There was a time when you needed to take a high risk to get rich: be an actor, investment banker, rock star or start your own business. But no more. Just get a good, safe job with a large corporation, survive the politics, climb to the top and then hold it hostage for money.
Today's sickening news announced the payment of $135 million as a "golden parachute" to a retiring banker: Wallace D. Malone, Jr. - long time chairman of SouthTrust and the key decision maker in its sale to Wachovia. Unsurprisingly, Wachovia accepted his benefit package when the sale of SouthTrust was being negotiated. Go to charlotteobserver.com for a detailed list of the absurd extent of his benefits.
I don't hold this against Mr. Malone. In fact I congratulate him for taking advantage of the ineptitude of money managers like myself who have been useless fighting excessive executive compensation. I also congratulate him for providing motivation for managers like myself to figure out how to stop this. Globalization sure hasn't put pressure on these labor costs.
Tuesday, January 31, 2006
Monday, January 30, 2006
Funding Health Care Innovation
Three posts have addressed challenges faced by the pharmaceutical industry (global intellectual property rights, drug development and management). While difficult, "big pharma" has always been resourceful. Rather than focus on efficiency by delivering a higher volume of old drugs at lower costs, "big pharma" has concentrated on higher impact through new discoveries. But, inequities have developed.
While benefitting from U.S.-funded pharmaceutical gains, the rest of the globe has not paid its fair share of the economic costs. Canada not only receives drugs from the U.S. at a lower cost than U.S. citizens, but has not invented one major drug since the government started providing health care in 1971. Much of their "efficient" health care system's ability to deliver quality is because of U.S. innovation and charity. Some facts from a recent article in the Economist point to such a dynamic in overall health care, not just pharmaceutical areas.
The U.S. spends 16% of GDP on health care, a percentage which is nearly twice the average of other developed countries. While this is large, the Economist also reports, "One survey of doctors published in Health Affairs claimed that eight of the ten most important medical breakthroughs of the past 30 years originated in America." It seems logical that higher costs and innovation would be linked.
However, those higher costs are becoming less manageable. As corporations reduce employee benefits, costs are shifted to the public sector. To thwart what appears to be a looming crisis, people are looking to cut costs. But that could be short-sighted. All agree that the U.S. system is responsible for a global increase in the quality of health care. Why not get other countries to pay more of their fair share rather than cut costs? Wouldn't this be a better long term solution? The answers may lie in better global intellectual property rights.
While benefitting from U.S.-funded pharmaceutical gains, the rest of the globe has not paid its fair share of the economic costs. Canada not only receives drugs from the U.S. at a lower cost than U.S. citizens, but has not invented one major drug since the government started providing health care in 1971. Much of their "efficient" health care system's ability to deliver quality is because of U.S. innovation and charity. Some facts from a recent article in the Economist point to such a dynamic in overall health care, not just pharmaceutical areas.
The U.S. spends 16% of GDP on health care, a percentage which is nearly twice the average of other developed countries. While this is large, the Economist also reports, "One survey of doctors published in Health Affairs claimed that eight of the ten most important medical breakthroughs of the past 30 years originated in America." It seems logical that higher costs and innovation would be linked.
However, those higher costs are becoming less manageable. As corporations reduce employee benefits, costs are shifted to the public sector. To thwart what appears to be a looming crisis, people are looking to cut costs. But that could be short-sighted. All agree that the U.S. system is responsible for a global increase in the quality of health care. Why not get other countries to pay more of their fair share rather than cut costs? Wouldn't this be a better long term solution? The answers may lie in better global intellectual property rights.
Wednesday, January 25, 2006
Kerkorian's GM (a.k.a. Greedy Mgmt.) Moves
Kirk Kerkorian has an inspiring story of a self-made man's perseverance, boldness and brilliance. (A good summary can be found in Wikipedia.) I have often told myself that he would be an investor to emulate. However, his investment decisions are extremely difficult to replicate without having his wonderful characteristics. His latest moves illustrate that point.
