Greetings from Spain! I will not be blogging this week because I am away on vacation. I´ve spent some time in Madrid and some time in Nerja - a beautiful town on the southern coast (near Malaga) filled with more English and Germans, it appears, than Spaniards.

I will say this about Spain: The Spaniards really understand the concept of work-life balance! They just "get it" a little better than we do. The typical work day here is 9am-2pm, then off until 4 or 5pm for lunch and siesta, followed by work until about 6-7pm. During the hours of 2-4pm, most shops are closed and everyone has an extended lunch/siesta. Although this has changed a fair amount in recent years (with the sacred hours of lunch/siesta coming under pressure due to the demands of the modern world), it is still alive and well in the small towns.

I think the rest of the world (especially we Americans) could stand to learn a thing or two from the Spaniards in this regard. Nevertheless, enjoy your vacation weekends. I´ll be back next week!

I live in New York City. I work in a business school. I received my secondary, and post-secondary, education at a business school. So I know a few Wall Street types. This is not to say I’m well connected among the Wall Street elite. I certainly am not. However, I do know my fair share of bankers, traders, private equity folks, and even the occasional hedge fund manager. I’m even lucky enough to count some of these folks as friends.

I think my friends are incredibly smart people. I often turn to them to exchange ideas about corporate activity, corporate performance, the market, and the economy. So I was taken aback by a comment I received in an e-mail from a friend last week about what has happened to highly-qualified, conservative money managers in his field. His opinion was that conservative money managers wrongly get money pulled from them during bubbles because they under-perform. He also claims to have witnessed it more than a few times in this current market.

I started to think about what he said, and the more I did, the more sense it made. We’d expect prudent managers to under-perform in boom times and over-perform in bust times on a relative basis. This is because they are less-willing to take on risk in bubbles when their imprudent counterparts are more willing to do so. However, in perfectly efficient markets, we would expect prudent and imprudent managers alike to have the same long-term mean performance on a risk-adjusted basis.

I’m not sure I’m willing to commit to such a strong-form efficient market hypothesis.

I do believe that inefficiencies exist, at its root, probably caused by some deviations from rational behavior on the part of economic actors. This is where the behavioral part of behavioral economics comes into play - the recognition that economic actors are not purely rational, but make decisions using certain cognitive heuristics that sometimes cause bias.

But that’s another story for a different day. Back to the story at hand.

There are some interesting implications to be drawn if prudent managers are punished during manias. If what my friend says is correct, then not only can we expect prudent managers to have money pulled from them in bubble years, but we can also expect them to be disproportionately fired during manias. This is probably because we tend to attribute out-sized performance to alpha in manias when, in fact, it’s likely beta. We see imprudent managers making out-sized gains and we think, "Wow, that manager must really know what he’s doing." Moreover, we start asking our prudent managers what’s wrong, wondering why they cannot earn like their imprudent counterparts. This is an irrational response.

What’s more disturbing is that the effect might not hold on the flip side. I certainly would expect imprudent managers who significantly under-perform during bear markets to have money pulled from them and to get fired. However, my sense is that in such instances we have much shorter memories when it comes to downside under-performance in bear markets, and the guys who under-perform and get fired probably aren’t out of jobs for too long. Instead of attributing the under-performance to alpha in bear markets, we attribute it to beta. Again, an irrational response.

This highlights one acute incentive problem that likely increases the amount of risk that even prudent managers are willing to take with their clients’ funds (a moral hazard of sorts). Specifically, because the funds under management do not belong to the manager, many seem to have taken the attitude, "If I win, great. If I lose, oh well." Should the money manager lose, the investor bears the greatest cost. The investor loses his money. The manager only loses his job, …and even then, probably not for long (and in the case of hedge funds, only after collecting their 2% vig of course).

Well by now, most firms have reported their 2Q 2007 results. So what can we make of them? Holding aside idiosyncratic, company-specific upside and downside surprises - for instance, results such as "our product is so amazing that everyone decided they had to have it" (e.g., Apple, Cisco) or "we’re in the midst of a restructuring and our strategy just stinks right now" (e.g., Nortel) - I saw two general patterns from the large, S&P-type firms.

