Microsoft – an accounting geek’s summarizes his purpose and lessons

This is not a post with investment conclusions.  It is more a little about my own voyage.  If you want the stock posts read the last two posts in order.

My purpose

The purpose of this blog (as stated in my profile) is:

to explore investment ideas. [This blog] differs from most investing blogs as I have no intention of talking my own book. However I will explore what is wrong with my investments and that means I need to talk about positives and negatives. I welcome criticism. I most value criticism which demonstrates that some of my ideas are wrong.

I wrote the post to try and explore what was wrong with Microsoft stock (which – for the record I own in small quantity).  I was slightly annoyed with the title put on the post when it was reprinted by Business Insider because it misrepresented my purpose.  That said – there are real negatives with the Microsoft story – and it is worth exploring them. 

Microsoft is (way) outside my usual beat.  I am an accounting geek.  I like to read accounts to find out where things have been clipped, where the statements are aggressive, where the bodies are buried. 

Microsoft is an unusual company because there are no bodies buried in the accounts.  The business is staggeringly profitable – and those profits are entirely visible in cash (and equivalents).  Usually I add value (if I manage to add it at all) by understanding how the business makes its money and how that is reflected in their accounts.  For me reading Microsoft’s accounts beyond a summary and cash flow statement is pointless.

With a complex financial institution (my usual beat) understanding the accounts can be a difficult job.  Schiff’s Insurance Observer still refers to “the blonde with more curves than Conseco’s financial statements”.  Microsoft’s statements are as curvy as Bill Gates.  This is a fabulous business – arguably the best business in the history of capitalism. 

So the question:

The outcome for Microsoft stock will be driven by whether – in ten years – we wake up and find that Microsoft has retained dominance in the way corporations interact with their data and a decent position in the relationship of retail consumers and digital data. 

If Microsoft is dominant in that they will be making much more money in a decade because there will be much more information – and more computers - and the cost-per-computer is not outrageous even if the total revenue line is. 

If Microsoft loses its dominance then the stock could have another weak decade (notwithstanding the fact that it starts at a low price relative to current cash flow).  The stock price is so low relative to indisputable current cash flows that Microsoft would really have to stuff it up from here to make the stock a worse investment than say the current ten year bond.  But this is technology and it is subject to rapid change.

In my semi-geeky way I tried to run through the threats to understand them.  The threats are obvious: virtualization (and hence the end of the hardware-dependent computer), virtualization (and hence the end of the client-server model Microsoft rode to glory), Linux (and free software generally), the resurgence of the Macintosh platform, and (possibly most importantly and certainly most obviously) the increase in (mostly non-Microsoft) mobile devices (which are increasingly how the young and the affluent consumer relates to music and the internet and to data generally). 

So far – with respect to most of those threats – Microsoft has not been victorious – but has left itself a place at the table.  Even Zune has a place at the table even if it is up the end... 

Microsoft has not had an unambiguous winner in a decade – but then they are so entrenched that even without a winner they remain a strong company.  They produced one (very) weak flagship product (Vista).  But they have a (very) good product now (Windows 7) – it is however sufficiently late to cede a lot of ground to Apple.  Still you could imagine a world with an absolutely brilliant Windows 10 (!) phone which integrates near perfectly with business data (being a thin client for the work computer) but also has a lossless music player, high quality music jacks, integrates with Facebook (or its successor) perfectly – oh – and it is as cool as any future iPhone.  It just has not happened yet – but a super-hot product would add 100 billion to the cumulative cash flow Microsoft might produce and make the stock a fabulous investment.

On virtualization the “clients” in my experience are mostly windows (or often virtualized windows servers sitting on linux boxes).  Microsoft has a position.  But the virtualization platforms are Citrix, VMWare and others.  The underlying operating system is linux.  Indeed Wikipedia gives a huge list of programs and Windows is by no means dominant.  Linux (outside the server market) remains a product for geeks and Baltic grandmothers (but is getting better rapidly).  Apple look like the winner in mobile devices – but it is early in that game still and I think Linux in its Android form is likely to wind up the winner just because Apple extracts too much margin and the Android product is likely to be just as good (except for the killer iPod app).  That said the Windows 7 phone reviews pretty well.  Ten years ago Palm was the likely winner in mobile devices.  These things change!

A comment on the comments

The comments were very high quality. Sure I found someone who believed that Linux must run on top of (pirated) Windows XP.  He simply could not believe that you could run a computer without Windows.  [That level of ignorance is itself interesting because it tells you just how entrenched Microsoft is…]  But I also found down-in-the-trenches people who could not imagine that any business could go all thin client.  [I observed however that quite sophisticated businesses have gone that way already – and it is far superior to the client-server arrangement for security and disaster recovery – but not only is it superior – it is cheaper.]   I found religious open-source zealots but also entirely practical people who thought you could not get fired for buying Microsoft.  (I noted that in the server business for many applications you would be fired for buying Microsoft…) 

I met open-source geeks who thought that Ubuntu – at its current rate of improvement – would be as user friendly as a Mac within 12 months.  That is aggressive. It took me considerable effort to permanently mount the windows-share hard drives on my new computer – enough difficulty that I can be sure Ubuntu is not ready for prime time.  But given the improvement between my first linux machine [a Mandriva 2006 release] and the current Ubuntu release I think Ubuntu will be up to it in a few years.  That said the Mac is more user friendly than Windows and it has not won the war at corporate level.  The better product does not necessarily win because of the advantages of incumbency.   

A comment on the stock selection

This a long way outside my circle of competence.  I reckon I can read a bank’s financial account as well as anybody – but nothing is added by reading Microsoft’s accounts.  So to do this I had to become more geeky than is natural for me.  Alas I discovered there is as much debate amongst geeks as there is debate amongst bank analysts and – like bank analysts – they are probably all wrong about most things. 

I really want to thank everyone who commented.

 

John

Follow up on the “geek post”

I never realized I had quite so many super-smart and geeky readers.  The quality of comments – especially those that came through my inbox – was amazing. 

This post attempts a synthesis.  That is difficult because many of the super-smart and geeky readers had diametrically opposed views.  This was typical:

The bottom line is none of this stuff matters enough to get religious about it. If you want to go through a four week learning curve to use Ubuntu, have it. If you want to use second-rate office software because it's good enough, by all means do that. But if you're preaching for a mass conversion to happen, don't hold your breath waiting. In all likelihood your son will soon want a Windows machine so he can play the same games his friends are playing.

And I have to say he is right.  Ubuntu is faster – and it is nicer for some things – but I have such huge capital embedded in Windows (years of use) that I will use Windows for many things.  Moreover getting Windows games to play on Ubuntu is (frankly) not worth the chop (even inside “virtual windows” – explanation below).  Also my son does have a windows partition – and the only thing he runs on it is Cyberlink Powerdirector 8.  Games get run on the Wii (or Playstation) – but a non-linear video editor is essential for him in these days of YouTube.  My son communicates with movies…

My purpose was not to learn to use Ubuntu.   My purpose was to work out where I stood as a stock analyst.  It makes no sense whatsoever to change unless you have very specific needs [the usual need being to maintain servers]. 

By contrast I was told a story about an elderly (and non-techie) woman in Lithuania who was given a brand new laptop with Windows 7 on it.  The first thing she did was wipe the disc and install Ubuntu.  Why?  Because she was used to it and knew how things worked.

And that is the point: these things have inertia – and the inertia is real.  Windows is useful primarily because it is there.  In particular:

(a).  The easiest system to use is the one you are used to.  If you use Windows at work it is likely you will use it at home.  I feel uncomfortable on a Mac because I have not used one since I gave away my Mac Plus.  [That I guess dates me…]  The woman in Lithuania felt uncomfortable with Windows because that is not what she is used to using.  The cost of changing (four weeks) is just too high. 

