Testing

Well, some things have certainly changed here in Omaha at the Berkshire Hathaway annual shareholder meeting.

Most striking, the crowd seems a trifle thinner than last year—not by a lot, and maybe not at all, but certainly the growth in attendance has stalled from the 15% compound rate of the last five years.

Perhaps this is one reason Warren Buffett did not announce the attendance figures at the start of the meeting, as he has always done; the other obvious reason being that he forgot. But Buffett doesn’t forget too many things, and he takes inordinate and deserved pride in the army of loyal Berkshire shareholders…

Whatever the reason, there’s another thing that’s different: the shareholders asking the questions are almost entirely Americans. That’s a big shift, coming as it does after years of a growing international presence. Two years ago, for example, 15 questions came from non-US shareholders, while last year there were six. This year there’s been one shareholder from Kashmir, and that’s about it.

I’ll ascribe this to Buffett’s switch to a lottery system for determining the shareholder questions, which was intended to eliminated the spleen-venting activists that began to appear at the microphones in recent years, not to mention the Buffett Adoration Society-types who were more interested in Buffett’s view on Life, Liberty and the Pursuit of Happiness—but has had the side-effect of eliminating the European shareholders’ key advantage: getting up at 4 a.m. Central Standard Time to be first in line was easy for them.

Of course, another thing keeping the international contingent at bay is the fact that once again, three reporters—Fortune’s Carol Loomis, The New York Times’ Andrew Ross Sorkin, and CNBC’s Becky Quick—are alternating with shareholders. Altogether, this has kept the “What Would Warren Do?”-type questions to a minimum, and put the spotlight on Berkshire and its businesses, which is where it belongs.

(Side note: an unusually high number of excellent questions are being posed by bright young financial analysts from the Greater Boston Area, which suggests somebody figured out how to game the “lottery” system anyway. Who says America has lost its competitive edge?)

But of all the differences between this year and others, the happiest is that Berkshire’s canny and sharp-tongued Vice-Chairman, and Buffett’s longtime business partner, 87 year-old Charlie Munger, is being unusually talkative. Indeed, by day’s end, Munger will have added his dry, acerbic commentary to all but two or three questions out of the 52 being asked. (In years past, Munger declined to answer, on average, a third of the questions.)

I’ll chalk this up to the presence of all the bright young analysts asking questions about Berkshire’s businesses and Buffett’s investing style—but another reason might well be the recent eruption of the David Sokol Affair and the attendant sharp focus on Buffett’s judgment in the matter, raising Munger’s rather substantial hackles and giving him the opportunity to rise, more than once, to his longtime business partner’s defense.

Indeed, my favorite moment thus far came when Munger practically grabbed the microphone from Buffett and—

But before we get to that, let’s say that the one thing that hasn’t changed is this: Buffett and Munger’s unique determination to spend six hours answering questions—some flattering, some not—without ducking, dodging, hesitating, or turning it over to the lawyers.

Now, back to the meeting…

(To be continued)

Jeff Matthews
Author “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”
(eBooks on Investing, 2011) Available now at Amazon.com

© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

We here at NotMakingThisUp have long noted in these virtual pages that Hewlett-Packard was about as good at manipulating Wall Street’s Finest as it was in manipulating printing ink, thanks to the wonders of the type of aggressive “Non-GAAP” accounting that supposedly went out of style along with the demise of Non-GAAP masters such as WorldCom, Enron and other scams, but was revived and perfected under the reign of Mark Hurd at HP.

Thus the fact that HP’s quarterly-earnings-obsessed past finally caught up with it is, as far as we’re concerned, notable only for the timing, coming as it does during a rip-roaring technology spending cycle. All bad things must, eventually, come to an end sometime.

Still, what’s happening today in the aftermath of this morning’s HP earnings call is what always happens when a company comes clean and WSF find themselves off-base: they get embarrassed by their own lack of intellectual honesty; the scales fall from their eyes; and the knives come out. Indeed, one of WSF is going to far as to declare (to what purpose we haven’t a clue, except to shift the blame for a bad stock pick to the company) “the Tomfoolery must end.”

We would argue the “Tomfoolery” has indeed ended at HP; that it began to end when Mark Hurd got booted; and that anyone looking to blame Hurd’s replacement, Leo Apotheker, simply because he had the guts to deliver the bad news that HP has been ginning up margins in the service business at the expense of the long-term health of that business strictly to hit Wall Street expectations and make the $13 billion Mark Hurd spent on EDS not look so goofy (something Wall Street’s Finest should have seen coming) would be shooting the messenger and missing the message.

Now, as always, we here at NotMakingThisUp express no opinion of HP stock, to the good or bad. And who knows if future results will match today’s guidance. But, at a bare minimum, we’d take Leo’s honesty over Mark’s beat-the-numbers management style any day.

Meantime, our reflections on Berkshire’s annual shareholder meeting, which we’re calling “Munger’s Revenge,” need attending to. Whether we’ll have them up here before Leo’s turnaround strategy takes effect at HP is not clear.

JM

© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

The Microsoft acquisition of Skype, in which Microsoft reportedly outbid the supposedly free-spending folks at Google by 100%, may prove an act of exquisite genius.

But we have our doubts.

Compare the $8.5 billion Microsoft is spending for Skype’s $860 million of 2010 revenue (and negative income) with the $10 billion Warren Buffett is spending for Lubrizol’s $5.4 billion of 2010 revenue (and three-quarter-billion income), and then ask yourself “Which has a better shot at paying off?”

Of course, one of the arguments in favor of the Skype deal–synergies and users and eyeballs aside–is that Microsoft gets a chance to use some of its offshore cash to buy the Luxembourg-based telephony business. In a sense, it’s “free money,” say the admirers…which is always a dangerous way to justify a deal. (Just ask the AOL shareholders who paid for Time-Warner with inflated AOL stock…)

Indeed, as big and splashy as this deal seems, we’ll bet dollars to donuts the write-off will be just as big and splashy.

