EU Problems with Greece

The wider problem in the EU

Background

The West German constitution of 1948 gave anyone who can establish German heritage the absolute right to claim German citizenship.  When the Berlin Wall came down in 1989, the Federal Republic was faced with the prospect of making good on that promise for millions of Germans who had been trapped behind the wall.

Thus the merger between the former BRD and DDR.  The terms were more political than economic, and were designed to minimize migration from east to west:  massive financial aid from west to east, and exchange of Öst-marks into D-marks at the rate of one to one (the real exchange rate would have been more like seven or eight to one).

The economic result of the reunion of east and west into one Germany was stagnation for the next ten years.  Since Germany is the largest economy in the EU, money policy was set  to lend support to the struggling giant.

This policy stance had a downside:  it sent massive stimulus into faster-growing countries on the periphery, like Ireland and Spain.  Overabundant money not only spurred overall economic activity and raised wage levels, but it also funneled energy disproportionately into domestic demand activities like residential construction and commercial property development.  In many ways, the peripheral countries experienced a variation of the “Dutch disease,”  with the difference that it was money policy and not a natural resource development that spurred the one-sided development.

The financial crisis

The financial crisis popped the speculative property bubbles that had grown up over years in Ireland and Spain.  It has also focused attention on the way Italy has been abusing its EU membership to fund excessive government borrowing.  So the EU had three problem cases.

Recovery of all three economies will likely be drawn-out affairs.  For Italy the question is one of political will.  For Spain and Ireland, the short-term issue is that export-oriented manufacturing has been supplanted by domestic demand-related businesses, especially those linked directly to housing and commercial construction.     Given that housing and construction aren’t going to be such hot businesses in the next year or two, growth will have to depend on export-oriented activities.

The outlook there?  Looking within the EU, Germany has a labor cost advantage and is a net exporter, in any event.  Outside the EU, the competition is China.  Spain and Ireland will gradually return to health, but the emphasis in that thought should probably be on gradually.

And then there’s Greece

Greece is the weakest link in the EU.  As best we know, the country has debt equal to 110% of GDP and a budget deficit of 12.7% of GDP.  These are really bad numbers.  Why the “as best we know” qualification?  Greece had an election late last year that produced a change in the ruling party. The new government discovered and announced that the prior administration had been falsifying the national accounts for years. Who knows whether the accounts we now have are correct or complete?

We know, qualitatively at least, that Greece is the Ireland/Spain problem on steroids, but with a gigantic government sector (over half of GDP) and rigid product and labor markets thrown in.  There’s also a bit of the Italy question mixed in–does a country that cooks the government books so it can act imprudently a while longer have the political will to do the heavy restructuring needed to restore fiscal and trade balance?

Recent developments

Rating services have downgraded Greece to a level below which the country would effectively be barred from issuing euro-denominated debt.

The euro has dropped several percent against other currencies on the worry that Greece will not be able to fix its own problems and will have to be rescued by the rest of the EU.

Speculation has also begun that Greece will seek to leave the EU instead, so that it can devalue its currency and thereby get some quick relief from its economic woes.

Finally, some have extended the thought that Greece will flee the EU to wonder if, say, Italy might not be next on the list of defectors.

My thoughts

None of the “easy” solutions for Greece are likely to bring any resolution to the crisis.  The EU is unlikely to bail Greece out, for fear this would send a signal to, say, Italy that its borrowing can go on unchecked and will ultimately be repaid by more responsible EU members.  Bailout also couldn’t occur, I think, before the EU welded itself into a more cohesive political/economic whole, something member countries and their citizens have shown themselves, in voting on the proposed EU charter, loathe to do.

Leaving the EU would not come without difficult consequences.  Would Greece accept responsibility for its euro-denominated government debt, even though a presumably immediate and large depreciation of the currency would make the burden that much heavier?  or would it default on its obligations and lose access to world credit markets?

“Muddle through,” the current watchword for the US and the UK, will likely become the EU strategy for Greece.  There may be some covert help from stronger EU members or from the EU as a whole.  But the key question will be the level of Greek resolve to set out on the difficult road to economic healing.  We won’t know the answer for several years, I suspect.

