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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About That “We’ll Close the Strait of Hormuz” Thing…

Iran renewed its oft-repeated threat to close the Strait of Hormuz  2 days ago.  This in response to the US cranking up sanctions to cut off all Iranian oil exports.  Markets and analysts shrugged.  Iran’s made this threat before and never followed through.  Why would it be different this time?

But the sanctions are different.  The response could be too.

The US is seeking to cut off ALL oil exports by Iran.  Its questionable if that will succeed.  But lets assume it does.

We cut off Iran’s ability to export oil.  Holding the Iranian economy hostage to achieve our (to me unclear) goals

Iran, backed into a corner with nothing to lose, takes the global economy hostage in response.  Iran cuts off the Strait of Hormuz.   “At its narrowest, the strait has a width of 21 nautical miles (39 km).  About 20% of the world’s petroleum (about 35% of the petroleum traded by sea) passes through the strait.

All hell breaks loose.  Oil prices spike.  Gas lines re-appear.  Markets crash.  Plagues of locusts.  Etc…

Or maybe not.  But its worth considering.  Particularly given this administration.  Trump has so far been lucky to avoid an improvisational, not-thinking-through-the-full-consequences, crisis.  This could be where our luck runs out.

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Elizabeth Warren May Win. Even if She Loses.

Watch Elizabeth Warren.  Whether she gets the Democratic nomination or not, she is methodically driving the agenda.  No matter how many votes she pulls, she’s setting up her ideas to win.

Warren is like Sanders in 2016.  Remember that he never expected to get as far as he did.  The real goal was always to shift the terms of debate.  Warren is following that same strategy.  The more specific proposals she puts down, the more she forces others to reply with specifics of their own.  Even if she loses in the primaries, she will have “won” in that longer game.

And if she does win the primaries.  These are some dangerously populist specifics…

  • Democratic presidential candidate Elizabeth Warren has identified something else to finance with her proposed wealth tax: wiping out student debt and tuition at public colleges.
  • She says her proposal would benefit 95% of the 45 million Americans carrying student debt and wipe it out for 75% of them.
  • Warren’s plan would also cut off federal money from for-profit colleges, which she says “enrich themselves while targeting lower-income students, service members and students of color and leaving them saddled with debt.”

The danger of these ideas is their simplicity.  Free money for “me” by taking back from “them.”  Like a certain kind of Republican lies to him/her self that cutting “waste, fraud, and abuse” will somehow pay for tax cuts deficit spending.  Warren’s proposals are equally simplistic, unrealistic, and enabling of the same comfortable self-delusion.  Everyone sort’ve knows its a lie.  But hey – I’ll get my money and the devil take the hindmost.  If 45 million debtors/ votes start thinking that way, its powerful stuff.

It is going to be really really really hard for Trump to combat these sort of ideas without either cranking up the coarse culture war (losing more suburban women voters) or responding with MORE specific “simple” policy proposals of his own.  Trump will probably do both.

Trump tries to avoid policy specifics, but he loves the big promises to “do stuff” about populist pain points like infrastructure, drug prices, health care, education, etc…  Warren is calling that bluff.  Making similar promises with more specifics.

It doesn’t matter if her proposals are also unrealistic.  What matters is the shift to specifics.   They sound actionable.  More than anything Trump has offered (so far).

Trump clearly has no principles.  If has to out-populist Warren, he’ll gladly throw Mitch McConnell and establishment Republicans under the bus.  As a serial thrower-of-people-under-buses, he’d probably enjoy it.

The resulting specifics will anchor the debate in the territory of left-wing populism, no matter who gets elected.

For those who see the world in terms of “Makers vs. Takers,” that would qualify as a nightmare scenario come true.  For “the establishment,” (of whom I am a card carrying member), this creates a pretty awkward choice on who to vote for.   For the Republican-leaning folks in the the establishment, the above solves for a double whammy.

A lot of affluent folks just paid a much higher tax bill last week.  A bitter harvest for loyally voting Team Republican.  If Warren’s strategy succeeds, they may have even more reasons to regret for putting tribal loyalty over self-interest.

