Friday, August 05, 2011

The Kraft-Cadbury Break-Up- I Take A Victory Lap

I could scarcely believe what I heard and read in the past day or so concerning Irene Rosenfeld's new plan to split the Cadbury-dominated snack foods of the post-merger Kraft from its groceries business.

I wrote these two posts, here and here, in September of 2009 and January of 2010, respectively.

Consider this passage from the first linked post,

"Stitzer's focus, via that strategy, becomes more evident with the next passage. The piece then quoted Cadbury's CEO again,

"I think scale works to a [point]," he said. "There's a confectionery buyer in retailers and I think you can focus on that buyer, and if you can offer chocolate, gum and candy, I think that's an advantage. What more can you offer to the confectionery buyer in the grocery store? They don't necessarily and are not generally responsible for anything but confectionery."

Putting these two views together, one what seems to be a really non-delusional, focused, in-touch CEO. One that understands his direct customers, the retail food merchant's buyers.

With them in mind, he's built Cadbury out within the scope of his current customers' pervue. But he rightly notes that Kraft primarily markets to other buyers, albeit within the same grocery store.

After the requisite administrative costs are shed, what then? What organic, post-merger accounting growth will be realized?

If anything, Stitzer is really making the case, by omission, for another approach entirely.

Why doesn't Kraft offer to sell its confectionary businesses to Cadbury for stock, and a seat (or however many make valuation sense) on the British firm's board?

That way, Kraft gets the value of scale within confectionary products, but avoids the curse of oversized conglomeration. Irene Rosenfeld's management team can focus on food products, while reaping the benefits of Cadbury's economies of scale within their category. In time, subject to deal terms, Kraft can sell its stake in the market, or to Cadbury, for a premium, while relinquishing board presence.

It argues for Cadbury's management to handle the commonly-held confectionary businesses, not for Kraft to get a larger collection of assets to mismanage."

And, then, this one from the second linked post,

"I still believe, as I did last September, that both parties would have benefited from Rosenfeld's selling Kraft's businesses which resemble Cadbury's, to the latter, taking equity in exchange.

Cadbury is simply a better management team than Kraft. If anything, I guess Cadbury shareholders should thank Stitzer and the board for getting top pound for the company, and walking away with cash after selling whatever Kraft paper they receive, while Kraft will be stuck trying to make this dubious tie-up pay off."

Funny how that worked, isn't it? A former Cadbury shareholder could soon repurchase the old Cadbury, plus some similar Kraft businesses, with the premium they received.

However, looking at the nearby price chart of the S&P500 Index and Kraft for the past two years, it appears that Kraft actually outperformed the Index. Probably on account of Cadbury, since Kraft was underperforming the Index for the five years prior to the acquisition, and still headed downward.

According to this morning's Wall Street Journal article, Rosenfeld had the idea to buy Cadbury, bundle the snack businesses, then split Kraft, as long as several years ago.

Even if true, this is corporate ego and obsession with power at its worst. The story would mean that Rosenfeld squandered Kraft shareholder money on the Cadbury premium, and on investment bankers, just to get to the point of now spending more money to split up the swollen Kraft.

Wouldn't it have been simpler and cheaper in the first place to have just approached Cadbury's Stitzer about such a combination? Rosenfeld could then have declared a special stock dividend of Cadbury shares received for the Kraft snack businesses sold the the British confectioner.

To believe that Rosenfeld's approach made more sense is to be caught up in the sort of wilderness of mirrors which can occur in large corporate managements. A lot of extra expense and effort just to allow Rosenfeld to appear to be the empress of a larger set of businesses, only to separate them once more.

One thing is true, though. According to my proprietary equity research, splitting the slower-growth grocery businesses from the higher-growth snack businesses will, indeed, allow the latter to deliver a consistently higher total return to their shareholders. The combination has certainly punished the latter, while investors price Kraft to an average that accounts for the former.

Thus my point that it made no sense to effectively destroy or mix value from Cadbury into Kraft in the first place.

An Example of What's Wrong with Local Government Spending

I saw an excellent example of local government services waste earlier this week.

As I walked through the lobby to leave my fitness club, I saw through the large windows that a paramedic ambulance was parked outside the main entrance. This occurs occasionally when someone has been injured or suffered a medical problem while exercising.

However, parked nearby was not one, but two local police cars. And, as I drove out of the parking lot, yet another emergency medical vehicle was pulling up to the building.

Being of a certain age, my immediate thought were the lyrics from Arlo Guthrie's Alice's Restaurant, which I can't quote, because of copyright issues making them unavailable online. But, to paraphrase,

'The cops were busy using all their cop equipment which they never get to use otherwise.....'

