Archive for July, 2008

Auction Rate Securities and How the Failure of One Market Can Snowball Into Other Markets

Thursday, July 31st, 2008

How can a failure in one market snowball and create failures in others?  Here’s a simplified example, in the case of auction rate securities (ARS).

Much has been written this year about the sudden illiquidity of the ARS market.  ARS are a product often used by companies to invest their excess cash.  The inability to properly value such securities led to problems because they need to be properly valued on a company’s balance sheet for financial reporting.  Additionally, when that cash was needed, reselling the ARS at what was their supposedly appropriate value was an issue, as they were trading at significant discounts because of market illiquidity.

An ARS is a debt security, most often a municipal or corporate bond, in which the interest rate is reset via a Dutch auction on each payment date.  Essentially, it is a long-term bond with a 20 or 30-year term, but with variable interest rate, so that it acts like short-term debt.  A Dutch auction, also known as a descending price auction, is the winning bid at which the lowest possible interest rate at which equilibrium occurs (equal numbers of buyers and sellers exist), such that all securities can be sold.  For ARS, the auctions to reset the interest rate usually are held every 7, 28 or 35 days.

In February, 2008, the market for ARS collapsed and more than 1,000 auctions failed.  This is because the ARS’ insurers were in financial difficulties because they previously had insured mortgage-backed securities that were now defaulting at higher rates.  Suddenly, the ARS were seen as riskier because the insurers backing them were less secure.  Although an auction may fail, the ARS’ rates do reset,  typically increasing to the maximum rate allowed for the issuer of that particular ARS.  Demand for the securities decreased.  The investment banks that make a market in these securities refused to act as bidders of last resort, which they previously had done.  Consequence:  the market for ARS froze.

Investment banks had pitched these securities as “cash or cash equivalents” to companies.  But cash and cash equivalents are considered liquid.  Suddenly, many companies which held ARS had to revalue their holdings, and some reclassified them as short-term investments.  These changes reduce cash holdings on the balance sheet.  In some cases, a company may technically default on its debt covenants based on the ratio of cash on its balance sheets.  Public companies with significant amounts of ARS as a percentage of cash could see a drop in their share prices.

Even if the issuer underlying a particular ARS is fine, the lack of liquidity and auction failure created problems for investors.  These problems, with began with the failure of mortgage-backed securities, spiraled into auction rate securities, affected companies’ balance sheets and perhaps, share prices.  This, simply put, is how the failure of one market can snowball into other markets.

The Legal Underpinnings of Annual Meetings

Thursday, July 24th, 2008

A corporation in the United States is a legal entity that typically is formed to conduct business.  Its internal affairs are governed by the law of the state in which it is incorporated.  That means that under state law, a company’s shareholders must annually elect directors and transact other business that may be appropriate at the time.  This may be done at an annual meeting.  However, it is not only state corporate law that governs annual meetings.

The corporation’s organizational documents – the articles of incorporation (AKA certificate of incorporation) and by-laws – also control annual meetings.  For example, they may allow action to be taken without a meeting, upon the written consent of the shareholders.  Organizational documents provide the skeleton of the annual meeting, in that that may provide for the meeting time, date and place (or the way to determine the meeting time, date and place), setting the record date to determine the shareholders who will be eligible to vote and the voting rights of various classes of securities if there is more than one class.

Corporations with securities registered on a national securities exchange also must comply (unless they are exempted securities) with proxy rules, the rules and regulations enacted by the Securities and Exchange Commission (SEC) under Section 14 of the Securities Exchange Act.  Broadly stated, a proxy is a consent or authorization to act for another.  Regarding an annual meeting, the SEC’s proxy rules govern the form of the proxy and the form of the annual report provided to shareholders, regulate the information to be presented in the proxy statement, address the procedures pursuant to which shareholders receive the proxy and annual report before a meeting, and also mandate certain filing requirements.

Finally, national stock exchanges  (e.g., the New York Stock Exchange) have listing requirements which include rules addressing annual meetings.  Corporations with securities listed on a national stock exchange must comply with such rules.

