Home Depot & Corporate Governance- Again: Frank Blake's Compensation Package

Today's Wall Street Journal ran an article detailing the compensation package of Home Depot's replacement CEO, Frank Blake.

I must say, it looks as if Home Depot's board has begun to come to its senses. According to the WSJ,

"Chief Executive Frank Blake didn't just accept a compensation package significantly less than the one his predecessor Robert Nardelli received. He also rejected the big retailer's first offer as too rich.

Among other things, Mr. Blake balked at getting restricted stock, which has value even if the share price declines. So the compensation committee dropped plans to give him restricted shares, according to someone close to the situation.

Mr. Blake preferred equity grants tied to performance measures, a salary of less than $1 million and a total package worth less than what Lowe's Cos. CEO Robert Niblock gets, this individual said.Mr. Blake wanted "to be totally aligned with shareholders," a second knowledgeable person noted.

According to a letter he signed Tuesday, Mr. Blake gets a $975,000 salary this year and could receive a $975,000 long-term incentive award, plus an annual bonus of twice that amount if he meets performance goals. Home Depot gave him, among other things, performance shares initially worth $2.5 million that could pay out even more after three years, based on the company's relative total shareholder return, compared with Standard & Poor's 500 companies. He also gets $2.5 million of options that he can begin to exercise only if Home Depot maintains a 25% increase in its share price above the grant date level for at least 30 straight trading days. He must also wait a year before he can begin exercising these options, which the company said would be awarded next month.

In 2005, as executive vice president of business development, Mr. Blake received $685,192 salary and an $825,000 bonus. He also got $2.9 million in restricted stock awards. Lowe's CEO Mr. Niblock received a salary of $850,000 and a $2.6 million bonus. He received $4 million in restricted stock."

While I applaud the board's restraint, and Blake's sensibility, in the design of his compensation package, I'm now somewhat mystified by how it justified his nearly-equally lavish compensation as EVP of business development. A job, by the way, which he seems to have bungled, given HD's miserable growth record under Nardelli-Blake.

On one hand, Blake's sub-$1MM salary comes close to my own recommendation that CEO's be paid a more modest fixed salary. And I wholly endorse the performance share values being tied to HD's total return performance, relative to the S&P, I don't think the board went far enough on this measure. I think the total amount should be a function of this measure, not just, as the article describes, some amount in excess of the initial $2.5MM.

Let's be clear about something. Blake has failed as EVP of business development. The firm hasn't developed sufficient new business. That's been a key problem. Now, with the departure of the failed prior CEO, Nardelli, the board is paying Blake what appears to be, for three years, approximately $5.5MM for even a poor performance. To me, that's just too much. It appears that Blake has already pocket in the range of $6MM from his time at HD already. Therefore, he now has essentially nothing to lose.

Ask your average US middle-level manager if he'd like the opportunity to earn $6MM for the next three years, even if he fails to meet his objectives. It's a job nearly anyone would want.

I think that means it's too rich of a deal. Given what I've learned about corporate performance from my research, I see the attainment of consistently superior total returns as sufficiently rare, and so valuable, as to merit significant incentive for its achievement. But anything less should just get a 'decent' salary. Something south of $1MM/year, with no bonus.

So, yes, the Home Depot board is heading in the right direction. And Blake is obviously astute enough to avoid the greedy behavior of his predecessor and colleague. But I think the company is still vastly overpaying on the come for performance it has no reason to believe it will realize from its new CEO.

Why is the Home Depot board giving away its shareholders' money so easily in the absence of performance guarantees, or evidence that consistently superior performance is likely under Blake?

Addendum: It's Davos Time Again

Yes, it's that time again. Time for the business, economic and cultural elites to gather at Davos.

Luckily for Maria Bartiromo, that's her reporting location for the next week. Timely? But of course.

Based upon today's Wall Street Journal article, about which I wrote here, this morning, I'd say Maria's very glad to be overseas for a few days.

Not that her interviews have gotten any better. She's still asking her typical softball questions, then turning on her 'amazed' facial expression, no matter what her interviewee says. Well, it's either 'amazed,' or 'furrowed brow deep thought.'

When is CNBC going to jettison the on-air-heads, male and female, and start cultivating more reporters and anchors who can actually express themselves articulately about business and economic issues without looking like they're reading it all off of a teleprompter?

More on Prince's Poor Leadership at Citigroup

Today's Wall Street Journal offered some rather specific examples of Chuck Prince's failure to lead or manage the overly-large, diverse financial services mess that we know as Citigroup.

Most of the article details the curious and extravagant behaviors of Todd Thomson, the recently departed head of the firm's wealth-management unit. By the way, in his eagerness and persistence to find something that Sallie Crawcheck might be able to do, he claims to have fired Thomson because he needed to get Crawcheck into that job immediately. No telling whether her junior analyst skills will be any more relevant to running Citi's wealth management group than they were for her as the company's ineffective CFO.

But, back to Thomson. Yesterday's Journal article, discussed in this post, here, described a China business trip from which Thomson returned early, with a 'non-Citi person,' stranding the Citi staffers he had flown over on the corporate jet. Today, we learn that person was non other than CNBC's leading on-air-head staffer, Maria Bartiromo. Sounds like a pretty cozy world up there at altitude, doesn't it?

Further, the Journal piece divulges that Thomson planned to spend $5MM of his unit's budget to feature Ms. Bartiromo and Robert Redford as hosts on a new television series to air on Redford's Sundance Channel.

How did Prince let things get so out of hand? According to the article, the firm's CEO has silently fretted over Thomson's spending and management of the Citi wealth management unit for some time. But, he did nothing until recently. Even the firm's largest individual shareholder, Prince Alwaleed, expressed dissatisfaction with the firm's expense growth.

What I find additionally remarkable, in addition to Prince's inability to execute on fundamentals like expense management, and to be allowed by his board to bumble this issue for so many years, is the lack of judgment of Thomson, a senior executive whom Prince left in place for so long.

Thomson had preceded Crawcheck as CFO, under the Weill regime which built the current, unwieldy structure that Citigroup operates. Along with extravagant spending on marketing and infrastructure for his wealth management unit, Thomson seems to have believed that hobnobbing with, or was it dating, CNBC's Ms. Bartiromo, and including her in luncheons with clients in the Far East, would add value to his unit.