Yesterday it was announced that he increased his ownership in General Motors stock back to 9.9% the company (56 million shares or about $1.2 billion). His cost basis was nearly $31 and the stock is in the low 20's. There was speculation that his sale of 12 million shares last December was not really for tax purposes, but was his first in a series of reductions in a quasi-admission of a mistake. (I did not agree.) Now it's clear that it was for tax purposes and that he may purchase yet more at these lower prices.
Now here's the amazing part. I have not read of an unsuccessful investment by him. He has created his $8 billion net worth out of a great series of investment decisions. He's already made piles of money on a contrarian bet on Chrysler. So if he has a nearly perfect investment record, is within his area of competence, is putting 20% of his net worth in an investment that can be purchased for 35% less than he did, why not follow him in?
First, the pros of buying GM. Toyota, a company without the legacy and structural costs of GM, is valued at $183 billion and sells roughly the same amount of goods - $175 billion. GM, on the other hand, is valued at about $12 billion, even though it sells more goods than Toyota - $190 billion. If GM even got half the valuation of Toyota, it would increase eightfold - a wonderful return.
Next, the cons of buying GM. Ill-defined brands. High capital intensivity. Bankruptcy really a possibility. Delphi, the big GM parts company filed and few thought that would happen. Further, GM could lose lots of money if Delphi employees strike or force GM to pick up some of the Delphi post-retirement liabilities. GM's liabilities are huge. With over 2.5 retirees per active employee, GM pays about $6 billion per year in health care costs and has a pension which is possibly underfunded by billions.
Kirk Kerkorian has hired Jerry York to spearhead the turnaround. He was the CFO of Chrysler and IBM in their successful turnarounds. There is probably not a better person to work on GM. He says a key phrase in a recent speech (found in a 13D of Tracinda), "GM has a mountain of liquidity on hand—both cash and non-core assets that can be sold. So it has the wherewithal it fix itself." As a one to three year hold, GM stock has significant potential to appreciate. But, as a long term hold, the business is not attractive, even though there is clearly money to be made.
Yesterday it was announced that he increased his ownership in General Motors stock back to 9.9% the company (56 million shares or about $1.2 billion). His cost basis was nearly $31 and the stock is in the low 20's. There was speculation that his sale of 12 million shares last December was not really for tax purposes, but was his first in a series of reductions in a quasi-admission of a mistake. (I did not agree.) Now it's clear that it was for tax purposes and that he may purchase yet more at these lower prices.
Now here's the amazing part. I have not read of an unsuccessful investment by him. He has created his $8 billion net worth out of a great series of investment decisions. He's already made piles of money on a contrarian bet on Chrysler. So if he has a nearly perfect investment record, is within his area of competence, is putting 20% of his net worth in an investment that can be purchased for 35% less than he did, why not follow him in?
First, the pros of buying GM. Toyota, a company without the legacy and structural costs of GM, is valued at $183 billion and sells roughly the same amount of goods - $175 billion. GM, on the other hand, is valued at about $12 billion, even though it sells more goods than Toyota - $190 billion. If GM even got half the valuation of Toyota, it would increase eightfold - a wonderful return.
Next, the cons of buying GM. Ill-defined brands. High capital intensivity. Bankruptcy really a possibility. Delphi, the big GM parts company filed and few thought that would happen. Further, GM could lose lots of money if Delphi employees strike or force GM to pick up some of the Delphi post-retirement liabilities. GM's liabilities are huge. With over 2.5 retirees per active employee, GM pays about $6 billion per year in health care costs and has a pension which is possibly underfunded by billions.
Kirk Kerkorian has hired Jerry York to spearhead the turnaround. He was the CFO of Chrysler and IBM in their successful turnarounds. There is probably not a better person to work on GM. He says a key phrase in a recent speech (found in a 13D of Tracinda), "GM has a mountain of liquidity on hand—both cash and non-core assets that can be sold. So it has the wherewithal it fix itself." As a one to three year hold, GM stock has significant potential to appreciate. But, as a long term hold, the business is not attractive, even though there is clearly money to be made.
