The Developing Compensation Philosophy of the Treasury Department

Here is a link to Gene Sperling's opening statement: http://www.treas.gov/press/releases/tg166.htm#_ftnref3

There are some very interesting quotes that help to frame Treasury's philosophy re systematic risk and executive compensation in this statement.

Compensation structures that permitted key executives and other financial actors to avoid the potential long-term downsides of their actions discouraged a focus on determining long-term risk and underlying economic value, while reducing the number of financial market participants with an incentive to be a "canary in the coal mine."

The testimony describes one investment bank which acknowledged the skew in its incentive structures:

Simply measuring bonuses against gross revenue after personnel costs with "no formal account taken of the quality or sustainability of those earnings."

It is clear that Treasury intends to broaden itself beyond its initial focus on financial services:

But what is important for our economy at large is the topic of this hearing: understanding how compensation practices contributed to this financial crisis and what steps we can take to ensure they do not cause excessive risk-taking in the future. And while the financial sector has been at the center of this issues, we believe that compensation practices must be better aligned with long-term value and prudent risk management at all firms, and not just for the financial services industry.

Here are the principles that were outlined in the "way forward":

Compensation plans should properly measure and reward performance.
- In other words, performance metrics should not just be based on stock prices but also relative performance and adherence to risk measurement. "Don't confuse brains for a bull market."

Compensation should be structured in line with the time horizon of the risks.
- The testimony discussed the trade-off of large short term gains that presented a "tail-risk" of large losses. Hence, the notion of stock compensation that is required to be retained for a long period of time, even beyond retirement, is being introduced. Also suggested that bonuses could be "at risk" and withdrawn if a poor year follows a good year.
Here is an abstract regarding executive pensions and their role in long term compensation.

Compensation practices should be aligned with sound risk management.
- The testimony refers to The Financial Stability Forum's Principles for Sound Compensation Practices. The authority and independence of risk managers is "all the more important in times of excessive optimism when consistent -though unsustainable -asset appreciation can temporarily make the reckless look wise and the prudent look risk-averse." The context of risk management is broadened to include all employees, not just executives, that may be incentivized for excessive and imprudent risks.

We should reexamine whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders.
-The testimony describes that golden parachutes were in place at over 80 percent of the largest firms as of 2006.

We should promote transparency and accountability in setting compensation.
-According to one Congressional Investigation, the median CEO salary of Fortune 250 companies in 2006 that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use consultants with such conflicts of interest.
House Committee Report on Executive Pay Also see blog for additional discussion.
Also please see Ferri and Maber abstract which describes the change that "say on pay" has made in making CEO compensation in the UK more responsive to negative results.
Also please see the CFA Institute survey's response to "say on pay"
Also please see "Shareholder Say on Pay:Ten Points of Confusion"

Executive Compensation-Government is Not Going Away

Corporate governance is a topic that many of us tend to ignore, leaving it to the institutions or corporate raiders that are looking to influence the strategic direction, the capital allocation, the corporate structures or the compensation structures of business.

Yet, the way business is run should matter to us all. We need the goods and services it produces, or the employment it provides. As shareholders, whether directly or through our 401-Ks or pension plans, the long term wealth that corporations create is important for our old age dignity and in fact, the national prosperity. Hence, the governance of corporations affects us all whether customer, employee, citizen or shareholder. The effectiveness of corporate governance is indeed a factor in determining whether companies survive and prosper or stumble and fail.

Some years ago, Jonathan Charkham noted in his book, Keeping Good Company :

“It is difficult to escape the conclusion that government has a role here as it is the only power in any land which can strike a balance between the conflicting wishes of competing interests. Furthermore, the framework within which these interests compete is one of government’s own making. Everywhere the corporation is a creature of statue not nature, designed to encourage the continuity of power that the sophistication of modern economies require. It is not government’s role to double-guess individual commercial decisions-but to ensure as best it can, that the structure it creates for companies contains checks and balances that are effective in resolving the tensions between differing legitimate claims.”

One does not undermine one’s dedication to capitalism by believing that companies are more than just engines to maximize return on capital. After all, one could repeal child labor laws, ignore plant safety, ignore anti-trust and thereby maximize profitability, but at what cost to society?

Playing for very high stakes has been an ongoing theme in American capitalism probably since Alfred Sloan of GM declared that “The business of business is business.” Excessive and sometimes fraudulent risks, competition, and the increasing size and complexity of organizations: these three factors have been at the heart of every corporate breakdown and crash and burn. The call for greater regulation and greater scrutiny has followed every scandal, for example, the salad oil scandal of the mid-1960’s resulted in more stringent commodity trading regulation after nearly taking down American Express and causing significant loan losses in the banking system.

So it is little wonder that the Obama administration has begun to scrutinize certain aspects of corporate governance, in particular, an effort to rein in executive compensation. Though far from setting executive pay ceilings at all corporations, the new compensation czar – lawyer and mediator Kenneth Feinberg – will have broad discretion to set the pay for roughly 175 top executives at seven of the country's largest companies, which received billions in government loans. He will set the salaries and bonuses of some of the top financiers and industrialists in the United States including Fritz Henderson (GM), Vikram Pandit (Citigroup), and Ken Lewis (B 0f A).

