Gabriel’s scarcity rent - it’s management stupid!

I often travel the route Barcelona Madrid (and backwards) for the day. By plane it’s rather tiresome and expensive: with an open fare you end up paying around 400€ for a 630 km flight (+ 630 km back).

Barcelona - Madrid is the world’s busiest route with 971 operations per week. The second one is Sao Paulo - Rio (894 per week) then Jeju/Seoul Gimpo (858 per week) and fourth is Melbourne/Sydney (851 per week).

In fact you have to go very low in the ranking to find another crowded European route. That would be Rome - Milan with less than 600 operations per week, which, by the way, is more than the most crowded North American continental route: Las Vegas - Los Angeles (553 per week)

Source: www.oag.com, data from September 2007

But things change. And this milk cow for the airlines faces its first serious menace ever: the high speed Spanish train service, also called AVE.

These brand new trains travel the distance of 630km (410 miles) in two hours and 35 minutes. Not too bad when it’s compared with the plane that takes roughly two and a half hours (not just flying but also spent in the check in and departure processes), and possibly more.

But, from an economic point of view, there are many hidden costs that must be taken into account. After all, what is it that you do in a plane? Well, you sit in a narrow seat, trying not to disjoint your legs, and pray that the person that will be sitting beside you is not extra overweight. In the train you have plenty of space. Being uncomfortable has a cost.

How much? Well, it depends on what you’re willing to pay to be more comfortable, of course, and how much your time costs.

How much are you willing to pay for that extra nap? Well, in a 45-minute-long flight, you’re going to have maximum thirty minutes of uninterrupted sleep. You won’t be able to sleep while you queue, while you’re being inspected at the burdensome security checks, while you wait your turn. But on a continuous 2 hours 35 minutes journey you’ll be able to.

As for opportunity costs, you won’t be able to do anything in the plane, apart from opening your laptop for half an hour. It’s completely wasted time. In the train you can use your computer as much as you want, use your phone, combine them and access the internet. Work, eat, talk, whatever you wish.

But externalities must also be taken into account. Environmental footprints can be four times higher for planes than for trains. That means that the train will always be more sustainable and, if we ever are to reflect the true external costs, energy efficiency will give the train an important lead over the plane.

Add those costs up: discomfort costs, opportunity costs, externalities and you will have a very competitive mean of transport. Which only means that competition has been increased, with a comparable service at a better price. In the end, consumers will be benefited from the additional choices, lower prices and the increased service levels that competition will bring.

That was what I was thinking when I decided to open the textbook I was carrying with me. The Managing Financial Resources module awaited me. Fortunately it was half way to Barcelona, 300 km per hour (186.41 mph), still an hour to go.

It supposedly began with a bubble. Just another bubble like the one I described on The South Sea Company (or how Sir Isaac Newton spurned the dismal science). The bubble was fuelled by an excess of liquidity. It had to end someday. We learned the word subprimes. We knew it had to mean trouble.

Liquidity injections were administered and succeeded. But they were just patches for a bigger problem. And then they asymmetrised the risk: there were institutions willing to provide liquidity when needed, to reward higher risks, to stimulate the economy further up and away from reality. Until the moral hazard was too huge.

And then it ended too abruptly. The wells of money simply drained and, those whose business was to ensure the efficient distribution of liquidity between the different players just became inefficient. From excess to world wide scarcity, even for sound projects. It became a financial crises.

Few crises have been so focused on the financial system like this one. Because that’s what’s really in trouble here, the whole financial system. I began in the UK with Northern Rock, now nationalised thanks to Alistair Darling. In the meantime Daniel Bouton from Societe Generale didn’t know what was happening in his bank until he lost more than his reputation. And the Swiss face value is also in an all-time-low: just take a look at UBS and Credit Suisse (also First Boston).

But where really is too darn hot is in the US. Bearn Sterns is in flames, expiring his final breath. Bought by $270 million, it was valued about $20.000 million one year ago. A 85-year-old Wall Street institution simply died.

