While many of us have been scanning financial headlines by the minute to see if the fabric of our financial system has yet to come completely unglued (and who can blame us), apparently there are other newsworthy stories outside of Lehman, Merrill, AIG, WaMu, and the like.

I found an article about executive compensation in China that appeared in last week’s issue of the Economist especially fascinating (see False Options). As the article explains…

How executives are rewarded is one of the many mysteries of China’s increasingly powerful companies. Unravelling it is important, not least because it should help to explain corporate China’s transformation from a state-controlled to a consumer-driven creature.

Research on this question has been surprisingly sparse. A new study by Zhihong Chen and Yuyan Guan, of the City University of Hong Kong, and Bin Ke, of Pennsylvania State University, casts a rare beam of light.

…Senior executives’ cash pay [at 83 large companies operating in China but trading in Hong Kong] was low by global standards: $180,000 a year on average. Almost every firm awarded stock options, worth an average of $140,000, giving bosses healthy top-ups as well as equity stakes—if those options were exercised. Remarkably, a lot never were. At more than half of the firms, no options were exercised within four years of vesting.

The authors of the study pose the following question:

“What forces make them [executives] throw away money [in the form of unexercised options] on the table?”

The article goes on to conjecture that the reason that executives in China do not cash out their options is likely cultural. I agree that there is a large cultural component to the differences in behavior between Chinese and American executives with respect to cashing out in-the-money options.

The authors of the study then add:

“If executives in general do not exercise stock options, how can the option scheme align executives with the interest in shareholders?”

Actually, I think that having management in place that does not exercise in-the-money options is, in some ways, a good thing for shareholders. After all, once executives have exercised their options and cashed out, their interests are no more aligned with those of the shareholders than if they never had shares at all. If executives are forced to hold in-the-money options, they have every incentive to continue working in the shareholders’ best interests to maximize share price. This not only makes their options more valuable, but more importantly for individuals from collectivist cultures such as China, it avoids the the public humiliation that would result from a drop in the share price.

I believe the point that the authors of the study were trying to make, however, is that if executives do not consider options a potential income-generating mechanism ex ante, then options provide no incentives ex post. If executives treat those options as if they don’t exist and never intend to act on them, then in theory, they could care less whether they have options in the first place.

But if the explanation for why Chinese executives are less likely to exercise in-the-money options is truly cultural, then the incentives likely still work as intended. It’s simply that executives are reticent to exercise the options on the way up for fear of how they will be perceived if they do so, and incentivized to continue to keep the share price above the strike price for fear of public humiliation if they do not. In my opinion then, they still serve a purpose.

So in this respect, shareholders of American corporations might be better served if their executives followed the example set by their Chinese counterparts.

For more on executive compensation and options, see my earlier posts A New Approach to Executive Compensation? and Is Restricted Stock the Answer to Executive Compensation?

Several weeks ago, in my post Troubling Signs for the U.S. Economy and its Corporations, I made two points:

1. In addition to the U.S. consumer struggling at home, consumers across the globe (especially in Japan and Europe) have begun to feel strain, resulting in decreased foreign demand for U.S. goods and services.
2. The U.S. dollar has rallied significantly in recent weeks impacting the foreign sales of U.S. firms.

Janet Yellen (President of the San Francisco Fed) echoed this sentiment in a speech she gave yesterday in Salt Lake City (see The U.S. Economic Situation and the Challenges for Monetary Policy, hat tip CR):

…export growth alone contributed one-half of the total real GDP growth [3.3%] registered in the second quarter. This element has been an important source of strength in our economy for over a year, being buoyed by strong growth abroad and by the weakening of the dollar. However, as I discussed, in recent months the dollar has risen somewhat and economic growth in many of our industrialized trading partners has slowed or even turned negative, suggesting that we can no longer count on exports as an important source of strength.

This is one of the effects that I spoke of in my previous post. However, it goes further. I would submit that not only will exports from the U.S. suffer, but the foreign sales of U.S. multinational affiliates will likewise suffer. Again, they will be impacted by the slowdown in the demand in the countries in which they operate, thereby decreasing profit. They will likewise be adversely impacted by the strengthening U.S. dollar as they repatriate income and report consolidated earnings in U.S. dollar equivalets.

For these reasons, and more, I am not seeing a rebound in corporate profitably for U.S. domestic or multinational firms in the 2nd half of 2008.

