Revisiting privatizations

Over the course of last year and this year, I have advocated that European countries facing excessive indebtedness and sub-par growth should consider selling public assets.  In the case of Greece, I noted in 2011 that ex-ECB board member, Juergen Stark, had estimated Greek public assets available for sale at around €300 billion; this was to be compared with a national GDP of €240 billion and an overall sovereign debt of €320 billion.

I also advocated the same course of action for others, such as Italy, Spain and France.  The benefits of such a policy would be to increase overall economic efficiency and to raise funds to reduce national debt.  It could also help develop a large and stable pool of savings for future retirees.

I also noted that the best example of what this policy could yield was the Chilean experience in the 1980s.  This is one in which I was closely involved as a banker and investor.  Back then, Chile received no outside financial help, in stark contrast to the current European situation.  Yet, thanks to well conceived debt-to-equity and debt prepayment programs, it managed to reduce its external commercial debt by one third without alienating international markets.

Therefore I was happy to read an interview of Mexican billionaire Carlos Slim in which he too advocated the sale of public assets as a necessary although not sufficient condition to get European economies back on track.

Countries are often reluctant to part with public assets, for very human reasons:

1.      Bureaucrats will lose a sinecure and a power base while employees may see their benefits cut back and even be terminated;

2.      Selling assets during a crisis is bound to bring less than optimal prices;

3.      Deep pocketed foreigners will take advantage of their momentary weakness to take control of national assets;

4.      Public services, once privatized, will be rationalized, resulting in higher tariffs and smaller geographic coverage.

 Indeed, reducing bureaucracy is one of the benefits of privatization.  In many instances, public employee benefits are far more generous than those accruing in the private sector, and the difference represents a subsidy which is unfairly borne by the latter and should be eliminated.  Privatizations often result in job cuts, but the resulting hardship can be controlled and reduced with compensatory and retraining policies and by the opening of new private job opportunities in a resurgent economy.

It is obvious that, at least in the beginning, public assets will be sold at depressed prices, but getting optimum prices is not the name of the game, putting the economy back on track is.  Besides, the cost of a weak economy with a depressed job market is far higher than the money left on the table, so to speak, by selling assets early.  And experience in Brazil and Chile has shown that, if privatizations are accompanied by sound fiscal and economic policies, markets soon adjust and subsequent asset sales command higher prices.

Rich multinationals or vulture funds are often the bugaboos that discourage countries from privatizing.  The reality is that it all depends on how privatizations are structured.  In Chile, most privatizated companies were bought by local entities, sometimes operators, sometimes financiers, sometimes by consortia which included local pension funds; in the case of the largest privatizations, special financing was made available so that local households could buy into blocks of shares that had been reserved for them (the so called capitalismo popular).  In Mexico, it is worth remembering that the largest privatization was won by a consortium of Mexican, American and French interests led by Mr. Carlos Slim who retained effective control.  I might also add that, in my experience, foreigners who have bought local companies on the cheap in times of great national stress end up paying a fair price over time, as governments find ways to extract more money or consideration from them.   One can only look at the electric utility sector in Brazil where the current government is trying to force through a new tariff regimen.

One large and apolitical source of funds to tap in order privatize public assets would be national pension funds.  These were instrumental in similar projects in Latin America and some Nordic countries.  Unfortunately, countries such as France, Italy and Spain largely rely on pay-as-you-go pension schemes, and their pension funds control very small pools of funds (0.2%, 4.6% and 7.9% of GDP respectively).   By contrast, pension funds in countries such as Chile (67%), Finland (82%) and the Netherlands (135%) are much larger and offer far more strategic flexibility.  It would be highly controversial in France in particular, but just imagine if it had a pension pool of 1 trillion euros!  If Italy had €900 billions and Spain €600 billion!  Such funds would dwarf the much maligned hedge funds and vulture investors; they would also match their long term investment horizons with the government desire to find stable institutional investors.

Finally, there is the fear that privatized public services will no longer serve the public, or that tariffs will be raised too high.  With sound regulations, the former concern can be allayed.  The real question is whether essential services should be subsidized, and if so how, or not.  If a country decides that the provider of such services should subsidize them, then privatization may not be appropriate.  Witness the continuing frictions between Telmex and the Mexican government on this issue, or worse, the case of the energy sector in Argentina or even EDF in France.  Countries can’t have it both ways: they can’t privatize and then control prices.  Ultimately though, tariffs may initially increase and then gradually decrease as most of the efficiency gains are passed on to customers.

The current debate in Europe has little chance of bringing about a workable solution to the prevailing financial and fiscal problems:  drastic austerity, be it via spending cuts or tax increases, cannot work because it is socially and politically unacceptable; fast growth is unrealistic because, in the absence of other measures, it is equivalent to Northern member countries subsidizing their Southern fellow members and cosigning their debts.