And those that bought companies using leveraging, namely private equity, now see the liabilities piling on top of the roof. Take a look at Blackstone: their profit for the last quarter was less than a half of what was expected, and dropping. Of course its value is dropping too.

We gave it complete freedom. They took it. They invested again and again in the same risky assets, albeit chopped and transformed so they didn’t look like they were the same: collateralised debt, mortgage insurances, mortgage reinsurances, credit swaps and all kinds of derivatives that were the same dog, different collar.

And when the system was in trouble: more liquidity. Await for some more in the next days. New bolts and flashes from the Fed to try to contain it all. But no regulations… in any case it would be too late for that. And always paying a huge price in inflation… until that game is not longer possible.
The dollar’s dropping. The safe heaven for savings all over the world that financed the US debt has ended. If you add up the soaring energy prices, and the huge public deficits, the US credibility is under minimum. The country risk is dangerously rising… no more overspending, no more cheap financing, the party is over.

I’ve been having a conversation about food prices. It’s a fact that they have skyrocketed lately, and they don’t look like they’re going to go down soon. Why is that?

The first reason is, of course, that now we are more people eating. I personally haven’t changed my eating habits, but a lot of Chinese, fortunately, have. The huge Asian country witnessed the birth and nurturing of million of “little Buddhas” that serve as a sign that a lot of Chinese don’t suffer the fate of their not-only-culturally impoverished parents. And the more people eating, the more scarce food becomes, and that drives prices up, the simple law of demand.

Prices soaring? Not guilty!

Another way of explaining why the prices raise is because of utility. Utility describes what the consumers feel about the products: the more utility, the more people are willing to pay for it. Food is not only useful but really necessary. That necessity is expressed in the price. Utility, thus, is part of the price of the product. If this was the beginning of the XXth century, Eugen von Böhm-Bawerk would say it’s not utility but marginal utility, and he’d be right. The utility depends on the eyes of the beholder. And the utility of food becomes less important as you are fed, and then focus to things like not-so-useful diamonds.

Thus the price is ultimately related to scarcity and utility. Food becoming more scarce means that we’re going to pay more for it. And don’t expect that to change.

But is it so great the difference between food consumptions? A few years ago we had all these surpluses at both sides of the Atlantic Ocean, not knowing what to do with so much cereals and milk, heavy-subsidised goods, and now we are running out of them? That surely would mean great savings for the EU and US governments and tax-payers!

So, where have all the surpluses gone? Have the “little Buddhas” eaten so much? I don’t think so.

A system is, by definition, an ordered set of elements that includes relationships between them. In a price system then, there are not only products, but also a series of relationships that link them. Those relationships are key to understanding the whole system. Some of them establish products as complementary or substitutionary. The former will need each other thus demand of fuel will raise the more vehicles exist, the latter will substitute each other thus the use for private cars will shrink in congested cities that develop efficient mass-transportation systems. In that case the perceived utility for public transportation will be greater for some people, boosting demand.

Surprisingly substitutive: guilty!

When biofuel was invented everyone hailed the newborn as a chance for sustainable energy production. Now we had something useful and expensive to convert our cereal overstocks into.  Very high subsidies were required to start building alternative sources of energy like this one, but there was a case for it: less dependency from “dangerous countries” and a lot of big corporations interested in the processes (and subsidies). A great alternative to fossil fuels was being born, and also a less polluting one.

But what we didn’t anticipate was that move would tie prices of food and energy together. Thanks to the newly created market distortion (sorry, I mean subsidy) now there are new induced scarcities throughout the food chain: for example less and more expensive grain for livestock for example. Nobody anticipated either, until the Nobel laureate Paul Crutzen did, that more farming requires more nitrogen, and that nitrogen is highly polluting, especially when it gets released to the atmosphere as nitrous oxide (N2O) by means of biofuel.