Back in March I expressed concern about Tata’s deal for Jagaur/Rover (see Buyers Remorse).

I think that this deal is destined to fail.

…For Tata, while bold, the deal just doesn’t make much sense. Aside from several luxury brands, an increased global presence, and some notoriety, I’m not sure what Tata gains. For example:

1. Where’s the synergy? Can Tata and Jaguar/LR share components, design, production, dealerships, or management? On its face, the synergies are just not there. But perhaps the investment was made for learning purposes, with Tata hoping to use Jaguar/LR capabilities to improve the quality and/or image of their existing automobiles. Possibly.
2. Can Tata rationalize Jaguar/LR’s production to make them more profitable? Actually, they cannot. They made pledges not to cut staff or close plants. And it’s unlikely that they would be able to reduce costs substantially by sourcing parts and supplies from India.
3. Can Tata right a ship that larger, more experienced, more formidable competitors had been unable to? In Jaguar and Land Rover, Tata is inheriting pieces of the old British Leyland Motors (Jaguar, Rover, Austin, Morris, etc.) that all tolled experienced (and continues to experience) more than 40 years of uncompetitiveness and underperformance. Quite simply, they are inheriting a lot of baggage (see Riding the Elephant for more background on British Leyland). It will be difficult for Tata to overcome this tremendous inertia.

Some analysts have argued that Jaguar and Land Rover were purchased on the cheap (at $2.3B minus $600M that Ford is throwing in to offset pension liabilities), and at the right time - when both Jaguar and Land Rover have a stable of new models about to hit the market (e.g., the Jaguar XF and the Land Rover LRX). These analysts point out that if these new models hit it big, it will make Tata’s acquisition look like a steal. However, this assumes that Tata can revive flagging sales at Jaguar and Land Rover in the middle of a downturn. Likewise, it assumes that Tata, by simply owning the brands, will not dilute their image. Finally, it assumes that the Jaguar and/or Land Rover brands can be revived after years of neglect and consumer dissatisfaction, and that consumers will once again be interested in buying relatively expensive, gas-guzzling cars and SUV’s (especially in the case of LR).

For all these reasons, I remain skeptical.

A recent article in The Economist echoes some of these concerns, but expresses some hope (see Now it’s Personal).

In the first quarter of this year JLR [Jaguar Land Rover] rang up profits of $421m.

But life has since become much harder for makers of large, powerful cars. In America, where petrol at $4 per gallon means big sport-utility vehicles have suddenly fallen from favour, Land Rover’s sales fell by 31% in the year to July.

So far, booming demand in Russia (up by 106%) and China (up by 151%) have more or less plugged the gap. Land Rover’s overall sales are only 2.7% lower year-on-year than in 2007. But JLR’s new boss, David Smith, acknowledges that the second half of the year will be much tougher. Land Rover’s production is being scaled back by 25-40%, depending on the vehicle model.

MY COMMENT: And it looks like things will be even tougher with global demand (even in places like China and Russia) slowing quite a bit.

A further worry for JLR is tightening environmental rules in most of its big markets. In Europe carmakers with fleets averaging more than 130 grams of CO2 per kilometre (g/km) are likely to face financial penalties by 2012. JLR is particularly exposed. Its best CO2 performer is the diesel Jaguar X-Type, which emits 154 g/km. Its worst is the Range Rover Sport which, in supercharged V8 form, chucks out 374 g/km.

MY COMMENT: JLR has a long way to go on emissions. It is not clear to me that Rover (given its portfolio of offerings) is anywhere near competitive.

One of the nice things about this article, however, is that it begins to detail JLR’s strategic plan for the next several years.

Mr Smith claims that JLR has a new nimbleness which allows it to exploit its smaller size. Strategy is set by a board consisting only of Mr Smith, Mr Tata and Ravi Kant, the head of Tata’s automotive business. Tata is committed to supporting the business plan until 2011, but the intention is that JLR should operate as a more or less independent, self-funding entity.

MY COMMENT: I’m not sure operating as an independent, self-funding entity should be Tata’s purpose with this acquisition. The best use of JLR is not to treat it as if it were a portfolio holding of Tata’s, but for Tata to exploit synergies with JLR - either reducing overall cost structure by sharing operations, parts, components, etc. AND/OR by using JLR as a means to learn - to help Tata develop up-market vehicles and learn about selling/manufacturing cars in developed markets.