In the meantime, we’re working on an update here from the Berkshire shareholder meeting, now that the dust has settled.

Whether we get it out before the Skype write-off is a bet we wouldn’t take.

JM

Q. Is there a question about the right way for publicly traded companies to report financial information?

A. I think the principles are cut and dried. The problem often lies in the interpretation of the principles. The basic principle is that anything, positively or negatively, that occurs inside a company or has a reasonable probability of occurring that could be viewed as impacting the information needs of an investor needs to be made public. You need to make it public to everybody at once, not just a select group, or not just dribble it out – fair, prompt and full disclosure.

—David Sokol, from “Businesses can avoid trouble by telling truth, Sokol says,” by Steve Jordon, Omaha World-Herald, March 17, 2002

A single, big mistake could wipe out a long string of successes.

—Warren Buffett, Chairman’s Letter, Berkshire Hathaway 2006 annual report.

Odd timing.

We were about to begin editing the final draft of our soon-to-be-published ebook, “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett,” when the David Sokol news hit the tape, generating simultaneous emails, phone calls and instant-messages that made it impossible to focus on the task at hand.

David Sokol, as everyone except perhaps a few nomads in the Empty Quarter of the Arabian Peninsula knows, is the Berkshire Hathaway executive who “resigned” suddenly and unexpectedly last month, shocking Wall Street in general and Berkshire Hathaway-watchers in particular.

Why all the shock?

Well, for one thing, Sokol was widely seen as The Successor who would someday take Warren Buffett’s place as CEO of the Berkshire Hathaway family of companies.

That’s a big deal, considering the fact that Warren Buffet is the most successful investor of his times (not hyperbole), and that Berkshire Hathaway, which his investment acumen created, today has more than a quarter-million employees generating close to $150 billion a year in revenues. That’s almost as big as General Electric.

Unlike GE, however, Berkshire’s home office doesn’t occupy a tree-shaded headquarters building in a leafy Connecticut suburb on 68 acres of land with 600,000 square feet of space, dozens of sharp-elbowed Vice Presidents jostling for position, and hundreds of home-office types toiling away.

No, the stingy and bureaucracy-shy Buffett runs Berkshire with the help of just 20 other professionals, in leased space on one floor in downtown Omaha, and he has been publicly discussing what he’s looking for in a successor with the same thoughtful deliberation he uses when discussing stock-picks, the state of the economy, and acquisitions like the recently announced $9.2 billion Lubrizol purchase.

Of course, David Sokol was never actually named Buffett’s successor. Buffett likes the limelight, for one thing; for another, he’ll run Berkshire until he drops dead; and for a third, until that time he can always change his mind about who should succeed him.

Still, so many signs pointed to Sokol over the years that Barron’s once picked him as the heir-apparent in a front-cover story.

Whatever David Sokol’s true position in that horse race, last month’s very public disruption of Buffett’s long-considered plans was surely a shock to the Oracle of Omaha himself, for Buffett thinks not in terms of months and quarters but in terms of years and decades, and he does not often see his well-made plans disrupted—especially not in such an ugly, public way—with the actions and integrity of a Berkshire “All-Star,” as Buffett refers to his managers, suddenly called into question.

This leads to the second, and bigger, reason for the stunned reaction to the Sokol Affair: what Sokol actually did before he “resigned.”

What Sokol did was this: he traded—quite profitably, it appears—in shares of Lubrizol while lobbying Buffett to have Berkshire buy the company. This kind of trading-in-advance-of-someone-with-deeper-pockets-than-you is known as “front-running” on Wall Street, and it is one of the first things even a summer intern learns never—ever—to do.

Sokol, of course, is no summer intern. He’s a veteran, not merely of board rooms but also of the ways of Wall Street. And as the quote at the start of this piece indicates, he is quite familiar with the rules of disclosure for public companies.

Indeed, Sokol’s first experience as president of a public company dates back to 1992, when he took the helm of an obscure but memorable outfit known as JWP (the old Jamaica Water Properties—‘Jamaica’ as in Queens, New York; not as in Bob Marley and the Wailers), where his Chief Financial Officer uncovered questionable accounting practices which Sokol admirably disclosed before submitting his resignation and moving on to the predecessor to MidAmerican Energy, even as JWP was moving on to Chapter 11.

Nor is Sokol some underpaid subaltern for whom the lure of a quick buck might seem too great to pass up.

During his 2000-2010 tenure as Chairman of Berkshire’s MidAmerican Energy group, Sokol earned, by our calculations, total salary of $8.8 million and bonuses of $53.9 million, plus a $26.25 million payout thanks to MidAmerican’s “Incremental Profit Sharing Plan.”

But that was not all David Sokol earned at MidAmerican, for not only did he work at MidAmerican, but Sokol was an owner of MidAmerican.

That’s because Sokol, Walter Scott (a Berkshire board member) and Greg Abel (a longtime MidAmerican executive who replaced Sokol as Chairman of MidAmerican when Sokol “resigned”), invested alongside Berkshire to buy MidAmerican in what was, in many respects, a good old-fashioned $2.2 billion leveraged buyout. (Berkshire owned 75% of MidAmerican when the deal closed; today it owns roughly 90%.)

Now, leveraged buyouts can be risky. On the other hand, they can be highly rewarding, too, as Sokol’s experience shows. All told, from 2000 to 2010, MidAmerican’s filings report he sold a total of $145.5 million in MidAmerican stock or stock-equivalents back to MidAmerican, taking his ownership as of 12/31/10 down to zero.