(b).  The price does not really matter.  The OEM cost of Windows is about $50.  The laptop lasts three years.  There is no way that anyone is going through 4 weeks of hard intellectual work of learning a new system (any new system) for saving of about $17 a year.  That is simply a non-starter.  This defends market share.  I hated going from my Mac to a Windows machine at work – but once I crossed that divide all my future machines were Windows.  However the young are back buying Macs and that will weaken the Windows incumbency.  There are a few places where Ubuntu has serious share (the Baltic states spring to mind) but that is rare.  The proof that price does not really matter is the sudden willingness of people to buy Macs at price points up to $500 higher than current PC offerings.  They do this because – well – the Mac is nice…

(c)  Lots of software is written already for windows – especially games – but also video drivers etc – that do not run as native on linux.  Moreover because the desktop share of linux is so small nobody wants to bother porting their software.  You use Windows because everyone else does.

(d).  Microsoft had a really useful suite of “developer tools”.  This meant that many businesses wrote software for their businesses that works in Windows and does not work elsewhere.  This also means that they have a reluctance to change.  [By contrast most business software these days is written with web-interfaces.  We have written a database for work – and our developer wrote it to work on our linux server – but the interface is our browser…]

Microsoft has not come up with a really good “must have” product in a while.  That said – Windows 7 is quite a good system – and even my tech friends who are linux devotees – confess an admiration for the new-found stability.  This will drive some sales as sensible people did not move from XP to Vista – but will move from either XP or Vista to Windows 7. 

Inertia matters and this bodes well for Microsoft.  The tailwind (developing countries) remains strong for some time.  Inertia saves the Western business momentum.  The cash-flow is robust for at least a few years – and will probably grow.  I even purchased some Microsoft stock.

Some thought I was overstating virtualization as a future because it is reliant on very fast connections.  There are a few responses to that.  Firstly within the enterprise (which is the core Microsoft market) virtualization is a reality now.  I know a 50 person financial firm whose computers are really two mondo-powerful servers.  The 50 staff all have a “virtual box” with the computing capacity shared on the servers.  One server would do the job – but two is for redundancy.  There are an exact copy two servers in a remote location about 50 miles away – that is the disaster recovery.  This is superior in lots of ways.  There are no distributed hard drives which makes data much safer from theft (you cannot walk out with a hard drive).  There are no USB keys or other ways to pilfer data in the field.  The computers are mobile – someone can log on from anywhere in the world.  If they move desk they do not need to move their computer.  The disaster recovery is really simple – and is an exact duplication of the work machines.  No decentralized data to lose.  No problem with mirroring. 

This is a sophisticated and superior set up.  But it is cheaper than the existing set up – and easier to maintain.  That is a winner.  What works there will work elsewhere.  I mentioned this to a UBS executive and he just said they were miles behind on that.  But hey – even UBS will catch up!  It will happen in the home too – maybe earlier in countries like Australia (which is rolling out the National Broadband Network) – but it will happen more generally.   I have gone personally from opposing the NBN (a costly government project) to being supportive (it will allow us to save huge amounts in IT infrastructure).  That said – if it works in Australia it will happen everywhere with sufficient population density.  Anywhere that you can deliver high definition TV on demand has more-than-sufficient bandwidth. 

Linux as the dominant operating system

So lets get to the big point.  I am going to put it in bold because it – at first look is such an outrageous statement – but I think it is inevitable.  Within 18 months the world’s biggest selling operating system (that is the one in the largest number of new devices) will be linux.  It is not even going to be close.  Within three years linux will be utterly dominant – maybe a 70 percent share. 

The thing is all that share will not be on laptops or desktops.  It probably won’t even be on tablets or pads.  It will be on telephone handsets.  The handset market is about a billion pieces per year.  The computer market maybe a fifth that.  The dominant phone operating system will be Android – and Android is just a cut-down linux.  Who cares about the front-end of Ubuntu (which is adequate).  What we should care about is the front-end of Android – which is a winner.

That has implications – and if you were a PC maker or a Microsoft investor you better think them through.  But I will outline a couple. 

(a).  You can run a windows machine or even a Mac on a linux machine using virtualization.  This makes possible Windows as an app – or for that matter Mac as an app.  This will require more computing power than a handset currently has (but give it time).  It will also require some form of “docking stand” into which you plug your keyboard, mouse, printer, very fast internet connection, sound system and maybe a hard drive for mass storage.

(b).  Virtual machines can be spread across multiple platforms and can share computing capacity with the platform.  So you can have your “windows as an app” which uses the handset for simple tasks (such as word processing etc) and uses the cloud’s processing power for complex tasks (such as rendering an MPEG4 movie for YouTube). 

This machine can be far better than the computers of today.  Here are a few drivers:

1.  Software only from repositories.  One of the reasons why Linux has far fewer glitches than Windows is the software loading process.  With windows I go to a site and download a .exe file and click (although there are even drive-by infections on the web).  Nobody polices the sites I get software from.  With Linux most software comes from “repositories” where the software is downloaded from vast servers.  (Downloading software from outside repositories is surprisingly difficult…)  When the software comes from “trusted sources” it is far less likely to contain a virus or trojan.  The Apps store is just a repository – and refusing to allow software purchases outside the store is a protection mechanism.  When we do cloud-software the service provider will probably also provide repositories.  Cloud computing increases security – and the absence of trojans will increase privacy.

2. Machines are mirrored in the cloud.  If you lose your phone you buy another one.  You then download your old computer from the cloud.  No data is lost.  The new “owner” of your phone will not have access to your machine without some serious identification – probably your thumbprint and a password.

So here is the question: can Microsoft – or even Apple – win the “pc as an app” war?  Is incumbency enough protection?  In the corporate area it clearly is enough for now.  The financial firm I described above is fully virtualized.  The servers run linux – but the (thin) clients are all Windows.

I learnt a bundle from the comments – so more requested.

Thanks.

 

 

 

John

 

PS.  I mentioned that the virtualized PC does not play games well.  There is a reason – I run a laptop.  To play the game well the virtual computer would need to take direct control of my graphics card.  If it does that the host computer (ie the linux box) loses control of it – and hence loses its screen images.  So I can’t play even simple 3d games in my virtual computer.  Every business function is fine – but the “fun-stuff” is not.  The graphics card companies (ATI, Nvidia) can probably solve this by having dual-chip graphics cards or the like.  But no matter where I looked I discovered that graphics cards were the biggest problem with my set up. 

It is probably good for me to have a work computer that cannot play games.  (Saves much time wasting.)  But it is not ready for general prime time.  Again solutions cannot be far away – but they are not really viable for a non-geek now.  [My computer will accept a second graphics card through a PCI slot.  This is precisely what is envisaged by the manufacturer when they put that option in the BIOS.]

A fund manager experiments in geek...

Forgive a long post – but I suspect this might develop into a theme.  My business partner thought I should break this post up – but I figured I should put the outline in one place and refer back to it.  There may be follow ups but this stands on its own.

My original motivation for this examination was Whitney Tilson's rather convincing looking buy case for Microsoft.  Microsoft is – by all conventional measures – pretty darn cheap these days.  Whitney Tilson (a well known hedge fund manager) details how cheap and he does so without mentioning what I think is the most important driver.     

The driver that I think Whitney was not mentioning – and which I have not quantified – is the shift of much of the world to laptops.  In America or Australia if I buy a desktop PC it almost invariably comes pre-loaded with Microsoft.  It is however a surprisingly easy thing to do to build your own PC – buying the components separately to get precisely the PC you want.  I have done it and works.  The reason this is possible is that standards have made the PC modular – all the plugs and protocols are common.  Nobody other than serious geeks (or gamers wanting to soup things up) does that in West – but in developing countries it is not uncommon for your local computer supplier to do it.  After all – if you put a computer together yourself you do not pay anything to Microsoft – and you can – if you want – you can install a pirated computer system.  By contrast. if you go to a computer shop in Mumbai there is a fair chance that the machines are “white label” and the system is “not genuine”.  However there is almost nowhere in the world you can buy a (retail) laptop (other than an Apple laptop) which does not come pre-loaded with Microsoft.  You used to be able to buy “bare bones” laptops in Australia – where you added your own memory and CPU to your own specs – but I can't find them anywhere.