Mr Smith’s strategy consists of three main elements. The first is improving customer service. Jaguar is already rated highly in America by J.D. Power, a consumer-research firm, but Land Rover “is not there yet” says Mr Smith.

The second is to recognise that, although JLR cannot compete across the board with the likes of BMW, Mercedes and Audi, it can be the best in its chosen segments. Land Rover, he says, has “benchmark products” in all its segments, and the XF, rated by several car magazines as superior to equivalent German cars, has shown what Jaguar can do. A new small Land Rover, based on the LRX concept-car displayed at car shows this year, seems certain to get the go-ahead, and Jaguar’s big saloon, the XJ, will be replaced next year with something sportier and more modern-looking. Mr Smith sees both Jaguar and Land Rover going even further upmarket, pushing into territory occupied by the cheaper Bentleys and Aston Martins.

MY COMMENT: This will be difficult for JLR to accomplish. One of the reasons JLR has a tough time competing effectively with the likes of BMW, Audi, and Mercedes is precisely because they don’t offer “across the board” models. They specialize in up-market saloons and SUV’s. BMW, Audi, and to a lesser extent Mercedes have a distinct advantage over JLR in their ability to spread development costs across models by using a single platform across multiple offerings (cars and SUV’s). This makes it difficult for LR to compete on cost with the likes of BMW, Audi, and Mercedes. Moreover, does JLR really believe it is in a league with Bentley and Aston Martin??

The third element is to reduce emissions. Jaguar is already a leader in lightweight aluminium construction and Mr Smith expects a 25% improvement in fuel efficiency over the next few years just by refining existing engines. But JLR is also investing $1.5 billion in new hybrids which will come on stream from 2012. Land Rover’s “e-terrain” technology, a diesel-electric hybrid powertrain with an electric rear-axle drive system, should give future Land Rovers even greater off-road ability while cutting emissions by 30%.

MY COMMENT: That is not enough. JLR does not currently manufacture one car that meets the European environmental standards that take effect in 2012.

And if all that were not enough, on top of all the strategic issues that JLR faces, for Tata there is the added difficulty of managing/coordinating operations across borders and cultures - i.e., an Indian firm managing a largely British operation. In cross-border deals, corporate culture needs to be integrated in a context complicated by differences in national culture. That is no easy task.

For JLR and Tata’s sake, I hope JLR survives to see 2012. But even if it does, there is no guarantee that it will turn into a profitable investment.

So I remain unswayed. I still think this is a bad deal for Tata.

One year ago in “How Good Were 2Q Earnings Really?” I wrote:

…we should think carefully (and critically) about why some firms performed well…especially those that used improved foreign sales as an explanation for such performance.

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

Two things (not unrelated) have happened since then that make that prognostication look more and more like a reality:

1. In addition to the U.S. consumer struggling at home, consumers across the globe (especially in Japan and Europe) have begun to feel strain, resulting in decreased foreign demand for U.S. goods and services. For an excellent summary of economies currently in (or slipping into) recession, see Nouriel Roubini’s recent post The Perfect Storm of a Global Recession.

The argument for some time had been that although domestic demand was stagnating, global growth would keep the U.S. economy (and the performance of its firms) chugging along, with increased exports substituting for domestic consumption. With a global consumer now struggling, and global growth quickly slowing, that reasoning looks tenuous. Re-coupling seems to be the order of the day.

2. The U.S. dollar has rallied significantly in recent weeks (by about 10% in DXY terms). This is a trend that I see continuing for awhile.

In my opinion, the explanation for the dollar’s strength has to do with the fact that now that many economies outside the U.S. are struggling, it is becoming increasingly clear that foreign countries will not only NOT be able not to raise interest rates to curb inflation, but will eventually HAVE to lower interest rates to address their own domestic weakness. This change in expectations for foreign central bank interest rates is U.S. dollar supportive. Add to that the flight to quality that generally occurs when foreign economies weaken, and we have a recipe for a sustained U.S. dollar rally. Mish has provided some excellent insight on the dollar in recent weeks (see U.S. Dollar Rally Continues, Currency Intervention and Other Conspiracies)

Should the U.S. dollar continue to strengthen vis-a-vis foreign currencies (and I expect that it will), it will put additional pressure on the earnings potential of U.S. multinationals that benefited from favorable exchange rates. A strengthening dollar not only makes U.S. goods and services more expensive for foreign consumers to purchase in their own currency, but it lowers earnings via the repatriation channel - the consolidation and reporting of foreign profits in U.S. dollar equivalents.

