is “tenure voting” the answer?

tenure voting

The weapon institutions are currently discussing to combat the potentially negative influence of activists on company management plans is called “tenure voting.

Under a tenure voting scheme, a shareholder accrues more voting power the longer he holds a given stock.  On day one, for example, the shareholder might have one vote to cast on proposals at a shareholder meeting.  This might rise to three votes after three years of continuous ownership and peak, say, at five after five years.

This heavier voting power given to long-term shareholders would, in theory at least, make it much more difficult for an activist investor with a hit-and-run strategy to coerce favorable action from a timid CEO.

the arithmetic of influence

An activist can have leverage over company management at present by buying, say, 3% of the outstanding shares to obtain 3% voting power.  If the typical institutional holder bought his core position five years ago and if institutions overall hold 60% of the outstanding stock, then with tenure voting in place the activist wouldn’t achieve the same amount of clout until he had accumulated at least 10% of the target firm’s stock.  Of course, the activist could also wait for a half-decade for his stake to achieve maximum voting power, but none strike me as having that much patience.

an effective deterrent

So tenure voting would likely insulate many of the large firms potentially under activist attack from such predation.

But…

–there’s a practical issue of implementation.  Instituting tenure voting at a firm would presumably require rewriting corporate bylaws.

–it doesn’t stop activist action.  It just changes the game.  Activists would have to adopt a two-step strategy, the first of which would be to court one or more big long-term institutional holders of a target firm’s stock.  Of course, this is arguably the intent of proponents of tenure voting–the presumption being that professional portfolio investors would rebuff the activists.  Maybe so.  But maybe not.  However, the obvious place to start would be index funds.  It’s not really clear what unintended consequences this might produce.

–tenure voting has been a traditional practice in places in Continental Europe like France.  In my view, it has been a disaster there, cementing in place an elitist old boy network of corporate managements that have had little regard for ordinary shareholders.  More than that, the French government’s move last year to make tenure voting mandatory for all publicly traded firms met with violent opposition from investors who know this system the best.

All in all, although I’m not necessarily a fan of activists, I think in this case the cure is worse than the disease.

falling sales, rising profits…

…are usually a recipe for disaster on Wall Street.  Yet, in the current earnings reporting season, a raft of companies are reporting this presumably deadly combination   …and being celebrated for it, not having their stocks go down in flames.

What’s happening?

the usual situation

First, why falling sales and rising profits don’t usually generate a positive investor response.

To start, let’s assume that a company reporting this way is maintaining a stable mix of businesses, that it’s not like Amazon.  There, investor interest is focused almost solely on its Web Services business, which is small but fast growing, and with very high margins.  AWS is so valuable that what happens in the rest of the company almost doesn’t matter.

Instead, let’s assume that what we see is what we get, that falling sales, rising profits are signs of a mature company slowly running out of economic steam.

So, where does the earnings growth come from?

Case 1–a one-time event.  Maybe the firm sold its corporate art collection and that added $.50 a share to earnings.  Maybe it sold property, or got an insurance settlement or won a tax case with the IRS.

All of these are one-and-done things. How much should an investor pay for the “extra” $.50 in earnings?  At most, $.50.  There’s no reason to make any upward adjustment in the price-earnings multiple, because the earnings boost isn’t going to recur.

Similarly,

Case 2–a multi-year cost-cutting campaign.  AIG, for example, has just announced that it is laying off 20% of its senior staff.  Let’s say this happens over three years, and that the eliminations will have no negative effect on sales, but will raise profits by $1 a year for the next three years.

How much should we pay for these “extra” $3 in earnings?  Again, the answer is that the earnings boost is transitory and should have no positive effect on the PE multiple.  So the move is worth, at most, $3 on the stock price.

Actually, my experience is that in either of these cases, the PE can easily contract on the earnings announcement.  Investors focus in on the falling sales.  They figure that falling earnings are just around the corner, and that on, say, a stock selling for $60 a share, the non-recurring $.50 or $1 in earnings is the equivalent of a random fluctuation in the daily stock price.  So they dismiss the gain completely.

why is today different?

I don’t know.  Although early in my career I believed that earnings are earnings and the source doesn’t matter, I’m now deeply in the only-pay-for-recurring-gains camp.