1. We missed expectations because the consumer is struggling at home.

2. We beat expectations because of better performance overseas.

I found these explanations interesting.

The first explanation we can all understand. It’s no secret that oil prices are high, the US housing market is not performing well, and consumers are getting squeezed. As a result, corporate profitability has taken a bit of a hit. Interestingly however, although we’ve heard so much about the potential for a slowdown in personal consumption, this is the first that I had heard companies acknowledge it in any kind of systematic way. It seems like it’s finally starting to have more than a mere modest impact on earnings, and it’s no longer limited to home builders, auto manufacturers, and appliance makers/retailers.

The second explanation I find more interesting. Why? Because I’m trying to reconcile whether the improvement in performance by large multinationals was due solely to shifts in exchange rates and repatriation of profits in US dollar terms, or if it’s due to improved fundamentals (i.e., global growth is strong and demand growth will continue into the future). The former implies that it is likely a short-term, one-time pop to earnings. The latter would be more reassuring as it would suggest that we can expect firms to benefit from their multinational status moving forward. I’m not sure where I fall yet on this one.

Looking at the dollar index (DXY) versus a basket of foreign currencies, we have seen the dollar drop more or less from around 85 over the last 3 or 4 months to around 80. This implies a 6.25% devaluation of the dollar in that time. So foreign income/sales repatriated into US dollars should look about 6.25% better. For a US firm that does 100% of its sales in foreign countries (let’s assume in exact proportion of foreign currency represented by the DXY), it’s earnings, once repatriated, will be 6.25% better than it would have been had the currency remained unchanged. For a firm that does 50% of its sales outside the US, that would imply a 3.125% (0.50*0.0625) increase.

So for me, the telling question is whether firms earned more or less than their percentage of foreign-to-total sales times the dollar devaluation.

If firms that reported solid earnings of type #2 only out-earned expectations by what we could have predicted given
the dollar devaluation and repatriation of profits, then maybe we should look at Q2 earnings skeptically. If so, then we should also probably wonder about whether the nature of the effect is temporary (either as a result of a future stabilization in the dollar or even a strengthening of the dollar). If temporary, we should not expect Q3 corporate earnings to look as healthy as Q2, …especially since I’ve seen more explanations of type #1 for Q2 earnings than in the past several years.

I should say that while this analysis is easy to consider in theory, it is complicated by several factors. First, it’s silly to assume that firms do business overseas in exactly the same proportion that the dollar index basket represents. For example, if 100% of a firm’s foreign sales were to Japan, using the DXY index would overshoot the improvement. Second, while it’s relatively easy to get the breakdown of foreign versus domestic sales for any company, it’s much more difficult to get breakdowns in sales and earnings by country. If you knew exactly how much each company sold (and/or earned) in each country, the calculation would be pretty straightforward because you could weight each country result by the appropriate exchange rate. Third, doing such a calculation also assumes that firms do not hedge. If firms were perfectly hedged, we should not expect to see any earnings explanations of the #2 type unless the improvement in performance is driven solely by fundamentals and not simply repatriation.

So then what am I trying to say here? I guess I’m saying that we should think carefully (and critically) about why some firms performed well in 2Q, especially those that used improved foreign sales as an explanation for such performance. Also, although imperfect, we can use the change in the DXY index (6.25%) times the percentage of foreign sales as a proxy for  how much better we could have expected firms to perform over analyst expectations had it simply been a repatriation.

If consumers continue to struggle in the US and it turns out that the improvement in Q2 performance was a result of a temporary improvement in the repatriation of foreign profits, we can and should expect a difficult Q3, …and a long road to economic recovery.

Last week (on July 23rd to be precise), Transocean and GlobalSantaFe announced that they would merge (see article). I meant to write about this deal earlier, but I got caught up in the middle of the excitement surrounding last week’s stock market drop. I’m over that now, …so I figured I’d come back to the Transocean/GlobalSantaFe deal.