My point is, Bartiromo is among the least capable of the many female anchors and reporters on CNBC. Unlike Becky Quick, Michelle Caruso-Cabrera, or Erin Burnett, all of whom demonstrate an on-air ability to hold intelligent, probing and useful dialogue spontaneously with interviewees, Bartiromo can be frequently seen squinting to read her teleprompter, so that she knows what she's supposed to ask next. She rarely, if ever, asks an intelligent or germane, follow-on question of an interviewee. Like Sue Herera and Liz Claman, Bartiromo seems more infatuated with her interview subjects than capable of providing any independent thought or critical questions.

You'd think that if Thomson wanted to impress his wealthy clientele, he'd have brought a better-qualified financial media personality than Ms. Bartiromo.

It doesn't say much for Thomson's judgment, or Prince's, for letting him function in an uncontrolled manner for so long.

Why is the exodus at Citi stopping with Thomson? Why aren't Crawcheck and Prince following him out the door? Can anyone truly claim that the loss of all three of these senior executives would actually further impair Citi's continuing inferior total return performance for its shareholders?

In the interests of Citigroup's ability to earn consistently superior total returns for its shareholders, and based upon my research findings, I think its board needs to consider large-scale housecleaning at the senior management level. The current management is focused on the wrong things, and inept at motivating the diverse company to execute on its plans. How much worse could they do with the current regime?

Corporate Performance and Scale: Citigroup

Yesterday's post on executive compensation and increasing sizes of large corporations has had me reflecting the issue of size for the last day.

What should we mean by corporate "size?" Assets? Revenues? Income? Employees? Market share?

It's not a trivial issue. I looked at all four of the internal corporate bases for scale when I conducted my proprietary research on corporate performance. However, after reading The Economist's report on executive pay, and noting the steady upward trend in corporate size, in terms of assets, I began to wonder if we have now crossed over the tipping point of size, as it relates to companies' ability to achieve consistently superior total returns.

I believe that my ideal company would be small, in terms of employees, but large in terms of revenues, income, and market share. When asset sizes growth is accompanied by employee growth of similar rates, I suspect that the seeds of faster unraveling of that growth are sown.

When I opened this morning's Wall Street Journal to read the right-hand column piece about Citigroup's woes, and Sallie Crawcheck's re-assignment, I immediately thought of the executive compensation topic, and corporate size.

Chuck Prince has failed at managing the unwieldy financial services behemoth that his predecessor, Sandy Weill, glued together. It's pretty obvious by now that it is simply too large and diverse for any one CEO to competently and effectively run in a manner which rewards shareholders with consistently superior total returns.

Thinking of size in another company, GE, and my post last August, here, I believe there's a case building for more corporate spinoffs, and fewer mergers.

There seem to be at least three colliding trends here.

First, we have ever-larger corporations, which show no evidence of being able to produce more companies which can consistently deliver above-market-average total returns for investors.

Second, we have conspicuous examples of very large, multi-unit, diversified conglomerates, such as GE and Citigroup, which are ineptly run by CEOs who succeeded the architects of the current confiruration.

Third, we have the increasing availability of technology and collaborative ventures which allow smaller, more nimbly-run firms to get access to needed technologies, products, or markets, without having to necessarily 'acquire' the assets and employees to do so. And to use advanced communications, logistics, transportation and marketing technologies to manage what they have more productively and efficiently.

The result, ideally, should be rising market values, market shares, and total returns for companies which do not grow assets or employees as fast as they grow revenues and incomes.

In a manner of speaking, is this not what some of the private equity buyouts are effecting with their purchases of poorly-performing, large companies?

I believe we are now seeing a period in which the escalated sizes of compensation packages, as discussed in The Economist's report, to reflect increasing corporate sizes, are drawing attention to the fact that the performances of such organizations are flagging. And that smaller, better-managed entities carved out of these merged giants would probably be more sensitive to markets, customer needs, competitive forces, and shareholders. This could result in more well-managed, smaller, but still above-minimum-economic-sized firms in which shareholders could invest.

More on Executive Compensation: The Economist's Special Report

Over the weekend, I read The Economist's 20 page special report on executive pay, in the current issue of the British news weekly. The report contains the usual excellent mix of historical information, empirical data and research, and sensible reasoning that I've come to expect from the magazine's reporting.

Of particular interest to me, however, was this passage, found on page 9 of the special report,

"As the average firm size increases, so each company must pay its top executives more. When managers control more assets, they can make more of a difference to absolute profits. Hence, in a competitive market full of bigger companies, boards will be prepared to spend more on talent. Using a schematic mathematical model, two American-based European economists, Xavier Gabaix and Augustin Landier, concluded that the sixfold increase in the size of American firms between 1980 and 2003 may account for much of the sixfold increase in managers' pay during that period. Tiny differences between the abilities of top managers could explain large differences in pay. Chart 2, from another study, shows how in historical terms the level of pay is still relatively low in relation to the size of companies."

To be honest, this particular piece of data was news to me. I suppose the continuing drumbeat of mergers should have alerted me to the trend, but I had no idea that the asset sizes had increased to this extent.

Shortly thereafter in the article, the report states,

"In fact, the typical chief executive of an S&P500 company, who earned just under $7MM in 2005, according to the Corporate Library, must think he is in the wrong job.....senior investment bankers stood to earn bonuses of $20MM-25MM in 2006 and top traders $40MM-50MM. To qualify for Alpha magazine rankings of the top 25 hedge-fund managers in 2005, you had to earn $130MM."

This puts some things into perspective, does it not? Essentially, we are faced with a simple conundrum which is going to make a lot of people very unhappy. Large corporations have gotten very much larger in the past 20+ years, and, thus, the CEO of such a company has a much larger effect, good or bad, upon the total return of those swollen asset sizes. While the lower-level workers may have experienced productivity gains as well, it's doubtful that they are on a scale of what may be possible for an effective shareholder-wealth creating CEO of a very large-cap US company.

Thus, we have William McGuire, late of UnitedHealth Group, making over a billion dollars based upon the peak value of his options.

On one hand, this aggregation of assets for the average large cap company means more opportunity to add value for shareholders. And, thus, a basis for higher compensation for those CEOs who achieve that via consistently superior total returns. For those that do not, however, it means larger compensation packages for even larger opportunity costs.

