Thursday, May 31, 2007

The Asian and Russian Economic Crises Smashed Latin America

The so-called "Asian Contagion" and the precipitous decline in the Russian ruble had poisonous repercussions for the economies of Latin America. The loss of confidence the international financial community felt in the Asian Tigers was indiscriminately extended to the region and huge capital outflows resulted. Interest rates soared and Latin American goods lost their competitiveness against even cheaper Asian goods.

Brazil in particular was hard hit, moving to a floating currency, abandoning its Real plan which was devised in 1994 to fight against inflation, and suffering a disastrous devaluation of the currency.

The main lessons learned from this horrific disaster were that an unsustainable current account balance can rapidly spin the economy out of control, that short-term capital is by its very nature prone to excess volatility, and that an inflexible exchange rate can compel a government to choose between a lingering financial death and immediate collapse.

Are Multinational Corporations Good for the Developing World?

Multinational corporations obviously have many effects both for good and for ill on the developing world. Nonetheless, it is unlikely that these cumulative effects are precisely neutral.

Given the significant technology gap between the developed and developing worlds, multinational corporations have a clearly positive contagion effect that spreads innovation quickly around the world. And even if these corporations don't directly share their expertise with anyone, the increased competition probably encourages domestic firms to be more efficient. Multinationals have greater access to worldwide capital markets, so they bring capital into the economy. They pay their workers higher than prevailing wages and provide management skills not locally available.

Taken together, these benefits clearly ensure that at least some multinational corporations are a force for good.

Yet, multinationals are also capable of exploiting their workers, maintaining control over their fiscal and intellectual resources, and preempting local development. The culture gap also introduces products that aren't appropriate because multinationals can't accurately understand local culture. And even if that doesn't occur, human rights abuses have been repeatedly documented by corporations that drop to local standards rather than rising to expectations.

A real danger for many developing countries is that multinationals create a net capital outflow, actually remitting more profits to their home country than they initially put into the local economy. When the multinationals use inappropriate technology for the country's level of development, they can actually drive many out of work and retard local development.

On balance, multinational corporations are neither an unmitigated good nor a force for evil. Rather, these corporations have numerous disparate effects, both intended and otherwise, that need to be evaluated on an individual basis. Still, the history of multinational development provides significant hope that the benefits from technology transfer outweigh most other considerations under most circumstances.

Saturday, May 26, 2007

China Shortchanges Its Poor

The IHT reports that while China is expected to continue its unprecedented streak of double digit economic growth, the communist nation has neglected vital social programs. The Organization for Economic Cooperation and Development issued a report that noted China's surging tax revenues have been outrunning growth in social spending. In particular, China has been engaging in a significant arms buildup aimed at Taiwan that has diverted tremendous resources from the rural poor.

The OECD predicts that China's surging exports will create an even larger trade surplus next year than its current record levels. This has enormous implications in the form of China's massive foreign reserves. Because the country has been sopping up excess liquidity by building foreign exchange reserves to prevent foreign direct investment from creating inflation, China has more than $1.2 trillion in foreign exchange.

China has recently committed itself to investing $3 billion in a US private equity group and talks about creating a national investment firm to invest its foreign exchange abroad in order to acchieve a higher rate of return.

China is an emerging economy with tremendous monetary resources. Nonetheless, in a country with hundreds of millions of people barely above subsistence levels, China could surely direct those resources more profitably toward its own citizens.

Adsense Arbitrage and Internet Advertising

The Computer Business Review Online is reporting that Google is shuttering the accounts of people who use Google's Adwords program to "buy" viewers and then direct them to websites full of high paying ads. Since on average only 1 or 2 viewers in a hundred clicks on an ad, these arbitrage opportunities only work when the price differential is fairly large. Apparently, savvy web developers have found lots of these situations. The best example of this situation is where the website purchases traffic related to "digital watches" very cheaply and then has many ads for Rolex watches which are worth a great deal.

Moral arguments about arbitrage in general aside, Google is foregoing significant revenue here in order to increase the quality of users' searches. Google makes money every time someone uses either Adwords or Adsense, effectively running both sides of this arbitrage for the website developer. Google is clearly gambling that the overall quality of the searches they provide to users is more valuable to their business than this revenue.

The real implication here, however, is that those engaging in arbitrage don't have a good alternative to use now that Google has shut them down. In particular, Yahoo! and Windows Live don't control enough of a fraction of the total web search market to replace Google. When Microsoft re-branded their search engine, they actually lost ground and Yahoo! has been unable to catch Google.

Advertising is turning into the second viable industry on the Internet, after the vices like adult entertainment and gambling. Hopefully, the Internet will be able to keep it clean.