And Sokol certainly earned his good pay, at least when measured by the gain in MidAmerican’s value over the years. When the Buffett and Sokol/Scott/Abel investor group bought MidAmerican in 2000, they paid $35.05 a share. Five years later, MidAmerican paid an implied $145 per share to buy back stock from Sokol, and by 2009 the valuation had increased to what appears to be $175 per share for Sokol’s remaining shares.

It is no wonder Buffett wrote in his March 30 letter, “Berkshire is far more valuable today” thanks to Sokol. And it is unlikely Buffett begrudges one dime of Sokol’s compensation, for Warren Buffett is, as he likes to say, “A pay-for-performance kind of guy.”

Yet Warren Buffett is also a Wall Street veteran. (He first visited the floor of the New York Stock Exchange when he was 10 years old.) And if anybody in the financial world knows “front-running” when he sees it, it would be Warren Buffett.

This brings us to the third, and biggest, shocker of the Sokol Affair: Warren Buffett’s own handling of it.

The way Buffett handled it was through a press release written in the form of a letter that first praised Sokol’s work for Berkshire and then divulged the stunning news that Sokol had bought, then sold, and then bought shares of Lubrizol during a period of time in which Sokol was encouraging Buffett to buy Lubrizol lock, stock and barrel for Berkshire Hathaway—which Buffett eventually would do.

Buffett summed up the matter, and simultaneously tried to close the door on it, by writing, “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful.”

To understand why this rationalization was so head-scratchingly, stop-the-presses stunning, one must understand that for a quarter-century Warren Buffett has been sending a version of the following memo to his managers (David Sokol, no doubt, included) defining what he calls Berkshire’s “top priority”—and that priority is not money:

This is my biennial letter to reemphasize Berkshire’s top priority….

The priority is that all of us continue to zealously guard Berkshire’s reputation. We can’t be perfect but we can try to be. As I’ve said in these memos for more than 25 years: “We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.” We must continue to measure every act against not only what is legal but also what we would be happy to have written on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.

Sometimes your associates will say “Everybody else is doing it.” This rationale is almost always a bad one if it is the main justification for a business action. It is totally unacceptable when evaluating a moral decision….

If you see anything whose propriety or legality causes you to hesitate, be sure to give me a call. However, it’s very likely that if a given course of action evokes such hesitation, it’s too close to the line and should be abandoned. There’s plenty of money to be made in the center of the court. If it’s questionable whether some action is close to the line, just assume it is outside and forget it.

As a corollary, let me know promptly if there’s any significant bad news. I can handle bad news but I don’t like to deal with it after it has festered for awhile. A reluctance to face up immediately to bad news is what turned a problem at Salomon from one that could have easily been disposed of into one that almost caused the demise of a firm with 8,000 employees.

Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable: We now employ more than 250,000 people and the chances of that number getting through the day without any bad behavior occurring is nil. But we can have a huge effect on minimizing such activities by jumping on anything immediately when there is the slightest odor of impropriety….

—Warren E. Buffett, July 26, 2010 (“Memo to Berkshire Hathaway Managers”)

That letter was reprinted in the 2010 annual report that went to all Berkshire shareholders a month before the Sokol Affair exploded, and it needs no elucidation.

After all, the sentiments expressed are exactly what Buffett and his long-time business partner, Charlie Munger, have been telling shareholders at his annual shareholder meetings for decades.

Indeed, Munger has proven to be even more emphatic than Buffett when it comes to what constitutes appropriate conduct—“being an exemplar,” as he likes to say. In a speech at Harvard Law School that still circulates on the internet, Munger once discussed the “isolated example of a little old lady in the See’s Candy Company, one of our subsidiaries, getting into the till”:

“And what does she say? ‘I never did it before, I’ll never do it again. This is going to ruin my life. Please help me.’ …. Well in the history of the See’s Candy Company they always say, ‘I never did it before, and I’m never going to do it again.’ And we cashier them. It would be evil not to, because terrible behavior spreads.”

Interestingly enough, Sokol tried to throw Munger under the proverbial bus in a CNBC interview shortly after the Lubrizol trades came to light by claiming his Lubrizol trades—unreported to Berkshire shareholders until after the fact—were somehow similar to Munger’s longstanding and fully disclosed interest in Chinese car company BYD, in which Berkshire subsequently took a stake. (Munger, appropriately, took no part in Berkshire’s BYD investment process—in fact it was Sokol who went to China to look at the company for Berkshire.)

So what did Munger—the man who spoke so sternly about the ‘little old lady’ at See’s Candies—have to say about Sokol’s Lubrizol trades? He called it “a glitch.”

Warren Buffett was right when, explaining the kind of risk-conscious individual he was looking for to succeed him as the Chief Investment Officer at Berkshire Hathaway, he wrote this line in 2006:

A single, big mistake could wipe out a long string of successes.

At the time, of course, Buffett was referring to financial mistakes—the kind of mistakes that brought down Bear Stearns, and Merrill Lynch, and Fannie Mae, and so many others just a few years later.

That those financial mistakes did not happen at Berkshire Hathaway during the worst financial panic since the Crash of 1929 was entirely due the rational, thoughtful, forward-looking individual at the helm of Berkshire Hathaway. Owing to that foresight, Berkshire Hathaway will continue to thrive under Warren Buffett and beyond thanks to the collection of durable companies that now make up most of Berkshire’s assets, even though it will never be the growth machine it was during his stock-picking years.

But the reputational mistake from that single, awful line, “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful”—a line that, while factually very likely the truth, just wiped out a long string of reputation-building successes—is not so easy to fix.

What you are reading and hearing is from people who believed—thanks to years of careful studying of what Buffett wrote in those annual letters and careful listening to what he said at those annual meetings—that Buffett meant what he said and said what he meant.

And they cannot believe what they have just read.