Tuesday, January 24, 2006
Unusual Drug Company Challenges
An article in today's WSJ illuminate some of the unusual challenges presented to the drug industry. The Journal reports that an estimated 6-10% of the world's drugs are counterfeit, amounting to over $35 billion worth of drugs. That is an enormous number. For perspective, that is almost equal to the entire industry's research and development budget.
Part of the problem is that some countries, particularly China, do not aggressively track down such counterfeiting. In response, drug companies have spent their own resources tracking down fake drug operations. The article highlights some of the actions taken by Pfizer, which almost amount to having their own investigative police force in China. What other global industry has to provide such services?
Fortunately, help appears to be on the way. A Chinese authority was quoted, saying "fake drugs is a business that is equivalent to murder," referencing the many deaths that have resulted from the use of counterfeit drugs.
Part of the problem is that some countries, particularly China, do not aggressively track down such counterfeiting. In response, drug companies have spent their own resources tracking down fake drug operations. The article highlights some of the actions taken by Pfizer, which almost amount to having their own investigative police force in China. What other global industry has to provide such services?
Fortunately, help appears to be on the way. A Chinese authority was quoted, saying "fake drugs is a business that is equivalent to murder," referencing the many deaths that have resulted from the use of counterfeit drugs.
Sunday, January 22, 2006
Media Disintermediation
Warren Buffett has long held media properties as part of that profitable "food chain" called branding. To be profitable, investments must slow the process of competing to zero profits that occurs with commodities. Brands help. Brands can encourage consumers to "pay up." But to create brands, media properties are necessary.
But media properties have been having investment problems of the same type. As I have blogged recently, newspapers, (as well as radios and televisions) are part of a disintermediation process driven by the Internet. As a result, media properties are losing their "tollway" characteristics. But a friend of mine argued that the "tollway" still exists because people need to trust their news source.
However, disintermediation is addressing the issue of trust in a novel way. Unlike the historical use of a gatekeeping media property separating companies from consumers, the Internet now allows direct linkage of company and conumer: whether through company website, or pdf file, or search engine or RSS feed. If interpretations are important, blogs can provide significant online and on-time commentary.
This thesis, persuasively made by David Meerman Scott in a complimentary ebook called "The new rules of PR," (and available at his excellent web log www.webinknow), appears financially confirmed: Buffett has purchased the company Business Wire for an estimated (by me) $500 million. Media disintermediation is at the core of Business Wire's growth. Formerly, Business Wire helped businesses disseminate information to the old "tollways" of the media world. Now, Business Wire helps businesses manage press releases in order to grow customer reach and direct branding. Further, new legal requirements for accuracy and timeliness on business releases help all involved. Business Wire gets more business because of heavier requirements and the businesses have releases which are considered more trustworthy - addressing some of my friends concerns.
As a financial aside, Business Wire appears to be already highly profitable. Business Wire charges $225 for each release. The top line of Business Wire is $125 million (yes, over a 1,000 releases per day!). The margins appear high, as the releases are already written. Business Wire has had a bottom line strong enough to allow former owner Lorry I. Lokey to donate $160 million over the past 10 years (mostly to schools: his alma mater Stanford and Leo Baeck Academy, a school in Haifa, Israel). At a contribution rate averaging $16 million per year, the business probably threw off at least $32 million of after-tax profit (most people don't donate over 50% of their income for tax reasons), leaving a pre-tax operating margin of nearly 50%. For financial types, I would estimate that Buffett paid about 8-9 times operating profit and comment that their largest competitor is London-based PR Newswire, a subsidiary of United Business Media, PLC.
But media properties have been having investment problems of the same type. As I have blogged recently, newspapers, (as well as radios and televisions) are part of a disintermediation process driven by the Internet. As a result, media properties are losing their "tollway" characteristics. But a friend of mine argued that the "tollway" still exists because people need to trust their news source.
However, disintermediation is addressing the issue of trust in a novel way. Unlike the historical use of a gatekeeping media property separating companies from consumers, the Internet now allows direct linkage of company and conumer: whether through company website, or pdf file, or search engine or RSS feed. If interpretations are important, blogs can provide significant online and on-time commentary.