Ironically, as the company size has risen so dramatically, the sector which is most-often involved in that activity, investment banking, pays its people even better than the CEOs of the merged companies it creates, as the second quoted passage notes. I suppose this is yet another symptom of industrial sales people typically earning more than the CEOs of the firms for which they work, so it's not, per se, part of the 'problem.'

Returning to the CEO compensation issue, the Economist report also notes, later on in the section, that many boards reward senior executives with options, as if they are free when, in fact, they become costly and dilutitive, on the bases on which they are typically granted.

This brings me to a more detailed idea for CEO compensation, based upon my proprietary research. If a CEO must be paid with options, why not make the maximal value of the options available be the product of the difference of the company's 5-year average total return with the S&P500, and the recent market value of the firm, multiplied by some reasonable fractional value, such as 10%. Thus, the CEO of an outstanding firm which had consistently out-earned the S&P500 would stand to gain 10% of that difference, multiplied by the value of the firm's equity.

Another topic which was discussed in the Economist's report is that of risks borne by CEOs, relative to the compensation they receive for a job that is experiencing a decreasing average tenure. However, from my observations, and discussions with a few CEOs, I believe the report misses an important behavioral aspect of this issue. Most CEOs of large companies would likely do the job for half of what they are paid, simply to enjoy the control of all those assets, as well as the high public profile that often comes with the territory of being a large company CEO. And, as I have contended in prior posts, if a company needs an effective CEO, offering an incentive-rich compensation package with a low fixed component should attract candidates who are confident they can deliver performance for shareholders. Does a board really want a CEO who has to be guaranteed immense riches in order to come aboard and attempt to enrich shareholders at a superior rate to the S&P?

We see far more consistent underperformance than outperformance among S&P500 CEOs, yet, to my knowledge, none of the former return the money as a consequence of their failure. Even GE's CEO, Jeff Immelt, who now boasts that 75% of his compensation is tied to performance, made upwards of $30MM before he took that risk. And, the tie-in is not as draconian as he would have others believe.

What is the price, and for what time period, that boards should pay, on behalf of shareholders, in order to suffer an ineffective CEO? It's as easy to pay little for failure as to pay a lot. Yet, if properly constructed, an effective CEO should, with the same compensation package, stand to make a considerable sum by succeeding for the shareholders.

To me, it seems that running ever-larger companies implies three things. First, it's more important than ever for boards to get compensation policies and levels 'right,' as failure is ever-more costly.

Second, CEOs who do consistently outperform the S&P500 on behalf of their shareholders, are doing a much tougher job, with larger asset bases, than their counterparts of 20-odd years ago were, and deserve much more income for doing so. Those who fail should be both paid much less, until they demonstrate success. If a board still needs to give a CEO 3-5 years to prove her/himself, the least they can do is withhold lavish compensation until the long-term performance record of a CEO is clear.

Third, perhaps the growth in average asset size of large companies is a mistake, viewed from a performance perspective. Should we have expected more consistently superior total return performances from the larger firms, if those mergers were value-creating? If not, perhaps the current outrage over CEO compensation levels is derative of the challenge of running companies that are, in fact, too large to be effectively led to consistently superior total returns.

GE's CEO Immelt's Arrogance in CNBC Interview

Here is a link to a video clip of yesterday's CNBC interview by Erin Burnett of her boss, GE CEO Jeff Immelt. While it is the fourth part of a longer interview played on the network throughout Friday, the juicy parts of this segment begin about midway through the clip.

Let me state what I feel is the problem with Immelt's attitude in the interview segment. As I wrote here, last March, Immelt has already been paid roughly $15MM in cash salary and bonuses. This does not even counting his deferred and retirement compensation, which, according to Forbes, as of 2005, was already totaling some $53MM. In the latter part of this interview segment, he casually dismisses discussion of his pay, insisting he is not in it for the money. Yet Immelt has failed to even keep GE's total return on a par with the S&P500 Index during his 5+ years at the helm of the firm. Taken in total, the interview depicts him as effectively ignoring his lavish overcompensation, and his underperformance, and, instead, focusing on how much fun he's having just meeting folks, facilitating the work of GE staff everywhere, and having a swell time.

Well, of course he's not in it for the money. Not now. I guarantee you, he was sure fixated on the money six years ago, when he took over the reins from Jack Welch.

How arrogant for Immelt to have failed to even keep pace with the S&P500 Index for over five years, as depicted in the Yahoo-sourced chart on the left (please click on the chart to view an enlarged version), and be lavishly compensated. Then airily wave off any thoughts that he should be criticized for his pay level.



To see GE's stock price over Immelt's entire tenure, here's a longer-term view of GE and the S&P500. As can be seen from late 2001 onward, the index ended the period up, while GE is down. Need one say more?

I won't try to quote his alleged motivations for running GE- you can hear them yourself in the video clip. Suffice to say, they are all of the motherhood and apple-pie variety. It's sickening. Having grabbed the gold, if not platinum, ring, Immelt now deflects any suggestion that he's overpaid. In fact, when Erin Burnett brings the subject up, Immelt sort of bridled at 'defending' or 'justifying' his pay, saying something like,

'If I have to spend a third of my time justifying my compensation, I'll quit and go do something else.'

That's not the exact quote, but it's close. And this, on the heels of his recounting what a merry, fun-loving, joy-producing time he's having as he reduces the value of GE's shareholder's equity.

On the subject of Bob Nardelli's exit package from Home Depot, Immelt wisely kept silent. You can see where he's going with that. If he says Nardelli deserves all of the money, Immelt looks like the arrogant, insensitive, greedy CEO that he is. If, on the other hand, he says Nardelli should give some of the package back, he needs to offer a reason. And then he's on record with the comment, would definitely be used against him, should he finally be shown the door by GE's board for continual failure to earn shareholders the market rate of total return over six years.

Honestly, I think Immelt is preparing for a quick, painless exit. It's almost as if he is saying,

"C'mon, I dare you. Pester me. So I can look noble and harried, and then get the hell out of Dodge while the gettin's good."

Sort of the B'rer Rabbit approach. Please don't hound me into quitting, 'cause I will. I really will. I'll take my total compensation that's north of $50MM since I became CEO and skulk off.

Puuullllleezzzzzz!!!!

Such drama. He's probably secretly envious of Nardelli. That stiff got off lucky. He was handed a headache known as Home Depot, screwed it up some more, and got paid to leave. Poor Jeff has to stay and try to clean up his mess! His old pal Bobby is out on the playground, being looked over by the Private Equity Gang for possible membership.