Airbus crackup benefits Boeing - Air France Splits Order

The Wichita Business Journal reports that Air France-KLM Group is splitting a $7.2 billion for new aircraft between Airbus and Boeing, with Boeing receiving the lion's share. The Airbus order is only worth $2.8 billion. This is enormously significant because of the French government's strategic interest in Airbus. Within the European model of developing "national champion" corporations that operate a significant share of their business for the benefit of their home country at the expense of higher profits, the move to order $4.4 billion worth of aircraft from Boeing reflects a growing realization that the troubles that have plagued the introduction of the Airbus A380 cannot be allowed to spread so far as to permanently damage the rest of French industry.

Boeing is not without its own difficulties in introducing its own "Dreamliner" aircraft, but the problems are clearly several orders of magnitude below Airbus's own.

It might be expected that Boeing would be gloating about its competitive success against Airbus, but company executives have been warning that the companies revenues could take a hit if the United States tries to realize a "peace dividend" following a pullout from Iraq. One executive even went so far as to speculate that as many as five major competitors could develop from countries like Brazil and India with the possibility of a Chinese corporation that could dominate the industry. While today this ranks as mere speculation, the undeniable truth is that the majority of the growth in the aircraft industry over the past few years has been in Asia. The development of a domestic aircraft manufacturer with government backing in China could cut into Boeing's long-term prospects.

Nonetheless, Boeing still intends to engage their Asian competitors - as if any other alternative would make any sense at this point.

Congestion Pricing Unpopular in NY

Newsday reports that small business groups are unhappy with Mayor Bloomberg's proposal to help the environment and increase the speed of transportation in New York by reducing congestion through "congestion pricing". Small business groups correctly view congestion pricing as a new tax on something that has always been free before. Ignoring for a moment the distributional effects on the poor who will effectively priced out of driving between 86th Street and downtown, congestion pricing is obviously capable of doing exactly what it was designed to do: reduce traffic.

The problem with most schemes for charging for road access is that new infrastructure needs to be built to differentiate between paying costumers and everyone else. Bloomberg apparently plans to avoid this hassle by using pre-existing infrastructure that already charges for bridge access.

Savvy investors should be on the lookout to buy a piece of infrastructure investments like toll roads. While the political nature of the situation in Manhattan makes it unlikely that a private company could buy all the public roads in Manhattan, the potential revenue stream looks unbelievably inviting.

Cities like London have already demonstrated that congestion pricing works to reduce traffic by forcing people to pay for a public good. And the people who are willing to pay more than $10 every day just to drive downtown are likely willing to pay $15 or even $20 in just a few years. Hedge funds and universities with large endowments like Harvard are the main players in infrastructure investments today, but if more cities follow New York's lead here in the United States, the market could really take off.

Friday, May 25, 2007

Uranium Prices Rising - Likely to Stay High

The world's energy markets have been fixated on the prices of oil and natural gas as geopolitical instability and production difficulties have driven the prices of these critical resources sky high. Yet a growing awareness of global warming and the effects of carbon emissions from fossil fuels has caused people to look for cleaner alternatives.

While nobody even ten years ago would have described nuclear energy as a clean energy alternative, today the proven technology's lack of carbon dioxide emissions makes nuclear power worthy of more than a second look.

Yet uranium prices have been on a tear, rising from only $7 per pound to $113 per pound.

The tremendous increase in price has been driven by a precipitous drop in inventories rather than an increase in demand - which has been been flat for the last five years. Cameco Corp. Inc, the producer of 28% of the world's uranium saw production at its largest mine delayed by two years due to flooding. Energy Resources, producer of 23% of the world's uranium, has also seen production delays in Australia.

Nuclear energy is going to see tremendous increases in investment in the coming years and uranium prices aren't going to drop. Of course, the actual price of uranium is a small cost compared to the other expenses associated with building and running a nuclear power plant, so most power plants aren't very sensitive to the price of their fuel.

The Chief Executive Compensation Premium

The NYT reports that the rewards of scaling the very top of the corporate ladder have grown significantly in the last few decades. A study put out by Carola Frydman of MIT and Raven E. Saks of the Federal Reserve found that chief executives today earn 260% more than their third ranked executives. Compared with the 1960s and 1970s, this represents a massive increase from the previous 80% premium.

The NYT is perhaps more interested in the implications of this shift in terms of basic fairness and economic equality, but their single-minded approach to the issue ultimately misses the point. The economic ladder of the 1960s and 1970s was indisputably flatter than the one today, but it didn't reach nearly as high. Obviously, the economic relationship between top-tier compensation and economic well-being does not automatically follow in the same way that straightening a ladder inevitably makes it taller. But the basic fact that most journalists overlook is that the changes in terms of executive compensation have come about as a result of a fundamental shift in the way society seeks to compensate its highest performers.

Stock options were almost unheard of in the 1960s and 1970s, but today most of the highest paid executives receive the great majority of their pay in the form of stock options. This dramatically increases the chances that the CEO is going to get a massive payout on retirement, but it also more closely aligns the financial interests of the CEO with the shareholders of the company.