This thesis, persuasively made by David Meerman Scott in a complimentary ebook called "The new rules of PR," (and available at his excellent web log www.webinknow), appears financially confirmed: Buffett has purchased the company Business Wire for an estimated (by me) $500 million. Media disintermediation is at the core of Business Wire's growth. Formerly, Business Wire helped businesses disseminate information to the old "tollways" of the media world. Now, Business Wire helps businesses manage press releases in order to grow customer reach and direct branding. Further, new legal requirements for accuracy and timeliness on business releases help all involved. Business Wire gets more business because of heavier requirements and the businesses have releases which are considered more trustworthy - addressing some of my friends concerns.
As a financial aside, Business Wire appears to be already highly profitable. Business Wire charges $225 for each release. The top line of Business Wire is $125 million (yes, over a 1,000 releases per day!). The margins appear high, as the releases are already written. Business Wire has had a bottom line strong enough to allow former owner Lorry I. Lokey to donate $160 million over the past 10 years (mostly to schools: his alma mater Stanford and Leo Baeck Academy, a school in Haifa, Israel). At a contribution rate averaging $16 million per year, the business probably threw off at least $32 million of after-tax profit (most people don't donate over 50% of their income for tax reasons), leaving a pre-tax operating margin of nearly 50%. For financial types, I would estimate that Buffett paid about 8-9 times operating profit and comment that their largest competitor is London-based PR Newswire, a subsidiary of United Business Media, PLC.
Saturday, January 21, 2006
New Area of Estate Planning
Estate planning changed rapidly in the late 1980's and early 1990's as changing tax laws intersected with changing interest rates and computerized modeling. Then the rate of new estate planning ideas slowed considerably for the past few years. But today's WSJ mentions a "cool" (pun intended, Brooke) new idea: estate planning for users of cryogenics.
Cryogenics is the process of suspending human remains with the hope that advances in science will allow for such remains to be "thawed" and revived. Most people dismiss such concepts as ridiculous, but there are some who think they can "take it with them." By placing funds into a "personal revival trust," these wealthy individuals hope their money grows virtually expense-free so that they will wake up to being the wealthiest individuals in the world.
Years ago, we used to joke about the idea that a family member could be frozen until all gifting plans had been completed. That joke might become a reality. Estate taxes are essentially a tax on the transfer of assets out of the estate to someone else. If the assets are retained within the estate, it would appear that those assets could continue to compound without taxation for centuries with some potentially lucrative benefits for family members.
Cryogenics is the process of suspending human remains with the hope that advances in science will allow for such remains to be "thawed" and revived. Most people dismiss such concepts as ridiculous, but there are some who think they can "take it with them." By placing funds into a "personal revival trust," these wealthy individuals hope their money grows virtually expense-free so that they will wake up to being the wealthiest individuals in the world.
Years ago, we used to joke about the idea that a family member could be frozen until all gifting plans had been completed. That joke might become a reality. Estate taxes are essentially a tax on the transfer of assets out of the estate to someone else. If the assets are retained within the estate, it would appear that those assets could continue to compound without taxation for centuries with some potentially lucrative benefits for family members.
Thursday, January 19, 2006
Steve Jobs on A Roll
The latest news about Steve Jobs rumor Pixar being acquired by Disney. If such an acquisition occurs, Mr. Jobs will likely become a director and own over 9% of Disney stock. It's appropriate. If there were a modern-day incarnation of Walt Disney, it would be Steve Jobs. Steve Jobs has an eye for what makes us feel good. Just as Walt Disney created cartoon characters that made us feel good, so, too, do the animated characters of Pixar and the products of Apple make us smile. In fact, the holiday season at our house was practically a Steve Jobs event. Despite the vigorous protests of my Apple-hating and trend-averse son Ross, the Granowski household acquired two iPods and one iBook. I'm learning that for evaluating a "consumer franchise," that most profitable kind of business, there's more than Microsoft/Intel functionality. There's good feelings - and people are willing to pay for that. If you don't believe it, look at the net margins of Pixar - an amazing 50%! (For the non-financial reader to have a sense of this number, the average net margins for a company in the stock market are about 7% and only rarely exceed 20%.)