Jeff Matthews
I Am Not Making This Up

© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Well, Hewlett Packard finally gave Wall Street’s Finest what they wanted.

Ever since Mark Hurd’s unceremonious dismissal, WSF have been pestering HP to define itself and its prospects, in much the same way that IBM defines itself and its prospects.

And yesterday HP finally did just that.

The answer, in case you haven’t seen it already, is this: HP will generate “at least” $7.00 in earnings per share by Fiscal Year 2014.

How, exactly, HP will get there is left somewhat to the imagination.

It does involve things like “connectivity” and “cloud” computing—two buzz words that are today’s version of the Internet Bubble-era “eyeballs”—and it relies, apparently, on the same kind of accounting hocus-pocus HP perfected during the Hurd years. (See “Hurd by Numbers” from August, 2010: http://jeffmatthewsisnotmakingthisup.blogspot.com/2010/08/hurd-by-numbers.html)

That’s because the $7.00 in “EPS” is a “Non-GAAP” figure—that is, it uses accounting principles that aren’t generally accepted by accountants.

For example, HP routinely excludes expenses related to past acquisitions to arrive at “Non-GAAP” earnings, even though it routinely includes the revenues from those acquisitions in its “Non-GAAP” sales.

If money managers could do that, they’d never have a down day, let alone a down year.

Still, Wall Street’s Finest like few things more than perceived certainty, and in this case the comfort of a specific earnings figure they can plug into their spreadsheets appears to be enough given the huzzahs from various quarters.

We will see how HP does in the next few years meeting that target, but we’ll make one bold prediction: since HP can exclude pretty much anything the company wants to exclude from “Non-GAAP” earnings so long as Wall Street’s Finest buy it, we will bet dollars to donuts the company will “beat the number” by at least a penny.

Jeff Matthews

I Am Not Making This Up

© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Wall Street loves a good write-off, and, sometimes, for good reason.

After all, stocks (and even, at times, Wall Street’s Finest) often anticipate news well in advance of when a company management team actually wakes up and smells the coffee—as, for example, when Best Buy recently announced it was closing its “Big Box” Best Buy stores in China.

Indeed, Best Buy more than once touted the expansion potential of its stores in that famously ruthless and price-sensitive consumer electronics market, as the following stories from our Bloomberg over the years demonstrate:

“Best Buys Says China is ‘Major Source of Growth’ as U.S. Slows”
John Liu, Bloomberg, February 22, 2008

—Best Buy Co., the largest U.S. consumer-electronics chain, will speed the rate at which it adds stores in China to tap surging growth in the Asian nation amid slowing sales momentum in its home market.
“China is without a doubt our major source of growth” outside the U.S., Robert Willett, head of the company’s international division, said at a briefing today in Shanghai by video conference. The nation will be “the most dominant market for us outside the U.S.” in three to five years, he said, without giving financial figures…

“Best Buy May Open 5 China Stores this Year”
John Liu, Bloomberg, August 29, 2009

—“China is the biggest growth opportunity in the world outside the U.S.,” Bob Willett, head of Best Buy’s international business, told reporters last night in the company’s second store in Shanghai…
Sales and profitability at the company’s first store in Shanghai’s Xujiahui shopping district have exceeded the company’s expectations, Willett said. “We’re delighted to be where we are,” he added…

Still, Wall Street wasn’t convinced. And for good reason: not only didn’t China become “the most dominant market for us outside the U.S.” (that would be Canada, as of today), the company’s “delight” turned out to be wildly premature, as the more recent press report made clear:

Best Buy Shuts China Stores to Expand Five Star Retail Brand
Bloomberg News, February 22, 2011

—Best Buy Co., the world’s largest consumer electronics retailer, will close all of its nine Best Buy branded stores in China to focus on expanding the more profitable domestic chain it acquired five years ago.
“Store openings will be focused primarily on the profitable growth platforms of its Best Buy Mobile business in the United States and its Five Star business in China,” it said today in a statement…

One interesting point about that news item is that the press release on which it is based hit the Bloomberg at a little after 9 p.m. EST on the evening of President’s Day, a stock market holiday.

What better time to deliver news that doesn’t seem to jibe with previous PR?

A second interesting point about that news item is that is also carried word of a write-off:

The company estimates that these restructuring charges, which include asset impairments, settlement of lease obligations, facility closure costs, severance costs, and inventory adjustments [emphasis added] will total $225 million to $245 million, including approximately $60 million of cash settlement costs…
—“Best Buy Announces Actions to Generate Improved Returns for Shareholders”, February 21, 2011


What is interesting about that write-off, pleasing as it must have been to those among Wall Street’s Finest who had been hoping for some sort of something out of a company that has been plowing ahead with Old Economy store openings as if the Internet hadn’t happened, is the inclusion of “inventory adjustments” in the list of charges.

It seems like only a few months ago the company’s CFO was reassuring Wall Street’s Finest that Best Buy’s inventory items were “of good quality” and that the company “did not expect a significant risk from actions required to rebalance our inventory positions.

Why, it was just a few months ago!

“Rounding off the impact in our domestic segment from the softer sales performance, inventory levels naturally ended higher at quarter-end. Comparable domestic inventory levels finished up approximately 8%. The increase was largely driven by the revenue softness versus our expectations for categories such as TVs, notebook computers, and gaming. Looking ahead to the fourth quarter, we do not expect a significant risk from actions required to rebalance our inventory positions. We have a significant volume of business ahead of us — still ahead of us in the largest quarter, and have the ability to moderate future purchases. In addition, the items currently on hand are of good quality.”

