June 17, 2016
Yesterday a man who was reportedly shouting slogans of the Leave side killed a Member of Parliament who was advocating for the Stay side in her hometown. Campaigning in advance of next Thursday’s Brexit vote has been temporarily suspended nationwide. Markets seem to believe this shocking development may be enough to turn the tide in favor of staying in the EU.
Yesterday, Philadelphia (pop. 1.5 million) became the first US city to impose a tax ($.015 per ounce) on sugary beverages. The tax will apply both to drinks containing sugar and those containing artificial sweeteners. The public health issue with the latter, according to my daughter-in-law, a lawyer and public health expert, is that they create a craving for sugar.
The key to passage of the measure, which has failed in numerous other US cities, appears to have been that the proceeds of the levy will be used to support early childhood education.
Not good for soda companies. Higher prices will likely accelerate the decline in consumption of soda already under way in the US, as well as stigmatize the drink. Microeconomic theory, which I think is right in cases like this, says that the cost of the tax will be shared between producers and consumers in proportion to their market power. My guess is that more than half the levy will have to be absorbed by soda companies through lower pre-tax prices.
Yes, Berkeley, CA (pop. 100,000+) already has a soda tax.
March 7, 2016
Caesars Entertainment and private equity
Private equity firms Apollo Global Management and TPG Capital took casino operator Caesars Entertainment private in 2008.
A unit of Caesars, called Caesars Entertainment Operating Company (CEOC), burdened with $18 billion in debt, entered a Chapter 11 restructuring in January 2015.
Junior creditors, who stand to lose most of their money in the proposed reorganization, are suing on the grounds that Caesars shifted valuable casino assets out of CEOC prior to declaring bankruptcy. They assert (among other things, I presume) that this violates a Depression-era law aimed at eliminating an abusive practice of early-century tycoons that contributed to the 1930s financial collapse.
I haven’t paid much attention to this situation. I thought it was a one-off. I didn’t see any way for me, as an equity investor, to make money from the goings on. In fact, I thought the most interesting aspect was that Nevada Senator Harry Reid was persuaded to introduce legislation–immediately quashed by saner colleagues–to make legal again the kind of asset stripping the plaintiffs say happened here.
Last week, though, another case popped up.
iHeart, formerly known as Clear Channel
iHeart Media (formerly known as Clear Channel) was taken private, again in 2008, by Bain Capital and Thomas H. Lee Partners. According to the Financial Times, iHeart has close to zero cash flow after interest expense on its $20+ billion in debt, putting its ability to repay $7 billion in principal coming due in 2019 into question.
The FT says senior creditors are worried that iHeart is preparing for a Caesars-style bankruptcy by shifting corporate assets out of the entity it will ultimately put into Chapter 11. They apparently also fear that iHeart, which is generating cash by issuing new debt and selling assets, will extract that cash from the firm by declaring large pre-bankruptcy filing dividends to equity holders.
Maybe this is just a cautionary tale about deals done in 2008. In any event, this behavior suggests that private equity firms aren’t the benign financial actors they would have you and me believe.
November 19, 2015
Basically, what he said in 1995 is that disruptive products have three characteristics:
–they emerge with a package of performance attributes that the big customers in an established market don’t want. So they appeal to underserved customers in the low end;
–they advance in performance rapidly (how they do this is left unexamined) and then begin to win away big customers from incumbents
–they’re typically ignored or misunderstood by incumbents, who are blindsided by their success.
The model Christensen appears to be generalizing from is the success of Japanese automakers in attacking Detroit, starting in the 1970s, although cars are not mentioned in the article.
Instead, two related examples are used to illustrate the theory: the move from mainframes to minicomputers to personal computers, and the PC-related shrinkage in form factor of personal computer hard disk drives.
In the original article, disruption is all about manufacturing and capital spending; services apparently couldn’t be disruptive. There’s also no mention of price. One of the greatest charms of minicomputers was they cost 5% (10%?) of a mainframe. The personal computer was approved by IBM and cost 5% of what a minicomputer did. It also freed us from the tyranny of the mainframe IT staff, which, at least in places I worked, simply ignored programming requests they didn’t feel like fulfilling. MAC vs. PC: of course the Mac lost, despite being a superior machine–it cost 3x what a Compaq did.
The stuff about hard disk drive I found really peculiar. The first Compaq I used weighed 31 pounds. Of course there was relentless pressure to reduce the weight and improve performance by shrinking the size of components. It’s hard to accept that no one in the hard disk drive industry understood this.
So Mr. Christensen didn’t know much at all about the industries he was theorizing about twenty years ago.
That’s not what bothers me about his defense of his theory in 2015.
G. E. Moore, a UK philosopher of the early 20th century, used to say that people could be classified either as Aristotelians, who in a conflict between facts and theory went with the facts, and Platonists, who would cling to the theory and disparage the facts. Mr. Christensen is deep in the Platonist camp. He says Uber isn’t “disruptive” because its service isn’t inferior and because it doesn’t exclusively serve people who can’t afford a taxi–and that’s how he defined the term twenty years ago.
Give me a break. The word disruptive has evolved from its 1995, pretty useless, form, whether Mr. Christensen likes it or not.
November 18, 2015
Although Activision (ACTI) has been very vocal about the importance of mobile games since the days of Kart Racer, it hasn’t until now made much progress in this category. Hence the acquisition of King Digital (KING) and its massive, but mature, hit Candy Crush. ACTI is paying $5.9 billion for yearly cash flow from KING of about $600 million.
The interesting part, though, is that ACTI is not paying in 100-cent dollars. It’s using $3.6 billion in cash that’s sitting idle overseas in the hope US tax laws eventually change. The sum would be worth $2.4 billion, after-tax, if it were repatriated today. The rest of the purchase price will be borrowed, at presumably a close-to-zero interest rate. So ATVI is really paying 7.8x cash flow for KING, not 10x.
Urban Outfitters-Pizzeria Vetri
On Monday morning, before the start of New York trading, Urban Outfitters (URBN) announced that it had agreed to acquire “substantially all” the Philadalphia-based Vetri Family group of restaurants. The fact of the acquisition was disclosed, but not the price–implying, I think, that the cost of taking control of the small number of high-end pizza and fine dining restaurants was immaterial. The announcement sliced well over $100 million from URBN’s market cap, however.
What URBN apparently intends to use the award-winning Pizzeria Vetri brand, built by a friend of the URBN CEO, to help create entertainment spaces (mini-malls?) where Millennials will want to spend time–and shop in the URBN stores conveniently (and exclusively) located right by the food.
I have no idea whether this is good or bad. For whatever reason, Cheesecake Factory, Dave and Busters, Chuck E. Cheese and truck stops are all that come to mind. I do think, however, the concept bears watching.