Austerity is necessary, but its focus should be a combination of shrinking the public sector and making the economy more efficient.  Privatizing public enterprises should be the key driver of this effort.

Growth based on EU subsidies and wealth transfers is a non starter; but growth based on a leaner, more flexible private sector is possible and sustainable.  Indeed, examples of this are easy to find in recent history.  Part of the privatizations proceeds should be earmarked to retrain downsized employees and to help them bridge a conversion period leading to new jobs in the private sector.

Finally, privatizations are essential to reduce sovereign debts in a manner which doesn’t disrupt markets, encourages new investments and keeps financing costs affordable.

At the end of the day, return to fundamental financial equilibrium and economic growth is possible but no single silver bullet exists that will do it all.  Rather, European democracies will need to find a workable balance of some austerity, some tax increases, gains in efficiency and delayed but better quality growth.  To that end, a broad privatization program is essential to help achieve many of these goals in a sustainable and socially acceptable way.  It would also provide the opportunity to establish a modern and potent retirement pension fund industry.

The Yellow Brick Road

It is too soon yet to guess who will be the next president, but not too soon to detect a change in the dynamics of the country.  And that is good news.  Perhaps unexpectedly, the American voters seem to take a greater interest in the substance of the debate and to realize that any solution will have to be negotiated in the political middle.

I think that it all began with the first presidential debate.  The Republican candidate, Mitt Romney, surprised almost everybody: he won, did so on substance and was much more moderate than the press had painted him to be (in fairness, he moved back to the center after having won the nomination on the right).  By contrast, the President demonstrated that eloquence needed a base in facts, in experience and in a successful track record to be effective, at least if you are the incumbent.  Though it had lapped screaming TV talk shows and the vacuity of The Wives of … reality programs for some years now, the public gave Romney a decisive victory in post debate polls because he had presented sounder arguments.

To my mind, the vice-presidential debate reinforced this trend towards problem-solving.  Vice-president Joe Biden was very aggressive as expected but was also very rude and at times contemptuous of his opponent.  His arguments often lacked substance and his tone was generally populist in the extreme.  By contrast, Paul Ryan was composed and displayed greater command of facts and numbers; he was also surprisingly at ease debating foreign policy.

Democratic pundits were delighted: Joe Biden has come out with all guns blazing.  Yet I think that this strategy was flawed.  For one, he made his boss, President Obama, look weaker.  For another, his demeanor seemed to have turned off the Independents and undecided voters who were less interested in televised combat and wanted to hear solutions to their and the nation’s problems.  Paul Ryan may have taken a lot of verbal abuse but he seemed to have won on points so to speak.

The next presidential debate will be interesting and likely will determine the outcome of the elections.  By temperament, President Obama is more collected than his vice president; he also will be faced by Mitt Romney, some 20 years his senior and a person with a strong track record in private and public life.  As is clear to most already, winning over the American Middle is the key to winning the presidency and there is ample evidence that the winner will need to win on substance: that is what people want, besides, while Obama is generally viewed as likable, Romney is no longer viewed as a cold hearted money-maker.

Whoever becomes president in November, it looks to me that the American people are realizing that the solution to the country’s problems will cause pain to everybody rather than a few thousand plutocrats: effective tax rates will have to rise (sorry Republicans) and public spending will have to be cut (sorry Democrats).  Failed experiments in Japan and Western Europe have brought this country back to reality and none too soon.  Welcome back to the Center!

Apple (and RIM) stock revisited, part 2

In an earlier post, I made the argument that Apple was not necessarily undervalued.  Since market valuation is by nature a relative concept, I would also like to make the argument that Research in Motion (RIMM) is most likely undervalued.

Since I wrote my first post on Apple, a few things happened.  One of them was that a power surge caused by a particularly strong storm destroyed my 2006 iMac.  Why was my computer plugged into the wall socket rather than into my surge protected outlet?… So I bought a new iMac, and it really is a thing of beauty, it works great and it couldn’t be easier to set up, for the most part.

 

As I wanted to retrieve some of the data from my original iMac and had bungled my first attempt, I called Apple’s hot line; their specialist couldn’t have been more helpful.  I also wanted to synchronize my iPod, and there, things got messier.  One staff at the Apple store told me that I could do that.  But when I called Apple’s hot line again, the new specialist declined to help, suggesting that I bring my new iMac, the hard disk drive of my old iMac and my iPod, all thirty pounds of them, to an Apple store for further assistance.  I was not happy.