As the world (particularly the newer markets in India and China) moves to laptops the “not genuine” problem for Microsoft evaporates.   Growth in laptops in India is nirvana for Microsoft. 

And Microsoft is so cheap that any increase in sales will make the stock look extraordinary.  The stock at this point does not need many drivers.   

The negatives are the re-emergence of Apple as the “must have” product – especially for the young and affluent and the encroaching of linux – which is now dominant in servers – as well as entering the retail market through things like the $250 net-book computer and through being the basis for some mass market products (ranging from Android phones to PVRs).

I wanted to explore the negatives (especially linux and virtualization) properly and so I spent a couple of weeks turning myself into a geek.  This post explores that journey. 

If you are a “real geek” and you know what you are doing you are probably going to find all of this shockingly naïve – but I still want your comments because that is how I learn.  If however you are like me and pondering the stock maybe I will save you some work. 

I will start with a conclusion which should not surprise any geek – but tends to surprise non-geeks:  linux is the “real deal” and is a much bigger threat to Microsoft than Apple.  However it will also change Apple's (laptop) business model beyond all recognition – and it will do so via virtualization.   It will also change the hardware business beyond recognition.  Indeed it is already doing so.

I have now changed my laptop to a linux (Ubuntu) machine and run a piece of software (Virtual Box) on it.  Virtual Box is a program which pretends it is another computer – a virtual computer.  On virtual box I run Windows.  This is – I believe – a superior set-up and it is unlikely I will ever run a machine primarily on Microsoft again.  I will explain why more fully below – but first I just wish to make a simple observation...  if I take the hard drive out of my laptop and install it in my old laptop everything works just fine – the whole computer is functional.  If I tried to do that with a windows operating system it would fail.  This is likely to be important in the future of computing because I will be able to migrate my computer from a laptop to the cloud – or possibly onto my (linux powered) phone.  It is unbelievably useful to have a hardware-independent computer. 

I warn in advance that I have not come to very strong stock-conclusions.  But I have learnt a lot – so this is a post to detail what I have thought along the way – and an invite to have the “true geeks” correct me. 

Three business models for an operating system

There are three business models around for operating systems – two of which are closed source (Apple, Microsoft) and one of which is open source (Linux, FreeBSD etc).  The first part of this post explains these models and hence explains what software is good for and what it is not and how that derives from the business model.

Historically the most important of these models is Microsoft.  Microsoft builds software which they license very broadly.  Anybody is allowed to build a computer and run Microsoft on it.  Microsoft sells to almost all computer manufacturers.  Hardware makers competed to produce better and faster and cheaper computers.  All of that competition took computers from a highly niche product in 1984 to a must-have for a very large part of the world.  Microsoft split the benefit of all that competition with their customers and became frighteningly profitable – probably the best business in the history of capitalism. 

But Microsoft's willingness to work with any hardware makers is also the big weakness in the system.   I have a computer assembled from bits found on Ebay and (sometimes literally) from bits at the side of the road – and it runs Microsoft Vista well enough.  It is probably different from any other computer in the world – but Microsoft has to make it run.  And that is difficult for Microsoft – and the computers are by-their-nature buggy.  This is meant to work with that – but conflicts are rife and sometimes computers have errors for unidentifiable reasons.  The reasons are unidentifiable because Microsoft does not release their source code and without that nobody (and I mean literally nobody) can actually work out what went wrong in some instances.  Microsoft can – but only because an “error report” gets sent back to them and – provided they get around to your problem – which presumably means provided the problem is widespread – they can issue a patch. 

And that roughly explains Microsoft's position in the market...  it works for everyone – but it does not work particularly well (though Windows 7 is an improvement).  Moreover Microsoft allows you to use cheap hardware – and that is a good thing. 

Apple deliberately took a different tack and the company almost failed.  However that tack has resulted in Apple’s new resurgence.  Apple do not license their software – and so – because they built every computer allowed to use Apple software they know precisely “what is in the box”.  Because they know “what is in the box” the machines work.  After all – they are not building for 100 thousand different configurations – possibly only the thirty or so configurations that they have sold.  And they can test the software on each of those configurations and if it works there they know it works.  (They also limit multi-tasking on some devices like the iPhone because multitasking with 100 thousand apps will produce combinations that they cannot possibly have tested.)  Less configurations means less complexity.  And because of that there is less “bloat” in the system which makes it faster (for any given hardware). 

But there is a downside with the Apple model – and the downside is that there is less competition between hardware markers.  Competition between hardware makers works for Microsoft far better than it works for Apple and it meant that Macs were always over-priced (even allowing for the fat margins that Apple builds into its hardware).  To some extent Apple solved this by moving to x386 (ie Wintel standard) chips – and allowing the Microsoft competition to work for them.  This made the machines cheaper but also allowed geeks to load Apple software on non-Apple machines (ie making a “hackintosh”).  

This model positioned the Macintosh in the market.  It was the computer that “worked better” and was not glitchy – but it was a niche product because it was more expensive. 

It was on this comparison that Microsoft rolled over Apple and became the dominant and most powerful computer company in the world.  Macs – it seemed – were doomed to be the (darn nice) niche product. 

When Apple finally moved to x386 chips the difference in production costs became less stark – but they remained – and they remain to this day.  Still – the fact that Apples work means that for many uses the total-cost-of-operation for a business running on Macs is lower than a Wintel setup.  I know a medical centre that recently changed and considerably cut costs.  Further – and this bears observation – computer hardware is now getting sufficiently cheap that the disadvantage of the Apple model (lack of competition in hardware) is becoming less significant. 

It is worth understanding how larger businesses (say 200 plus computers) have dealt with the problems of Microsoft.  Essentially they have tried to give Wintel platforms the advantages of Apple platforms via standardization... 

What they do is rather than have 200 different computers throughout their business they have maybe one, at most three different models in use at any time.  These computers are essentially identical and they have – sitting on the IT guys desk – three exact clones.  When new software arrives (say for example a Microsoft update) the software is thoroughly tested on the three clone computers to make sure it produces no glitches.  If the software (or hardware upgrade for that matter) causes no problems they roll it out across the network with all the computers being changed when staff power them up in the morning.    The system works because the IT specialist controls “what is in the box”.  By controlling what is in the box (often restricting the right of staff to load their own software) they get Apple levels of reliability but the ability to buy Wintel priced hardware.  They do however pay a price on hardware – which is that they often get tied to exact specifications for computers.  If their business expands they can either (a) get a new computer specification in or (b) order more computers under the old specification.  When they do the latter (which would be most the time) the hardware maker has leverage – and selling old computers to business at old prices can be surprisingly profitable.  [After computers should fall in cost by about a percent per week – so selling an old computer at an old price is a massive winner for the vendor... and is an important part of Hewlett Packard’s business.]  Big business – through standardization – are – in this view – trying to emulate the advantage of being Apple.

There is a third model out there – which is the truly open-source model.  In open-source the source code for the software is public and so – with appropriate expertise anyone can see what is going on in the software.  [This is different from both Microsoft and Apple as their proprietary software makes computers running on them into true “black boxes”.]  If you know what is going on in the software you should (again with appropriate expertise) be able to make your hardware work with it.  If your hardware causes glitches you can fix it (or fix the drivers) because you can see what is going wrong.  The hardware makers have both the means and the incentive to make sure it works.  With Microsoft and Apple they have the incentive but not the means (they can't see the source code).  So Linux is strangely the best of both worlds – there is competition between hardware makers so it uses cheap hardware and uses it well and it is really stable – as stable as Apple. 