Sunday, January 15, 2006
Future of Newspapers
At dinner tonight, I asked my children if they would eventually read newspapers. They said yes, probably, even if the news was not up-to-date. That was my first insight - that the daily newspaper had "old" news. I had seen that recently when the newspaper reported that all but one miner had survived an explosion while the television reported that only one made it.
Then I asked what they would get from a newspaper, if not news. They said articles and features like crossword puzzles. I then asked them how much they would be willing to pay for these services since most of them were available for free on the Internet. That was a surprise. They did not know that most papers are available for free online. They said that they might buy the paper as a luxury. That was my second insight - that the daily newspaper is moving to a "luxury" category. Nice, but not necessary.
From that short discussion, it seems clear that newspapers will be forced to reinvent themselves. Just as multi-topic magazines like Reader's Digest and Redbook were amply supplemented by specific topic magazines like Golf or Gourmet and three television stations were joined by three hundred, so too could the daily newspaper become a wide range of different newspapers in specialty areas. In some ways, the Wall Street Journal is already such a publication. Further, just as $0.25 coffee is now sold for $3.50, so too could a luxury system develop around the daily newspaper.
And the other side of the business - the advertising - is just as challenged. When my son and I spoke about how I would sell my guitar (if my son is unable to teach me how to play), the answer was clearly the Internet. Classified ads, a major profit center for newspapers, is clearly going away. It seems as if the only real forced advertisers are the grocery stores.
Warren Buffett commented in the 2004 meeting that two things were almost certain to happen to newspapers: circulation would continue to decline and advertising revenues would also decline. Highly successful investors have been purchasing newspaper stocks as they continue to drop. I am still trying to figure out what is the right price to pay for a business whose only visible future is decline.
Then I asked what they would get from a newspaper, if not news. They said articles and features like crossword puzzles. I then asked them how much they would be willing to pay for these services since most of them were available for free on the Internet. That was a surprise. They did not know that most papers are available for free online. They said that they might buy the paper as a luxury. That was my second insight - that the daily newspaper is moving to a "luxury" category. Nice, but not necessary.
From that short discussion, it seems clear that newspapers will be forced to reinvent themselves. Just as multi-topic magazines like Reader's Digest and Redbook were amply supplemented by specific topic magazines like Golf or Gourmet and three television stations were joined by three hundred, so too could the daily newspaper become a wide range of different newspapers in specialty areas. In some ways, the Wall Street Journal is already such a publication. Further, just as $0.25 coffee is now sold for $3.50, so too could a luxury system develop around the daily newspaper.
And the other side of the business - the advertising - is just as challenged. When my son and I spoke about how I would sell my guitar (if my son is unable to teach me how to play), the answer was clearly the Internet. Classified ads, a major profit center for newspapers, is clearly going away. It seems as if the only real forced advertisers are the grocery stores.
Warren Buffett commented in the 2004 meeting that two things were almost certain to happen to newspapers: circulation would continue to decline and advertising revenues would also decline. Highly successful investors have been purchasing newspaper stocks as they continue to drop. I am still trying to figure out what is the right price to pay for a business whose only visible future is decline.
Thursday, January 12, 2006
Changing Reaction to Drug Industry
Taking shots at the drug industry has been alot like criticizing our parents: fun, commonplace but basically harmless. It's easy to complain about our parents. They cast such a big shadow on our lives and seem to have made our lives more difficult than necessary. Worse yet, it feels one-sided as they move along seemingly impervious to our problems without having any of their own.
Global opinion has joined in this childish rant against drug companies: "they're selfish and insensitive to my needs." As a result, the drug companies' outcry against importation of cheaper drugs, generic lawsuits that amount to "legal lotteries," clever ploys of managed healthcare and absurd domestic legal actions has been ignored or laughed at as just another marketing ploy. But, awareness is growing about the damaging impact of these issues. Last year, only 20 new drugs were approved, despite $38 billion in expenditures for research and development. This implies a cost of nearly $2 billion per drug approved. This approval rate is down from 31 new drugs in 2004, which had implied a then stunning cost of nearly $800 million per drug approved.
