Would you rather manufacture Plasma TVs, or sell them?

In the last post, I was commenting on the results of President Bush’s 2008 fiscal stimulus checks.  While economists differ, it seems that there are increases in consumer spending due to consumer fiscal stimulus.

My second question was, even if we had spent all of our rebate checks on plasma TVs, how bad would that be?  The background for the question has a broader theme.  Is manufacturing (or agriculture or other industries that built America) something we should really be doing at home?

To answer this question, I wanted to think about profit margins and the supply chain.  Best Buy is the largest electronics retailer in the US and account for 21% of electronics sales.  Best Buy’s return on capital is 21.4% over the last 5 years

Panasonic is the largest manufacturer of Plasma TVs.  While they don’t break out their data by product, the overall return on capital of Panasonic has been 3.5% over the last 5 years.

So, if I gave you $1,000 . . . let’s say I called it a stimulus check, and asked you to invest it, would you rather invest in the operation that would give you 20% of it back per year ($200) or 4% ($40)?  It starts to look like there is a reason why business people decided not to pursue the relatively capital intensive, low margin plasma TV business…

But, you argue, most of that money that goes to Best Buy gets passed on to folks like Panasonic.  Shouldn’t we go where the most money goes?   Well, your data is correct.  Best Buy’s overall gross margin is around 24%, meaning that of every $1 we spend at Best Buy, only $0.26 goes to Best Buy, the other $0.76 go to their manufacturers and shipping.  So at the top line, the revenue line, you’re right.

Not so fast.  You should really be thinking about Return on Capital, not revenue.  If total revenues were the only deciding factor of an attractive business, then we would all be in the food business.  After all, it’s the largest world industry by revenue.   But we don’t do that, because at this point we know that it’s not a great return on capital (or a great growth and margin business).  It’s not the industry that the US should base its economic growth upon.

So, as an investor, I’d rather sell Plasma TVs than make them.  And as a policy advisor, I’d rather put dollars in consumers and businessmen’s pockets, and let those folks make the millions of tiny decisions that drive the U.S. economy.

“Buy American” is bad for the economy

The massive economic stimulus plan contemplated (now passed) by Congress has one buried feature that is wrong-headed:  “Buy American”.

The idea behind “Buy American” is seductive to President Obama and Congress.  To shore up the economy and protect American jobs, infrastructure projects will be forced to use only American steel, iron, and other construction equipment like picks and shovels.

“Buy American” is a mistake.  It will cost American jobs and cost international cooperation in American security.

Win some, lose some more
“Buy American” can generate 1,000 jobs in the steel industry according to analysts at the Petersen Institute for International Economics.  The cost? 63,000 Americans will be added to unemployment lines when our trading partners retaliate.

And retaliate they will.  While United Steelworkers Union President Leo Gerard claims that “Buy American” is not protectionism, the EU has already threatened retaliation should the plan go through, with similar saber-rattling from other friendly nations like Canada and Mexico.  Together, these trading partners account for nearly half of all US trade (US Census Bureau).

Economic retaliation against the US could begin an economic downward spiral similar to the Great Depression.  The protectionist Smoot Hawley tariff act of 1930 increased tariffs on imports, which quickly led to retaliatory tariffs on US exports.  The result? Unemployment rates increased from 8.7% to 24.9% by 1933.

That’s 1 out of 4 Americans out of work.

Manufacturing job losses have been a legitimate concern for years.  Nevertheless, U.S. exports have risen by nearly 70% in the last decade, driven by sectors in which America is the global leader – high tech and services.  The venture capital industry is the envy of the world, with world leaders trying to recreate the “Silicon Valley model” of entrepreneurship and technology.  If the goal of the stimulus plan is to revive the US economy and the US steel industry in particular, a far better use of the funds is to invest in technologies and education that increase US industrial competitiveness.

We are not the lowest cost manufacturer of most items. We are not a standalone economy.  Most US households own cars from Japan, clothing from Malaysia, and dog food from China.  The popular Apple iPhone is “designed in Cupertino, CA” but assembled mainly from parts sourced in Singapore and Taiwan.  Apple makes more profit (50% according to iSuppli) than their entire foreign supply chain.  And they would make substantially less profit if they had to produce the whole thing in the USA.  It’s not Apple’s specialty.  The healthy flow of trade keeps our standard of living the envy of the world and reduces the impact of this economic crisis.

Trade One War for Another?
As we begin the long process of restoring our international image as a world leader and beacon of freedom, we are about to break a commitment that could squander the international goodwill and spirit of cooperation inspired by the inauguration of President Obama.