—Jim Muehlbauer, CFO, Best Buy, December 14, 2010

That was during the prepared comments; when pressed during the Q&A, the CFO elaborated:

“So, looking at what inventory trends are sitting there today — and more specifically, what the specific inventory is, we feel that we’re in a good position to move that inventory through the balance of Q4, and actually moderate purchases of future inventory. A lot of that stuff that’s in our balance sheet today, 30 days from now, it will be gone. So we’re really talking about what’s our reorder pattern going forward.”
—Jim Muehlbauer, CFO, Best Buy, December 14, 2010

Now, the “inventory adjustments” included in the near-quarter-billion worth of charges announced in the late-night February 21 President’s Day press release may well have no bearing on the “stuff” that was on Best Buy’s balance sheet on December 14.

But we’ve always marveled at the number of green Insignia boxes and blue Dynex boxes on the shelves at our local Best Buy. Those Insignia and Dynex brands, of course, are Best Buy brands—part of the reason Best Buy’s gross margins have held up so well in a ruthless business.

“Inventory adjustments” aside, the most amusing part of the press release titled ‘Best Buy Announces Actions to Generate Improved Returns for Shareholders’ is, we think, the fact that roughly half the actions announced as being designed to “Generate Improved Returns for Shareholders”—closing Best Buy-branded stores in China and Turkey, and slowing new store openings in the U.S.—were 180 degrees opposite what the company had been talking up not long ago.

Indeed, here’s how CEO Brian Dunn reacted when one of Wall Street’s Finest dared suggest that Best Buy was evolving from “a growth story” into “more expense and return focused” on the December 14th call:

I have to jump in. We sort of reject the notion that we’re not a growth Company as well. You’re absolutely right that we’re focused on expanding on our margin rate and extracting value for what we’re able to do for customers, and actively pursuing businesses where we can make a difference that are margin-rich. But we absolutely see ourselves as a growth Company.

—Brian Dunn, Best Buy CEO, December 14, 2010

To which we anticipate Wall Street’s Finest saying, on the next conference call, “Great write-off, guys!”

Jeff Matthews
I Am Not Making This Up

© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Two significant shareholder letters were released this week.

The first was from Sears Holdings’ Chairman Eddie Lampert; the second from Berkshire Hathaway Chairman Warren Buffett.

And while it is certainly easier, and a lot more fun, to write about good news—as Buffett has been accustomed to doing over the years at Berkshire, in contrast to the kind of bad news that has issued forth from Lampert’s fading retail giant of late—there is, even so, a remarkable difference in both the substance and style of letters by two men who actually have a great deal in common.

For one thing, both started out as hedge fund managers. For another, both are without peer in their fields, and fabulously wealthy as a result. For a third, they each got into the position of writing annual shareholder letters as a result of taking control of a fading, once-giant, public company. Finally, they each spent years personally wrestling with how to turn the original business around.

In the end, of course, one (Buffett) decided the rational thing was to disinvest in the original business and re-create the company to his liking, while the other (Lampert) is still wrestling with Sears even as he extracts cash from “hidden” assets like real estate and minority-controlled subsidiaries.

Still, differences between the two men are legion (Midwest publicity-magnet versus East Coast recluse, for starters) and do not end with how they played the hand they were dealt: differences in how to hire, invest, manage and incentivize people are revealed in almost every sentence of the respective shareholder letters they have penned.

Indeed, so remarkably different are the letters that we here at NotMakingThisUp couldn’t help but compare the two, by topic.

On Investing Excess Cash:

“As we have done since we took control of Kmart in 2003, we will continue to evaluate alternative uses of the company’s cash flow and capital resources to generate long-term value for all shareholders. Each year brings with it different circumstances, and we expect to have a variety of opportunities to invest our cash in the years to come. Our discipline in evaluating opportunities leaves us prepared to weather difficult times as well as to prosper when economic conditions improve.”

—Edward S. Lampert

“Our elephant gun has been reloaded, and my trigger finger is itchy.”

—Warren E. Buffett

On Management:

“We continue to make changes in our broader leadership team, as we allocate more responsibility to leaders who have delivered results and seek to attract leaders who are capable of improving performance in areas that have lagged. In particular, we want leaders who are capable of transforming key aspects of our business, as retail is increasingly impacted by new technologies and social interaction.”

—ESL

“Our trust is in people rather than process. A ‘hire well, manage little’ code suits both them and me.”

—WEB

On Investing for the Long-Term

“We will continue to make long-term investments in key areas that may adversely impact short-term results when we believe they will generate attractive long-term returns. In particular, we have significantly grown our Shop Your Way Rewards program, improved our online and mobile platforms, and re-examined our overall technology infrastructure. We believe these investments are an important part of transforming Sears Holdings into a truly integrated retail company, focusing on customers first.”

—ESL

By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well…. That’s what allowed us to invest $15.6 billion in 25 days of panic following the Lehman bankruptcy in 2008.

—WEB

On Making a Key Hire

“Lou knows what it is like to be the 800-pound gorilla from his days at IBM, and he knows what it is like to compete against 800-pound gorillas from his days at Avaya. He also understands how technology can shape and change companies and industries. The profound changes that many industries, including retail, are currently experiencing require new thinking, new leadership and new business models. Information and technology have always been an important part of the supply chain in retail, but more and more it is becoming critical that we use information and technology in a much more profound way to deliver great customer experiences. Lou is a proven winner, and I am excited to have him as the leader of our company.”

—ESL

“It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of—and sensitivity to—risk…. In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed. Finally, we wanted someone who would regard working for Berkshire as far more than a job.

“When Charlie and I met Todd Combs, we knew he fit our requirements.”

—WEB

On How to Deal with a Cyclical Business:

“Given the large proportion of the Sears Domestic business which is in ‘big ticket’ categories and linked to housing and consumer credit, Sears is much more susceptible to the macro-economic environment than Kmart. But I don’t accept this as an excuse: our results at Sears in 2010 were completely unacceptable. The profit erosion at Sears Domestic occurred primarily in appliance-related businesses and in the Full-line Store apparel and consumer electronics businesses….

