Published by clickbroker.blogspot.com
Bloomberg’s “Lilly Erbitux Cancer Drug Not Worth Price, U.S. Scientists Say” and The Wall Street Journal’s “Cost-Effectiveness of Cancer Drugs Is Questioned” report on a study published by NIH oncologist Tito Fojo and NIH bioethicist Christine Grady questioning the cost effectiveness of high cost cancer drugs. Most of the cancer drugs approved in the last 4 years cost over $20,000 without consistently extending survival.
It looks like the controversial British National Health Service (NHS) methodology for determining the value of pharmaceuticals might be crossing the Atlantic. The UK National Institute for Clinical Excellence (NICE) advises the NHS on the cost-benefit of drugs. In general, Britain has valued a “quality-adjusted life year” at £30,000.
The study’s authors cite an average survival increase of 1.2 months for Eli Lilly (LLY) and Bristol-Myers Squibb’s (BMY) Erbitux, costing $80,000 for a course of treatment. Similar results were found for Roche’s (RHHBY) Avastin and Nexavar, costing $34,000. Nexavar is co-marketed with Bayer and Onyx (ONXX). Given that each treatment targets cancer differently, an effective cocktail is beyond the affordability of any health insurance plan – public or private.
Like most healthcare dilemmas, there are multiple sides to this controversy. Despite rhetoric to the contrary all sides involve rationing. The British ration on the payment side; only paying for the drugs that produced quantifiable results on a patient by patient basis. The pharmaceutical companies capitulated rather than be excluded from reimbursements. The NHS must be rebated when an expensive cancer drug does not produce results for an individual patient.
The British system is particularly effective when a high cost drug can produce extraordinary results in a small subset of patients. Given that the cost of manufacturing pharmaceuticals is a very small fraction of their selling prices; this model can very be effective for the companies as well. But the wide operating margins are not enough to convince the companies to change their business model in the US.
The US private insurance companies ration high cost drugs through co-pays and coverage caps. Biological and other high cost drug are often classified as “level 4” with little or no reimbursements. The result is that doctors must limit patient access to one high cost drug at a time without knowing if the one they picked would be effective.
This drug lottery serves no one. The patient would be better served by giving the doctor the freedom to experiment with multiple drugs either separately or in combination. The likelihood of putting the cancer in remission certainly would be greater, and more companies would have access to selling their drugs to each patient. The drug companies would have to agree to share the revenue allocated to the cocktail for each patient.
The drug companies are vigorously defending the status quo in the US. Instead of adapting their business models to “pay for performance” or shared revenue for a course of treatment, they have embarked on an elaborate public relations scheme. The companies claim that most patients don’t pay the “benchmark or average wholesale price” and besides if the patient cannot afford their medicines, the companies will help. Many patients have gone bankrupt with this kind of help. And even if the patients do not pay full price, it is often because the rest of the insurance pool chips in through high premiums.
The American method of rationing high cost drugs leads to Russian Rolette for the patients. Until sufficient genetic or diagnostic testing is available, why not make all cancer drugs available to all patients and reimburse drug companies for results? Just like one private insurer cannot give guaranteed issue policies without adverse selection, the pharmaceutical industry must act in concert to support revenue sharing.
No disclosures.
Pharmaceutical Dollar Rationing by Results
Nothing is ever “Off the Books” in the Financial World
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Several articles came out last week pointing to Morgan Stanley’s (MS) purchase of a controlling interest in Citigroup’s (C) Smith Barney via a joint venture and Bank of America’s (BAC) purchase of Merrill Lynch might have been misguided. Bank of America often called Merrill’s retail operation its crown jewel, and Morgan Stanley stressed the need for mass in wealth management. Despite Bank of America’s touting Merrill’s recent profits, the core profitability driver of full-service retail brokerage is waning.
The Wall Street Journal’s “Reconsidering Wealth Managers” reports that a Merrill Lynch Global Wealth Management and Capgemini Group survey showed that more than 25% of high net worth individuals withdrew funds or entirely closed their wealth management accounts. Wealthy clients have moved over half of their balances to simpler, lower margin investments such as cash and bonds. Smaller and regional banks were the beneficiaries. Capgemini says the business remains profitable as the full-service firms strive to increase assets under management.