Taken together then, in addition to a struggling U.S. consumer, U.S. corporations face several additional headwinds moving forward: Foreign consumers that are now struggling - not willing, or able, to purchase U.S. goods and services - and less of a repatriation windfall as well.

Ouch!

I apologize in advance if this post is a little wonkish, but I thought it was an issue important enough to warrant comment. I promise to return to my usually un-wonkish ways in future posts.

Myles Shaver and I wrote a paper several years ago in which we questioned the usefulness of a particular ratio - export intensity (click here for a copy of that paper). Export intensity is simply a ratio of export-to-total sales (expressed formally as export sales divided by total sales, where total sales is domestic sales plus foreign sales). Export intensity, you see, has become one metric by which researchers gauge the export performance of a firm. Our objection to this measure was that when export intensity increases, it can be difficult to determine whether that happens because export sales increase, domestic sales decrease, or some combination of the two (by mathematical construction, both end in the same result). Moreover, because export and domestic sales are interrelated, we must consider their joint impact on each other rather than artificially hold one (e.g., domestic sales) constant.

This is but one example of how ratios make inference difficult. Robert Wiseman (Michigan State University) excellently summed up a broad class of problems with ratios in a working paper entitled “Making Researchers out of Monkeys: On the Misuse of Ratios in Management Research” (contact Prof. Wiseman for a copy). In that paper he details how the use of ratios is not only controversial, but can also lead to statistical estimation and inference problems.

Which brings me (in a long-winded way) to what I want to write about today - ratios used by analysts in finance. Specifically:

1. Price/Earnings - Share price divided by earnings per share

2. Price-to-Book - Share price divided by the book value of the firm

These ratios suffer similar shortcomings to those described above, yet analysts often treat them as if the denominator were fixed.

I’ve had enough of folks in the financial community parroting something to the effect, “Well, its price/earnings is historically low, so that makes this equity a good buy” or “It is trading at less than book value therefore the equity is undervalued.” If I had a dollar for every time I’ve heard something along those lines, I’d be wealthier than Bill Gates.

The real issue is not that the ratios are low, but why the ratios are low.

There are several plausible explanations. One is that the ratio is low because the numerator is low - the equity’s price, for whatever reason, is not in line with what the denominator suggests it ought to be - consistent with what the analysts would like to have you believe, or wish were true. Another is that the ratio is low because the denominator is too high - there are issues with earning estimates and/or the book value of the firm - inconsistent with the views of analysts that bandy this information about. (There are other reasons that these ratios might not be in line with their historical averages - e.g., as a result of structural shifts in the broader economy - but I will not address those here).

Let’s, for example, assume that the latter reason is the “correct” one - that the problem is actually one with the denominator. What then would this suggest? If that’s the case, then it’s not the price of the equity that’s wrong, but rather, estimates of earnings (whether current or forward) that are erroneous. Likewise, it could be that book value is off.

This is not implausible (especially in times such as we are currently living). Don’t forget that many of the same folks who tell us that P/E ratios are low are also those who estimate earnings. Analyst estimates of earnings are notoriously sketchy, either as a result of predictable bias, or simple miscalculation (see Lim, 2001 JOF). Moreover, my hunch (although I can’t provide a cite to any concrete research off-hand) is that analyst estimates of earnings become noisier at economic inflection points.

Book value is not a given either. Book value is simply the best accounting estimate of the value of assets. Who’s to say that the accountants have it right? Let me provide an example - that of banks during the credit crisis. Banks have a book value. It is simply the fair value of the assets that they hold. But we’re really not sure of the “true” value of those assets to the firm unless they have a liquid and transparent market, or until they are sold. So with respect to the stated book value of a bank - does it truly represent the value of those assets, or is it an estimate that could be off? As we’ve learned with many banks over the past year, that value could be off quite significantly. So then if we observe a low price-to-book ratio, it could simply be that the denominator is off - that the assets of the firm are not accurately valued.

Low P/E ratios and low price-to-book ratios are certainly informative, but sometimes not in the way most analysts implicitly assume. It doesn’t necessarily indicate that the equity is undervalued. Rather, price could be the fixed parameter - acting as a signal that earning estimates and/or book values are too high.