A Management Flaw – and Financials Disasters That Shouldn’t Have Happened

Thursday, July 17th, 2008

One critical flaw that has hobbled and even killed companies is not managing growth.  Companies that don’t manage their growth produce unhappy customers, unhappy vendors, unhappy franchisees and sometimes, spectacular flame outs.  Why would a company put itself in this position?  Lots of reasons . . . attempting to grab market share, be the first into a new market and dominate a niche, management hubris or just plain greed.

Here’s an example of management hubris:  I interviewed for an executive position with a $700 million company that started growing extremely rapidly (It had doubled in the past 2 years.).  I spent 1.5 hours with their head of HR.  He told me, “We don’t have competition” and “I’d rather have someone do C+ work and get it done tomorrow than A work and get it done next week.”  Those sort of red flags say to me that when this company falls, it’s going to fall hard.

Two companies that should’ve been category killers, but ended up flaming out, are Boston Chicken (which changed its name to Boston Market) and Krispy Kreme Donuts.  Both had fanatics among customers and captivating products.  Both were loved by Wall Street.  In both cases, there was no dominant national chain in their niche, a la McDonalds in the hamburger category (KFC offered fried, not rotisserie, chicken.).  Both flamed out.

In Boston Market’s case, large loans fueled growth that occurred much too quickly.  Essentially, the company began to see itself as a financial, not food service, company, making money selling franchises instead of focusing on growing steadily and producing high quality meals.  The company failed to build a strong management team and had high executive turnover.  Food quality varied from unit to unit and even in individual units, depending on the time of day and number of customers.  Even its marketing strategy, with constant coupons, led to higher growth and lower margins.  Eventually, it filed for bankruptcy.

When Krispy Kreme opened in new areas, cars waited in long lines.  Although founded in 1937, its downturn came when it saw how lucrative franchising could be.  It sold its first franchise in 1995 and went public in 2000.  Its stock soared.  Yet it grew too rapidly without addressing a fundamental flaw:  stores that were too big – for selling just doughnuts – and cost too much to operate.  Some stores were too close together.  The company later began selling doughnuts to supermarkets, cannibalizing franchisees’ sales and flooding the market with product, lessening its cachet.  Franchisees paid high equipment and supply fees.  Ninety percent of sales were doughnuts, a much higher rate than competitors that diversified their offerings.  In other words, the company grew much too rapidly without first proving their franchise model.

On June 29, private equity firm MGL Asset Management Group LLC bid $7.25/share to take the company private.  But the company once traded at almost $50/share.

China and India Follow up – Investment and Economic Ramifications

Thursday, July 10th, 2008

A month ago, I wrote about the emergence of China and India in the world economy.  Their expansive growth, though, results in their being more greatly affected by global economic trends.  As Investor’s Business Daily notes in U.S. Slowdown Shows In Drop of China ETFs, lower consumer confidence and drops in spending among American consumers has hurt Chinese economic growth.  That’s because the U.S. is the largest export market for Chinese goods.

Technical analyst Michael Kahn, in his Barron’s column, What Happened to China and India?, states that both countries are in bear markets.  While the long-term fundamental stories are sound, there’s no technical reason to expect a recovery in the Shanghai “A” share index, the Bombay Sensex index or the iShares FTSE / Xinhua China 25 Index Fund (FXI) anytime soon.  The latter is a popular ETF that mirrors an index of the largest 25 Chinese mainland companies traded on the Hong Kong Stock exchange.  More information is available on the FTSE / Xinhua website.

The Death of Customer Service?

Friday, July 4th, 2008

One-hundred percent of businesses talk about how important customer service is, how their customers are number one, how much they value their customer relationships. My experience is that, for many businesses, customer service is something to talk about, not do. Only a small percentage of companies make it a primary focus. Here’s a case in point.

Since December, 2007, I have been trying to get a major metropolitan newspaper to deliver a Sunday paper to me. My goal, as I’ve stated to them, is that “I want to wake up when I want on Sunday morning. I would like to make a cup of coffee, open my apartment door, look down and see the newspaper.”

I’m between houses and am renting in an urban area, so what I’ve asked for shouldn’t be a problem, given that distribution is one of the primary functions of a newspaper. Yet, the company’s inability to consistently provide me with a newspaper one day a week has led even their publisher to agree that their performance is unsatisfactory . . . but nothing has changed.

