Treasury Report on Germany's Trade Surplus Is Incomprehensible

The big headlines about the U.S. Treasury, and hence the Obama administration, criticizing Germany's export-led trade policy seemed outlandish.  So, as I always do, I try to get to the source and see for myself.  The source is the innocuously titled report. "Semiannual Report on International Economic and Exchange Rate Policies." 

Most of the facts recitation, charts and discussion are unsurprising because they've already been discussed ad nauseam in lots of print and discussion sources.  The stage is set by this factual recitation.  The euro area current account was close to balance in 2009-2011, and it increased to a surplus of  2.3% of GDP in the first half of 2013.

The report also notes, "On a real effective basis, the euro appreciated by 2.7 percent in the first
half of 2013 and by a further 0.6 percent in the third quarter of 2013."  Keep this in mind.The report continues,

  "The euro area economy expanded by 1.2 percent, on a seasonally adjusted, annualized basis (saar), in the second quarter of 2013, marking the first expansion of economic activity in the euro area in seven quarters. Expansion was supported by domestic demand growth in Germany - though growth in Germany still continues to rely on positive net exports, which continues to delay the euro area’s external adjustment process – and on domestic demand in France."

This is an incomprehensible logical leap, so let's back up to the facts that may, or may not support this. The German current account surplus in the first half of 2013 was a bit more than 7% of GDP.  The Netherlands ran a current account surplus during the same period in excess of 10% of GDP.  So, if Germany were somehow able to run a domestic demand constraining, export-led policy in the face of a rising euro, then what were the Netherlands doing?  The answer is that the contention is economic humbug.  

Later in the report we read,"Germany’s current account surplus, meanwhile, rose above 7 percent of GDP in the first half of 2013, with net exports still accounting for a significant portion (one-third) of total growth in the second quarter, suggesting that rebalancing is not yet occurring domestically."  Wait.  This means two-thirds of the total growth in the second quarter was accounted for by sectors other than net exports.  How can the Treasury's political conclusion laying the burden for the eurozone's adjustment process at the feet of German trade performance be justified?  

The performance came despite the fact that the currency movement was unfavorable.  I would call it good performance.  On the other hand, the report doesn't offer the detailed trade statistics among countries or regions to delve into the problem further, but the growth of the Chinese economy and the push for 'infrastructure investment' alluded to in the report was probably a source of Germany's strength in net exports.  

In fact, the discussion about China seems to raise more questions about their continuing management of their economy, despite the strong nominal increase in the renminbi during the period.  China continues to build foreign reserves and there is no sense of their economy rebalancing  towards domestic consumption.  China, however, gets a free pass in the reports discussion of international adjustments.  

The German reaction to the political nature of the Treasury's report was strong, as reported in the Wall Street Journal.   "The German export growth story is mainly in emerging markets like China, the implicit criticism that Germany should export less and consume more—there I have my doubts because [European] periphery economies don't have products Germans would consume,' Mr. Brzeski said."

The Sears Way: Kill the Lands End Brand, Then Spin It Off to the Public.

My family and I were early customers of Lands End.  Did they sell the same kinds of polo shirts, trousers, and oxford dress shirts as many other retailers?  Yes.  But, the company's value proposition and culture were totally different, and once we were sold on this, our family could reliably buy our wardrobe staples through their catalogs. They even pioneered certain categories like duffel bags and winter wear, offering high quality at just above discount prices.  Their stuff lasted forever.

Two of their staples for men were the basic men's polo shirt and khaki trousers.  Quality of the basic fabrics was high, and they always had nice details like collars that lay flat and buttons that didn't break. Founder Gary Comer began his business career in advertising copy writing, and I confess that the catalogs themselves were fun to read.  They continuously reinforced in story the company's corporate messages:

• We provide wardrobe basics of the highest, department store quality, or better, at discount store prices, and we deliver to your door.
• Lands End spends a lot of time with our suppliers and designers to make the basics better.  We pay attention to detail, e.g. rolled collar dress shirts as opposed to fused collars. 
• If you're not satisfied, ship it back to us on our dime, no questions asked. And, this was actually true.
• You can always talk to us on the phone, and we're farm folks in Wisconsin who love to talk to our customers.