The Obama administration argues that poorly designed compensation packages encouraged some Wall Street executives to take on excess risk in the mortgage market and elsewhere, which in turn helped trigger the financial crisis and a global recession. As Barney Frank, chairman of the House Committee on Financial Services observed (bolded words are my emphasis):

“It is not the role of government to set policy regarding the amounts that are paid in compensation to top executives, nor to deal with the question of how that compensation is allocated among salary, bonuses, retirement packages, etc. But as Secretary Geithner’s remarks recognized, there are two very important points that we should address.”

“First, shareholders must be empowered to have a major role in the process of setting overall compensation. While it is not the government’s role to say that a certain amount is too much, it is very much the right of the people who own the company to speak out if they think excessive compensation is being proposed. The system of say-on-pay that was piloted in England is a reasonable way to do this, and I was proud that the House adopted the bill that came from the Financial Services Committee to institute this in 2007. Unfortunately, the bill did not go forward in the Senate, but I am optimistic that with the support of the President, we will be able to enact this important principle into law. Recent evidence in England shows that when shareholders are in fact troubled by excessive compensation, say-on-pay is an effective tool for them.”

“I also agree with Secretary Geithner’s annunciation of the principles that should guide the structure of compensation – not the amount. But I differ with his view that this can be accomplished by strengthening the independence of compensation committees. Given the inherently close relationship that exists between CEOs and other top executives on the one hand, and boards of directors on the other, it is very unlikely that you will ever get the degree of independence that will allow the boards of directors to be left completely on their own to set compensation. That is part of the reason for say-on-pay. But it is also the reason why legislation should be adopted that instructs the Securities and Exchange Commission to set principles which prevent boards from providing compensation systems that lead to excessive risk taking.”

Many proxy statements this year contained “say on pay” shareholder proposals, almost all of which were opposed by managements. I am strongly in favor of such proposals which now appear to become the law of the land. Though these proposals are not enforceable per se, they do provide moral suasion and have had influence in European countries that have adopted the practice for example, Royal Dutch Shell. See also the recent impact in some UK retailers.

Proxy statements frequently contain a report from the compensation committee which generally outlines the company’s philosophy of compensation, what it uses as its peer group for a model of compensation, and what sorts of behavior are being rewarded both short and long term. In general, the compensation committee charter suggests that compensation should align managers’ interests with those of shareholders. An excellent template for what should be part of the compensation committee’s report was recently produced by the California State Teachers Retirement System. Among the points that CSTRS suggests is some specificity regarding the role of risk in incentive compensation:

“The role of risk in the context of the executive compensation program, which should include both a defensive perspective (how the committee ensures potential compensation does not incentivize excessive risk), and an offensive perspective (how the program is designed to incentivize appropriate risk and aligns the interests of management with those of long-term owners)”

Our summer intern, Drew Levine, recently completed a study of proxies that we have voted at our firm and run some statistics on components of executive compensation trends versus share price performance. If shareholder and management interests are truly aligned, one would expect some degree of correlation between comp and share performance. Sadly, that has not been the case. Here are some of Drew’s observations:

After conducting analysis of executive compensation data, it is safe to say that there is little to no correlation between stock price performance and compensation. The data compiled is from a tumultuous time in the stock market where nearly all of the companies we voted on stocks were down. One would think that because the company's stock performed so poorly the executives pay would subsequently suffer, but that was certainly not the case in some instances. The strongest correlation in the data was the percentage increase or decrease in bonus compensation in relation to stock price performance. However that measure of correlation was still extremely low at .21 for the CEO and .16 for the CFO. It's shocking to see that there really is no correlation between pay and performance because one would think that would be the most basic and truest basis for compensation. What I found most surprising was the average salary and total compensation growth from 2006-2008. It is amazing to see that although the majority of these companies were struggling with the economic downturn, the average salary growth for the CEO in 2008 was 74.9% and their total compensation growth for 2008 was 25.7%. What this indicates is that executives are increasingly taking more base pay with the knowledge that because their company's stock won't perform well, they will not get the oversized bonuses that they were used to receiving just a few years ago. Although, when looking through the data, it was relieving to see that in most of the companies the executives did not receive bonuses for 2007 and 2008.

In 2007 and 2008, we surveyed 79 and 92 CEO's respectively, and 55 and 81 CFO's respectively. This was due to new hires and fires at the executive positions. From year end 2006 to year end 2007, the average stock price of the company's surveyed was up 26.7%. From year end 2007 to year end 2008, the average stock price was down 40%. The average salary for the CEO in 2007 and 2008 was just over $1,000,000 and the average salary for the CFO during the same time frame was around $600,000. The average bonus for the CEO and CFO in 2007 was over $1,000,000 each with that number decreasing to about $450,000 for the CEO and $300,000 for the CFO in 2008.