The lifeblood of the retail operations is pumping highly profitable structured products to individual investors. Value adding through packaging and “access” to alternative investments had been the brokers’ mantra. It is here where the firms are trying to create an extraordinary resuscitation to again begin attracting both high net worth and institutional clients.
Bloomberg’s “Ambac Cut to Junk as Main Unit ‘In Runoff,’ S&P Says” suggests the market for structured products continues to be sick. The very same investment banks that are trying to retain investors’ interest in structured products are suing to prevent Ambac (ABK) and MBIA (MBI) from allocating capital to restart their municipal bond insurance businesses. The banks are scared the monolines won’t have enough capital remaining to back insured CDOs. The monolines are in turn suing the underlying mortgage originating banks for breach of warranties.
The Wall Street Journal’s “Repackaging by Banks Helps CMBS” reports that Bank of America, Citigroup and Morgan Stanley are repurchasing the highest tranches of unloved CMBS to sell them again with credit enhancement increased from 30% to 50%. They hope to rekindle institutional interest and make profit from a reduced spread over treasuries.
At the other end of the spectrum, the Financial Times’ “Banks rush to rescue of credit card trusts after record defaults” is reporting that American Express (AXP), Bank of America, Citigroup and JP Morgan (JPM) are buying the lowest tranches of credit card securitizations so they can absorb the first losses instead of investors. JP Morgan is even replacing some lower quality WaMu credit card loans with its own to reduce the loss ratio in certain trusts.
Keeping the credit cards trusts viable is particularly important to banks because as consumers prepay balances, the trusts’ capacity is recycled into new loans. If losses reach a certain point, investors can accelerate payments reducing the capacity of banks to issue credit card debt. Banks are trying every manipulation possible to prevent that from happening.
Changes in accounting rules might force banks to include off balance sheet trusts (or securitizations) back on their books. The deciding factors include control and risk of loss. This could make the all of these efforts to revive the shadow backing system irrelevant. Fed Chairman Bernanke should take note. Add to this the proposed Consumer Financial Protection Agency (CFPA) warning retail investors about the dangers of structured products and alternative investments.
Where does this leave our mega banks? Their investing banking businesses will become more dependent on traditional capital raising and trading, and their commercial operations will become more dependent on funds processing and traditional banking. When everything remains on the books, the whole operation becomes less profitable, including their prestigious retail wealth management chains.
Disclosures: Author is long ABK, BAC, C and MBI.
The Post Office, FedEx and UPS Model for Health Insurance
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The New York Times posted the transcript of President Obama’s Tuesday, June 23 news conference. I though he expressed the right balance on Iran’s political situation and was refreshingly articulate and direct on the need for a government run health insurance plan for consumers. The President used the Republicans own logic to defend the need for a government option.
President Obama: “Why would it drive private insurance out of business? If -- if private -- if private insurers say that the marketplace provides the best quality health care; if they tell us that they're offering a good deal, then why is it that the government, which they say can't run anything, suddenly is going to drive them out of business? That's not logical.”
President Obama: “But just conceptually, the notion that all these insurance companies who say they're giving consumers the best possible deal, if they can't compete against a public plan as one option, with consumers making the decision what's the best deal, that defies logic, which is why I think you've seen in the polling data overwhelming support for a public plan.”
The President came just short of refusing to sign legislation that did not contain a public option, indicating he will be expending unlimited political capital to get it. The logical extension of his argument would be if FedEx (FDX) and UPS (UPS) have prospered by competing with the Post Office, why can’t Aetna (AET), CIGNA (CI), Humana (HUM), UnitedHealth Group (UNH) and WellPoint (WLP) annihilate any competition from government run health insurance. Consider that FedEx and UPS are winning after the Post Office had over a 100 year head start.
The need to make a profit did not hinder the success of FedEx and UPS, and all these private insurers have a running start on the government. If profits are a disadvantage in competing than why did state governments allow nonprofit Blue Cross plans to be converted into the for-profit WellPoint colossus? If WellPoint cannot compete with the government than let Blue Cross go back to being nonprofit. Was WellPoint’s argument that a for-profit insurer can provide better service and more value to the consumer than a nonprofit invalid?