“When industry margins are shrinking, an organization must respond by adding new innovative products and bundling them with services and solutions that meet customers’ evolving needs….

“The new management in our appliance business has already taken actions to rebuild leadership in this area and to further reinvigorate the Kenmore brand….

“In parallel to the efforts that we are making to increase the productivity of our Sears stores, we are also looking at adding world class third-party retailers to our space. Earlier this year we announced that Forever 21 will be taking over 43,000 square feet of Sears space at South Coast Plaza in Costa Mesa, CA…”

—ESL



[Editor’s Note: We are not making this last part up; the author also discusses leasing out space to Whole Foods].

“Our businesses related to home construction, however, continue to struggle…. A housing recovery will probably begin within a year or so. In any event, it is certain occur at some point. Consequently: (1) At MiTeck, we have made, or committed to, five bolt-on acquisitions during the past eleven months; (2) At Acme, we just recently acquired the leading manufacturer of brick in Alabama for $50 million; (3) Johns Manville is building a $55 million roofing membrane plant in Ohio…; and (4) Shaw will spend $200 million in 2011 on plant and equipment, all of it situated in America. These businesses entered the recession strong and will exit it stronger. At Berkshire, our time horizon is forever.”

—WEB

On Wonderful Businesses vs. the Wonder of Financial Legerdemain

“I wouldn’t be surprised to see our share of Coke’s annual earnings to exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.”

—WEB

“In April, we had the opportunity to purchase an additional 17% of Sears Canada for $560 million, increasing our ownership from 73% to 90%. In 2010, Sears Canada has paid two dividends, which returned $639 million of cash to Sears Holdings. Of course, of the cash we received in dividends, we would have received $518 million without the additional shares purchased (because we already owned 73% of Sears Canada), so in effect we received $121 million in dividends on behalf of the additional shares purchased in 2010.”

—ESL

On Reinvesting in the Business, or Not

“Furthermore, not a dime of cash has left Berkshire for dividends or share repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month.”

–WEB



“We invested more than $400 million in capital expenditures in 2010, including significant investments in stores in important markets, and contributed over $300 million to our pension and post-retirement plans. We invested just under $400 million in Sears Holdings share repurchases in 2010, a slight reduction from 2009….



“Share repurchases are not a panacea, nor are they a singular strategy. Yet they are more than just the return of capital to shareholders… As a form of discipline on alternative capital allocation strategies, share repurchases can magnify returns.”

–ESL

Did He Really Say That?

“At Sears Holdings, we seek to create long-term value for our shareholders. Like Apple, we seek to do so by improving our operating performance, innovating, and delighting customers…”

—ESL



[Editor’s Note: The first and last time you will see ‘Apple’ and ‘Sears’ in the same sentence, at least for some time to come.]

“As one investor said in 2009: ‘This is worse than divorce. I’ve lost half my net worth—and I still have my wife.’”

—WEB



[Editor’s Note: Buffett’s letters have always been suffused with a 1950’s-era Hugh Hefner-style male/female sensibility, but it never ceases to amaze us that he continues with the nagging-wife jokes]

On ‘Painting the Bull’s-Eye’ of Performance

“Charlie and I believe that those entrusted with handling the funds of others should establish performance goals at the onset of their stewardship. Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull’s-eye around wherever it lands…. To eliminate subjectivity, we therefore use an understated proxy for intrinsic value—book value—when measuring our performance.”

—WEB

“Despite our challenging performance over the past several years, the difficult economic environment, and the dramatically changing retail environment, we have generated very attractive returns for shareholders since May 2003, when we assisted Kmart in its emergence from bankruptcy.”

—ESL



[Editor’s Note: While SHLD stock has more than quadrupled from the aforementioned May 2003 “bull’s-eye,” it is in fact down more than 50% from its 2007 peak.]





What Happens to the Wrong Managers

“This requires us to part ways with some who have given great effort, but who have fallen short of the performance required for us to be competitive.”

—ESL

“Our compensation programs, our annual meeting and even our annual reports are all designed with an eye to reinforcing the Berkshire culture, and making it one that will repel and expel managers of a different bent.”

—WEB

What Happens to the Right Managers

“We will continue to provide great opportunities for talented individuals to run businesses, while holding them accountable for performance.”

—ESL

“Many of our CEOs are independently wealthy and work only because they love what they do. They are volunteers, not mercenaries. Because no one can offer them a job they would enjoy more, they can’t be lured away.”

—WEB

On Throwing Good Money after Bad

“At Berkshire we face no institutional restraints when we deploy capital… When I took control of Berkshire in 1965…the dumbest thing I could have done was to pursue ‘opportunities’ to improve and expand the existing textile operation—so for years that’s exactly what I did. And then, in a final burst of brilliance, I went out and bought another textile company. Aaaaaaargh! Eventually I came to my senses, heading first into insurance and then into other businesses.”

—WEB

“We have a need to manage the scale of our operations at the same time as we transform them. The activities required for transformation are vast and time-consuming. As the retail industry is reinvented, we intend and expect Sears Holdings to be a significant player in this reinvention.”

—ESL

Sentences We Didn’t Want to Read

“By aligning our associates with our customers, not with our stores or products, we believe this reinvention will play out in our favor.”

—ESL



[Editor’s Note: That was perhaps the most astonishing sentence we have ever seen in a Chairman’s Letter—the runner-up being the one that follows.]

“To update Aesop, a girl in a convertible is worth five in the phone book.”

—WEB

Jeff Matthews

I Am Not Making This Up

© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

“The question I get most often is, what’s the next new thing that’s going to save the consumer electronics industry? And my answer is, it’s not any one single thing, but rather the connection of all the things that we have, both to each other, to the content that we love…and to be able to be mobile and move that around any place where we are.”