The customer service folks were women working out of their homes to earn a little extra money, and they knew the catalogs, loved the company, and really enjoyed helping customers with sizing and color questions. All of the above is a concrete example of a company's value proposition written into a corporate culture, which people were proud to advertise themselves.  This was the Lands End brand.

Now, it is been totally debased, and we've written about this before.  The clothes are awful.  If possible, they are a step below the early, trashy Target private label line Merona, and even worse than Penney's Stafford private label line.  Perhaps a step below Wal-Mart would be the appropriate comparison.  The customer service folks are gone, and they're generic call center people who probably handle dozens of catalogers. 

I would never need to call about returns, because no one in their right mind would buy this merchandise in a Sears store.  They are laid out like dump tables in an Odd Lots store. 

So, when the spin out story is put together, it will be an empty shell.  The folks who now provide the comparable quality merchandise are L.L. Bean or Eddie Bauer, but they are significantly more expensive. Lands End could never recapture their niche from these two, and other, competitors, of which there are many niche catalogers, like Duluth Trading.

So, today's story is about Sears trying to "unlock value" from Lands End.  Good retailing companies are about a sustainable value proposition, execution and a strong culture.  Sears has sucked all of these out of the company that Gary Comer founded.  Hedge fund managers can't operate companies, so beware of one who is selling one he operates.

Consumers Will Soon Face Choice, Technology and Budget Fatigue

Desktop computing was going to die, as consumers and business users moved to laptops, notebooks and ultrabooks.  Soon after this, the world was going mobile, and computing was converging on the phone. Then, limitations of screen size, carrier spectrum, and battery life moved tech companies towards tablets.

A recent forecast by Cisco Systems projects that by the end of 2013, the number of cellphones, tablets, laptops and other wireless devices (such as those connected to smart sensors) using global spectrum will exceed 7 billion devices, about equal to the world's population.  This, in our opinion, is one of the elephants in the room. Now, let's move on to Apple before we return to our main theme.

According to the technology research team at Credit Suisse, Apple shipped 33.8 million iPhones in their recently reported FY13 4th quarter, up 26% yr/yr. By fiscal year 2015, CS projects that the iPhone will account for 55% of sales and about 62% of its profits.  The company now has $91 billion  in net cash. Is there a problem?

A minor one is Carl Icahn's absolutely loony idea to drain the cash to buy back shares, take on debt and create "shareholder value."  Wall Street Journal "High Definition" columnist Farhad Manjoo puts it very aptly,

"Mr. Icahn doesn't seem to realize that Apple, like all tech companies, is ephemeral. It is a giant perched atop an ever-shifting mountain of silicon, a behemoth whose success is as tenuous as it is fantastic. To the extent that Apple can guarantee any future for itself, its salvation is in its cash. It needs to spend its money on its future."

This is spot on, but the problem is "How will consumers use technology in the future?"  Apple is increasingly positioning itself in the high end, meaning smartphones with ASPs of $400 or more, according to CS.  This will protect profits, but will also cede market share to Samsung, HTC, and other Android manufacturers. It is however a conventional strategic direction.

But, Apple is number one in tablet computing, with a 40% market share, according to CS.  Its tweaking of the prices points for the most popular iPad Mini should expand its market share, when taken together with its its new iOS which promises the same user experience across Apple phones and over iMac notebooks and laptops.  Apple quotes a statistic that says with 39% market share of tablets, 81% of web traffic from all tablet Web traffic comes from iPads.

Spectrum rationing through different price plans will eventually rear its head again.  As we've said before, most tablet users we've seen are taking, uploading and emailing photos, downloading and viewing videos of television, sports and movies, and doing routine web based queries for restaurants and amusements, along with reading email, online publications.  None of this seems to be productivity-related work for an employer's enterprise, the area where Microsoft dominates with its Office franchise.

