Friday, January 30, 2009

Starbucks Shrinks!

In three posts last year- here, here and here- I discussed the failure of Starbucks' CEO Howard Schultz' growth strategy.

Finally acknowledging a slump in high-end retail sales, Schultz is cutting 6,000 store employees and 700 headquarters staff, as well as closing 300 additional stores above the 600 closures announced last year.

As I have noted in prior posts, the firm exposed itself to this sort of risk when it sought growth from lower-income customers. Those store openings and employee additions, which caused breakneck growth only a few years ago, have now had to be reversed.

The nearby price chart for Starbucks and the S&P500Index shows how the coffee roaster's equity price has fallen by some 40% since late summer, when I wrote the first post noting the beginning of its pullback. The silver lining is that it hasn't lost appreciably more than the S&P.

Meanwhile, McDonalds, which added better coffees to their menu, is running smoothly and posting gains.

Good management shows, and Starbucks clearly still doesn't have it.

Our Best Economic Sectors Remain Safe From Government "Help"

It's been a tough last two quarters for the American capitalist system.

Uncle Sam forcibly took stakes in the nation's largest commercial banks, induced the publicly-held investment banks to become chartered commercial banks, took over AIG and lent billions to GM and Chrsyler.

The good news is that these are not the engines of growth of our economy. In fact, information technology, bio-medicine and other innovation-fueled sectors have studiously avoided involvement with Washington.

You don't see Google or H-P taking government money.

In the banking sector, it may well be time to correct the country's historic vulnerability to a legion of small, poorly-run and failure-prone community and local, state-chartered institutions. As such, nationalizing the sector might well close a recurring weak spot in our nation's economic system.

The most recent bout of financial-sector induced US economic troubles stemmed from inept and jealous CEOs and senior executives in the financial sector attempting to make it a 'growth' business.

Unfortunately- for all of us- the financial services sector, being a derived business of a nation's economic activity, cannot be a growth sector over the long term. Individual products, over short timeframes, can achieve 'growth' status akin to a technology business. But, beyond that, with above-economic-growth rates come excessive risk.

Something with which we are now all familiar.

As for US-domiciled auto assemblers, they are ready for the scrap heap. Contrary to the protests of their defenders, Ford, GM and Chrysler have little role in defense production. Better cars are made by foreign-based producers in southern US plants.

Like it or not, putting all three of these firms into Chapter 11 bankruptcy was and remains the right thing to do. Profitable parts of them would be merged or acquired. The loss-making parts would be closed. Shareholders would bear the capital losses, while government could provide modest but necessary stipends to displaced employees.

Losing the corporations that are GM, Ford and Chrysler doesn't mean losing all of their products, nor all of the jobs associated with them.

I'm as sceptical of government intervention as the next person, and probably moreso. But in these cases, the damage could be much worse. As it is, some tens of billions will be lost in a last gasp to help the auto assemblers. But, fortunately, it's not as if a vital, value-creating industry is being corrupted and hijacked by Washington- yet.

Of course, time will tell whether the current administration meddles in the successful, high-growth, value-adding portions of our economy. But, for now, those parts are safe and operating without further Federal "help."

Thursday, January 29, 2009

About Creating "Bad" Banks

There is much ado this week about a putative 'bad bank' asset disposition plan from Treasury.

Well, sort of. Despite having months to conceive his plans for the financial sector and the economy at large, Treasury Secretary Tim Geithner apparently still needs a few more months to figure all that out. Heavens knows what he was doing since November.

Regardless, let's take a step back and consider just what it means to create a 'bad bank.'

First, it's basically Bill Seidman's RTC redux. Back in the late 1980s, in the aftermath of the S&L crisis in which those institutions borrowed short, lent long and low, and largely went insolvent. The thrifts were closed, loans collected into the Resolution Trust Corporation, and sold off to investors at deep discounts, providing many of the latter healthy returns. The 1980s S&L/RTC crisis was more about stupid funding strategies than bad loans.