Stock options lead to wildly inflated pay packages that "fairness" types are going to criticize as being basically unfair to Joe Six-Pack. Yet Joe Six-Pack actually does better if the CEO is working non-stop to get that titanic payout than if the CEO spends the day at the golf course - which is precisely where the old fixed compensation scheme left the incentives for the CEO to go.

Society in general has become a much better place to be if you're the CEO. But if the CEO is watching out for everyone's interests in order to advance his or her own, everyone ends up better off.

Wednesday, May 23, 2007

Entrepreneurship Roughly Constant Over Time

Businessweek reports that an annual study by the Kauffman Foundation has come the same conclusion that it has for the last 11 years - an average of .29% of the adult US population starts a new business each month. While this means that 465,000 new businesses are started every month, the relative constancy of new business formation is unexpected.

Most people would intuitively believe that more new businesses would be formed during periods of either rapid growth or recession (due to reduced opportunity costs associated with starting a new business). Yet the data suggests that the rate of business formation is largely unaffected by macroeconomic events.

Of course, considering that most new businesses are in the construction and service industries, it isn't hard to rationalize that these areas of the economy have been less affected by volatility than the rest of the economy. Although the housing boom crashed rather spectacularly right after the last data were collected. Next year's survey will help to clear up the effect of sectoral influence on entrepreneurship.

Nonetheless, the most attention-grabbing part of the survey was the racial breakdown. Asian entrepreneurship grew faster than average from a higher basis than average, non-Latino whites were average, and African Americans actually fell from a significantly lower basis than average.

The real kicker of course is that immigrants of all racial groups clearly outdistanced even the most entrepreneurial racial group.

The geographic distribution of entrepreneurship was also interesting. Chicago (.18%) and Detroit (.13%) were both well below the rate for African Americans. The Midwest has been economically lagging, so it looks like the effect of slower growth on encouraging new business formation either doesn't exist at all, or is counter to its intuitive direction.

Entrepreneurship is critical to the future of the economy because owning your own business is one of the best ways to build wealth. Most "wage slaves" never build enough capital to get ahead because it takes dedication to save money that comes in the form of a paycheck. Business owners on the other hand, build equity in their business and have something significant to sell on retirement.

Tuesday, May 22, 2007

China's Growth Comes at Environmental Cost

Businessweek reports that China's state media released data that show the country's environment is deteriorating.

While "spring sandstorms" helped to reduce air pollution by blowing the problem away from the area it was produced, the country's water supply continues its downward spiral. According to China's own "watered down" standards, less than 70% of major Chinese cities have water that ranks as "qualified". This is a drop of 5% from just a year ago. But the truly frightening truth of China's rivers and streams is obscured by these figures.

There have been a series of industrial accidents that polluted Chinese rivers which the government ineffectually attempted to cover up. One of the accidents was so bad that no amount of government intervention could disguise. The northeastern city of Harbin, with well over one million people, lost its only source of water when an industrial plant upriver completely poisoned the river with a massive dumping of benzene, a toxic chemical that is known to cause cancer.

China's political leaders are absolutely correct when they say that their efforts to clean up the environment are being effectively hamstrung by the need to continue economic growth. China's economy has grown faster than 10% per year for the last five years, but the country's primary competitive advantage in the international arena continues to be the availability of hundreds of millions of workers willing to work for almost nothing. China has made admirable progress in the urban areas that export to consumers around the world, but the countryside remains a decided work in progress.

The cleanest countries in the world are also the richest. This is no accident, as wealthy people are far more likely to pay to clean up their environment than the poor. China's problem is that the country has so many citizens trying to make a better life that they will irreparably damage their environment before they have enough money to repair their mistakes.

The environment has gained tremendous cachet in the West, perhaps most notably with the super trendy cleantech industry. China's growth is going to happen. At this point, only significant technological progress is going to enable that process to occur with minimal environmental disruption.

Friday, May 18, 2007

DaimlerChrysler Deleveraging as Private Equity Ramps Up

Reuters reports that DaimlerChrysler's CFO Bodo Uebber has announced that the company will significantly reduce its use of corporate debt. At a time when private equity group Cerberus is using enormous debt to leverage its commitments to Chrysler, DaimlerChrysler is moving in the exact opposite direction.

Just how much does DaimerChrysler plan to reduce its reliance on commercial paper? Almost completely. The company will not issue bonds "in the quarters ahead". Daimler AG, as the company will be known once the Chrysler sale is complete, is making a strange decision.

The price of corporate debt is quite low and doesn't appear to be rising in the near term. Companies that engage in leveraged buyouts, like Cerberus and KKR, are on a tear making investments in otherwise uninspiring companies based almost entirely on their observation that those companies are under-leveraged.

MBA students around the world have long learned how to calculate the appropriate balance between equity and debt that maximizes the profits of shareholders, yet companies have consistently been far more financially conservative than those calculations suggest they should be. Of course, their are other costs associated with taking on excessive debt that cannot be expressed in purely financial terms. Many wealthy individuals are uncomfortable with taking on significantly more risk by increasing the debt of their businesses.

