The 737 Max, DSL Networks, and the Creeping Rot in Our Current Model of Shareholder Capitalism

Our current economic model does a lot of things well, but it reliably fails with long-lived assets.  That sounds like a pretty bloodless comment, but the consequences are – literally – murderous in some cases.  

In telecom, we are watching the slow-motion equivalent of the Boeing 737 MAX debacle.  The cancer is incremental investment in an asset (the 737 airframe, copper-based networks) that have hit the end of its useful operating life.  When the truth becomes impossible to ignore and the bill comes due, all that incremental spend gets written off with the obsolete asset.  Leaving you strapped for funds and time to replace it.  The sunk cost fallacy leading on to its logical,  self-destructive end.

Its a bit depressing if you are trying to maintain faith in shareholder capitalism.  About 20 years of pretending a totally obvious problem and need wasn’t there.  Until the creeping crisis accelerates to ramming speed.  It makes me think of the Hemingway quote: “How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.”

I kept going back to accounting 101 for asset-heavy businesses.  Incremental capital investment doesn’t magically generate (or demand) incremental revenues.  The whole point of asset lives and depreciation expense is to estimate how long until you need to replace that asset. At the end of that life, you must re-invest to maintain the existing revenue stream.  There is ZERO incremental return on that investment.  Just the privilege of staying in business.

  • The 737 was past its sell-by-date. Boeing knew it. But they tried to get out one more turn of the crank by slapping on new engines and using software to cancel out the resulting balance problems. Hundreds of people have died from that greedy calculus.
  • The copper network has been past its sell by date for decades now. The Telcos invested in increasingly fancy and expensive DSL gear to get a few more turns of the crank out of it. 20-30 years that could have been spent rolling out fiber at equivalent or lower total cost. Now that bill is coming due. People haven’t necessarily dies as a result, but rural and less-affluent areas lacking decent broadband are struggling to keep or attract businesses and jobs. Helping to feed the anger that is tearing away at our national fabric.
  • How many public infrastructure assets – roads, bridges, airports, subways – are creaking under endless layers of fresh paint  instead of being replaced wholesale? 

The 737 and Telecom examples aren’t the only ones. This seems to be a recurring problem with our current economic model. Managers charged with stewarding an asset loot it instead.  Shareholders cheer them on. The logic is “we’ll get all the cash flows and the next guy will be left holding the bag.” The negative externalities of that under-investment – rural blight and hundreds of people killed – are never factored into that calculus.

What follows is a more telco-specific rant. It’s what inspired this post but its a bit inside baseball.

After reading the CenturyLink and other telco transcripts. A durable, 10-20 year trend is getting underway.

  1. CTL’s prepared comments started with fiber Fiber FIBER! everywhere.  You would’ve thought it was Zayo’s call.  OR a re-run from 2000.  Most shocking was the whole “we’re going after SMB out of region” comment made in the Q&A.  Wow.   I haven’t heard a telco talk that much about building out new fiber plant since, well, last week’s Verizon call.  And the Vodafone call.  And most other recent telco calls.  Except AT&T – which only confirms the trend as T is always the dumb money.  Seriously, the shift in tone and focus was remarkable.
  2. If VZ and AT&T’s wireline business held a stand-alone call, they would sound exactly like CTL.  The voice revenue gravy train is finally grinding to a halt.  Consumer yes, but more so SMB.  The stats on the CTL call were pretty horrifying.  It’s not the revenues they need to replace, it’s the 99% gross margin profits.  Being telcos, they are reacting to the obvious at least 5-10 years too late, but they are most definitely reacting.
  3. The only hope is high-speed data delivered over a fundamentally lower cost network.  Which is what Verizon is actually doing under the cover of this 5G build.  Building out fiber for 4G backhaul and to sell real high-speed data services to businesses all the way down to SMB.  Like CTL, Verizon can see the rot in its own business.  So it might as well exploit that take-away opportunity out of region while shoring up its own.
  4. It all sums up to a wave of local network investment we haven’t seen in decades.  If they don’t invest, we have the Frontier call to remind you where things are headed.  That is worth a look.  Cutting EBITDA guidance in half because revenues are falling faster than they can cut costs.  There is no bottom to that pain on their current course.  Their path out is replacing those voice revenues with broadband.  That needs 1 GB speeds to be viable long-term. And that capex spend can’t be covered by existing (falling) cash flows.  So they’ll go bankrupts, wipe out the debt, and spend frantically to make up for 10 years of lost time.  Expect the same from Windstream.
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Calix – If You Sh*t in Your Own Backyard Often Enough…

I figured I’d publish my post-quarter Calix update here.  As someone noted to me, I probably won’t be getting a Christmas card from them.  🙂  But if the emperor is prancing around in new clothes made of nothing more than delusion, I’m not obliged to play along with the charade.

See below for the post-call note I sent to Calix’s CEO and Chairman of the Board.  See link below for a PDF of my more detailed article on Seeking Alpha.

—————————————————————————————

In an alternate universe, there’s a Calix with appropriately lowered expectations, a detailed investor deck, and intact credibility.  It is currently rallying from $6 to $7.50 on the quarter’s results.  People who bought ahead of the quarter are starting to relax and settle in for the ride.  New investors are reading a clear, detailed shareholder letter that focuses on 2020 prospects.  Doing their own math and thinking about buying in.  The deep value folks who’ve supported CALX, feeling good about a job well done, are maybe marking up the price where they’ll start selling off to the growth crowd.

All is well in that alternate universe.

In our reality, we are wallowing in the swells. Engine off.  A windmilling rudder.  Cash is low. Praying a storm doesn’t hit before we get headway again.  The easy excuse is “What can we do if Frontier and Windstream shifted plans on us?”  The answer is You can do plenty right now.