I’m also feeling a little bad because all of my previous posts about M&A deals have been skewed toward positive sentiment. I liked the Sirius/XM deal. I liked the IHOP/Applebee’s deal. I even thought that the Whole Foods/Wild Oats deal wouldn’t have ended up half bad. As I’ve said on this site many times, most M&A deals fail. And since most M&A deals fail, it’s time to stop being a cheerleader. It’s about time I find I deal I object to. So here goes…

Quite honestly, I don’t know much about either firm. I know that they are both oil drilling companies. I don’t know much about the industry though either. I know, I know, you’re probably thinking, “Why the heck are you writing about this deal then?” I’m writing about this deal because there were a couple of things about the deal that raised a few eyebrows for me.

First, this deal was pronounced a “merger”. I always love that word - “merger”. It’s nice and meaningless.

There was a time when “merger of equals” actually meant something, …but it had more to do with the way in which a deal of that type was treated from an accounting standpoint - whether using the purchase method or a pooling of interests (for background see here) - than any real difference between a merger and an acquisition. There were some benefits to having a deal categorized a “merger”; specifically, it allowed firms to use a pooling model in which earnings were not diluted as a result of the amortization of goodwill over time (as in an acquisition). In order to qualify as a “merger” the firms being merged had to exchange equity (it had to be a stock deal), and they had to demonstrate that they were roughly of the same size and worth. Only then would a “pooling of interests merger” be allowed. But the FASB got rid of the pooling of interest method in 2001, requiring all deals to use the purchase method of accounting - whether merger or acquisition.

In that sense then, a merger was an accounting fiction.

But we still like to refer to deals as mergers. And we (in the popular press and in academia) will often call deals “mergers” when the firms are roughly equal in size or stature, in deals that involve stock swaps, and/or in deals in which the management of both firms agree to “share” the management of the new firm (i.e., no one party to the deal clearly dominates).

In reality however, labeling something a merger doesn’t mean very much. Those of you who know me know that I don’t believe that such a thing exists anymore, and you know that I think that deals that are presented as “mergers” are actually a bad idea. So that’s one reason I’m writing about this particular deal.

I’m not exactly sure why this deal was labeled a merger. I don’t think it is because they are the same size because Transocean is significantly larger. It might have something to do with the transaction, which involved a healthy amount of equity. In my opinion however, it mostly has to do with the goal of preserving the management teams from both firms to run the new combined entity, and to do so in a way that shares power. According to the article…

“Transocean Chief Executive Robert Long will continue as CEO of the new company, while GlobalSantaFe CEO Jon A. Marshall will serve as president and chief operating officer. GlobalSantaFe Chairman Robert Rose will be chairman of Transocean. The two companies will be equally represented on the new board.”

I think a merger of this type is a patently bad idea. When it comes to integration, sharing power across firms leads to conflicts over the appropriate way to go about the integration and results in delays in achieving synergies, slower integration times, greater staff defections, and ultimately, higher integration costs. It also can end in an ugly power struggle among senior management that can hurt the performance of the combined entity. Go ask folks at Daimler, Chrysler, AOL and Time Warner.

This is not to say it can’t be done. It just makes it much more difficult and much more costly to pull off. And given that synergies are difficult enough to achieve, adding another layer of complexity in the process of integration does not help. Integrations tend to go much better when one company clearly takes the lead. The more powerful partner (usually the acquirer) then has the latitude to rationalize, recombine, and redeploy assets as it sees fit, and in a more efficient manner.

The equity markets obviously don’t agree with me. When the deal was initially announced, shares of Transocean rose 7.9 percent while GlobalSantaFe shares rose 8 percent. Maybe the synergies present and/or the amount of pricing power this will give to the combined firm overwhelm any integration difficulty they will face by trying to make this a “merger”, and the market reaction may have reflected that. I reserve the right to remain unconvinced.