The change of computer also necessitated the transfer of some Adobe programs which required the de-authorization of my previous iMac.  The Adobe customer support person was efficient and told me that I would receive by email a link to rate his service.  I did, but I was very surprised to see that the questionnaire also asked about my satisfaction with similar support service from Apple.  Clearly, the questionnaire was not tailor-made for me, but it made me wonder: besides its ongoing Flash Player saga, did Adobe know something I didn’t about Apple customer service?

The second thing that happened was when my wife suggested that I upgrade my iPad to IOS6 as she had just done.  Aware of the Apple switch to proprietary map software, I asked her if she still had Google Maps, which she confirmed.  Yet much to my annoyance, when I rebooted my iPad, both Google Maps and Youtube aps were gone!  At no point in the upgrading process had I been forewarned that I would lose these two aps, and the new mapping ap, too cleverly in my opinion, had a similar icon to that of Google, except that, underneath, it said “Maps” rather than “Google Maps”.  My wife had been fooled and so, I suspect, many other users.  The iPad allows you to “restore” an earlier version of its software, except that restoring will not get rid of IOS6 and therefore will not get your Google Maps and Youtube back.

Today, much was made of the Apple CEO’s apology for installing a poorly performing mapping application.  In my view, he should have apologized for not giving his customers an informed choice of upgrading or not.  In this instance, a company that prided itself on being customer focused, sacrificed its customers to its ongoing battle with Google.  Which brings the question, aesthetics apart, if Apple justifies its premium pricing on providing a premium experience, what happens when this experience (technical assistance or software upgrade) starts to falter?

The final thing was the release of the latest RIMM quarterly results.  Much has been commented already.  Suffice to say that the loss (ex-goodwill impairment) was lower than expected, cash holdings were slightly increased despite selling devices at a loss (thanks to cost cutting and a reduction in working capital due to business shrinking), sales fell sharply from a year ago but the subscriber base increased at an annualized rate of 10% quarter-over-quarter.

Earlier this week, RIMM’s management disclosed some of the features of its upcoming Blackberry 10.  Even to a non-geek like me, the upcoming RIMM smart phone looked sleek and well thought out.  Will it have many meaningful applications?  Will it have something comparable to Skype or Apple’s Facetime?  I don’t know.  A keyboard and a touch screen versions are set for release during the first quarter of next year.

At the time of this writing, RIMM has no debt and a market value of US$3.9 billion.  Net of cash, its enterprise (or business) value is US$1.6 billion.  This works out to US$20.4 per customer.  In other words, the company is priced as if it were going bankrupt.

Yet, it looks like the company has the financial resources to produce the BB10.  It also looks like it will have the resources to market it, as it will receive financial support from carriers that are anxious to reduce Apple’s negotiating leverage and interested in having a wider smart phone offering.  It is true that RIMM runs far behind Apple and Android-powered phones and that it is unlikely to catch them any time soon, if ever.  But it does have strengths, apart from his new technology: a secure network, a hardcore customer base, and excellence in text messaging.

We already have a “going out of business” value estimate for RIMM: US$1.6 billion.

What if it makes it?  That is very difficult to estimate, in part because RIMM has already announced that it will strike alliances and licensing agreements with third parties which will share the downside as well as the upside of the BB10 and beyond.

If we look at Apple, we can make some very rough estimates: its revenue per iPhone is about US$660, its gross margin US$ 430 and its net profit after-tax US$270.  Using a p/e multiple of 13, each one million iPhone sold would have a market value of US$3.5 billion.  Analysts expect that it will sell over 160 million units in 2013.

RIMM is not the market leader that Apple is, its new BB10 may be priced lower than the iPhone 5, its leverage with sub-contractors is much weaker, and as we already pointed out, it has decided to share some of its upside.  So for argument’s sake we will assume that its normalized net profit/BB10 unit will be US$150; using an arbitrary p/e multiple of 11 and assuming that RIMM sells 10 million new phones a year, its market value would then be US$16.5 billion (I assume that all excess cash balances will have been consumed to ramp up the business).

 

Which will it be?  Probably neither of the above, but somewhere in between.  The key decision though is whether RIMM will make it or whether it will bomb. 

I think that it will make it.  I also fear that Apple may be starting to suffer from the kind of hubris which stellar performers almost inevitably fall into, sooner or later.  Putting it all together, I see more upside with RIMM than with Apple, even considering the very steep challenges that the former is facing.

I am long RIMM and have no position in Apple.

May 29, 2024

The police presence was heavy as usual, but the oppressive, volatile atmosphere that had cast a pall over the Champs Elysées, and indeed the whole city in previous weeks, had lifted.  Instead, an air of expectancy mixed with curiosity had gradually set among the assembled multitude.  But the police prefect was taking no chance, as dozens of armored transports and riot control vehicles were massed, out of sight, on the rue de Ponthieu and Avenue Kleber.