As the worldwide financial market spun out of control last year, representatives from twenty nations – the so-called G-20 – met in Washington to devise a global strategy for containing the economic crisis. The centerpiece of the strategy was simple: no new trade barriers. The logic of this move was equally simple: we may not know how exactly to get the economy moving again, but we do know that increased trade barriers will make the situation worse.
If we renege on the G-20 commitment we made just three months ago, we likely create greater difficulties across our relationships. Canada, Germany, Britain, Italy, and France are all NATO allies deployed in Afghanistan, and are all among our top sources of steel. They are likely to be less willing to deploy more troops in Afghanistan if we harm their economies. China, our second largest source of steel, will be less willing to reexamine its artificially undervalued exchange rate – a major cause of job losses in the United States. And protectionism will further exacerbate a belligerent Russia, another major steel resource.

A New Deal Better
Smoot Hawley led not just to a trade war, but deepened the destabilizing economic conditions that led to the rise of Adolf Hitler, Nazi Germany and the last World War.  While the world landscape is drastically different than the 1930s and “Buy American” is smaller than Depression era policies, America deserves a better deal.  A New Deal Better between the laissez-faire dismantling of financial regulation that contributed to our current economic crisis and the protectionism represented by “Buy American”.  Investments that will build infrastructure, educate the workforce, and stimulate innovation for the future.  Investments that will reap benefits decades in the future.  Investments that can start immediately.

Venture Capital Bailout

Amidst the weekly reports of over 500,000 layoffs at U.S. corporations, another contraction is going under-reported.  The number of venture funds is shrinking, with membership in the NVCA dropping from a reported 1,000 firms in 2000 to around 600 today.

But not to fear, the fiscal stimulus package currently in joint committee has something for everyone, including for out-of-work VCs.  The bill increases the dollars headed to SBICs, or Small Business Investment Corporations, by 50%.  SBICs are, essentially, venture capital firms that have Uncle Sam as one of their major investors (known as Limited Partners in VC legalese).

The 50% increase in government allocation to these firms is regardless of their prior performance.  If the VCs lost every dime of their initial investments, they get some nickels to try again.

The rationale for this VC stimulus package is that venture capital firms allocate money to small promising companies prudently, which is true, and quickly, which is not.  Speed is of the essence in saving the economy, but venture capital firms spend several years deploying their initial capital and several more years until the follow-on capital is deployed.  This is not a quick stimulus for our beleaguered economy.

Lack of speed is only part of the plan’s problem.  Venture firms do not allocate their dollars without first extracting a fee.  These fees range from 2 to 2.5% of the money per year, plus 20% of the profits.   With $17 Billion of capital already committed to SBICs, (according to NASBIC, the industry association of SBICs) an additional $8 Billion of new capital in this stimulus plan will generate a windfall of $800 million in fees for the venture firms over the next 5 years.  Those fees don’t save jobs in floundering technology start-ups.  They pay venture capitalists and their staffs.

The fees paid to venture firms to distribute this money represent a tax on deploying this capital, and do not include the costs of the Small Business Administration to administer the funds.  Contrast this with a reasonable alternative – reducing the income or payroll taxes on technology companies to spur growth, innovation, and employment.  The reduction in taxes on these companies is immediately felt by the organization rather than the VC’s one to three year investment delay.  The tax reduction allows dollars to flow completely to the technology company without the bureaucratic tax of the SBA and the intervening VCs.
But perhaps the VC business needs propping up?  No. More capital in the industry will harm venture capital rather than save it.

Even though the number of venture firms has declined over the decade, practitioners and observers still believe that the industry, investing about $20B per year, is over-capitalized.  As recently as 1994, before the dot com bubble, the venture capital industry deployed just over $4B, according to the National Venture Capital Association.  That’s a 13% per year growth rate.  With substantial growth, the competition for investing in start-up companies has increased, raising prices for companies and depressing returns for the entire industry.  The average VC fund has not had a positive return for their investors since 1999.  The venture capital industry needs less, rather than more, money.  More money might continue the malaise for additional years.

While the local economy might benefit from the increased investment dollars and fees spent in our community, the long-term effect on the ecosystem of venture capital and entrepreneurship will be net negative.  The continued poor performance of the venture capital community could permanently break the engine of economic growth that makes Silicon Valley the envy of every Silicon Alley, Silicon Desert, and Silicon India in the world.

The speed with which the stimulus package is being assembled is apparently warranted to head off doom, but the VC bailout is one of many programs we will discover, later, to be under-vetted and susceptible to unintended consequences.