Monthly Archives: May 2011

Goldman’s trading “huddles” are back in the news again

May 13, 2011 By in Getting financial advice, Investment firms, Trading, Where are the customers' yachts? Tags: , , , , , , Leave a comment

Reuters reported on Tuesday that the Massachusetts Securities Division is considering administrative proceedings against GS for its conduct in weekly meetings of analysts and traders, called “huddles.”

I wrote about the Goldman huddles when the news first broke a little less than two years ago, so you can read more detail in that post.  It’s not clear whether the meetings still go on, but when the Wall Street Journal revealed their existence, the huddles were weekly get-togethers of GS’s analysts and proprietary traders.  Their purpose was to develop short-term trading ideas involving stocks GS analysts covered.

The issue is how the results, which sometimes ran contrary to the recommendations in GS’s published research, were disseminated.  GS apparently used them in its own trading.  Institutional salesmen privy to the meetings’ output passed the ideas on to a small number of the firms largest clients.  However, GS didn’t inform the rest of its customers, who were left to act on an official “buy” recommendation when favored clients were being told to “sell.”

Massachusetts has long been a leader in sticking up for the rights of ordinary citizens in financial matters, so this is an interesting situation.  I don’t think the case is as open and shut, however, as, say, the Raj Rajaratnam insider trading case was.  Three reasons:

1.  Every GS research report contains several pages of disclosure in small print at the end (I’ve checked).   Sometimes the disclosure section is longer than the report.  But the fact that GS may act against its official recommendations and tell different things to different clients is among them.

2.  According to the WSJ, analysts were “guided” not to utter the words “buy” or “sell” in the meetings.  So while circumlocutions may have made it clear what the conclusions arrived at in the meetings might have been, establishing that in court might be hard.

3.  GS equity research really isn’t that good, in my opinion.  Its strength has always been the collection of large amounts of factual information about companies and industries.  Its weakness is analysts’ judgment.  And the firm has slipped badly in the annual research department rankings by the Institutional Investor magazine, among others, in recent years.  So GIGO might be another defense.

One other note:  the Reuters article refers to the recently-issued GS 10Q.  Footnote 27 to the financial statements mentions in a general way GS discussions with the Massachusetts regulator.  Either the Reuters reporter is incredibly observant, or someone (the regulator?) called her attention to it.  Can it be that what we’re seeing are the first steps in a systematic investigation by regulators of Wall Street behavior before and during the financial crisis?

Disney’s eventful 2Q11 (ended 4/2/11)

May 12, 2011 By in Current Market Thoughts, earnings conference calls, Entertainment, Industry Analysis, internet, Lodging, Retail, Stock ideas Tags: , , , , , , , , Leave a comment

the results

After the close of trading in New York on Tuesday May 10th, DIS reported financial results from its 2Q11, which ended on April 2nd.  The company posted earnings per share of $.49, up 2% year on year, on revenues of $9.1 billion, up 6%.  This compares with brokerage house analysts’ consensus of $.56 a share.  The stock fell by 5.4% on Wednesday, as a result.

the details

DIS’s accounting is complicated, both because the company is a conglomerate and because it’s in the entertainment business, where bookkeeping conventions are really convoluted.  Nevertheless, here goes:

media networks

Led as usual by ESPN, operating income from cable was up 15% year on year for the three months, at $1.357 billion.  Broadcasting gained 36%, posting profits of $167 million.  The $1.524 billion Media Networks earned represents more than three-quarters of DIS’s operating income for the quarter.

parks and resorts

Operating income from Parks and Resorts was $145 million for 2Q11, down by $5 million from the year-ago period.

Two special factors influence the comparison.

–Royalty income from Tokyo Disneyland, which is essentially pure profit (and which I’ve never really paid attention to), was lost for the 20 days Tokyo Disneyland was closed after the devastating earthquake/tsunamis in Fukushima prefecture on March 11th.  As a rough guess, I’d say the closing reduced DIS’s operating income by $20 million (DIS management said in its conference call that lost royalties and Disney Store income amounted to $25 million, but didn’t break out the two components.)

–In addition, only one week of the highly profitable Easter/Spring Break period fell in 2Q11 versus both weeks in 2Q10.  The Easter calendar shift represents a difference of $23 million in the year on year comparison.

On an apples-to-apples basis, I think operating income from Parks and Resorts would have been up by 25%.

studio entertainment

Operating income was $77 million for the quarter, down 65% year on year.  Mars Needs Moms, a leftover from former Studio management. Need I say more?  I will, anyway.  Box Office Mojo estimates the film, released on March 11, cost $150 million to make.  Rotten Tomatoes rated it 35 out of 100.  Through May 8th, its worldwide box office was just under $21 million, according to BOM.  Ugh!