You see, the towns out my way in north-central New Jersey have very little violent crime. Or much crime at all, for that matter. Getting onto a local police force in any of these towns is the equivalent of being paid to drive a car all day while listening to the radio. Oh, yes, and they get to carry guns to intimidate the citizenry. Let's not even discuss what their pensions will be after a mere 30 years, likely without ever drawing a weapon.

So seeing two police cars with four members of the local town's police force visiting a fitness club for someone's medical issue was more than just over the top.

It's emblematic of our society's overspending nanny-state nature.

Meanwhile, taxpayers footed the bill for the needless police time and expense, and probably the extra medical vehicle, as well.

One wonders how much of the local police budgets are padded for staff to handle unnecessary calls of this nature.

It's a small, simple story of local government excess, purchased with tax dollars. But multiply it thousands of times, many days per year, and you get some idea of why our society is costing ourselves so much more than it did mere decades ago.

Thursday, August 04, 2011

The Truth About Who Pays Corporate Taxes

Are you as sick as I am of hearing, courtesy of the recent federal debt limit debates, that 'big/rich corporations should pay more/higher taxes?'

I don't think I could watch CNBC or Bloomberg for the past month without hearing some Democratic Congress member, the president, or a liberal pundit repeat some variant of that old saw.

Trouble is, it demonstrates complete economic illiteracy by those who mouth those sentiments.

Harvard economics professor Greg Mankiw wrote in his blog, borrowing from his textbook,

"But before deciding that the corporate income tax is a good way for the government to raise revenue, we should consider who bears the burden of the corporate tax. This is a difficult question on which economists disagree, but one thing is certain: People pay all taxes. When the government levies a tax on a corporation, the corporation is more like a tax collector than a taxpayer. The burden of the tax ultimately falls on people—the owners, customers, or workers of the corporation.

Many economists believe that workers and customers bear much of the burden of the corporate income tax. To see why, consider an example. Suppose that the U.S. government decides to raise the tax on the income earned by car companies. At first, this tax hurts the owners of the car companies, who receive less profit. But over time, these owners will respond to the tax. Because producing cars is less profitable, they invest less in building new car factories. Instead, they invest their wealth in other ways—for example, by buying larger houses or by building factories in other industries or other countries. With fewer car factories, the supply of cars declines, as does the demand for autoworkers. Thus, a tax on corporations making cars causes the price of cars to rise and the wages of autoworkers to fall.

The corporate income tax shows how dangerous the flypaper theory of tax incidence can be. The corporate income tax is popular in part because it appears to be paid by rich corporations. Yet those who bear the ultimate burden of the tax—the customers and workers of corporations—are often not rich. If the true incidence of the corporate tax were more widely known, this tax might be less popular among voters."
While I have grown weary of federal elected officials of both parties displaying their economic ignorance, even as they dangerously legislate tax policy, I fault even more the business network pundits who continue to spout this nonsense without correcting the fallacy that corporations really pay any tax at all.
Ultimately, as Mankiw explained, it's taxpayers, either as company owners, consumers, or employees.

Wednesday, August 03, 2011

McGraw-Hill's Slide Into a Possible Break-Up From Outside

I read with interest the recent headlines that two investment funds have bought comparatively large stakes in McGraw-Hill with the aim of forcing it to break the firm up. It couldn't happen to a nicer plutocratic empire.

I've written several prior posts concerning the firm here. I recalled that I wrote this piece, noting the brief inclusion of the firm in my equity portfolio, but not that it was almost five years ago.

The intervening years have not been good to or at the firm. Thanks to Terry McGraw trying to pump growth at S&P's ratings unit on the cheap, the firm's fortunes soured in the immediate aftermath of the late-2008 equity markets collapse.

Since then, it's about paced the S&P, but that leaves it with a -20% return over the five year period, while the index has finished flat.

With its largely unrelated ratings, educational and other publishing unit, and equity data subscription business, the firm has been an unwieldy conglomerate for decades. Much like GE, it has long since lost any reason for its integrated nature.

Except, of course, the ability to employ various McGraw family members and fuel their increased wealth.

My own experiences with S&P's equity data unit have exposed that business as poorly run. Customer support from the technical people is superb, but the sales and administration are abysmal, with those employees rarely knowing what's going on with customer accounts.

A few years ago, I mentioned a particularly vexing problem to a senior executive who is also a McGraw family member. There was never a reply, indicating, evidently, a sort of supreme disconnect between the family member employees and the real operations of the firm.

It doesn't surprise me that some outsiders have detected an opportunity to buy the firm's shares now, at what they believe to be a lower value than that of the pieces of the firm, once separated. Nor does it surprise me that Terry McGraw issued a typical corporate-speak response.