There are many implications of the use of biofuels, some positive, some are not. But it’s not easy to take a look to the global picture.  In between of so many interested views and sponsored applied science it will take some time and a lot of effort to get perspective on the issue. But one thing is clear: don’t blame it on the “little Buddhas”.

Operations have always interested me. I’ve worked with supply chains, studied them, comprehended them. But, what I don’t understand, is why that motto of “leaning the supply chain” is considered an universal truth. Reminds me that one of “leaning -and trimming- the organisation” whose long-term results -only now are beginning to be known.

Because sometimes leaner is simply not the most adequate choice. Sometimes you need to be able to offer greater flexibility, better response, even at a greater cost.

What did prompt this reflection in my mind? Well, a friend of mine wanted to buy a new car, so I told him it would be a good moment because the car sales had dropped around 10% this year in Spain.

It looks like the bargaining power of customers has increased, hasn’t it?

Well. In fact something slightly different has happened. Concessionaires have resolved to reduce costs, specially reducing stock. They only have the star models, but not anything that may be a little customised. That means nine months for my friend to get the model he wants. Can you imagine that?

I understand that promoting a series of basic models by penalising the consumption of the rest of the catalogue is a way to reduce variability and variety. But that could be useful in a highly busy and stressed supply chain and that’s not exactly the case.

In this case I understand we should focus the supply chain in some strategical intent to promote sales in a weak season. That way we shouldn’t want to reduce variety but induce new sales. And that means offering an appealing selection for the customer and an improved service. I don’t exactly see improved service with lead times around nine months.

In this case, the savings are surely lower than the opportunity cost of not selling a model. Specially when you still have plenty of space left in the premises (I bet they have not shrunk because of market’s weakness), and specially when competitors may have chosen a different strategy.

Sometimes some savings are simply not worth it.

The subprime crisis has arrived. Yes, many anticipated so. That’s what happens when economy depends on expectations. They take some time to change and, when they change, they do it abruptly. Like those subprime mortgages that have transformed from “hot products” to “hot potatoes”.

Overall is not a matter of solvency but liquidity. I agree, tell that to those that will not be able to afford the mortgages, maybe up to 500.000 people in the US. But investors do not worry much about them. Investors just get scared and they stop pouring endless capital… until they start to do the same somewhere else.

Because companies still report record earnings and the price of gold has been rising non-stop. That means that the machine is still working.

But let’s not be too complacent. A wider crisis can still arise. If gold is “hot”, ABS are cooler than ever. ABS are asset-backed securities, financial products made up of mortgages and things alike that are covered by a real asset, such as your home. These are a way for banks to get cheap financing and externalise risks, because the default risk is transmitted by the ABS, while it wouldn’t be with debt, for instance.

If banks get increasingly difficult to finance, they will transmit this additional cost to companies and consumers. And that’s an entry point to generate a widespread crisis. Central banks should add additional liquidity to the system by lowering rates, but that seems unlikely given their current policies.

But, what about private equity? Now it will be more difficult for them to get cheap capital to finance, that’s for sure. But that doesn’t mean they have no future. On the contrary, they are now more needed than ever, because they are the ones to provide that leaning, that additional shakedown that companies needed in times of more expensive credit.

Remember, there’s much more to private equity than leveraged buy-outs, they have an important role in the markets, and that means they have an important role to play in this new situation.

PD: I read this morning in “The Economist” that the US were thinking of “relief measures” for the crisis. Then I changed to a Spanish newspaper and read about the Popular Party (centre-right and opposition and presumed liberal) to propose the right not to pay mortgages during a year for the unemployed. Alarmed by both news I couldn’t help the thought: regulation must ensure that the system is not abused but, let the market regulate itself. Although some regulations will be painful, it’s the most effective way we’ve come to know.

It’s increasingly easier for alienated bare-footed queuing passengers to blame Heathrow (BAA) for the illnesses of the deficient British airport system. Even easier to blame there is the Spanish owner: Ferrovial. But a systemic look at the problem reveals that the responsibility is wide spread, and it may not be that easy.