Medicare has an extremely low overhead for the level of insurance it writes. Yes it does incur a great deal of fraud, but more money is saved in overhead than spent in fraud. Private insurers can thrive alongside of a government plan if they balance the cost expenditures of enforcement with the cost savings of enforcement, and run leaner operations. The private insurers can leave the marketing and sales to the proposed exchanges, eliminate medical underwriting and start contracting with medical providers by the patient rather than by the service.
A certain amount of enforcement is necessary to prevent excessive fraud, but private insurers waste far too much money on administration for the benefits they provide. This is why they can only survive in an environment where their competitors do the same. The President wants to break this cycle using a government run health insurance plan as his tool. Once the environment changes, the private insurers will change and continue to be profitable.
The President’s argument could be equally applied to the pharmaceutical companies spending more on sales and marketing than research. But President Obama is not yet ready to slay that horse.
The real question the private insurers must answer is whether Medicare is more competitive because of lower overhead or lower payments to providers? I believe the emphasis on lower provider payments is far overstated. Medicare is more competitive than private insurance because it has far less fat.
No disclosures.
Big Pharma’s Divide and Conquer Strategy
Published by clickbroker.blogspot.com
Multiple recent polls have indicated that Americans want a government run health insurance option and President Obama seems to be holding the line. Republicans say the people cannot be trusted because they don’t understand that they would be getting a “pig in a poke.” Liberal Senator Dianne Feinstein appears to have sold out to the health insurance lobby saying that the Democrats need to spend more time on costs and the government’s role. How could the Democrats not be ready? Are the Democrats slowly caving?
We have the good and the bad, so here’s the ugly. Both Bloomberg’s “Obama to Appeal to Public on Health Care as Senate Struggles” and the Financial Times’ “Obama health plan gets boost from drugmakers“ are reporting that the large pharmaceutical companies are offering about $80B in savings to the Medicare drug insurance beneficiaries. The companies are offering discounts of up to 50% for seniors to purchase medications in the benefit donut hole between $2700 and $6153 in expenditures. It does not speak well of the President to embrace this disingenuous attempt to divide the American people.
The pharmaceutical companies have excelled at charging Americans the highest prices in the world by offering strategic discounts to Medicaid, Medicare, and to a lesser extent certain pharmaceutical benefit managers and private insurers. They have attempted to garner public sympathy through the Montel Williams commercials touting “if can’t afford your medications, we might be able to help.” At the same time, drug companies are continually increasing prices to retail consumers.
President Obama, I call on you not to be entrapped by the rhetoric of the past. If you are looking for “green shoots” of industry cooperation to help sell healthcare reform, I can understand. But this is not one of them and it is unlikely that the CBO will score this favorably. The benefit does not go to the government.
Helping some of the people has long been a successful tactic used by the medical establishment to maintain the status quo. We cannot emerge from healthcare reform a divided nation. We cannot allow some members of our society to pay more or less than others based solely on age or the state they happen to live in. Each attempt to divide us puts one more nail in the coffin of real healthcare reform.
Reverse Converts Kill Retail Investors
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The Wall Street Journal’s “Reverse Converts: A Nest-Egg Slasher?” tells another sad story of retail investors being sold products they did not understand. Should we have the same sympathy that we had for buyers of Auction Rate Securities (ARS)? I think not. Reverse converts (or as JP Morgan (JPM) calls them Reverse Exchangeable Notes), promise returns of up to an annualized 17.25% on a 6 to 12 month deposit. Investors, retail or not, should clearly understand this is not simply interest.
At least ARS were bonds at their core. Whether any investor truly understood how ARS operate is another matter. What the Journal is calling interest on reverse converts is actually the combination of a small amount of interest added to a large put premium. This structured product is really just a very inefficient way for a retail investor to sell a put.
The Journal cites Barclays (BCS) and Citigroup (C) as large banks issuing these securities. But I was only able to find the JP Morgan Term Sheet for Reverse Exchangeable Notes due December 31, 2009 through Incapital LLC’s Structured Investments website.