  1. Significantly improve the depth and detail of your disclosures.  What does Calix 2.0 look like?  I have no idea.  Maybe you’ve hinted at it in conference 1-on-1’s.  That sort of selective disclosure isn’t going to work for a $400m cap left-for-dead stock.  Put it on paper and get it out there.
  2. Fix your forecasting and guidance process.  Quarter after quarter we see a reliable skew towards insupportable optimism.  Put on some corrective lenses that aren’t quite so rose colored.  Forecasting is tough, but most companies get it more right than Calix does.  OR at least get it wrong in both directions.
  3. Change your tone.  I wasn’t at the Cowen conference and I have no idea what was said, but [Cowen Analyst] didn’t hang himself with that table-pounding note [ahead of the quarter that drove CALX up to $7.50] unless someone handed him a whole lot of rope.  One more person with singed fingers.
  4. Promote or hire someone with intact investor credibility to add weight to a more sober message.  A credible message still needs a credible messenger.

The above won’t get Windstream and Frontier back to buying, but it would eliminate a massive uncertainty discount.  The weight of that uncertainty depresses the valuation.  It also depresses trading volumes.  The quarter-by-quarter stream of self-inflicted whipsaws only drives people away.

If you shit in your own backyard long enough, people stop coming over.  Other people start writing up the truth for all to see.  Its not a lot of fun for anyone.  So do something to change the situation.

https://seekingalpha.com/article/4277547-calix-drifting-mercy-market-tides

Key messages From The Seeking Alpha Article (link to PDF below or link to website here.)

Calix_ Drifting At The Mercy Of Market Tides – Calix, Inc. (NYSE_CALX) _ Seeking Alpha

My best guess is CALX will drift with the market until we get to the 3Q19 report – probably in mid-October. A decisive turn in the numbers may not come until 2020.

Today’s market reaction just takes CALX back to mid-June 2019 levels. With the stock holding above $6 today, the pre-quarter run up and subsequent drop could be seen as just a blip in an improving trend. But there is damage done.

Calix has singed the fingers of yet another crop of recent buyers who might have been convinced to become long-term holders of the company. Questions left un-answered by management on the 2Q19 call (see below) will also make it that much harder to find new buyers. Investors tend to be wary about crediting improvements in advance after a stock has burned them so frequently and recently. In the meantime, that leaves Calix and its current owners at the mercy of market tides.

I continue to hold the stock. I’ve done enough digging to see through to those improving fundamentals. Per the below, there is still 50%-100% upside on 2020 numbers with more potential in 2021. The question is how long it will take until numbers turn up decisively enough and/or disclosures improve significantly enough for the market to price that in.

————————————————————————

At some future date, the numbers will win out. The market will duly price them in. A more forthcoming approach to disclosure would bring that date forward by several quarters. It is mystifying and frustrating that Calix management (and its Board) doesn’t seem to grasp that truth.

Calix produced a 7 page investor letter on July 23. They held a 36 minute call on July 24. Yet they failed to answer some very simple questions that would seem central to analyzing and understanding the stock. I present them below. Their call transcript is here.

Questions Left Un-Answered on the Call.

Calix 1.0 to 2.0 Transition/Trajectory: Calix management it pitching a “Calix 1.0 to Calix 2.0” transition to a higher gross margin, more software-based, more profitable business model. But they have given no detail. What is a reasonable range of margin expectations for Calix 2.0 at maturity? How long to get there? How big are Calix 2.0 products and service as a percent of total revenues today? When will it become a majority of Calix’s revenues? The only comment given on the call was a highly un-specific “our [new] platforms are growing very rapidly, but still off of, let’s say, minority numbers. Our traditional and supporting products or our legacy products are still the large majority of the business.

Composition of the Customer Base That is Actually Growing? Calix did (finally) disclose that CenturyLink, Windstream, and Frontier are down from over ¾ of revenues to “less than ¼.” CenturyLink was 17% of 2Q19 revenues, leaving bankrupt WindStream and struggling Frontier at around 7% combined. So we know who is shrinking. But we know very little about who is growing. Calix gives no detail on the composition of the other 76%+ of its revenues. We know that Verizon and CityFibre are relatively big and growing fast, but we don’t know how big or how fast. We are wholly in the dark on the rest of their customer base. This is particularly frustrating as one of Calix’s great strengths should be its relatively wide customer base among rural telcos, cable companies, electric cooperatives, and new over builders. That diversity could be perceived as a strength if we had some numbers to back it up. The only detail given on the call was “Headwinds from our publicly traded ILEC customers will continue through the third quarter and into the fourth quarter. We are confident that these headwinds will no longer be a meaningful factor in the business entering 2020. It is worth noting that not many years ago, this narrow category of customers represented more than 3/4 of our business. Today, that same set of customers delivers less than 1/4 of our business. The flip side of this story is the robust nature of the future Calix business model. We continue to add new customers at a rate greater than 100 per year. That is remarkable. And as the headwinds from our legacy business subside, this new business will continue to shine.”

Outlook for Verizon and CityFibre? Engagement With Other Potential Marquee Customers? Calix management did provide a significantly more detailed update on marquee customers Verizon and CityFibre (see quote below). It is not clear if they will continue to deliver that much-needed context. Moreover, they continue to provide no insight into engagement with other large potential customers. It is never advisable to count chickens before they are hatched. But it would help to have some rough color on how many eggs are left in the nest that might hatch.

Cash Flow Outlook? As a rule of thumb, telcos like to see about one quarter’s worth of cash (or more) on their supplier’s books as a cushion in the event of a downturn. For Calix, this would amount to about $100-$150m. Net cash at present is about $10m. Calix does seem likely to turn cash positive in 3Q19. It appears to have the continuing support of its lender Silicon Valley Bank (the source of the $25m revolving debt shown on the balance sheet). Calix also has roughly $15-$20m of excess inventory that should convert to cash as its contract manufacturer recovers from its 1H19 production problems. But it doesn’t appear that Calix will be comfortably liquid until well into 2021. Will they be able to finance growth in the meantime? When will shareholders see a cash return on their invested capital?