 “I wonder if he will bring his kids” wondered a thin man in a bright yellow Tshirt.  “Carla will not let him!” shot back his neighbor, “Besides, they don’t speak French so they wouldn’t understand what’s going on” added another.  “Well, is he coming or what, we’ve been waiting since four o’clock!” complained a neatly dressed middle aged woman.

HE had been waiting for an even longer time, twelve years to be exact.  He had lost the 2012 elections more than his adversary had won them.  The French had rejected an hyperactive President in favor of a calmer, blander alternative; they had turned their back on “a certain idea of France” and voted in favor of a more comfortable, traditional vision that had much in common with that of an ostrich in imminent danger.  In truth, HE had not helped his case: during most of his term, his unbound energy notwithstanding, he had rarely given a sense of what his governing priorities were or should be, and during the presidential campaign, he had shied away from focusing on the challenges and policy choices that faced the nation.

Hated by many, radioactive to his fellow UMP members, Nicolas Sarkozy had accepted a fellowship at the Hoover Institution of Stanford University.  Within a few years, he had added a teaching position at the university’s Political Science Department and become involved with Stanford’s famed Business School.  In 2018, the IPO of  Uwin, in which he had invested $200,000, made him the first billionaire ex-President.  He was half way through his traversée du desert[1].  Now a very wealthy man, and the symbol of the modern politician who reinvented himself successfully if unconventionally, Nicolas Sarkozy would spend another six years trying to reenter the French political scene. 

Far from the Californian shores, France was not doing so well.  Neither the new president nor the French felt like paring the budget.  Having promised his electors economic growth rather than public spending cuts, President Hollande found it difficult to backtrack, even when faced with a budget deficit bigger than expected.  Taxes on the rich were raised yet they brought in but a fraction of the needed revenues.  So fiscal policy was relaxed, deficit targets were postponed and pressure mounted on the ECB and Northern Europe to provide additional deficit financing.

Had France been isolated, it may have been forced to face the music, but it was not alone; Spain and Italy were in the same situation, having to push through austerity measures which were increasingly unpopular and politically explosive. 

On the other hand, Germany, already facing slowing economic growth and the fallout from China’s recession, was growing more and more concerned that its financial commitments vis-à-vis the eurozone were becoming so large as to be internally destabilizing.  Netherlands, Finland and Austria were on the same page, and in any case too small to shoulder a greater eurozone assistance program.

This all came to a head at the Antwerp conference of 2014.  The new Spanish prime minister, who had just spent two weeks battling with the regional governments of Catalonia, Andalusia and Murcia, announced that he was neither in a position to accept more outside supervision from the troika nor to pay the sovereign debt as scheduled.  His Italian homologue noted that his new coalition in Congress wished to revisit some of the reforms voted under the Mario Monti government and that, in any case, the Spanish crisis made it impossible for Italy to access the financial markets on sustainable terms.  France for its part had been under a three weeks general strike which had escaped the control of the two dominant unions, the CGT and the CFDT, and leftwing splinter parties under the leadership of Jean-Luc Mélenchon were calling for the nationalization of half of the companies in the CAC 40 index.  President Hollande had to decide which way to go.  In the end, he calculated that he couldn’t win over the strikers or the opposing political parties because they would never accept the necessary remedies which, in any case, he didn’t himself fully embrace.  He also felt that the country was far richer than generally acknowledged and could take care of its own financial problems if these were, at least partially, reduced.

On October 15, 2014 in Antwerp, Germany, Finland, Austria and the Netherlands formed the New Eurozone, anchored by the Euromark(€Mk).  Central banks’ balances with the ECB were to be settled via new 10 year ECB bonds.  Given the instant 30% appreciation of the €Mk vs. the €, Germany took an immediate mark-to-market loss of some €200 billion on its ECB credits.  On the other hand, it also showed a comparable gain on its outstanding sovereign debt for the opposite reason.  The top French, Italian and Spanish banks were nationalized.

In the months and year that followed this historical event, it became clear that Anwerp solved only in small part an economic problem, but was even less successful dealing with political challenges.

The German economy took a hit, but not as hard as some had feared.  The €Mk proved a serious headwind to exports and corporate profits, as German exporters cut their margins to the bone to preserve market share.  Imports by France, which represented 19% of total, plunged.  On the other hand, parts and other imports from France, Northern Italy and Spain rose.  Corporate efficiency campaigns went into high gear to mitigate the pricing headwind of a strong currency.  Endowed with a super strong €Mk, German companies accelerated new capital investments in Asia, Mexico and the US.  By the end of 2017, the German economy had regained it mojo, and the timely Chinese recovery proved an added bonus.