Still, the rewards of leverage remain clearly visible in the new leveraged buyout firms that are remaking the business world. DaimlerChrysler is making a decision to reduce its risk profile at a time when much of the smart money is betting in the opposite direction. Only time will tell who is right.

Thursday, May 17, 2007

Bernanke Sees No Subprime Mortgage Contagion

Reuters reports that Fed Chairman Ben Bernanke has come around to the conventional wisdom that the subprime mortgage woes that so captivated the media will not metastasize into a broader recession.

Of course, the housing sector is still the weak link in the economy these days, taking more than 1% off GDP after the top of the boom. The economy's dependence on the housing sector has been both underestimated and surprisingly narrow. Economic growth in retail has collapsed as the faltering housing market cut off easy access to home equity. Yet, the industrial sector has been almost completely unfazed. Exports have been soaring, and productivity outside of the construction industry has been chugging along nicely.

One of the unanticipated consequences of the housing sector's weakness has been the fate of Latin America. Many recent immigrants of Latin American extraction have found a livelihood in the construction industry - and they routinely send remittances back to their home countries to share the wealth with relatives. Since the top of the housing market, job prospects for these immigrants have gotten much worse and remittances have collapsed. The amount of money being funneled back to Mexico has fallen by more than 30% in the past year, and this big drop will have real consequences.

Many areas of Mexico, and not just in Chiapas, are almost completely dependent on these remittances. In five Mexican states, remittances from the United States are greater than the rest of the economic activity by everyone who remains in the country.

Subprime mortgages don't seem to be holding the US economy back, but the unintended consequences for Mexico and the rest of Latin America will certainly be severe.

Monday, May 14, 2007

Putin's Energy Empire Grows

The IHT reports that Russia has succeeded in winning a contract to build a natural gas pipeline to important Caspian resources in Turkmenistan. The deal reflects a triumph of sorts for economic pragmatism and Russia's control over the energy sphere in its own backyard. The United States had been aggressively pushing an alternative pipeline that would have run away from Russia in an attempt to loosen Russia's grip on Europe's energy markets.

Of course, American diplomats and the assorted multinationals behind the alternative proposal were operating from something of a disadvantage. Russia claims the pipeline it plans to build will cost $1 billion. The American pipeline would have cost $10 billion. Turkmenistan was nonetheless willing to look at the American proposal because of its potential to get the country out from under Russia's thumb.

In particular, Russia's current energy needs are met by buying approximately 80% of Turkmenistan's natural gas for about $100 per 1000 cubic meters. The problem from Turkmenistan's point of view is that Russia is simultaneously selling its own natural gas for $255 to Europe.

Turkmenistan's president will no doubt attempt to use the spectre of an alternate pipeline to encourage Russia to pay more for the energy, but ultimately the only economically viable proposal involved a pipeline to Russia.

At the same time, Putin continues his brutal energy diplomacy with Europe. The world watched with baited breath when Russia cut off supplies to Europe through Ukraine when Ukraine siphoned off some of the natural gas to run its economy. But Russia also shut down a pipeline to Lithuania in July and hasn't turned it back on. Lithuania's continued energy insecurity could spark a confrontation between the EU and Russia the next time Putin tries to raise rates.

Sunday, May 13, 2007

Chrysler Buyout Saga Continues

Reuters reports that private equity firm Cerberus Capital Management LP is now DaimlerChrysler AG's preferred buyer for its Chrysler assets. This significant information, from people willing to talk to the Detroit News, suggests a shift in interest from the formerly preferred Magna International, a Canadian auto parts maker. The shift is significant because until recently, one of the primary differences between the competing bids was that Cerberus was willing to give the current management and employees a large ownership stake in the firm. Yet just on Thursday, Magna indicated that it was also willing to make similar concessions.

Since no official announcement has been made, this shift might be only the outward reflection of negotiations that occurred quite a while ago or even a complete fabrication designed to somehow influence the strength of the competing bids.

Nonetheless, one unmistakable view of the shift away from the traditional auto business buyer to a private equity concern is that DaimlerChrysler is responding to the continuing weakness of the American automakers. Private equity has recently taken on the role of buyer of last resort in the larger equity markets, snapping up companies that otherwise look sickly to industry insiders. If the Germans have come to the conclusion that management is sufficiently unable to right the ship at Chrysler, they must see the ability of private equity concerns to create additional value by dramatically increasing the leverage of Chrysler as a big plus.

The important thing to remember is that private equity concerns like Cerberus lack the industry specific knowledge of players like Magna have. They also tend to adopt a decidedly mid-term view, planning to sell the company in about five years. Running an organization the size of Chrysler is less akin to driving a lawnmower and more akin to driving a battleship in terms of its turning radius. It might take five years to turn the business around under the best of circumstances.