Before this, I had thought that the recently installed Studio head had thoroughly cleaned house last year, so that nothing like this could happen again.  From what I’ve read, however, it seems holdover executives defended MNM fiercely enough that it got made.  If I understand correctly, the damage to the quarter from Mars Needs Moms, other than that no revenue to speak of came in, is $50 million spent to promote it and a $20 million writedown of the film’s balance sheet carrying value.  DIS management implied that it had already taken prior writedowns of MNM in earlier quarters. Hopefully, this is the last we hear of the film.

consumer products

Operating income was up 7% year on year at $142 million.  If I’m correct about a $5 million Disney Store loss in Japan (the number could be too high), ex-Japan, profits would have been up by 10%.  Not great, but not so bad.

interactive media

DIS lost $115 million on the operating line in 2Q11, a little more than 2x the deficit this time last year.  The larger red-ink figures come primarily from the acquisition of Playdom last year.  $34 million represents an ongoing quarterly writeoff of part of the acquisition cost.  The rest of the increase seems to come from DIS working out that Playdom games weren’t quite ready for prime time and needed considerable polishing.

2H11?–more moving parts

–On the film front, Thor was released last week; worldwide box office through May 10th is $266 million, according to BOM.   Although neither the New York Times  nor the Wall Street Journal liked this one, Rotten Tomatoes rates it a solid 79. 

Pirates of the Caribbean: Stranger Shores opens on May 20th. 

Cars II debuts on June 24th.

All three promise good news for Studio Entertainment in 3Q11.  How good in terms of earnings will depend on what assumptions DIS has about the ability of these movies to sell DVDs–that will be the key determinant of how each movie’s costs are allocated against revenue.

–Life in Japan is gradually returning to normal.  But citizens are questioning whether to exercise self-restraint (jishuku) in consumption as a way of showing solidarity with those in Fukushima.  The mayor of Tokyo, for example, is strongly in favor of jishuku.  It’s unclear how Tokyo Disneyland or Disney stores in Japan will be affected.

–DIS’s cable contracts call for higher levels of payment by affiliates to DIS once specified performance levels are achieved.  DIS met these targets last year during 3Q, which is unusually early.  It will likely not trigger some this year until 4Q.  For the full year, DIS thinks affiliate revenue recognition will be up by $17 million year on year.  But the payment recognition pattern will be:  $228 million down year on year in 3Q and $245 million up in 4Q.

–3Q will contain one week of Easter/Spring Break, meaning about a $25 million boost to Parks and Resorts revenue.

–finally, although the ad market is booming, comparisons in the second half, which contained a lot of political spending last year, get tougher.

EPS for the second half?  If someone forced me to make a guess, I’d say $.70 in each of 3Q and 4Q, giving about $2.60 for the fiscal year.  I’d pencil in $3.00-$3.25 for fiscal 2012.  But a lot depends on how well DIS’s series of potential blockbuster films actually delivers.

stepping back a bit

It’s easy to get lost in the twists and turns of DIS’s complex financial reporting.  Looking in a more general way, we know that:

–the advertising market is booming and that ESPN is going from strength to strength.

–The parks are rebounding, as the world economy recovers, although jishuku may retard progress in Japan until fiscal 2012.

–If we’re lucky, the film business has had its last real clunker–and of course Mars Needs Moms may never be surpassed on the downside.

–And an optimist might hope that Interactive Media may draw close to breakeven, as promised by DIS management, by fiscal 2013.

The biggest near-term risk is that labor disputes in the NFL and NBA reduce ESPN’s viewership.  DIS argues that it can substitute NCAA sports, if necessary, and remain relatively unscathed.  I’m not convinced.  I’m not saying DIS management is wrong.  I’m saying that for now I don’t want to bet.

If one could put that concern aside, DIS is set to grow at about a 15% rate over the next few years and is trading at about 16x this fiscal year’s earnings and around 13x fiscal 2012’s.  The stock’s valuation doesn’t seem excessive to me, but I’d prefer to be a buyer on weakness.  (Remember, though, that I’ve sold my stock at about this level, so my conclusion could have an element of wishful thinking in it.  But I am concerned that strikes by professional football and basketball players could have a significant negative effect on ESPN, despite DIS management’s analysis of the situation.)


initial thoughts on Microsoft/Skype

May 11, 2011 By in Current Market Thoughts, Industry Analysis, internet, Private equity, Recent Market Action, Stock ideas, Technology Tags: , , , , , , Leave a comment

the purchase

Yesterday, May 10th, MSFT announced it had agreed to buy Skype from its private equity owners for $8.5 billion in cash.