For the 2009 proxies we voted, we emphasized voting for "best practices" such as shareholder's votes on executive compensation (say-on-pay) and shareholder's ability to call special meetings. Many people forget that the shareholders are the real owners of the company and that management is working for us. For that reason we find it important to vote every proxy for companies which our clients hold shares and not just throw them away like many shareholders do.

Looking at total compensation for the CEOs rather than just bonuses, the correlation to share price performance is non-existent at -0.03. Apparently, CFO total comp has a somewhat stronger link to share price performance at a still rather weak 0.19. Here is a spreadsheet of our compensation study and the statistical correlations that we observed.

Last year, the CATO Institute published a paper on Executive Pay Regulation versus Market Competition by Ira Kay and Steven van Putten which argues that: “The misperceptions that drive regulatory efforts are grounded in the idea that the market for executives is not competitive and that pay levels do not reflect supply and demand for talent” (pg. 1). Kay and Van Putten argue that the “myth of managerial power”, executives control over the board which sets their compensation, leads to greater regulation because lawmakers believe that the market is rigged as they put it. The authors present evidence to the contrary that says that the market is actually competitive and that the appropriate level of executive compensation tracks performance.

This may well have been the case but we face a new reality. We had better become accustomed to the idea of big government as regulations to restore financial order come into force. Jeff Immelt, in a recent address to the International Economic Forum in Montreal stated it most succinctly, “The government has moved in next door and it ain’t leaving. You could fight it if you want but society wants change. And government is not going away.”

A Report from Today's Citigroup Meeting re Governance

Corporate governance has always been an important part of value investing. Obviously, most of us hate waste when precious company resources are squandered to build executive dreams rather than shareholder capital. Misallocation of capital and failure to optimize returns on capital have led me at times to conduct activist campaigns with some managements. This can lead to stormy verbal exchanges, but occasionally, has led to real change in management strategy, abandonment of some projects, and greater focus.

Though managements can ignore shareholders for a period of time, the annual meeting of shareholders allows investors an opportunity to vent, to express opinions, and to make suggestions.

Today, I attended the Citigroup annual meeting, as you can imagine, a very raucous affair.

I thought readers may find it helpful to see a question that I posed to Richard (Dick) Parsons, the chairman of Citi. Much of the board of Citigroup has been in place for many years, and though management has started to slowly bring in some new board members (with actual banking experience) some of the "deadwood" remains.


Mr Chairman, my question relates to the effectiveness and qualifications of our Audit and Risk Management Committee.

On page 35 of our proxy, we have the Report of our Audit Committee which indicates that the Committees meetings facilitate communication among members of the Committee, management, independent risk managers, internal auditors, and Citi's independent auditors.

On page B-3, Annex B of the proxy, the Committee is charged to review and discuss with management, at least annually:

"Developments and issues with respect to reserves" and "Off balance sheet structures and their effect on Citigroups consolidated financial statements." as well as

"Effectiveness of the bank's advanced systems for the calculation of risk-based capital requirements"

Under the section regarding the "Oversight of Risk Management", the audit committee is charged with responsibility to review with management the categories of risk the company faces including financial, operational, reputational risk AND

Review the risk policies and procedures adopted by management.

No one can deny that risk management at Citi has been an abysmal failure. It seems that the mission of this company was a Star Trek mission..."To boldly go where no man has gone before."

This company lived under an illusion of prosperity...an illusion that has been endorsed by the lack of oversight and ability of the Audit Committee to fulfill its responsibilities.
Over the last five years, the Chairman of our Audit Committee was Mike Armstrong, who at the same time served on the Executive Committee. That same committee was chaired by none other than Bob Rubin whose hypocrisy and denial of the risks that have taken this company down, all shareholders are suffering for.

I am at a loss to understand how someone who was on an Executive Committee, supposedly steering this lumbering ship, could maintain independent judgment by chairing the Audit Committee. Obviously, someone here, most likely the Nominating Committee agrees since:

Mr. Armstrong, who has been a director since 1989 is no longer part of the Audit Committee, as of this year, continues his "service" to our Company on the Nomination as well as the Compensation Committee. Much as this company has suffered under an illusion of prosperity, it appears to continue to suffer under an illusion of competence.

During Mr. Armstrong's tenure as the Audit Committee chairman, the incalculable loss in shareholder value due to his failure, and the Committee's failure to properly manage risk has led to some of the spirited discussion that you are experiencing today. I applaud Mr. Armstrong's removal but wonder about how much more damage is feasible after his 20 years on this board.

I see we have now appointed John Deutch to chair the Audit and Risk Committee.

John has been part of the board for two tenures, initially between 1987 and 1993 and currently since 1996. John is a brilliant scientist who has served this nation with distinction as an Undersecretary in the Department of Energy as well as the Director of Central Intelligence. It seems that one of the things most lacking at Citi is central intelligence.

John apparently did a BA in History and Economics back in 1961, presumably he may have studied some accounting back then, perhaps Accounting 100, though unlikely to have studied anything about risk management or auditing.