Message to analysts: Denominators matter too!

So the next time you hear analysts extol the virtues of a particular equity for the reasons stated above, don’t accept their opinion blindly. Instead of buying their thesis, be sure to seek out the underlying cause for the drop (or rise) in those ratios.

Last night I stumbled across a WSJ article reporting that Google is planning to open a venture capital arm (see Google to Extend Reach with Venture-Capital Arm). Who better to comment on Google’s plans than Gary Dushnitsky, one of the foremost scholars on corporate venturing. Gary is a friend and colleague from Wharton; and given his expertise, I asked him to share his thoughts as a guest blogger. Hope you enjoy his perspective. I’m hoping he will chime in from time to time with commentary on strategy, entrepreneurship, and related topics.

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Today’s news (July 31, 2008) suggest that Google is the latest company to join the Corporate Venture Capital (CVC) club. The practice of minority equity investment in entrepreneurial ventures has been around since the 1960s. Corporate venture capital, however, might be remembered by most as a curiosity of the late 1990s, when many leading corporations (Dell, Microsoft, and Lucent to name a few) entered only to fold their venturing units a couple of years later. Yet there are also anecdotes to the contrary. Intel (Intel Capital) has been a major player in the venture capital space for many years, as has Motorola (Motorola Ventures), Johnson & Johnson (JJ Development Corporation) and even the Central Intelligence Agency (IN-Q-Tel).

The (yet unconfirmed) news from Mountain View, CA are even more surprising when one takes into account another bit of news from earlier this year. In March 2008, KPCB launched iFund, a $100M fund dedicated to investing in “…market-changing ideas and products that extend the revolutionary new iPhone and iPod touch platform” (see here for details). The interesting observation is that Apple chose not to pursue this line of investment via corporate venture capital. Moreover, Apple is not a limited partner in iFund. Apple’s actions are somewhat surprising given that (a) it sits on large cash reserves upwards of $10B, and (b) it had experience with CVC investing in the past.

There are many issues one has to consider when structuring a CVC program. Google might have a head start on some of these issues, such as gaining traction with the venture capital community, and carefully managing relationship with entrepreneurs. However, internal issues often prove the most taxing. The topic of compensation, for example, tends to be highly contentious. Independent venture capitalists stand to make millions through ‘carried interest’ (i.e., keeping about 20% of the profits). Traditionally, the compensation package of CVC personnel follows corporate-wide policies – only a handful of CVC programs award ‘carried interest’ to their investment professionals. In a recent study with Professor Zur Shapira (Stern School of Business, NYU), we observe that the lack of ‘carried interest’ is prevalent among CVC programs and critically affects the investment practices they undertake [Dushnitsky and Shapira. 2008. “Entrepreneurial Finance Meet Corporate Reality: Comparing Investment Practices by Corporate and Independent Venture Capitalists,” Academy of Management Best Paper Proceedings].

Whether ‘Google Ventures’ is a good idea or not – only time will tell. The evidence, however, suggests that there is room for cautious optimism. I conducted a comprehensive study of strategic value of CVC investment along with Professor Michael Lenox (Darden School of Business, UVA). We analyzed the innovation output of 247 CVC investing firms, and compared it to that of their industry peers. The results indicate that corporations investing in CVC experience greater patenting output [Dushnitsky. and Lenox. 2005. “Corporate Venture Capital and Incumbent Firm Innovation Rates” Research Policy, 34(5):615-639]. In a related study, we explore the overall financial benefits to the parent corporation. Analyzing the same data, we find that CVC-investing firms exhibit higher Market-to-book value, in comparison to industry peers. The premium, however, is experienced solely by strategically-oriented CVC programs while financially-oriented programs experience a discount [Dushnitsky and Lenox. 2006. “When Does Corporate Venture Capital Investment Create Firm Value?” Journal of Business Venturing, 21(6): 753-772].

The adage goes “If you cannot beat them, join them.” In our entrepreneurial, innovation-driven economy Google is clearly heeding the call. Will Brin, Page, Drummond, and Maris be able to claim “Veni, Vidi, Vici?” That all depends on “How the group will be structured and what sort of investments it is likely to target,” which according to the WSJ still “remain unclear.” Hopefully we will not have to wait 7 years to find out…

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Gary Dushnitsky is an Assistant Professor, and the Goergen Fellow, at the Wharton School (University of Pennsylvania). You can find a biography and his research papers on his website.