Internal Management Changes to Address Persistent Forecasting Errors and Operational Failures. In the past three years, Calix has experienced two major operational failures – poorly negotiated, negative margin services contracts that dragged down results for all of 2017 and the more recent disruptive manufacturing shift out of China in 2018-2019. Calix has also persistently failed to set and communicate realistic forecasts and guidance to investors – as evidenced by the jagged path of the stock price. It would seem to behoove the company to 1). Make structural management changes to improve execution going forward. 2). Discuss and disclose those changes so investors might have more confidence in that future execution. As it stands, it is not clear if Calix management even sees a need for structural improvement.

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A Chilling Reminder To Take the Madness of Trump (and Trumpism) More Seriously… Plus a Meuller Coda.

Back to the Fed and other matters next week.  I’ve been away from a real keyboard and a bit busy lately.  But had to share this bit.

I’ve been reading a phenomenal (both writing and content) book titled “Defying Hitler.”  Key to its fascination is that it was written in 1939 (unpublished until 2000).  The author goes about dissecting the Hitler phenomena – writing before the full horrors of WW2 and Nazism came to be.  I’m about halfway through it and can’t put it down.  It is brilliantly written – more a memoir than a polemic.  The author is also so poignantly likable and obviously prescient.  I highly recommend it.

He largely ignores Hitler the person to inquire into Hitler as a product of his times.  The question he struggles with is “How did the tides of society and politics and economics conspire to push this manifestly horrible little man into power?”  What phenomena of societal/economic/political conditions enabled Hitler’s rise?  How did reasonable, respectable, establishment Germans (like himself) let something so unreasonable happen?

This quote rang chillingly true for me.  Remind you of anyone?

“Hitler himself, his past, his character, and his speeches were still rather a handicap for the movement that gathered around him. In 1930o, he was still widely regarded as a somewhat embarrassing figure… And then there were the contents of those speeches: the delight in threats and in cruelty, the bloodthirsty execution fantasies. Most of those who began to acclaim Hitler at the Sportpalast* in 1930 would probably have avoided asking him for a light if they had met him in the street. That was the strange thing: their fascination with the boggy, dripping cesspool he represented, repulsiveness taken to extremes. No one would have been surprised if a policeman had taken him by the scruff of the neck in the middle of his first speech and removed him to some place from which he would never have emerged again, and where he doubtless belonged. As nothing of the sort happened and, on the contrary, the man surpassed himself, becoming ever more deranged and monstrous, and also per more notorious, more impossible to ignore, the effect was reversed. It was then that the real mystery of the Hitler phenomenon began to show itself: the strange befuddlement and numbness of his opponents, who could not cope with his behavior and found themselves transfixed by the gaze of the basilisk, unable to see that it was hell personified that challenged them.”

To be clear, I am not equating Trump with the real-world Hitler (see Godwin’s law below).  I AM equating the Trump phenomena with the Hitler phenomena as the books’ author understands it (in 1939, before the full arc of Hitler’s monstrosity played out).  A populist vulgarian whose transgressiveness is key to both his appeal and apparent invulnerability.  Characteristic of an entire parade of horribles today – Boris Johnson?  Viktor Orban?  Le Pen?  Nigel Farage?  Etc…

The chilling part of the book is how the author narrates the inch-by-inch surrender of “reasonable people” to a madman’s unreasonable demands.  “Everyone” comforts themselves that some higher authority – the law, social norms, big business, labor – will somehow rein in or temper the madness.

It rings uncomfortably true with Democrats denial before the election (people won’t actually vote for him, will they?) and Republican’s denial after the election (he’ll surround himself with competent people! sotto voice and we’ll still get that fat tax cut and my team is winning…).

It also echoes with the “well, the country might go to hell but my team will win the next election and that’s what matters” reasoning that seems to be motivating the UK’s conservatives as well as the Senate’s Mitch McConnell.  Everyone bends a little bit – assuming someone else will step in before all is lost.

It hits dead on on the inchoate, hesitant, hypnotized impotence of reasonable people to come to grips with Trump.  that “befuddlement and numbness of his opponents, who could not cope with his behavior and found themselves transfixed by the gaze of the basilisk.

The quote above is a sad coda for Mueller’s non-performance at this week’s congressional hearings.  We had an older, respected, Republican-voting man in the twilight of his career with 7 hours on the national stage.  Put aside what his report said or didn’t say.  Sometimes the facts matter less than the truth.  As a patriot, Meuller should have lied through his teeth in the most colorful, sound-bite friendly language he could muster.  Torching his reputation for careful establishment probity to ring the alarm.  Shaking “reasonable people” out of their torpor in front of that “basilisk stare.”  Sometimes the path of true patriotism lies with shading (or ignoring) the truth…

Anyway.  I’m not despairing yet.  I don’t think Trump is all that dangerous.  Hitler was a madman.  Trump is simply self-serving.  Trump is (thankfully) proving to be a paper tiger in many matters.  But that doesn’t excuse reasonable people from confronting the un-reasoning forces propelling him.  The damage done by overt racism, jingoism, and devil-may-care spending will take a long time to repair.  In many cases, things will simply remain broken.  Especially as regards the USA’s overseas credibility, which matters more to me than maybe it should.

Anyway.  Do read the book.  You’ll better understand the chains that bind today’s reasonable people (which I assume is most readers here) in the face of the unreasonable.   And it is brilliantly written.

A book summary and “Godwin’s law” below.

Godwin’s law (or Godwin’s rule of Hitler analogies)[1][2] is an Internet adage asserting that “As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches 1”;[2][3] that is, if an online discussion (regardless of topic or scope) goes on long enough, sooner or later someone will compare someone or something to Adolf Hitler or his deeds, the point at which effectively the discussion or thread often ends.

Book summary.

Written in 1939 and unpublished until 2000, Sebastian Haffner’s memoir of the rise of Nazism in Germany offers a unique portrait of the lives of ordinary German citizens between the wars. Covering 1907 to 1933, his eyewitness account provides a portrait of a country in constant flux: from the rise of the First Corps, the right-wing voluntary military force set up in 1918 to suppress Communism and precursor to the Nazi storm troopers, to the Hitler Youth movement; from the apocalyptic year of 1923 when inflation crippled the country to Hitler’s rise to power. This fascinating personal history elucidates how the average German grappled with a rapidly changing society, while chronicling day-to-day changes in attitudes, beliefs, politics, and prejudices.

