Monthly Archives: November 2014

Etihad’s business class upgrade auction

While other airlines only send lame e-mails with offers to book a car or hotel connected to your flight, Etihad has a more exciting question: would you like to bid for an upgrade to business class? If you bought an economy class ticket, Etihad will “auction” upgrades to business class for each leg of your journey. The process is in three easy steps: make an offer using a slider that indicates the offer strength, enter credit card details, review and submit. The airline will then notify you via e-mail if the upgrade request has been approved (and only then charge you).

Etihad upgrade auction

Easy to use, and I would gladly participate if I could make a token low bid of let’s say €100 or €200 with a 10% or 20% probability that I would be lucky enough to get a seat. In other words, a “small investment, huge pay-off” bet. An offer strength indicator indicates the range of past successful offers for similar flights. Unfortunately, in my case, the slider tool does not allow a bid below €560 per leg, which would get me into the “red” category (this translates to me as: unlikely to be accepted). Starting at €595, you get into the “yellow” category (suggesting you have some chance of acceptance), and starting at €765 you are in solid dark “green” (suggesting it is highly likely that the bid will be accepted).

Frequent travelers have posted tips for successful bidding on the internet, such as:

  • Look at what it would cost you to purchase the business class fare
  • Bid slightly over the minimum bid
  • Check how full the flight is. Make a pretend booking online, in both business and economy, so you can get to see the seat map for each cabin. If business class if empty your chances of an upgrade are good. If economy class is super full, your chances of an upgrade are quite good as airlines overbook flights all the time so freeing up your economy class seat could help.
  • Decide what the upgrade is worth to you.
  • The kind of ticket you purchase may matter.
  • Your frequent flyer status with the airline may count.

Given that my original economy ticket was €988 roundtrip, I am not feeling I get a good “deal” here, as an economy ticket plus two upgrade bids would not be significantly cheaper than booking a business class ticket from the start.

In short: I love the concept, a nice incremental business model that could generate a good amount of additional revenue for Etihad by getting already “captive” economy passengers into those empty business class seats, but the deal has to make the customer feel he “wins” as well versus walking up to the ticket desk at the airport and buying an upgrade there.

Factually correct, contextually lacking

I often contemplate the nature of reality. Even, or maybe especially, when I review a company’s public proclamations about its financial performance. What is fact and what is fiction? Is somebody trying to put a “spin” on the story? “Objects in the rear view mirror are closer than they appear”….

Fair and accurate representation

When reading earnings releases and annual reports, it is important to realize that companies are required under accounting regulations (and are hopefully intrinsically/ethically driven) to provide financial statements that are a “fair and accurate representation” of the company’s financial position, results of operations and cash flows. These financial statements inherently include “some amounts that are based on management’s best estimates and judgments”. Finance is more an art than a science. Companies that are “listed” (their equity or debt is tradable on stock exchanges), use either US GAAP or IFRS (depending on where they are listed (US or Rest-Of-the-World)) to guide their (subjective) interpretation of the complex operational reality.

So far, so good. Financial statements are put together using judgments and subjectivity. That’s not necessarily the area where I have surreal experiences when trying to inform myself about a company’s success (or lack of it) through studying its earnings releases and annual reports. I get very cautious, as well as excited to uncover the underlying data and “truth”, when I get to those parts of the information where a “spin” is put on the facts: sections such as the “letter to the shareholders”, the 1-page graphical summary showing 5 to 7 key indicators, or the PowerPoint slides provided with the earnings call. Let me discuss several areas where “reader beware” applies. Disclaimer: I am not “accusing” any of these companies of misstatements or of misinforming shareholders, just pointing out that there are cases where information is provided that might be factually correct, but where shareholders that fail to inform themselves about the broader context of these facts might draw the wrong conclusions.

Beware of the time horizon

GE is a great company to study and follow. Always executing multiple big strategic initiatives at the same time, and transforming the business portfolio by making bold moves. The earnings releases and investor outlook meetings are significant events in my calendar. You do however need lots of background knowledge about the company to properly judge some of the statements made.

GE example #1 is the 2Q 2011 earnings release comment on the execution of the capital allocation plan, with a factually true claim of having announced a “third dividend increase, up 50% since 2Q 2010”. Mathematically, this is completely correct: on July 23, 2010 the first increase (from $0.10 to $0.12 per quarter) was announced, then on December 10, 2010, the second one (from $0.12 to $0.14), and on April 21, 2011, the third one (from $0.14 to $0.15). However, this statement omits the 68% dividend cut announced in February 2009, from $0.31 per quarter to $0.10 per quarter. So yes, a multi-step dividend increase from $0.10 to $0.15 does equal a 50% improvement, but it is at the same time still down more than 50% from the “pre-cut” levels. In late 2014, the dividend is at $0.22 per quarter, a further increase versus the lowest point in 2009, but still not back at 2005 to 2009 levels.