My wife and I had dinner over the weekend with some close friends who were visiting from Washington DC. One of our friends just so happens to be Chief of Staff for a U.S. Congressman. He was interested in my views of the financial crisis, and the conversation quickly turned to the recent SEC-imposed ban of naked short-selling on a host of financial institutions (see SEC Restricts Shorting 19 Financial Stocks for background).

My friend and I agree on many issues. This was not one.

It is his view (and by extension, that of his boss) that short-sellers (UPDATE FOR CLARITY: He meant short-sellers in general, naked or otherwise) are to blame for much of the ills that have befallen U.S. banking stocks. He believes that by talking their books, hedge fund managers have effectively caused runs on banks. Moreover, he suggested that rumors passed from fund managers to CNBC, then reported on CNBC as fact (even if only as “alleged” fact), exacerbate the problem.

C’mon now, are you kidding me???

As much respect as I have for this friend, who is quite intelligent, I think he’s misguided on this issue. Blaming short-sellers for the failure of banks is as ludicrous as blaming Charles Schumer for the failure of IndyMac.

It is not the short-sellers that have caused the problems, but the banks themselves for lending irresponsibly thereby impairing their own balance sheets. Short-sellers are simply calling it as they see it, making logical deductions from the information at their disposal.

Now this does not mean that there are not instances of fraud, and I agree that fraud and attempts at outright manipulation should be prosecuted to the fullest extent of the law. However, to make a well-reasoned case for why certain banks are not healthy (even if consistent with your underlying trading position) is not fraud. Concerns about the health of banks not only should be raised - they deserve to be raised. The public ought to know what professionals truly believe about a company, for good and for bad. And for whatever it’s worth, the short-sellers often have it right (see Nasty, Brutish and Short).

Short-sellers provide a vital service to the functioning of our capital markets. Restricting their behavior is not only myopic, but also raises questions about the legality of those restrictions, and the “fairness” of the system (see Naked Fear for a nice summary of key issues).

And the point about how information relayed by CNBC can lead to a run - again, who’s joking whom? By the time information is disseminated by CNBC, it’s old news.

If you truly want to know about the health of a bank, there are two places to look - its balance sheet (if you’re so inclined to pore over such minutiae) and/or the credit default swap market (as bond traders are fairly keen at evaluating the health of corporations).

For what it’s worth, the credit default swap market has recently been sounding the alarm over Washington Mutual (see WaMu: Liquidity Options Running Low, Credit Default Swaps on WaMu, Uninsured Depositors at WaMu Begging for Trouble, or Death Spiral Financing at WaMu), among others.

To my knowledge, there has been no run on WaMu yet reported by CNBC. But if WaMu were to fail, I would not be surprised.

And that would have nothing to do with this post.

I’ve never been fond of the distinction that folks make between Main Street and Wall Street, as if there were some actual divide between the “real” economy and the “financial” economy. My hunch is that the correlation between the performance of our financial institutions and the performance of our economy is fairly strong (and positive). And if anything, that correlation is becoming stronger as we move toward an increasingly service-based economy (with more than 80% of our economy now devoted to services).

Nevertheless, if there were ever a company that speaks to the general health of our economy, it is American Express. Amex is a consumer and business finance company, and scrutinizing the behavior of its customers can provide insight into the direction of the broader economy. So where the adage once was, “As General Motors goes, so goes our economy”, my guess is that could be changed to, “As American Express goes, so goes our economy.” After all, consumer spending accounts for something like 70% of GDP.

It is for this reason that I was troubled by the earnings presented by American Express (see American Express Falls), and also by subsequent comments made in the conference call.

Don’t get me wrong. I am not troubled by what Kenneth Chenault said. Just the opposite. I applaud him for being honest about current conditions. Rather, I was troubled by the content, and what it likely means for the U.S. economy.

As reported by Bloomberg:

American Express Co., the biggest U.S. credit card company by purchases, fell the most in New York trading since the Sept. 11, 2001, terrorist attacks after earnings missed analysts’ estimates and the lender withdrew its 2008 forecast.

Chief Executive Officer Kenneth Chenault said yesterday in a conference call that the business climate was “much weaker” than earlier this year and American Express was hurt in the second quarter by rising U.S. unemployment and falling house prices.