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The Scariest Chart In The World Part 1

I am re-posting this as the charts didn’t show in the prior version for some reason.  I’ve pasted them in a different format.  Please view the post in your browser if need be.

All that money the Fed has been printing?  It’s not actually circulating.  The faster the Fed prints it, the slower it seems to go.  Money went from flowing like water in the 90’s to maple syrup in the 2000’s to molasses in 2010’s. 

You don’t need to know anything about monetary policy to read the three charts below (same data series starting from 1959, 1987, and 2007 respectively).  Something has clearly down-shifted drastically since the 2007 bust after starting to slide ahead of the 2000 bust.

That something is “monetary velocity.” Best understood by its folk definition – how fast a dollar bill changes hands as it moves around the economy.  Calculated as the quantity of money floating around at a given level of GDP.  A little money moving quickly = high velocity.  A lot of money moving sluggishly = low velocity.

What makes this double scary is the final chart, which is (roughly calculated) monetary velocity for Japan since 1996.   The Japanese have been printing money like mad, but its circulation has just decelerated.

I’m going to pick this up in a subsequent post, but take a look at these charts.  Take a look at the excellent post cited below.  Let it all rattle around for a bit

Velocity 1959 – Present

Velocity 1989-Present

Velocity 2007-Present

Japan chart (roughly calculated myself as GDP divided by M2 Money)

Rough Calculation of Japanese Monetary Velocity 1996 – Present

A more textbook explanation of Monetary Velocity follows (the linked piece is excellent BTW)

Money velocity, as might be suggested, isn’t necessarily how frequently a certain $1 bill exchanges hands in the economy through financial transactions. Hence the concept of money velocity spuriously suggests that its increase comes as a consequence of economic actors’ increased willingness to spend the same amount of money at a faster pace. But that’s not actually what’s taking place. Rather, money velocity is more accurately a measure of the rate of credit formation.

If the product of the money supply, M, and the velocity of money (i.e., credit formation), V, increases – i.e., M*V – this will either increase prices, P (i.e., inflation), increase real output, Q, or both.  The relationship was first expressed by Irving Fisher back in 1911: M*V = P*Q

P increases through an increase in spending. Q increases if the sum of productivity growth and growth in the number of hours worked in an economy increases.

One common criticism of central banks in recent years has been seemingly profligate monetary printing, or the idea that vast expansions of the money supply are inflationary. This is not correct, given that this money needs to be spent before it can influence prices and therefore inflation.

This is, for example, why Japan is expanding its money supply so rapidly. For demographic and other reasons, Japan has been fighting the ogre of deflation for nearly three decades. If the demand for lending remains low and credit isn’t formed in sufficient enough quantities – i.e., a fall in V – then the Bank of Japan has no other option but to keep expanding the money supply, M, in order to keep M*V above its previous mark.

If M*V falls, deflation sets in. This is bad, given some low level of inflation is necessary to incentivize consumption, which is primarily how developed economies grow.

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Why the Fed “Has” to Cut Rates.

The Fed “has” to cut its short-term rate.  Why?  Because their current lending rate seems to create an arbitrage incentive for banks to NOT LEND.  As currently structured, the Fed’s rate policy appears to be an active drag on the economy.

The chart below shows three interest rates.

  1. The Fed’s (now 2.35%) Interest on Excess Reserves rate: “The IOER is the interest rate paid to banks for the deposits they hold with the Federal Reserve above those required by banking regulation.
  2. Market rates on 1 year (1.8%)  and 2 year (2%) Treasuries.

What if someone could borrow at the 1.8% or 2% treasury rate and put that borrowed cash to work earning that IOER 2.35%  rate?  It is only a  0.35% to 0.55% profit, but it is (literally) risk-free.  Someone can do exactly that.  Federally chartered Banks are the only entities that can make deposits at the Fed and earn that IOER.

https://fred.stlouisfed.org/graph/fredgraph.png?g=o7S0

I have NO IDEA if this is actually happening out there.  But that dynamic may be one reason why market-driven rates went into free-fall shortly after crossing over the Fed’s 2.35% IOER rate (see chart below).  A whole lot of banks exploiting a free money opportunity.  Regardless, the gap leaves the Fed exposed until they cut the IOER (which means a general rate cut).

The problem with the above is twofold.

  • Earning risk-free money at the Fed is a lot less work than the hard work of lending money to living breathing economic actors.  So the bank’s incentive is to sit back and earn deposit money at the Fed, not stimulate the economy.
  • The arbitrage profit gets BETTER as market-driven rates fall.  The selling pressure of a bank selling (imaginary) treasuries into the market would tend to push rates lower.  So the more banks sell to fund the trade, the more they will earn on the trade.  That is the really dangerous dynamic.

A caveat that this is just my thinking.  I may just be howlingly wrong on some important bit of the mechanics.  But the numbers above are real and there is clearly something broken in there.

There are any number of clever ways to sell Treasuries (that you don’t actually own) which effectively puts you on the hook to pay the interest on those Treasuries – 1 year treasuries (promising to pay 2% to the seller) or 2 year treasuries (promising to pay 1.8%).   So you sell $1b fake treasuries to someone promising to pay 1.85% (a 0.05% premium), they turn around and deposit that $1B at the Fed where it earns 2.35%.   It’s only a $500,000 profit on that $1b, but if you add a few more zeros it adds up…

And in answer to the next question – Yes, that is a hidden subsidy to the banks at the expense of the real economy and your average hard-working man on the street.  So happy you asked.

And in answer to your next question.  No, you can’t just go to the Fed and deposit YOUR money at 2.35%.  Because they don’t let little people (or even really big but non-bank-magic-circle people) step up to that deposit window.

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Trump’s Mexico Tariff Gambit May Be Good News.