Another problem the world didn’t need.



The Mets and the 4Bs–Beltran, Bay, Bengie (Molina) and Bernie (Madoff)

The analyst’s disease is that you can’t stop analyzing, whether it has to do with the stock market or not.

I’ve been struck by what I think is peculiar behavior by the Mets over recent months.

1.  All-Star centerfielder Carlos Beltran just had arthroscopic knee surgery that will likely keep him from playing during the first month of the upcoming season.  The Mets are reportedly upset enough about this, even though Beltran says the Mets gave permission for the operation, to have sent him a letter that would be the first step toward voiding his contract.

Yes, not having Beltran in center field on opening day lessens the chance that the Mets will get off to a good start–and thereby help to fill the (very expensive) seats in their new home, Citi Field.  But Carlos is a superb outfielder.  He plays hard and has played hurt.  What good does it do the Mets to make their displeasure public, other than to embarrass Beltran?  Is the fast start really so important to the Mets that they’ll risk alienating one of their best players?

2. During this offseason, the Mets signed a strong-hitting free agent outfielder, Jason Bay.  Yes, this is great–especially so if the Peter Gammons report that the Red Sox, his former employer, were worried about his long-term health proves incorrect.  But where’s the pitching?

3.  Bengie Molina has just reportedly turned down the Mets offer that had $1 million more in guaranteed money than the one he signed to play for San Francisco this season.

4.  This brings us to the fourth B, Bernie Madoff, a long-time friend of the Mets’ owners, the Wilpon family, and–until his Ponzi scheme was uncovered–holder of season tickets right behind home plate.  Madoff added insult to injury for his victims by commenting after his arrest that he only accepted as clients people he considered not financially astute enough to recognize the implausibility of achieving the financial results he claimed.

There’s no evidence to connect a suddenly more frugal Mets organization to losses they may have suffered from investing with Madoff.  What we do know is this:

1.  The list of 10,000 or so Madoff victims contains over 400 entries for the Wilpon family and about a dozen for the Mets.

2.  Financial journalist Erin Arvedlund, author of a recent book about Madoff, claims the Wilpon family lost as much as $700 million in the Madoff Ponzi scheme, an assertion the Wilpon family strongly denies.

3.  CNBC has reported that the Wilpon/Mets loss could be as high as $300 million.

4.  The court-appointed trustee tasked with recovering Madoff investors’ assets says that two Mets accounts withdrew $47.8 million more than they originally invested.  This isn’t necessarily as good as it sounds, since the trustee may seek to force the Mets to give back the money, since it isn’t investing profit but rather money others deposited with Madoff.

Let’s try to take a rough guess at the Mets’ revenue and expenses (I’ve read or heard some of the numbers.  Others I’m making what I consider reasonable guesses, but they need to be refined with more research.  But I think they’re at least directionally correct.)

Ticket sales for 2009 were reported to be about $115 million.   The club has cut ticket prices by about 10% and season two at Citi Field may draw fewer fans coming just to see the new stadium.  So let’s put 2010 ticket sales at $100 million.  Add $20 million from Citigroup for naming rights and $15 million for profit from food, parking and team merchandise, net of related expenses and stadium operating costs.  Figure that SNY cable TV generates $40 million.   Total:  $175 million.

Let’s take the Mets bill for players’ salary for 2009 as being $150 million.  Add to that $40 million for what amounts to stadium debt service expense and another $10 million for coaching, the minor league system plus administration.   Total:  $200 million.

If these numbers are roughly correct, a $150 million player payroll seems to imply a $25 million loss for the Mets this year, even figuring in cable revenue.  Without that, the loss would be $60 million.

I may be missing some important source of revenue, but if I’m not, the Mets would be in trouble whether it incurred Madoff losses or not.  Madoff losses would only make the problem more pressing, by removing–from either the Madoffs personally or the Mets corporately, or both–a savings cushion that could postpone dealing with the cash shortfall.

