Monday, April 24, 2006

Dow Jones's Glass House

Dow Jones’s Wall Street Journal had itself a good chuckle last Saturday at the New York Times’ expense. This brought to mind the saying that those who live in glass houses shouldn’t throw stones.

In case you missed it, the Journal’s breakingviews section hosted an imaginary exchange of letters between Henry Kravis and the New York Times’ Arthur Sulzberger, Jr. Here’s one of my favorite parts of the imaginary Kravis epistle discoursing on Sulzberger’s business challenges:
Investors just hate the sector. The S&P publishing index is down 20% in two years. Your shares have done a lot worse -- down by nearly half. Part of the problem is that you want to run this business for the long term, as your family has since 1896.

That is hard when you have aggressive outside shareholders snapping at you. Your dual-share structure gives you some protection. With just a sliver of equity, your family controls nine of 13 board seats. Not many executives can boast of such insulation from the vagaries of pesky stockholders.

Not many, that is, except for the Wall Street Journal’s parent, Dow Jones. Dow Jones’s Class B shares offer a similar degree of insulation from economic reality. According to its most recent proxy statement, the Bancroft family controls 13.3% of Dow Jones common and 76.5% of the Class B accounting for 61.7% of the Common and Class B voting power. And Dow Jones’s board is full of dicey family relationships, including:

  • Christopher Bancroft of the founding Bancroft family who owns 18.7% of the Class B shares and 293,000 shares of Dow Jones common;
  • Michael Elefante, a partner at Hemenway & Barnes, the Bancroft’s trustee, which controls 27.9% of the Class B shares and 5.7% of Dow Jones common;
  • Elizabeth Steele, Chris Bancroft’s first cousin, who owns 7.8% of the Class B shares and 3% of Dow Jones common; and
  • Leslie Hill, an airline pilot and first cousin, once removed, of Bancroft and Steele, who owns 131,000 common shares and 79,504 Class B shares.

And it’s more than a little curious that Dow Jones’ Corporate Governance Committee includes Hill, Steele, and Elefante. How about keeping these coupon clippers away from governance altogether?

Moreover, Dow Jones’s stock market and financial performance is nothing to boast about. To wit,

  • Stock price. In the last five years, Dow Jones’ common fell 33% compared to a somewhat more dismal 40% for New York Times Class A;
  • Revenue. In the last five years, Dow Jones’ revenue declined at 3.6% average annual rate to $1.8 billion, pretty lame compared to the New York Times whose revenues crept up at a 0.4% average annual rate to $3.4 billion;
  • Net Income. In the last 12 months, Dow Jones earned a paltry $60 million in net income compared to $267 million for the New York Times; and
  • Net margin. In the last 12 months, Dow Jones’s net margin was a thin 3.4% -- roughly half the New York Times’ 7.9%.

I’m all for stripping away the dual-share structures that keep newspapers from competing effectively and maximizing common shareholder value. I just find it ironic that Dow Jones fails to apply the same snarkiness to its own clunky governance as it does to its rivals’.

Friday, April 21, 2006

Confirmation bias in politics and business

I keep seeing confirmation bias -- the notion that decision makers seek out information that's consistent with their beliefs and ignore information inconsistent with them. This is of more than academic interest. For example, if you're competing with a company and you know the CEO's biases, then you can more easily predict the competitor's behavior. This predictability can help you craft strategies which exploit the gap between reality and the CEO's biases.

The best recent example of confirmation bias in politics is the decision to go to war in Iraq. According to a leading CIA officer in Europe during the run-up to the war, the administration met with a leading Iraqi foreign minister, Naji Sabri, who told the White House that Iraq did not have weapons of mass destruction. After meeting with the source, the White House lost interest in him. According to the CIA officer,

They didn't want any additional data from Sabri because, "The policy was set. The war in Iraq was coming and they were looking for intelligence to fit into the policy."

Yesterday's New York Times gives a business example -- highlighting the confirmation bias of Enron's Jeff Skilling:

Mr. Skilling's testimony revealed that he increasingly sought validation for what he believed, rather than listening carefully when he was told about problems at the company.