Moreover, as reported by Calculated Risk from Amex’s conference call (see here and here):

“Fallout from a weaker U.S. economy accelerated during June with consumer confidence dropping, unemployment rates moving sharply higher and home prices declining at the fastest rate in decades,” said Kenneth I. Chenault, chairman and chief executive officer. “Consumer spending slowed during the latter part of the quarter and credit indicators deteriorated beyond our expectations.“

“In light of the weakening economy, we are no longer tracking to our prior forecast of 4-6 percent earnings per share growth. That outlook was based on business and economic conditions in line with, or moderately worse than, January 2008. The environment has weakened significantly since then, particularly during the month of June.”

“Over the past month or so, we have seen clear signs that the US economy is weakening. Unemployment rates, as we know, took the largest jump in over 20 years. Home prices declined at the fastest rate in decades, and consumer confidence is at one of its all-time low points. Card member spending particularly among consumers slowed sharply during the latter part of the quarter. Credit indicators as we signaled a few weeks ago deteriorated beyond our expectations, and by almost any measure the US economy and business environment are much weaker than the assumptions we first spoke to you about back in January and the conditions that existed in early June. Now this fallout was evident across all consumer segments, even our longer-term super prime card members.”

“Affluent customers in some situations are cutting back on discretionary spending…we’re seeing a slowdown in spend across the board…The severe decline in home prices and the marked rise in oil prices have had a fundamental impact on consumer budgets and behavior. Not just as it relates to mortgages and home-related spending, but also across the full spectrum of the consumer economy…we now believe the economic weakness in the US will likely worsen throughout the remainder of the year…” (emphases added by Calculated Risk)

Given this information, my expectations are that the chances for a second-half rebound are extremely remote, irrespective of what happens to oil prices (see Mish’s excellent posts on Deflation here and here). Moreover, I now expect conditions similar to those experienced by Amex to spillover to a broader swath of corporations, …not limited to housing, finance, and consumer discretionary.

For me then, this news speaks to the breadth of impact that we should expect from this recession - on both Main Street and Wall Street. My call therefore is still for long-and-deep versus short-and-shallow.

One month ago, in reference to Inbev’s offer for Anheuser Busch, I wrote (see Ambush by Inbev?):

…no way, ain’t gonna happen.

It was my opinion that the proposed takeover of Anheuser by Inbev would not be a successful one. I had several reasons for such a view. First, I thought that the deal involved far too much debt (Inbev had proposed to put only around 13% down), and in the current credit environment I thought they’d have difficulty arranging the financing. Second, it was clear that top management, and certain members of the Busch family (including August Busch, the CEO) did not want AB to be acquired. It looked as if they would attempt just about anything to thwart the deal. And third, I felt that there were so many interested parties running interference (e.g., politicians, unions, consumers) that they would eventually scuttle any deal.

OK, so back to the present. On Monday, Anheuser Busch agreed to a $52 Billion takeover by Inbev (see Anheuser-Busch Accepts $52 Billion Inbev Offer). Boy was I wrong…

That’s ok though - I’ve been wrong before and I’m certain I’ll be wrong again. However, as I mentioned in a follow-on post last week (see Inbev and Anheuser: Cooler Heads Prevail), I thought it was great news that executives at AB agreed to discuss the deal with Inbev. They finally put the interests of the shareholders before their own. As I also mentioned in that post, I have an inkling that Adolphus Busch IV (uncle to August Busch) had a little something to do with AB’s change of heart.

Now that the two parties have reached an agreement in principle, the deal is still not quite out of the woods. It must go through the regulatory channels to receive approval. But at this point, with the support of AB, I think that the Anheuser Inbev deal is likely to get the go-ahead.

Assuming that they do get the go-ahead, the issue then becomes: Will this acquisition work?

According to Bloomberg, Inbev will finance the purchase with $45 Billion in debt (see Inbev May Raise $4.6 Billion). That’s a whole heck of a lot of debt, leaving them little margin for error, and likely forcing them to dispose of assets to raise capital (most likely the theme parks).

The St. Louis Post-Dispatch had a nice article on some of the other cost-saving measures that Inbev will likely implement (see Inbev Faces Challenges). They acknowledge (and I agree) that it will not be an easy task for Inbev to generate value out of this acquisition. They write:

The deal is based largely on the premise that Budweiser will succeed when sent to the far reaches of the globe, and that two companies with dramatically different cultures can merge into a smoothly running global powerhouse.