After the close on Monday, URBN reported disappointing earnings results. I didn’t listen to the management conference call; I read the Seeking Alpha transcript instead. Weirdly, to my mind, there’s virtually no discussion of the acquisition. Someone makes a (lame) joke about having to know about cheese prices to be able to cover the company in the future. Someone else asks how this will affect future asset allocation (management gives a non-answer). But that’s it. There’s not even a sycophant offering the CEO a chance to explain his grand vision. Just silence.
My take is that analysts who want continuing access to management will , like Sgt. Schultz of television’s Stalag 13, want to “know nothing.”
February 16, 2012
Odds and ends are hard to come by, it seems. But I’ve found several interesting items, all at once, that don’t appear to fit anywhere else. If there’s a theme to them, it’s the nature of investment banking.
Yesterday’s Wall Street Journal contains a report on an upcoming scholarly article that details the medical problems that a group of budding investment bankers developed during their first decade on the job. The ailments include: “insomnia, alcoholism, heat palpitations, eating disorders and an explosive temper.” Long working hours and stress are the causes.
There’s more to to these maladies than the article related, in my opinion. A lot of this stress is self-induced. It’s not like being a surgeon, where making a mistake can mean a patient dies. These rookies are in a winnowing process. Not everyone will go on to make mega-bucks. Some will leave the industry, others will take lesser positions on sales desks. And unlike investment management, where I worked, and where there are at least performance numbers to act as an evaluation tool, it seems to me that the i-banker evaluation standards are much more subjective–and therefore out of the rookie’s control.
I find it surprising that at first no one realizes the importance of taking care of your body–eating right and exercising–in reducing stress. Part of me also has a sneaking suspicion that part of the problem is the dubious nature of some things investment bankers do.
…which brings me to a second O&E.
Yesterday’s Financial Times has a piece on the use of private detectives to vet Chinese family-owned companies whose arms are the target of potential investment by private equity or hedge funds.
No one in his right mind thinks that investing in a project sponsored by a family-owned company means that you’re part of the family. Au contraire, going in you’ve got to realize that, while you may get a good deal–and a better one that you could get for yourself–the family will always make out better than you will. This is the sense behind the Wall Street saying that you should always have your own money in the company where the family has the most of theirs. It’s also something that portfolio investors and industrial companies going into China have known this forever.
Apparently, foreign private equity and hedge fund managers have only recently figured this out. Presumably, bitter experience has been the teacher. In any event, they now hire private detective firms to diagram for them the full extent of family empires and the interconnections among their various parts. The hope is that this will unearth conflicts of interest, undisclosed dealings with related parties and questionable accounting. None of this is peculiar to China, of course. But investors will almost always have better access to such information–from school or business acquaintances, or just from the rumor mill–in their home markets.
What I found most interesting, though, is the final paragraphs of the article. In it, the reporter distinguishes between investigations done for private equity/hedge funds and those done for investment bankers. In the former case, clients want all possible information. In the latter, clients don’t. The FT cites a Hong Kong investigator as saying that investment banking clients restrict the scope of an investigation to relatively “safe” areas, like public records, so that the inquiry won’t turn up information that will derail the deal. …another stress builder?
My final O&E comes from the Wall Street Journal. All I can find online is a video but there was a print article yesterday. The article was pretty awful, though. It made the main point, that the SEC is investigating Henry King, the head of research for Goldman in Taiwan, for passing on inside information. But it added on a lot of extraneous filler.
There’s no evidence that Mr. King has done anything wrong. But Taiwanese companies are the heart of component manufacturing and assembly for the world’s tech devices. Interviewing them about their businesses was been standard practice for securities analysts around the world for decades.
What the SEC is presumably looking into is whether companies in the Goldman research universe revealed confidential information–either about themselves or their suppliers/clients–to Mr. King, and whether Mr. King then selectively passed the data on the favored clients rather than publishing it.
I have two thoughts: Taiwan’s businesses are notoriously opaque, and I wonder if Goldman’s “trading huddle” idea made it toTaiwan?
December 11, 2011
As you can see from the date below, it’s been a long time since my last Odds and Ends. But in the gallows humor fashion that prevails on Wall Street, I’ve seen two quotes over the past week or so that I think deserve mention, even though I don’t see that either has obvious equity investment implications. Beginning with the less impressive one:
–“I am being prosecuted for not cooking the books” –Andreas Georgiou, quoted in the Financial Times on November 27th.
Greece’s national account reporting has long been a bone of contention between that country and the EU. Thanks to the election of the Papandreou government last year, we now know that the Greek national accounts had been fudged for years. From what I’ve read, it sounds like the major political players used to gather in a smoke-filled room to “massage” the data into a form they found more palatable than the actual figures.
When the IMF came on the scene in 2010, Mr. Georgiou was made the head of a new Greek statistics agency charged with producing accurate numbers. As the FT notes, since the new body’s creation questions about the reliability of the data Greece submits to the EU have evaporated.
So Mr. Georgiou is a hero, right? …but nooo.
Tomorrow, Mr. G is going to court. He’s being accused of “acting against the national interest” (is this treason?) by preparing national accounts that are too gloomy. If convicted on this criminal charge, he could go to jail for life. Ouch.
–“I simply do not know where the money is.” –Jon Corzine, ex-CEO of MF Global, testifying before a congressional committee on Thursday.
The money in question is the estimated $1.2 billion that’s missing from customers’ accounts at MFG, which was forced into bankruptcy after Mr. Corzine’s “bet the farm” wager on Eurozone sovereign debt went sour.
I listened to much of the testimony on Bloomberg radio while I was driving to Pennsylvania that day. Mr. Corzine did say he felt bad about the way events had turned out. But the quote above isn’t the only eyebrow-raising thing Mr. Corzine, who helped author the Sarbanes-Oxley Act while he was in the Senate, said. (Sarbanes-Oxley mandates that company managements maintain high standards of internal financial controls and external financial reporting.)
He said, for example, that in effect he didn’t know much about the day-to-day operations of MFG.
He also replied to one questioner that he “was given to understand” that regulatory and outside accounting inspection of the company’s books and procedures was satisfactory–implying he hadn’t looked at the reports or talked with the inspectors himself (despite Sarbanes-Oxley).
He allowed as well that it was possible subordinates had misconstrued comments of his as being orders to take money from customer accounts and use it for MFG’s benefit …but, if so, that wasn’t really what he told them.
And he attributed the absence of the records needed to trace the missing money to unusually high trading volume. Huh? Where were the computers?