On this point, Burnett coyly hinted that maybe Jeff could duck the entire Congressional witch hunt on executive compensation that is coming, and simply join the private equity world, where, she solemnly intoned, he'd probably be paid hundreds of millions of dollars. Immelt could barely contain his grin at that point. But he pretended not to know or care what he'd be "worth." Question is, though, given Nardelli's and Immelt's failures to even match the S&P as CEOs, who'd actually pay them to underperform in the private equity world?

I suspect the only way those two will actually get jobs in that sector is to pay to play. You know, put their sizable compensation kitties up as a stake, to be allowed into any deals. Nobody has actually saying they could do better elsewhere than their miserable records running publicly-held companies.

Meanwhile, Jeff has to try to get GE running in some semblance of mediocrity, if not better. Sadly, given how forgiving and supine the company's board has been, mediocrity would probably be sufficient for that group.

It is truly a sad day for publicly-held firms. No wonder private equity is hunting with such abandon. With guys like Immelt sporting such an arrogant attitude while mismanaging GE, can you blame the private equity guys for offering low-ball premiums to victimized shareholders? Not to mention the media, especially Immelt's own captive network, CNBC, lobbing softballs at him, and joining him in denial about how he's overpaid for failing to deliver even average market value to his shareholders for over more than half a decade now.

Productivity vs. Wage Levels & Manufacturing Jobs

A week or more ago, CNBC featured one of their occasional guests, Dr. John Rutledge. Rutledge is a man of impressive credentials as an economist, academic, and businessman.

Amidst a debate with other economists, Rutledge reminded everyone of reminder of an old conundrum. To wit, wage growth moderation translates into productivity, which fosters economic growth. Thus, if you measure an economy via value growth, and productivity, not the level or growth of one input's incomes, i.e., wages paid to labor, then you put inputs in their proper perspective.

However, if your first, and primary measure of economic health is simply wage levels and growth, you will probably miss the big picture of productivity growth and overall healthy economic growth.

This echos discussions I had years ago with a then-partner about consumer benefits of productivity vs. their effects on incomes. Lower wage growth, via higher productivity, means less-expensive goods and services, and, thus, effectively higher productivity-adjusted incomes.

Then there is the question of compensation packages. The old method of measuring bi-weekly paychecks to estimate national incomes is surely outdated. How does a Wall Street bonus get counted? Or equity participation by workers in the profits of the firm?

Lastly, there's the question of type of business to which an economy allocates its resources. Do we really want our economy putting hefty resource allocations into rather plain, undifferentiated jobs which are low-skill assembly-line or metal-bashing?

Yesterday's exchange, on this point, between Fed Chairman Ben Bernanke and Vermont Socialist Senator Bernie Sanders was priceless. Sanders tried his best to maneuver Bernanke into agreeing that we need to preserve old-line, low-paying manufacturing jobs, at the expense of a growing, productive economy. Ben didn't bite, and, instead, tossed Sanders a couple of curve balls.

First, he directly contradicted Sanders, and stated that, on balance, despite some marginal job losses, the overall economy benefits from free trade. Second, he asserted that our trade deficit is caused, not by our trade policies, but by our savings and investment policies. That is, we attract capital by not providing sufficient resources ourselves, thus, creating a deficit, not by just buying too much as imports.

For a discussion of why this is not, however, all bad, see my post here, from January 1st, on the recent WSJ article by Edward Prescott.

What was troubling, however, was Bernanke's agreement with other Senators, that our overall deficit, which has actually been shrinking, and our 'savings rate,' are worrisome.

These are important points, because flawed governmental tampering with our macroeconomic framework could derail the productive, profitable use of our capital to drive economic growth with low inflation. If the economic framework becomes distorted, it will be all the more difficult for our publicly-held, private enterprises to create the value our society needs, as capital, to continue investing, creating innovation, and providing for retirement assets for the aging members of our society.

Paradoxically, as Prescott points out, we need more debt and capital, if necessary, from abroad, not less, to feed the unique, premier value-creation engine that is our US capitalistic economy.

Apple & Microsoft: Recent Developments

Much has been made of the recent surge in Apple's stock price since the unveiling of the iPhone and AppleTV last week. Similarly, pundits are now noting Microsoft's recent stock price resurgence of the past six months.

For my own portfolio, Apple did not make the list for January's selections. Thus, I sold my position the day before the MacWorld announcements regarding the new products.

Is either Apple or Microsoft now a "buy?" Has either company altered its long-term fortunes recently?

For comparison, I've downloaded four Yahoo-sourced charts (larger versions may be seen by clicking on each chart) displaying stock prices for Microsoft, Apple, and the S&P500 Index level for the past six months, one, two and five years.

Surprising as it may be, over the last six months, Apple is actually the best performer. Both companies easily beat the S&P, but Apple also handily beat Microsoft.

Apple's price increase reflected, in part, its resurgence from a horrible drop in the first half of 2006, illustrated in the next chart.

Notice, too, how both companies' stock prices fell at about the time in the spring when economic pundits wrongly believed that the US economy was heading for a recession.

Looking at the past two years, we see that Apple again significantly outperforms Microsoft, which is essentially tied with the S&P. The latter two barely eked out a gain, while Apple rose handsomely.

The last chart, below, shows the five year price histories. Once again, the magnitude of Apple's outperformance, relative to Microsoft and the index, are apparent. It's not even remotely close.

My point is, when viewed over any period substantially longer than just the last six months, Microsoft is really not looking all that remarkable. My proprietary research shows that it takes at least three years to really sort out the merely temporarily lucky firms from the truly consistently excellent ones. Apple has done this, but Microsoft is very far from doing so.

This makes Microsoft essentially a timing stock. It may continue rising. Then again, it may not. How many people do you think actually bought Microsoft last July, expecting a 50% rise? Probably not too many.

Of course, some analysts argue that the XBox is for Microsoft what the iPod was for Apple. That it will transform the software titan. Well, it is, but with one important difference. The iPod saved and dramatically reconfigured Apple. Microsoft is so much larger, with so much more mass in its computer software operations, that the XBox's effect on the company can't be as large as the iPod's was on Apple. So, it's unlikely that Microsoft has sufficient arrows in its quiver right now to continue anything resembling its recent stock price run up. So, in the long run, I doubt that the XBox can 'save' or 'turnaround' Microsoft. To do that, it would have to be spun out, off, or out to shareholders. Then, of course, it wouldn't 'save' Microsoft, but simply benefit the shareholders who paid for XBox's development.