The basic concept is the purchaser or investor of a reverse convert is issued an unsecured note from the issuer in $1,000 increments. The investor is paid a coupon much higher than prevailing interest rates, but can lose some or all of their investment. The return of capital is based on the price performance of a single reference stock. The upside is limited to return of capital at par plus the monthly coupon.
JP Morgan’s term sheet specifies 3 notes linked to the price performance of Deere (DE), Wells Fargo (WFC) and Whole Foods (WFMI). The coupon rates are 13.75%, 17.25% and 12.25% annualized for 6 months. But the allocations between “interest on deposit” and “put premiums” are 9.75% and 90.25%, 7.77% and 92.23%, and 10.94% and 89.06%. The effective interest that investors are being paid is just about 1.34% for all three. When commissions and “hedging fees” of up to 6% are added in, it’s a pretty expensive way to sell a put. The hedging is for the benefit of the issuer.
The sequence of dates is critical to understanding the product: pricing date, settlement date, observation date and maturity date. Notice the pricing date comes before the settlement date and the observation date precedes the maturity date. Each of the notes has a protection amount: 30%, 40% and 40% of the reference stock price on the pricing date. The shares per note are calculated by dividing the par value ($1,000) by the pricing date closing stock price.
The monitoring period extends from the pricing date to the observation date. If the reference stock’s price falls below the protection amount at any time during the monitoring period, the investor loses protection of their principal. Once protection is lost, return of capital at maturity is the lesser of the note par value or the value of the shares per note on the observation day. JP Morgan’s term sheet gives excellent examples of many different scenarios.
Coupons are paid regardless of whether protection is lost. But if protection is lost, the issuer can return capital at maturity as either the actual shares in the reference stock or the cash equivalent. The cash equivalent is the pricing date shares per note multiplied by the observation date stock price.
The reference stock’s company has no obligation to the investor. The investment is only backed by the credit of the reverse convert issuer (JP Morgan in this example). Think what happened to retail investors in Lehman structured products.
Let’s compare reverse converts to directly buying the reference stock or selling (shorting) a put on the reference stock. The reverse convert has no upside if the stock advances, a fixed exercise price if the stock falls, no stock dividends and limited liquidity. Buying the stock provides dividends, liquidity and upside. Selling the put allows the investor to earn interest on his proceeds as well as the cash maintained for exercise, the transaction can be closed before expiration, and is far more liquid than reverse converts. All three investments have equal downside, so the added liquidity of the second two differentiates.
Whether you buy a reverse convert or sell a put, you have to be willing to be exercised at the strike price. Retail investors will have to maintain enough funds in their brokerage accounts for the exercise to sell a cash covered put, so the upfront is the same. Option contracts are for 100 shares, the amount of shares in a reverse convert will vary by share price on the pricing date.
The key lesson for investors is you are really selling a put, not buying a bond when investing in a reverse convert. And your transaction costs are much higher than simply selling a put.
After all this, I asked myself is this the reason we needed to save the thundering herd of Merrill Lynch (BAC) and Morgan Stanley Smith Barney (MS)? Just like the Federal Reserve and Treasury are trying to recreate the shadow banking system, the full-service/high cost brokerages are trying to create the retail high-margin structured products business.
Reforms, what reforms?
Disclosure: Author is long BAC, BCS, C and WFC.
The New and Improved Auction Rate Securities
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Wall Street’s ability to reinvent itself along with the premise that any package can be sold for more than the sum of its parts is just as dependable as the unveiling of the new and improved Tide (PG) laundry detergent each year. Most of Wall Street’s packaged goods are no more valuable to their clients than the faux improvements to consumer packaged goods. But profits in packaging are the reason both exist, not to create real value for Wall Street’s or Main Street’s customers.
The Wall Street Journal’s “New Security Shifts Risk to Borrower” reports that Citigroup (C), Goldman Sachs (GS) and Morgan Stanley (MS) have introduced the new and improved auction rate securities (ARS) to the municipal bond market. They just cannot believe that long-term debt can’t be masqueraded as short-term debt for a profit. The target audience is the tax-free money market funds. These funds are rightfully skeptical.