All this would be darkly humorous, except for the damage done to customers who trusted MFG. In addition, the account we have so far of the last days of MFG makes no sense at all to me. I’m afraid the situation has the same kind of feel to it as the initial reports of trouble at Olympus in Japan. You know how that turned out.
January 19, 2011
I first learned about online sports ticket resale networks about a decade ago when Ticketmaster was trying to set one up. Of course, the leader in this business turned out to be StubHub, now a part of eBay.
As I understand it, the dynamics of the business are as follows:
Sellers–Historically, season ticket holders at sporting venues end up not using around 40% of the tickets in the package they buy. Online networks give them the opportunity to sell those tickets instead of giving them away. They can do so legally, easily, anonymously and in advance of a given event.
Users- —They can shop for tickets legally and not in large ticket bundles. They can buy them in advance and be sure the tickets are genuine. They also get access to sporting events they would not otherwise be able to attend, and to premium seats not sold by teams individually.
Governments–The argument to repeal anti-scalping laws is a familiar one, and has two parts: legal resale takes money away from organized crime, and proceeds become subject to tax.
Teams–No one I’m aware of talks about this, but it seems to me that resale networks were sold as a concept to teams by pointing out how this would allow them to raise ticket prices. Say a customer buys tickets for two seats next to each other for 40 games at $100 each. That’s $8,000 for a season. I think it’s the total expense that matters to the fan. If so, then if a team can raise ticket prices by 20%, while providing a resale channel, the customer can keep his annual outlay at $8,000 by reselling about a fifth of the tickets his season ticket plan compels him to buy. Great idea in a boom economy. Not so good in a downturn.
On Monday, I came across an article in sports section of the New York Times about how resale networks have fared in the recession. Although not a particularly incisive account, it does make a number of interesting points:
–annual revenues in the ticket resale market are now around $3 billion, or about 35 million tickets.
–sales grew by 26% last year for StubHub, the biggest factor in the market, despite the fact that average ticket prices fell by 2.5%
–since 2006, that is, over the recession years, average prices have fallen by 20%-30%
–The composition of sellers in the market has changed drastically. Pre-recession, sellers were 60% ticket brokers, 40% season ticket holders. Those proportions have reversed.
–This suggests that ticket broker sales have remained constant, while season ticket holder sales are now 21 million seats, or 2.3x what they were in 2005 (when, according to the Times, the market was $2 billion).
–The article implies, but doesn’t quite state, that growth has come through transactions where the season ticket holder takes a loss.
This last finding is in line with my personal experience, but a region that offers the Mets, the Nets, the Devils and the Islanders is probably not typical.
Creating a parallel distribution network for tickets is turning out to create a raft of problems for sports teams that don’t produce a high-quality product. Online resale reveals the true market price of tickets. In the case of the Nets, admittedly an extreme example, $20 face-value tickets can be had for $1-$2. I wonder how many go unsold, even at that price? Also, with so many tickets available online, this channel has to be cannibalizing sales of tickets directly from the team for any game that’s not sold out well in advance.
Investment implications? …none for the stock market that I can see. It seems to me this is one more case where the internet has undercut inept management (think: the Wilpons) in a hide-bound industry. Worry about the potential for a downward spiral in ticket sales sparked by unhappy season ticket holders may also be one reason even good teams are willing to pay large amounts of money for star players in free agency.
January 13, 2011
It has been quite a while since I’ve found any odds or ends to write about. But I’ve been travelling this week and decided to attack the stack of issues of Foreign Affairs that has been piling up next to one of my computers. And I found one.
The article that caught my eye is by historian Niall Ferguson and is titled “Decline and Fall; when the American empire goes, it is likely to go quickly” on the cover of the March/April 2010 issue, and “Complexity and Collapse: Empires on the edge of chaos” on the inside. Either title gives you the general idea of what he has to say.
- The conventional view of the rise and fall of empires makes considerable use of the notion of symmetry. Countries rise gradually in prominence, reach a peak of power and then gradually and, sometimes, gracefully decline. Although Professor Ferguson doesn’t say so, this pattern is found in Aristotle’s description of the growth, maturity and aging of the individual human being. This, of course, is the same guy who said that women are inferior to men because they have fewer teeth. Not great on scientific method!
- Traditional historians, from Vico through Gibbon, through Toynbee and Paul Kennedy, have started with this template. They then describe the ebb and flow of past empires, selecting evidence for their narratives that fits the unquestioned assumption of symmetrical up and down—and ignoring the rest.
- A more modern—and accurate—overall description is that empires are complex adaptive systems, like the internet, characterized by “dispersed agents, a lack of central control, multiple levels of organization, continual adaptation, incessant creation of new market niches, and the absence of general equilibrium.”
- Empires “go critical” and explode/implode when they lose the flexibility to change. This happens all at once, not. Look at the UK or the USSR. Two key factors are common in this loss of ability to change: a large government fiscal deficit, and the attempt to make foreign policy through the use of military force.
Ferguson is a popularizer (not necessarily a bad thing) of ideas that have been floating around in the academic and policy communities for some time. So his is not a new idea. But the process he describes is very common in emerging market economies.
The obvious case in point today–and the reason for the Ferguson article– is the US, a waning superpower with high government debt and involved in significant and expensive foreign wars. The facts that the idea of sudden collapse is in the are, and that the experience in emerging markets is so similar suggest that perceptions–and investor money flows–could change very quickly.
The clear casualties would be the dollar, interest rates in the US and domestically-oriented stocks.
This is not an idea that will make any difference in day-to-day stock market trading any time soon, in my opinion. But it’s worth keeping in the back of our minds.
October 6, 2010
the Harvard endowment
Major universities, whose fiscal years match their academic calendars, are now reporting the latest year-end results for their endowments. Many have adopted the “endowment model” pioneered by Yale and Harvard over the past twenty years. The general idea is that universities have little need for daily liquidity, so they should use this attribute to their advantage to maximize investment returns by participating in a healthy dose of long-term, high-profit, but illiquid projects.
The Great Recession has shown, I think, that several characteristics of this strategy weren’t understood well enough by its practitioners, or their supervisors:
–in a bad market, illiquidity can mean it can be several years before an investment can be even partially sold,
–private equity deals often involve not only an initial investment but the possibility of further cash calls by the general partners. In the case of Harvard, this potential liquidity drain amounted to over $11 billion–or about a third of the entire endowment–when the current manager arrived two years ago.
–in my opinion, pricing of illiquid investments can be a serious issue. Take the simple example of owning a house. Say you paid $200,000 for it three years ago. Your town assesses the value for taxes at $150,000. You’ve had it on the market for $175,000 for a year with no buyer in sight. Your neighbor has recently mailed the keys to his similar house to the bank, which has sold it quickly for $50,000. What’s the real price of your house?