Finally, somebody's listening to the drug companies' plea for help. Today, the FDA announced new guidelines for the preliminary phases of drug development. These moves are aimed at ultimately raising the number of new drugs introduced by making the development process more reasonable and less costly. It's a welcome turning point for the drug companies.
As when our parents really do have problems, we become reminded of who got us "down the road." No industry has done more for quality of life on this planet than the drug industry. It looks like some people are starting to remember that.
Global opinion has joined in this childish rant against drug companies: "they're selfish and insensitive to my needs." As a result, the drug companies' outcry against importation of cheaper drugs, generic lawsuits that amount to "legal lotteries," clever ploys of managed healthcare and absurd domestic legal actions has been ignored or laughed at as just another marketing ploy. But, awareness is growing about the damaging impact of these issues. Last year, only 20 new drugs were approved, despite $38 billion in expenditures for research and development. This implies a cost of nearly $2 billion per drug approved. This approval rate is down from 31 new drugs in 2004, which had implied a then stunning cost of nearly $800 million per drug approved.
Finally, somebody's listening to the drug companies' plea for help. Today, the FDA announced new guidelines for the preliminary phases of drug development. These moves are aimed at ultimately raising the number of new drugs introduced by making the development process more reasonable and less costly. It's a welcome turning point for the drug companies.
As when our parents really do have problems, we become reminded of who got us "down the road." No industry has done more for quality of life on this planet than the drug industry. It looks like some people are starting to remember that.
Wednesday, January 11, 2006
Wal-Mart Woes
The article on the front page of the WSJ today ought to provide some clue as to whether Wal-Mart (WMT) is the "knight in shining armour" or the "evil empire." For decades, WMT has been regarded as a friend to the consumer, dramatically increasing the purchasing power for the middle and lower classes. Suddenly, WMT is touted as the "evil empire," mistreating employees, customers and vendors. I have been shocked by comments on WMT by clients and prospective clients. It's like hearing about the local high school athlete and scholar who is now rumoured to be a neighborhood rapist. The business of reputational change is not only fascinating but critical to investing. So, what's going on here?
The article details two organizations: Wake Up WalMart.com and Wal-Mart Watch. The first organization, call it "wake up," is financed by the grocery workers union. The second organization, call it "watch," is financed by the service workers union. Both organizations have alot in common. They both were "born out of the four-month grocery strike against Safeway, Albertsons and Kroger in Southern California two years ago. The big chains argued that they had to cut wages and benefits in order to compete with Wal-Mart, and the workers ultimately made significant givebacks." In addition, they are both top-heavy with former Democratic party campaigners from Howard Dean and John Kerry campaigns. Despite such similarities, it appears that there are some theological differences.
"Wake up" ran recent ads focusing on discouraging Christians from shopping at Wal-Mart because Jesus would not embrace Wal-Mart's values of "greed and profit at any cost." However, "watch" holds that Jesus would say the ad was a mistake. How strange. WMT was a hero to Americans for taking away from the profits of small businesses and redistributing them as lower-priced goods. The name of Jesus was never invoked. Now, WMT, for doing the same job it's always done, except impacting unions rather than small business owners, is suddenly such a villain as to justify the name of Jesus and the wrath of Christians. To me, it just looks our our local athlete/scholar has hurt the wrong girl's feelings.
The article details two organizations: Wake Up WalMart.com and Wal-Mart Watch. The first organization, call it "wake up," is financed by the grocery workers union. The second organization, call it "watch," is financed by the service workers union. Both organizations have alot in common. They both were "born out of the four-month grocery strike against Safeway, Albertsons and Kroger in Southern California two years ago. The big chains argued that they had to cut wages and benefits in order to compete with Wal-Mart, and the workers ultimately made significant givebacks." In addition, they are both top-heavy with former Democratic party campaigners from Howard Dean and John Kerry campaigns. Despite such similarities, it appears that there are some theological differences.