a little history

If you recall, e-Bay bought Skype from its founders–who opened up for business in 2003–for a total of $3.1 billion ($2.6 billion up front, an additional $500 million in incentive payments) in 2005.  The idea was that free phone calls between seller and bidder would somehow boost e-Bay’s online auction business.  That didn’t work.  In 2009, after Meg Whitman was ushered out of the company and new management began to clean up, e-Bay tried to sell Skype.  Only then did it learn that Ms. Whitman had neglected to secure the basic intellectual property behind the internet phone service (whoops!).   But e-Bay eventually managed to sell roughly 70% to Silver Lake for a price that valued the whole company at $2.8 billion (Silver Lake did manage to acquire the IP from Skype’s founders).

After freeing itself from the “bureaucratic mess” of e-Bay, as the New York Times reported, quoting a Skype blogger, the company dusted itself off, filed for an IPO about eight months later and simultaneously began exploring the possibility of a private sale.

Enter MSFT, which intends to link Skype to its e-mail, X-Box and office collaboration offerings on the idea that this will make them all more attractive.

This will be the largest purchase for MSFT ever, though not its highest-ever offer.  Remember, MSFT made an unsuccessful $44+ billion bid for YHOO in 2008.  In that instance, the YHOO board (strangely, given the firm’s operational difficulties) rejected the $31 a share offer, which was at about a 60% premium to the pre-bid price.  The S&P 500 is about flat since that time.  YHOO has  new CEO and is now trading at just under $19.

why Skype?

Skype is probably not the purchase you or I would make if we had a loose $8.5 billion lying around.  I don’t think it’s one that GOOG would make  …or AAPL   …or WMT.  In addition, as far as I can see, MSFT had no interest in Skype when it was in the process of being sold for less than $3 billion a year and a half ago–which for me is the most troubling part of the deal.

But the acquisition may not be as bad as it looks on the surface.  It also gives you insight, I think, into what MSFT sees as its best viable investment options.  To elaborate:

foreign earnings

1.  Like many US-based international companies, MSFT has a ton of profits it has earned overseas that are lying around in low-yielding offshore bank accounts.  There are two reasons for this:

—economically, repatriating these earnings to the US would subject them to federal income tax at a rate of 35% minus any foreign tax paid.  Since the funds are presumably in low- or no-tax jurisdictions, a company returning the funds to the US would have to fork over a third of the money to Uncle Sam. Why do it without a clear domestic need for the money?  Suppose you repatriated a large amount, paid tax and then figured out you wanted to use it for an acquisition abroad?  Better to keep your options open.

—financially, unrepatriated funds can’t be used to pay dividends to US shareholders.  So in some sense, this money is not worth 100 cents on the dollar to US shareholders.  A generation ago Wall Street would have worried about this and applied a discount PE multiple to low-tax foreign earnings.  No more.  Today’s investors seem to me to be indifferent to the tax rate a company pays.  They capitalize all after-tax earnings at the same rate.  So in today’s world, repatriating funds, which lowers reported eps, lowers the stock price as well.   …another reason not to do it.

If we assume MSFT will pay for Skype with money marooned in a zero tax rate jurisdiction, then paying $8.5 billion for Skype in Luxumburg is like paying $5.5 billion in the US.

a quick-and-dirty payback analysis

2.  In an interview with Forbes, Silver Lake says that if MSFT manages Skype well, it could eventually be worth $25 billion-$30 billion.  (Huh?  If this is the case, why in the world are they selling 100% of what they own?)

Let’s assume, just for the sake of argument, that Skype, which is around breakeven in its seventh year of operation and has only 8 million paid users, somehow grows profits in a linear fashion to $500 million five years from now and $1 billion in ten years, before earnings flatten out but continue at the $1 billion a year level.  Let’s also assume that MSFT doesn’t spend a penny integrating Skype into its software offerings.  How long does it take MSFT to recover its $8.5 billion?

The answer is 13.5 years.

That’s a looong time, especially in the fast-changing world of the internet.  In fact, if we were calculating a present value and not just a simple payback, or if we were assuming the MSFT has to spend money to integrate Skype (which it will have to, I think), recovery would be even loooooonger.