After my initial dismay at the Mexico tariffs news, a certain optimism began to creep in.  The move is a disaster when seen through the cartoon lens of “Trump is a loose cannon.”   But it shows a way out of the current trade/economic mess if you start from “Trump is a pretty darn good reality TV show director.”  

To sketch this out;

  • Trump is in a bind with the China trade war.   He and the Chinese have no face-saving way to get out of the mess.  In TV terms, the plot-line has hit a dead end.
  • So you introduce a plot twist!  Some way to blast yourself sideways out of a narrative dead alley.  No matter how implausible.  “It was all a dream.  JR/John Snow/whoever really isn’t dead.”  Whatever it takes to shift the narrative.  Distract the audience, but keep them tuning in.  “Trade War with Mexico!!!” fits that bill.
  • Trump can get the “win” with Mexico he can’t get from China.  Some sort of toothless agreement with appropriately deferential noises from the Mexican government (said through gritted teeth with fingers crossed).  Because the US can’t push China around, but we can definitely push Mexico around.  Mexico’s tepid reaction suggests they understand the game and are (necessarily) willing to play along.
  • Conflate and confuse.  A “win” with Mexico is loudly announced around the same time as the less-than-a-win with China.  The halo effect keeps Trump’s faithful “tired of winning so much.
  • By August, Trump has talked tough, done little, and the economy/markets are back to business.

The timing for all this drama also comes into focus through that reality TV lens.  Trump is running the show to get it renewed for another season.   Putting us in act 3 of a four act play.  You build dramatic tension and drama in the 3rd act (keeping viewers engaged).   You use the 4th act to deliver a neat and tidy resolution – just in time for the applause election.

The above might be a little too neat and tidy.  But that is the point of good reality TV.  It is falsely tidy drama, not real “reality.”  By all reports, Trump learned a lot from “The Apprentice.”  That is arguably what got him into the White House.  It is definitely how he is going to try to stay there.

 

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Damned if We Don’t. A Glimmer of Hope if We Do. Worried The Fed “Don’ts” Instead of “Do’s.”

Lets do what so many self-described free-market thinkers won’t;  believe the market is smarter than a few, very human folks at the Fed.  A now-decisively inverted yield curve is the bond market “telling” the Fed it needs to cut short-term rates.

Cutting rates should re-draw the yield curve by pulling down the left side of the line (short-term rates) and cranking up the right side (long-term rates).  That will be perceived and experienced as a stimulus.  Markets will rip and etc. etc.  If the Fed doesn’t cut rates, we risk a recession.  The market is telling us cutting rates is the right thing to do. 

If the market is right, why is the Fed is shuffling its feet?  Partly because today’s economy seems so strong and unemployment so low (present situation bias).  Partly because it fears future impotence (“impotence” just is not a happy word).  So does the Fed ultimately choose action or inaction?

  • If the Fed acts by inaction.  The yield curve tells us we’ll have a recession sooner versus later.  When it comes, the Fed will fire all the bullets in its policy weapon.  That intervention will likely prove inadequate.
  • If the Fed acts by cutting rates.  This defuses the immediate recession risk.  The economy probably ticks along nicely for a while – tariff threats notwithstanding.  But the Fed unloads most of its policy ammunition.  Leaving the Fed powerless when some future shock tips us into a recession.

Whichever path the Fed takes, we end up (faster or slower) in the same place.  Out of bullets on conventional monetary stimulus.  Wallowing in a downturn or possibly spiraling into a deeper depression.  Unable to deploy the weapon of (meaningfully large) fiscal stimulus; politically hog-tied by 30-40 years of faith-based rejections of “wasteful government spending” in any guise at any cost.

Eventually our politics would change enough to substitute fiscal stimulus for monetary stimulus.   But remember that means turning over the Senate, not just the White House.  Call me in 2024?

There is a a third possible scenario if the Fed cuts rates quickly nowSomething somehow somewhere (gasp) sparks some decent (3%-4%) inflation.  The economy “overheats.”  That is serious-people-Fed-speak for workers regaining bargaining power and clawing wage gains back out of cash flows currently shifted to record-high profit margins.   Debt risks diminish as inflation eats away at now-low-real-rate mortgage and bond obligations.  The strong economy auto-reloads the Fed’s policy weapon as inflation pushes nominal interest rates ( real growth + now-higher inflation) back to more normal 5%-7% levels.  Everyone lives happily ever after.  Even the anti-government spending crowd wins in the same way as anti-vaxxers that manage to avoid the reality of a measles epidemic – they don’t even have to question their own faith-based delusions.

I’m worried the Fed doesn’t cut rates.  Pretending they are smarter than the markets.   Tipping us into a self-inflicted, unnecessary recession.  Why?  Because cutting rates leaves the Fed powerless to intervene in the future.  “Powerless” isn’t a word any institution willingly embraces.  Although “recession” isn’t a great word either – especially if it improves the chances of anti-bank-crusaders Elizabeth Warren or Bernie Sanders in 2020.  It’s a tough choice, but reality is a tough place.

Absent rekindled inflation, we’ve seen this movie before.  In Japan.  It’s a long slow slog without much drama to enliven the misery.  So really, most people haven’t really seen this movie before (myself included).  The Japan story was a depressing financial widow-maker that played out to a shrinking, now-tiny audience.  Most people read the (terrible) reviews and stayed far far away.  I think that is why I’m finding it so hard to find much decent English language insight on Japan’s last 20-30 years.  Even though it might foretell our next 20-30 years.

We’ll know about the Fed’s decision in the next 6 months.

  1. If they don’t cut rates, we have a clear and present danger.
  2. If they do cut rates, we watch (and hope) for inflation, but plan for something far worse.  Maybe a crash course in modern Japanese economic history (ugh).

In this post, I’m going to assume  you’ve read my post linking to the excellent NYTimes article explaining our out-of-whack interest rate environment.   If you haven’t, swing over and give it a skim.  We’ll wait.  Just don’t wander off to that click-bait cat video mid-way through.

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Required Reading. Seriously. Make the Time. Forward It.