GE segment profit 2009-2013

GE example #2 is the segment profit graph from the 2013 annual report. It covers the 2009-2013 timeframe, and shows an impressive increase of $8.8B or 56% from $15.7B (2009) to $24.5B (2013). The graph omits the detailed split between the key segments, which would have shown you that the industrial businesses “only” went up by $1.8B over these years, while most of the increase comes from GE Capital going from marginal profitability in 2009 of $1.4B to much healthier profitability levels in 2013 of $8.3B. A key data point to know for investors, which is not provided in the graph of page 1, but in the summary of operating segments on page 42. Furthermore, the graph uses the common 5-year comparison, whereas a broader 7-year comparison would have told you that segment profit was a stunning $25.6B in 2007. In other words: yes, GE has shown significant profitability improvement in the 2009-2013 timeframe, but its profitability in 2013 is not yet back at pre-crisis 2007 levels.

GE revenues 2009-2013

GE example #3 is the 5-year revenue graph from the 2013 annual report. It shows GE’s revenue shrinking from $154B in 2009 to $146B in 2013, and suggests that this is largely due to having NBCU as a fully owned subsidiary in the past (contributing $15B revenue in 2009) to a minority shareholding and subsequent full sale to Comcast (contributing a final $2B in revenue in 2013, i.e. a drop of $13B over the 5-year period), plus the deliberate shrinking of the GE Capital business portfolio (causing a $7B drop in revenue). These statements are factually true, but firstly omit the context of the 7-year overview where GE historically had a much higher 2008 revenue of $180B (!) including NBCU, and $163B excluding NBCU. Secondly, the incremental revenue impact of acquisitions like Converteam, Dresser, Wood Group Well Support, Wellstream, Clarient, Lufkin and Avio is not mentioned or split out. If you split out the revenue impact of a significant divestment like NBCU, shouldn’t you split out the positive revenue impact of the acquisitions in the same graph?

Beware of “non-GAAP” supplemental information

Companies in the healthcare sector tend to be highly profitable in most years (EBIT margins in the 15-20% range), but have very volatile earnings. Many of these companies provide “non-GAAP” supplemental information, stating that the alternate figure more accurately reflects their company’s performance. In most cases, this means isolating “unusuals” or “special items” from the performance: common examples are litigation charges and settlements, product recalls, restructuring costs, acquisition-related charges. The non-GAAP (“after clean-up”) profit in almost all cases is higher than the GAAP profit (what the official accounting rules tell you to report).

Baxter adj EPS 2009-2013

Baxter provides a graph every year of “Earnings per Diluted Share (adjusted)*”, a nice smooth graph of steadily increasing EPS. Earnings per Share is a fairly straightforward metric: total net income divided by the number of outstanding shares. Repurchasing of shares by a company can have a huge effect, as it decreases the denominator in the equation. In Baxter’s case, the adjustment of the numerator (earnings, or net income) has a much bigger effect. In 2010, the net income was $1.4B, while the non-GAAP profit (excluding special charges) was $2.4B, a difference of $1B. Strangely enough, this huge difference is not explained in any detail in the annual report, but there is some small print explaining the “*” mark: “Please see the company’s website at for a reconciliation to earnings per diluted share.” My personal opinion in this is that companies should make these adjustments (on a line item basis) an integral and upfront part of their financial reporting.

A review of other companies (J&J, Abbott, Hospira, BD) in the healthcare sector showed that the significant size and number of non-GAAP items is common practice in this industry’s financial reporting. Hospira even turned a 2013 GAAP loss of $8MM into a $348MM non-GAAP profit by adjusting for 9 different special items.

Beware of euphemisms

The letter to the shareholders is a useful document to read, it informs you of the company’s strategy, accomplishments, and performance. Be careful with the wording, as euphemisms are sometimes used that should trigger a desire in the reader to dig more deeply into the actual financial performance. Just like the phrase “Mr X is pursuing opportunities outside the company” is often a nice way to say Mr X was fired, companies can use sentences like “….. created significant headwinds for the company. Despite these challenges, the company also enjoyed many accomplishments” to talk “around” the problem. This is the time to pause and dig into exactly what the size and impact was of those headwinds, and whether these headwinds were one-off or will continue to have an impact in the future, before turning to the accomplishments that are likely to be of a significantly smaller size.


“Objects in the rear view mirror are closer than they appear”

Annual reports and quarterly earnings releases should not just be legalistic documents that are mechanically filled in, with templates copied from the previous period where only the numbers updated. Any company should provide an accurate and full representation of the strategic, financial and business risk situation, both in letter as well as in spirit. Drawing selective attention to some items rather than others is not quite the same as lying, but I would not call it fully transparent either.