In France, the competitive boost gained from a weaker euro was transitory.  It weakened the case for deeper reforms.  It depressed consumption and therefore tax revenues.  Faced with a diminished purchasing power and depreciated savings, the population soon became restless and clamored for “a new deal”.  But faced with high borrowing costs, the government had limited resources.  So, in 2015, new taxes were levied on those who profited from the devaluation, mainly exporters and international firms.  Next, private savings were channeled to finance what amounted to general budgetary shortfalls.  As this was not sufficient, the government reached farther for new sources of funding.  In 2017, “Social Solidarity Financing Programs”, or PROFINSS, were started whereby public assets, services or institutions were used to collateralize new public debt issues.

The state of affairs was not very different in Italy and Spain.  In particular, social and political unrest had become pervasive in Spain where the central government was still faced with a volatile conflict with the regions.  For the first time in recent memory, Italy was faced with its own kind of regional strife, as Northern Italy was in open conflict with Rome.

With stagnant economies and restive populations, these three countries pressed the ECB to increase its emission of money, trying to compensate some of the adverse effects of this policy with export incentives and targeted compensatory schemes.  By 2020, most French salaries included indexation provisions and inflation had risen to 7% p.a.  At the same time, price controls had been expanded, so that the official consumer price index was widely viewed as understating inflation by several hundred points.

As we have seen the Antwerp conference and its aftermath had brought France little relief.  The 2017 presidential elections were hotly contested but the right lost handily, divided as it had always had been.  President Hollande also lost, to his minister Arnaud Montebourg.  The new president was viewed as more charismatic and “progressive” yet not as extreme as Mélenchon. Yet Mélenchon and his Left Party scored big at the legislative elections and assured their participation in the new government.  Also scoring big was the National Front of Marine Le Pen with the support of some refugees from the UMP.

By the time the 2022 elections came around, the world economy had mostly recovered from its slump of a decade before.  China was in the midst of its Domestic Frontier program aimed at accelerating the development of its Western provinces.  Mexico had become the latest emerging markets star and the leader of a revitalized Latin American free trade group which included Chile, Peru, Colombia and a reborn Venezuela whose oil production had reached 4 million barrels per day thanks to the historic opening of its energy sector to private companies.   The US too was on the mend, having flirted twice with disaster but finally built a block of moderates from both parties in the House.

Southern Europe lagged behind.  In France, the 2022 had brought a new president, former Socialist Party Secretary Martine Aubry in the same role of conciliator as that thrown upon Montebourg five years earlier.  The opposition was led by Marine Le Pen as the leader of the Union pour un Movement Républicain-UMR, the result of the fusion of the UMP and the National Front.

By then, the Socialists and the UMR parties had hardened their positions, as each firmly believed that it could impose its views, bloc the other and win over the support of the population thanks to massive demonstrations or other spectacular action.  Crime had become a major social issue and how to combat it was a key political battle ground; the CGT and CFDT unions backed the government while the police unions supported the more vigorous policies advocated by the opposition.  Over the next two years, the policy stalemate continued and pressure built.

In 2024, with little economic growth, continued capital flight and persistent inflation despite administrative price controls, the government took the fateful decision to nationalize what it called the Six Strategic Pillars of the economy: Electricité de France, France Telecom, Lafarge, Renault, Suez and Total.  The government had expected that this move would not be overly disruptive; after all, the Paris stock market had been in a state of torpor for years, all six stocks traded at already depressed levels and state intervention in their affairs was already pervasive.

Market and popular reaction was however wholly unexpected.  While many had not minded the state controlling prices and browbeating wealthy executives, they were now aghast that the attack was directed at their own property.  Also, while stock prices had been depressed for a long time, dividend yields were attractive as they approximated official inflation levels.  Finally, the nationalization raid had come out of the blue and nobody knew what else was in the offing.  On the far left, politicians were up in arm when the prime minister announced that compensation would be paid “based” on market prices; why should taxpayers money be used to reward those who had unjustly profited at the expense of the working class?  Institutional investors, for their part, wondered whether they should wait or just dump all their holdings.

On that day of May 21, 2024 the already depressed CAC 40 dropped by 27% before trading was halted.  International suppliers made it clear that they would suspend all non-essential dealing with the Six Pillars until further notice.  S&P, Moody’s and Fitch downgraded the Six’s credit ratings by five notches triggering sharp drops in their bond prices.  French sovereign and other top corporate bonds swooned in unison.

On the morning of the 22^nd, the Paris Stock Exchange didn’t open for trading and a €4 billion OAT issue was cancelled.  By noon, when trading finally opened, the CAC 40 fell another 11% whereupon the exchange was closed for the day.  Sporadic runs by depositors on branches of BNP, Crédit Agricole and Société Générale were reported in Lille, Strasbourg and Grenoble.