Last quarter Chrysler was the only major American automaker to keep its head above water. Ford and GM are in free fall and Toyota is seemingly unstoppable. Yet just a recently as 2005, Toyota recalled more vehicles than it sold. The American auto consumer is a fickle beast and winning today is no guarantee of winning tomorrow.

Saturday, May 12, 2007

Google Goes to Court

Reuters reports that Google is going to face a jury trial that could potentially put its entire business model at risk. The lawsuit centers around an alleged trademark infringement inherent to Google's Adwords program, which is responsible for 98% of Google's revenue. This isn't the first time someone has sued Google over its business model, but Geico settled out of court and Louis Vuitton sued in French court. Having never faced a jury trial before, Google's performance in court could change the face of the Internet economy.

The case was originally filed in 2003 by American Blinds and Wallpaper Factory Inc., the top reseller of window blinds. The suit centers on the ability of American Blinds' competitors to buy the company's name as keywords to link to their sites.

No relevant case law exists to cover keyword advertising, so even if the court finds in favor of Google the appeal process in likely to set the relevant rules of Internet advertising for years to come.

The suit will be heard in San Francisco, which should generally favor Google as the tech savvy community is full of people who love to use Google's various products. But American Blinds is obviously serious about this case given their tenacious pursuit of litigation.

The American legal system is in many ways built on the notion of trial by jury, and now twelve jurors are set to determine the fate of Google's business model and with it much of the Internet economy. Let's hope they're paying attention.

Friday, May 11, 2007

Green Tech Gets a Big Leg Up

The EE Times reports that IBM is planning to spend $1 billion on energy saving technologies that are designed to cut power usage 42%. This is potentially a much larger savings than it might seem at first blush, because IBM's technology is critical to many data centers. These data centers, which drive the digital economy, are power guzzlers that have been growing exponentially. Saving more than 7000 tons of carbon emissions per year would be good if IBM alone could do it, but IBM's technology will be leveraged across many companies.

Google is one of the world's largest users of data centers. With a presence in 13 states, Google is expanding geographically into areas with cheap power. This can most clearly be seen in Google's move to Council Bluffs, Iowa. The key to Google's methodology is hooking thousands of low-cost boxes together to create the essentially instantaneous search results that the world has come to rely on. The upshot is that as the individual machines wear out or break, they are constantly being replaced. If IBM can achieve significant power savings, these power savings will likely be implemented immediately.

In the money hungry technology world, one billion dollars doesn't last as long as might be hoped. The so-called "burn rate" required to keep up will the bleeding edge is frighteningly large and rising all the time, but IBM's outsized commitment to green technology is a sure sign that the movement is achieving real change.

While the environmentalist movement's mindshare is indisputable, many people still question the case for global warming. Yet even if global warming is the greatest hoax since time began, the business case for reducing power consumption is quite strong. The power infrastructure in the United States is very old and running at nearly 100%. Achieving more computing power with less energy is a sure way forward. It takes decades to get power plants out of the planning stages and into everyday production, and it has become clear that the pipeline of power plants ready to come on line tomorrow is empty.

More energy means more pollution, but it also means more money. IBM plans to spend money to make money, but in the process they will save everyone else a great deal more.

Thursday, May 10, 2007

US Trade Deficit Keeps Growing

Reuters reports that the US trade deficit rose to $63.9 billion in March on the back of higher oil prices and massive imports. While higher oil prices were doubtless expected by anyone who has filled up their gas tank lately, the strong prices of imports were surprising.

The dollar is experiencing a period of extraordinary weakness, especially against the euro and the pound. Yet American consumers are not making the sorts of substitutions toward domestic goods that would be expected in these circumstances. The economic logic of buying less from expensive European manufacturers and more from domestic producers is apparently being overwhelmed by other considerations.

At the same time, the whole notion of the trade deficit is really just a statistical construction. What difference does it make if the US is purchasing goods from manufacturers in Arizona or China? Ultimately, the only aspect of the transaction that really matters is whether or not the consumer is happy with the deal. In an environment where China is purposefully depressing the value of its currency in order to encourage a shift in production towards its borders, it makes sense that Walmart is going to buy goods from China.

National borders are the great red herring of economic analysis. All wealth is ultimately held at the individual, not the national level. Now that everyone is off the gold standard, there is not even the visible transfer of gold around the world to reflect international trade flows. Goods and services are constantly moving across borders around the world, and given that there are typically much greater barriers to trade across borders than inside any given economy, the trade that overcomes these greater transaction costs is slightly more valuable than other trade. Yet international trade accounts for only about 20% of the US economy. Compared with many other smaller countries who routinely depend on the international marketplace for 70% of their production, the US is relatively unfazed by currency dips and booms.

Higher gas prices are bad for the consumers of energy and good for its producers. Sadly, most of those producers are countries with otherwise deplorable policies. But the ultimate shift away from fossil fuels is only likely to occur once the current energy infrastructure becomes too expensive. Rising energy costs are bad for consumption but fill a necessary role signaling the need for change. Once the US economy shifts away from its reliance on fossil fuels, historians will look back on this change as a net positive.