Why did my portfolio selection process not include Apple, after holding it these past six months? Well, the one-year price chart explains why. Over the past year, Apple's return was not all that much better than the index's. And that simply doesn't provide enough margin for error in my selection process. It's quite possible that Apple may be selected again in the coming months. But for now, it's just not quite 'superior' enough, recently, to merit inclusion.

For what it's worth, I saw Steve Ballmer mock and insult the iPhone this week in a CNBC interview. He was, I believe, appearing with Verizon personnel to attempt to demonstrate Microsoft's presence in the corporate communications market. While many of Ballmer's comments are probably correct regarding the iPhone, his company hardly has a presence on its own, and the existing phone-based services are not all that good. But what was very revealing was Ballmer alleging that he really doesn't focus that much on his company's stock price. No kidding. When you are now independently wealthy, why should you? Your best friend is chairman, and you are financially secure.

Of course, it's not Steve Ballmer's company, or Bill Gates' company. It's the woefully-under-represented shareholders' company. And it performs like one, doesn't it?

So, my expectation for the coming months is: no 'buy' signal from my selection process for Microsoft, but maybe for Apple.

Apple Corp: Devil or Angel?

My partner sent me a recent article from the New York Times written by Randall Stross, entitled, "Want an iPhone? Beware the iHandcuffs."

The essence of the article is that Apple (Computer) Corporation has behaved insensitively and arrogantly in its design of the iPod product line, and its iTunes online music store. At issue is the management of copyrights, use of purchased music by the user, and the copying of music tracks.

Within days, ironically, Alan Murray, managing editor of the Wall Street Journal, weighed in, both on CNBC and in print, on the personal arrogance of Apple's CEO, Steve Jobs.

My partner went so far as to suggest, as we discussed the article, and this post, that Apple is guilty of a Robinson-Patman and/or Clayton Act violation on the basis of "tying."

I may be in the minority here, but I don't really believe Apple has: a) done anything illegal; b) done anything inherently wrong, and/or; c) behaved in some 'evil' manner.

My contention is that those who would substantially innovate existing products, or bring to market large-scale new products, of necessity, must make provisions for entire systems of products and services. As such, in order to even offer the products or services, they must design and be responsible for, at least initially, the provision of all the components for the system. In order to make this profitable, the innovating company will appear to be overly-concerned with control of the components of the system, and will also appear to not care about its interoperability with other systems, without which, the innovative system may function effectively.

Let me mention a few other examples of this phenomenon: Edison's electric power system, Westinghouse's competing alternating current electrical power system, General David Sarnoff's RCA Corporation television broadcasting and viewing system, and Phillips' audio cassette technology.

In all of these prior examples, an innovative company had to provide for a complete system in order to offer a sensible value proposition to multiple user classes.

Take television, for example. To market television, RCA had to design, produce, test and manage the input devices- cameras, amplifiers, processors, broadcasting equipment- network equipment, and receiving devices- televisions. The company had to design, sell and operate a standardized system of equipment, in order for television stations and viewers to be assured that their products would work correctly as part of the heretofore nonexistent system.

Apple did something similar for music some six years ago. Prior to iPods, we bought music at $14-18/disc, as an entire album. If you wanted one or two songs on an album, tough luck. You had to buy the whole thing, to buy it legally.

Then along came Apple's iPod and iTunes online music store. Mind you, prior to that, nobody could figure out how to shake the music industry out of its lethargy, as technology seemed poised to illegally 'solve' the music purchase problem that users had- how to buy individual tracks of music.

Do Apple's products use a different, proprietary encoding process for its iTunes music? Yes. Are Apple's products the only choices for playing digitally-encoded music? No.

Microsoft, Sandisk, and several other vendors also offer MP3 digital music players. And, hey, you can always dust off your CD player. Nobody's putting a gun to anyone's head to force them to buy an iPod. Or use iTunes.

Even when you buy an iPod, there is no "tying" arrangement which forces you to buy anything on iTunes. Unlike the original "TBA" (for tires, batteries and accessories) tying cases, for which the Clayton Act was used to halt the practice, Apple requires no purchase from or of one product, in order to use another. iTunes may be used to buy music, by the song, and play it on your PC. Or to record it onto a CD. You needn't have an iPod to use iTunes. Similarly, you may rip your existing CDs, using iTunes, into tracks to store on your iPod. But no 'purchase' is required to do this, aside from the original iPod purchase.

This system has been so successful that Microsoft, RealNetworks, and eMusic all now compete to offer online music. The consumer has choices.

In fact, the closing paragraph of Mr. Stross' article reads thusly,

"Pointing to South Korea, where copy protection has disappeared, Mr. Goldberg invoked the pithy aphorism attributed to the author William Gibson: “The future is here; it’s just not widely distributed yet.” "

I contend that, without its closed system, Apple would have had little economic reason to innovate with its iPod/iTunes system in the first place. Is it really bad for innovation to be restrictive and controlled at first, if, without such restrictions, the innovation never occurs?

This is the central argument in patent policy and law. How much protection is sufficient to produce innovation and growth, societal advancement, and how much is too much, which strangles emerging technologies.

Closed systems initially assure revenue and profit for the innovator. In time, if the innovation is useful, but deemed too restrictive, others will typically get around the technology issues.

Or, if the technological barriers are too heavily relied upon, they may be simply leapfrogged. Landline telephony's stranglehold on the communications network was eventually supplanted by wireless technology, resulting in the value of those landline telephone companies plummeting far more rapidly than was imagined. The entire anti-trust efforts against the industry during the 1980s and 1990s has all been for naught, as AT&T has now been reassembled, albeit with far less monopoly power than it had twenty years ago.

Music and entertainment is far less concentrated, as an industry sector. Already, other product solutions for listening to music are available which do not involve Apple's products. Therefore, for people to continue to complain about Apple's product strategy, vis a vis its copy management aspects, suggests that Apple's offerings still retain certain unique features, but these complainers do not wish to accept the terms of purchase and use of an iPod or iTunes.

