Chrysler Pulls out of the Clone Wars

Joseph B. White writes in today's Wall Street Journal that Detroit is rethinking the wisdom of selling three or four versions of the same car under three different brands. Why? "[I]n a market with more than 300 different models -- depending on how you count -- fielding two or three or even four of the same basic car can lead to some very thin slices of pie, especially when increasingly well-informed shoppers can figure out in two or three mouse clicks that a Saturn Outlook and a Buick Enclave and a GMC Acadia are just three different styling takes on the same large crossover wagon."

White continues, "Chrysler's senior management recently declared that it wants out of the clone game. The company, which has the advantage of being closely held and thus not as concerned about what outsiders think, has outlined plans to kill a flock of its slow-selling clones, and focus its efforts on selling more of each model that remains."

After all, "Customers don't care whether they buy a minivan from a Dodge dealer or the Chrysler dealer just down the street. They just want a good minivan. In these difficult times, Chrysler can't really afford the capital and marketing effort to promote two functionally similar versions of a three-row box on wheels."

Read "Send Out the clones."
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Cynthia Jacobs talks to CFO magazine

Cynthia Jacobs is the internal auditor who blew the whistle at MCI-Worldcom, got herself fired, and exposed one of the most spectacular frauds and bankruptcies of the dot.com boom and bust era. One can argue, with some justice, that she is the "mother of 404," the provision in Sarbanes-Oxley that requires publicly traded companies to have their internal controls externally tested and certified.

Her book, Extraordinary Circumstances, has just been published and this interview speaks about it and the conflicts of interest that test men's moral fiber.

Financial Terms and Concepts

1) IRR: the Internal Rate of Return. The IRR is the discount rate that equates the present value of the future cash flows to the initial investment. More generically, the IRR is the discount rate that makes the sum of the present values of the cash flows zero when the investments are considered negative cash flows. The Internal Rate of Return on a bond is the yield to maturity.

2) Free cash flow (FCF): is the cash flow that a business generates and is available for distribution to debt holders and equity holders. It consists of the cash flow thrown off by operations minus the use of funds from the growth in its net working capital and from its capital expenditures required to maintain the firm's growth. It is commonly approximated by:

free cash flow = EBIT plus depreciation expense minus income taxes
minus the change in net working capital minus capital expenditures

This definition has the advantage that an external analysts can find the data on published financial statements. However, it has two disadvantages:

• It does not adjust for other accruals which may be distorting EBIT.
• The proper measure of FCF would use the required growth in net working capital and the required capital expenditures not the actual amounts. These requirements, of course, are not published. An analyst might estimate the firm's growth requirements and substitute his own estimates for the published actuals.

3) Operating Leverage: a firm's dependence on fixed costs rather than variabble costs. The greater a firm's operating leverage, the greater its business risk: i.e., the greater the impact of fluctuating demand or cost shocks on its profitability.

Interest rates & The Economy

Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently to the other party's peril. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlords require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than he or it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions.

Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me for the true risk of my living less the actuarial tables predict.

In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's managers do?

They note that if the bank can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.

The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from the new loans to get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for higher interest, but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off even if the loans go sour.

Neither the the bank nor the depositors are behaving the way they would in the absence of deposit insurance. That is the essence of moral hazard.

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Wichita's Unemployment Rate is 3.9%

The Bureau of Labor Statistics announced that the unemployment rate in Wichita was 3.9 percent in November. This comes after Friday's report that the national unemployment rate rose to 5.0 percent in December. Although Wichita's November unemployment rate was up from October, I believe the rate reported for October was low due to sampling error.

While the national economy has slid into an economic recession, Wichita's economy led by aerospace and natural resources continues to grow. The number of jobs grew 3.9 percent over November, 2006.

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Are We In A Recession?

[Graph courtesy of the federal Reserve Bank of St. Louis. Click on the graph, to enlarge it.]

The employment report issued by the Bureau of Labor Statistics (BLS) on Friday sent the stock market down by 250 points. Although employment as measured by firms' payrolls rose, there was virtually no growth over November and the unemployment rate jumped to 5.0 percent (from 4.7 percent.)

Few are saying we are already in a recession, but more are thinking the danger is increasing. Look closer, particularly at the unemployment data: they are a real worry!

There are two separate surveys the BLS uses to gauge the strength of labor markets: the establishment survey and the household survey. For the establishment survey, firms are asked how many employees they have on their rolls. In the household survey, households are contacted and asked who is working and who is looking for work. In recent years cyclical analysts have largely ignored the household survey for two reasons. The month to month noise in the household survey is greater. Secondly, the population controls for the survey from the Census Bureau distorted the time series in the early years of the decade.

Ignoring the household survey is a big mistake. Right now it is giving off strong signals that we are already in a recession.

The unemployment rate has risen from 4.4 percent in March to 5.0 percent in December. Although the drop in November and the jump in December were noise associated with an early Thanksgiving, a decline of six tenths of a percent over nine months is not noise! It is difficult to find a comparable rise that was not part of an economic contraction.


Total unemployed have risen by almost a million (917,000) since March. See the attached graph. Although the population benchmarks through off comparisons in the number of unemployed from one year to the next, they do not affect the measured change from March to December.

A positive note for Wichita's economy, employment in transportation equipment other than cars and trucks continued to rise.