—Michael Vitelli, EVP Best Buy, Oppenheimer Conference, July 15, 2009

“We have to move rapidly in recognizing the transparency of pricing.”

—Michael Vittelli, EVP Best Buy, Bloomberg, “Best Buy May Switch to Wal-Mart-Style Everyday Prices,” February 9, 2011

Poor Best Buy.

The company—which navigated the consumer electronics store-wars so cannily it become the Last Man Standing among “Big Box” retailers—now watches the non-box likes of Amazon.com grow electronics and general merchandise revenues 71% in its just-ended quarter, while Best Buy’s U.S. brick-and-mortar sales actually declined in December.

All things considered, of course, this should come as no surprise, what with software, music, movies, TV shows and even video games going digital…not to mention the fact that computers have shrunk into book-sized tablets and pocket-sized smart-phones that can be ordered and delivered online, without the need to shlep to a Big Box retailer like Best Buy.

Yet Best Buy’s own online business rose only 13% in the month of December—a still far cry from Amazon’s online domestic growth in electronics.

Now, to Best Buy’s credit, the company did not become the Last Man Standing among consumer electronics chains by standing still. Indeed, ever since 1983, when it changed its name from “Sound of Music” and opened its first superstore, the company has moved ahead of trends in the business.

In fact the company’s most important—and gutsy—move came in 1989, when management shucked the commissioned-sales model of computer and TV-selling, letting consumers shop for themselves and making Circuit City’s high-pressured sales model obsolete. Furthermore, as consumer electronics became an ever-larger piece of the American home, Best Buy moved to ever-larger store formats.

One more thing Best Buy did to distinguish itself from its peers, and boost margins: it entered the private label business with both feet, creating its own Dynex and Insignia brands, whose blue (Dynex) and green (Insignia) boxes containing everything from 55 inch LED High Def TVs to clock radios and boom-boxes can be seen all around the store.

Largely as a result of those moves, Best Buy caught the previous decade’s cathode-ray-tube-to-flat-panel tsunami from start to finish.

Outside the Big Box, however, Best Buy’s moves haven’t always been so prescient.

A Fiscal 2000 “comprehensive strategic alliance” with Microsoft involving “significant co-marketing between Microsoft Network of Internet Services, BestBuy.com and Best Buy’s retail stores” was never much heard about again.

In 2001, the company paid $696 million for Musicland, “to continue its revenue growth beyond fiscal 2005,” as the 10K said at the time. Unfortunately, Musicland didn’t make it past fiscal 2004—at least under the Best Buy umbrella.

The company sold Musicland for “no cash consideration” in the summer of 2003.

By then Best Buy had also bought Magnolia Hi-Fi, with the stated goal of growing the high-end home theater purveyor from 13 stores to “up to 150 stores nationwide.” And while Best Buy stores today do indeed have Magnolia departments (in the corner near the TV displays), there were all of 8 free-standing Magnolias across the land, according to last year’s 10K.

Similarly, Best Buy bought Geek Squad in 2002, with the goal of making it “North America’s largest provider of in-home computer installation services,” and in 2005 announced plans to open 20 to 50 stand-alone Geek Squad stores “in the next 12 to 18 months.” (One of Wall Street’s Finest actually told Fortune Magazine around that time Geek Squad could earn more than a quarter-billion in operating income on a billion in sales in 2007.)

And while Geek Squad—like Magnolia—has been rolled out in Best Buy stores, the count of stand-alone Geek Squad stores was 7 as of the Fiscal 2010 10K.

In 2006 Best Buy bought Pacific Sales Kitchen and Bath Centers, saying “we expect to expand the number of Pacific Sales stores in order to capitalize on the rapidly growing high-end segment of the U.S. appliance market,” and although the Pacific Sales store count has more than doubled since then, according to the 10K, sales have not nearly kept pace.

In 2007, Best Buy spent $89 million to buy Speakeasy, an “independent broadband voice, data and IT service provider” to help make Best Buy the “one-stop shopping” destination for small business customers. And a year later the company paid a reported $121 million acquisition for file-sharing pioneer Napster “to reach new customers with an enhanced experience for exploring and selecting music and other digital entertainment products over an increasing array of devices.” A much-ballyhooed 2010 move into the video game trade-in business dominated by GameStop has submerged without much of a ripple.

Along the way, the Best Buy Big Box kept getting bigger, eventually reaching 45,000 square feet, which seemed barely big enough to hold everything in those pre-Amazon.com, pre-Internet days, when a product needed to be sitting on a shelf in order for the consumer to see it, learn about it and evaluate its strengths and weaknesses.



But at least one retailer proved that a brick-and-mortar store could compete in a dot.com world.



In 2001, Apple began opening retail stores that would average only 6,000 square feet, and although the move was initially dismissed by nearly every techno-commentator in Silicon Valley, by fiscal 2010 each one of those tiny stores was selling, on average, a whopping $34 million a year of Apple products.



And that is roughly the same average annual sales figure as a domestic, big box Best Buy.



(Anyone who has shopped at an Apple Store and a Best Buy knows that at an Apple Store, you’ll be surrounded by students surfing the internet on Macs and iPads, toddlers playing games on iTouches, and slightly uncomfortable Baby Boomers talking to thin, black-shirted, ear-ringed Apple people carrying iPhones that can swipe your credit card and get you out of the store in minutes.



(The Best Buy experience, by comparison, is no longer so much fun, what with all those non-commissioned “Blue Shirts,” as the ex-Blue Shirt CEO himself likes to refer to them, pushing extended warranties and unwanted software on customers it formerly left alone to browse, as anybody who accidently bought the Kasperksy AntiVirus product along with their notebook computer at a Best Buy knows.)