Voting against Hillary created a vacuum.  Warren is aiming to fill it with her ideas if not herself.  If her ideas catch fire, it really doesn’t matter how she does herself.

 

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“Secrecy, Self-Dealing, and Greed at the (fill in the blank here).” Feeling Almost Sorry for the NRA.

Sharing this summary (below) from Axios and looking forward to reading the actual New Yorker piece on actual paper when it arrives in the actual mail (quaint I know).

It leaves me genuinely sorry for the ordinary people still bankrolling the NRA.  A zillion years ago, there were reasonable NRA supporters out there.  Some have stepped off the crazy train.  But how many have been taken along for a ride ending somewhere their 15-years-ago self would hardly recognize (or approve of)?

But this isn’t just the NRA.  So many other institutions have trod the same path into self-dealing malignity.  This sort of rot has set in equally across Right and Left, Labor and Capital, or most any such divide.  So much of what people see as a “deep state” conspiracy is much less organized and much more banal.  It is just deeply greedy people doing what gets them paid.  Consequences be hanged.

  • Private equity taking down so many retailers.  Amazon gets the blame, but its mostly asset stripping.  Load up the debt and extract dividends until it bleeds to death from lack of staffing and inventory.  Sears.  Toys’R Us.  Payless Shoes.  Etc…
  • Hillary Clinton’s campaign.  Social media is more effective, but political consultants don’t get paid a percentage on it.  TV ads aren’t doing squat, but an anointed insider group DOES get paid via side-deals.  Where would you guess Hillary’s spend went?  Into a (very profitable for some) rathole.
  • Facebook and (increasingly) Google.  Creeping after that next dollar across the line between “invasive” and “creepy” and heading inexorably towards “just plain evil.”  Facebook is at least sort’ve transparent about it.  Google is still clinging to the shreds of its own “don’t be evil” self-delusion.  And Apple only seems less evil because they are making a virtue out of failure (to monetize our attention as effectively).
  • Fox News going from “biased media” to “Shameless Party Propaganda Organ.”
  • For-profit education (predatory but well marketed) displacing community colleges (helpful, but not so marketing savvy).
  • Private prison companies seeking to expand into immigrant detention prisons facilities by hyping up anti-immigration sentiment.
  • Insert your favorite example (Left or Right) here…

Working your way back in time, I find myself stopping somewhere in the Gordon Gekko “greed is good” ethos of the late 80’s and early 90’s.  The boomers were young, wearing those yellow ties with the dots on them, drinking Amstel, and doing deals.  Today, they are reaping what they sowed.  As are all the rest of us.  Sigh.


8. “Secrecy, Self-Dealing, and Greed at the N.R.A.”
“The N.R.A. is now mainly a media company, promoting a life style built around loving guns and hating anyone who might take them away,” writes Mike Spies in a deep dive for The New Yorker.

  • Spokesperson Dana Loesch and activist Colion Noir are the organization’s most famous faces, but they “are not technically employed by the N.R.A. Instead, they are paid by Ackerman McQueen, a public-relations firm based in Oklahoma.”
  • “For more than three decades, Ackerman has shaped the N.R.A.’s public identity, helping to build it from a niche activist organization into a ubiquitous presence in American popular culture.”

Why it matters: This relationship seems “to be largely responsible for the N.R.A.’s dire financial state. … [A] small group of N.R.A. executives, contractors, and vendors has extracted hundreds of millions of dollars from the nonprofit’s budget, through gratuitous payments, sweetheart deals, and opaque financial arrangements.”

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Platypus As a Service. Why I Own Atlassian

I recently did a short, intentionally light-hearted Atlassian write-up.  So sharing it here.  I own a big chunk of Atlassian for the reasons below.  I plan to keep it for 5-10 years.  Note, however, that it is very richly valued and this is in no way a  investment recommendation.

I am also fond of Platypi…


The Platypus and the SAAS company Atlassian have two things in common. Both are native to Australia and both are unique in their class. The Platypus is the only mammal that lays eggs. Atlassian is the only major SAAS (Software as a Service) player without a salesforce.