And that’s nothing compared with figuring out what the carrying value should be for, say, a chain of electronics stores in Poland that your private equity manager has bought. My, perhaps cynical, worry has been that no one involved in deals like this has any incentive to pencil in a low value. Everyone collects more in management fees or in bonuses if the value is high.
So I decided to look at the most recent Harvard endowment report to see what light it might shed on these factors. Here’s what I found:
–in the report for June 2007, Harvard said its ten-year return on private equity investments was 30% per year. That’s about 14x your money, and compares with an annual benchmark return of 14%. In most recent report, the ten-year return is reported as just above zero, vs. a benchmark return of 2%. Yes, the time frames are different. Making 30% a year for seven years means (only) having 6x+ your initial investment. So going from that to no return means a loss of (only) 85% or so of your funds. I guess it could happen if you were using a lot of leverage. My thought is that the economic value of the underlying assets hasn’t changed that much. Pricing has. An important question is: has the pricing haircut gone far enough or is there still a lot of hope in the figures.
–capital call obligations have dropped from $11 billion+ two years ago to $6.5 billion now.
–in contrast with the fiscal 2007 report, no chart of portfolio composition is shown.
–the fiscal 2007 report is filled with buzzwords and say very little. In contrast, the current one uses plain language and appears to have been written by an experienced professional investor.
the Commonwealth Games
The run-up to the latest Commonwealth Games, in India, isn’t going smoothly. Facilities aren’t finished. Newspaper reports say the roof of one newly built venue has fallen in and a footbridge has collapsed. Reviews of the proposed living quarters for athletes have included words like “filthy” and “uninhabitable”–characterizations the Indian government disputes. Sharp contrasts are being drawn between this performance and the recent Olympic Games in Beijing.
“Common sense” might tell a foreigner that India should want to put its best foot forward while under the international sporting spotlight and that, therefore, construction should be the highest quality and done on time. Doubtless, Indian citizens would be more familiar with local construction companies and the politics of government tenders, and perhaps have had different expectations.
I don’t mean this comment to be a criticism of India. I think it’s just another reminder that when learning about an economy other than your own, it’s best to check your “common sense” in an airport locker, and not assume that the way things might work in your country–even at a very basic level–is the way they do elsewhere.
June 29, 2010
The New York Times reported yesterday that the court has just unsealed documents from a three-year old lawsuit against DELL brought by corporate buyers of OptiPlex computers between 2002 and 2005.
According to the Times, the documents show DELL knowingly used faulty capacitors (gizmos that regulate the flow of electric current in the computer) made by a Japanese company, Nichicon, in the OptiPlexes it built and shipped over the three year period. The Nichicon capacitors leaked chemicals, causing the PCs to fail prematurely. They also may have been a fire hazard.
The documents also show that when customers complained, DELL didn’t reveal the true problem, In some cases, DELL even blamed the customer for the breakdown, claiming poor ventilation or overuse caused the PCs to stop functioning.
Why would DELL do this?
Putting sound management practice, defense of the brand name and plain old ethics aside, you might understand–from a short-term cash flow perspective, anyway–why a company might be tempted to try to cover up manufacturing flaws in already shipped computers. DELL marks its PCs up by about 20% from its cost of goods. This means replacing a defective computer with a new one would cost 4x the profit the company earned on the original sale. Given that DELL shipped 11 million computers with the Nichicon capacitors inside, the burden would potentially be immense.
But even looking at the situation in the most cynical way I can, what I’ve just written seems to me to be the strongest possible argument not to ship the faulty computers in the first place. So the real question is why did DELL take the risk of doing so?
There’s no good answer, in my opinion. But there is one characteristic of DELL’s business that might tempt it to roll the dice.
DELL is a negative working capital company. That is to say that it gets paid by its customers long before it has to pay its suppliers. Dell’s 10k from January 2003, for example, shows it was owed $2.6 billion by customers but that was more than offset by the $6.0 billion in trade credit extended by its suppliers. So DELL was temporarily holding cash of $3.4 billion that it would ultimately be needed to settle creditors’ bills.
On the same date, DELL had $4.5 billion in cash on its balance sheet, but a tiny working capital deficit. This means that if DELL just stopped selling stuff completely, within a year it would need all its current assets, including the cash–plus a little bit more–to satisfy its current liabilities, of which the largest was creditors’ bills.
Looking below the current line on the balance sheet, DELL had another $5.3 billion in investments, most of that in highly liquid form. So it could easily meet all of its obligations, including salaries for its sales force and headquarters staff, without a problem.
Still, the thought of having billions in cash just evaporating from the company’s coffers must have been a scary one. At some point, Wall Street would notice and react negatively. So too would customers. Raising outside finance would presumably require disclosing the capacitor problem, so that might not have been a great option. My guess is that this is why DELL crossed its fingers and shipped low-quality computers.
The end result of the decision? –lawsuits and a tarnished reputation.
The Chinese gaming capital continues to boom. It looks like second quarter gambling revenue will be up on the order of 60%-70% year on year. This suggests results for Wynn Macau (1128) and Sands China (1928) will be eye-popping.
AAPL has announced that the newest iPhone has sold 1.7 million units in its first three days on the market–and that only because AAPL ran out of stock. This news comes a week after the company reached the 3 million unit milestone for the iPad. Together they add up to about $3 billion in revenue, of which about $2.5 billion falls in the current reporting period. This is a lot better than Wall Street has been expecting.
Bloomberg is also carrying a story today–no comment from AAPL–that AAPL will begin selling the iPhone on the Verizon network next January–maybe a response to the inroads Android smartphones are making in the US.
May 27, 2010
MSFT is overhauling its entertainment/devices division, according to theNew York Times. Over the past decade or so it has been run by Robbie Bach, a 22-year MSFT employee and former investment banker, who is retiring. From now on e/d will be run by Steve Ballmer, MSFT’s CEO.
It’s hard to know what to make of this. I met Mr. Bach a couple of times in the first years of his tenure with the entertainment division, during a time when his main job was the X-Box. I found him to be a pleasant person, brimming with confidence, and displaying excellent presentation skills. The strongest impression he left with me, however, was that even after months on the job, he knew virtually nothing about the industry he was competing in, and was blissfully unaware of that fact.
In the time before the launch of X-Box and PS2, the consumer electronics business believed that the next big thing would be hubs placed in consumers’ homes, through which all types of information, productivity and entertainment content would be delivered. Sony was touting the PS2 as the first device of this type, and the initial step on the road to its control of the consumer market. Bill Gates was convinced by advisors that MSFT could not let this happen. Hence, the X-Box, whose mission was to contest Sony and establish MSFT’s presence in the home, whether the effort initially made money or not.