But, again, like GE, non-performance is a tough sell. GE has finally begun to unravel, with the entertainment properties that Jack Welch mistakenly acquired having been sold to Comcast.

For McGraw-Hill, it's not a stretch to see the publishing pieces sold to larger competitors, or just split off, while the ratings and financial data units also go their separate ways. Leaving, I suppose, the McGraws to count their money as they gather in either the compound up in Connecticut or their place in the Adirondacks.

Like many companies long-identified with a family still involved in the firm, McGraw-Hill looks like it may be at that point where saner, smarter heads prevail and relieve the family members from making more management mistakes.

Tuesday, August 02, 2011

Another Old Federal Spending Myth Blown Away

This past weekend edition of the Wall Street Journal featured an excellent editorial by Prof. Richard Rumelt entitled World War II Stimulus and the Postwar Boom. Rumelt is a professor of business at the UCLA Anderson School of Management.

Much as Amity Schlaes book, The Forgotten Man, corrected many of the economic myths which had grown up around FDR's failed Great Depression programs, Rumelt's piece highlight the real source of US economic growth during and following WWII- forced consumer savings, not government spending.

Rumelt begins his piece by observing,

"Despite two years of fiscal and monetary stimulus, the U.S. economy is sagging. This has renewed the argument over the usefulness of more stimulus, and many of its proponents make an analogy to World War II.

Last month, former Obama adviser Larry Summers put the case this way: "But for Hitler and the military buildup he caused, FDR would have left office in early 1941 a failure, with American unemployment above 15 percent and with the recovery promise of the New Deal shattered." And in 2008, Princeton's Paul Krugman referred to "the enormous public works project known as World War II."

This is received wisdom to many economists and historians, but it skates around key facts of the World War II economy. Chief among them: Government policy didn't stimulate personal consumption, as Keynesian policy makers aim to do today, but rather enforced thrift.

During World War II, there was no investment in civilian infrastructure and the government placed severe restrictions on consumption. That meant significant portions of the massive government spending went toward saving and private debt repayment. Thrift restored personal balance sheets, ultimately setting the stage for the postwar boom."

Those are the themes of Rumelt's editorial. Here are some of the supporting data he cites regarding his theses,

"In 1939, before the U.S. entered the war, about 15% of the work force was unemployed. The war eliminated unemployment by moving 11% of workers into the military, where they were indentured at low pay with little ability to purchase consumer goods. Another 5% were directly employed by the government as military support personnel.

As the military swelled, the civilian work force declined to 53.9 million in 1945 from 55.2 million in 1939. A shrinking civilian work force and surging government demand created wage inflation of about 5% per year. Higher wages, plus about 20% more hours worked, generated a 65% increase in real (inflation adjusted) national disposable income between 1939 and 1945. But, remarkably, total consumer spending did not rise to match these higher incomes. During the 1941-45 war years, over 22% of disposable income was saved.

This high saving rate was driven by fiat. Thanks to wartime rationing, Americans were only allowed to purchase small amounts of sugar, butter, meat, gasoline, tires, shoes, bicycles, processed foods and other goods. Plus, there was virtually no production of new cars, radios, home appliances or housing. In fact, when inflation and increased working hours are taken into account, consumption per hour worked actually declined for the bulk of civilians during the war. Civilian living standards stayed at Depression-era levels.

Americans' wartime savings over 1941-45 were $142 billion, about $1.3 trillion in 2005 dollars. These funds went to pay down consumer credit, buy War Bonds, and bulk up savings accounts. During the war, outstanding consumer credit fell to $5.7 billion from $7.2 billion, a 44% reduction in constant dollars.

Despite higher incomes, household mortgage debt rose only slightly during the war, falling by 17% in real terms. As a consequence, the overhanging debt that had plagued households since the start of the Great Depression was dramatically reduced and household balance sheets markedly improved.

When hostilities ended in 1945, many expected that an expanded civilian work force, plus reduced federal deficits, would bring back the depression of the 1930s. There was indeed a brief recession in 1946, but as production was rededicated to consumers and rationing was lifted, people rushed to replace rusted-out automobiles and broken-down refrigerators. The returning soldiers got jobs, moved to newly constructed housing in the suburbs, and the postwar boom was on. And it was greatly accelerated by households' renewed capacity to take on debt.

Consider the ratio of household debt to disposable income over the decades from 1919 to 2010. Data (from the Federal Reserve Flow of Funds, the Bureau of Economic Analysis and other historical records) show that the debt ratio started a sharp upswing in 1920-22 with the 1920s housing boom and the introduction of consumer financing by auto makers and producers of home appliances, rising to 41% in 1929 from 16% in 1919.