There is however a downside – which is that frankly – nobody much has an incentive to make the whole thing work for the end retail user – that is – the user interface has generally sucked.  The thing now comes with two user interfaces (Gnome and KDE) and nobody has much standardized anything.  Moreover the interfaces are run by committees and – by the standards of open-source products – they are bloated.  This downside is rapidly been remedied.  A couple of years ago I tried using linux on the desktop (using Mandriva and OpenSuse) and frankly it was not much chop.  I now use Ubuntu and it is nice (meaning moderately friendly).  The remedy however is slow at coming.

This description places Linux in the market too.  The description is (a) stable, (b) able to use any hardware and (c) less-attractive and user-friendly around the interface.  This makes it perfect for nerds and geeks who like the stability and like being able to run their peculiar hardware setups and don't care that it requires some expertise.  The place where linux found its main home was on servers.  Servers are computers that run all the time set up by geeks and let run without much attention.  They tend to need to work together.  They are perfect for linux.  Microsoft has slowly and surely been losing the server market to linux.  If you need your server to work really reliably with hardware of various ages it is almost certainly running some form of linux (or maybe FreeBSD another open-source alternative).   The Googleplex unsurprisingly runs on linux derivatives as does the space station and probably most nuclear reactors.  Its a great system but user-friendliness has always been an issue.  [I know that the linux geeks will object to that statement – but it is odd having to learn codes like “sudo apt-get install cinlerra” and discovering it does not work…]

One more thing that linux offers is considerable ambivalence about which hardware you use.  You can run it on many kinds of computers.  If you take your hard drive out of one computer and install it in another computer it will probably work straight away.  Both Apple and Microsoft are very hard-ware specific.  This willingness to be used on many computers is a massive help for a system administrator because she can update the hardware and it will work.  Compare this to when you buy a new laptop and you need to reload everything on your shiny new machine.  Hardware portability is anathema for Microsoft because Microsoft sell new software every time someone buys a new machine.  I replaced my laptop because well – my Dell machine was a turd – and Microsoft – bless them – extracted over a hundred dollars from me.  I was not replacing the system which was adequate – I was replacing the machine which was inadequate.  Hardware independence would have been incredibly valuable to me because there would be much less problem with migrating settings and other painful but essential tasks. 

Apple is more comfortable with hardware independence because you are always using Apple hardware into which a massive margin is built.  Microsoft make their money selling software – Apple by selling hardware at fat margins.  You know this because you can buy an Apple operating system for $40 down at the local shop – and it is a better system than Windows.  The only problem is (at least according the end user license*) you are obliged to run this on an Apple machine.  Microsoft sell licenses for their system for about 8 times this sum. 

The ipod, iphone, Ubuntu, virtualization and other business model changes

There have been several large challenges to the outline I described above.  These were not all that predictable – or at least if you predicted them you might have made a fortune on Apple stock.  I will deal with them in order.

Firstly Apple have found a niche where their product is simply superior.  It is consumer products for non-geeks that want to be (a) super reliable and (b) easy to use.  The first of these was the iPod.  It was a dead-easy to use music player that met an enormous consumer desire.  The previous products in the space (portable CD players, Walkmans) were – at least by the standard of an iPod – very inferior. 

The thing about a music player or a phone is that it is ultimately not-that-expensive and it is really important that it just works.  And so the Apple model is just superior.  And you know this – how would you feel about having Windows on a phone?  The question answers itself – there is no reason for a buggy thing (or even a thing with a reputation for bugginess) on a product designed for limited functionality and unsuitable for hardware expansion. 

The other non-buggy operating system (linux) is also suitable for phones and Google has done it – the so called Android – which is really a dressed-up version of very-small-linux. 

The niche here for Apple however is for products that are resistant to hardware expansion and have to just work.  iPads, iPhones and others fit.  The completely closed software shop is part of the way to get these things to work.  If the software shop is completely closed then you know it won't cause glitches because you control (a) the software and (b) what is in the box.

Windows 7 might be modified for a tablet PC but it is likely you will think about Windows on a tablet just like you think about Windows on a phone?  Why bother? A linux limited purpose computer makes more sense – and that is what most netbooks are.    The $200 netbook comes with an operating system and some basic software (web browser, word processor, spreadsheet etc) – and with little expectation by the customer that they will dramatically expand their use.  A super-stable open-source system is just fine.  [You do however attract consumers by allowing games and fun-stuff – and the Apple software shops do that better than an open-source platform.]

The second big change is that the front-end of linux is now becoming more user-friendly.  Ubuntu is the big driver here.  Ubuntu is a distribution of linux originating in southern Africa with an explicit aim of user-friendliness.  Also some of the key products (for instance Open Office) have crossed the threshhold where they are as nice and as functional as the Microsoft equivalent.  For most people Ubuntu is a superior operating system to Windows.  It is less bloated, does all the key functions and is more stable.  Ubuntu has made netbooks at $250 possible – it is a fully functional operating system that will work on a cut-down computer and can be distributed without paying the pound-of-flesh to Microsoft. 

There are however problems.  The first is several bits of key software will not run on Ubuntu/Linux.  For most consumer uses the show-stopper is iTunes.  Apple produces a version for (inferior) Microsoft but will not port it to linux.  My guess is that doing so would seriously undercut their own business because – frankly – linux has the stability advantage of Apple at a fraction of the price.  From my perspective the difficult programs are Windows Media Player, Windows live writer and my feed reader.  There are several open-source products which will play Windows streams.  However when the streams become heavily featured (with interactive slides for instance) the open-source players simply fail.  I have learnt to hate companies that do their conference calls using proprietary Microsoft systems.  [The biggest offender is Bank of America.  Will IR please stop it.  Pretty please you slime-bag monopolist lovers...] 

Still I can't expect Bank of America IR to stop using Microsoft proprietary systems for their conference calls until there is a critical mass of people who complain or cannot listen – and there will not be a critical mass of people who complain until there are enough people who go open source.  We have a critical mass problem.  You are forced to continue to use the inferior Windows product because – well – everyone uses it.  And everyone else uses it for much the same reason.  The $250 net-book is a serious threat to Microsoft because it might over time produce the critical mass of people who use Ubuntu or like systems – and that will enable us all (even those of us with pricey laptops) to switch to Ubuntu.  [It is a threat that Microsoft is meeting by allowing cheaper operating systems on super-cheap laptops.  You can buy a Window 7 laptop in Aldi in Sydney for the same price as a software license.  Obviously Microsoft has discounted somewhere…]

There are also other costs of using Ubuntu.  The main one simply being that things are different to what you are used to – and hence difficult.  For instance you go to the “start” button in XP to turn it off.  Who would have guessed that?  But you “know” it instinctively.  Likewise you know that there is a “snapshot tool” in Vista – but you do not know that the equivalent in Ubuntu/Gnome is “shutter” and you need to download it as it is not standard with the system.  We have many years of human capital invested in Windows – and even though it is “inferior” it takes some weeks to change.  It is not a light consideration.  Inertia is a powerful thing.  (Mind you Microsoft faces its own inertia as it tries to move happy-enough XP customers to superior Windows 7.  Inertia cuts both ways.) 

I strongly suggest you (dear readers) solve the inertia problem for your family and give your 7-10 year old kids old computers loaded with Ubuntu.  Relative to anything else you can give them on an old machine it is mondo-powerful – and they will grow up understanding computers in a way that you simply do not if you are not a geek.  Open-source is a superior learning environment.  [My son loves Ubuntu...]  Any school teacher who runs a primary school computer classroom where the computers are not Ubuntu is – frankly – being lazy.

There is a reason why Ubuntu has suddenly got better though – and that there is a rich individual – and more recently Google is behind it.  There is an internal Google operating system (not publicly released) called Goobuntu.  Security concerns mean that Google staff are now prohibited from using Windows.  More pertinently the new (highly minimalist) Google operating system (the Chrome system) is a cut-down version of Ubuntu.  Google intends on using Ubuntu and its derivatives to hammer Microsoft – and – frankly – the faster your children learn to use them the better.  [The cost for an individual changing is high – I reckon about 4 weeks of productivity – about what it has cost me... but the cost for a child is zero because they have no human capital built into the alternative system.]