In addition, if any money the Mets put aside for deferred payments to players was lost to Madoff, the team’s immediate problem may not be worsened but its long-term financial situation would be.

Transfer pricing–what you need to know about it

What it is

In all but the simplest companies, it often happens that one unit of the firm provides a good or service to another unit, which uses it in a product it sells to the outside world.  In some cases, unit #1 has no customer other than unit #2; likewise, unite #2 may have no other source than the internal one, unit #1.

For management control purposes–figuring out whether the units are earning money or doing a good job in other ways, as well as for other reasons I’ll write about below, companies want to decide a notional price at which unit #1 “sells” its output to unit #1.  That selling price is called the transfer price. The process of figuring out what the price is is transfer pricing.

Three ways companies use transfer pricing–

Management control:

There are lots of ways of figuring out the transfer price, all with their plusses and minuses.

The process can be complicated.  Unit #1, for example, may have external customers as well as internal ones.  Unit #2 may have external sources of supply in addition to the internal one.  However, internal and external customers may have somewhat different requirements, so products available on the open market may not be strictly comparable to the internally produced ones.  So market price may be hard to use.  The competitive situation within an industry may also argue against selling to or buying from certain external parties.  In addition, cost-plus, another common method, may just institutionalize inefficiency.

The process can also be intensely office-political.  This stands to reason, since a dollar of notional profit that goes into the bonus pool of unit #1 is a dollar that stays out of the bonus pool of unit #2, and vice versa.  In well-managed companies, everyone is slightly unhappy and things work out for the best.  In poorly-run firms, internal pricing may reflect the delusions of the chairman or testifies to the infighting skills of the most “profitable” units–an creates horrible distortions that end in ruin.

Tax planning:

Except for the smallest and simplest companies, there’s no reason that different units in the firm have to be in the same tax jurisdiction.  In fact, there may be very good reasons to have them located in different states or different countries.

When I began investing in the Japanese stock market, I soon came across lists of the financial results of foreign brokers located in Tokyo.  Virtually every one was making huge losses.  As I asked around to try to figure out why this should be, I found out that many trading transactions were legally structured to occur in Hong Kong instead of Japan.  Why?  The total tax on profits for a transaction done in Tokyo would be over 50%.  In Hong Kong, the tax would be zero. So Tokyo had the costs of maintaining research, sales, a trading desk and investment banking–and the trades were farmed out to Hong Kong.

At one time, many computer manufacturing operations were set up in Ireland, which offered tax incentives, had a low income tax rate and was inside the EU.  Let’s say you make a PC in Ireland and ship it to the UK (a high tax-rate regime) for sale to a consumer electronics store.  Should you set the transfer price from manufacturing subsidiary to distribution subsidiary high or low?  Obviously, high–unless you had tax loss carryforwards in the UK that you wanted to use up.

You can see the effects of this sort of activity in the low tax rate reported by publicly traded companies with extensive foreign operations.

Twenty years or more ago, investors didn’t like low tax rates.  Theorizing that the phenomenon was only temporary, the custom in the UK was for analysts in their reports to explicitly correct or “normalize” the tax rate to whatever the (higher) norm was for a purely domestic company.  In the US, investors mostly made a mental adjustment and paid a correspondingly low p/e for the stocks of low tax-rate companies.

Today as far as I can see, no one makes this distinction.

There is one hitch to the low tax rate strategy.  For the US, and also typically elsewhere, if the profits held in a low tax-rate regime are repatriated to the home country, they are subject to tax at the full home-country corporate rate.  And unless repatriated, the funds can’t be used to pay dividends.

Foreign exchange controls:

Some countries, developing nations in particular, may regard their holdings of hard foreign currency as a scarce national resource.  So they restrict companies’ ability to convert local currency profits into foreign currency and send them out of the country.