My comment: As I’ve written before on this blog, culture can be the key to making/breaking a union. In this case, the cultural component is especially complex. The two firms obviously have different corporate cultures. However, because this is an international deal, those corporate culture differences are compounded by differences in national culture - how the Belgian, Brazilian, and American managers get on.

The article continues:

…the beer industry carries high-profile examples of beer not crossing borders easily, said Roman Shuster, an analyst with Euromonitor in Chicago. Brahma, for example, is a cautionary tale as InBev plans to send Budweiser into untapped markets. Brahma is a top beer in Latin America but much less prevalent elsewhere. InBev planned earlier in the decade to take Brahma worldwide, but the effort fizzled…

My comment: I do not expect Budweiser to suffer the same fate as Brahma. American-made products still carry caché abroad. They are a status symbol (for good or bad) for consumers from many countries, and a signal that a country (especially a developing country) has “arrived”.

In addition to the cross-distributional synergies that Inbev will try to generate, they will also attempt to rationalize AB’s operations:

Anheuser-Busch is expected to become considerably leaner when InBev applies its trademark cost-cutting. In a conference call Monday morning, victorious InBev executives laid out their plans to expand cost-cutting already under way at Anheuser-Busch. InBev envisions a deeper cost-cutting plan than the one A-B unveiled last month, when it was trying to fend off InBev. Anheuser-Busch’s plan to cut $1 billion in expenses through 2010 will be expanded to a $1.5 billion effort over the next three years.

The ramped-up cost cuts will include about $360 million from greater leverage with suppliers, more aggressive production efficiencies and “elimination of corporate overlapping functions” — which likely will lead to job losses at A-B’s corporate headquarters in St. Louis.

One thorny issue is whether — and to what extent — InBev executives will shake up A-B’s network of more than 600 beer distributors in the U.S. …InBev may see those distributors as ripe for cost-cutting, some analysts said. InBev has a record of tough dealings with distributors in Brazil, one of its main markets.

All told, I’m pretty happy I’ve been forced to eat my words on this one. I’m glad the two firms are coming together; otherwise, how would we get to see the fun part - how the Anheuser Inbev integration plays out. Buckle up.

The New York Times and Wall Street Journal are reporting that Inbev agreed to raise its bid for Anheuser Busch to $70 per share (see Inbev Raises its Offer, Inbev Boosts Offer). This raises the premium offered for AB from about 30% to nearly 40%. As a consequence, AB has agreed to consider the offer, and has opened lines of communication with Inbev.

I applaud the two firms for ratcheting down the hostilities. I also applaud them for recognizing that this is a deal worth discussing (and considering) rather than bickering over. AB’s rebuke of Inbev’s initial offer was a blunder. Inbev followed that blunder with one of their own, by taking the issue directly to the AB shareholders, drawing the ire of U.S. politicians and consumers in the process.

Personally, I think much of the credit for bringing the two parties together belongs to Adolphus Busch IV (uncle to August Busch IV, the current CEO). When this deal turned hostile, Inbev decided to offer its own slate of directors to oust AB’s current board. It so happens that one of those proposed directors was Adolphus Busch IV (I’d actually be interested to know the back-story for why he agreed to serve as a director on the competing slate). As reported by The Economist last week (business brief, sorry no link):

InBev, a Belgian brewer, intensified its efforts to win Anheuser-Busch by nominating an alternative board. The slate included Adolphus Busch IV, who wants the Busch family to negotiate with InBev. He is an uncle of Anheuser’s chief executive.

Provided that talks between Inbev and AB do not breakdown, we can now all turn our attention to where it rightfully belongs - to the issue of how Inbev will create value by bringing these two firms together. As I have mentioned in previous posts (see Ambush by Inbev and Anheuser’s First Ploy), there are lots of reasons to bring these firms together - there are some real distributional and operational synergies. However, as with any deal, achieving synergies can be difficult (see Why M&A Deals Go Bad), …especially for cross-border mega-deals of this sort (see DaimlerChrysler Post Mortem for a case in point).

Then there’s also the issue of whether or not the deal has become too rich - whether the achieved synergies will more than compensate for the premium.

Although the deal is getting friendlier, it has also gotten pricier…