There is a third major change to this operating system business – and that is “virtualization”.  Virtualization is the business of running a machine within a machine – or for that matter a machine across several machines pretending it is one machine.  For instance when you query Google it seems like you are querying one machine – but in reality the Googleplex is maybe a million machines pretending it is one machine.  Similarly one machine can be running six to 100 virtual boxes on it.  This will fit many of my readers.  If you ran a financial business with say 100 staff with their own machine the way you would set it up is with four (powerful) servers – two in the main office – and two mirrored machines in the remote back-up location.  Each staff member would have their own “virtual machine” sitting on the paired servers.  They would have allocated RAM, processing capacity and hard drive space but when that is not been used it would be allocated to other staff members.  Every virtual machine could be made available off-site (for example if staff members travelled).  When staff change their desk their machine (which is virtual) does not need to be moved.  More to the point – the machine is entirely hardware independent.  If you need more RAM collectively you just add it.  The servers would be running some flavor of Linux (probably SUSE or Red Hat), the virtual box would be either open-source (“Virtual Box”) or proprietary (VM Ware) and sitting on the virtual box would be Windows or Ubuntu or – for that matter – Macs.  [I will discuss virtual Macs later on...]  The computer can be migrated from one server to another dead easily [the “hardware” is the virtualization program].  It can be scaled easily.  It can be duplicated easily.  Moreover the system can be made generally redundant easily (the Googleplex has much built-in redundancy – if a computer or a thousand computers in the Googleplex goes offline it does not much affect the service).  VMWare is arguably the hottest stock in the hottest sector at the moment. 

The beauty of hardware independence is that everything can be changed – and by running (extremely stable) linux and (unchanging) virtualization programs you can bring the stability of linux to everything.  The virtualization set-up is frankly superior – and it will improve the stability of Microsoft – perhaps eventually to Apple levels. 

And that sounds fantastic for Microsoft – but alas it comes with a very big price ticket.  Microsoft relies on hardware dependency for sales.  The reason I buy a new operating system is that my Dell sucked – not because I really wanted to own Vista (or even Windows 7).  I was happy-enough with XP.  I had to upgrade simply because – well I had to upgrade my hardware.  The motive for buying a new computer is almost never because it runs the latest version of Windows.  The motive is that it is a bigger, more powerful computer and my old one can't keep up with my demands (or is defunct as per most Dells).  Indeed there is a cost to upgrading.  [I hate the new picture-driven menus on Office 2007 – and have reinstalled my old Office 2002 because I am used to it.  The upgrade sapped productivity and gave me the incentive to learn Open Office.  After all – if I have to learn it all again I should – by rights learn it all again on something that is free and possibly superior...]

Virtualization – and hence hardware independence – will simply mean that Microsoft sells much less.  Indeed – I can't see why they need to sell anything at all after they have sold you a virtual seat – you can just upgrade the hardware around your machine and keep the software as pristine as you like.  Indeed if the server you use is out there in “the cloud” you will never need anything other than a terminal.  Virtualization – and hardware independence – is really scary for the boys from Redmond.  [By far the most unconvincing argument in Whitney Tilson’s piece is that Microsoft is a key player in the new trend of virtualization.]

And Microsoft know it too.  A while back Microsoft was telling us it wanted to change its model for selling the product to business.  Previously they sold it on a one-off license basis.  Now they wanted to rent it.  And well might they – because with virtualization you might go a very long time between upgrades.  They know that consumers (who buy machines rather than seats) would not be interested in that – but maybe they could sucker business along with a lower first-time charge. 

Apple and virtualization

This is a harder topic.  Apple by-and-large do not sell to “the enterprise” and their computers do not virtualize that easily (primarily because in most countries they will not let you).  The Apple End User License Agreement (EULA) makes you agree not to install the software on any non-Apple machine (except in countries where such a restriction is illegal).  I think Australia is the most notable “except in” country – which means (I think) I am allowed to install the software on a non-Apple machine.  [Third line forcing rules in our antitrust legislation would make it a criminal offence for Apple to enforce their license terms...]  Anyway I set up Snow Leopard on Virtual Box – and to tell you the truth – installing it the first time was a first-order pain.  However copying it would be easy.  [After all – it is virtual and I can copy it very quickly – it is just hardware independent software...]  I am going to close it and give my snow-leopard disc as an upgrade to a friend because – frankly – now I run Ubuntu a Mac is simply not that attractive. 

Apple don't sell much to “the enterprise” and their model is to sell the software cheap (the system cost me about a tenth of a Microsoft system) and make money on retail sales of hardware.  If they can get Apple into big business they win – and they are not savaging their own hardware sales.  Apple might get to sell some of their (outrageously expensive) server products to companies that might virtualize.  And the given you only need to buy the seat once – and the young customers love their Macs (for good reason) it might actually be the sensible way to run.  They might also sell virtual macs through the cloud – at a rental fee. 

I suspect however there is another game here.  Hardware independence is a truly wonderful thing for mirroring.  When I take my Windows hard drive out of my Lenovo and put in the (crappy) Dell it does not work.  But my linux disk does.  I can set up a mirror for my laptop to a desktop at work (as the same information will work in both places) – so I do not need to cart the laptop with me to and from the office.  Given how fast computer processing is getting small and powerful there is a reasonable chance I should be able to clone a whole computer into a mobile phone – and keep it in my pocket – but have it securely running on the desktop as well.  Apple could win at this – and I do not want to speculate as to where they are going.

So back to Tilson’s argument

Microsoft clearly is really cheap.  And there is a huge driver he has not even talked about – the shift of (say) India from white-label desktops to “genuine Microsoft” laptops.  But I suspect the whole business is more vulnerable to a complete paradigm shift (virtualization, cloud etc) than I would like.  There is a chance Microsoft’s business just collapses – and with it the hardware business.  Hardware independence really is the big deal and whilst I might consider the stock I would not label the holding permanent.  The boys from Redmond should be scared because they rode the wave of distributed desktops and laptops to glory and that wave looks a little stale now.

 

 

John

PS.  In doing this someone suggested to me that if you play a Microsoft Midori (their future virtual offering) disk backwards it asks you to pay homage to the Great Satan.  He however suggested it was far more dangerous to play it forward.  In that case it might actually install Microsoft Midori. 

PPS.  Whitney… if you have made it to the end of this then I am saying hello.

Some rare links

I do not do links often – so they have to be good.  These two are gems and I am (a) sick in bed and (b) working on a very long post on a new topic which may not be posted as I am not sure I understand it…

The first link is to Jim the Realtor who has been doing some down-in-the-weeds looking at shadow inventory in San Diego.  His conclusion is non-consensus – the problem is massively overstated:

More on shadow inventory

His observation accords with the conference calls of many banks.  Southern California is – if you believe the bank spin – and you now have reason to – better than most commentators think.

Florida remains worse – possibly much worse.  (Alas I have a small bet on a regional bank in Florida that is not quite working out…)

The response to Jim the Realtor is to argue that the true “shadow inventory” is in property not yet foreclosed on.  Alas in Southern California it seems the delinquent inventory is falling too.  (Again Florida looks worse…)

The second link is a detailed reading of the Valukas report into Lehman’s failure.  The “Economics of Contempt blog” (which I should put on my blog-roll) goes through the ways in which Lehman faked its liquidity.  [I was short Lehman at various times and it never even occurred to me that they were faking their cash balance…]  This does not go to the core issue of solvency – but it does speak to the culture (and possibly to criminality).

Economics of Contempt on Lehman liquidity.

Happy reading…

 

J

California Dreaming: requesting comments from Wachovia customers

The defining character of bank results up until Wells Fargo was (a) rapidly improving credit and (b) declining revenue.