The most straightforward of the ways creative companies try to get around such policies is through transfer pricing.  A foreign company with a subsidiary in a developing economy will typically act as the sole agent for purchases of foreign materials and equipment for its sub, as well as being the distributor of its finished goods abroad.  The parent can aggressively mark up the foreign currency price of the materials supplied to the domestic company.  And the local sub will sell finished goods at very low prices to the parent, so that the lion’s share of profits will be realized in hard currency and outside the developing nation.

The financial crisis–where are the indictments?

Something to keep watch on out of the corner of one eye–investigation of the financial crisis

Nothing much done so far…

To me anyway, one of the most striking aspects of the current financial crisis has been the lack of interest–so far–in investigating and prosecuting any possible illegal activity by banks or bankers that ended up putting us in the weakened financial condition we now find ourselves in.  Why has no one been held accountable?

Areas of possible investigation are numerous.  Who, if anyone, for example, falsified loan applications that allowed unqualified borrowers to purchase houses they couldn’t pay for?  What supervisors encouraged the process?  What did the people know who created the derivatives that exported the problems to other institutions?  What did they tell the counterparties?

How did the financial industry accumulate such large off-balance sheet liabilities of very low quality, in what seems like a large-scale repeat of the Enron debacle?

Who inside Bank of America decided to withhold the truth about Merrill Lynch’s weak financial condition from shareholders who were voting on the proposed merger?  Why was the SEC so eager to brush this under the rug?

How could Bear Stearns file a 10-K for 2007 showing $60+ in book value and be insolvent a few months later?  What about Lehman?  AIG?

…in contrast to the junk bond scandal

In the junk bond of the late Eighties, in contrast, Michael Milken was quickly called to task.  Prominent portfolio managers, if not jailed, were at least removed from their positions and barred from the investment industry.

The public wants an accounting…

Although they may not be able to cite details, the average citizen realizes that there is something wrong if millions have lost their jobs, their houses and their savings, yet the bankers who caused the problems are not only still employed but enjoying record paydays.  It isn’t that they’re rich that bothers people–after all, no one is angry at Bill Gates or Sergey Brin–but that the bankers have abused a semi-monopoly position to do untold economic harm to the country, yet they’re riding higher than ever.

People also can’t help but notice, as Robert Reich recently pointed out, that the banking lobby has contributed close to $400 million to Congress over the past year, most of that to legislators directly involved in policing the banking industry.  And if an incumbent’s constituents somehow aren’t aware, a challenger will be more than happy to enlighten them.

…and the political winds may be changing

The SEC, once apparently eager to cover up the BofA/Merrill affair, has recently filed additional charges.  And it has just begun a probe of collateralized debt obligations.  Why the interest now?

My guess is that Congress, deeply responsible for the financial crisis on both sides of the aisle, hoped that public anger would dissipate.  But it hasn’t.  If anything, the large profits banks are now making, and the huge bonuses they are paying to executives whose ineptitude caused the banking collapse, have fanned the flames of public discontent.

So the calculus of risk has changed.  Better to take the chance of being implicated through an investigation than to have the near-certainty of voter retribution if they do nothing.

Why this may matter

Throughout my career, I’ve thought that politics had a lot in common with sports.  That is, both are interesting, entertaining, but basically irrelevant for investors.  Under most conditions, gridlock would be the most probable, and also the best outcome one could hope for.

I now worry that as a country we’re deeply enough in debt that we can’t afford to suffer much more damage at the hands of Washington.  We could also get wholesale turnover in Congress next November if people stay (justifiably) angry about lack of action to prevent a new financial crisis, with unpredictable consequences.

Would we be better off with a bunch of new people who think natural resource companies should be nationalized so that somehow that would lower prices?  What would we do if we ended up with a crowd that thought we should let neighbors die of starvation/lack of medical care because their great grandfathers made a declaration of independence from Europe (thereby entering a pact with the devil).  I don’t know.  And uncertainty breeds lower prices.

Intel’s December 2009 quarter–exceptionally strong

INTC’s results

INTC reported results for its December 2009 quarter after the market closed last Thursday.