Wednesday, May 9, 2007

Venture Alliance Partners - A New Force in Private Equity

Private equity has been on a roll recently, but navigating this sector requires exceptional management. The tremendous growth of hedge funds and other "alternative investments" has driven large amounts of capital toward many obvious investments, driving valuations out of the range of profitable acquisition.

Venture Alliance Partners is a company with a strong commitment to the values that initially attracted so much capital to this sector in the first place. With an emphasis on exit strategy and knowing how to monetize the next great idea, the company is poised to grow going forward.

Silicon Valley is starting to regain some of its luster, but the giddy days of endless profits are over. Intelligent investors would favor an alternative that recognizes the danger of fads and knows how to avoid the pitfalls. Venture Alliance Partners is ready to ride the trend without following anyone else off the cliff.

Toyota Crushes the Competition

Businessweek reports that Toyota is about to report some amazing earnings numbers for this year. The company predicts it will have profits of $12.9 billion. And this is occurring in the same market that Ford and GM are witnessed significant losses. Incredibly, Toyota's operating margins are likely to rise to nearly 10% which would be the highest in the industry.

Sales in the United States, Toyota's most profitable market, don't show any signs of slowing. Analysts credit Toyota with aggressively rolling out bigger trucks and SUVs to compete with American companies at the same time it retains focus on the smaller, more efficient vehicles that Toyota is known for.

Toyota's green image, largely the result of the success of its Prius hybrid, is somewhat greater than the truth. Toyota's vehicles haven't been getting much more fuel efficient lately. Rather, the company is responding to consumer preferences for bigger vehicles. Given the rapidly rising price of gas at the pump, it is unclear that this trend will continue.

Toyota struggled with enormous recalls between 2004 and 2006 that briefly out-paced new car sales. The company has refocused on quality and integrating its non-Japanese supply chain more carefully. Toyota is struggling to avoid a backlash from American consumers by building more vehicles in the USA, but has been slower to build production in North America than either Honda or Nissan.

Toyota today stands astride one of the more competitive global markets. In spite of national protections that sometimes give its rivals a big leg up, the company has built itself into one of the most profitable companies in the world. The challenge of much higher gas prices will challenge the entire auto industry, but Toyota's nearly $13 billion profits will give it quite an advantage.

Monday, May 7, 2007

Excess Liquidity and the Leveraged Buyout Boom

The IHT reports that some of the private equity firms which depend on access to cheap credit with few strings are complaining about an excess of liquidity. While precise measures of liquidity are prone to error, it is clear that the amount of liquidity has been increasing rapidly. The Bank of England estimates that liquidity has doubled in the last four years.

The high price of oil, which shifts enormous resources away from the developed world to oil sheiks in the Middle East, has further exacerbated the liquidity troubles. And at least until now, China's trade surplus has gone largely uninvested. When China decides to mobilize its capital in the global markets, this will further spread liquidity.

Liquidity by itself is not a bad thing. Quite the reverse, many good investments in the past have gone unmade because of a lack of liquidity. But as the subprime mortgage market recently demonstrated, easy money leads to loose credit practices. The mortgage market is unique in its general low level of risk, but capital investments and leveraged buyouts can be very high risk. When cheap credit is extended largely without conditions, many more loans are extended than would be accepted otherwise.

Even the private equity firms themselves are concerned about the easy credit markets because competitors are encouraged to step in and bid up the price of acquisitions. These more expensive, more heavily leveraged investments then become much more risky and investors become less likely to profit.

Ironically, the Fed's chairman Ben Bernanke is currently receiving public pressure to lower interest rates in order to spur growth during a period of excess liquidity. In this environment, Bernanke is likely to leave interest rates alone for the seventh straight meeting. This will probably leave him looking indecisive and reduce his credibility in the short term, but the alternative is even worse. Bernanke can't give in to market pressures even if he will be praised in the short term.

Leveraged buyouts are fueling much of the mergers and acquisitions activity driving the stock market higher these days. The leverage is cheaper than ever thanks to excess liquidity. The liquidity would be fine in isolation, but unfortunately it is accompanied by loosened lending standards. Interest rates aren't likely to resolve the problem anytime soon, in spite of the housing bust. Hopefully the private equity gurus will have the intelligence to proceed cautiously. But don't hold your breath.

Sunday, May 6, 2007

Private Equity Pursuing Music Giant EMI

Reuters reports that three American private equity firms, namely Fortress, Cerberus, and One Equity, are all interested in paying something in the vicinity of $6 billion for the British music group EMI. The entry of significant private equity dollars indicates a major shift from as recently as March, when EMI rejected a $4.2 billion bid from Warner Music.

EMI is one of the world's largest music companies but the industry has faced difficulties adjusting to the presence of digital distribution and the resulting ease of stealing its product. While Napster has been vanquished and reincarnated within just a few years as a legitimate distribution channel, the development of countless clones with technology designed to avoid legal challenges indicates the ultimate weakness of the business.