When I state that bank credit in the US is clearly and unambiguously improving my email runs hot with people arguing that the banks are faking it.  But they are not – and there are lots of tests of that.  The problem was and remains revenue – the extreme out come is the Japanese outcome – banking without revenue, credit losses, glamour or highly paid bankers.

But the Wells Fargo result was different.  Revenue was flat.  That result is so much stronger than the competition it is silly.  Moreover interest margins were up.  Again – this differs sharply from the competition.  One correspondent wrote to me and tells us that Wells Fargo shows how it is done.  However that does not do the problem justice.  The numbers do not tell you how it is done – they just tell you that it is being done (provided the numbers are not faked).

My best guess is that Wells is using its (legendary) ability to extract revenue from a customer base to either service better or screw over (depending on your perspective) the customers of Wachovia.  This quote I think is the story:

The merger integration activities are proceeding on track and the combined company continues to produce financial results including revenue synergies better than our original expectations.

Now I have seen a lot of banking mergers with dodgy estimates of “revenue synergies”.  After all revenue synergies means extracting more financial services revenue from customers than they were previously paying – and – as even the most casual observer has noticed – most Americans pay a lot of revenue to financial institutions. 

But in this case they are ex-post claiming “revenue synergies” and – the numbers show – are probably achieving them.

So this is a call to former Wachovia customers.  What is it that Wells Fargo has changed so that you pay more money to the bank? 

Comments please.

 

 

PS.  Obviously this is part of it – but it does not explain all the numbers:

Year over year, CDs declined $63 billion, primarily the result of $57 billion of higher-cost Wachovia CDs maturing, yet total core deposits were down only $3.9 billion from a year ago.  Checking and savings deposits represented 88 percent of total core deposits. Our average deposit cost was 35 basis points.”

Already a short follow up on Tarrants and Astarra

The local paper has reported that Ross Tarrant has closed the financial planning arm of his business. 

Ross Tarrant’s business survived the financial crisis – according to quotes attributed to him in the local paper – by taking undisclosed commissions called “marketing allowances” to direct money into Astarra funds.

His business however it appears does not survive his clients having their retirement savings stolen.

The Tarrants website is dead today too.

Australia has a system of privatized social security.  The US flirted with such a system too.  However this case shows that getting ordinary members of the public to deal with intermediaries (brokers, financial planners etc) can often be a quite one-side affair.  The local paper also points to a local (coal) miner who lost $200 thousand in this debacle.  He says he would never have invested had he known about the secret commissions.  I guess that is why they were secret.

Astarra and the financial planners – Ross Tarrant tells us how his business survived the financial crisis without shedding a job

By now it is obvious – the money in the Alpha Strategic Fund – now named the Astarra Strategic Fund – has been stolen. Who was the actual controller of this theft and who was “just following orders” has yet to be judicially determined – but Shawn Richard – the front-man for this mess in Australia – put forward (under privilege) the Nuremburg defense: he was just following orders from Jack Flader in Hong Kong.

More interestingly he testified that he paid large undisclosed commissions to financial planners – sometimes going under the rubric of entirely undocumented loans and sometimes called “marketing allowances”. The loans were particularly peculiar – after all when was the last time a financial institution “lent” you a million dollars based on a handshake with no documentation and not recorded in any accounts?

Anyway Ross Tarrant – who I gather perceives he has done nothing wrong – was the recipient of “marketing allowances”. He runs a large financial planning firm in Wollongong NSW. The local paper has reported that he has come out fighting. This may be the only time in my life I have quoted the Illawarra Mercury with approval – but this deserves to be quoted in full…

Tarrants managing director Ross Tarrant has broken his silence on bombshell claims his company accepted secret, illegal kickbacks from failed fund manager Trio Capital.

A NSW Supreme Court hearing last week was told Tarrants allegedly accepted $840,000 worth of secret payments last year as an incentive to invest clients' money in the failed venture.

In a statement released yesterday, Mr Tarrant described the money as a "marketing allowance" and said while the firm did not normally accept commissions, the one-off payment helped the firm survive the global financial crisis.

"During ... one of the greatest financial crises of our time, the receipt of this once-off marketing allowance from Astarra enabled Tarrants to weather the GFC without shedding a job," Mr Tarrant said.

"After receiving the marketing allowance from Astarra, Tarrants returned to a 98 per cent fee-for-service position."

I do not think this needs any embellishment.

(PS. For those that do not know the Mercury is a small – usually reactionary – local paper - which - given the style - I incorrectly thought was News Corp)

Part VI in the Ed Hugh series – Emporiki decides not to compete on deposits

Lets recap my arguments from the early parts of this series.  In Part 2 of the series I showed that if the Greek sovereign defaults either (a) it leaves the Euro and forces all Greek companies to convert all cash assets and liabilities to Drachma or (b) the Greek institutions including – say National Bank of Greece – will wind up going bust.  In the archetypical sovereign default with a fixed currency (Argentina) not only did the sovereign default – but all private debts got redenominated in Pesos.  I argued the same must happen in Greece if Greece were to default because Greece would want to save their institutions.  Nobody has argued why this won’t happen.  Then again nobody has provided a decent mechanical explanation for how it does happen – we don’t know how to leave the Eurozone even if you want to.

In Part 3 of this series I showed you the balance sheet of Emporiki – the Greek controlled subsidiary of Credit Agricole.  The balance sheet showed 8 billion euro of interbank funding funding the Greek business.   I argued that if Greece went off the Euro those interbank funds would be repaid in Drachma with a loss determined by the post-default trading level of the Drachma.    

Every Euro of deposits raised in Greece is a Euro that does not flow across the Greek-French financial border and it is a Euro not subject to devaluation if Greece were to go off the Euro standard. 

In my view the real risk to Credit Agricole in Greece is NOT credit losses (their lending has not been outrageously bad).  The real risk is that Greece leaves the Eurozone and the assets and liabilities of the Greek banks are revalued in Drachma. 

Into this I want to throw a slide out from Credit Agricole’s recent presentation on how they are dealing with their Greek subsidiary.  They are making a conscious decision NOT to pay Greek interest rates on term deposits – and they expect their deposit book to shrink from 22.5 billion Euro to 15.8 billion Euro.  Presumably they will need to fund another 7 billion Euro from France.

 

What to call this?  Double or nothing!  If Greece leaves the Eurozone Credit Agricole has almost doubled their losses.  But – if Greece stays in the Eurozone – hey – they make more interest margin for the next few years because they pay cheap French financing cost to fund Greek business.  [Isn’t that how they got into this mess in the first place?]

They better hope I am not right.  If I am I can expect the resignation and disgrace of Credit Agricole’s CEO.  This is a dangerous game.

--

Turning Japanese? Comments on the latest bank results

I am thinking out loud here – and hope for comments.  For our portfolio it has not been a happy few days.  You will need to click for the tables.

==============

With a due apology to the Vapors the new bear case for American banking was laid out in recent results (especially Bank of America).

No sex

No drugs

No wine

No women

No fun

No sin

No credit cards

No wonder it’s dark…

I’m turning Japanese

I think I’m turning Japanese…

The second post on this blog (back in the days when I had twenty readers) ran through the financials of a typical regional Japanese bank.  I picked 77 Bank (because I once owned it) but I could have picked one of about fifty others.  The bank had a great looking deposit franchise off which they made no revenue.  After all how do you make any money out of a deposit book when interest rates are zero?  It is impossible to make deposit spread.  And – in Japan – there was such anemic loan demand that loan spreads had collapsed to near zero.  The bank had fabulous credit but remained vulnerable to even the smallest credit downturn because there was no pre-tax, pre-provision earnings to offset the losses against.  Anything above the near zero losses would impair capital.  This was a nightmare of banking without revenue, without credit losses and entirely without glamour.  If you were a shareholder at least you could shrink the bank and return capital (though the Japanese seldom do that).  If you were an employee it was worse – all except the very senior employees were paid below what they might have earned had they chosen to be an industrialist rather than a banker – and pay rises were not possible because the banks could not afford them.  In America high bank revenue allowed some (very) highly paid employees – but this did not happen in Japan. 