X-Box achieved the first objective, but lost billions doing so. Then came a great stroke of luck. MSFT was all but handed the game console market on a silver platter when Sony chose to delay the launch of its next-generation machine, PS3, until over a year after MSFT came out with X-Box 360.
Somehow, MSFT has since lost that market share to a combination of the Nintendo Wii and a resurgent Sony.
Not only that, but MSFT has also lost its position in the cellphone market to AAPL and GOOG. Zune was unable to compete with the iPod. And MSFT saw its years of effort in the tablet market go up in smoke as it (to mix metaphors) has been blown out of the water by the iPad.
What’s hard to know about this? –whether it’s a good thing that MSFT figured out that changes were needed, or a bad thing that it took them this long. My guess–just a generic observation about how companies seem to run, not any deep insight into the workings of MSFT–is that internal financial projections for this division are far bleaker than the outside world realizes and the financial pain became too much to bear.
early termination fees
Although iPads are flying off the shelves and it looks like my thought that AAPL will sell 2 million of the devices this quarter wis too low a number, AT&T has recently announced that it’s doubling its early termination fee for the iPhone to $350. Not a great sign, but my guess is that this has nothing to do with the iPad. It’s competition from Android. I also think any erosion in iPhone profits will be more than offset for the time being by the success of iPad. But it’s something for AAPL holders to watch.
VZ has announced that it is doubling its early termination fee of its FIOS cable/internet service to $350. Not a good sign, either–although it’s not clear whether the competition is traditional cable companies or customers deciding to get their entertainment directly from the internet.
one of my credit cards
I accidentally transposed two numbers when I was writing a check to pay a Chase credit card bill last month, resulting in a balance of $27 carried over into the following month. What was the interest charge for owing that $27 for one month? $9.53, which is about 35% of the balance–and almost 500% annually. I thought Congress had passed a credit card reform bill.
April 14, 2010
Ben Stein and Steve Wynn
I was listening to CBS radio the other day and heard a commentary from a Wall Street Journal reporter who cited Ben Stein as saying that the biggest problem facing the US today is that no one trusts Wall Street.
This is a very peculiar thing for Stein to say. In addition to being a financial advisor, an award-winning game show host and an economist, Stein is also the guy sitting on a park bench in a suit and sneakers touting freecreditreport dot com in that company’s commercials.
Who is freecreditreport…? It’s a company that has been in hot water twice with the Federal Trade Commission, according to the New York Times.
What has it done? Part of the consumer credit rating agency Experian, freecreditreport… runs advertisements warning of the dangers of identity theft and offers a “free” credit report to viewers who log into the company website. The catch is that you have to sign up for a credit monitoring service that can cost $15 a month if you don’t cancel it within seven days after you get the “free” report.
Experian also doesn’t mention that a truly free credit report is available at annualcreditreport.com.
So on the one hand, Stein is bemoaning the damage done to the country by lack of faith in the financial system. On the other, he’s a pitchman for a company the FTC has fined twice for misleading customers.
Experian’s latest move: As of April 2, purveyors of “free” credit reports must disclose on their websites that the only authorized source of free credit information is annualcreditreport.com. Rather than do this, Experian is charging freecreditreport… users $1, which it gives to charity.
Way to go, Ben!
In the most recent quarterly earnings conference call for WYNN, Steve Wynn discussed in a most enthusiastic way the company’s intention to acquire a controlling interest in a company that had obtained a license to build a casino on the waterfront in Philadelphia.
The license had originally been awarded to a group led by the Mashantucket Pequots, who own the Foxwoods casino in Connecticut. The project had made little enough progress, however, that the state was apparently threatening to revoke the license and reissue it to someone else. Hence, the group’s approach to WYNN a few months ago.
Mr. Wynn was reportedly equally enthusiastic about the project when speaking with the state gaming commission in March and with the mayor of Philadelphia earlier this month. Then, out of the blue, WYNN issued a terse statement a week ago saying the deal was off.
The mayor was stunned. The gaming commission professed to know nothing. Local opponents to the development cheered. The governor, who I think has been very involved in selecting licensees, had no comment.
Why the last minute reversal? Some have suggested that WYNN initially underestimated the strength of local opposition to the proposed casino site. Others, apparently unhappy players at Foxwoods, have speculated that WYNN decided Foxwood wasn’t upscale enough to be a good partner. Still others have surmised that WYNN has its eye on the partly-built Revel casino in Atlantic City instead.
We may never know, although if the Revel rumors are true, we’ll find out in short order. But I don’t think any thought expressed above is correct.
I think it’s important to note that a Philadelphia casino is not a key element in WYNN’s development strategy, although the company appears to want any US expansion to be outside Las Vegas. Also, the project itself wasn’t big enough to have a noticeable impact on WYNN’s growth profile. Personal embarrassment to Mr. Wynn aside, the deal was not that hard to walk away from.
My guess? Based only on seeing other deals go sour, I think the original license holders wanted to change the terms of the deal to make it more favorable to them after WYNN got the seal of approval from the regulators and the mayor but before any binding legal documents were signed.
February 17, 2010
Happy New Year! Welcome to the year of the Tiger–a couple of days late
Yesterday, I posted comments on a paper written by Alok Kumar (now at U Texas, Austin) and George Korniotis (Federal Reserve) while they were professors together at Notre Dame. In it they conclude that investors over the age of 70 have inferior returns from buying and selling individual stocks because of a downhill slide in cognitive abilities that gathers speed from about that age on. I’m not sure that’s an inevitable conclusion, but the idea is an interesting one.
While I was looking at the paper, I noticed a second one on Professor Kumar’s website. This one will soon be published in the Journal of Accounting Research. It’s entitled, “Self-Selection and the Forecasting Abilities of Female Securities Analysts.” I think he has this one exactly right.
He starts with a review of academic literature (don’t blame me for this, I’m just repeating what Prof. Kumar is saying) which concludes that women in general are:
–more risk-averse than men, as well as
Therefore, they’re generally not as good as men at picking stocks. Nevertheless, female securities analysts perform better than their male counterparts. Why? They are “a special breed of competitive women” who choose to pursue a career in a male-dominated industry.
For female securities analysts, Professor Kumar’s research shows that:
–their earnings forecasts are more likely to be “bold,” that is, away from the consensus, than men’s,
–their forecasts tend to be more accurate than men’s,
–stocks react more strongly to new analytic insights by women, even though their thoughts tend to receive less publicity than men’s.
As a result of their skills and superior job performance, women are:
–more likely than men to advance to high-profile jobs, and
–less likely than men to be demoted to lower-profile jobs or forced to move to lower-profile firms.