Downloading music illegally is getting easier all the time, and the potential to download higher value products like movies is increasing the returns to mounting this diminishing learning curve. The music industry's attempts at digital rights management, or DRM, have been a titanic failure. In addition to failing to prevent any reasonably dedicated teenager from getting a hold of music, the whole process has had the effect of creating an adversarial relationship with customers.

EMI has been underperforming its industry over the past few years and has actually lost money in the last quarter. Given the profitability of the rest of the industry, even as it struggles with change, this indicates EMI's management is not up to the task of answering the digital challenge.

All of this clearly begs the question: "Why is EMI suddenly worth so much money?" The better question is: "Why would private equity firms be willing to pay significantly more than music industry insiders for the company?" The answer seems to be that music industry insiders are focusing on the unique value proposition of the underlying business while private equity gurus are more concerned with the balance sheet.

The music business may not be what it once was, but significant revenues are a certainty for the foreseeable future. At the same time, the recent spate of private equity firms engaging in leveraged buyouts across numerous industries with widely different businesses and risk profiles seems to indicate that relative to the price of capital, most publicly traded companies are insufficiently leveraged. EMI is a giant business that has lost its way. The company is losing ground, but that actually makes it a more compelling takeover target.

By taking a company with essentially no debt and leveraging it to the maximum, the Americans plan to take value stored in the enterprise itself and cash out quickly. EMI is slowly sinking, but it isn't drowning. A quick turnaround could net substantial returns on resale in five years when the company has returned to profitability.

Experts know their area of expertise and not much more. Music industry insiders see a floundering giant, but private equity sees untapped potential. Only time will tell if the money that private equity can squeeze out of a leveraged buyout will outweigh the loses at EMI's main business.

Saturday, May 5, 2007

Asia's Foreign Reserves - A New Pool

Businessweek reports that a group of Asian nations who collectively hold 65% of the world's foreign exchange reserves has agreed to create a new "pooling arrangement" to help prevent fallout in the aftermath of incidents like the 1997 Asian Contagion that rapidly spread throughout the region. The group is motivated by the perception that the IMF, the global body usually acting as a lender of last resort in these types of scenarios, imposed conditions like higher interest rates and lower government spending in exchange for loans.

The first obvious implication of this unprecedented regional cooperation is that China, Japan, and the rest of southeast Asia are finally willing to cooperate without outside interference to advance their own interests. The continued economic dynamism of the region will ensure that an increasing share of the global economy will depend on the institutions constructed by the region. Despite the recent historical weakness of these financial institutions, this new multilateral endeavor indicates that the major players have internalized the importance of cooperation.

The second, far less positive implication is that much of the region, and China in particular, is interested in constructing a parallel global economic framework that embraces nonintervention in nation economics as a first order principle. The real concern here is that enabling despotic regimes such as Thailand, Myanmar, or even North Korea will result in humanitarian disasters. But just as frightening to the economies of the region is a commitment to not imposing fiscal reforms. The real causes of financial collapse are weak institutions and poor policy. By setting up an additional bulwark against failure before intervention by the IMF, this "pooling arrangement" is going to ensure that weaker, less wide-ranging reforms are enacted at the conclusion of each economic shock, making future failures more likely.

The good done by increasing political cooperation between these critical components of the global economy is at least partially offset by the purpose of their cooperation. The world would be much better off if China and the rest of the region put their reserves into existing institutions like the IMF in exchange for increased consideration. With the failure of the Doha Round at the WTO, the world looked immediately to bilateral agreements to continue trade progress. While regional cooperation is superior to earlier bilateral cooperation, only truly global cooperation will best advance everyone's interests.

Friday, May 4, 2007

Oil Refiners Profit - Is it Gouging?

Reuters reports that American oil refiners are set for record profits this summer as demand peaks and supplies tighten. The industry uniformly blames an aging infrastructure and new government regulations that mandate more exotic, less polluting fuels. Astonishingly, margins today are better than they were in the immediate aftermath of the 2005 hurricanes which shuttered a quarter of US fuel production.

The government has conducted repeated investigations into price manipulation at the behest of numerous populist politicians who see prices at the pump soaring far more rapidly than the price of crude oil. Those investigations found no evidence of price gouging but numerous "independent" surveys of rising prices show clear evidence of manipulation.

The root problem with rising gas prices is that demand in the United States is almost completely inelastic. Despite an enormous run up in the price of gas at the pump, Americans have not cut back on their fuel consumption at all. For all of the people loudly complaining about the prospect of higher fuel costs, the aggregate response of the nation has been to do nothing. The economy is becoming slightly more efficient at squeezing greater economic growth out of the same amount of petroleum, but the total amount of oil flowing through the nation's economic veins has remained constant.