Revenues of $10.6 billion exceeded the high end of the company’s guidance and came within a whisker of equalling its December 2007 high-water mark.  Earnings per share of $.40 exceeded both consensus estimates of $.30 and the 2007 level of $.38.  Gross margin of 65% was an all-time record.

Ex charges for settling an intellectual property licensing suit with AMD, Intel earned $.55 for the quarter.

These are extremely impressive figures.

Intel also upped its guidance for first-quarter 2010 revenue from $9.4 billion to $9.7 billion and suggested that it expected 10%+ revenue growth for full year 2010.  This expectation, which I think is conservative, would imply earnings per share for the company in the $1.60-$1.70 range.

The details:

Strength was primarily in consumer demand.  The Americas and Asia-Pacific, up 15%  and 12% quarter on quarter respectively, were the stars.  Japan, up 8%, and Europe, +15%, lagged slightly behind their historical patterns.  Overall, quarter on quarter growth was about 2x the seasonal norm.

Among product categories, notebooks showed the sharpest growth.  Servers were also strong, with demand shifting to the higher (and more profitable) end.

Atom chips for netbooks became a $1.4 billion business for INTC during 2009.  Quarter on quarter growth was only 6%, suggesting (to me, anyway) that demand is starting to flatten out.  INTC made two interesting remarks about Atom, however:

1.  the company has studied the buyers of Atom-driven devices carefully and has detected virtually no cannibalization of traditional notebooks to date.

2.  until recently, typical buyers have been in the developed world and have wanted a second, simple, light device–often to replace a traditional laptop while traveling.  During the December quarter, however, 25% of purchases have been by telecom operators, for to give to customers purchasing a cell data contract.  INTC expects that this kind of purchase will quickly become mainstream, especially in the developing world.

Sell-through has matched sell-in closely.  INTC can see very clearly what is happening in customer businesses representing about 70% of sales.  While there was some inventory buildup from sub-normal levels during the quarter, as far as INTC can see, its results accurately represent end-user demand (rather than stockpiling by distributors or OEMs).

INTC now only expects a modest uptick in sales to corporations during 2010, as users replace the aging Windows XP with Windows 7.  This seems to me to be a change from the company’s prior belief that the shift would be rapid, because XP is so old and the costs of maintaining now-antiquated four-and five-year old PCs are so high.  Slow adoption would be the norm, as corporate data center managers wait for the bugs in new MSFT software to be found and fixed before they shift from an older system.  Likely?  See below.

After five years of slimming down, the company is starting to expand staff again.

My thoughts

I’m not an INTC expert, so take some of what I say with a grain of salt.

The current management of the company impresses me much more than I had expected when I started monitoring INTC a few months ago.  I still have a lot to learn, but I no longer consider it the corporate dinosaur I thought it has been for the past ten years or more.

INTC has somehow made the shift from an older generation of chips made with spacing between parts of 45 billionths of a meter to newer ones with 32 nanometer spacing, while spending less than its depreciation.  True, INTC is reclassifying some expenditures as research and development, but I find this still a startling achievement.

According to MarketWatch, the consensus earnings estimate for INTC for 2010 is $1.53 a share.  That’s a lot too low, I think.  If corporate PC purchases exceed INTC’s now-modest projection, even my $1.70 could prove low.  It may well be that the largest companies, citing security issues, will move with customary caution, but my guess is that smaller concerns won’t wait.

In response to an analyst’s question on the conference call, INTC pointed out that its strongest growth has been coming from emerging markets for years.  Who wasn’t aware of this? –at least one professional tech analyst covering INTC, implying that the scope for positive earnings surprise may be larger than I would have imagined.

Yes, there are warts.  The fourth-quarter tax rate is very low.  More important, it’s not clear to me how INTC will fare in an increasingly smartphone, e-reader world.  But at 12x this year’s earnings and a 3% prospective dividend yield, it doesn’t seem to me that there’s a lot of downside risk.  And if the management is as smart as I suspect it may be, INTC may well adapt to a new operating environment more easily than most expect.

