Five Tales of Subtraction

Christine Benz: Hi, I am Christine Benz for Morningstar and welcome to the Friday Five. Here to discuss five recent tails of subtraction in the market is markets editor Jeremy Glaser. Jeremy, thanks so much for being here.

Jeremy Glaser: I am glad to be here, Christine. I wish we could subtract some of this volatility, but I guess that is not going to be the case.

Benz: We thought we were getting off to a pretty steady pace, but it's really gone crazy recently. So, Jeremy, what do you want to talk about today.

Glaser: Well, this week I want talk a little bit about inflation, Hewlett-Packard, Europe, Google and finally, Abercrombie &Fitch.

Benz: So let's talk about inflation. We've really been seeing some increasingly worrisome numbers about inflation. What's going on there?

Glaser: Sure. What could really subtract a lot from consumers' wallets and also from your investment returns is that inflation seems to be picking up a little bit again. We had seen the numbers really start to be muted and then this week with both the Producer Price Index and the Consumer Price Index which rose about 0.5% overall really gave us a little bit of pause that inflation maybe isn't completely as under control as we had assumed. Granted, core inflation is still relatively low, and these numbers are still reasonable in the grand scheme of inflation. But given that economic growth is so slow, we're concerned about that those price levels rising.

The other concern is that the Federal Reserve may not particularly want to tighten our monetary policy and try to get that inflation under control. Fed chairman Ben Bernanke has basically committed to keeping rates low through 2013. If anything, he would look at to do more easing than he would to tighten up policy. So inflation really did start to get out of control and really did start to pick up from these levels. We might not have a ton of policy tools available to take care of it without also affecting economic growth in a really serious way. So, I think that it is troubling, and these numbers are not a good sign.

Benz: Right. Especially, given slower growth, and I think also the fact that inflation is a global phenomenon, right? It's not just driven by what U.S. consumers are doing. The emerging markets have the potential to stoke inflation that affects consumers here in the U.S.

So, Jeremy, you also want to talk about HP getting out of the PC business, I am old enough to remember the firm's big acquisition of Compaq and how contentious that was. It was such a big deal about a decade ago. What's going on with HP, and why does it want to exist that business?

Glaser: Yeah, this was a surprising one. HP has decided to spin off its PC business. So it will discontinue webOS, the tablets, and the phones it bought from Palm, just about a year ago.

Benz: So brand new to the firm almost.

Glaser: Yeah, and it's kicking that out as well. And HP is just trying to subtract. I think that management has been disappointed with the performance of the stock of HP and decided to kind of kick it into high gear by getting rid of this low-margin business that is hardware sales. PCs are commodity products; a lot of people don't care if they have an HP PC, a Lenovo, or a Dell. It's really hard to differentiate yourself there.

Where you differentiate yourself is in services, and I think IBM showed this--by exiting by the PC business--that you can really succeed in selling these services. I think HP wants to go down that road. The firm is in talks to a company for about $10 billion out of the U.K., and I think HP's really going to try to focus on those higher-margin, higher-service areas that management thinks can build a better competitive advantage. We'll have to see if it's successful for the firm.

It definitely isn't unwinding of their really decades-long strategy of becoming a behemoth in the PC space. It is the largest PC maker. It has a lot of scale and capability there. So maybe the services business will work out for HP, but the firm is going to be competing with IBM and with a lot of companies that have been pursuing this strategy for a long time. It could be a bit of a messy breakup, and I think it's a story, at least to when we're talking about HP, that's going to be in the news for a long time.

Benz: So this tablet business is an interesting side story. Has anyone really been able to make a go at Apple in that space?

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Glaser: Not really. It's been a tough one. For HP, it obviously had one tablet, and now the firm is out in less than a month. BlackBerry and Research in Motion with its Playbook has not done very well. The Android tablets I think are gaining a little bit more traction but are still nowhere compared with the iPad's popularity. It's been a tough nut to crack.

Benz: So, you mentioned Motorola. Let's talk about Google's move to pick up Motorola Mobility announced earlier this week. What's your take on that deal?

Glaser: Yeah, that's really would have been probably the only big tech news story this week, if it weren't for the HP news. Google really came out of nowhere, and this was really surprising for almost everyone, with a $12.5 billion purchase of Motorola Mobility which was the spin-off of Motorola that does mobile phones and the cable set-top boxes, and that Google is going to start getting into the hardware manufacturing business, the hardware design business which is something that the firm hadn't been in before and Google really had focused on software.