Microsoft continues to plug away at its phone franchise through Nokia. It's financial impact on the company is and will be de minimus in the near term. Their efforts with Surface and Windows 8.1 has a similar aim to Apple, though.  That is, a Windows 8 user should have a similar user interface experience from desktop, to mobile, to laptop/tablet.  Microsoft is trying hard to converge the laptop and tablet into one. Its price points are probably still off, and Microsoft's relationships with developer communities in mobile are evolving very slowly.

Google, meanwhile, is showing that it can create relatively lower priced products in smartphone and tablets, with the Nexus lines.  These, in our opinion, are controlled experiments rather than an effort to seize significant market share.  Android is too fragmented and fractured an operating system to migrate across the traditional computing platforms. However, Google may be looking at essentially leapfrogging the shorter term moves of Apple and Microsoft.  I can't recall the name of the presenter who said that Android is a perfect system for computing without a traditional user interface; he showed the example of a mirror at home.  The user, using hand gestures, could access broadcasts or find information on something as mundane and ubiquitous as a mirror, so no dedicated, battery draining display.

Apple does have some choices to make to ensure its future growth, remembering that it is an extraordinarily profitable company with an 8% effective tax rate or so. Microsoft has made some decisions for now, but its fate is far from clear, given its institutional and leadership uncertainties.

Consumers, on the other hand, will wake up one day and realize that they have too many devices and are paying too much, even with hidden subsidies, for news and entertainment.  For U.S. companies, the worldwide middle class in developing countries will be effectively closed off to them because of their relentless focus on protecting their developed market franchises.

Technology companies have always been ephemeral, as Mr. Manjoo observes, and it remains to be seen which ones can successfully navigate the consumer technology future.

One American's Personal Encounter With Syria

The Bread of Angels: A Memoir of Love and Faith by Stephanie Saldana
My rating: 5 of 5 stars

In August of 2012, the Wall Street Journal featured a column by Stephanie Saldana on the kidnapping and execution of Jesuit priest and Abbot Paolo Dall'Oglio by rebel forces. At the end of the poignant column, the credit said that Stephanie Saldana was the author of "The Bread of Angels," and I knew that I had to read it.  It paints an intimate portrait of a young woman of Mexican-American heritage from San Antonio, Texas, who decides to spend a year in Damascus.  It could be described by readers as a travelogue, a story of broken romance, or yet another story of a spiritual quest.  I has elements of all of these.  For me, in light of our possibly deciding to attack Syria, it had a different impact.  It showed how little we know about places with rich histories, like Syria.  Even the author, who had studied Arabic in university and knew about Middle East history, she was unprepared for what she found.

The people in her story are richly drawn, and they all welcome her, and her 'landlord' adopts her as a granddaughter and invites her for coffee two or three times a day.  Syrians too know very little about Americans, and Stephanie certainly opens their eyes too. Understanding among countries will never be advanced by politicians no matter how high minded or well educated.  International amity and cooperation is built on the thousands of little interactions among real people, like Stephanie and her grandfather, called the Baron. This would be a great selection for a book club, and I'm going to offer it to my wife as an idea.  It's a timely, but timeless read.  Highly recommended.


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Costs of the Greek Exit From the Euro

"Huge, Massive, Crippling." Words like these are bandied about by European politicians when talking about the costs of a Greek exit from the euro.  But, we would like to know, in the words of Monty Python, "How big is it?"

A 2012 study which is still quoted today, comes from a private forecasting group, Prognos AG, commissioned by the Shaping Sustainable Economies Programme of the Bertelsmann Group. The summary is contained in Policy Brief No. 2012/06, "Economic impact of Southern European member states exiting the eurozone."

Unfortunately, it looks like a model of comparative statics underlies the conclusions of this study.  It really doesn't come to any measurable conclusions for the basic question.  Instead, just like the run up to our great bailout of the US financial system, it just cries wolf.

