mr. Hodock observes: "It was easier to prepare a bowl of soup and a sandwich from scratch." "

This is classic product development-gone-wrong material. Corporate denial and an insistence on customer acceptance of the product, despite warning signs to the contrary.

It reminds me of two additional product development fiascos, one of which was also a Campbell's flop.

The first was a staple of product development classes when I was a college and graduate school student- DuPont's legendaery Corfam. The synthetic shoe material was to revolutionize footwear and vault DuPont into another large, engineered product market, just like nylon and rayon.

But it wasn't to be. The material didn't really wear well. Even some of DuPont's own employees, recruited to test the idea, reported this. But, as with the Campbell's soup-and-sandwich example, DuPont's management refused to acknowledge the feedback. This led to an embarrassing failure of the product in the market.

The other Campbell's new product disaster was dry soups.

When I worked at the Wharton Applied Research Center as a graduate student, one of my projects involved the study of using Campbell's soup for dieting. Without going into details, this, too, flopped.

Howeve, a friend of mine who ran the overall project told me of a Campbell's initiative a few years earlier. The company had studied the dry soup market, and determined that there was room for a Campbell's product line.

Being Campbell, the packaging was, of course- a can!

That's right. Rather than a smallish, rectangular box, like Knorr or Lipton, Campbell's put their dry soup in a can.

Not unexpectedly, it, too, failed in the marketplace. The firm's management was simply too narrow-minded to consider other packaging than its standard approach.

I agree with the book's explanation for these mistakes, as Akst summarizes,

"Why do such innovation blunders occur? Mr. Hodock cites several convincing reasons: a company's me-too impulses, which can lead to me-too products that people don't need or want; the high turnover rate among marketers, who are often young MBAs with more attitude than experience; an unwillingness to give the boss bad news ("That Apple Newton you've been counting on to save the company? It doesn't work."); chummy and inattentive boards of directors; and the short-term focus of chief executives, which can lead to the hasty development of new products.

Worst of all, marketers are just human. "People fall in love with what they create," Mr. Hodock says. "All too often that love is blind . . . normally rational people become evangelical salesmen for their dreams rather than practical, objective business executives." "

Of all the reasons, though, I think the last is the most significant. It's significant because, with an effective product development process in place, it should be easily avoidable. In my marketing education, at two separate business schools, product development was taught from the perspective that companies need to successfully balance and reconcile two opposing forces: a need to generate many potentially profitable new product ideas, and a need to efficiently and effectively winnow these ideas, via routine, objective procedures. The result should be genuinely creative, profitable products which have been objectively vetted, tested, improved and molded to have a good chance of market success.

Maybe they don't teach this in business schools anymore. Or perhaps the ever-more frenetic pace of business in the past few decades has resulted in the shredding of a carefully-designed and managed new product development process.

Or perhaps too many inexperienced MBAs have gotten involved, and the process has degenerated into individual attempts to ride a new product to fame, riches and success.

Whatever the reason, it makes for very entertaining reading. And reminds us that not all new products become iPods, iPhones or Crocs.

Sunday, February 10, 2008

Yahoo's Continuing Troubles

A Wall Street Journal article released just prior to the announcement of Microsoft's proposed takeover of Yahoo catalogued the company's dilemma.

In part, it read,

"Yahoo Inc. issued a sober revenue outlook, saying it faces "headwinds" in 2008 amid weak online spending by some advertisers, prompting an 8.5% drop in its shares to 2003 levels.

The Sunnyvale, Calif., Internet company also announced it is laying off about 1,000 of its 14,300 employees in mid-February as it reported a 23% drop in fourth-quarter profit and an 8% rise in revenue. Some of the employees targeted by the layoffs will have the opportunity to find other posts at Yahoo in its priority business areas.

Yahoo also announced that it renegotiated a contract set to expire this spring with AT&T Inc. that shifts from focusing on selling Internet access together to sharing ad revenue and offering content on AT&T's TV service, Web portal and mobile services.

The new financial terms weren't disclosed but Yahoo said it expects to receive $300 million to $400 million upfront from AT&T as part of the contract. In exchange, AT&T will "retain full ownership of the customer relationship," an AT&T spokesman said, and will no longer share revenue from broadband subscriptions with Yahoo.

But one person familiar with the matter said that Yahoo expects to exceed its annual revenue from the current deal -- which has been estimated around $250 million -- on average over the four-year life of the new agreement, when the upfront payment is factored in."

One has to ask, irrespective of Microsoft's bid, is:

"Does Yahoo have much value as a going concern, rather than, say, a marketing partner or just some assets to strip?"

It's retro-CEO, Jerry Yang, hasn't really moved the needle at the firm in six months. Now they acknowledge facing 'headwinds' in 2008.

They renegotiated the ATT deal, but at what ultimate price? Yes, they get greater upfront cash flow, but they lost any direct connection with the customers. How long before ATT replaces Yahoo's content, or offers less for it? Is there really that much content on Yahoo that is proprietary?

The Microsoft bid offers some consolation to Yahoo shareholders that they might soon have a way out of their current mess. From the looks of the latter's management's recent statements, it's about the only hope their shareholders have anymore.