Professor Kumar’s explanation? The brokerage business is one of the last bastions of gender inequality in the US. This is well enough known that only the smartest and most highly motivated women enter the industry. Less qualified women select themselves out. Investors also know that to survive as a securities analyst a woman has to have significantly better skills than a comparable-level man. So as a woman begins to establish herself, investors will be very eager to hear what she has to say.
My experience says that this is absolutely correct. The only thing I would add is that Wall Street is a walk in the park for a female analyst compared with foreign stock markets. So the work of a female securities analyst outside the US is even more worthy of careful consideration.
October 16, 2009
Wal-Mart vs. Alice.com
Wal-Mart has begun selling personal products on-line, in direct competition with Alice.com. Wal-Mart intends to charge $.97 per item for shipping vs. free shipping at Alice.com, so it will be interesting to see how prices settle out.
It isn’t yet clear how the competitive dynamics in this nascent industry will play out. On the one hand, Wal-Mart’s presence validates the idea and will doubtless help it grow faster than it otherwise would. On the other, it’s always easier to prevent a competitor from gaining a toehold in your market than it is to recapture market share once a rival is well-established.
Japanese margin traders
Around the world, if you asked investment professionals who the worst investors in their markets are, the answer would be individuals trading on margin.
In my experience, the worst margin traders in the world are those active in the Japanese markets. That may not really be fair, though. They may be the perfect contrary indicator only because they are just the easiest to see clearly in market data.
When Japan was a more interesting stock market, the general rule was than the market was oversold when margin traders in the aggregate had lost 30% of their money. The market was at speculative highs when margin traders were at breakeven. The idea that margin traders might make a profit was a thought beyond the bounds of comprehension.
What are Japanese margin traders doing now? They’re speculating in currencies, according to the Financial Times, and are massively long the US dollar. The Japanese government is preparing regulations to limit margin borrowing for individual’s currency trading to 50x, implying that leverage currently exceeds that by a lot.
A train wreck waiting to happen.
September 2, 2009
Disney announced on Monday morning that it was bidding for Marvel Entertainment (a stock I own). That’s not the odd thing. MVL would strengthen DIS’s appeal to males and give a boost to its video game effort. DIS would possibly provide animation talent from Pixar and would certainly bring MVL’s worldwide distribution into the major leagues.
The strange thing is that DIS didn’t announce the actual terms of the deal to investors in general until it filed an 8-K, its second about the deal, on Tuesday.
The terms of the deal, it’s DIS stock and cash, are complicated, but that’s no excuse for withholding the information. Basically, if I understand the 8-K correctly, MVL share holders participate in 100% of any upside in DIS stock from last Friday’s close at $26.84, but suffer more than 100% (110%?) 0f any downside.
I called the DIS investor relations people–try to find them on any DIS website!–on Monday afternoon. When they hadn’t called back within 24 hours, I called again (they weren’t down to me on their list) and found the information on the SEC’s Edgar site.
I also noticed that the newspapers and Bloomberg–mimicking the unclear language of Monday’s press release–all had the deal terms wrong. (Here’s the Edgar link if you’re interested.)
I don’t know enough about DIS to decide whether this is a once-in-a-lifetime snafu or just business as usual. It’s pretty awful either way, just a question of whether DIS is a serial bungler or not.
The peculiar welcome to potential new shareholders is one thing. There’s also an issue of fairness involved. Who, if anyone, knew the real terms of the deal on Monday?
Disney, lift your game!
August 13, 2009
At the end of last month I wrote a post about the search agreement between MSFT and YHOO. In it, I remarked on the almost complete absence of factual information about the deal in the joint press conference–most unusual–and the fact that MSFT, unlike YHOO, had not filed a related 8-k with the SEC.
MSFT still hasn’t filed one, although YHOO did file another 8-k on August 4th, which discloses the broad outline of the agreement. The nuts and bolts are still to be worked out.
What I find really strange is that the information in the August 4th 8-k was not made available to analysts or shareholders in time for the joint announcement of the deal. To me it looks like the data were withheld to make sure analysts weren’t able to ask intelligent and specific questions in public.
If so, this would be a very worrying sign for shareholders of both companies.
August 2, 2009
The Wall Street Journal is reporting that a number of brokerage houses have halted sales of leveraged and inverse exchange traded funds, as the same time as state regulators have begun to investigate marketing practices for these exotic vehicles.
Leveraged ETFs typically have names that suggest the funds will produce, say, 2x the return on a given type of investment; inverse ETF names suggest that they will go up if a given market goes down, and vice versa. According to the WSJ, however, fewer than half of the leveraged ETFs have produced results over a recent twelve month period that are in line with what their names imply. Over the same time span, 88% of inverse ETFs have done the opposite of what their names suggest.
At first blush at least, this has to do with the way these ETFs releverage themselves on a daily basis. For a fuller explanation of why this is so, see my post on leveraged and inverse ETFs.
July 30, 2009
A review of Gillian Tett’s new book, Fool’s Gold
Gillian Tett is the knowledgeable and articulate reporter who heads global markets coverage for the Financial Times. Fool’s Gold (Free Press, New York, NY, 2009) is her account of how the current financial crisis came to be. Her subtitle, How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe, gives us her conclusion.
An unusually good book
Fool’s Gold is an unusually good book, for two reasons:
Ms. Tett’s position at the FT has given her a front-row seat for all three phases of the crisis that the book describes and analyzes: the development of financial derivatives from the mid-Nineties, their “perversion” by bankers who ignored basic risk control procedures in their quest for personal gain, and the subsequent financial collapse which began in early 2007.
Ms. Tett has the rare gift of being able to describe the evolution of very complex financial products in straightforward terms. So you don’t need a math degree or a deep knowledge of the physics of Brownian motion to understand what’s going on. In addition, she has an encyclopedic knowledge of the firms and personalities involved, so the book also serves as a chronicle of the evolution of the financial industry over the past 15 years.
Three parts to the story
The book is organized around the experiences of a group of risk control experts at J. P. Morgan.
In the Innovation section of Fool’s Gold this group develops a new, and profitable, way of hedging the risks of the bank loans on J.P. Morgan’s balance sheet, thereby increasing the bank’s loan-making capacity. They apply their methods to all sorts of loans, but draw the line at mortgage-backed securities. Why? There are virtually no historical data that can be used to assess the riskiness–what happens to default rates in a national economic downturn–of this kind of security. So J. P. Morgan stays away.