John has served on the Audit Committee of our Company since 1997 and hence, likely drank the Kool-Aid as to the Illusion of Prosperity.

John has served on other boards, mostly as a member of the nominating committee or technology committee but I see that he has served on the Finance Committee of Cummins Engine.

The last time that Citi had a Finance Committee, it was chaired by Jamie Dimon in the mid-90's...I hear he's done pretty well since.

John's only other service on an audit committee was at CMS Energy where while under his tenure, where:
-the Company had to restate its financials for its energy trading business a la Enron
-it had inflated its revenues by $5.3 Billion
-had to engage in major asset sales in order to survive, selling off most of its foreign operations in India, Brazil, Australia...unusual for a funny little utility in Midland Michigan
-and presided over the CMS stock falling to an 18 year low and down some 90% peak to trough.

I suppose that in some ways, John may be imminently qualified to add value given his experience, nevertheless, it does seem odd to offer an audit committee post to someone who presided over disaster in his only prior "at bat."

It is surprising to look at the current board, outside the new additions, and see so many characters,who though they may have a lot of management experience and executive expereince, seem to lack accounting or audit or even finance credentials. As Buffett has said, there are many banks but few bankers. It appears that none of our existing audit committee members have any prior financial services experience!

I note that the audit and risk management committee has many members who, like Mr Deutch and MrArmstrong presided over this seemingly out of control disaster.

Andrew Liveris since 2005 on Audit

Ann Mulcahy since 2007 on Audit

Dr Judith Rodin since 2004 on both Executive and Audit Committees

Shareholders can no longer countenance the shameful incompetence of our Audit and risk committees financial expertise where it is clear that there is none.

Rather than your vote, they deserve a dressing down that would knock years off their lives. We have been victims of their steely eyed stare into nothingness.

Mr Chairman, is it not time that the same standard applies to our board as has been applied to some former members of management...the standard that sent our Chief Risk Officer in 2007 to the dugout to contemplate the meaning of "sub-prime"...the same standard that sent Chuck Prince into a glorious retirement at huge expense to shareholders...out presumably for dance lessons.

Mr. Chairman, I respectfully submit that it IS time for meaningful change in our Audit and Risk Management Committee.


...................................................................

Most of us investors tend to vote with our feet and simply sell the stock. I urge you to read the proxy statements and if there is something egregious that you see, to let the board know and to let it be known in a public forum. Stupidity needs to be aired out and benign neglect needs to be addressed.

Change, though glacial and slow can be achieved. I am more than happy to use this blog as a forum to bring some of these matters to readers attention.

Disclaimer: I, my family and clients may have a position in certain securities mentioned in this post.

NCR versus Diebold

Courtesy of Seeking Alpha, I have been privileged to have been introduced to an exciting new research product called Gridstone Research. Gridstone is a new research platform that combines financial data, operational data, and unstructured textual information about a company into a structured useful form.

As I become more proficient with its use and application, I will be incorporating Gridstone into my financial models.

For now, a very basic look at NCR versus DBD's profitability over the last several years.

http://tinyurl.com/d2kjv8

Disclaimer: I, my clients and family may have a current position in securities mentioned in this blog post.

Techonomics and the ATM

 

“By prevailing over all obstacles and distractions, one may unfailingly arrive at his chosen goal or destination.”- Christopher Columbus

Needless to say, it has been an incredibly tumultuous environment. The economic outlook, despite a few specks of light in a dark sky remains quite bleak. Despite this, I have been encouraged by valuations, by the tape action, and by the prevailing sentiment that continues to express doubt in the strength of this rally.

For today’s thoughts, I would like to focus on the tech sector. Tech stocks, in my view, are beginning to discount a recovery and unlike the tech bubble of the turn of the century, generally constitute reasonable business models. Many of these companies have substantially improved their manufacturing footprint to lower cost geographies. Many enjoy recurring revenue models.  Many enjoy strong reputations and decent customer loyalty. However, in a climate of falling capital expenditures by their customers and the experience of building inventories, and falling prices for commodity products, the industry has generally been swift in its response by cutting employment and focusing on cost control.

Real tech spending fell at almost a 24% annualized rate in the fourth quarter (according to Ned Davis Research), the biggest drop since 1990 and in fact, much larger than the 18.6% drop in Q2 of 2001, when the tech bubble burst. As a percentage of GDP, tech spending fell to just 3.6% of GDP down 0.3% Q4/Q3 and down from a peak about two years ago of just over 5%. The quarter over quarter drop in tech spending to GDP exceeded the drop in the 1973-75 and 1981-82 recessions.

The industry responded by cutting production and employment. Capacity utilization in the industry went from just over 80% to 59.9%, a record low.

It is important to keep in mind that many of these trends are quite long in the tooth, in many cases having portended the industry recession. We may well be near the end of the downtrend in this industry. For example, new info tech orders declined for 28 months post tech bubble…currently, we are in the 34th month of decline in this metric. The semiconductor book-to-bill ratio declined for only 13 months post tech bubble…now, we are in the 31st month!