Its 2007.  Someone sends you a simple, definitive article on mortgage-backed securities.  You shrug and move on to a cat video.  2 years later, struggling with a financial meltdown, you wish you had taken time to read it.

In that spirit, review the attached piece.  It is the best layperson’s summary I’ve seen for what is currently going on out there with the price of money.  The charts alone are worth it.  Not saying we have a repeat of 2008-2009 ahead, but something is definitely wonky out there.  And we could.

From The New York Times:  The Bond Market Is Trying to Tell Us Something (Worry)

Bond yields, the yield curve, inflation expectations, Fed-rate predictions. The bond market might seem indecipherable but it’s full of important clues about the economy.

 

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Calix (CALX); A Hobby Farm, But Still 2x or Greater Upside

One last post on Calix and then back to my regular not-so-scheduled programming.  Actually I’ve got a backlog of posts so I’ll try to space them out.  I sent the below out vie e-mail last night, but figured I’d post here too.  Partly to have a “live” copy up for later reference.

I figured I owed an update on Calix after a pretty eventful month. Over the course of May, I’ve written two letters to Calix’s Board and met once with Calix’s Chairman Don Listwin. I also wrote an investment outlook in Seeking Alpha. All are attached at the bottom of this post.

The meeting with Calix’s Chairman was productive, but not constructive. My specific suggestion was that Calix hire an empowered, execution-oriented COO to balance its more visionary CEO. He flatly rejected that idea. Nor did he accept my other concerns.

My “Getting Better or Getting Worse?” conclusion is below, but I would encourage you to read the attached documents. The letters were carefully written to be as constructive as circumstances allowed.

The Seeking Alpha investment write-up was my attempt to answer the Chairman’s repeated question of “If you are so unhappy, why don’t you just sell the stock?” That I would instead try to effect change as a co-owner seemed to perplex him. More worrying, it seemed equally beyond him that Calix’s Board might take action itself. His passivity left me perplexed in turn.

Getting Better or Getting Worse? Getting Better, but Calix Will Always Be a Hobby Farm.

Per my 3Q18 comment, “things are good enough even these yahoos (probably) can’t screw it up.” I was wrong then, but still (I think) directionally correct..

Short Term – Positive Catalyst Ahead

  • Calix remains cheap vs estimates for a reason. No-one has confidence they can execute and actually hit those estimates. The cash situation is now also dangerously tight – the immediate reason I decided to write to the Board.

  • But all that negativity baked into the stock also creates a clear, near-term positive catalyst if they fix recent production problems. Critically, that fix is less a bet on Calix’s (in)competence and mostly a bet on the competence of their outside contract manufacturer. The CM’s are generally competent folks, so this is probably a good bet at the current price.

  • Calix still has great technology with customers that will drive strong revenue growth as 2019 plays out. The second half of 2019 was always going to show solid organic demand.  The 1st/2nd quarter production shortfalls will further boost the second half by adding in catch-up sales on previously unfilled orders. That solves for a strong 2H19 which should put Calix back on the path past $11. Where it was in December before their most recent screw-ups.

  • From there, I’ll re-assess my position. Factoring what I’ve learned about Calix’s long-term execution and governance weaknesses into that decision. See the attached Seeking Alpha article for more details, valuation and price outlook.

Long Term – Calix Will Never Amount to More Than a Hobby Farm (Absent External Activism).

  • If Calix had better management, Calix could be a great company. It doesn’t. It won’t be. Calix’s Board is unlikely to change or shore up current management.

  • In my letters and meeting, I did my best to puncture the bubble of mutually-reinforcing self-regard surrounding the CEO, Chairman, and at least one other Board member. I believe I failed to do so. The emperor still thinks his new clothes are just dandy. His buddies are still reassuring him “everyone” agrees. The parade goes on. I’ve got a more psychologically explanatory analogy rooted in Orson Welles “Citizen Kane,” but it was too much to dive into here.

  • In short, Calix will remain a hobby farm – run primarily for the CEO and insider’s gratification. I did consider that risk 3 years ago. My bet was the CEO would fear the public shame of investor indifference (now verging towards ridicule) more than the private shame of asking for (needed) help. That bet proved wrong.

Depressing, but still a 2x or more return from where it is today. Going from “Awful” to “OK” still makes for a nice gain.  Its too bad going from “OK” to “Good/Great” looks so unlikely. But if Calix’s CEO and Board won’t square up to that, we don’t have to stay along for their ride.

Meeting with Chairman Don Listwin – Productive, But Not Constructive

Productive. I learned a lot.

  • I learned a lot about Calix’s governance. Or lack thereof.

  • I came away more confident with the bet Calix likely recovers from its production woes and posts decent 2H19 numbers. Why?  The Chairman seemed to be almost daring me to sell out at $6.50.

    • From his tone, he was presumably anticipating my future regret after CALX’s price recovered. I read that as confirmation he believed the short-term cash situation is manageable and the contract manufacturer is likely to resolve the production problems. Of course I may have misread him. Also his confidence in Calix could prove misplaced.  It has certainly disappointed before.  Per the attached article, I’m basing my bet on the more solid plank of the contract manufacturer’s competence and incentives. Plus what we already know publicly about customer demand.

But Not Constructive. I concluded Calix is a hobby farm. Per my meeting wrap-up notes.

  • Chairman Don Listwin does not seem particularly interested in constructive engagement with shareholders. He seems to view public markets investors more as renters than as co-owners. He expects shareholder concerns to be dealt with by shareholder exits, not by Board action. He asked me several times “why haven’t you just sold the stock.” I felt like a vexatious tenant being asked by a landlord “if you’re so unhappy, why don’t you just move out?” It was not a conversation between co-owners.

  • He did not see scope for the Board to take action that might realize more value faster for all owners. In general, he had a curiously passive, victim’s view of his and management’s role at Calix.

    • He seemed to view the low share price as reflecting poor judgment by overly short-term investors. The valuation stemmed from the market’s lack of vision, not investor’s lack of confidence in execution based on Calix’s prior track record.