Meanwhile, the drive to satisfy Wall Street and carry the Best Buy brand around the world led to larger moves than buying Napster, Geek Squad and the rest.



The company spent $3.5 billion on one of those “return-value-to-shareholder” buybacks in 2007, when the stock traded in the $40s…good for both those who sold to the company and for—who else?—Goldman Sachs, which served as the counterparty to the accelerated share repurchase program.

More strategically, the company spent $1.1 billion in 2008 on a 50-50 joint venture with Carphone Warehouse in Europe, which has indeed helped Best Buy roll out well-staffed mobile phone desks in its own stores—although plans for a fleet of big box Best Buy stores across stodgy old England haven’t materialized as fast as Wall Street’s Finest expected.

Indeed, when the original deal was announced in May, 2008, the Carphone CEO said “we will have stores trading in 2009,” but the first UK Best Buy big box actually opened in May, 2010, and the company recently—according to press reports—backed out of a deal for its first north-east England store near Newcastle.

It may be a coincidence, but shortly after that deal fell through, Scott Wheway, CEO of Best Buy Europe, resigned his post, although he is staying with the company for a period of time. This came all of 18 months after Wheway got the job, at which time Robert Willett, then chairman of Best Buy Europe, announced the appointment by saying “Scott is the consummate retailer,” among other nice things.

Now, in case you’re wondering why Mr. Wheway’s change of position didn’t make much news, it may have something to do with Wall Street’s rumor mill.

Shortly after the Wheway news hit on the morning of February 1, a report popped up on the indispensible Briefing.com: “Best Buy shares spiked following a rumor that Pershing Square could take a position in the stock.”

Pershing Square, of course, is the hedge fund vehicle of Bill Ackman, the genius who, among other things, saw value in General Growth Properties when it had been left for dead, and helped create billions of dollars of value for his investors and General Growth shareholders at the same time.

Why an Ackman-for-Best Buy rumor got so much credence as to add nearly half a billion in value to Best Buy’s market capitalization—and wipe the Wheway resignation off the news page—probably relates to Ackman’s reputation for taking positions in real estate laden-retailers like JC Penney and Target, and then agitating for the unlocking of its value from the more mundane retail operation sitting on top of it.

And JC Penney, whose board Ackman recently joined, is indeed loaded with real estate.

Penney owns 416 of its 1,100+ stores (with 119 of those located on ground leases), as well as 3 million square feet of distribution space, 1.8 million of warehousing space, 6.5 million of direct fulfillment center space, its 1.9 million square foot home office in Plano, Texas, and 240 acres of adjacent property.

Best Buy, on the other hand, seems not so encumbered with the stuff Ackman seems to love.

According to the Fiscal 2010 10K, Best Buy owns 24 US store locations and 32 buildings on leased land, out of 1,000+ US store locations, plus 3.1 million square feet of distribution center space (out of 10 million total) and a 1.45 million square foot corporate office.



So, real estate-wise, Best Buy looks to be somewhere in-between Borders Group (another Ackman investment, but one that did not work out as well as General Properties), which leased all its stores and owned only some of its headquarters building, and JC Penney.



Nonetheless, the Ackman rumor seems too good for Wall Street types to resist.

It appeared on Briefing.com back on January 5th (“Best Buy jumps on increased volume; Hearing rumors that Bill Ackman is targeting BBY”), and, in slightly different form, on January 3rd (“It was rumored that Best Buy could be seeing private equity interest.”)

And while we have absolutely no idea what view of Best Buy, if any, Ackman actually possesses, based on the once-every-four-week schedule it looks like the rumor should crop up again—especially if the kind of startling disclosures contained in the recent Bloomberg story quoted at the top are anywhere close to reality.

Here’s how the story began:

Feb. 9 (Bloomberg) — Best Buy Co., the world’s largest consumer electronics retailer, may curtail three decades of tactical discounting and move instead to its own version of the everyday prices pioneered by Wal-Mart Stores Inc.

With Americans increasingly using smartphones to comparison shop, consumers are unwilling to wait for sales if they find better deals elsewhere, said Mike Vitelli, executive vice president and co-head of the North America division.

“We have to move rapidly in recognizing the transparency of pricing,” Vitelli, 55, said in a Feb. 7 interview at Best Buy’s headquarters in Richfield, Minnesota. Internal discussions about making the switch are at an early stage, he said.



There was more, with the kind of thought-provoking detail you don’t get in the usual quarter earnings-per-share reportage from Wall Street’s Finest:

During a Best Buy staff meeting, Vitelli was willing to say out loud: “Why do we carry inventory when we train consumers only to buy it’” on sale, said Rick Rommel, a senior vice president who helps run a unit that tests new concepts.

“If the pricing isn’t everyday, the consumers just wait,” Rommel said in an interview. “Our inventory sits and waits for that next promotional moment.”

Switching to consistent pricing would “be very powerful,” said Barry Judge, Best Buy’s chief marketing officer. “It makes our pricing much more transparent than it is today.”

Best Buy’s weekly newspaper circular would be “a whole lot easier to lay out” with prices easier for consumers to understand, Judge said.

“The prices are the prices,” he said.

The retailer is also reducing the number of items it sells to focus on products that sell well, Vitelli said. By the end of the year the company will carry fewer than 100 TV models in the average store, down from about 140 a year ago. Slower-selling products will continue to be sold online, Vitelli said.

—“Best Buy May Switch to Wal-Mart-Style Everyday Prices,” By Chris Burritt and Clifford Edwards, Bloomberg February 9, 2011.

It will be interesting to see how Best Buy handles what Bloomberg calls “the switch”—especially with all those Dynex and Insignia products sitting on Best Buy shelves in stores across America…and all those Ackman rumors sitting on trading desks across America.

Jeff Matthews

I Am Not Making This Up



© 2011 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.