I can think of two possibilities, though:

–Suppose Wall Street is coming to believe (rightly or wrongly) that we’re mired in a slow growth environment that will last for a long time.  If so, maybe we can’t be as dismissive as we were in the past of the “wrong kind” of earnings growth.  Maybe company managements that are able to deliver earnings gains of any sort are more valuable than in past days.  Maybe they’re on the cutting edge of where growth is going to be coming from in the future–and therefore deserve a high multiple.

–I’m a firm believer that most mature companies formed in the years immediately following WWII are wildly overstaffed.  I also think that even if a CEO were willing to modernize in a thoroughgoing way–and I think most would prefer not to try–it’s immensely difficult to change the status quo.  Employees will simply refuse to do what the CEO wants.  As a result, this makes companies showing falling sales prime targets for Warren Buffett’s money and G-3 Capital’s cost-cutting expertise.  In other words, such companies become takeover targets, and that’s why their stock prices are firm.

two aspects of securities analysis: quantitative and qualitative

quantitative analysis

The quantitative aspect is easier to describe.  It, however, is much more complex and detailed and may take months to complete.  As a professional, I always thought part of the art of portfolio management was in deciding how much of this I had to do before I bought a stock, how much I could obtain from brokerage house securities analysts, and how much I could leave to fill in after I established a position.

The quantitive plan consists in a projection of future company performance–revenues, operating profits, interest, depreciation, general expenses, taxes…–for each line of business and for the company as a whole, over the next several years.  Creating spreadsheets this detailed is an ideal that’s striven for but seldom reached in practice.  That’s because companies rarely disclose this much information in their SEC filings.

Lengthy reports, called basic reports, issued by old-fashioned (i.e., “full service”) brokerage houses are the best example of what a quantitative analysis should look like.  Signing up for Merrill Edge discount brokerage will get you access to such reports.

The most important thing about them, in my view, is the analytical work, not necessarily the opinion.  I think the Merrill analyst covering Tesla, for instance, does extremely good work.  All the relevant issues and numbers are clearly laid out.  Last I read, he thought that fair value for the stock was around $75 a share.  Although he provides very valuable input, and he may ultimately be proven correct, I think he’s way too pessimistic about the stock.

qualitative analysis

This is the general concept behind an investment.  It’s extremely important–more important than the exact numbers, in my view–but it may be as short as an elevator speech.  In most cases, the shorter the better.

Examples, many of which are not current:

–Wal-Mart builds superstores on the outskirts of US cities with a population of 250,000 or less.  They offer better selection and lower prices than downtown merchants do, so they take huge market share everywhere they open.  There are a gazillion such towns left to exploit.

–J C Penney is trading at $25 a share. It owns or controls property that has a value, if rented to third parties, of $50 a share, plus a retail business that is making money.  The latte is worth more than zero as-is.  Let’s say $5 a share.  Taking control of JCP and breaking it up could double our money.

–Adobe is changing from a sales model for its software to a rental one.  This will eliminate counterfeiting, which is probably much more extensive than anyone now realizes.  We know from other industries that going from buy to rent probably doubles profits, even without considering eliminating theft. No one seems to believe this.   Therefore, ADBE’s profit growth over the next two or three years will be surprisingly good.

–Company X is a cement company.  It’s currently beaten down by an economic slowdown and is trading at 40% of book value.  At the next economic peak, it will likely be trading at 100% of book–which will be 20% higher than it is today.  Therefore, the stock should triple in price.

More tomorrow.

Avago (AVGO) and Broadcom (BRCM) …and Intel/Altera

Two days ago the rumor hit Wall Street that chipmaker and serial acquirer AVGO had found its newest target, BRCM.  Yesterday the offer was announced:  cash and AVGO stock, in approximately 45/55 proportions, totaling $37 billion.

my thoughts

When customers in a given industry group become bigger and more powerful, the natural response among suppliers is to do the same.  This is part of what is going on here.  More than that, AVGO appears to seek out companies whose technological virtuosity far outstrips their management skills.  So it gains not only the marketing benefit of size but also the rewards of improving the profitability of firms whose main virtue has been their intellectual property.

What’s striking about this deal is that in revenue terms AVGO is more than doubling its size.  Although I have no intention of selling the AVGO shares I own, experience says that acquirers often bite off more than they can chew when they make the jump from small acquisitions to super-size ones like this.

One of AVGO’s rumored other targets had been Xilinx (XLNX), the junior partner with Altera (ALTR) in the field programmable gate array duopoly.  I had thought that ALTR would feel more favorably disposed to overtures being made by Intel (INTC), given the possibility that AVGO would buy XLNX and turn the firm into a much more aggressive competitor.  That threat is now gone.  INTC must now rely on pressure on ALTR management from its major shareholders (shareholders are, after all, legally the owners of ALTR and the employers of management) to return to the negotiating table.