Maybe it's me, but I simply see nothing illegal in Apple's actions. It's smart product management policy. They have constructed a legal, technological barrier which provides them with price maintenance benefits, but stops far short of being an illegal monopoly.

It may be argued that iPod profits funded the iPhone and AppleTV. Both are likely to influence and affect, respectively, communications and video entertainment. Does anyone think that an iPhone will only call other iPhones?

Over the long term, closed systems either prove their worth, or become susceptible to competition. Even when the first option seems to occur, as in telephony, over a sufficiently long term, even it becomes an example of the second option.

EBay and StubHub

An article in last week's Wall Street Journal detailed the acquisition of StubHub by EBay. I wrote about StubHub in a post here, last September.

In my earlier piece, I asked why TicketMaster and its clients didn't accept the responsibility for doing a poor job of ticket pricing, in order to get guaranteed, although lower, upfront revenues across their many venues.

In this piece, discussing the upstart's acquisition by the online auction giant, the focus is missed opportunities. Doesn't EBay's purchase of the ticket reseller sort of indict their own business development model? StubHub is only six years old. If this doesn't demonstrate EBay's paucity of ideas now, what does?

As an online resale venture, EBay should have owned this market. Instead, it had to cough up $310MM for it. And we're not talking about buying a corporate titan. StubHub is a shoestring operation, compared to either TicketMaster or EBay.

As with many other businesses which have outgrown their initial, value-adding concept, EBay now seems to have to grow revenues at much lower margins than in the past. In this case, paying upfront to secure access to a business they missed starting themselves earlier in this decade.

Dell, Home Depot, Wal-Mart, Microsoft.....these are all companies whose core value-adding breakthrough eventually exhausted itself. As the Yahoo-sourced chart on the left demonstrates (please click on the chart to view the enlarged version), now EBay is joining them. The firm outperformed the S&P500 during 2002-04, and then began to slide. Since 2004, it has actually declined in value, while the index has continued its steady, gentle rise. So, while EBay has outperformed the S&P over the entire period, it has not consistently, nor recently, outperformed it.

It's not wrong, per se, for EBay to be buying StubHub. However, I think it's a sign that you won't be seeing the firm return to earning consistently superior total returns for its shareholders anytime soon. If they can't grow profitably and organically in their own product/market space, what do they possess with which to add superior value for their customers and, thus, indirectly, their shareholders?

More Business Holiday Wal-Mart Bashing on CNBC

Today is a Federal holiday, so the equity markets are closed. There is no Wall Street Journal. And CNBC has 'alternative' programming running.

As it so typically does on days like this, CNBC trotted out its apparently award-winning video piece, by on-air analyst and commentator David Faber, which spotlights Wal-Mart.

I admit to never having sat throught the whole production at one go. I've seen quite a bit of it in segments, though. It's fair to say that it highlights both good, and bad, facets of the company, and features extensive interview footage with the current CEO, Lee Scott, as well as some time with retired CEO David Glass.

However, my point in this brief post is to suggest that maybe CNBC is stoking the anti-Wal-Mart fires merely by running this thing every business holiday. I swear that this is at least the third time in twelve months that they have done this.

If you search this blog for the term "Wal-Mart," you'll recover 20 articles which mention the company. If you read this column regularly, then you know I am not exactly a fan of Wal-Mart's CEO, management team, or performance. But I bear absolutely no animosity toward the firm, per se. It's a matter of poor performance, not a personal grudge.

With CNBC, I am beginning to wonder if they simply want to hurt Wal-Mart as much as possible, until, I don't know....the company fires Lee Scott? Closes its last American store?

With so many thousands of hours of video footage, why must CNBC resort so frequently to just one, long video production about one harried company, nearly each business/Federal holiday?

Validation and Echoes of My Video Distribution Prediction

The Wall Street Journal ran a piece detailing some of the new deals being cut to mainstream video content straight onto Internet TV. The Journal's article concludes, as I did last fall, here, and here, that these deals

"could undercut the role of cable and satellite companies."

Apparently, we now have Starz and Showtime distributing their content to the web for TV viewing. Nickelodeon is doing the same. Vehicles such as the Microsoft XBox 360 can be the terminus for the program, from which it will be fed to the user's television.

a Forrester Research source pronounced that,

"if you're a cable operator, this is very disturbing."

Indeed, it is. While, as the article points out, the move may not occur overnight, the die is definitely cast.

In a related article in the Journal, two days later, CBS is reported to be plunging headlong into this model, under the aegis of Leslie Moonves. As the owner of old media 'assets,' such as network television, print publishers, and outdoor media, CBS was more or less left holding the bag, when Sumner Redstone split Viacom from CBS.

Although Moonves denied that recent ratings softness was related to the also-recent, bold moves into the digital world, one cannot be so naive as to believe this. Moonves just saw his boss fire Tom Freston, at Viacom, for being too slow to move his businesses to the internet.

In fact, the title of the Journal piece about CBS is "CBS Ties Its Future to Internet Efforts."

Despite the reluctance of many, including my consulting friend, S, to believe that a video content disintermediation from network, via the internet, to television, could be so soon in coming, apparently I am not the only one who sees things this way. Not only are others seeing the implications, but major old-media companies are already throwing in the towel and heading for what they hope are choice pieces of 'real estate' in the new, online content world.

With Apple's recently-announced 'AppleTV' initiative, and Microsoft's XBox360, the wireless links from PC to TV accessory are now in place. All that remains is for prices to begin to slide, and consumers will be capable of controlling the when, from where, and how of their video content consumption, via the internet.

Look for broadcast networks to offer less new or premium content, and, as I wrote in some of the above-linked pieces, producers to vend their content directly from their own websites to consumers, completely bypassing anything but the iTunes "general store," or similar content aggregation websites.

Innovation, Commoditization, and Steve Jobs

Thursday's Wall Street Journal yielded an interesting piece on innovation. The second section of the newspaper has a new feature, entitled "The Informed Reader."

Under the subtitle, "Strategy," we are told that Columbia Business School's Bruce Greenwald once stated,

"In the long run, everything is a toaster."

This piece of idiocy was meant to warn that any product is ultimately and eventually reduced to a commodity.

Whoever thinks this is true must not be a marketer, or not have studied marketing.

The article goes on to cite MIT's Media Lab researcher Michael Schrage as finding that "innovation has a continued role, even in such staid objects as toasters and vacuum cleaners."