    • What I saw as mis-execution, he saw as Calix management falling victim to unfortunate external circumstances.

    • He did not see room or reason for the Board to take action that might improve or reinforce management and execution.

  • Absent a split within the Board, I concluded further private engagement with Calix’s Board probably wouldn’t be constructive or productive. I remain unclear as to why the activist investor on the Board (Dan Plants of Voce Capital) has had so little impact. Regardless, given the above, internal change is unlikely at Calix given the current Board. Change will come either through further external activism, or not at all.

The Seeking Alpha Article

Don kept pushing me on why I hadn’t sold already. I went away and asked that same question myself.  The article linked to below and attached came out of that exercise.  Setting out the balanced investment case as I saw it. It is worth a review if you own CALX yourself. With particular reference to the section on management and governance.

Why did I publish it? I saw no point in further dialogue-of-the-deaf. So I figured I would make double use of the write-up.  Seeking Alpha is a crowd-sourced research site. I’ve found it a useful resource for under-followed stocks. I figured a write-up there would shine a light into an otherwise ignored corner of the market. Any illumination is better than none, even if it necessarily casts a fairly harsh light.

https://seekingalpha.com/article/4264289-calix-cheap-reason

Calix_ Cheap For A Reason – Calix, Inc. (NYSE_CALX) Seeking Alpha

Letter 1 & 2 Both to Calix Board April May 2019

Calix A Hobby Farm But Still 2x Return Update 26May2019

 

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Calix (CALX) The Hobby Farm Model isn’t Working for (Non-Executive) Shareholders.

As some of you may know, I have a fairly large investment in a Telecommunications Equipment company by the name of Calix.  I actually have a very modest profit in that investment, but it has been a tough 3 years.  The chart (CALX) looks like an EKG of a heart-attack.  It has felt like that too.

The lived reality of the past three years has been sort’ve the inverse corollary of the Warren Buffet quote.

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”  Warren Buffett

Particularly frustrating is that Calix’s future prospects looked good three years ago and, today, they have never looked better.  Really!  Seriously!  You just have to get over the 25% drop in February followed by the (self-inflicted) 15% drop in March.  Look to the future!  It gets a little old.

I find myself today on a bit of a tightrope.  Fed up and concerned about a series of self-inflicted disasters.  But painfully aware the next 12-18 months “should” finally see Calix realize its potential.  With that oh-so-slippery term “should” being the primary source of my present and past discomfort.

I am but a humble individual.  But I can’t just shrug and not try to do my part, however small, to try and nudge the company onto a more steady path.  To that end….

See link below for a PDF version.  It is a LOT more readable.

Letter to the Calix Board of Directors, 28 April 2019.

As a vote of “No Confidence,” I plan to WITHOLD my shareholder votes for Calix CEO Carl Russo’s nomination to Board. I detail my concerns below. The voting deadline is May 21.

A substantially identical version of this letter was received by Don Listwin, Calix’ Chairman on April 24th, 2019. It is not clear if the that letter was ever forwarded to the full Board as addressed and as requested.

I sent a follow-up to individual Directors on April 28. The text is below. I do know that follow-up was delivered today, April 29th.

Calix’s Earnings Call is Wednesday May 1st. I thought it important to note these concerns before the call. Before the message risks being swamped by the details of and market reaction to Calix’s 1Q19 production problems and 2Q19 guidance.

Steve Kamman , Berkeley, CA

April 28, 2019

Calix’s Board of Directors Individually and Collectively.

c/o Corporate Secretary, Ms. Suzanne Tom

Calix

Dear Mr. Christopher Bowick, Ms. Kathy Crusco, Mr. Kevin DeNuccio, Mr. Mike Everett, Mr. Don Listwin, Ms. Kira Makagon, Mr. Michael Matthews, Mr. Kevin Peters, Mr. J. Daniel Plants, Mr. Carl Russo,

I have grave concerns about the current and future direction of Calix. I assume you share many of them. Sometimes it helps to have someone else put those concerns into words. Hence this letter.

Carl needs help. He may be too proud to admit it. But you can help him nonetheless.

In my view, Calix needs a strong, empowered COO to help Carl run operations day-to-day. Someone whose joy is making the trains run on time.

Calix has the potential to do great things. But it needs someone to dig in and do those things. It needs consistent, focused, careful execution that drives steady cash flows. Especially given how far Calix has run down its cash reserves.

Taking that load off Carl serves the best interests of the majority of (non-executive) Calix shareholders. A COO’s salary is less expensive than a cash raise.

Continuing with an un-changed executive structure would amount to repeating the same experiment, but hoping for different results.

Carl Needs Help. He’s Taken Calix as Far as He Can Alone.

Carl has taken Calix to the cusp of great things. He has delivered inspired, visionary innovation. But his execution has taken Calix to the brink of a cash crisis.

  • The trap was loaded by spending $40 million of cash reserves on share buybacks just before losing tens of millions on cash-burning Services contracts – all while operating at a structural loss.

  • Calix now risks springing that trap shut after mis-executing a crash plan to shift production out of China in only 2 quarters.

  • We are one mis-step away from a ruinous cash crunch.

In his prior roles, Carl has done best when paired with strong, operationally-minded executives to handle the day-to-day. Calix shareholders have suffered from the absence of that complementary, counter-balancing skill set.

Calix’ stock is @60% below its $13 IPO price over a period the S&P 500 returned 198%. CALX has generally traded below 1x EV/Sales for 3+ years. The company has burned down cash. It is now navigating its 2nd self-inflicted operational crisis in 2 years. We may risk a cash crisis. All against an improving economic backdrop.

I’ve Owned a Lot For a Long Time. I Know Calix and Carl Well.

I own XXX,000 shares of Calix (some since 2011). That puts me among your top 10-20 shareholders. If you eliminate computer-driven and index funds, I am likely one of your top 10 human shareholders.