What makes Skype an attractive investment for MSFT, then?  The simple answer is that this is the highest-return investment the company can find that’s within its core competence.  Yes, it could buy something in an unrelated field, like a department store or a circus or a mining company, as Big Oil did when it was flush with cash in the mid-Seventies.  But ideas like those are always disasters.  In other words, the Skype deal underlines how mature a company MSFT is.

the trouble with auction markets: evidence from e-Bay with, maybe, implications for stock market investors

May 10, 2011 By in economics, Trading Tags: , , , , , , , Leave a comment

“The Bidder’s Curse”

I was looking at the latest (April 2011) issue of The American Economic Review and came across an article titled “The Bidder’s Curse,” by Ulrike Malmendier of Cal Berkeley and Young Han Lee of Virtu Financial, a computer-driven market-making firm in New York City.  The article describes bidding patterns for online auctions on e-Bay.

The study has two parts:

1.  The first is an analysis of bidding in auctions of a board game, aptly named (for the sellers, anyway) Cashflow 101, over an eight month period in 2004.  Two different sellers with excellent feedback from customers conducted the auctions of brand-new games.  The important characteristic of the auctions for the study is that each seller continuously displayed a fixed “Buy It Now” price of $129.95 (later raised to $139.95) for the game on the same webpage as the auction.

Their result: despite the availability of Buy-It-Now, 42% of the auctions ended with the “winning” bidder paying more than the Buy It Now price.  If you factor in the higher shipping costs charged to auction winners, the percentage of auction winners overpaying rises to 73%.  In 27% of these cases, winners paid an extra $10+; in 16% of the cases, winners paid an additional $20+.

2.  The second aspect of the study was a snapshot view of 1,929 different auction results involving a wide variety of product categories during three different months in 2007.  This was to address the possibility that bidders’ (crazy) behavior might be limited only to Cashflow 101.  It wasn’t.  Overbidding happened in these auctions as well–between 44% and 52% of the time, depending on the sample taken.  The average overpayment was 10%.

What should we make of this behavior?

According to the authors, it isn’t that the winners don’t understand what e-Bay is about.  Both rookie bidders and veterans overpay.  Nor is there a relationship between the number of bids a person makes and overbidding, nor one with the total time span in which bids are made (both are ways of calculating the effort a bidder is spending on the auction).  Yes, sellers may create a favorable atmosphere for the auction by, say, setting the initial price low and the Buy-It-Now price higher than what you could buy the article for elsewhere (the latter is almost always true).  But none of this window-dressing explains why anyone bids more than the Buy-It-Now price.

The study finds a few factors that do seem to influence the bidding process:

–the closer the Buy-It-Now price is physically located to the auction price on the webpage, the less likely it is that overbidding will occur

–anyone who has already bid and gets a “You have been outbid!” notice by e-mail tends to respond by overbidding

–overbidding is sparked by a small number of auction participants.  Overbidding is slow at first but feeds on itself if these participants make up more than 10%-15% of total auction bidders.  From a seller’s perspective, then, it becomes very important to create conditions that will attract this segment to the auction–or at least to let in as many people as possible.

my thoughts

People talk about the “winner’s curse” in an auction.  In its simplest form, this is the idea that an auction winner is the individual who has the highest estimate of the value of the item being sold.  No one else thinks it’s worth that much (otherwise, they’d continue to bid), so chances are good that the winner has overpaid.

The bidder’s curse is a lot worse than that.  The Bidder’s Curse study cites earlier research whose conclusion is that in 98.8% of instances, an item being auctioned on e-Bay can easily be located elsewhere on the internet for less than the Buy-It-Now price.   In a world where bidders collected even the most basic, readily available information, everyone would know how much the item is worth and auctions would never reach the BIN price.  IN addition, of course, the BIN price should be an upper bound to bidding.  In contrast, the article documents the prevalence in the e-Bay world of an ill-informed and economically indifferent cadre of overbidders who end up determining many auction results.

As far as the stock market goes, I think there are two questions for any investor to ask:

–The more critical is whether we’re members of the class of chronic overbidders.  In this case, active investing will only lose us money; passive investment is the only way to go.

–Marketers distinguish between impulse purchases–like anything within reach in the checkout line–for which consumers have little concern about price, and research purchases–like a house or a car–where consumers prepare themselves through careful study and price comparison before acting.  It may be easy to dismiss the e-Bay results as being in the impulse category and to conclude, therefore, that they have no relevance for buying stocks.  I’m not sure that’s right.  The Cashflow 101 behavior seems to me to have a lot to say about how small-cap tech stocks work in the US.  And the overbidding phenomenon may have wider applications, as well.