Earnings expectations have weakened substantially. The 2009 median expected growth rate has dropped to about -10% from expectations in early 2008 of about +20%. Though growth expectations post tech bubble bottomed at -26% in September of 2001, this coincided with the bottom in these stocks. From a valuation standpoint, price-to-book and price-to-sales ratios are below the 2002 troughs. The current price-to-book ratio is at 2.5 times as compared to the September 2001 trough of 3.3 times. The price-to-sales ratio is currently at 1.5 times as compared to the prior 2.1 times.

Here is a screen (courtesy of Cash Flow Analytics ) of high tech companies with revenues greater than $100 million that have produced free cash flow though the last twelve months.

http://tinyurl.com/c6zj3s

 

As you can see from the screen, there are many cheap stocks from which to select, in many cases with excellent balance sheets.

One subsector within technology that I believe has been ignored is the ATM sector. As one can imagine, at a time when banks are more concerned about retaining capital to ensure their solvency in a deteriorating credit environment, there should be little propensity to spend on ATMs. Investors remain concerned that increasing bank failures, potential nationalization, and general credit concerns will severely impact the operating performance of the ATM manufacturers. Yet, some of this concern may well be overblown. During the S&L crisis of the 1980s when almost 1500 banks failed, the ATM manufacturers experienced rising sales as new banks emerged and surviving banks increased their focus on efficiency and innovation to reduce their costs.

The global market is dominated by Diebold (DBD)and NCR (NCR). Demand for self-service solutions has been steady from the large national banks that have rolled out deposit automation and bulk checking products. Roughly two thirds of ATM demand is replacement driven. Replacements are driven by regulatory and technological changes as well as aging of the equipment which has a useful life of six to eight years.

In a recent broker conference, NCR’s CEO Bill Nuti described the recurring nature of his business:

“ I think we also have a fairly stable revenue stream inside the Company. When you look at our revenue stream, approximately 40% of it is services, annuity-based services maintenance, which has contracts that stem from a year to five years in length, and a fairly stable revenue stream.”

“Another 10% of our revenue is in consumables. That tends to be fairly stable. This would be purchasing of paper rolls for point of sale or two-sided thermal paper technologies and printers. Another 20% or so comes in the year vis-a -vis backlog. Backlog coming into the year that we expected to turn in the year.”

“So, you've got about 70% of the revenue stream that's relatively reliable, strong revenue stream. The rest, of course, comes from success within the year.”

“ I think large banks in the US will continue to roll out deposit automation at a fairly aggressive rate in 2009. We have a very good position in that particular segment of the banking market.”

One of the important technological developments in the ATM industry has been the direct deposit taking ATM where the money is deposited immediately as opposed to an envelope-taking ATM.

Nutti describes the advantages of this technology:

“A return on investment has been nothing short of outstanding for the banks that deploy deposit technology. In fact, today, the reason why in this environment you're seeing banks roll out deposit technology as aggressively, is because they're being, basically, the departments of the banks that are rolling this technology out are being told by the leadership of retail banking, we need to get X tens of millions of deposits out of the branch and automated onto a machine because of the cost savings.”

 

“So, the cost savings are phenomenal for a bank to take someone who was once depositing checks in a branch vis-a -vis a teller now onto a machine. And so you're seeing tremendous cost savings.”

“I've got one customer who recently was requested to move more rapidly with deposit automation because they need 60 million checks that were normally deposited in branches to now be deposited vis-a-vis deposit-taking ATMs. So, that's one customer. And you can imagine, you could put any number, any dollar savings you want against the 60 million checks and come up with a pretty good ROI given the cost difference.”

The difference is discernible to customers as well, spending only seconds rather than waiting inline in a branch for a teller. The bank would far rather employ a person as a salesperson, selling additional higher margin services and establishing customer relationships rather than depositing checks in a drawer.

For NCR,there is also exposure to the airline industry and its self-serving kiosks. NCR is the number one provider of these devices to the airlines with an 80% share. According to the company, to check in by waiting in a queue at the airport costs about $3.15 per transaction. Checking in by kiosk runs $0.14! That is a tremendous cost savings.

The company anticipates that it will generate free cash flow in 2009 despite needing $200-$250 million to fund its pension plans. Currently, the company has $403 million in cash and investments per share (roughly $2.50 per share) net of debt.

The company launched over 50 new products in 2008, the highest number in more than a dozen years, including the launch of the industry's newest and most innovative ATM family, NCR SelfServ.

In the retail industry wit introduced a next-generation self check-out solution, 5.0, and other point of sale solutions that have captured significant market share.NCR is gaining significant traction in expanding its self-service strategy into new industries including the entertainment industry that promise to open up future avenues of growth for NCR.