As a practical matter, managements have a lot of autonomy, despite the fact that we the shareholders are, technically speaking, the bosses.  Wall Street seems to believe that ALTR is holding out for a higher price from INTC.  While that may be the rhetoric being used, I think the real issue is more basic.  Who would want to go from being the master of all he surveys as the top dog (and treated as a demigod) at a major publicly traded company to being a near-invisible division head in a conglomerate?

stock buybacks: the curious case of IBM

Regular readers will know that I’m not a fan of stock buybacks by companies.  I believe that even though buybacks are advertised as returning cash to shareholders in a tax-efficient way, their main effect–even if not their purpose–is to keep the dilutive effects of management stock options away from the attention of ordinary shareholders.  Admittedly, I haven’t done a study of all firms that buy back stock, but in the cases I have looked at the shares retired this way somehow end up offsetting new shares issued to management.  As a result, you and I never see the slow but steady shift in ownership away from us and toward employees.

In recent years, activist investors have made increasing stock buybacks a staple of their toolkit for “helping” stick-in-the-mud companies improve their returns.  Certainly, accelerating buybacks can give a stock an immediate price boost.  But since I don’t believe that the usual activist suspects have your or my long-term welfare as shareholders at heart, I’ve had an eye out for cases where extensive buybacks have ceased to work their magic.

I found IBM.

Actually I should put the same ” ” around found that I put around helping two paragraphs above.  I stumbled across an article late last year in, I think, the Financial Times that asserted all IBM’s earnings per share growth over the past five years came–not from operations–but from share buybacks.  A case of what Japan in the roaring 1980s called zaitech.  Hard to believe.

I’ve finally gotten around to looking.  I searched in vain for the article.  I found a relatively weak offering from the New York Times Dealbook, whose main source appears, somewhat embarrassingly for the authors, to have been IBM market-speak in its annual report.  I did find an excellent two-part series in the FT that I’d somehow missed but which appeared earlier this month.  It’s useful not only conceptually but also for IBM history.

IBM

The FT outlines the essence of the IBM plan to grow eps from $11.52  in 2010 to $20 by this year–a target abandoned last October by the new CEO..  Of the $8.50 per share advance, $3.50 was to come from revenue growth, both organic and from acquisitions; $2.50 each were to come from operating leverage–which I take to be the effect of keeping SG&A flat while revenues expanded–and share buybacks.

What actually happened from 2010 through 2014 is far different:

–IBM’s revenues, even factoring in acquisitions, fell by 7% over the five years

–2014’s operating profit was 5% higher than 2010’s

–net profit grew by 7.0%, aided by a lower tax rate,

–nevertheless, earnings per share grew by 35%!

How did this happen?

Over the five years, until share buybacks came to a screeching halt in 4Q14, IBM spent just about $70 billion on the open market on its own stock.  That’s over 3x the company’s capital expenditures over the same period.  It’s also about 3x R&D expenditure, which is probably a better indicator for a software firm.  And it’s over 3x dividend payments.

The buying reduced the share count by 315 million to 995 million shares.  The actual number of shares bought, figuring a $175 average price, would have been about 400 million.  I presume the remainder are to offset shares issued to employees exercising stock options (although there may be some acquisition stock in there–no easy way to find that out).

results?

What I find most interesting is that, other than a flurry in the first half of 2011, the huge expenditure did no good.  IBM shares have underperformed pretty consistently, despite the massive support given by the company.  And IBM has $13 billion more in debt that it had before the heavy buybacks began.

Where is the company now?

I don’t know it well enough to say for sure, but it appears to me that it has taken recent earnings disappointments to jolt IBM into the realization that the 2010 master plan hasn’t worked.  A half-decade of the corporate equivalent of liposuction and heavy makeup has not returned the firm to health.  Instead, IBM has burned up a lot of time   …and a mountain of cash.

I think it’s also reasonable to ask how ordinary IBM shareholders have benefitted from the $60+ per share “returned” to them through buybacks.  I don’t see many plusses.  The stock dropped by about $20 last October, when IBM officially gave up the 2010 plan, so some investors were fooled by the company’s zaitech.  But spending $60+ to postpone a $20 loss that happened anyway doesn’t seem like much of a deal.