I have maintained throughout this blog that I thought that zero interest rates in America would have a different outcome to zero interest rates in Japan because Japanese banks are predominantly deposit franchises and zero interest rates are very bad for them – but that American banks – especially larger American banks – are fundamentally lending franchises and zero interest rates would not impair their ability to make a spread on the loan book.  In other words I thought that American regional banks (and super-regionals like Wells and Bank of America) would not become large versions of 77 Bank but instead would return to strong profitability.

This is a deep and fundamental call – and about 25 percent of our portfolio at Bronte is based on this call – so – to put it mildly it matters to us.  There are two historic models for post-banking collapse banking sector recoveries.  There is the typical model applied in Scandinavia and for that matter in Australia after its last round of banking troubles (1992) but also in Thailand, Malaysia, Indonesia and many other places.  That model has the competition wiped out or seriously impaired by the crisis followed by (a) a slow repair of credit impaired balance sheets offset by (b) solid profitability as competition is sharply reduced by the crisis and banking services remain central to the economy.  In this model banks either die in the crisis or give you 10 to 20 fold returns from the bottom of the crisis as the surviving banks mop up the (very rich) spoils.

There is an atypical post-crisis banking situation which was Japan.  In Japan the banks were always deposit rich (a function of their historic savings culture described in this post) but they became even more deposit rich as customers cash preference increased to hitherto unheard of levels.  Loan demand however turned completely anemic – and though competition was somewhat reduced margins were crushed to the point that banks were – at best – marginally viable. 

Lots of readers ask me to explain my Bank of America position – especially given I have been so skeptical of their past accounts.  The explanation is easy – I have seen this movie before.  I looked at the competition a few years ago (essentially a massive shadow banking system outside the majors) and note (with glee) that this low-margin competition is simply no longer there – and as far as I can tell – it is not coming back.  I believed that bank revenue would be strong – at least for the survivors – and if you put a five-to-ten-year time horizon hat on.  More than that – I thought the revenue – spread over a few years – would be more-than-enough to cancel out the excesses of the last boom.  [I expressed that view several times on the blog…]

But there is that other movie.  That movie is in Japanese – only the subtitles are in English.  A good proportion of my readers are bankers.  Dear Readers, you better hope it is not that that movie – because if it is your bonus will be small for the next few years – after which you will negotiate a pay cut.  Beyond that your income will go into a bit of a decline.  One day some of you will wake up and find that – as a fairly senior banker – you are paid about as much as policeman.  Welcome to the middle-and-lower-middle class.  In a Japanese scenario bankers are paid less – much much less.

The important thing as a stockholder however is not what next quarter earnings will be (they will be difficult).  It is whether – five years from now the surviving American banks are milking their privileged position as survivors or whether the margins have collapsed as-per-Japan making banks horrid businesses. 

It is in this context I want to make some comment on recent bank results.  I am not interested in whether next quarter will be difficult.  I am interested in whether we are “turning Japanese”.

Firstly credit is better than even the most ardent bulls would have predicted at the base of the crisis.  If you are still bearish big American banks on credit you either think they are faking it on a grand (even criminal) scale or you believe in a massive double-dip or you are just not looking.  Credit is unambiguously improving in the numbers.  Most the bears in the financial blogosphere – and there are many – were flat wrong on how long credit would take to turn.    

Properly adjusted delinquency is falling (albeit slowly) and charge-offs are falling relatively fast.  Charge-offs on mortgage credit at JPMorgan for instance dropped by a third during the quarter.  JPM however did state in the conference call that the new lower level of credit losses were flat over the quarter and Jamie D was careful to indicate that you should not extrapolate the falling credit losses into future quarters.  That said – even sustainably higher than historic (but not threatening) sustained credit losses should not be a problem because you should be able to price the higher credit loss expectations into loan margins. 

Which of course brings us to the bad part of the bank results – revenue.  The revenue situation has suddenly got ugly – so much so that it challenges the central basis over which part of our portfolio is organized – which is that we are not replaying the Japanese movie – and that bank revenue will be fine long term just as it has been after most (but not all) banking crises.  The trillion dollar question in bank valuation is “are we turning Japanese?”  As the Vapors suggested in their classic 1980 track – turning Japanese is no fun (it is also no sex, drugs, wine, women or sin – and in the banking context it is no credit cards). 

The market did not like the JPMorgan result and they hated the Bank of America result.  The problem is revenue decline – and guidance as per revenue decline.  The guidance is simply horrid.  BofA is not known for down-beat conference calls – but this was decidedly downbeat.  I would love to summarize it – but – hey – but Stephen Rosenman has done so far better than me.  Sorry to copy in full – but you can go to the original:

Bank of America's (BAC) conference call is a must read. Warning: it is not for the faint of heart. Its implications for banking, now that Congress has passed credit card and financial reform, are not pretty.

1. The Card Act is expected to cost $1 billion after tax.

2. Regulation E/Overdraft policy changes have already cost $1 billion after tax. The fourth quarter of 2010 will see a further reduction of $2 billion pre tax.

3. The Dodd-Frank Bill impact at this point is uncertain because hundreds of rules need to be written still. It is expected to be very costly.

4. The Durbin Amendment in the Financial Reform Bill is expected to decrease debit card revenue each year by as much as $1.8 to 2.3 billion starting in Q3 2011. BAC expects to take a $7 to $10 billion charge in goodwill in Q3 2010 due to the impairment of the debit card goodwill.

5. Net interest margin is dropping. BAC's dropped 16 bp to 2.77%. Per the call, the low interest environment is flattening the returns banks can get for their borrowed money. Loan demand is weak. As a result, net interest income was down over $800 million from Q1 2010.

These 5 banking nightmares will likely visit other financial institutions. BAC is the first to quantify some of them. BAC reiterates throughout the call that it has no idea how to "mitigate" these. While the legislative action may be intended to help level the playing field for consumers and to prevent banking excesses, for now, it appears to be leveling the financial institutions.

It is surprising that Congress would inflict these new burdens on the banking industry in a fledgling recovery. The idea was to prevent new bubbles from forming. It would be sadly ironic if the reforms were to cause the recovery to fizzle. After all, how many recoveries have occurred without the banks?

Disclosure: No Positions

I read Rosenman’s piece and got bullish.  The reason is that 1, 2, 3, and 4 on this list are one-offs.  They will compress margin – but they do not lead to sustained margin pressure.  That is fine because the bank will – over time – be able to make up the margin elsewhere.  As Jamie Dimon might say – if the diner can’t charge for ketchup they might just charge more for the hamburger.  They are – if I might put it this way – not Japanese style events.  In Japan the bank can’t seem to get away charging for anything. 

Alas number 5 on the list is Japan writ-large.  Loan demand remained anemic for decades and eventually loan spreads went close to zero.  Loan spreads are falling normally – after all older high rate mortgages are refinancing into lower rate mortgages – and I think that will be fine.  As long as the competition is not to bad the bank will keep a good margin.  Alas some parts of the bank have very bad loan demand.

Front-and-center is credit cards.  BofA has one of the lowest spread, highest credit quality card books in America.  Here is the quarterly data from their cards business.  (Remember to click for the full table… and you will need it for the conversation below.) 

 

Now note this is not a junky fee-driven credit card business.  The gross interest yield is only 10.9 percent (and falling!).  There are still new accounts.  But the balances outstanding are now only 143 billion – down from 169 billion.  This fall is happening across America.  The Federal Reserve data have total revolving consumer credit outstanding falling from 905 to 824 billion in the same period – but BofA is losing share (from 18.7 percent to 17.3 percent).  These are the highest spread product on BofAs book.  There is no obvious problem with originating new accounts – just maintaining balances.  In all of BofA’s results this the “most Japanese” thing you can see. 

The rest of the book – well margin is tight – but it does not look to be driven by the things which made Japan so painful for bank shareholders.  In the credit card book – not so much.