For Diebold, some 50% of its revenues are service oriented, consisting of annual maintenance, servicing and monitoring contracts. In North America alone, the company has over 120,000 annual contracts to service the installed ATM base with a renewal rate of well over 90%. The company has generated about $250 million- $300 million in EBITDA annually whereas capex has run around $40 million.  A concern is that DBD has been the subject of an accounting investigation by the SEC relating to revenue recognition practices. From a corporate governance standpoint, last March United Technologies (UTX) offered to buy DBD for $40 per share which the company rejected as inadequate. Recently, the company allowed a poison pill provision to expire. Back in 2005, the board dismissed most of its senior management because of poor internal controls and controversy about its election systems division which represents about 5% of sales.

The company has made significant strides in cost reduction since the 2005 disaster. As per its most recent conference call:

“More than just squeeze cost out of the old process, they identified best practices that were new to Diebold and implemented them successfully. As a result of the success of this initiative in 2008, we expanded the effort to eliminate an additional $100 million of cost out of the Company by the end of 2011. Key to the next 100 million, we expanded our relationship with Minlo, our logistics partner in the supply chain area. They assisted us in reducing our finished goods warehousing footprint from 89 company operated facilities down to three Menlo operated logistics centers. One center located in Greensboro, North Carolina is a flexible delayed product configuration facility serving market in North America and Latin America. This helps us improve lead times to customers while reducing costs.”

“We also improved manufacturing footprint. We have 85% of our production in low-cost geographies. By increasing production in low-cost geographies, we are also manufacturing our ATM products closer to our key customers in growth regions in Asia and eastern Europe. In addition, we consolidated security manufacturing facility in Ohio, with existing facility in North Carolina. To further streamline our operations, we expanded our vendor managed inventory system. We continue to leverage our relationship with Ariba implementing best practices and direct indirect procurement processes.”

NCR trades at merely 2.6 times trailing EV/EBITDA reflecting $1.5 Billion in equity market cap, $333 million in debt and over $700 million in cash or an enterprise value of $1.1 Billion.

DBD  trades at 7.6 times EV/EBITDA with $1.5 Billion in equity market cap as well, but $620 million in debt and $360 million in cash or an enterprise value of $1.7 Billion.

Here is a look at the quarterly progressions of working capital management, capital intensity, and ROIC for these companies:

http://tinyurl.com/cm7vc2

In conclusion, I believe that there are many opportunities within the tech sector that are worth further exploration and investigation. By prevailing over the many distractions, focusing on value, and relying on recurring revenue models, investors can earn significant long term returns with some patience. I believe that the ATM industry in particular represents an unappreciated sub-sector in tech.

 

 

 

 

 

 

Happy New Year!

What can be said in New Year rhymes,
That's not been said a thousand times?
The new years come, the old years go,
We know we dream, we dream we know.
We rise up laughing with the light,
We lie down weeping with the night.
We hug the world until it stings,
We curse it then and sigh for wings.
We live, we love, we woo, we wed,
We wreathe our prides, we sheet our dead.
We laugh, we weep, we hope, we fear,
And that's the burden of a year. - Ella Wheeler Wilcox

What a tough and rugged year it has been for all of us in capital markets! Who could have imagined the volatility, the fear, the panic that we, our friends, clients and employees felt at times. To our friends at Lehman, the Bear, and many others in investment banking, losses are particularly deep as victims of the financial tsunami that washed through the financial system.

We think of all of you as the old year passes and the hopes for a new year are in our hearts. We thank you for your readership, your support, and your thoughts! We are looking forward to a regular dialog through this blog and through some new and exciting alternative channels that we are developing. We appreciate the ongoing support of friends like Henry To of marketthoughts.com and David Korn of The Retirement Advisor. Special thanks to Geoff Gannon who has one of the most insightful blogs in investing. I look forward to hearing more about Geoff's ongoing publishing projects. I would be remiss in not mentioning David (Dah Hui Lau) who is determined to dedicate his life to value investing as well as a fellow Ontarioan Nurse B who continues to Triage his Way to Financial Success.

Finally, the ongoing help of The Wall Street Transcript as well as Cash Flow Analytics have helped mold and shape many of our thoughts and theories. Our friends at Seeking Alpha have also provided great support in terms of distribution of ideas as well as access to conferences.

Best of the New Year!

Rick

Finally, an Irish toast:

In the New Year, may your right hand always be stretched out in friendship, never in want.

Fair Value, Mark-To-Market and Financial Reporting-Another Revision?

Less than a week to go for 2008, and the Financial Accounting Standards Board (FASB) has a proposal which it has thrown into the arena to address the problem of fair value.

Mark to market accounting has stirred up a very ugly debate between its adversaries and its proponents. Mark Sunshine, in a Seeking Alpha post some months ago noted that: " Mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse." Other prominent naysayers as far as the current accounting rules for mark-to-market include Steve Forbes and noted fund manager, Ron Muhlenkamp.Here is a recent interview where they discuss mark-to-market accounting.Forbes does not mince his words:

"Henry Paulson is the worst treasury secretary in living memory. But even though he's miserably mishandled this financial crisis there's still time for him to turn things around. He can--somewhat--repair his reputation. He simply needs to back away from the disastrous policies and practices that have defined his tenure."

