HP, Lenovo, and Required Returns

A big week in Silicon Valley.

Google buys Motorola Mobility for $12 Billion,  HP shut down its WebOS hardware operation (shortly after purchasing Palm) and looks to sell off its entire PC hardware division (after purchasing Compaq), while at the same time purchasing Autonomy for the (insane) price of $10 Billion. Autonomy sells structured data search services — its clients are large firms. Autonomy is in the high margin monopolistic “space”, whereas PCs are in the commodity space.

The cited reason for HP wanting to divest itself of its (profitable) consumer hardware division is falling margins.

HP doesn’t want to be in the low margin business — it wants to be in the high margin business, and it would rather sell off or liquidate capital rather than accept lower margins. It is not enough merely to be profitable. HP wants a high operating margin, and high earnings growth rates.

The market responded by shaving 20% off the price of HP stock.

In other words, if firms do not get the margins that they believe are expected of them, they shrink.

The buzz is that Samsung (a Japanese  Korean firm) is the front-runner to become HP’s hardware partner.

IBM also got out of the PC hardware business — due to falling margins — selling its PC manufacturing assets to Lenovo — a Chinese firm. Again, in China interest rates are extremely low, at least for politically favored entities.

It seems that every firm in the U.S., if it comes to believe that it cannot obtain 20% earnings growth, liquidates.

It can sell of its capital to nations in which firms have low funding costs.

In the U.S. capital is expensive, while in other countries it is cheap, and the U.S. is systematically divesting itself of all but the most profitable firms even as other nations expand investment.

And yet this is happening in a low IR environment.

My only explanation — what my gut tells me — is that dynamic effects have caused the rental rates demanded of capital to remain high even though risk-free borrowing rates are low. By dynamic effects, I mean that as interest rates fall, share prices rise, and investors who see the total gain, come to expect the large gains, which must ultimately be realized as high earnings and/or high earnings growth rates. Paradoxically, a long period of cutting borrowing costs can lead to a high cost of capital, if the past gains become embedded into “sticky” expectations of future gains.

This doesn’t bode well for domestic investment or employment.

UPDATE: Fixed some typos, added details of Autonomy and some handwaving re: dynamic effects.

UPDATE 2: Changed Asian slur — calling a Korean Company Japanese, and thus removed reference to low CoC in Japan — thanks Max!

HP, Lenovo, and Required Returns

10 thoughts on “HP, Lenovo, and Required Returns

    1. Yep! My gut says that this is why we have such high unemployment. The important question is why, with OIR at zero, firms are still shutting down projects that don’t earn such high margins — why they would rather sit on cash even as profitability is through the roof.

      1. anon says:

        The reason: CEO and board of directors stock option plans …

        It’s more profitable to shrink and then show dynamic growth with high profit margins for a few months and cash out, than to become a big but slow growing utility.

      2. Yes, it’s certainly better to have dynamic growth, and I think the mechanism you identified is very important now.

        But I don’t think it’s the whole story, as stock options are relatively new.

        I think something more fundamental is going on, but my thinking isn’t very clear on what it could be.

        Firms shrink in order to maintain a certain earnings rather than having the earnings adjust.

        The after tax net operating surplus of non-financial corporations has been remarkable stable, under a variety of different interest rate regimes. Look at chart 1:


  1. Sergei says:

    Scary. However, the MMT policy of budget deficits might make it even worse. The economic system does not need deficits but rather balanced budgets with a certain tolerance level of volatility of outcomes. Deficits are a signal that the system is wrong and pushing deficits simply cements the wrong structure. While this logic is the same as neo-classical, the driver of it and reasoning behind are completely different.

  2. I think you can have all the deficit spending you want if you also include high marginal tax rates and heavy taxation of corporate retained earnings.

  3. Max says:

    Samsung is Korean, not Japanese. Non-US stocks have a higher prospective return (higher dividend yield etc) than US stocks. Even Japanese stocks are starting to look decent.

    1. Thanks, Max! I made the correction in the post. Stupid of me, but we will need to wait and see which firm actually becomes HPs hardware partner.

      But I’m not sure what you mean by “Non-US” stocks have a higher prospective return. Are you including cap. gains? Which nations? The Asian growth model is built around subsidies to capital, primarily through the banking system. The U.S. is a bit unusual in its heavy use of equity and bond markets as opposed to bank-based finance.

      In the latter case, the bank lending rates are what is important. If some firms have access to cheap funding, with implicit debt forgiveness or other credit subsidies, then this puts them in a position to operate a low margin business that a U.S. firm cannot, irrespective of what the prospective returns are for certain foreign equities from the point of view of a U.S. investor.

      1. In other words, I *also* think that many foreign stocks are more attractive now. But this is because U.S. earnings expectations are insane, so they are bound to dissapoint, leading to sell-offs.

        The day that corporate executives of mature firms routinely say “We expect our earnings growth to be 3%, as the NGDP growth rate is 4.5%, and new (faster growing) firms will take 1.5% of that” — and the market accepts that — is the day that U.S. stocks become decent prospects. But as long as firms keep promising 8%, and pension funds expect to get 7-8%, and the bottom up analysts are expecting 20%, then I don’t think U.S. stocks are a good buy.

        At that point, it’s just a question of can you rush to the exits before everyone else, even as you benefit from the insane optimism.

        By the same token, whether foreign stocks are a good buy also depends on what investors expect to get versus what will actually happen.

        The argument that I was making in this post is that U.S. investors are expecting far too much, which not only makes stocks a bad buy when they inevitably disappoint, but it also means that projects which should continue to get funded if the return demands were realistic are not being funded under the current return demands.

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