By the 23^rd, the UMR had called on the government to explain its ill advised nationalization in Congress, with supporters and detractors engaging in shooting matches and government members occasionally ducking for cover as projectiles of various shape and weight flew across the Chamber.  Outside, civilians, union members, and employees of the Six were picketing, milling around and waiting for something to happen.

On the 26^th, two things became crystal clear: (1) the government was going to fall, and (2) the UMR had zero chance to replace it.

And so, on the 29^th of May, 2024, at approximately 6 pm, Nicolas Sarkozy, former president (2007-2012), former fellow of the Hoover Institution, venture capitalist extraordinaire, walked up the length of the Champs Elysées, accompanied by his wife Carla and his two daughters, and by the clamor of half a million French.  His hair was grey and his cheeks were rounder, but years of surfing in California had helped him stay in shape, and he effortlessly glided up the famed avenue. 

The government had resigned; President Aubry had asked Nicolas Sarkozy to form a new one.  She had also agreed to resign within three months so that new elections could be called.  Already, brand new banners, white and blue background with “France Avenir” in bold red letters, were fluttering in the breeze, portends of campaign soon to be launched.

The above is just an exercise in political fiction, although it attempts to find a realistic base in history and economic realities.  But it is only that.  Alternative scenario could have been proposed which would have a chance of happening.  The point of this fable is not to guess what the future will be like.  It is to illustrate as vividly as possible the fact that the latest debt and European crises have had severe economic consequences, yet relatively mild political ones. 

In our view, the next few years are likely to bring about political upheaval on a scale comparable with the economic upheaval we have been through so far.

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[1]  Literally, crossing of the desert.

Apple stock revisited

 

Apple is the most valuable publicly held company in the world, with a market capitalization of $652 billion as of today.  Its huge success is well deserved, as more than any consumer goods producer, AAPL offers products that combine high quality, style and ease of use.  Furthermore, AAPL has had the foresight to secure software and hardware design and ownership and to integrate services and devices as it famously did with iTunes.

There is no argument that Apple is a global success story and that the company has gone from success to success first with its Macs, then the iPods, iPhones and iPads.  The question is whether the stock is a buy at current levels.

As someone who bought the stocks years ago at $14 to sell it for a quick $10 gain a few months later, and who felt he had been very astute, I am not be the best judge of the company’s prospects.  But I do have a view, which is that the critical factor is the gross margin.

Most analysts argue that the stock is cheap because it sells at a p/e multiple of 16.2 times trailing 12 months earnings.  This p/e multiple is further lowered to 13.4 if we deduct from the market capitalization the value of the excess liquidity[1].  That is true, but this “cheapness” is due to a very high gross margin.  This margin reached 44.1% for the last trailing 12 months, vs. 40.5% in 2011 and 29.1% in 2006.

One could point to IBM which achieved an even higher gross margin of 46.9% in 2011.  The difference is that IBM’s business is more stable, being based mostly on services; IBM’s gross margin was 41.9% in 2006, not so different from today.

Unlike IBM, Apple relies essentially on one product, the iPhone, for about 65% of its gross profits with the Mac, the iPod and the iPad for roughly 12% each.  The iPad may bring some added diversification, but time will tell.

While Apple was a pioneer with the iPod, iPhone and iPad, competition is now heating up with giant electronics firms such as Samsung and Google invading its turf with ever more performing products.  This is not a setting conducive to fat margins.

Another factor to take into account is that Apple’s products are expensive; I suspect that the penetration of Apple’s products among the middle and upper socio-economic strata is pretty high.  Apple’s share of smart phones is estimated at 38% in North America, 26% in Western Europe, 25% in Japan and 20% in Asia[2].  One would think that to gain greater market share, Apple would have to target lower income buyers, which is not compatible with selling expensive, high margin products. 

So what if Apple’s gross margin were to revert to its 29.1% level of 2006, everything else being equal?  The p/e multiple would rise to 27.7, and 23 after deduction of excess liquidity.  Quite a different picture, although one that may be unrealistically bleak; after all, even if winning greater market share likely necessitates selling lower price and margin products, replacement devices for higher-end customers would probably remain very profitable.

Since I don’t know how long such a margin erosion might take nor its extent, and since, in any case, the future is always uncertain, I will take the average of current and estimated p/e multiples after deduction of excess liquidity.  I get 18.2.  This is not excessive, but neither a bargain nor a sure win.  This assumes that Apple’s excess liquidity of more than $110 billion will be either distributed to shareholders or wisely invested.  Finally, for reference sake, let us note that Samsung Electronics shares trade at a p/e multiple of 14.9 on the same 12 month trailing profits and ex-liquidity.

In sum, I think that investors who consider buying Apple shares shouldn’t focus on the low p/e multiple but on the high gross margin.