"His first mistake was to support the weak-dollar policy that sparked and fed the crisis. Then he continued to enforce mark-to-market accounting rules. Mark to market destroyed bank balance sheets. Now insurance firms are faltering under its weight. But there's still time for common sense...And while mark to market is fine for publicly traded stocks, it makes no sense when you don't have a market, as with packages of subprime loans. And it also makes no sense for long-term insurance reserves. Paulson and the SEC can suspend this inane rule in a heartbeat, yet they refuse. Adhering to one position without regard to consequences and expecting a different result is the definition of insanity. It's time for Paulson to follow the path of reason."

Proponents of mark-to-market generally perceive greater transparency with its usage. For example, here is a part of a letter to FASB by Rebecca McEnally of the Investors Technical Advisory Committee (IATC):

"The ITAC believes that it is especially critical that fair value information be available to capital providers and other users of financial statements in periods of market turmoil accompanied by liquidity crunches such as we're now experiencing. In the absence of timely fair value information, uncertainty increases, further exacerbating market instability and causing investors to withhold investable funds or demand a hefty uncertainty premium. A cornerstone of the restoration of investor confidence must be to provide the information investors need to make risk-based decisions."

"Regulators recognize that fair value measurement is an essential tool in their oversight and monitoring of the risk management practices and risk profiles of financial institutions, and ensuring that the institutions' capital provisions are adequate to support the risks embedded in the financial instruments and other assets the institutions hold and the financing used to support those assets. Given this widely-recognized critical importance of providing relevant, high-quality financial information to the markets, the ITAC has been dismayed to learn that a few managers of major financial institutions, along with representatives of industry organizations representing some financial institutions, are now calling for a suspension of fair value reporting for financial instruments. They argue, in effect, for a return to the old financial reporting model for financial instruments in effect decades ago with its out- of-date historical cost reporting and lack of transparency, particularly for embedded financial risks."

The proponents credit the transparency they believe that mark-to-market has brought to capital markets with the market's improved understanding of the risks and consequent selling off of many financial services stocks.

"Recently, some have attempted to shift the blame for the current crisis from the poor business and investment decision-making, including the flawed underwriting, securitization, risk management, and disclosure practices in which they engaged, to fair value financial reporting, a "shoot the messenger" argument. This reasoning is both perplexing and misleading. In fact, the current requirement to report financial instruments at fair values was instrumental in the uncovering of the deep and widespread problems in the markets. The long-term solution to the problems relies heavily on the retention of the requirement to provide fair value information to investors and regulators: the higher the quality of fair value information that is provided, the faster will be the necessary market adjustments to the problems."

"What those making the argument fail to recognize is that these are not abnormal features of the measurements, per se, but rather characteristics of the normal functioning of markets as investors reassess risks and rewards and liquidity disappears for poor quality securities and investments with little transparency. Some downward price revisions will inevitably result in the triggering of covenants that the original purchasers of securities or lenders demanded as a condition of investing in the securities and agreeing to the terms upon which the capital was provided to issuers. Again, these triggers are a normal part of the contracting process and designed to protect the investors, including lenders. The fact that the triggers were activated is not an indictment of the measurement system but rather is a direct function of the poor or deteriorating quality of the investments. Arguing that by not recognizing the poor or deteriorating quality of the investments we will somehow solve the problem is not only inappropriate but is a variant of the "shoot the messenger" argument: Pull the covers over the problems and maybe they will just go away."

I certainly recognize that under most normal circumstances, there is great transparency in fair value as opposed to other methodologies. However, it is also very clear to me that a myopic and complete focus on fair value can in effect be liquidation or bankruptcy value in times of severe systemic stress. I would agree with Forbes that the triggering of covenants that has resulted from large and probably unnecessary write-downs has caused more panic than elucidation as far as asset values. As he said very colorfully:

"Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline."

A compromise of sorts appears to be coming. The FASB would like firms to include in their financial statements a table which provides a comparison of three different reporting measurements:

1. The reported carrying value
2. Fair Value
3. Incurred Loss Amount

These changes would allow managements to highlight future cash flows of securities that will be held to maturity and are available for sale. Though the near term "fair value" or "market value" in a very constrained and illiquid market may look dreadful, the majority of many of these assets will likely pay off over their long term maturity. Hence, the "incurred loss" category when it demonstrates that few losses have actually been incurred may create some substantiation of long term value that is more realistic in my opinion than what we have now.

This proposal labelled proposal FAS 107-a, if approved, would go into immediate effect for reporting periods after December 15th, 2008! That puts more than a little uncertainty into forecasts of fourth quarter financial services profit forecasts. But at least the uncertainty may be somewhat positively skewed in favor of less write-down in the recognition of "fair value."

Part of the backbone of accounting is what's known as the conceptual framework which describes the function and purpose of accounting. As the FASB and the global body, the IASC consider a new conceptual framework, they propose (italics are mine):

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Capital providers are the primary users of financial reporting. To accomplish the objective, financial reports should communicate information about an entity’s economic resources, claims to those resources, and the transactions and other events and circumstances that change them. The degree to which that financial information is useful will depend on its qualitative characteristics.