I know Telecom Equipment and Calix. I covered both at Fidelity Investments and CIBC/Oppenheimer since 2001. At Fidelity, I bought into Calix’s 2010 IPO at $13. Over 2011-2013, I experienced first-hand a now-familiar pattern of bold promises (taking CALX to $22) and weak follow-through (driving it down to $5).

I also know Carl Russo well. I first met Carl in 2001. I am personally fond of Carl. But I have done my due diligence over those 18 years. Carl is a visionary thinker and a great salesperson. He is less strong in execution.

Over the past year and a half, I have sought to engage with Carl. I have concluded that is no longer, and may never have been, constructive.

Calix’s Recent Track Record Points to Continuing, Structural Weakness in Oversight, Controls, and Operational Execution.

Operational discipline has been a recurring weakness at Calix since the IPO. But I will focus here on patterns over the past two years. In 2017 and now 2019, mistakes were made that lie directly in the remit of a CEO or COO.

  • Supervision, oversight, and remediation of Executive-level errors.

  • Internal communications and chain of command.

  • Investor communications, relationships and reputation.

2017: Unrealistic targets, weak oversight and flawed execution dragged Calix into a self-inflicted crisis that consumed tens of millions of dollars. We can’t quantify revenues lost from un-signed customers worried about viability/valuation. Most investors walked away.

Carl is not responsible for negotiating those money-losing Services contracts. But look past that immediate error. Consider the response that followed.

My concern lies in how long it took 5 to 8 months – to uncover, investigate, and scope those losses. It was a delayed, fumbling reaction that points to deeper structural problems. That failure of supervisory oversight was the CEO’s responsibility.

  • On the May 9, 2017 call, Calix gave guidance for an extremely strong second half rebound. This was based on (false) confidence the Services problem was confined to Windstream. In retrospect, that guidance was clearly fantastical.

  • Evidently, 5+ months in, senior executives still hadn’t understood the breadth and depth of the baked-in contract losses that would drag down the rest of 2017. Calix had already fired the executive responsible. Why hadn’t anyone dug deeper by May 9th? An effective operational manager would have immediately investigated and quantified the risks embedded in all the contracts. Instead, Calix sailed on blindly toward an iceberg dead ahead.

  • A broken internal communications dynamic most likely explains how senior management remained ignorant long enough to deliver that fantastical May 9th guidance. It took 5 to 8 months for executives to understand the damage buried in those contracts. It beggars belief that lower-level staff at Calix didn’t already know more Services contracts were rotten. So why didn’t senior management know until sometime between May 9th and August? Middle and line management clearly chose NOT to pass the bad news up the chain of command. Senior management didn’t dig deep enough to find out. Then it bubbled up in the numbers.

  • Calix didn’t disclose the damage to shareholders until the scheduled August 2017 call. With no pre-announcement, the result was a chaotic “surprise” call that lacked clarity. The stock dropped @40%. The reputational damage was far greater. Analysts have dropped coverage. Meeting schedules are hard to fill. I know first hand than many investors have simply removed CALX from consideration. Calix is generally perceived as a sort of “hobby farm” for Carl.

2019 – Echoes of 2017: Calix is exhibiting a similar pattern of failure in the botched production shift out of China. I do not yet know, before the call, how bad the situation truly is. Even if it isn’t as bad, 2019 bears the same hallmarks of insufficient oversight and poor internal/external communication.

  • Overly aggressive targets set beyond the organisation’s capability to deliver.

  • Weak oversight of day-to-day execution to reach those targets.

  • Delayed recognition and/or disclosure of the problem. Calix held its call on February 5th. Someone at Calix already had to know production was going badly 5 weeks into the quarter with only 7 weeks left to go.

    • If Senior Management didn’t know. Why isn’t bad news making it up the chain? What structural/cultural failings does this point to?

    • If Senior Management did know. Wasn’t it already evident by February that Calix would struggle to make its 1Q19 production goals? Why wasn’t that disclosed? When was the Board told?

    • The February call also saw a -25% stock price drop from a revenue miss Calix’ management did not judge material enough to pre-announce. News that cuts the price -25% would seem “material” by definition. That judgement call further undermined investor confidence in Calix.

To Achieve Carl’s Vision, Calix Needs Someone to Execute On It. A Different Skill Set.

Steady, focused, operational oversight is critical at any company. A repeated pattern of failure in 2017 and 2019 makes clear that is lacking at Calix.

Carl is a visionary thinker and a brilliant salesman. He deserves tremendous credit for bringing Calix to the cusp of great things.

But Carl is (still) operating without the effective, empowered counter-balance he so clearly needs. That balance was key to his prior success.

Mistakes will be made. A COO won’t stop that. A strong COO can minimize shareholder’s losses from those mistakes. Surfacing problems before Calix sails blind into an iceberg. Setting achievable targets with realistic margins for error.

At this point, Calix needs execution more than it needs vision. Especially given the tight cash situation. Hiring a strong COO will cost shareholders less than raising cash on ruinous terms.

An Intervention Serves the Best Interests of Non-Executive Shareholders. The Board Should Help Carl. Even if He Isn’t Asking for Help.

Today, Carl is still alone at the helm. He is too stretched. He has no-one to counterbalance his blind spots. He needs someone.

The situation does not give me a great deal of confidence in Calix’s prospects. Especially over an operationally critical 2 years with so little cash on hand.

I invested in Calix because its valuation did not appear to square with its future prospects. Today, Calix still could be on a path to great things. That much-delayed potential is why I have so far held on to my investment.

  • With Verizon, CityFibre, and others ramping up spending, 2020 Revenues of $500m to $600m and Earnings of $0.50 to $1.00 seem reasonably achievable.

  • With 5G ramping up and broadband becoming a basic utility, revenues and EPS well above that are achievable in 2021 and beyond.

Calix just needs focused, steady, patient execution.

Carl needs help.

Hire someone to help. Get the trains running on time.

Your views may differ, but I am sure you have considered some of this yourselves. My hope is this letter might clarify those thoughts and encourage you to act on them. I look forward to discussing this further.

Sincerely yours,

Steve Kamman

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