I first subscribed to the paper when I moved to Massachusetts in 1999. On March 9, though, I wrote a letter to the publisher canceling my subscription and asking for an explanation why they couldn’t deliver my paper. Here’s what I wrote:

“I did not receive delivery of my newspaper on the following dates: December 9, December 16, December 30, January 6, January 13, February 10 and March 9. Formal complaints have been filed, promises have been made. Alas, all to no good.

Instead of receiving my Sunday paper, I have, however, received many, many excuses from those in your organization and from your distribution center in Chelmsford. I’ve learned that there continually is a new driver (that’s the main excuse), that the driver is having a problem, that they have ‘visualized the driver leaving the paper there.’

Today, I heard again that ‘we don’t have a key for the building,’ which was not true because I’ve heard it before and spoke with the management office about it. ‘Management won’t give us a key’ is another common excuse that’s also untrue. Even if that were true, I did discover my newspaper on one afternoon, thrown out in the snow in front of our building on one of the dates in February that I did receive it, so they could at least do that.

Again, today, I was told (once again) that I would receive a replacement paper within an hour and the driver would ring me. Of course, it never showed up and no one contacted me (once again).

I’ve also heard, over the past couple of months, that ‘I don’t know what else to tell you.'”

I cannot fathom why this organization has so much difficulty performing a function so basic to its business. With increased competition from other media, one would think that in an era of declining newspaper circulation, publishers would make an extra effort to ensure customers are satisfied. Particularly in urban areas – and in my case, in a large apartment building – the marginal revenue of a single additional subscription pretty much goes to the bottom line. I can’t believe I’m the only subscriber having these problems.

The publisher wrote back to me that “the management of our circulation department has been made aware of the delivery problems you have experienced” and he hoped I would give them a chance to win back my business. The editor, who I’d also copied on the letter to let him know why his news was being read by one less person, wrote me that he forwarded it to the Senior Vice President for Circulation and Marketing and to the Director of Call Center Services (who is also listed as a “Relationship Marketing Director”).

Consequently, I was disappointed that over the next four weeks, I received only two Sunday newspapers. Opening my door was like playing Russian roulette: I never knew if a paper would be there or not. I called once and was told the paper was delivered to the wrong address. But I never received a replacement.

So I contacted the paper’s management again. The relationship director emailed me that the “horrible service . . . makes no sense” and “It will be fixed.” The publisher wrote me that “50% service is unsatisfactory.” He assured me that my delivery problems “have not gone unnoticed.”

The following Tuesday, I received a daily paper, which I do not want. The relationship director wrote that “That should be fixed.” I received emails from him about all the people in the organization he’d spoken with. But I’m not interested in how they do it. I just want to open my door and see a newspaper on Sunday morning.

Over the next three weeks, I received two Sunday papers. I also received a call from someone at the newspaper asking again about how they could get a key to the building. Since I had answered the question over and over, I referred him to the relationship director. Once more, I wrote the director. I said, “I can’t spend any more time answering anyone else’s questions on how to get your operations done. I just want my paper.”

Last week, my intercom rang early on Sunday morning. The delivery person brought the paper up and handed it to me, along with a lecture when I asked him to please just bring the paper and leave it in front of my door.

Now, I understand what it’s like to deliver newspapers. I had a rural route for years growing up, trudging through snow, in the hot sun, seven days as week – and those Sunday papers, full of ads, were heavy. I got up early before school and even had an after-school route, until the afternoon paper shut down. I learned that customers were golden – they paid your bills – and you never, ever spoke harshly to a customer.

What’s clear, other than the disconnect between management and the folks on the ground, is that customer service is not valued in this organization. It’s not a priority of the paper’s leadership and that attitude flows right down to the delivery people. A newspaper needs to write news. It needs to sell ads. But if you can’t provide that information to your customers, what’s the point? Eventually, you’re going to go out of business.

This major metropolitan newspaper is going through all the motions of customer service, but the low priority they assign to it means it is highly ineffective. I’ve written the publisher and the relationship director that “I don’t think my expectations are too high, but you can’t get the job done. Please leave me alone.”

I’ve received a response. They say that the problem is deplorable and has now been fixed. The saga continues . . . .