Financial reporting information is a faithful representation if it depicts the substance of an economic phenomenon completely, neutrally, and without material error. It must also be relevant.

In my view, the substance of financial reporting should focus on the long term substance of the transaction rather than the strains of the current capital market. Perhaps the new proposal begins to address the situation. Perhaps what is sacrificed in terms of timeliness and verifiability is offset by improvements in comparability and relevance.

Unfortunately, forecasting results will become even more difficult as accounting rules may be modified at the worst possible time, the year-end for most companies. But, if implemented, these rules may provide a bit of sunshine and upside at long last to a sector that has been wrapped in uncertainty and fear if not deprived of common sense for some time.

Happy Holidays!

A simple and sincere message to all. Here's wishing you the best of holidays in this blessed season.

Wishing all of you a Happy Hanukkah, a Merry Christmas, and peace!

Looking forward to 2009, a Happy, Healthy and Prosperous Year for all!

Rick

Stocking Stuffers

It has been a remarkable year. It has been year that many of us would just as soon forget. The cascading effects of deleveraging have been rampant across all markets.

The financial turmoil of 2007-08-09? has deeply affected households as well as businesses in most parts of the world. The reduction in the target Fed Funds rate since September of 2007 has been dramatic going from 5.25% (it really was this high!) at the beginning of this period to its current range of 0 to 0.25%. As any borrower knows, reductions in Fed Funds do not result in immediate parallel movements in interest rates that you and I pay, nevertheless, interest rates are likely lower than they otherwise would have been.

After peaking at a multi-decade high of +9.8% in July, the US producer price index (PPI), inflation rate has completely collapsed to +0.4% in November.

Little wonder that investors are huddling for warmth, are seeking "guarantees," and are about as risk-averse as I have ever witnessed. I warn my analysts about turning into "life insurance company treasurers" seeking relative shelter rather than seeking capital appreciation. Strangely, for long term real returns what appears to be safest in the capital markets at the moment may well be the most dangerous investment you can make,treasury bonds.

In this weekend's Barron's (subscription required) Rob Arnott, the former editor of the Financial Analyst's Journal provides some very thoughtful discussion in this interview by Lawrence Strauss.

As he describes,

"What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally, in November, we saw the beginnings of a rationalization where some markets did begin to recover-but some markets had been hit beyond any rational valuation of the risks associated with those assets."

Arnott goes on to describe very aptly, the behavioral tendency of most investors to continue to bank on "winners" rather than looking for bargains.

So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors.

He describes the current environment as "the richest environment of low-hanging fruit I've seen in my career."

A further key point...

"This is not a time to be hunkering down in the safety and comfort of the Treasury curve." "There are tremendous opportunities right now."

This being the holiday season, I suspect that Mr. Market has provided us some gifts for the taking if we choose to partake. I will be putting together a number of screens of bargain or quality ideas that I think may contribute to a happy new year. As well, I will be providing a review of many of these names in the coming days and weeks.

I will start with a list of Stocking Stuffers, as you will see, not necessarily very high quality businesses with strong competitive advantages. This list was constructed using Reuters and the following assumptions:

1. Price under $10 per share...i.e. Stocking Stuffers
2. Operating margins on a Trailing Twelve Month (TTM) basis better than that of the respective industry and showing improvement versus last year or two years ago.
3. Company must be generating free cash flow in the most recent TTM period
   
4. PE multiple must be within 20% of the lowest PE in the last five years
5. Enterprise Value/EBITDA must be less than six times.
   

Here's a look at several reporting formats for this screen:

Stocking Stuffers-Operating Margins, PE's, FCF

Stocking Stuffers-ROI, ROE

Stocking Stuffers- Debt Leverage


Here is another screen but rather than considering operating margin improvement, this screen looks for the following attributes:

1. Price under $10 per share but above $1.
2. Stock price below book value per share
3. Cash exceeds debt
4. Interest coverage more than two times
5. Net earnings must be positive for the most recent twelve months.

Remember that frequently, book value can be a misleading metric for value investors. Companies which chronically earn below average returns on capital or equity may well have assets whose valuation needs to be written-down. Impairment of these overvalued assets can lead to too low a price to book ratio. It is also important to note that companies that have a history of buying back stock at prices above book value will drive down Book Value and hence increase P/BV. Consequently, excellent companies that have generated excess cash and treated shareholders well by returning capital through buybacks will be missed by P/BV screens.

Book Value Bargains?


The Barrons interview makes it clear that Arnott favors investment grade corporate bonds at this stage. Spreads against treasuries have widened to immense gaps, for investment grade about 6% over treasuries, for below investment grade, perhaps 15-20%. As Arnott suggests, even if defaults reach historic proportions, it would take several years of defaults to lose a 20% spread in the competition against treasuries.

As Arnott concludes, and I agree, the less you hold in Treasuries, the better you are likely to perform in 2009. Riskier assets are priced to provide some significant returns for the coming years.

We'll have a deeper look at a few of the names within these screens over the coming days and weeks.