Now, however, the nature of the 'bad bank' is different. This time, our largest commercial banks, as well as smaller ones and specialized lenders, e.g., Golden West and Countrywide, with Federal and state regulatory tacit approval, lent mortgages on only 5%, or less, down.

Consider two banks with different approaches to loan or securities value loss recognition.

Bank A, like Merrill Lynch, promptly begins to clean up its books by writing down questionable asset values. It rapidly erodes its capital, becoming nearly insolvent. It is taken over and merged with another institution, its shareholders losing everything. There may, or may not, be Federal loss-limiting guarantees on some of the loan portfolio.

If there are such guarantees, then not only investors, but all taxpayers, have just shared the losses of the badly-managed bank.

Bank B, however, holds out and avoids writing down its losses for months. Eventually, Treasury creates a 'bad bank' to buy bad loans from commercial banks. The theory is that, once freed of the bad loans they chose to make, these ailing commercial banks are now healthy and able to make new loans.

But before we know that, we need to know at what general price level the assets were transferred to the Treasury's 'bad bank.' I wrote about this dilemma back in late September of last year, in this post, when Bernanke and Paulson first unveiled their TARP plans. Specifically,

"Further, if Treasury bids such high, close-to-maximum-economic value prices for these securities, then there is virtually no chance of the US taxpayer realizing any gain on subsequent sales. At best, they may breakeven.

At the other extreme, though, also described by Bernanke, if Treasury's bid is a little above the fire sale price, but well short of the economic, or 'hold to maturity' value, then the selling bank receives little extra capital, and not much more in the form of marking similarly-held securities up to the bid, either.

What is it that I am missing? This isn't going to work!"

In fact, it didn't work that way, and was never actually implemented as stated. Now, Geithner's Treasury faces the same dilemma in creating a 'bad bank.'

If Treasury pays face value for the loans, fully recapitalizing the banks, then Bank B's management was smart in playing for time. In effect, by gaming the regulatory system, Bank B lives to make more bad loans, while Bank A was closed for the same offenses.

If, however, Treasury buys the bad loans at economic, or lower, value, which might be as low as the 37%-or-so value Merrill accepted in its funding deal last year, then the banks aren't sufficiently recapitalized to survive. Bank B is determined to be insolvent and, like Bank A, closed and/or merged with another institution.

In the latter case, taxpayers end up owning the bad loans at distress prices, so they don't share in the losses of the inept lending institutions.

From this little mind experiment, we've learned something valuable.

If Treasury pays at or near face values for the bad loans that will fill the 'bad bank,' then taxpayers, who individually may have chosen not to own equity in the ailing lending institutions, effectively find our government buying the losses from those banks anyway. And society is penalized for the sins of a few inept lenders, while the lenders get to remain in business and, in fact, are encouraged to lend again.

If Treasury pays economic, or lower, values for the bad loans to fill the 'bad bank,' then incompetent lenders and their institutions pay a price for their mistakes, and taxpayers don't subsidize them.

Either way, however, there is a net loss of recognized value to society, in the sense that the merry-go-round of overvalued assets stops and those values are forcibly reduced.

In the case of the RTC, the private, publicly-owned financial sector was not recapitalized by the government. Instead, weak and failing thrifts were eliminated, capacity removed, and a healthier, if temporarily smaller financial sector remained.

If Treasury creates the 'bad bank' by compensating existing publicly-held, private financial institutions at or near face value for recognized 'bad loans,' this will not be at all like the 1980s RTC solution.

Instead, Treasury will, in effect, be recapitalizing shareholder-owned institutions with public money, making taxpayers effectively own the mistakes, while rewarding the incompetent management that managed to hold on long enough to get this ultra-sweet deal.

Talk about moral hazard!

This would be among the worst things to happen to capitalism that ever occurred in the US.

Private financial companies are relieved of their mistakes and given money to err again. Taxpayers are socked for the losses, despite their perhaps not having chosen to ever buy equity in the incompetent financial institutions.