In June 2001, one day before he flew to San Francisco to give a speech, Mr. Skilling sought assurances that everything happening in California's newly deregulated electricity market was on the up and up. Enron has to be "absolutely pure as the driven snow," Mr. Skilling told Richard Sanders, then an Enron lawyer. "So one more time," he said. "We're pure as the driven snow, right?"

A lawyer then told Mr. Skilling about the strategies that traders had used, many of them later found to have contributed to manipulating the market. Mr. Skilling felt comforted that the problems had been handled, he testified this week. Mr. Sanders assured Mr. Skilling that the lawyers had ordered the tactics stopped as soon as they were discovered. "O.K.," Mr. Skilling said. "So we're as pure as the driven snow?"

It does not surprise me that the White House and Skillings operated this way. What would surprise me is to find a leader who does not.

Tuesday, April 18, 2006

Sandy's flawed farewell

Sandy Weill retires from Citicorp today. He leaves with all the trappings of a successful New York business career – over a billion in stock, admired philanthropy, and fawning press -- but the core business concept that drove his career – one-stop shopping for financial services -- is fundamentally flawed.

Weill pioneered the idea that consumers would buy all their financial services – banking, stock brokerage, mutual funds and insurance – from a single provider. To put that idea into practice, he acquired the pieces and put them under the same corporate parent. He did this first by acquiring a string of brokerage firms and merging them with American Express. When it turned out that Weill and Amex CEO James Dixon Robinson, III mixed like chalk and cheese, Weill was tossed out. A down but not out Weill started over again with Commercial Credit, a Baltimore consumer lender, which he used to buy Primerica and Travelers – ultimately merging with Citicorp in a $70B merger.

Weill’s weakness was not in doing the deals but in making the concept of one-stop-shopping work. The problems are legion:

  • Lack of consumer demand. Consumers don’t want one firm to have control of all their financial assets and liabilities – viewing such concentration as unnecessarily risky;
  • Enormous systems challenges. Cross-selling, say, insurance to a banking customer requires systems that keep a single view of all the customer’s relationships with the institution. These systems are hugely expensive and time-consuming to build;
  • Territoriality. Moreover, the banker in charge of that customer fears that the insurance sales person could upset the relationship with that customer – cutting into the banker’s livelihood; and
  • Training. If the institution tries to solve this problem by making one salesperson responsible for all the customer relationships, there’s a huge training cost needed to make that single salesperson knowledgeable in all the products.

And the proof of these flaws is in the pudding. From a stock market and financial perspective, Citigroup has not exactly dominated the dojo. For example,

  • Below average shareholder value. Compared to its peers, Citigroup’s 360% stock price increase over the last decade is below the 390% average of its peers. Lehman Brothers, for example, has seen its stock rise 11-fold during the period. And over the last year, Citigroup’s stock is up just 5% compared to a 34.3% average for its peers;
  • Flat revenue. Over the last five years, Citigroup has increased revenue an anemic 0.8% annual average compared to a 3.9% growth for its peers. Bank of America’s revenues during the period climbed an average 7.8% per year;
  • Below average profit growth. Over the last five years, Citigroup has increased net income a respectable 11% annual average – but this falls short of the 15.4% growth for its peers. Merrill Lynch net income during the period increased an average 24.6% per year; and
  • Below average productivity. Citigroup’s sales per employee were a respectable $857,143 in 2005, which falls short of the $1,081,169 average of its peers. And Citigroup’s performance falls way short of Goldman Sachs’ $2,260,870.

Weill will enjoy a comfortable retirement. However, due to his flawed one-stop-shopping concept, smaller shareholders won’t be able to use Citigroup’s stock to do the same.

Monday, April 17, 2006

India's winning ways

This morning the stock prices of India-based computer services companies are rising fast. Infosys (INFY) +5.9%, Satyam Computer Services (SAY) +4.3%, Wipro Technologies (WIT) +4.3% and Cognizant Technologies (CTSH) up $2.53 to a fresh 52-week high above $61.22.

These stock price increases are certainly justified by financial performance. These Indian players are growing six times faster than the computer services industry while earning four times the profits. Since corporations are looking to get more out of their computer services providers while spending less, the simple solution has been to hire India-based IT services providers. The demand for such providers has grown almost six times faster than the industry. For example, the 2002 NASSCOM-McKinsey Report estimated that the Indian software and service industry generated $15.5 billion in 2004 revenues and is expected to grow at a 34% compound annual growth rate to $50 billion by 2008.