Conventional wisdom holds that software is sold, not bought. Most SAAS companies have invested heavily in Sales and Marketing. In the last year, SalesForce spent 46% of revenue on Sales. ServiceNow spent 46%. ZenDesk spent 49%. WorkDay spent 32%.

Last year, Atlassian spent 0% of revenue on Sales and 21% on Marketing its software development and workflow tools.  I won’t even try to detail what the software does here.  Suffice it to say that, with 138,000 paying customer accounts and 39% revenue growth last quarter, Atlassian’s services have evidently been bought not sold.

Atlassian still posted a -1.5% operating loss in 2018. Where did it spend? Atlassian plowed 46% of revenues back into Research and Development. Contrast that with R&D/revenue ratios of 14%, 20%, 27%, and 43% at Salesforce, ServiceNow, ZenDesk, and WorkDay respectively.

So software that sells itself isn’t cheap to build. But R&D spending accretes and compounds in value over time. Most Sales spending walks out the door every night. In the next ten years, most SAAS investment will go into making Sales millionaires. Atlassian’s investment will be building a mountain of well maintained code.

That code mountain will stack up high versus others. Atlassian spent $475m on R&D in 2018. Almost as much as ServiceNow on less than half the revenues. That dollar spending level is probably enough to both maintain Atlassian’s base and invade adjacent markets. Notably, Atlassian is already attacking ServiceNow’s and ZenDesk’s Service Desk markets from the bottom up.

R&D investment also doesn’t increase in lock-step with revenue growth like Sales spending does. Atlassian will eventually level off R&D investment and drop incremental revenue growth directly to profits. Atlassian’s peers risk slowing revenue growth if they ever ease off on Sales spending.

The Platypus hasn’t had much success outside of its singular ecological niche. The oddities of its Antipodean cousin Atlassian, however, may give it an evolutionary advantage over its conventional peers.

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The Squandering of American Soft Power. FAA Down. Is the FDA Next?

We seem to live in a squandering age.  Particularly when it comes to namby pamby intangibles like “trust,” “truth,” and “influence.”  The debacle of the FAA and the 737 MAX aircraft is a particularly depressing example.   Over the course of 48 hours, decades of accumulated soft power just went down the drain.

The world used to gladly outsource aviation safety regulation to the FAA.  If we said it could fly here, it could fly anywhere.  A clean example of US soft power.  The benefits of setting the regulatory agenda also accrued here.  It is one reason Boeing has done so well for so long.

The long-term-greedy, cynical, smart response to the Ethiopian Air crash should have been an immediate grounding of the 737 MAX.

  • The long-term greedy solution is always to get ahead of the problem and look like a leader.
  • The cynical solution is always to ostentatiously “make” a decision for a course of action you will be forced to take regardless.
  • The smart solution is to ground the damn plane before it kills more people.

Instead, the FAA diddled around.  The Chinese and Canadian aviation regulators announced groundings.  When the FAA finally did act, they came out looking like craven, corrupt, captured regulators.

The first rule in the Craven Corrupt Captured Regulator Handbook is “don’t obviously appear to be a craven corrupt captured regulator.” This was just dumb. Even a corrupt cop knows you gotta make a token arrest if your mob bosses shoot someone in broad daylight downtown.

Boeing didn’t help.  They also should have read the situation correctly and “voluntarily requested” a temporary grounding.  That also had to be page 1 of the crisis communications plan they must have updated when Lion Air’s 737 MAX went down.

The end result?  The world has learned they can no longer trust the FAA.  Note the Ethiopian Air flight’s Black Box flight recorders are going to France (home of Airbus) for analysis. The Ethiopians didn’t trust the US to do the work.  That bit of news hasn’t been reported as widely or loudly as it should be.

The world learned a similar lesson about US financial regulators in 2007-2009.  They FDA’s gatekeeper role in medical devices could be up next.

The benefits of regulatory capture are concentrated with a few.  The damages are recorded against the faith and credit of the United states as a nation.  Isn’t late stage capitalism fun?

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If “Sea Level” Changes, Everything Changes. But How? Tsunami? Land Rush? Japan?