Google, China and Rupert Murdoch

From Kant to Mao…

In the late eighteenth-early nineteenth century, thinkers in continental Europe began to shift from explaining the world as a well-made watch (basically static, “what you see is what you get”) to a biological metaphor that pictured the world as a growing, evolving organism.  They also started to worry that “common sense” experience might not be the open book everyone thought, but instead might contain deliberate deceptions of the unconscious mind.

Karl Marx developed the latter trains of thought into a theory of the evolutionary development of political forms culminating in a paradise of social and economic equality for all.  Lenin added the fillip that if the downtrodden masses weren’t traveling fast enough on the road to socialism, it would be ok for the Communist Party to speed the process up in any way–including lots and lots of violence– it could. (Yes, pretty simple-minded for today’s tastes.  But, for what it’s worth, replace “socialism” with “democracy” and you have the US neo-conservative position on the Middle East.)

For China, the last surviving overt bastion of this point of view, the Party is the guardian of truth; everything, including the communication of information, is politics.  The US, neo-cons aside, has pretty much stuck with the older idea that there’s a self-evident objective reality,  and a “right” way of doing things that everyone is capable of  figuring out by himself.

…to Google in China

This brings us to Google’s entrance into China.  On the one hand, China’s a huge, fast growing market.  On the other, as the price of entry into a media business there (every country in the world regards media as a strategically important field), Beijing required that Google allow search results to be censored–so, that searches like “Tiananmen Square massacre” or “Dalai Lama,” which might cast the Communist Party in an unfavorable light, would come up empty.

Google agreed to China’s conditions.  But the company also decided to host all its email from outside China, so that the government couldn’t simply get email data by physically grabbing the servers.  Gmail quickly became a favorite for human rights activists (though Beijing would probably describe them as political criminals instead).  In recent months, those accounts have been the focus of cyberspace attacks emanating from China.  A couple of days ago, Google finally got fed up and threatened to close up shop and leave China, despite its enormous  profit potential.  What it’s fed up about is less than clear.  My guess is that Google’s fear is that China’s next step will be to try to seize Google’s analysis of users’ search histories and patterns.

Should Google have expected any different treatment from what it has received?  It might have hoped for something different, but expected? –no.  From the earliest days of adopting the capitalist economic system, China made it clear that it was doing so because there was no other choice.  The economy was too big and too complex for central planning to work any more.

But China made it equally clear that this new freedom did not extend to politics, where the Party would remain supreme.  In particular, the government’s deepest fear has always been social unrest.  Anything that would lead citizens to question the party’s moral authority is forbidden.  After all, the Party is the group of visionaries that is leading the way to socialism.

Google’s stance is thoroughly American

I find something pleasingly American in Google’s position–the idea that the individual has “inalienable rights” apart from the group he is a member of.

This can’t be simply naivete

The US has a long history of rabidly partisan tabloid journalism.  In fact, News Corp., the greatest proponent in the English-speaking world (maybe the entire globe) of communication as a form of propagandizing, has been very active in US media for many years.  Writers for the Wall Street Journal, for example, have been complaining that since the News Corp. takeover the editing process now involves deleting references to Republican shortcomings and adding a double dose of Democratic miscues.  Taking a page–whether wittingly or not I’m not sure–from Lenin’s playbook, Fox News styles itself as “Fair & Balanced,” implying its rivals are not.  News has even spawned a (pale) imitator to its cable offerings from the left in MSNBC.  I’m not a particular fan of Mr. Murdoch or of Fox, but in a certain way you have to admire them both.

Yes, making itself a forum for a Republican point of view has made Fox News immensely profitable and has given it tremendous political clout.  But unlike the case in China, if you don’t already know this, you can easily find out from a rival publication–where, as in the citation above, you can also learn how Fox shapes the facts to fit its political bent.  Also, you won’t find the police at your door to arrest you for watching news on a non-Fox channel.  And I’ll still be blogging next week, as well.

What is it then?

My guess is that the optimists inside Google thought of the Communist Party in China as Murdoch writ somewhat larger.  They’ve now discovered their mistake and how different the political system there is.  Leaving is probably Google’s best option.