Service as the key to success

Razor and blades (Gilette, Wilkinson). Printer and toner (HP). Instrument and consumables (Applied Biosystems). Aircraft engines and service (GE, Rolls-Royce). Smartphone and data usage / call minutes (Verizon, Vodafone). Each of these is an example of a business where building an installed base is key, as the subsequent service revenue (in the broad sense of the word) is both lengthy in duration as well as highly profitable. Some companies make significant business concessions in pricing of the former (the “equipment”) to get access to the latter (the “service”). It might even be a rational economic decision to sell the equipment at a loss, provided the service revenue and profit stream is captive and customers cannot easily switch to other service providers. Alternatively, a structure where a customer gets a longer term free-of-charge use of a piece of “demo equipment”, but pays for the consumables, could make sense.

RR service-OE revenue

Rolls-Royce provided a nice rule-of-thumb chart in its very informative investor briefing in June 2014: services revenue is at least 4 times net OE selling price over the lifecycle of an engine program. GE at the end of Q3 ’14 had a total backlog (orders committed, but not yet delivered) of $250B (!), of which $180B in services and $70B in equipment. Half of GE’s backlog is in the Aviation business. GE implicitly provided Operating Margin (EBIT) percentages (see my article on GE’s service versus equipment margins) for each type of business: equipment at around 10% OM, service at 30% (disclaimer: across GE’s broad industrial portfolio, not specifically for aircraft engines). Service proves to be an attractive revenue and profit generator for both these companies.

Which indicators should we track to measure the service business’ earnings potential?

It’s important to have estimates of how the installed base of a company’s equipment placed with customers will develop. The potential for service revenue then depends on the usage of the equipment and the contractual structure of the service agreement. In the aviation business, billing for engine service contracts tends to be based on hours flown times rate per hour. Therefore, RPK (Revenue Passenger Kilometers) or RPM (Revenue Passenger Miles) are key indicators for companies like Rolls-Royce and GE, and often mentioned on the first page of investor briefings and earnings releases. If RPK/RPM goes up or down, it has a significant impact on the most profitable part of their business!

RR total care

The beauty of the British Pound

A short reflection on the beauty of the British Pound.

Well, not really on the currency itself: I used to encourage the Brits to actually give up the British Pound and join the Euro, as their economy is closely interrelated with that of the rest of Europe and a joint currency might facilitate trade, but after studying the great works of Nassim Taleb (“The Black Swan”, “Antifragile”) I have become more skeptical about fragile complex systems we do not understand (like the Euro) that might have many unwanted side effects. So let me proclaim myself to be an agnostic on the question whether the Brits should continue to use the British Pound.


Rather, I would like to reflect in this article on the beauty of the British Pound banknotes, in particular the back side of them. Each is graced with a portrait of a great British scholar: the £10 note with Charles Darwin (1809-1882), and the £20 note with Adam Smith (1723-1790). I am disappointed that Smith got to be on the £20 note and Darwin “only” got the £10 note, as I deem the scientific impact and reach of Darwin’s ideas far more noteworthy than those of Smith (even though I studied economics myself, rather than biology). Not only does Adam Smith get to be on a note of higher nominal value, there are also many more £20 notes (1.8 billion) than £10 notes (700 million) in circulation. So who wins the popularity contest? I think neither of them would have cared, if they were still alive. The amusing thing is that Adam Smith was a Scottish economist, the first Scot to appear on an English note.

The beauty of having these two scholars on the British Pound notes is that they teach us a similar concept: Darwin’s discovery of the mechanisms underlying evolution, and Smith’s discovery of the mechanisms of wealth creation. To simplify and summarize matters greatly: one of Darwin’s key propositions is that those organisms that are best adapted to their environment have greater chances of survival, one of Smith’s is that division of labour in manufacturing causes a great increase in the quantity of work that results. In short: adaptation and specialization, concepts that have significant applicability in the area of business strategy, as well as career planning. Are you (and/or your company) working on those things that you are technically competent at, that you enjoy doing, and that pay reasonably well? If so, your earnings potential, your job satisfaction, and “chances of survival” (in a dynamic and turbulent economy, with lots of companies going bankrupt, and jobs under threat of restructuring) are likely to be higher. Those are the questions that I contemplate every time I have British Pound banknotes in my hands. Good triggers for reflection. I am lucky to visit the UK on a regular basis, and use its analogue currency whenever I can. Adam Smith will be around on the £20 note for many more years, as “his” £20 note was issued in 2007 as part of “Series F”. Charles Darwin will sadly be replaced by Jane Austen in 2017 on the £10 note, but has had a long run in circulation since 2000.