I’m still seeking clarity on what the heck is going on out there with interest rates.  I figured I’d lay out the questions and see if it helps spark any insight.

Interest rates matter like sea levels matter.  The tide goes up and down, but you sort’ve take for granted that “sea level” is a fixed constant average.  Most of humanity lives near water, so that’s an important measure.  But one we can safely ignore because, well, it’s a fairly fixed constant (leaving global warming aside for a moment).

Interest rates worldwide have tanked.  We have negative real rates (adjusted for inflation) in Japan, German, Sweden, etc…  The US is just barely positive.

These are market-driven rates (10 and 30 year).  The Central banks don’t have their thumbs on those scales.   The Fed’s recent move to stop raising rates is clean evidence its raising the short-term rate scale wasn’t doing squat with long-term rates.

If I traveled back in time 10-15 years and showed a current yield curve interest rate chart to an audience of investors and economists, they would.

  1. Not believe me.
  2. Assume 2019 must be experiencing a five alarm economic crisis.

In reality, we are just sort’ve chugging along.  So what are some plausible scenarios/expectations?  In sea level terms.

  1. Pre-Tsunami:  Apparently the sea receded noticeably before the Thailand Tsunami hit.   People wandered out to look at the near-shore sea floor.  Unaware all that water was going to come back in a wave of destruction.  Maybe today’s low rates are a prelude to another economic maelstrom as we destroy all the debt piled up and un-written off since the 2008 financial crisis.
  2. A permanent shift?  Maybe we’ve slain the inflation beast and the new normal is just that.  Normal.  In which case there’s not too much to worry about.  If anything, we should be rushing to buy all that new beachfront property where the ocean used to be.  Or something like that.
  3. Prelude to Deflation?  The Japan “lost decade(s)” scenario?  We’ve succeeded too well in slaying the inflation beast.  We’re tipping over into deflation.  We’ve over-cranked on monetary policy tools and won’t crank enough on fiscal policy tools.
    • Monetary:  The Fed only has 2-3 points of interest rate cuts available for the next downturn.  It typically needs 4 or even 5.
    • Fiscal:  Government spending to stave off recession is anathema to too many politicians.  Egged on by the .01% who can ride out a downturn but suffer disproportionately from inflation and hate to pay taxes.   Just look at what a heavy lift the lame, anemic, pop-gun “stimulus” was in 2008.

I am most concerned about Scenario 3.  Probably because I have a gut feeling it is what is actually going on out there.  Inflation is anemic everywhere.  A downturn probably tips that to deflation.  And deflation is really really hard to get rid of.  Inflation is like an illness requiring surgery.  It can be beat with enough short-term pain.  Deflation is like a chronic wasting disease.  It just lingers and lingers.  See “Japan 1990-2019”

The other reason I suspect scenario 3 is that most commentary seems as perplexed as I am.  And most if it is still centered around scenarios 1 and 2.  That is at least partly because we have the best explanatory tools for those scenarios.  Like the joke about the drunk fellow looking for his keys under the lamppost; “Well, I lost them somewhere over there, but the light’s better over here…

I have a nasty feeling Japanese economists have insight to offer, but I don’t speak Japanese.  Most economic thinkers and policy makers don’t either. So I’m left staring at the receding surf line and wondering to go forward, run to high ground, or buy an off-grid cabin stocked with canned food and a shotgun.

So that’s why I’m so worried about interest rates.  Any suggestions or comments would be welcome.  Sorry for any typos I’m on a flight later today and wanted to send this out.

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Technical Debt Leading to Technological Bankruptcy. Then Actual Bankruptcy. Cloud Computing Offers a Solution.

I figured I’d share part of an e-mail exchange this morning on the concept of “Technical Debt.” The term is well understood term in technology circles, poorly understood by investors, and totally ignored by accountants.  It explains a lot about winners and losers today.

Per the quote below, I wish this concept of “technical debt” actually sat on balance sheets. It is there regardless.