And to pay for all of this, Treasury prints or borrows money, thus either devaluing the dollar or saddling the entire society with the interest and principle costs associated with the stupid lending decisions of some publicly-held, privately-owned banks.

That scenario makes no sense. The only defensible course of action is the creation of a 'bad bank' through loan purchases at lower, economic prices, resulting in bank closures, a reduction in lending capacity, and stronger resulting institutions. Which is what Anna Schwartz advocated last fall.

Wednesday, January 28, 2009

Private Equity's Perfect Timing On Going Public

The Wall Street Journal ran an interesting article last week in their Heard on the Street column concerning private equity. Entitled, "Private Equity's Ultimate Buyout," the piece discussed the plunging prices of various formerly-private equity shops like Blackstone and Fortress.

Back in October of last year, I wrote this post on a similar topic. My point in that post was that Blackstone sold out to the public at a market top. I wrote, in closing,

"So, amazingly, I was correct in my cynical view that the best of the private equity shops either called, or defined the market top with its IPO."

The Journal piece goes further, noting how many billions of dollars of cash was taken out of these private equity firms by their founders, upon their initial sale of minor stakes to the public.

According to the article, Blackstone netted $2.6B, Fortress $1.3B, and even Apollo group took in $1.2B, after a cash dividend of nearly $1B paid to owners.

Of course, since their IPOs, all three firms' valuations have declined precipitously. Sure, the founders still had equity stakes in their firms, but with billions taken off the table, does that really matter now?

The Journal notes that the three firms' equity prices have declined between 85% and 95% since the respective IPO dates.

Which goes to prove my contention that you never, ever want to be on the other side of an IPO of any equity-oriented investment bank.

First, they don't sell at a trough. They are smarter than that. If they are selling, why on earth do you want to buy. Their very sale means they think the asset- their firm- is overvalued. In each case here, the founders were correct. If anything, you should consider buying puts on the shares, rather than buying the equities.

Second, these firms are not managed the same way when so much cash is off of the table. Either the founding owners can now take excessive risks with outsiders' money, or they might just take it easier, having realized billions in cash returns. Either way, the prior track records of prudent, steady returns is probably over.

I'm happy to say I never even considered buying an investment bank IPO. Goldman Sachs made us some nice returns in the past few years, prior to 2008. And we were out before its severe decline last year.

But, just on principle, you would never catch me buying when a private equity firm is selling a share of itself.

Tuesday, January 27, 2009

What Ken Chenault Isn't Telling You About AmEx's Performance

This morning's Wall Street Journal's front page of the Money & Investing section carries a headline at midpage screaming, "AmEx Net Sinks 79% as Customer Spending Falls."

Buried in the article is the passage,

"In addition to cutbacks in spending, the financial firms that issue credit cards are being hit hard by strapped consumers, who are falling behind on the bills with increasing frequency."

Maybe so, but that first element is circular, and Ken Chenault isn't telling you why AmEx is experiencing such a drop in charge volume.

The truth is, AmEx encouraged it. How?

Beginning several months ago, the firm began cutting the credit lines of even its best customers by 50%!

For example, a colleague of mine was told, while on a business trip, that his AmEx card had reached its limit. In a scene reminiscent of that old AmEx ad showing a young man being embarrassed when his Visa card can't handle the charge for his fiancee's ring, or a business dinner, this colleague was told to come up with another way to pay his hotel bill.

Upon contacting AmEx, he was told that, to use his card again that month, he'd have to immediately send them a check. Mind you, this customer has been with AmEx for decades.

Going back some twenty years, it was common knowledge at Chase Manhattan Bank that credit card users charged more in proportion to their credit lines. The key to the process of profitably growing credit card businesses is to sensibly extend more credit to capable, creditworthy customers, who will then, as a group, on average, obligingly carry higher balances.

AmEx has stood this principle on its head now, cutting credit lines, and, thus, balances and spending with their cards.

It should come as no surprise that the firm is now seeing a plunging net income.