The airport sector has been traditionally underinvested. A very important stakeholder, the surrounding communities, has been reluctant to give way to hostile-perceived enlargements. Justifiably worried about the environment, may that be atmosphere or noise, or simply about the territorial impact in hindered neighbouring villages, new infrastructures take so many years to be constructed that capacity always lags demand. The results: outdated infrastructures that are working over-capacity, and need to be maintained, overhauled or simply redesigned while in operation, leaving a poor image to travellers passing by.

More capacity is coming: brand-new T5 will open in March 2008

But what does it take to open a new terminal? There’s a lot of regulation in that too. Regulation that can be changing at any moment, as the new security requirements. BAA is required to enforce the law, a law that has changed to tougher requirements that imply additional costs.

But, that’s another point, tariffs are regulated. Airports are not free to choose what they charge the customer. In the case of the British Airports it was decided at some point that they wouldn’t compete with each other. Instead they were to be bound by decree tariffs. So the passengers would spill from one another filling all them up.

It has certainly happened. But the model needs a lot of overhauling too. Competing airports would make additional capacity out of thin air, and improve the customer service. Airports would feel the need to adapt to their customers: both airlines and travellers, and would need to align costs and prices. Do I really need to praise market economies here?

In my opinion, that’s what the Spanish owner Ferrovial is looking forward to. They had to incur in huge debt to buy BAA at a higher price than expected. And right now they are bound both by harsh requirements and fixed tariffs. In a free market they’d be competing against other airports bearing a much lower debt. And they’d have the first say on which airports to sell. If I was them, I’d pressure for that using public opinion, a very important stakeholder in this sector.

And when social brokers, namely the media, align with public opinion pressuring for change, the government complies.

My fellow student Andrew wrote about CSR, corporate social responsibility, and made me think.

Wikipedia defines CSR as a concept that organizations, especially (but not only) corporations, have an obligation to consider the interests of customers, employees, shareholders, communities, and ecological considerations in all aspects of their operations. This obligation is seen to extend beyond their statutory obligation to comply with legislation.

That responds to an increased sensibility of society towards sustainable development, as well as social issues. There are many investors that claim that they take CSR into account before deciding which investment to choose. Forgive my scepticism but I’m not sure if that’s only another way to make an exotic fund.

CSR is voguish at the moment. Many write about it, less practice it and even less perceive the consequences of it.

Anyway, although CSR is increasingly required and demanded to companies, you can’t expect CSR to make them act against their own nature.

Let me elaborate on that. Companies look for profit. That’s their goal and that’s the way it should be if they are to grow or even survive. You can say that they must diverge part of their profit into the society that bought their products in the first place. But, when the nature of the social or environmental problem is related to excessive consumption, I’d even say conspicuous consumption quoting Thorsten Veblen, you can’t expect the companies to help.

It’s true some companies have changed their products to more healthy ones, but, they are not promoting less consumption, reducing their promotion, increasing their price. In fact doing that would be irrelevant because they’d simply be substituted by competitors and market, and consumption, would stay the same.

Many social and environmental issues don’t have their origin -or solution- in the offer, it’s demand: our part.

We customers are on demand’s side. The parents have much more to say about their offsprings’ obesity than the companies have to say. The same about throwing water away or wasting energy. It’s our duty to be responsible consumers, not their obligation to teach us how to consume. And it’s so easy not to be responsible…

And they help us not to be. Let’s be realistic. At the same time, companies also have learned to transform their PR message to profit from our worries. They tell us they -and their products- are greener, lighter, healthier so that we can forget those issues and keep buying. They give us the alibi we need to divert our attention from the environmental issues, health issues, weight issues… whatever. We are already doing something, right? We are helping with our responsible shopping.

It’s the system. Economists can’t account for what they cannot measure. And you can’t measure happiness, or excess of weight, you measure the quantity of candy bars sold. In the same way we do not take into account the contamination we are producing with our low-cost flight. (although we still have the concept of externalities that, as a concept, has many things in common with the concept of CSR).