The key factors that are expected to contribute to this growth are:
  • High service quality. Indian companies have developed high quality delivery processes. For example, a 2004 NASSCOM survey of international quality standards of the top 275 Indian IT services companies reported that 195 companies had acquired International Standards Organization (ISO) 9000 quality certification. According to NASSCOM, during 2004, 74 Indian companies received a level five assessment under SEI-CMM, developed by the Carnegie Mellon University. Level five is the highest level attainable under the SEI-CMM standards, which assess an organization’s quality management system and systems engineering processes and methodologies;
  • Large supply of English-speaking IT professionals. In the view of Satyam Computer Services’ management, India ranks second to the US as the country with the largest population of English-speaking IT professionals. According to the NASSCOM Strategic Review 2004, educational institutes in India produce 290,000 engineering students and 139,000 computer software engineers each year. Given the shortage of technical labor in the US, India’s ability to produce so many technically trained people is a source of competitive advantage for Indian IT service companies; and
  • Significant cost advantage. The cost of employing IT professionals in India is significantly lower than in the United States. For example, A NASSCOM study estimates that India enjoys a 25% to 50% cost advantage over US-based IT services firms.

Peter S. Cohan & Associates recently compared US and India-based computer services firms. A comparison of EDS and Cognizant from that study is a case in point. At the core of Cognizant’s advantage is a much lower average cost per employee. In particular, Cognizant, at $19,689 per employee, spends 16% of EDS’s $98,707. This cost advantage enables Cognizant to outperform EDS on every statistic that matters. In particular, in 2005 Cognizant

  • Grew sales at a 34% annual rate while EDS’s shrank 4.5%;
  • Boosted profits 40% while EDS’s fell 5.4%;
  • Increased its stock market value 49.3% while EDS put in a respectable 35.4% increase;
  • Earned net income of $6,831 per employee, over five times the $1,281 that EDS earned;
  • Generated a gross margin of 46% compared to a paltry 19% for EDS; and
  • Sported a net profit margin of 18.7% compared to a razor thin 0.8% for EDS.

If India can continue to enjoy these enormous cost advantages while enhancing its service quality, it will continue to outsell and out-earn its global competitors.

Saturday, April 01, 2006

Time to pay the piper

Two-thirds of GDP growth is spurred by consumer spending. Over the last several years, that consumer spending has come largely from consumers borrowing on their credit cards and through home equity loans.

As long as the value of homes has risen and credit card interest rates have remained reasonable relative to borrowers’ incomes, consumer spending has continued to drive forward the economy.

But there is a downside to all this borrowing and spending. The Fed feels compelled to control inflation. And it has tried to do so by raising interest rates 15 times in the last several years. This raising of interest rates is beginning to reverse the direction of the housing market. And as the housing market experiences greater supply than demand, housing price increases have slowed. Thus the ability of consumers to borrow more money against the value of their homes has evaporated.

Moreover, with roughly a quarter of all mortgages in the adjustable rate category, consumers will find themselves paying more for their monthly mortgage payments when the mortgage rates reset over the next couple of years. The reset is likely to happen even as the value of the homes, which banks use as collateral for the mortgages. declines.

As home foreclosures continue to rise, banks are likely to sell these homes quickly to minimize their bad loan write-offs. This sudden addition to the supply of real estate is likely to create further downward pressure on real estate prices.

What will be the source of future economic growth? The answer depends on where you sit. For consumers, there will not be economic growth. Anyone working in the US automobile industry faces job and wage cuts with limited opportunities for future employment. And anyone who in the past depended on rising real estate prices to pay for healthcare, home heating and cooling, and gasoline will need to cut back.

By contrast, these are the best of times for private equity firms who have been able to use debt to finance the acquisition -- at a discount – of divisions of underperforming corporations, such as GM, spruce them up and sell them at a profit to public shareholders, corporations, or other private equity firms.

Economic history aptly demonstrates that growth based on borrowing is short-lived and has dire consequences. By contrast, economic growth based on innovation leading to an expanded supply of equity can spur new industries, create new jobs, and enable more workers to become entrepreneurs.

The current decade’s growth has been driven by borrowing. And the odds are good that we will see in the next five years many of debt’s negative consequences.