The basic conclusion?  "...Greece defaulting on its sovereign debt and leaving the European Monetary Union would in and of itself have a relatively minor effect on the world economy..."  The reissued Greek currency "would be devalued relative to all other currencies, and the scope of this devaluation remains every bit as uncertain as the extent of a (debt) haircut."  Wow.  This is deep stuff.  Even the remark about being devalued relative to all other currencies seems a bit flippant. What if an exit were accompanied by real economic reforms and a commitment to minimally enforce statutory tax collections?  I would surmise that the the devaluation compared to Italy, Portugal, and Spain, for example, could be less than the devaluation compared to Germany, for example.  So, from this study, we really know nothing new.

The totally speculative conclusion is that a Greek exit, "..could..undermine investor confidence in the Portuguese, Spanish and Italian capital markets and thus provoke not only a sovereign debt default in those states as well, but also a severe worldwide recession."

Look an exit from the euro is something that is not even legally contemplated, and there's no doubt that it would be extremely messy with lots of unforeseen, unintended consequences.  Hedge funds and profiteers of all stripes would make out like bandits.

However, the current house of cards has enormous costs associated with it as well, and any comparison to a Greek exit has to be based on better economic models and netted against the costs of the current inefficient, dysfunctional regime.  The ECB's failure to do its own job by quickly forcing European banks to mark down their holdings of European sovereign debt to some remotely realistic economic value is a disgrace.

A thoughtful Greek exit (and they certainly have lots of smart, internationally known economists) would be aimed at real economic reform, a healthy tax system including collection and enforcement, budgetary and pension reform, and an independent monetary policy for a currency whose initial devaluation would put into place adjustment mechanisms that would eventually allow sustainable growth.  In any case, Greek elected officials would once again be in charge of their affairs.  Can it be done?  Maybe.  Maybe not.

However, the current six year European economic hoax continuing into the indefinite future doesn't serve the interests of the peripheral members of the EU.

Microsoft Reports Solid First Qtr 2014: Does 'One Microsoft' Make Sense?

Introducing the quarterly results, Microsoft CFO Amy Hood's talking points script must have had the word, "execution" written in large, bold type.  We would hear over and over about how well the company had executed against its goals in the quarter, given the macro headwinds in tech, the move to "One Microsoft," and the higher "cadence" of the company, as demonstrated by the release of Windows 8.1 less than a year after the initial version.

The highlight on execution was probably deliberate, and it was done to differentiate Microsoft's performance from that of HP and IBM, where both CEOs lamented their teams' lack of execution.  The real story in the quarter was the performance of the Commercial segments, formerly referred to as the Enterprise segment.

Following the most recent Analyst Day, we wrote,

"The Enterprise businesses are attractive and Microsoft may ultimately be a stronger competitor than Oracle and other established players on the software and services sides, but that is still an open question.
One of the most interesting slides from Kevin Turner's presentation is one depicting revenue from three large scale corporate customers, pre and post-cloud computing services.  It shows Office 365 and Azure customers, and the year-over-year revenue gains are on the order of 20% or better.  Again, the problem is that the sales efforts and compensation models for these businesses are quite different from the consumer businesses.  Let the Microsoft Enterprise stand alone and do its thing while creating value unencumbered by the legacy of a consumer-unfriendly culture endemic to Microsoft."  

 Total Commercial Licensing and Other Business increased 10% yr/yr, from $10.19 billion to $11.2 billion in the current year's quarter.  Commercial Licensing revenue increased 7% yr/yr to $9.59 billion. The more transactional annuity business increased by 8%, which also helped by allowing more revenue recognition in the current quarter; the company said that contract renewals had also been strong. Other Commercial Licensing Business increased 28% yr/yr to $1.6 billion, as Microsoft's cloud conversions and new business gained traction.  The company said that two-thirds of new Microsoft Dynamics ERP customers chose a cloud configuration for the software deployment.

Overall, this segment's performance was clearly head and shoulders above that of the comparable commercial businesses of HP and IBM.  Given that the company has a new segment financial reporting format, the company provided both a new and old presentation to help during the transition.  In what was formerly called "Servers and Tools," revenue increased by 11% to $5.052 billion, while operating income increased by 17% to $2.026 billion.  SQL Server revenue grew by double digits, while SQL Server Premium revenue grew by more than 30%. So the problems HP and others faced with the erosion of commodity x86 server sales and margins did not hit Microsoft in the quarter.