As the economy dipped into recession in 1930, household incomes fell and people made dramatic reductions in spending for consumer goods in order to hold onto their cars and homes. Falling incomes forced the debt/income ratio to a peak of 61% in 1932. By 1940, the ratio had slowly worked its way down to 40%, about where it had been in 1929. Then, with the advent of the war and rationing, the ratio plummeted to 20% by 1944-45, a level not seen since 1924.

Today, households carry a much greater relative debt burden than they did in 1929, largely due to a 25-year mortgage binge. Between 1980 and 2007, disposable income grew at 5.9% per year while household indebtedness grew at 8.7% per year—a clearly unsustainable situation. As in 1939, this hangover of debt blocks new rounds of consumption and dulls the impact of fiscal and monetary stimuli."

Stunning figures, are they not? I'm in my fifties, so I recall my late father's stories about "life during wartime." The gasoline rationing, lack of tires. Buying black market aviation gasoline which burned out the cylinders in his used car. The stories of meat, butter, sugar and egg rations. It occurs to me that my own children know nearly nothing of those privations for almost half a decade in the early 1040s.

Rumelt then turns to Summers' folly, explaining what emulating WWII's approach to economics would actually mean in today's environment,

"If one wanted to replay the economics of World War II (without the war), it would mean high consumption taxes aimed at the middle class, and putting 30 million Americans to work at minimum wage or less. No serious politician could put forward such a plan.

The difficult truth is there is no easy cure for the present hangover. Myopic policies allowed credit to be pushed over its natural limit. Credit expansion shifts consumption from the future to the present, but the future has now arrived. Policies aimed at reigniting the credit-driven consumption boom of the last 25 years won't work.

Instead of looking for a pre-election year pop, it would be wiser to focus on transitioning from credit-driven economic growth to growth that is, once again, driven by new productive investments. The key policy aims should be removing the tangle of tax, policy, regulatory and human-capital impediments to domestic private investment."

Which brings to mind, for me, this post from last Friday. Imagine! Actually encouraging people to save for purchases, rather than simply borrow for immediate gratification.

On that latter point, as if summoned by my writing this post on Monday afternoon, as I finish this, I hear Paul Krugman on Bloomberg television haranguing for, of course, more federal borrowing, higher taxes, and more spending in the face of economic softness.

Like Summers, Krugman apparently was absent from economics school the day they taught the theory of economic cycles. You know, how economies naturally move through recession, recovery, expansion, slowing, then recession again.

Trying to slice off the unwanted slow and recessionary phases, in order to have only expansions, just isn't feasible. No matter how much money government prints or borrows.

Instead, as Rumelt notes, what actually leads to robust expansion in a mature economy is capital formation based upon savings, not endless borrowing and government budget deficits.

Monday, August 01, 2011

Friday's GDP Numbers

The much-anticipated US government's formal news release of GDP for Q2 and revised Q1 came with disappointing data:

"Real gross domestic product -- the output of goods and services produced by labor and property

located in the United States -- increased at an annual rate of 1.3 percent in the second quarter of 2011, (that is, from the first quarter to the second quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 0.4 percent."

And on prices and spending,
"The price index for gross domestic purchases, which measures prices paid by U.S. residents, increased 3.2 percent in the second quarter, compared with an increase of 4.0 percent in the first. Excluding food and energy prices, the price index for gross domestic purchases increased 2.6 percent in the second quarter, compared with an increase of 2.4 percent in the first.

Real personal consumption expenditures increased 0.1 percent in the second quarter, compared with an increase of 2.1 percent in the first. Durable goods decreased 4.4 percent, in contrast to an increase of 11.7 percent. Nondurable goods increased 0.1 percent, compared with an increase of 1.6 percent. Services increased 0.8 percent, the same increase as in the first."

Over on Bloomberg television, Tom Keene said he thought the Q1 revision was a typo when he first saw it. The GDP data provided an explanation and, probably, a good reason for the fifth S&P500 down day last week. From 1345.02 the prior Friday to 1292 and change on the last trading day of July, the equity index reflected ongoing US broad economic difficulties.

Recall, if you will, the administration's robust 4% annual GDP wishes-as-forecast. We're a long, long way from that.

While the government debt limit and spending cut drama continues to play out, one would be forgiven for seeing the GDP, price and weakened Q2 spending data as more lasting, deeper reason to doubt whether the US really ever exited from the recession begun in 2007.

Still, this need not mean a plunging S&P500. The larger global US companies comprising the index continue, in the short run, to profit from economic growth elsewhere in the world, with more favorable business conditions abroad than at home.

Not that even this will last indefinitely. But until deleveraging makes more progress in the form of reduced expecatations of government pensions and benefits globally, and subsequent higher personal savings rates and lower consumption, US equities may remain attractive.