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[1]  Defined as cash and bond holdings.  We consider that 2% of the average of sales for 2011 and estimated sales for 2012 is used in the business and therefore doesn’t qualify as excess liquidity.

[2]  Source: Gartner, JP Morgan.

Riding the TGV

I just returned from two weeks in France, visiting family and friends and enjoying the natural beauty of the Alps.  I also had plenty of opportunities to read local newspapers and watch news programs.  And yes, I took the famed TGV from Paris to Annecy, a 320 miles trip which took just 3 hours and 40 minutes. 

My tentative conclusion is that the French economy is not about to collapse, rather, it is starting a multi-year process of slow decay until it reaches a moment of truth which could be five to ten years in the future.  Although I am not expecting an impending crisis, I think that we should pay close attention, for as Mark Twain once said, history may not repeat itself but it does rhyme.

For the American tourist roaming the country and its capital, it is quite obvious that France is a very rich country.  In particular, its physical infrastructure is very impressive, and it is evident that much money has been invested there.  The above mentioned TGV now serves most large cities, is very comfortable and runs on time; the Air France terminal 2 at Roissy Charles de Gaulle is airy, its shopping gallery is magnificent and its bathrooms would make any New Yorker familiar with the old Pan Am terminal cry;  the RER (equivalent to our Metro North in New York) is likewise fast, efficient and well designed; finally, parkways are devoid of the craters, ridges and potholes that we regularly but unsuccessfully try to dodge on a daily basis.

To the economist, it is also clear that French households have less debt and more savings than us and that the country has many assets that could be sold to very willing foreign investors, witness the sales this year of Gevrey-Chambertin and Vosne-Romanée vineyards to Chinese investors.  Other assets are more intangible, such as leading technologies and a global outreach that goes back centuries.  Yes, France is a very rich country.

The problem is that the world has been changing faster than France; worse, France has moved in the opposite direction.  Historically, the wealth of France has been built on its large domestic market and later on importing riches from its colonies.  Today, in order to maintain its standard of living France must export more and compete with imports from foreign producers.  Yet, instead of strengthening its private sector, it protects a bloated public sector which accounts for well over half of its GDP.

As I wrote in previous notes, French governments have had little understanding of, or use for, the markets.  So long is the tradition of government intervention, from Colbert’s reforms to de Gaulle’s Five Year Plans to Mitterand’s nationalizations, that they believe that markets are either easily willed to toe the official line or to be held in high distrust.  This was evident even under President Sarkozy and crystal-clear under President Hollande. 

Since he took office, President Hollande has studiously complied with promises he made during his election campaign, such as lowering retirement age, raising the minimum salary, raising taxes on the rich, lowering gasoline prices and hiring more teachers.  It is good to keep one’s promises, but even if they are detrimental to the future of the country?  His supporters will argue that the pension adjustment covered only a fraction of the retiring population (true), that the raise in minimum salary and the drop in gasoline prices were small (also true).  But the problem is that the opposite decisions were called for, such as progressively raising the retirement age, lowering effective labor costs and leaving gasoline prices for the markets to settle.

The proposed tax increases on the rich included elements of utter farce:  taxing individual revenues in excess of 1 million euros at a 75% rate but excluding artists and professional athletes from that; including stocks and ownership in one’s business for purposes of levying taxes on net worth but excluding works of art.  As one commentator noted, it is as if the government wanted an elite of soccer players and collectors of Louis XIV dressers.  The government now says that it will introduce these taxes “intelligently”; this reminds me of the French minister who told a New York audience in 2000 that the 35 hour week law had plenty of leeway to defang it.

The point is that the current government seems unaware of the gravity of the financial and economic problems that France faces, yet comforted by the wealth of the country; accordingly, it seems to believe that gentle policy adjustments are sufficient, that so long as private companies make a profit their taxes can be raised, and that high revenues and corporate profits are evidence of profound social injustice.

Essentially, France like most countries is bound by its culture, and as we all know, national cultures change little and only over extensive period of time (witness A. de Tocqueville and A. de Custine’s enduring relevance to the US and Russia respectively).  I don’t think that the Hollande government can or wants to significantly correct its initial choices and orientation, nor that the French people want it to.  I think that even if a flash crisis strikes Greece, Spain or Italy, France will not budge appreciably and that fundamental reforms a la Schroeder will have to wait until 2016 at the earliest.

Why should we care?  Because history rhymes.  What we are witnessing in France reminds me of what has happened to another very rich and sophisticated country, Argentina.  Despite occasional bouts of recovery, Argentina has not returned to its economic glory days of the 30s and 40s.  This last decade, this country has successfully “picked the pockets” of its foreign creditors, its retirees and companies operating on its territory to fund its populist policies; price controls have distorted its energy sector, crime is rampant, inflation is well into double digits and now foreign exchange controls are used as a last attempt to stem capital flight.  Many Porteños say that Buenos Aires is the Paris of South America; that is true, and more than they know.