Only the board of directors knows why almost five years elapsed before anyone noticed the plan had long since gone off the rails.

Ackman, Actavis, Allergan and Valeant

This is a situation I didn’t pay much attention to while it was going on but which I think has interesting implications for merger and acquisition activity in the future.  It doesn’t seem to me, however, that investors in general understand exactly what went on.

The bare bones:  Bill Ackman, of Pershing Square fame (and J C Penney infamy) bought just under 10% of Allergan, the maker of botox, and urged the company to put itself up for sale.  Ackman then allied himself with serial pharma acquirer Valeant to make a joint hostile (meaning against the wishes of the target) bid for Allergan.  Actavis, a third pharma company, emerged as a “white knight” to rescue Allergan from Valeant’s clutches with a bid that topped Valeant’s offer by about 15%.  Valeant conceded defeat.

 

This is the latest enactment of one of the oldest dramas on Wall Street.  A “black knight” makes a hostile bid for a vulnerable company.  The target firm, realizing that it is now in play, understands that at the end of the day it will most likely be acquired.  The only choice that remains to the target is to choose who the acquirer will be.  Invariably, it determines to join with anyone but the black knight that has caused all this trouble.  That’s why hostile bids fail as often as not.

For this reason, one of the bigger problems in the m&a game is that no one really wants to be the black knight.  Once the villain has appeared, however, there’s usually no trouble in finding someone willing to ride to the rescue.  In most cases there’s at least one potential acquirer hoping against hope that someone else will make the first move.

 

The Ackman innovation: in February, when he and Valeant became co-bidders for Allergan, he agreed to pay Valeant 15% of his Allergan profits if a third-party ended up acquiring Allergan.  This created a win-win situation for Valeant, which would either come away with Allergan or with several hundred million dollars for having played the black knight role.

Issues:

–what was the Allergan price at which Valeant shifted from hoping to acquire the company to wanting to collect a fee from Ackman?;

— did Valeant ever really expect to own Allergan?;

–most important, will this maneuver work again?

I don’t know  …but the answer to question #3 depends a lot, I think, on the answer to #2.

 

analyzing sales rather than earnings (ii)

The answer the Bloomberg Radio reporter gave to the question, “Why sales, not earnings?” was that sales are harder for a less-than-honest company to manipulate.  In some highly abstract and technical way this might be true, but in any practical sense the reply is ridiculous.  Stuffing the channel is a time-honored, easy to do way of inflating sales.

Still, there are instances where an investor will want to look at sales rather than earnings.

1.  Value investors looking for turnaround situations will seek out companies with lots of sales but little in the way of earnings.  They’ll benchmark the poorly performing firm against a healthy rival in the same industry.  They figure that if the two firms have comparable plant, equipment and intellectual property, then a change of management should enable the weaker firm to achieve results that are at least close to what the stronger one is posting now.

As I see it, this mindset is what separates value investors from their growth counterparts.  The latter, myself included, begin to salivate when they see a strong bottom line; the former are magnetically attracted to big sales/no profits firms instead.

2.  Especially in the tech world, companies often go public before they become profitable.  AMZN, which didn’t report black ink for eight years after its IPO, is the poster child for this phenomenon.

Potential investors routinely look at the size of the market a given firm is addressing and the rate of its sales growth as a way of gauging its potential value.  This is a tricky thing to do, since it requires us to decide how much of the money the company is now spending is akin to capital spending–one-time foundation laying that won’t recur–and how much is spending that’s needed to generate each new sale.  Put a different way, it’s a decision on what is SG&A and what is cost of goods.  As AMZN illustrated, there’s huge scope for error here.

(An aside:  I attended an AMZN IPO roadshow presentation.  Management mostly said that during the PC era investors could have bought then-obscure companies like MSFT and CSCO and made a fortune.  The internet age was dawning and AMZN offered a similar chance.  Nothing but concept.)

3.  A simpler variation on #1  + #2, which is currently being worked vigorously by activist investors at the present time, is to find companies that may not break out results by line of business but which in fact operate in two different areas.  In the most favorable case for activists, the target firm will look like nothing special but have one high-growth, high-profit area whose strong performance is being obscured by a low-growth low/no-profit sibling.  The activist forces a separation, after which growth investors bid up the price of one area, value investors the other.

 

Obviously, no one uses just one metric.  But the way I look at it, the only persuasive case for using sales as the keystone to analysis is the value investor use I outlines in #1.