"Wake up" ran recent ads focusing on discouraging Christians from shopping at Wal-Mart because Jesus would not embrace Wal-Mart's values of "greed and profit at any cost." However, "watch" holds that Jesus would say the ad was a mistake. How strange. WMT was a hero to Americans for taking away from the profits of small businesses and redistributing them as lower-priced goods. The name of Jesus was never invoked. Now, WMT, for doing the same job it's always done, except impacting unions rather than small business owners, is suddenly such a villain as to justify the name of Jesus and the wrath of Christians. To me, it just looks our our local athlete/scholar has hurt the wrong girl's feelings.
Tuesday, January 10, 2006
Interpublic Group Update
Today, Interpublic Group's (IPG) management presented a much-awaited update on their business situation. IPG is one of the largest ad agencies in the world, owning such shops as McCann-Eriksonn and Foote, Cone and Belding and receiving over $6 billion in revenues. The ad industry is attractive to investors because capital requirements are fairly low while the operating margins are fairly high - at around 15%. With a return to these industry norms, IPG could see its stock price double, in a likely valuation move from 0.6 of sales to 1.2 times sales. Why is the stock price so depressed?
Many trace IPG's woes to its rapid growth. During the 1990s, IPG went on an acquisition spree, acquiring over 300 companies. In order to finance these acquisitions, IPG issued ample amounts of stock and also borrowed money. But it was not alone. Omnicom (OMC) and WPP Group (WPPGY) used the same approaches. Why did major problems emerge for IPG and not OMC or WPPGY?
One clue is in the overdue and recently released (9/30/2005) 2004 10K for IPG. In this 414 page report (roughly double the size of a large 10K), the auditor states, "the scope of our work was not sufficient to enable us to express, and we do not express, an opinion..on..internal control over financial reporting as of December 31, 2004." Internal controls are critical as they give rise to the reliability of a financial report. The report goes on to list an unheard of eighteen areas of deficiencies in controls.
Many trace IPG's woes to its rapid growth. During the 1990s, IPG went on an acquisition spree, acquiring over 300 companies. In order to finance these acquisitions, IPG issued ample amounts of stock and also borrowed money. But it was not alone. Omnicom (OMC) and WPP Group (WPPGY) used the same approaches. Why did major problems emerge for IPG and not OMC or WPPGY?
One clue is in the overdue and recently released (9/30/2005) 2004 10K for IPG. In this 414 page report (roughly double the size of a large 10K), the auditor states, "the scope of our work was not sufficient to enable us to express, and we do not express, an opinion..on..internal control over financial reporting as of December 31, 2004." Internal controls are critical as they give rise to the reliability of a financial report. The report goes on to list an unheard of eighteen areas of deficiencies in controls.
Sunday, January 8, 2006
Applaud Higher Payouts to Shareholders
A recent article in the NYT derided the currently higher rate of dividends and stock buybacks, declaring that such shareholder payouts may lower growth opportunities. This points to a common misperception. Many analysts value companies based on their ability to grow earnings. At first blush, this is appropriate. However, earnings growth created without the reinvestment of earnings is much more valuable than the same earnings growth created with the reinvestment of earnings. A simple example is to take identical companies which both make $1,000,000 year after year. One company, call it the "retained earnings" company, decides to put all of its earnings into a savings account earning 5%. As a result of the investment income earned on the savings account, its next year's income is now $1,050,000. The other company, call it the "payout all earnings" company, pays out all of its earnings to shareholders as dividends. Its income stays at $1,000,000.
Analysts typically make the "retained earnings" company more valuable than the "payout all earnings" company by assigning a higher p/e ratio because of the growth in earnings. For example, they could value the "retained earnings" company, at $20,000,000 because the earnings of $1,000,000 are divided by the required return - 10%- less the growth rate - 5%, for a p/e of 20 ($1,000,000/.05). On the other hand, the "payout all earnings" company might be valued at $10,000,000 because the earnings of $1,000,000 are simply divided by the required return - 10%- less the growth rate - 0%, for a p/e of 10 ($1,000,000/.10). Here, the "retained earnings" company is worth twice as much as the "payout earnings" company! (Now visible is one reason CEOs do major acquisitions.) But is the "retained earnings" company really worth more? I think not.