The colleague in question was so furious that he closed every AmEx relationship he had, including business loans, and transferred all of them to a local bank's competing credit card.

AmEx has been a sinking ship ever since their naturally-hedged businesses, travelers checks and credit cards, unlinked. Without the free source of funding, their credit cards became less competitive just as credit card volumes soared.

This is yet another financial services company which, pursuant to today's first post, should have been allowed to die, merge, or be acquired, rather than become a commercial bank and suck up public funds to survive.

Carl Icahn On Corporate Governance

Carl Icahn wrote a piece in Friday's Wall Street Journal on corporate governance. Coming from a guy who regularly invests in equities of companies he feels are poorly run, it's worth reading his thoughts.

He wrote,

"Private enterprise forms the basis for our economy. It provides most of the jobs we enjoy and creates the wealth that raises living standards. New government spending can only do so much to repair the economy. Reshaping corporate management can do much more.

The problem with doing nothing is obvious. Faltering companies are now soaking up hundreds of billions of tax dollars, and they are not substantially changing their management structures as a price for taking this money.

How does it serve the economy when we subsidize managements that got their companies into trouble? Where is the accountability? More importantly, where are the results?"

On this point, I am in total agreement with Mr. Icahn. We are currently wasting money by subsidizing badly-managed companies, e.g., GM, Chrysler/Cerebrus, Citigroup, BofA, and AIG.

Icahn suggests Congressionally-mandated reforms,

"Changes are needed and can come if Congress insists on reforms that make corporate boards and managers more accountable to stakeholders.

First, Congress needs to pass legislation giving shareholders enhanced rights to elect new boards, submit resolutions for stockholder votes, and have far more input on executive compensation and other issues. As companion to these reforms, Congress needs to pass legislation that prevents managers from making it more difficult for shareholders to exercise their ownership rights.

Managers often come up with creative ways to perpetuate their reigns of error. These include myriad takeover obstacles like poison pills, bylaw provisions, and others devices that thwart shareholder efforts to hold managers accountable.

If Congress is reluctant to make wholesale changes at the federal level, it can enact one simple provision that would allow many of the needed changes to take place on the state level: It can give shareholders the right to vote to move a company's legal jurisdiction to a more shareholder-friendly state such as North Dakota. Currently that decision is in the hands of company boards."

While I continue to disagree with investors', including Icahn's obsession with the pay of senior management, I don't disagree it's worth having Congress pass Icahn's proposals, one way or the other. The state's rights option is very appealing by creating 50 competing corporate domiciles.

Mr. Icahn closes with these sentiments,

"What we need are measures that let the capitalist system produce jobs and economic activity, with minimal but effective government oversight. Government spending is an important catalyst to economic gains, but we need to focus on improving the way private companies are managed so private capital can flow into them.

Lax and ineffective boards, self-serving managements, and failed short-term strategies all contributed to the entirely preventable financial meltdown. It is time for battered shareholders to fight back.

It is time for change and the place to start is in the corporate boardrooms of America."

It all sounds good, and very patriotic. But, really, just how do thousands of individual shareholders mount an attack upon a few members of the board of a large corporation?

Why isn't plain old share price the best investor weapon? Sell shares of companies you don't want. If enough shareholders do this, and other investors short the stock, the price will fall to a level that makes current management vulnerable; to creditors, predators, or simple liquidation, at which point some better management team swoops in to recover any salvageable value.

What's wrong with this scenario? Isn't it the ultimate in capitalist retribution? A poorly-run company simply loses value, until it no longer has capital with which to operate?

Monday, January 26, 2009

The Problem Facing Chase & Wells Fargo

There's an interesting problem now facing Chase and Wells Fargo banks.

How do they price and take risks when their two largest competitors, BofA and Citigroup, are effectively nationalized banks?

Citigroup's net market value is now less than Federal infusions.

So if BofA's, if my arithmetic is correct. The bank's current market value is roughly $31B, but it has been given two $20B TARP infusions, plus an open-ended $115B loan loss line for the Merrill purchase.