  • Keeping your software running can be thought of as paying the interest charges on a credit card.
  • Re-writing your software is paying down the actual principal amount you owe.
  • Skimping on software maintenance and replacement balloons that technical debt balance.  But that is the next CEO’s problem (repeat that phrase a few times over several decades).
  • Until the technical debt comes due.

This is a pretty clean way to understand a lot of older companies.  It is particularly applicable to Telecom companies worldwide.  They have 20-30 years of technical debt  coming due.  Millions of lines of rotten code in old billing systems, provisioning systems, and support systems.  Sitting on top of rotten copper in a non-data-friendly network architecture.  The telcos only paid interest and never paid down the principal.  So they are, technologically (and in some cases literally) bankrupt.

The article below is also an excellent explanation of why Public Cloud services can help minimize accumulation of technical debt.  Older companies with unpaid technical debt  balances will still have to pay them off – largely paying in to the Cloud.  Newer companies will use cloud to stay nimble.  Eventually killing off the old, encumbered behemoths.  That pattern will play out across a lot of industries over the next 20 years.

This dynamic is why AWS is going to be such a monster.  Hopefully one day Amazon does us all a favor and spins out AWS so we can invest in it directly.

https://techcrunch.com/2018/12/15/the-business-case-for-serverless/

“The problem with this approach comes back to an old axiom in software development: “code isn’t an asset—code is debt.” Code requires an entry on both sides of the accounting equation. It is an asset that enables companies to deliver value to the customer, but it also requires maintenance that has to be accounted for and distributed over time. All things equal, startups want the smallest codebase possible (provided, of course, that developers aren’t taking this too far and writing clever but unreadable code). Less code means less surface area to maintain, and also means less surface area for new engineers to grasp during ramp-up.

Herein lies the magic of using managed services. Startups get the beneficial use of the provider’s code as an asset without holding that code debt on their “technical balance sheet.” Instead, the code sits on the provider’s balance sheet, and the provider’s engineers are tasked with maintaining, improving, and documenting that code. In other words, startups get code that is self-maintaining, self-improving, and self-documenting—the equivalent of hiring a first-rate engineering team dedicated to a non-core part of the codebase—for free. Or, more accurately, at a predictable per-use cost. Contrast this with using a managed service like Cognito or Auth0. On day one, perhaps it doesn’t have all of the features on a startup’s wish list. The difference is that the provider has a team of engineers and product managers whose sole task is to ship improvements to this service day in and day out. Their exciting core product is another company’s would-be redheaded stepchild.

If there is a single unifying principle amongst a startup’s engineering team, it should be to write as little code—and be responsible for as few non-core services—as humanly possible. By adopting this philosophy, a startup can build a platform that can process billions of transactions at an extremely predictable, purely-variable cost with nearly zero devops oversight.”

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A Dead Canary In The Telecom Mines. Investors Beware.

Miners used to carry caged Canaries for early warning of toxic gas.  The Canaries would keel over from the gas before the miners would.

The Canary here is US Telecom CenturyLink, who recently cut its dividend by 53% while raising 2019 capital expenditures by 16%.  CTL is a $14.5B pipsqueak compared to $225b behemoths like Verizon and AT&T.  But its labored breathing is a dangerous sign across the Telecom complex.

If CTL had cut its dividend and its investment spending, this would just be a run-of-the-mill cash crisis.  What makes CTL’s move remarkable is plowing roughly half its $1.16B dividend cut back into network investment.  That points to a more existential crisis.

For all the talk of a fiber-optic future, huge swathes of CTL’s network are still old copper lines running to homes, small businesses, and even many large-ish businesses.   Most of that copper is mostly depreciated off CTL’s books.  But those assets are still generating cash.

Depreciation lives exist for a reason.  If you are making pots of cash off an asset past its useful accounting life, it’s a pretty good indicator those cash flows are at risk.  At some point, the actual physical assets go past their useful life and need replacing.

The rub is that delaying that replacement spend is lucrative for all concerned.  The cash keeps rolling in.  Investors are happy.  Managements are happy.  Why end the party?  That has been the fairly comfortable position of telcos for the past 20 years.