I have a history of commenting on the original ARS: "Auction Rate Securities: Who’s to Blame?", "Retail Investors stuck with Auction Rate Securities", "Auction Rate Bonds are not Cash Equivalents" and "Mechanics of Auction Rate Securities". Although, none of these commentaries have been favorable, I found the mechanics of the products fascinating.
The new twist is that the municipalities (borrowers) must buyback (repay) the loans if the money market funds (lenders) want to withdraw (sell). This makes the loans putable if the funds are not satisfied with the weekly “auction.” The municipalities would have between 7 and 12 months to refinance.
Theoretically the municipalities would be paying a variable interest rate based on short-term debt for a long-term commitment. But the commitment is very much one-sided; the municipalities bear both the interest rate risk and refinancing risks. The lenders only bear the credit risk. Why wouldn’t the municipalities just sell long-term variable or fixed rate debt and eliminate the early put option? If their credit rating falls, the municipalities might not even be able to refinance. The only possible advantage for municipalities would be a slightly lower interest rate as the cost lenders would be willing to absorb for the put option.
The interest rate would be reset every week based on a short-term municipal debt index, rather than an actual auction. So there is no risk of a failed auction. With the risk removed from the underwriters the fun can really begin. I’m sure there will be all types of protection available for sale to both the borrowers and lenders. Interest rate swaps that the municipalities cannot hope to comprehend would just be the beginning.
Surprisingly, the SEC has approved this product for money market funds. Apparently the temptation of the pay-option ARM for irresponsible behavior has taught our regulators nothing. Are our municipal and state governments any more sophisticated or smarter than boom era homebuyers in resisting loans they don’t understand?
These products present unneeded risks to both borrowers and lenders with little value added for the trouble. The only difference this time around is the investment banks appear to be trying to immunize themselves.
Disclosure: Author is long C.
Penske Automotive’s far from Virtual Saturn
Roger Penske is no lightweight; a former champion race car driver and now CEO of the Penske Automotive Group (PAG). PAG is the second largest publicly traded automotive retailer with 310 showrooms divided almost equally between the US and UK, along with 25 collision centers and the exclusive Diamler Smart car distributorship in the US. The $11B+ revenue company specializes in foreign and luxury nameplates. Penske is also the driving force behind several non-publicly traded businesses including Penske Racing and Penske Truck Leasing.
USA Today interviewed Roger Penske for “Roger Penske: 'We're going to build a Saturn team'”. PAG’s purchase of General Motor’s Saturn brand is expected to close in October. PAG will be buying the brand, the 350 dealer distribution network and the parts inventory; but no manufacturing. GM has committed to supply the Aura sedan and Vue and Outlook SUVs for 2 years. Other Saturn models will be dropped. The PAG press release gave no details as to how many of GM’s Saturn employees and which GM assets will travel with the brand.
Buying the Saturn brand is very much more complex and risky than being the national distributor for Diamler’s Smart or JM Family Enterprise’s Southeast Toyota. JM Family, a private company, is the sole remaining independent Toyota distributor in the US. Owning the Saturn brand means that PAG will theoretically have to design and subcontract the assembly of vehicles in addition to distribution and dealer support.
Penske talks optimistically about being freed from manufacturing and the ability to source models worldwide, giving PAG a distinct cost advantage. But just like the semiconductor foundry business, customers must cover the fixed costs when they commit to a production volume. Also it is likely that PAG will have to finance the parts inventory for its manufacturing subcontractors and commit to certain volumes, like Dell (DELL) and Hewlett-Packard (HPQ). PAG will have to purchase or lease any equipment, dies and fittings required to customize other manufacturers’ vehicles for the Saturn brand.
While the new Saturn’s capital outlays and long-term labor commitments are less constraining than fully integrated manufacturers, they are far from nonexistent. The operation is not quite as virtual as it first appears and is highly dependent on continued overcapacity in automobile manufacturing. Advanced Micro Devices (AMD) similarly trying to run a virtual operation might find the cost of committing manufacturing an impediment to competing with its rival. Though completely different industries, there are many parallels between the AMD and PAG business plans.