Schrage cites Hoover in vacuum cleaners, and GE in toasters, to highlight how even seemingly-mundane products can be revitalized, technologically repositioned, and become a source of significant new revenue growth.

Yes, you worry because anyone can produce what you do, but not everyone can emulate the design of what you do, when you do it.

And this puts a premium, of course, on continuous innovation. Or, as I see the output, consistently superior revenue growth. The successful future of a company lies in innovating any or all of the 'four Ps' of marketing- product, place, price and promotion- in order to better serve customer needs. Surrendering to price competition is the first step along the road to commoditization.

Which brings me to Steve Jobs. Jobs has proven to be a genius in his later career. But this was not always the case. Recall his serious stumble in, first, mismanaging the early successes of Apple Computer, and then recruiting John Sculley to succeed him.

In retrospect, I believe this simply demonstrated that Jobs is at his worst in a slugging match of equals, i.e., commodities. When he attempted to go toe to toe with the other personal computer makers, and Microsoft, he ended up frustrated, bored, and out of a job.

Recall, if you will, that he took a few trusted aids and started Next, which was ultimately bought back by Apple, for its object-oriented code assets.

Jobs' attempt at pushing forward a little on communications needs resulted in the failure Apple called "Newton."

In contrast, Jobs hit grand slams with his work at Pixar, and the iPod line. He is clearly at his best inventing the future, far out in front of current solutions.

In this respect, is he not rather like Thomas Edison? Like Edison, Jobs is often hustling and marketing just as fast as he's developing product. Like Edison, Jobs is egotistical, a reportedly demanding taskmaster, and short on giving named credit for much of what comes out of his development teams.

However, if anyone needs a clear example of how innovation can effect companies, look no further than Apple. With an impressario at the helm, someone who seems to simply love what he is doing, the firm has simply left Microsoft and Bill Gates in the dust when it comes to leading his firm into new, growth markets.

Yes, innovation is crucial for long-term growth in equities. One must not confuse the ability of virtually any product or service to be replicable, given time. The key is to realize that it does take time, and, in that time, the innovator can be, once again, steps ahead of the mere copiers.

For me, Frank Perdue's branding of chickens and chicken parts opened my eyes to this as a young marketing student in graduate school.

Looking back to the beginning of this piece, and the Greenwald quote, one wonders how a business school professor could be so short-sighted as to reduce innovation and marketing to a zero-sum game, confusing replication with innovative designs and solutions for customer needs.

Forecasting Economic Health with One Indicator: The Yield Curve

Monday's Wall Street Journal's Money and Investing section featured a piece on the analytical import of the prolonged yield curve inversion.

By now, everybody, even those who have not studied economics, knows that inverted yield curves have, historically, frequently been associated with recessions. The trouble is, the indicator sometimes gives false positives.

Then there is the criticism that, if forecasting a recession was that easy, why aren't these economists shorting equities already?

Those doubting the indicator allege that 'this time, it's different.' They point to global demands for a safe haven for cash. Or that 'markets have changed.'

I suppose this debate will continue until either a recession does, incontrovertibly, arrive, or the economy continues its low-inflationary growth phase for another year or so.

Perhaps the moral is that you need to use multiple forecasting methods, not just the inverted yield curve, to predict recessions. Any one tool is prone to being misled. A suite of tools, providing a sort of 'information theory' approach to the task, would be better.

In the meantime, I suppose everyone will continue to watch the yield curve and the GDP's quarterly growth numbers for the next six months with heightened 'interest,' as it were.

GM's Bulging Inventory of 2006's "Hot" Cars

Monday's Wall Street Journal reported that GM's unsold finished goods inventories of cars have become enormous.

The article states that, at the end of December, GM

"had more than one million vehicles in stock in the U.S. That's equivalent to about 41,000 vehicles for every point of its 24.6% U.S. market share. By contrast, Toyota..., one of the world's most profitable auto makers, carried about 16,000 vehicles of inventory per point of its 15.4% market share.

Among the unsold vehicles, the piece later explains, are some of the models that GM's management felt were "hot" models for last year- the Chevrolet HHR, the Buick Lucerne, and the Saturn Aura. Some of these cars now have a 90+ day supply sitting on lots across America.

Apparently, we have yet to see the much-vaunted, newly-creative GM emerge. Because the products they evidently pinned much of their 2006 sales hopes on are sitting, unsold, in storage around the country.

GM finds itself in a vise of its own device, in that it must, on one hand, cut costs, such as inventory financing, and, yet, maintain production in order to generate cash flow to assist its 'turnaround.'

Failure to keep production levels up starves it of cash to pay its mountain of fixed liabilities relating to healthcare and pensions, but unsold inventory ties up much-needed liquidity, as well as spurs price cuts via low-interest rate sales programs.

Interestingly, GM's haphazard pricing tactics have contributed to its woes. With much car shopping initially done online now, the company's reliance on relatively higher sticker prices, coupled with the expectation of dealing on financing, causes many buyers to exclude the company's products from consideration.

Of the dilemma, GM's CFO, Fred Henderson was quoted as saying,

"This is the area where we have a lot of work to do in the future."

No kidding.

Having been in the auto business for, oh, nearly a century, with, at one time, the overwhelming market share in the American auto market, you would think GM's management would, by now, have its customers' buying behaviors down pretty well, wouldn't you?

Evidently not.

Yet another firm for which 2007 is starting out with a thud.

China's Dependence on Tobacco and Smoking

Last week, the Wall Street Journal ran a piece on China's dependence on tobacco as a centerpiece of its economic development.

The article focused initially on the province of Kunming, which has based much of its economic growth on the product. However, as the piece began to broaden to encompass all of China, the information began to look truly scary.

The Chinese death number is expected to double by 2005.

"One third of all Chinese men now age 29 or younger will die prematurely from tobacco-related diseases."

Allegedly, more Chinese people smoke than are in the US. One estimate of the cost to China last year from smoking was $5B, in medical expenses and lost productivity.

There are many details about the Chinese tobacco industry in the article, but I'm not really interested in recounting or commenting on them in this piece.

Rather, I have two major questions, as a result of reading the Journal piece.

First, can a country afford to either kill off its productive assets, i.e., its citizens, prematurely, and/or foot the immense medical costs for their smoking-related illnesses? Second, could tobacco become the achilles heel of the Chinese economy, in much the same way that a lack of focus on profitability and, then, borrowing in a foreign currency, were to the Japanese economy in the 1970s?