Bain Luxury Goods Worldwide Market Study: Spring 2011 update

May 9, 2011 By in Asian economic development, China, Current Market Thoughts, economics, emerging markets, Hong Kong, Industry Analysis, Luxury goods, Retail, Strategy Tags: , , , , , , , , Leave a comment

Note:  you can also get my analysis of the October 2011 Bain Luxury Goods Worldwide Market Study.

Last week Bain released an update of its annual Luxury Goods Worldwide Market Study, created by the head of its luxury goods practice, Claudia D’Arpizio (thanks to Bain for providing me with a copy of the presentation materials).

While the buying habits of the affluent may have some interest in themselves, studies like Bain’s (which is the best I’ve seen) are particularly significant for investors. Publicly traded global luxury companies are an excellent way of participating in the superior growth of emerging countries without having to take the risk of owning consumer-oriented stocks in local markets.

The main conclusions from the April update:

1.  The 2010 holiday season was surprisingly strong.  To some extent, we already knew this from earnings reports, but–

–in addition to Greater China (the mainland, Hong Kong, Macau, Taiwan), the US was notably robust

–the high end did the best

–internet sales, although still small, are growing more quickly than the overall industry

–when the final reports are in (not for another month or two for some companies), 2010 will likely show global luxury sales surpassed the 2007 peak of €170 billion.

2.  2011 is following in the same vein. 

–retail continues to show double-digit same store sales growth, resulting both from higher traffic and from higher average purchase

–Chinese tourists are boosting business in Europe (over half of Chinese luxury spending is done abroad)

–wholesalers are restocking, after a couple of lean years.  Highly cyclical categories, like watches and menswear, are enjoying a rebound.  More stable areas, like leather goods and women’s shoes, are also showing strong growth.

3.  Greater China will pass Japan as the #2 luxury goods market this year, likely posting sales of €22 billion (up 25% year on year) vs. Japanese revenue of €17 billion or so (-5%).  The US will remain the #1 market at about €52 billion (+8%)–although, if we counted tourist purchases, China may already be #1.   According to Bain:

–the Chinese consumer is younger and more open to e-commerce than the typical Western luxury goods buyer

–the market is more skewed toward male consumers

–demand for luxury goods is spreading from the biggest cities on the east coast to second- and third-tier cities inland, following the development of the overall Chinese economy

–global luxury brands are increasingly shifting from distributing in China through wholesalers to opening company-owned stores there.  This move raises the capital intensity of their Chinese businesses.  But it also allows the firms to capture the lucrative wholesale to retail markup, as well as to better control their inventories and their brand message.  Perhaps most important, it signals the brands’ higher level of comfort in selling to consumers on the mainland.

4.  Japan will likely begin to recover from the March 11th earthquake in 3Q11.  Still, full-year luxury sales will probably fall by 5% from last year’s level.  Two Japanese luxury goods issues:

earthquake

–luxury goods stores were closed for ten days after the Fukushima earthquake/tsunamis on March 11th, due to lack of electric power.  Business was good after the stores reopened.  But (to me, anyway) it’s not clear how much, or for how long (six months?) luxury goods spending will be affected by feelings of jishiku –the idea that one should refrain from excessive consumption to show solidarity with those who suffered earthquake losses.

–business in Japan’s second city, Osaka, hasn’t been affected

secular

For many years, Japan was a premier market for Western luxury goods, driven by the strong preference of perhaps half the population (a much bigger proportion than elsewhere) for these products, and a willingness to pay much higher prices than prevailed in the rest of the world.   In my opinion, two developments of the late 1990s began to change this favorable picture:

–younger Japanese began shifting to local brands, partly as a rejection of their parents’ values, partly because Japanese brands were more affordable

–older Japanese began to retire (the working age population peaked in 1996).

I’m not quite sure why, but as Bain notes, these factors only impacted the Japanese luxury goods market in a significant way in 2007, when sales were flat, year on year.  In the two years since, revenues have dropped by about 15%.  Pre-earthquake, industry estimates for 2011 were for revenues to stabilize–but not increase.

Sales may get a temporary boost as Japanese GDP gains from spending to rebuild holes and factories destroyed by the earthquake/tsunamis, but my guess is that this is only a temporary reprieve.  Bain expects only 1%-2% annual growth in Japanese luxury goods purchases over the next several years from the depressed levels currently.

my thoughts

Ex Japan, the global luxury goods market looks to be in excellent health, driven by explosive growth in Asia ex Japan and expansion at a better-than-GDP rate in the US and EU.  Bain also highlights the increasing importance of developing markets like Brazil, Russia, India and the Middle East.  Today they amount to only about 7% of the world luxury goods market, but they are growing very quickly.  Companies able to manage their Japanese exposure effectively appear to me to be very well situated for superior growth.

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