I believe PAG’s greatest difficulties will go beyond financing manufacturing and getting commitments to the highest quality plants. First, can PAG design vehicles with a consistent theme or message that instantly distinguishes them as Saturns? Will contract manufacturers be willing to build cars with the plastic shells that make Saturns distinctive? Will manufacturers be willing to rebadge their best products for Saturn?
If the new Saturn can shop the global parts bins to build high quality unique vehicles, they could be successful. But the vibes I’m getting is that Penske wants to shop the world market to rebadge the lowest cost products for Saturn’s high customer satisfaction dealerships. This is an explosive combination and not very value adding. As the number of vehicle sources proliferate, so will the dealership parts and service complexities. And customer satisfaction will soon fade if quality is not consistently high.
This case study is just beginning and it is difficult to know how PAG will balance the design vs. rebadge question. But the migration toward electric cars speaks well for the new Saturn’s ability to be a nimble designer and distributor in the future. PAG must be very careful not to reach for the bottom of the barrel in the last few years of the gasoline age. Doing so will kill it before the Saturn brand can truly prosper in the easy to assemble electronic age.
No disclosures.
Is it as Simple as New-GM vs. Old-GM?
Picture the 1970’s; we’re cruising down the boulevard of dreams in our softly suspended land yacht when suddenly we hit the sand like a beached whale. Gas becomes tight and GM quickly downsizes its fleet with disastrous results. Too bad it was only a false alarm and GM was able to enter the 1980’s back to its gas guzzling ways.
Instead of fighting the Japanese midsize and large car advance heading into the 1990’s, GM once again did a side fake to SUVs. GM has a history of avoiding the distasteful competition with either total avoidance or lame attempts to meet the competition. CEO Fritz Henderson touted a few of GM’s stellar products, leaving us thinking that they moved little from mediocrity. Just watch those full-size cars float up and down on the highway and image how well they handle.
Two things puzzled me when I listened to both President Obama and Fritz Henderson’s speeches on Monday, June 1, 2009. The first was that neither told us what customers can expect in the products from the new GM. The second was how can GM be easily split when there is a matrix relationship between products and factories?
Henderson said GM’s product development needs to be less scatterbrained; fewer new vehicles introduce with more successes. But Henderson did not tell us what would compel a customer to buy a GM car. Along with that we need to know from GM what separates a great car from a mediocre one. And what defines GM across all its vehicles. Until GM can answer those questions, they are still lost. No amount of government money, great engineers, frugal accountants and conscientious hourly workers can save them.
Let’s assume miraculously, some customers still find GM relevant in the future. After all, even the Republicans still have a small remnant of Karl Rove’s famous base. Does GM still build highway cruisers and SUVs to please its shrinking base or does it create a few high performance cars with great handling? Henderson implies both during his speech. A little halo covers over a lot of mediocrity. You can see that there will be no new GM in the customers’ minds.
Companies can only reinvent themselves when they are willing to give up their core constituency and define themselves to a new audience. It requires letting go of the security blanket and clearly defining yourself in the characteristics of every brand and every product you sell. GM cannot define itself because it still wants to be all things to all people. Reducing the number of brands does not change that.
So if there is no new GM in the products and the customers’ minds, then the only benefit left is cost reduction. The work force is being reduced and wages are dropping significantly, but it is happening at a huge cost. The pension plan still needs to be funded and government is forcing the new GM to fund the retirees healthcare with a $6.5B preferred paying 9%. And workers are not being let go, they are being bought out. GM will be reacquiring certain Delphi parts factories that it jettisoned years ago. It looks to me like a combination of a UAW jobs and retiree social welfare program with an AIG-like (AIG) pass through to save the auto parts industry.
Now we realize that while the workforce and wages will be reduced most legacy costs will still remain. While GM’s unsecured debt will exchanged for equity, GM still has plenty of other debt and obligations remaining. Just think about the cost of winding down and closing plants, and the environmental liabilities that will remain. That leads to the question of whether the creation of a new GM will hold up in bankruptcy court.