On the matter of the first question, I suggested to some friends that the Chinese economy would have to absorb a massive amount of healthcare-related costs, much as America's automakers have had to do for their retirees. My cynical friends opined that, 'no,' the Chinese would not be so burdened, because the Chinese government will simply let its smoking-induced ill citizens die without much medical care.

If that's true, then let's simply examine the consequences of that. How much premature loss of trained economic assets, in the form of a society's people, as workers, can a country sustain, before its productivity is affected? The ultra-low-wage jobs will soon migrate elsewhere, so, like all other developing economies, China will have to sustain its economic development upon creativity and productivity. How can it do that if it only gets 20-25 good years, on average, per worker, before they become ill? I don't know the exact life-expectancy loss from the Chinese smoking habit, but you get my point. It's surely a drag on the Chinese economy, if only as a simple ratio of reduced lifetime economic output per trained worker.

Thus, my second question. Could this seemingly incidental facet of Chinese society eventually torpedo its plans to dominate global economics? I guess, on one hand, premature deaths from smoking will lower the average age of the population, and reduce the pension cost problems. However, more seriously, is it possible that a significant loss of economic capacity, productivity, and skill, from premature worker deaths, could hamper China's ability to compete with healthier society's?

Will the health and producitivy penalties of tobacco in the long run offset its near-term boost to the Chinese economy? I recall that, in the late 1970s and early 1980s, the American business media was fixated on the coming economic domination of Japan. The country seemed unstoppable. Until, that is, its obsession with market share and growth, to the exclusion of profits, hollowed out its financial strength. Then, its dollar-denominated debt proved a crushing burden, because they had to service it with their own yen.

After all the loss of productivity, via healthcare and legal costs, that America has suffered from asbestos and tobacco, one would think the Chinese could build upon such lessons and avoid the same fate. Evidently, as a society, they aren't yet that smart.

Finally, for the moralists among readers of this blog, what, if anything, can other societies do, as they watch the Chinese promote the early death of their own people? Is there any appropriate action other societies can take? Or would that constitute unwanted, baseless interference in the civil affairs of another society?

McDonalds Resurgence

Last weekend's Wall Street Journal ran an article on McDonalds, the fastfood titan. Now that it's in my portfolio, the story caught my eye.

As the nearby Yahoo-sourced price chart indicates (please click on the chart to see a larger version), the company really has turned around in the last five years, and outperformed the S&P over the period.

The firm's CEO, Jim Skinner, was a part of the management team that began to improve McDonald's four years ago. He moved up to his current job when one CEO died suddenly, and the next resigned to wage a battle with cancer.

What I liked about Skinner's responses in the interview was how clear-thinking and sensible he is. For instance, he said,

"....we proved that we were getting bigger but not better. And we have to be better. Your experience today at McDonald's has to be a better experience than it was yesterday. People have limited time today. They don't want to get up and go, "Gee, I don't know. Do I think I can go to McDonald's?" "

Skinner has a clear focus on his customers' behaviors, which is always heartening in a CEO, especially in a retail business, where there are so many individual purchase decisions each day.

Later in the interview, he is quoted as saying, regarding the four-year old turnaround strategy,

"We had contributed $4B or $5B to capital expenditures and building new stores over four years, and yet we didn't have any corresponding incremental operating-income growth. So we decided to focus on our existing restaurants. Those of us that were hardcore restaurant people, which I was at the time, were saying, "Look, we've got to do a better job of delivering what we called quality, service and cleanliness on a daily basis in our restaurants." And value. Because value proposition's very important."

Skinner's remarks show how sharp this company's management team is. He related later that a considerable amount of time and effort of every senior manager is spent identifying and grooming their upcoming talent. He attributes the company's ability to 'accelerate our momentum' to 'selecting the high-potential people.'

When asked what his biggest remaining challenge is, Skinner replied,

"I worry about complacency. We're not satisfied. We have a lot of work to do."

That's what I love to read about from CEOs whose company's shares I own. Toyota's CEO says the same thing, whereas his faltering rival, Rick Wagoner of GM, feels he's on track.

I loved the things I read about Jim Skinner, and McDonald's, in the Journal piece. It impressed me so much, that, having just bought some of its shares, I had lunch there yesterday, on the way back from a midday errand.

It was everything Skinner contended. The food was well-prepared, and less expensive than I expected. The store was very clean. Though after the noon-time rush, one employee did nothing but circulate among the tables, wiping off food remnants and spraying, then wiping them clean with a disinfectant. My visit was fast, clean, and delivered familiar food. The menu even seemed simplified and easier to use than I recalled on my last visit to a McDonalds some years ago.

Needless to say, I hope the company continues to do well. At least for the next six months of my portfolio investment. Based upon Jim Skinner's interview in the Wall Street Journal, I'm confident that it will do so.

Wal-Mart's First Gaffe of 2007: Scheduling Part-Time Workers

It's 2007- a new year. Within only three days, we have the first significant Wal-Mart gaffe of the year.

Last week, the Wall Street Journal carried an article discussing Wal-Mart's latest productivity improvement approach. They are employing new, dynamic labor-scheduling software which more closely matches store staffing to customer volume, as well as observes various constraints, such as employee hours worked, overtime, etc.

These guys just don't get it, do they?

Sure, labor scheduling software can be a good thing, within limits. But in their zeal to become the most efficient retailer, Wal-Mart risks total alienation of even the few capitalists who can still defend them.

This is the type of corporate behavior that brought us unions in the first place. It's just not wise. Why would you want to go after your own employees' qualities of lives and abilities to earn reasonable livings?

To me, this is just an open invitation to be pilloried again by a now-Democratic House and Senate.

Do you wonder, as I do, if Lee Scott has any common sense at all? Perhaps these continuing gaffes are, in fact, emblematic of the core competencies, or incompetencies, of the company?

On the heels of last year's many problems- the mistaken upscale repositioning, the race-based store segmentation, the reversal on selection on an ad agency, and public relations "ambassador" Andrew Young's invectives against other minorities- we now have the world's largest retailer improving productivity seemingly on the backs of its workers.

I'm all for efficiency, but, in reality, there are advisable limits within which a company should stay, in order to not invite regulation and excess scrutiny from government. I think Wal-Mart is off to a phenomenally bad start to this new year.