But, even if the plane left without us, it would still produce (almost) the same amount of CO2, right? Why bother?

Just some thoughts to share

My readers (thank you for being there) already know that Blackstone is a private equity firm that I like and I’ve been following lately (See China and Blackstone: bad news for capital markets, good news for private equity).

I’ve always visualised private equity firms as a way to avoid the market’s constraints, and the firm’s constraints also, to be able to make longer term moves in order to ensure efficiency and the emergence of sunk benefits inside the firm (See Defensive strategies from private equity).

The funny thing is to see how a private equity firm just decides to go public. In any case, makes a lot of sense to me. At least the market recovers part of what has been taken off it. ($4.13 billion are a nice prodigal son to welcome home)

And Blackstone decided to do just that and went public last Friday.

Graph source Yahoo Finance

This graph is from IPO-day. If you read the news, it was a success, as the PR guys and gals are saying: biggest US IPO in the last four years, executives going mega-rich and all that stuff.

And I concur that it was a success. But not a wild success: a mild one.

In the picture, the trade for Friday: the share ended up at $35.06, far higher than the initial price of $31, a 13% more… of course it went up, it was already over-subscribed. But, take a second look, it didn’t go that far up. The Fortress Investment Group went 33% up in its IPO last February, and it wasn’t as sexy or hyped as Blackstone.

Things are changing. As I have also written before, cheap money is going scarce. (see Rates keep raising: is this the end of cheap money?) And maybe we’ve reached the peak. Bond’s yields are going up too.

Let’s take a peek at the market:

Graph source Yahoo Finance

The graph is the Dow Jones Industrial Average Index over the last year. The two curves below are the Relative Strength (RSI) and the Money Flow (MFI).

The RSI measures the internal strength, the momentum, and it’s indicative when the security reaches a high and the signal fails to reach one. It’s not as low as it was in March’s crisis, but it’s in the second lowest for the last year.

The MFI also measures momentum but takes into account volume as well as price. In this case it has shown repeatedly how the market was loosing strength, thus slowing the slope, so there is a divergence there. In any case it would be worrying if this signal went below 20%, which has not happened.

But my point is that things are not as bright as they were before. And probably things will be harder from now on. If these guys were discounting new highs, they could have waited for a better moment. But they decided to go in now. There must be a reason for that. Behind the curve probably we will find a bumpier road, not the accustomed highway they’ve enjoyed until now.

And, just another thought, another interpretation from a different perspective: is it sustainable that private equity firms enjoy a 15% tax rate while public companies are at 35%? Doesn’t seem quite fair. There’s a hard debate on this and proposed changes on legislation on the way… is Blackstone equity already discounting the conclusion of the debate? (or at least the uncertainty)

Last food for thought today: KKR has also announced it will go public. (yummy, yummy)

It’s funny that the Wall Street Journal published this week an article about the consolidation of the European airline industry. I’ve written about Iberia and it’s many contenders in two previous posts: Airlines corporate hunt: British Airways and TPG finally join forces to buy Iberia and Iberia and its brides… where’s the value?

What has happened this time about Iberia? In fact very little.

I don’t know what the WSJ article said because I’m not a subscriber. But this wave of consolidation that they talk about has come to a stall in Spain. Why?

BA and Iberia: having second thoughts?

One of my assumptions was that, where there is a flagship airline, there are also political interests. No need to prove me wrong. Politics have a lot to do with that. And it’s Iberia who has been stalling the situation.

Because Iberia’s dominant position in Spain, specially in Madrid, has a lot to do with political connections. They have been granted the best slots and the lion’s share of Madrid brand new terminal: T4.

Madrid’s brand new Terminal 4, granted to Iberia and OneWorld

The Spanish government has already required that Iberia needs to be Spanish to keep enjoying the privileges it already enjoys (exclusive routes, slot assignement, top location at Spain’s first airport).

In time this privileges will cease to exist, specially when European regulations in open skies come to be in effect. But I don’t know any single country that doesn’t -or didn’t- protect its flagship airline.