And we've seen that Vik Pandit sold off his brokerage unit to a joint venture with Morgan Stanley under pressure from the Feds. Ken Lewis was forced to consummate a bad merger with Merrill Lynch because of Federal coercion.

How do John Stumpf and Jamie Dimon compete against a force even larger and prospectively more coercive than the organized crime?
Specifically, while Citi and BofA might actually take fewer new market risks now, they alsom might be coerced into accepting losses on consumer loans or mortgages as part of a Congressionally-mandated 'forgiveness.'
Further, as Bill Siedeman noted on CNBC a few weeks ago, as soon as a bank is seen as being backed fully by the Federal government, its capital costs decrease, its need for capital disappears, and, thus, a key cost component is subsidized.
When competing for loan business, will Chase and Wells Fargo use higher internal capital costs, thus making them less competitive?
Chase and Well Fargo, though performing better over the past six months than Citigroup and BofA, per the nearby price chart, have each still lost roughly 40% of their equity price.
How long before investors abandon the latter two banks, fearing pre-emption by the Federal government, to which Ken Lewis acquiesced at BofA?
It's a very interesting and unusual situation never before seen in US financial services. One can't help but think that heavy governmental intervention, to the point of essentially owning two of the nation's largest banks, by assets, will have to have a damaging impact on competition in the sector going forward.

Sunday, January 25, 2009

Thain Ousted From Merrill-BofA By Lewis

John Thain's recent firing as head of the Merrill Lynch units of BofA seems to reinforce the sentiments I expressed only last month, in this post. I wrote,

"Now, Thain is also remembered for gulling investors in December and the first quarter of 2008 to put money into the disintegrating brokerage firm, then claiming they didn't need to raise any more capital. To me, Thain is tarnished by some of what he did early on at Merrill, and for even leaping into the mess. I think it smacks of too much ego and too little perspective on the unfolding disaster that was in process a year ago.

Maybe I'm alone in this view, but I think Thain's time at Merrill has diminished his reputation and raises questions about his judgment."

My view hasn't changed. And I've held it since back in late 2007, when, in this post, I wrote,

"Merrill represents the last of an otherwise dead model, the retail wire house. Sure, Merrill bought and grafted on investment banking in the past decade. But it hasn't internalized the risk management skills which seem to have prevented Goldman Sachs, Morgan Stanley, and Blackstone from suffering the same losses during this year's financial crises.

For an experienced, capable outsider, though, the job might ultimately hold more risk than opportunity."

To me, this whole affair continues to be an embarrassment and the downfall, in time, of both CEOs- Thain and Lewis.

Sure, this week's revelations of Thain's expensive renovation of his office at Merrill amidst its hemorrhaging losses is quite a statement to his lack of judgment, even at micro-levels. That sort of arrogance and waste looks really bad in retrospect. It's hard to believe the stories are only surfacing now.

But, judging from the recent editions of the Wall Street Journal, and comments on CNBC, others are finally seeing what I did over a year ago. Thain didn't perform proper due diligence on Merrill, in so great a rush was he to prove himself one more time. His ego got the better of him.

But Lewis looks bad for throwing over his own common shareholders, under government pressure. Not to mention his first mistake, which was even offering to buy Merrill.

I thought he should have simply hired their brokers, if he really had to have them, rather than buy the whole mess. Merrill never had a particularly stellar investment banking team, nor trading function, for that matter. And Lewis wouldn't know how to manage those anyway.

But, given that he mistakenly wants a full service, full cost brokerage force, simply luring them from Merrill, or, better, picking them off from a bankrupt Merrill, or one taken over by another firm, would have been cheaper and simpler.

But, for now, Thain is the goat. And I agree that it might be a long time before he is well-regarded again in financial services. For now, it's probably time for him to open that small hedge fund and take money from a few friends, so he can hang out a shingle and expense some of his business activities for the coming few years.