The responsible choice – replacing the asset – is particularly painful because it generates no incremental return for that incremental investment.  You spend a whole lot of money just to keep the cash flows already coming in.

This painful math is familiar to anyone who’s ever spruced up a rental property.  You might see a small boost in income from the investment, but you are mostly spending to maintain the current income stream.

The Telcos have, instead, taken the slumlord approach.  Just let the asset wither and lower rents to keep the place occupied.  This works until the building is no longer habitable and even low-rent tenants start to leave in droves.

The declining slum model fairly describes much of CTL’s network today.  Declining business and residential revenues providing an increasingly skimpy cover for largely fixed operating costs.  So CenturyLink is cutting it dividend and putting roughly half of that cash towards replacing its asset base.

CTL is the canary in this coal mine because they don’t have a wireless business to hide behind.  Or the media and entertainment assets that AT&T and Verizon have both diversified into.  So CTL can’t hide the rot at its core.  But that same rot affects most developed world telcos.  Deutsche Telekom’s recent capitulation on copper life-extending pipe-dreams in favor of fiber investment stands out in particular.

This explains why most Telcos are quietly embarking on massive new network builds without the fanfare of the dividend cut (yet).  Often blaming government prodding or under the PR cover of building out 5G.  Pulling shiny new fiber an re-starting the clock on a 30-year-depreciation lifespan.

Investors should expect the next 20 years to look very different from the last 20.  Steady spending of incremental capital for little or no incremental revenue.  Not to say the current model of over-earning on depreciated assets is dead forever.  Pencil it in for a return around 2050 to 2070.  But it will be a hard slog to get there from here.

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Amazon’s New York Pullout – The Questions Not Asked. Equity Spin Coming?

In all the comment around Amazon’s decision to cancel their “HQ2” in New York, I’m surprised to see some salient questions un-asked.

  1. After such an exhaustive public search, why didn’t Amazon just pivot to the #2 choice? If New York didn’t work, why not just call the runner-up?  It is obvious there wasn’t a credible #2.  So was the search itself just a sham PR exercise?   An attempt to shake down New York for concessions?
  2. What business units were to go to Amazon’s new headquarters?
    1. Northern Virginia is an obvious location for a unit that could use some structural breathing room – the Amazon Web Services Public Cloud.  It is already a stand-alone organization with its own compensation plan.  It has a huge government presence already.  With massive data centers located in Ashburn Virginia (just outside the blast radius of nukes hitting DC).  And AWS is the likeliest candidate for the DoD’s $10b over 10 years “JEDI” contract.
    2. New York would be an obvious location for….?  My best guess is Media and Advertising.  Two New York industries and two major Amazon initiatives.  In that case, the HQ2 search was always a sham and Amazon ends up building a similar sized presence in NYC (without all the fun subsidies).
  3. To what end all this separation? A spin-off of AWS and Media as separate stocks seems the most likely answer.  Eliminate the conglomerate discount, eliminate conflicts of interest, and fend of the anti-trust authorities.  
    1. The original HQ2 justification was talent diversification.  That no longer holds water given Amazon’s chosen locations were equally bad “war for talent” labor markets with equally bad traffic and growth-related challenges.
    2. AWS, in particular, would benefit from more formal separation from Amazon’s other businesses.  AWS wants to sell to all comers.  But Amazon’s ambitions in retail, health care, financial services, and transportation push a lot of potential clients into the arms of Microsoft’s Azure and Google’s Cloud Platform.  The two arms are already separate in practice.  A wider, more formal separation would eliminate a drag from AWS and give it a proper (probably astronomical) valuation.
    3. Media and Advertising don’t seem to suffer similar negative drag from linkage to Amazon proper.  It might be the simple (and probably valid) valuation argument.  Advertising business are generally worth more than an agglomeration of warehouses and grocery stores.
    4. Lurking behind all of the above could be a preemptive action on the anti-trust front.  If you see a potential break-up threat, why not do it yourself on lines of your own choosing?

I might circle back to these later.  Although, having written this, the itch seems pretty well scratched.  As always, any thoughts, feedback, or comments are deeply appreciated.

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