In the Perversion section, the main figures in the book discover that other banks are dealing in mortgage-backed security derivatives in massive quantities. Have these other banks–Bear Stearns, Citigroup. Merrill Lynch…–figured out a way to solve the risk assessment problem? Apparently not. They appear to be simply ignoring it. Even worse, they’re in some cases lending hedge funds the money they need to buy what will become known as “toxic” assets. (Ms. Tett has reported elsewhere that toward the end, issuers were claiming that mortgage-backed security risk could be assessed using the insurance mathematics for the chances of a spouse surviving the death of his/her mate by a year.)
In the Disaster section, the wheels come off.
Social Anthropology Epilogue
In her intriguing Epilogue section, Ms. Tett, who, by the way, has a doctorate in social anthropology, writes:
“In most societies, elites try to maintain their power not simply by garnering wealth, but also by dominating the mainstream ideologies, in terms of both what is said and what is not discussed. Social “silences” serve to maintain power structures, in ways that participants often barely understand themselves let alone plan.” p. 252
In other words, life is many times like the story of The Emperor’s New Clothes–and until something shatters the collective illusion, it’s easier not to rock the boat.
Ms. Tett provides some obvious examples of the “elite” behavior she describes.
CEOs of the biggest banks, with the notable exception of Jamie Dimon, are portrayed as knowing close to nothing about the financial products that were the mainstay of their profit growth.
The regulators also fail to do their jobs. AIG, which is at the center of the mess, had very little regulatory supervision–this despite the fact that its now-infamous Financial Products business was run by associates of Michael Milken, the junk bond king imprisoned for securities fraud. Alan Greenspan, who was responsible for mortgage regulation, testified before Congress earlier this year that he did nothing because he thought the mortgage market should more or less take care of itself. But in the same testimony, he appears to me to have said, in his typically convoluted and unclear manner, that congress had told him to turn a blind eye toward mortgage securitization and he had done what he was told–so why was congress now upset with him?
The rest of us, as investors or as ordinary citizens. I’m not sure I agree with this, other than in the general sense that we get the government that we deserve. During the heyday of the junk bond, if a salesman told you that you could buy a mutual fund that had three times the yield of a money market fund, but was just as safe, common sense would tell you that this couldn’t be true. But I’m not sure that, if you heard that mezzanine CDO of ABS were bad enough to shatter faith in the US financial system, you should know enough to chart a course of action.
June 3, 2009
A review of John Taylor’s new book, Getting Off Track.
John B. Taylor is now a professor at Stanford and a fellow at the Hoover Institution, but he’s best known as the high-ranking government economist who put forward the “Taylor rule” for formulating monetary policy. He has just written a short book (76 pages), titled Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (Hoover Institution Press, Stanford, Ca, 2009).
The title says it all.
In the book, Mr. Taylor documents three main points, all dealing with human and institutional failure:
1. by deviating from a rules-based approach to money policy during 2002-2004 and setting the Fed funds rate substantially below what circumstances required, the Fed created a massive housing bubble, with whose severely negative economic effects we have been dealing for the past two years.
2. when interbank lending markets ceased to function normally in mid-2007, the Fed inexplicably misdiagnosed the problem (despite economic studies furnished by Mr. Taylor and colleagues) as being one of liquidity rather than counterparty risk (i.e., the solvency of the other party to a trade). So the Fed wasted a year treating the wrong malady.
3. when the crisis intensified in late 2008, Mr. Taylor shows that credit market conditions did not deteriorate after the bankruptcy of Lehman Brothers on September 15th, as is commonly thought. They really worsened only after the Congressional testimony on September 23rd about the TARP program by Mssrs. Paulson and Bernanke. As Mr. Taylor puts it, the huge subsequent spike upward in interbank lending rates reflected “the public’s realization, shock, and fear that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe.”
Mr. Taylor’s policy recommendations are what one might expect–for the authorities to be more disciplined and systematic in their preparation for possible problems; and to provide more complete information to the public about what monetary policy actions are likely to be, as well as what the current state of the financial system is.
What’s implied, but not said
What I find most intriguing about the book is what is not said explicitly. Mr. Taylor is unfailingly polite. The picture sketched is not a pretty one, but the reader is left to connect the dots himself about who was responsible for what. For example:
1. Mr. Greenspan was the Fed chairman from 1987 to 2006. His first fifteen years were spent continuing the Volcker project of bringing inflation in the US as close to zero as practically possible. Only when the task is complete does Mr. Greenspan realize that if inflation is close to zero, it is close to zero, that is, it might slip below–into deflation–every once in a while. That wouldn’t be good. But Mr. Greenspan’s reaction appears to be to panic and lower the Fed funds rate in an inappropriate way, and with disastrous results for the economy. Where was Mr. Greenspan’s preparation for success?
(An aside: to me, perhaps as disappointing was the day Mr. Greenspan was summoned to testify before Congress and refused to acknowledge any responsibility for the financial crisis. Questioning came around to his role as mortgage regulator. If I understood Mr. Greenspan correctly, he said/implied that the lax supervision of Freddie Mac and Fannie Mae he had provided was as much scrutiny as Capitol Hill had told him it would tolerate. Implicitly, then, the mess these agencies had created was Congress’ fault.
I can understand that Congress might have given Mr. Greenspan to understand that he should tread lightly around the mortgage agencies. What I don’t understand is why he should have acceded to the request.)
2. Much of modern economics stems from a study of the Great Depression, a crisis of liquidity, with the goal of never letting anything like that happen again. Mr. Bernanke is one of the world’s foremost experts on the Great Depression. Despite evidence to the contrary, he applies to the current crisis the remedies appropriate for the Thirties, sort of like the man who has a hammer and makes every problem a nail.
3. Mssrs. Paulson and Bernanke scare the wits out of the financial world by their lack of a systematic approach to the financial crisis. True enough. In particular, Mr. Paulson, despite his long and successful career on Wall Street, was able to demonstrate fascinatingly little knowledge of how our financial system works. But Mr. Taylor mentions nothing about the partisan bickering in Congress during this time, the demands for porkbarrel projects in exchange for votes, the Republican rhetoric about letting the banks fail and rebuilding from scratch, the failure of the TARP bill to pass in the House of Representatives. Mr. Taylor may figure this is par for the course. But I found it particularly scary.
All in all, something well worth getting out of the library. It will be interesting to see what effect the book will have on the financial crisis post-mortem.
May 20, 2009
MGM Mirage and Genting casino difficulties: the Ho family
The New Jersey Division of Gaming Enforcement has the reputation of being the most vigilant regulator of casino operation is the US. Worldwide, I think its only peer is its counterpart in Singapore.
According to an 8-K filing with the SEC yesterday, the NJDGE has recommended to that state’s Casino Control Commission that MGM Mirage be told to sever its links with Pansy Ho as a condition of being allowed to operate casinos in New Jersey. Ms. Ho is the daughter of Hong Kong billionaire Stanley Ho, who is a 50/50 partner with MGM in the MGM Grand Macau casino.