There must be an adjustment made, charging a "cost" to the company for retaining the shareholder's earnings. For example, because I, as a shareholder, do not receive the funds, I could assess a "cost" to the earnings valuation by charging for my lost use of funds. Since I am paying 7.25% for money from the bank, I might charge it to the growth rate, resulting in a denominator of 12.5%, for a p/e of 8 ($1,000,000/.125) and a valuation of $8,000,000 for the "retained earnings" company. Now the "retained earnings" company is now worth 25% less than the "payout all earnings" company rather than twice as much in the earlier analysis - a significant difference.
Analysts typically make the "retained earnings" company more valuable than the "payout all earnings" company by assigning a higher p/e ratio because of the growth in earnings. For example, they could value the "retained earnings" company, at $20,000,000 because the earnings of $1,000,000 are divided by the required return - 10%- less the growth rate - 5%, for a p/e of 20 ($1,000,000/.05). On the other hand, the "payout all earnings" company might be valued at $10,000,000 because the earnings of $1,000,000 are simply divided by the required return - 10%- less the growth rate - 0%, for a p/e of 10 ($1,000,000/.10). Here, the "retained earnings" company is worth twice as much as the "payout earnings" company! (Now visible is one reason CEOs do major acquisitions.) But is the "retained earnings" company really worth more? I think not.
There must be an adjustment made, charging a "cost" to the company for retaining the shareholder's earnings. For example, because I, as a shareholder, do not receive the funds, I could assess a "cost" to the earnings valuation by charging for my lost use of funds. Since I am paying 7.25% for money from the bank, I might charge it to the growth rate, resulting in a denominator of 12.5%, for a p/e of 8 ($1,000,000/.125) and a valuation of $8,000,000 for the "retained earnings" company. Now the "retained earnings" company is now worth 25% less than the "payout all earnings" company rather than twice as much in the earlier analysis - a significant difference.
Saturday, January 7, 2006
Buffett's Prescription for Portfolio-Building
"The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. " 1996 Annual Report, Berkshire Hathaway. Here, Buffett provides a standard for understanding the components of a portfolio. The implicit standard for buying, holding or selling centers around a zone of competence (not preference - an all too common mistake) and not popularity, Federal Reserve behavior, or a Wall Street analyst's opinion.
Pfizer CEO Seems Highly Reactive
Today's front page article in the WSJ highlights challenges faced by the pharmaceutical industry and Pfizer in particular. Purchasing groups, such as insurers and drug benefit managers, are creating structures to encourage patients to utilize lower cost generic alternatives before stepping up to the brand name. This "step therapy" is seen as eroding the pricing power of Pfizer and other major pharmaceuticals. Indeed, it does. But does this capitalistic presence warrant Pfizer CEO McKinnell's statement: "our strategy is to survive this period and survival is the right word" ? No, the world's largest pharmaceutical company with $50 billion in sales, $20 billion of cash equivalents and no debt on its balance sheet has alot going for it. But his statement does reveal what's on his mind - survival - as CEO, that is.
IBM Freezes Pension Plan
IBM's move to freeze its pension plan is significant. Unlike companies reducing benefits because of looming bankruptcy or harsh competitive conditions, IBM has reduced benefits to its employees by $450 to $500 million per year by stating that "it is the prudent, responsible thing to do," while earning over $8 billion last year. The willingness to freeze the plan demonstrates that 1) employees do not adequately understand the value of a pension plan versus a savings plan (a detrimental "out of sight, out of mind" example), 2) companies viewing the problems with the auto manufacturing industry have concluded fixed cost liabilities are too dangerous to maintain and 3) that IBM, which has used its pension assumptions to massage earnings, does not see any more such "rabbits in the hat." (Gretchen Morgenson of the New York Times has written extensively on Big Blue's tricks.)
Subscribe to:
Posts (Atom)