I think that this really has less to do with its desire to be in the low-margin handset business and more to do with their desire to pick up this patent portfolio. I would say management is trying to subtract the patent trolls out of the equation, and when it comes to the Android operating system, Google has been fighting off patent attacks from basically all comers who are trying to say that these Google products infringe on patents from a number of different companies. By buying Motorola and the intellectual property that comes with that, Google will be able to defend against these better. It will be able to say, "Hey, you said you have this patent for the way that these emails come in, but look, we also have this patent."

That's really how lot of these battles are fought; the firm lost the bidding war for the Nortel patents. I think that Google saw the Motorola deal as an attractive opportunity to buy a company that maybe wasn't cheap, but it is able to get not a crazy valuation for it but pay up just a little bit extra to get those patents. I don't think that Google really sees the actual business as being terribly successful on the phone side, but it should help the firm continue to grow the Android operating system and get into that tablet market as we are talking about earlier. So I think that the deal might make sense; it might not be a huge negative for Google shareholders. We still think their share are undervalued for Google and that this is probably a smart intellectual property move, if not a smart hardware move.

Benz: Jeremy, another tale of subtraction is, some of the slowing growth that we've been seeing in the eurozone, in particular Germany had been one country thought to have pretty good growth. But that seems to be slowing down, and the same thing is happening in France as well. What's going on there?

Glaser: Eurozone growth was disappointing. For the whole eurozone, it was 0.2%. Now they look at a sequential quarter over quarter and not like we do in the United States. So it would be a little bit better than that if measured the same way as we measure gross domestic product in the U.S. But still, it's slowing, and I think that that's a big concern because the idea was that the stronger eurozone countries, such as Germany and France, will be able to kind of grow their way out of this crisis and that they will be strong enough and their economies will be strong enough as they could prop up the peripheral countries. They would be able to prop up all of these stabilization packs, all of these big pools of money that are going to be used to bail out Greece, Portugal, and maybe even some other countries.

But now it looks like that may not be the case. Germany is a big exporter, and a lot of the export markets where the country sends its goods to aren't doing very well. There's no one to really buy them, and if that slows the German economy, it just makes all of Europe's problems so much harder and just compounds all of the issues we've been talking about for months now. So this was not good news. Hopefully it's a temporary blip and that we'll be able to see growth in Europe soon, in that the countries will find a way to at least get back on more stable footing. But this is a very discouraging growth report.

Benz: And with austerity measures looming over the eurozone, as well, is it your view that could hobble growth even further?

Glaser: Yeah, it's not going to be good for growth. As we saw in the United Kingdom, when it introduced its austerity measures, growth came down quite a bit, and they haven't even gotten to the bulk of the cuts yet. They did some very simple things, but a lot of the bigger cuts are even further down the line. And I think they could even see a bigger drag on growth there. So I think these other countries like France, Italy, Spain, and even Germany have to look at austerity and have to look at making cuts. It's going to be a drag on growth, and that's just going to make the problem that much more difficult.

Benz: So, Jeremy, the final tale of subtraction today has to do with Abercrombie and Fitch. The firm wants to have a certain TV persona stop wearing Abercrombie clothes. Who is that, and what's that all about?

Glaser: Well, Abercrombie has decided to pay, what's been reported as a substantial sum of money to The Situation from MTV's Jersey Shore to stop wearing the company's clothes. Usually endorsement deals go the other way, but Abercrombie decided that seeing him on TV wearing Abercrombie clothing that was not good for the company's brand image, and that not what Abercrombie was trying to protect its potential customers. So the clothing retailer asked him to stop doing that in exchange for that sum of money, which is an interesting marketing take.

But the rest of the marketing must be doing pretty well because the firm had earnings this week that looked pretty good for a high-end teen retailer, which is the kind of business that you think would get squeezed pretty hard in hard times. So people are still out there, buying Abercrombie clothes. The firm is having great success on its direct-to-consumer online platform, it's having great success in Europe. So we'll see if it will be able to keep it going, that Abercrombie will be able to keep its clothing off people management sees as undesirable wearing it. But at least from a financial standpoint, it's working out pretty well for the company so far.

Benz: Good to know, not that either of us has ever seen Jersey Shore. But it's nice to keep tabs on these things. Thanks so much for joining us, Jeremy.

Glaser: You're welcome Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.