One thing however leaves me a little chirpier.  Purchase volumes actually rose – and they rose well in the quarter.  The quarter had almost Christmas purchase volumes.  The effect is even more pronounced with debit purchase volumes (ie purchases that do not create a debt).  The American consumer did not stop spending – more they just stopped borrowing.  I do not know how much of this is people stopping paying their mortgage but still paying their credit card – but there is some evidence that is happening.  Perhaps the strongest being JPM’s statement that about half of the JPM second mortgage where the primary mortgage is delinquent are still paying their second mortgage.  The same borrowers are also presumably paying off their credit card balance but intend to default on the mortgage.

Finally – and this comes to the competition point – the average yield on this credit card book is sub 11 percent.  That is a high interest rate for Bank of America but not a high interest rate for credit cards generally.  Despite the tone of the credit conference call (unremittingly bleak as to revenue) I suspect there is a little flexibility to increase pricing in this area.  After all the idea of a new securitisation driven credit card originator poaching the business – that seems unlikely.  But we will wait and see on that.

Business lending is NOT turning Japanese

Business lending volumes suck.  But hey – in non-Japanese fashion the margin on them is actually increasing – it was 2.32 percent verus 2.03 percent a year ago.  This is not turning Japanese – it is far more like a conventional post-crisis bank recovery in which margins get fatter. 

This does not look anything like a post-crisis Japanese bank – there the margins fell asymptotically to zero.

Finally – what is the long-term downside?

This gives me a little comfort – not much – but comfort in misery nonetheless.  Japanese banks have low single digit ROEs.  5% is sort-of-typical.  This would suggest that they should trade at very low multiples to book – but they do not.  In Japan a 5% ROE is not too bad – because it needs to be compared to a zero percent bond rate – as long as a bank earns more than its cost of capital it should trade above book – and 5% is more than the cost of capital in Japan.  So banks with shockingly and sustainably low ROEs trade above book.  They might actually a good investment relative to JGBs and you can get outperformance out of misery.  BofA is no longer trading far above book.  In a Japanese scenario I am not sure you lose to much.  But alas you can get really really bored waiting to make no money and misery can last a long time.

For comments please.

 

 

John

Post script: since I wrote this Goldies reported – and their revenue was also crunched.  So was their allowance for compensation – albeit from very high levels. 

Bank of America comes clean – well sort of …

Bank of America has finally admitted that it understated the quarter end assets and liabilities for the years 2007 to 2009.  It does not (yet) admit that similar transactions took place in many other years and it does not spell out the effect of these transactions on BofA’s need to carry capital.  To quote BofA’s local paper:

Bank of America Corp. has told securities regulators that it made six quarter-end transactions from 2007 to 2009 that were not in "strict compliance" with accounting rules.

In correspondence with the Securities and Exchange Commission, the Charlotte bank said the so-called "dollar roll" transactions were designed to meet internal balance sheet limits. The bank said it does not believe the transactions had a material impact on its financial statements, according to a May 13 letter posted by the SEC late Friday.

I wrote a post stating that BofA had long been reducing its quarter-end balances in March this year so this should not surprise regular readers.  Nor will not surprise regular readers of the Huffington Post and many other places where my article was reprinted.  I think the WSJ also had a poke at the story after my blog post.  Alas the story died down as BofA issued denials only to retreat from those denials in a (then private) letter to the SEC. 

BofA note that the transactions did not change reported profit.  I agree.  The transactions were however designed to shrink reported quarter-end balance sheet and hence reduce the apparent need to hold capital.  One of the reasons why BofA was short capital when the crisis came was that they did things like this to reduce the stated need for capital and they ran capital close to the “apparent” minimums. 

Anyway there are things that bug me about BofA’s admission.  Firstly at senior management it appears that they did not even know they were doing this.  The company denied the bleatingly obvious in the aftermath of my original blog post.  I do not think they were directly lying – the better explanation is that they simply did not know.  Moreover they now state that the transactions “were designed to meet internal balance sheet limits”.  In other words some internal part of the bank was using more balance sheet – hence more capital – than it was permitted under internal risk controls and entered into quarter end transactions to hide it. 

Lets put this more directly.  BofA imposes internal risk controls (usually called limits).  BofA staff enter convoluted transactions to avoid having to meet those limits.  Head office does not know – and only in response to an SEC subpoena (following a blog post a nondescript fund manager in Australia) do they conduct a review and find these transactions.  This is – it seems – worse than the transactions itself.  What it demonstrates is that BofA does not police its own risk control rules until forced to by SEC subpoena.  Put that way you have to ask “who in BofA will be forced to resign?”

More pertinently – this could be spotted by a (very) careful reading of annual and quarterly reports from Australia.  Everything needed to demonstrate that there was something strange about quarter ends could be done by someone with the published annual reports and quarterly summaries.  If anyone on BofA’s board carefully read the accounts they would have spotted the same thing.  (I guess that this demonstrates that the entire BofA board did not or was not capable of undertaking such a careful reading of their own accounts.)

My original post did this for 2006.  In 2006 as I showed the quarter end assets were substantially less than the assets averaged over the quarter.  In some quarters the difference is 46 billion dollars (substantially more than the 10 billion admitted to in 2007-2009).  The same incidentally is true of 2005 and I think (though I have not rechecked) that I first spotted this in 2004.  So far BofA has not come clean about those years.  But then again we now know that head office did not know that within the bank parties were entering transactions designed to thwart internal balance sheet limits – so if BofA cares to check they will find that the problem exists over many years. 

My estimate is that – as a result of this transaction – BofA’s looked like it required about 2 billion dollars less capital than it should have been carrying had it stated its balance sheet fairly.  2 billion in capital is significant – but is remains small in the overall problems that BofA had during the crisis.  This is – in an accounting sense – a second-order issue.  But as a statement about BofA’s control culture it is not good.  [The culture of hiding risk taking however should – in a post-crisis environment – be relatively easy to address…] 

The unnamed counterparty

These transactions were done – according to press articles – with counterparties unknown.  It is passé these days to charge the prostitute but not to charge the John.  The press however would often prefer to report on the (high profile) John than the prostitute.  Either way I wish this were corrected.

The transactions designed to hide quarter-end assets and debt were described as “roll transactions”.  I guess I am new at this game but I had not previously heard that jargon.  Anyway – with a “roll transaction” there has to be a counterparty who is willing to prostitute their balance sheet and allow the “assets” (at least temporarily) to be stuffed in.  The willing whore in this case was almost certainly Japanese – at least for some quarters.  Japanese banks typically had average balances of securities LOWER than end period balances (Mizuho is an exception).  I once meticulously went through the quarterlies of MUFJ and found exactly this trend.  In their SEC filings MUFJ tends to report its capital (or at least it did in those days) as average capital to average assets.  (I guess that makes sense when their end-period assets are stuffed with assets parked from American banks.)

Still if some trader at BofA (or someone else wanting to skirt BofA’s internal controls) wants to park assets at quarter end – and to pay good money for that privilege – then who am I to suggest that otherwise lowly profitable Japanese banks should say no?  

 

John

 

Disclosure:  I have never thought that we should use the blog to “talk our book”.  We will occasionally explain why we own things (which I guess is talking our book) but we are happiest discussing what is wrong with our positions.  Our biggest position remains long Bank of America (and it is more-or-less the only stock I suggest when people want a stock tip).  BofA might argue that with friends like us they don’t need enemies.  Maybe that is true – but perhaps they need board members that can read accounts. (I am offering…) 

Also – for the SEC – note that BofA shareholders have suffered much already because BofA took too little capital into the crisis.  What you should be seeking from BofA is not penalties – it is a process for fixing their internal controls so that head office can ensure that divisions are not entering transactions designed to thwart internal controls.  Surely that is far more important than a rap over the knuckles? 

Hey – the SEC should not need to seek this.  BofA should just do it.  I anticipate being a shareholder in a decade – so this matters to me.