The issue appears to be how independent Ms. Ho is of her father, who had monopoly control of casino gambling in Macau for years, but who has long been alleged to be connected with organized crime.
Although the Financial Times reports the elder Ho has never been accused of any offenses in either Hong Kong or Macau, two years ago the Singapore government required the Malaysian casino company Genting to end its business association with Mr. Ho before granting it a license to operate one of two casinos on that island.
If the NJ Casino Control Commission follows the recommendation of its enforcement arm, MGM could face difficult choices. It’s possible that Nevada, which has already approved the relationship between MGM and Ms. Ho, would reconsider its decision. So selling its interest in the Borgata casino in Atlantic City might not provide a solution. Disposing of its Macau interests might not be that easy, either, since the buyer would presumably place himself in the same position that MGM is in now.
This situation seems to me to have the potential to develop in a very unfortunate way for MGM. I’m surprised there hasn’t been any effect on the stock. Either the market knows a lot more than me, or a lot less. Stay tuned.
April 22, 2009
The Financial Times had a recent article on bankruptcies in the age of credit default swaps (CDS).
My experience has been that a company is thrown into Chapter 11, not by its bankers or bondholders, but by its trade creditors. Say the cleaning service or the supplier of pencils hasn’t been paid. Typically, the creditor goes to court with its unpaid bills and asks that the firm be put into receivership. The banks don’t want this to happen, so initially they pay the debtor company’s bills. After a while, the banks get fed up with the drip,drip,drip of money going out the door and allow the bankruptcy to proceed.
The Financial Times report refers to the recent bankruptcy filings of Abitibi and General Growth Properties. In both cases, some creditors has bought insurance against the possibility of the company’s default through over-the-counter CDS agreements. So, even though these creditors were holding debt obligations of the company, which would lose value in bankruptcy, they also held CDSs, whose value could only be realized if the company did in fact become bankrupt.
These creditors might well have concluded that their best course was to force the bankruptcy. They would collect on the CDSs and would doubtless get something more for its bonds through the bankruptcy court. So their interests could be entirely at odds with those of the other creditors.
My guess is that this will be an important issue for medium-sized companies now in financial trouble. For them, bankruptcy will be a more real and imminent threat than usual. So these firms may be more amenable to merge with a stronger rival. Certainly, they will begin to think of countermeasures.
In theory, this could be an issue to shake the financial world to its root. In practice, I don;t think it will be. Doubtless the sellers of this default protection will quickly factor into their prices, or their willingness to provide insurance coverage at all, the character and past actions of the buyer. So I don’t think it’s likely that anyone could start a cottage industry of buying lots of CDSs, a few bonds, and then precipitate a bankruptcy filing–unlike in the Wild West, where, when a greenhorn arrived in town, locals quickly insured him, names themselves as beneficiaries and shot him.
April 1, 2009
AIG bonuses and the GM bailout–unintended consequences.
Yesterday, Bloomberg reported that President Obama believes that a prepackaged bankruptcy is the best solution to GM’s woes and that Chrysler will probably have to be broken up and sold piece by piece. In the case of Chrysler, this idea isn’t so politically unpalatable to what has shown itself to be a highly partisan Democratic majority in Congress, which derives significant financial support from the auto unions. The reason is that Chrysler is owned by a hedge fund. But GM?
Investors have seen so much over the past six months that a GM bankruptcy doesn’t have the shock value it might have had late last year. And there has been time to think out how to minimize the negative consequences on the company, its suppliers and customers of a filing. The question is not so much what President Obama believes, but what he can get past Congress. Here’s where the AIG bonuses come in. How can Congress grandstand about paying large sums of money to AIG executives for horrible performance–clearly responding to the outrage of their consitituents–and then allow similar continuing multi-million dollar compensation payments to the present management of GM by bailing the company out? In the GM case, this would not be the kind of thing that would be done once and then forgotten. There’s every reason to believe that, under current management, GM’s plans would fail and the company would be back in Washington lobbying for more money. So to a representative thinking about reelection, voter outrage about AIG makes it clear that a GM bailout would be an albatross around his neck in November 2010.
March 31, 2009
From press accounts, there was a lot of talk at last week’s Game Developers Conference about the demise of the shrink-wrapped video game software business.
For a third-party developer like Activision (my family and I own shares) or Electronic Arts, the issue is a pretty simple one. Assume that the developer’s out of pocket cost for a game unit, including royalty to the console maker + manufacturing expense, is $10 and that the unit wholesales for $50. To keep things simple, assume there is no unsold inventory on the retailer’s shelves. So the developer has $40 per unit to cover development and marketing costs.
How many units can a potential “A-list” title be expected to sell? Well, there are about 300,000 hard-core gamers in the US, who buy just about anything that comes out. That would bring in $12 million. This compares favorably with game development costs of , say, $10 million for a game from one generation ago, and of $5 million two generations ago.
So two generations ago, making a profit from a decent game was a no-brainer. One generation ago, hard-core gamers alone could still bring the developer within shouting distance of breakeven. But today’s development costs can be $25 million–meaning a game has to attract several hundred thousand casual gamers just to cover its development costs. Certainly, this can be done. And mega-hits still make tons of money. But the losses on so-so games have shifted from tiny to huge, making the shrink-wrapped software businesses look more and more like the movie studios.
Also, even before Nintendo came out with the Wii, casual gamers were becoming a harder target to woo. The emergence and success of online games like Kart Rider from Nexon, where the basic game is (more or less) free but where the participant can buy enhancements to his car or pay to accessorize his rider, have made capturing the casual gamer’s dollars a more difficult task.
The industry has known about these trends for years. What seems to differentiate the two big players, ERTS and ATVI, from each other is execution. Despite being the bigger company and having had a very early start with online virtual worlds (Ultima) and casual online games (its deal with AOL), ERTS looks like pretty much the same company it was five or ten years ago. In hindsight, ERTS also a big mistake in turning down the chance to buy Blizzard when Vivendi was in desperate financial straits at the beginning of the decade. Of course, no one knew then how big Worlds of Warcraft would be.
ATVI, on the other hand, has steadily built itself up through the years to the point where many investors would consider it a genuine alternative to holding ERTS. Then came the company’s transformative merger with Vivendi’s video game division, which, to me, anyway, puts the company in a class by itself.
This industry is not well understood by Wall Street, despite being covered by some of the best analysts around. Since both are classified by S&P as technology stocks, portfolio managers tend to hold one (usually ERTS) as a defensive position when they aren’t feeling good about more industry-oriented tech names.
Maybe as a new bull market emerges and investors carefully rethink their beliefs, both will get a more positive reassessment.