Removing Pontiac from the GM lineup does not mean that GM can simply just close the Pontiac plant, because there is no such thing. GM has always produced multiple brands in the same factories. So moving Pontiac to the old GM is meaningless. Likewise, to close a plant that produces Chevy and Pontiac models would mean the costly moving of gigantic equipment and realigning computer systems. So the question of which GM owns which plants is just the start, then comes which GM owns what equipment inside the plant starts the real quagmire. Does the old GM produce parts and assemble cars for the new GM? Do the two GMs have to cooperate to the detriment of the old GM? What do the creditors of the old GM think? And lastly is the old GM a continuing entity or does it just go into liquidation when the new GM no longer wants it?
Some creditors have already appealed the formation of the new Chrysler. Chrysler was a cleaner separation because all of its brands moved. But certain creditors felt that the sale of select assets to the new Chrysler was just a standard reorganization thinly disguised to benefit some creditors over others. With Chrysler at least a new party, Fiat, is a participant in the “purchase.” This does not leave much justification for GM when the owners of the new GM and are just a subset of the creditors of the old GM.
All told the GM bankruptcy journey has just begun, and it won’t be short and certainly not sweet. I see no product plan, no manufacturing plan and no appeasement of the creditors. All I see at this point is President Obama implementing social policy and trying to protect the Pension Benefit Guarantee Board.
Disclosure: Author is long AIG.
Should Starbucks have been more Cost Conscious during the Boom?
Bloomberg’s “Starbucks Pushing Landlords for 25% Cut in Cafe Rents” got me thinking about when is the right time for a growth company to start being concerned about operating costs? For years Amazon (AMZN) told us not to worry about profits while they were in a hyper growth phase and they turned out to be right. As the online retailer matured, its investments in efficient operations have lead to sustained profitability. Now I believe that the Kindle e-book reader is a loss leader that too will become sustainably profitable.
Both the basic Amazon and the Kindle have invented their own ecosystems, in a way very much like Apple’s (AAPL) iPod and iPhone. The Kindle can download e-books wirelessly from anywhere. Starbucks has also created its own ecosystem, based on the combination of its captive prepaid card and competitively addicting coffee. The key difference between these players goes beyond industry. Amazon and Apple are constantly pressured for increased efficiency to provide competitive consumer pricing whereas Starbucks (SBUX) was counting on steadily increasing consumer pricing.
Home Depot (HD), Starbucks and Whole Foods (WFMI) all are recovering from the growth at any cost syndrome. Just like the home builders during the bubble, their attitudes were that they had a limited amount of time to dominate their markets.
During many Home Depot conference calls this past decade, management said it was okay for a new store to cannibalize an older one down the block as long as the two together had increased sales and total profits. Lower margins were the price of expansion. By the time former CEO Robert Nardelli left, retired plumbers and other craftspeople had been replaced by inexperienced salespeople in a desperate attempt to save costs. Likewise Circuit City sacrificed its most knowledgeable and best performing salespeople as a desperate attempt to cut costs before bankruptcy.
As Home Depot’s new CEO has stopped its expansion and is improving the customer experience with new experienced craftsmen and better skilled salespeople, Starbucks can take solace that it has never sacrificed its talent. But Starbucks was a big player in the game of cannibalizing its existing stores with new stores. They would often open stores on opposite sides of the same street or multiple floors in the same mall to the catch that marginal customer.
Starbucks and Whole Foods both belonged to the cult of pay any price for the best locations. This has always puzzled me because both were prestige bands capable of driving traffic to the benefit of any shopping center or mall. During the boom, many mixed use developments touted these retailers as amenities to their condos, offices and apartments. Why didn’t Starbucks and Whole Foods use this leverage to achieve advantageous leases years ago?
As the economy worsened, both Starbucks and Whole Foods started playing hardball with landlords of their abandoned and future stores in development. They had buyer’s remorse just like preconstruction condo buyers in Miami and Las Vegas. They are trying any means from legal to economic threats to break leases.
Bloomberg reports Starbucks is now directly negotiating with landlords, and realtors are telling their landlord clients that they should capitulate. Quiznos (with over 1000 restaurants) has successfully reduced rents by 15% to 20% by offering landlords extending leases. Starbucks is looking for more.
These are all very different companies that all shared enormous growth. All but Amazon were profitable early on, and all but Amazon disregarded costs for growth. History has already told us the winner of this race. Only Amazon has managed its fixed costs and efficiency from the start.
No disclosures.
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