 

I am not saying that France will end up where Argentina is today, what I am saying is that there are enough cultural and other similarities for France to watch out and try to get off the Argentine-like track on which it is now engaged.

The US are different from France culturally, historically and geographically.  It is unlikely that much of the population will shift away from traditional American values at the same time.  Its immigration provides an energy and a source of renewal that is unique in the world.  Yet we have been very reluctant to admit that a major effort is required from everybody to get out of our predicament.  As in France, the Obama administration has hesitated to tackle public spending and has played the “tax the rich card”.  Had it stated that taxes would be raised on all Americans to make up for any shortfall in public cuts, we would be more advanced on the path to recovery.  There still is time, and there is a far more vigorous public debate in this country than in France or Argentina as to how to regain our economic health and achieve better social harmony.  But the clock is ticking and the dangers of failing to act are in plain sight for all to see.

The Standard Chartered Bank plc saga, part I

I will not be alone in saying that the Standard Chartered Bank’s compliance problems with the New York State banking regulator (Department of Financial Services - DFS) caught me by surprise. 

I have been following this bank for several years, as it seemed to provide straight forward banking services internationally and made a good return in so doing.  Management seemed quite competent.  Finally, the fact that it had acquired what remained of American Express Bank Ltd. where I spent the first 16 years of my professional career added to my interest.  Actually, I was looking for a good entry point to invest in its stock.

However, the misdeeds that it allegedly committed and apparently did not contest as well as what has transpired so far about its senior management’s conduct have led me to suspend any investment attempt.

Essentially, the bank was accused of willingly defying US regulations forbidding banks to channel money of sanctioned countries such as Iran through the US.  The DFS accused it of laundering more than $250 billion over several years through its US banking operations, of falsifying internal records to prevent regulators from tracing the identity of its Iranian clients and of filing untrue reports.  That a major bank decide, in a very big way, to defy the laws of its host country is simply baffling.

The reaction of senior and top management in this whole affair further raised alarm bells in my mind.  There was of course the now infamous email exchange between the Head of US operations and his superior in which the former clearly outlined the dangers of the bank’s course of action and the latter replied “who these f*** Americans think they are to tell us what to do”.  There was also the truculent initial response to the DFS action stating that only $14 million of transfers had been mishandled and that the bank was contemplating countersuing for damage to its reputation!  This from a bank that had been under Federal oversight from 2004 to 2007 for money laundering.  Then, in short order, the bank agreed to settle with the DFS, paying $340 million and accepting renewed oversight.  As Butch Cassidy asked the Sundance Kid in the eponymous movie, “Who are these guys”? 

What is worrying in this case is that this is not an instance where a low level trader decides to go rogue.  It is likely that the decision to continue doing business with Iran was vetted by the very top management; the Board of Directors was probably at least aware of the decision/policy, and if it was not, then more serious questions must be asked.  What management decides to choose Iran over the US?  What kind of senior manager blurts out the f*** word when referring to the Congress of a host country?  So far, I find no reassuring answers.  Either we are dealing with a culture or a strategic problem. 

The cultural hypothesis is that the top echelons of the bank include throwbacks to the Indian days of the British Empire, except that New York is not a remote outpost in the bush.  When a senior manager not only refuses to listen to his country manager’s cogent alert and advice but also responds with unrestrained fury, when the corporation lets it be known of its intent to counter sue its regulator for damage to its reputation, under the circumstances, I, for one, wonder about the culture of the place.

The strategic hypothesis is that the bank’s main focus is emerging markets, many of which, by definition, are less closely regulated than developed ones, often condone business practices which would be frown upon elsewhere, and in some cases are governed by regimes which are not models of good behavior.  New York is important to the bank for providing access to the US dollar system, but the Americas-Europe-UK segment accounted for only 10% of Standard’s operating income in 2011.  In that sense, and in my view, the bank probably has a higher risk profile than generally acknowledged.

Bottom line, the US regulatory and judicial process is not over by a long shot as the Federal Reserve, Treasury and the Justice Department are still to conclude their own enforcement actions.  I am among those who applaud the DFS decision to go public and break the apparently stalled multi-party negotiations.  I found the allegations against the bank shocking (called me an old-fashioned banker). 

Finally, having myself spent most of my banking and investing careers in emerging markets, I have come to the conclusion that the Standard Chartered business model is riskier than previously thought, and more importantly, that such higher risk profile is unlikely to be easily reduced. 

At some point under the right circumstances and at the right price, the bank may become an interesting investment or trading idea.