Consider virtually any other industry with a huge, totally captive consumer base and tremendous barriers to competition that squash out new competition. Over the past fifty years, the oil industry has actually not been particularly profitable given the necessity of its product to the rest of the economy. In fact, as recently as 1998, crude oil prices as low as $9 a barrel threatened the viability of the industry.

In any event, the rest of the world has already dealt with significantly higher gas prices than the United States. European nations in particular tax oil so heavily that seven or eight dollars a gallon are more likely than three. The next time that someone suggests that current levels of gas prices are going to cause a downturn or even a prolonged recession, remember that the oil sheiks do not yet control the world economy.

Thursday, May 3, 2007

Murdoch Bids for Dow Jones and the Wall Street Journal

Businessweek reports that Rupert Murdoch's News Corp. has offered a hostile bid for control of Dow Jones and Co., the financial information powerhouse, with a massive 66% premium. Most analysts covering Dow Jones business empire, which includes the Wall Street Journal, were previously under the impression that the company was fully valued at its old price of just $36 per share. That Murdoch was willing to offer $60 a share for a company firmly entrenched in the dwindling print media is astonishing.

Murdoch's high offer for the company will likely prevent most private equity companies from offering competing bids because even with the use of extensive leverage, it seems unlikely that the company could be flipped within a decade at a substantial profit. The beauty of Murdoch's bid is that the prospect of integrating the Wall Street Journal with his existing media assets at Fox and his upcoming Fox Business channel makes the company worth substantially more to him that to any other conceivable rival. The only competitor with the deep pockets necessary to fight back in a bidding war is GE/NBC which could engage in purely defensive bidding to try to protect its valuable CNBC franchise. Not very many people watch business news on CNBC, but the wealthy audience is an advertiser's dream and the resultant profits make it one of NBC's more valuable properties.

The only thing standing in the way of Rupert Murdoch is the family with a controlling share of ownership in Dow Jones and Co. The Bancroft family has made use of their two-tier ownership structure to resist many previous bids for control of the company. The company is structured in such a way that while the family does not own the majority of the company, their shares have extra voting power which makes their acceptance of any deal crucial. Nonetheless, not all of the Bancroft family is opposed to the bid and the prospect of an increased bid seems likely to convince enough younger family members to sell. The sale has provoked intense interest across the media because of its implications for the value of many other media properties. With print circulation in free-fall, if Murdoch can find a web-based strategy to leverage the "old media" into the future, he could save the fourth estate.

Of course, whether or not Murdoch succeeds in purchasing the Wall Street Journal is beside the point. The print media is dying as society simultaneously loses interest and moves online. The old subscription model of payment which enriched the newspaper business for so long must give way to a solely advertisement based system. In an era where information is free, eyeballs are still worth a fortune to advertisers.

Tuesday, May 1, 2007

Ford in Free-Fall

Reuters reports that Ford's April sales numbers fell 13 percent from a year ago. This might be easily dismissed as just the next chapter in the ongoing saga of Ford's difficulties, but the breakdown of the results yields some surprising results.

Ford's Expedition, a monster SUV, saw its sales rise 27%. And the Navigator, another leviathan, had sales that rose 13%. In contrast, the F-series pickup was down 12% and car sales were down over 23%. Clearly, Ford's car sales were hurt by the end of fleet sales to car rental companies that Ford decided weren't generating any profits.

Now, SUVs saw tremendous declines the last time gas prices went way up, and oil is heading back up again. But this time buyers aren't buying gas guzzlers without realizing the possibility of a tank of gas costing $100 is quite high. Rather, these affluent buyers don't seem to care. Given the social force of the global warming driven "carbon footprint" movement, it is all the more remarkable that consumers would choose to buy SUVs.

Detroit automakers in general are facing the music these days as Toyota has finally climbed past GM to become the world's number one automaker. But Ford seems to be suffering disproportionately. Chrysler's sales actually rose in April, albeit an anemic 2%.

Ford's saving grace up until now has been the strength of its F-series pickup. These trucks have been the best selling trucks in America for decades and their loyal buyers are among those most suspicious of foreign competition. But with sales on its flagship product falling 13%, the writing is now on the wall.

Something major needs to happen at Ford for a turnaround to work. Ford's management is hardly unaware of the problem. Ironically, Bill Ford was one of the early American proponents of environmentalism and his signature achievement was building one of the most environmentally conscious auto plants in the world. It's going to take more than incremental improvements in salesmanship and design to fix things.

Ford needs to completely re-brand itself around an innovative new design. Ford has admittedly been trying this for a while now, but the new designs really haven't caught on. Ford needs a sea change in leadership at the very top of the company to finally put all of its top talent on the products of the future. Ford finds itself in the awkward position of being a horse company competing against early auto companies. For a significant period, Ford is going to need to sell both horses and cars, but the company would be penny wise and pound foolish if it put any of its top people on its horse operations. Ford needs to put its top talent on the wave of the future, because if it doesn't the company may get put out to pasture.