Under the new presentation, which shows Gross Profit contribution by business segment, I took the Commercial Business gross profit as a percent of Microsoft's consolidated gross profit less the 'corporate' gross profit, and one sees that the commercial businesses accounted for 67% of the gross profit dollars in the quarter compared to 62% of the gross profit dollars in the prior year period.The rest of the corporate gross profit comes from Devices and Consumer Licensing. For me, the commercial business performance was the high water mark for performance in the quarter.

The problems in the personal computer markets did affect Microsoft, but not as badly as would have been expected.  Windows OEM revenues fell 7% yr/yr, but that compares to a 15% yr/yr decline in the fourth quarter of FY13.

Bing;s Search advertising revenues increased 47% yr/yr, and the Bing! search engine had an 18% U.S. market share in the quarter.  Search volumes and revenues per search both increased in the quarter, due to better algorithms and advertising.

The model upgrades for Surface generated $401 million in sales, with the 32 MB Surface RT being the popular model. Inventories are in place for the selling season, but the levels are not as aggressive as with the introduction.

A lot is expected from the Xbox product launches, but I have some doubts about the heavy duty gamers caring that much about a somewhat incremental hardware upgrade.  The gamers care about the games, and Microsoft is not in that business.  The future of Surface, Windows 8.1, Windows Phone, and Xbox are all TBD.  It sounds like the company is trying to improve its own lackluster performance, but it remains to be proven, beyond one Christmas season.

The company returned $3.8 billion in cash to shareholders in the quarter, with a 22% increase in the dividend.  This is certainly nothing to sneeze at.  However, looking at where profits are generated in the consolidated company, it still isn't clear at all that there should be "One Microsoft."

Finally, I would question if there exists one person who could make a believable claim to have the skill sets and the inside credibility to lead this company on a multi-year path to sustained organizational optimization and shareholder value creation.  More on this later.

No United States of Europe

"A European Union running fiscal policy for its member states out of Brussels was never in the cards--that could not have been a noble experiment. " (Out of the Box blog, January 2012)

Today, the Wall Street Journal puts our headline more delicately, "Plans for Political Union in Europe Unravel."  What a surprise!  

The story further notes, "Germany is leading the resistance," which was the inevitable outcome because, as we've long held, the interests of France and Germany diverge fundamentally as they concern the euro, the improbable economic union, and the unimaginable political union.  

We've also written about the need for the EU to increase the competitiveness of all its members, which covers the gamut of issues from barriers to labor mobility, budgets, agricultural subsidies and many other member practices that hamper the effectiveness of the common market.  So, an adviser to Chancellor Merkel put these issues on the table when the WSJ reported,

"He (Herr Meyer-Landrut) proposed that EU leaders attending the meeting agree on a set of indicators, such as rising labor costs, that would signal when a country's economy is veering off course. He also said national governments should sign binding promises on economic overhauls that EU leaders would monitor."

The proposal, which is eminently on point, found no takers, and it generated a French rejoinder about needing to focus on "social cohesion."  The fissure is evident again, as well as the fact that Italy and the periphery have no interest in having their national policies subject to EU monitoring.  

If this is the case for a rather straightforward economic rationalization that would benefit the euro, how on earth could a political union ever be on the table?  It isn't and it won't be under any conceivable circumstances.

Since the EU built the Brussels bureaucracy ahead of the creation of a meaningful currency and economic union, the talks and meetings will continue for the indefinite future.  Otherwise, the bureaucrats would be out of jobs and there would be lots of vacant buildings and apartments in Brussels. 

The euro will continue to limp along as a currency until the next shock again threatens the stability of the failed experiment.  The ECB will raise its head again, and we'll have the same rounds of discussions.  The system really does not serve the economic interests of citizens of the entire European union.