The government’s point: we’ll still protect the status quo, but only for a Spanish company. And Texas Pacific Group or British Airways are not exactly Spanish. But, how do you know if Iberia is Spanish right now? How can you know who, in fact, owns free floating shares?

Anyway, these are advantadges that no company should have, regardless of its nationality. They are just imperfections of the market that the consumer ends up, as always, paying. But that’s how it is, and that’s how I like to tell

State Highway 121, Texas, U.S.

More noise from Texas

And right now another Spanish company, the infrastructure operator CINTRA is fighting for a highway concession in Texas: State Highway 121. The company already exploits two highways in the US: Chicago Skyway and Indiana Toll Road, and is already constructing a third one in Texas: SH 130. The concession was granted to CINTRA, but it has been recently revised. The Texas Transport Commision still has the final word but taking back a concession already granted to a Spanish company wouldn’t help politically Texas Pacific Group interests in Iberia.

Which strategy now?

Just let the time pass. Iberia has not given any of the contenders its data, and it is for a very good reason. The longer it takes, the better. Why? Spain will hold a general election in nine months. Maybe the government will change but, in any case, the government will be less pressured and open to negotiations.

Those of you who read me know my ideas about private equity and how it has become an increasingly efficient way to invest the “big bucks”. I wrote about this in China and Blackstone: bad news for capital markets, good news for private equity.

I have to confess I like the concept of private equity. Although private equity firms probably wouldn’t considering hiring me, I’d hire them to increase efficiency. Their whole business is about efficiency gains: buy some under-performing firm, use your credibility to increase debt to pay the buy-out, make it perform again. If the gains are similar to the costs, the company is yours… *for free*.

Of course I’m exagerating. That’s a simplification, but, for comparing purposes, what happens if you compare their strategy to the diversification strategies undertaken by big companies? We have extra resources, we are not really interested in giving them away to our investors, or owners, so we are going to buy some business out of our core knowledge and know-how to have less risk and at the same time less yields.

Why should anyone do that? Well, managers would say there are synergies to be gained, but, as you know, sometimes those synergies never make it out of the power-point file.

The real reason to do that is that the managers need to keep busy, and need content to present in their next shareholders meeting, probably speaking about another business they don’t know anything about. (Fortunately, neither the shareholders)

Are they paid to do this? Are they suitable to do this? Hell, no!

Not so long ago, they were pretty relaxed and calm because nobody would object anything to that strategy. Even shareholders didn’t see that it was easy to reduce their risk just diversifying investments in different companies instead of diversifying core businesses.

If the investor can diversify by himself, companies shouldn’t try ventures alien to their business.

Then, why were the big companies so unperturbed just doing that? Because they were huge. Or at least too big for hostile takeovers.

And then came KKR with RJR Nabisco (See article about KKR here), and Cerberus with Chrysler (See article about Cerberus here), starting a series that could end with ABN Amro or who knows what. Being huge is not safe anymore.

A new signal emerges from markets. It’s the end of diversification. It’s time to concentrate on your core business. For public companies there’s only one protection strategy for private equity. And it’s no longer to be huge, now you need to be efficient instead.

Barbam propinqui radere, heus, cum videris, praebe lavandos barbulae prudens pilos
(in latin, if you neighbour is being shaven, do get your beard ready)

*Efficiency will save you from private equity*

Got an interesting non core business? Let it go. Otherwise private equity will come for you, and spin it off you.

Inside the non-efficient companies lie a lot of unused resources that justify the gains private equity need as an excuse to assault them. If only those companies could use those same resources for protection…

But that would mean being efficient again. That would mean ruthless reestructuring. That would mean hard and painful decisions. That would mean having to face change, sometimes radical change. That would mean challenging established authority. In short that would mean working more and better.

One last problem about leaning and trimming yourself: why do it yourself when private equity can do it more efficiently than you? (And market seeks efficiency, somehow)