Hewlett-Packard: After The Autonomy Debacle, Is There Value Left In The Stock?

| About: HP Inc. (HPQ)

It seems that not even the largest corporations in the United States can escape one of the business world's simplest and most powerful truths: it is far easier to destroy a company than it is to build it. And perhaps no Fortune 500 company embodies this idea more than Hewlett-Packard (NYSE:HPQ). Decades of hard work by Bill Hewlett and Dave Packard are unraveling as HP seems to be spiraling towards irrelevance. And while CEO Meg Whitman is doing everything she can to rectify the situation, she has been dealt an extraordinarily difficult hand, one made even more difficult by the allegations that Autonomy has, in essence, defrauded HP, costing its investors billions (more on that later). In this article, we will provide a brief overview of HP's fourth quarter results, and then delve into more detail about the issues at Autonomy, and whether or not there is value left in the company. For the record, unless otherwise noted, financial statistics and management commentary used in this article will come from either HP's Q4 2012 earnings release, or its Q4 2012 earnings call transcript.

Q4 & 2013 Guidance: On the Road to Recovery? Or on the Road to Irrelevance?

On a non-GAAP basis, HP posted EPS of $1.16 for Q4 2012, with revenues coming in at $29.959 billion. HP actually beat non-GAAP EPS estimates by 2 cents, but missed revenue estimates by $500 million. A bright spot was the company's operating margin. At 10.39%, it not only beat the consensus estimate of 10.1%, but actually expanded from the 9.73% operating margin in Q4 2011.

However, margin expansion, while certainly a welcome development, cannot serve to mask the underlying weakness of HP's core businesses.

  1. PC revenue was down 14%, driven by a 16% drop in consumer PC revenue and a 13% drop in commercial revenue. Operating margins of 3.5% fell by 1.2% in just a quarter, highlighting the structural issues of the PC industry.
  2. Printing revenue dropped 5%, driven by a 20% drop in hardware sales.
  3. Service revenue dropped 6%, driven by a 7% drop in business services.
  4. Revenue declined by 9% in the company's Enterprise division, which is what HP is leaning on to move it out of its current malaise.
  5. Software revenue grew by 14%, driven by 48% revenue growth in the company's software services division (Autonomy is included in the software division's results).
  6. Financial services revenue grew by 1%, but assign little importance to this, for if HP is beginning to rely on financing as a source for growth, it should be taken as a sign that the company has all but given up.

CEO Meg Whitman took the time on the call to focus not only on the numbers, but on HP's position in the market, as that has been a chronic source of worry for the company's investors. She stated that HP gained share in the printing market during the quarter, and that the company's new line of laser printers is off to a promising start. 3Par is growing at double digit rates, and Meg Whitman believes that HP can accelerate this growth as new products are launched. Furthermore, Whitman sounded confident about HP's cloud offerings, which now have over 850 customers, and while she did not disclose Q4 cloud margins, she stated that they were above the company's forecast (full-year margins of 11.7% for the division are within the company's 10-12% forecast).

HP forecast Q1 EPS of $0.68-$0.71, well below the consensus of $0.85. But, the company is maintaining its full-year guidance of $3.40-$3.60 in non-GAAP EPS for fiscal 2013. Naturally, there was (and is) a good deal of skepticism regarding the maintaining of guidance, and ISI analyst Brian Marshall was blunt on the call, essentially asking HP why it thinks it can actually meet its fiscal 2013 guidance. CFO Cathie Lesjak responded by stating that,

"It really all comes down to our view of the second half. We definitely see that the second half per normal seasonal trends is higher than the first half and we're seeing that is skewed even more as a result of the restructuring programs that we've talked about and the fact that, again, the non-US programs ramp later in fiscal '13, the non-labor components around SKU reduction, supply chain simplification, business process reengineering and real estate also have the investments on the front end and are starting to pay off in the second half of '13"

In essence, the company believes that its restructuring efforts will begin to bear fruit in the second half of the year. CEO Meg Whitman also jumped in to answer the question, adding that,

"Obviously when we gave guidance for Q1 we knew this was going to be a question, so we went through in quite some detail looking quarter by quarter, product by-product, business by business, channel partner by channel partner, top 250 customers by 250 customer, and feel comfortable around the 340 to 360. So I would add that we understand what your concern is, but we feel good about our 340 to 360 estimate."

We think that it is possible for HP to meet this guidance. In her tenure as HP's CEO, Whitman has not shied away from taking writedowns or diving into the company's business. She has been frank in her views of what has been (and is) ailing HP, and if she has examined the company's business units in as much detail as she is claiming, then we believe that the company can meet its fiscal 2013 guidance. CEO Meg Whitman believes that HP can, and will recover. The company has stated that fiscal 2013 will be one of its transition years, and based on the low-end of the company's guidance, EPS of $3.40 will represent a 16.05% decline in non-GAAP EPS relative to fiscal 2012's $4.05 in non-GAAP EPS. A company as large as HP cannot turn itself around in just one fiscal year. But, there are signs of progress in fiscal 2013 guidance. HP guided for GAAP EPS to be between $2.10 and $2.30 for fiscal 2013, as compared to a GAAP loss of $6.41 per share in fiscal 2012. Even with continued restructuring, HP expects to be solidly profitable on a GAAP basis in fiscal 2013, positioning itself for a rebound in fiscal 2014 and beyond, if everything unfolds as HP envisions.

Autonomy: Fraud, Scapegoating, and Managerial Responsibility

HP's Q4 2012 results were overshadowed by an $8.8 billion writedown related to the company's acquisition of Autonomy, which cost the company $10.3 billion. $5 billion of the writedown was due to what HP called "serious accounting improprieties, disclosure failures and outright misrepresentations at Autonomy Corporation plc that occurred prior to HP's acquisition of Autonomy and the associated impact of those improprieties, failures and misrepresentations on the expected future financial performance of the Autonomy business over the long-term." The remainder of the writedown was caused, ironically, by the dramatic fall in HP's own stock price.

Given that Autonomy has now cost shareholders billions more, analysts naturally pressed the company about who is responsible. Barclays analyst Ben Reitzes asked Whitman,

"Meg, with regard to the Autonomy situation, we understand what you're doing in terms of going after the folks that you feel misled you, but what about internally? Who's responsible internally for the acquisition? How are you analyzing yourself internally, the Board, I think everybody at the Board was there when the Autonomy decision was made, except for Mr. Whitworth. So what's the introspective, what are you doing internally to make sure that you have the right processes and who are you holding accountable internally, if anyone, to make sure this doesn't happen again and that maybe even there's some folks internally that need to be held responsible and we could see repercussions of this in the near future? How are you looking at it internally?"

Meg Whitman's frustration regarding Autonomy was palpable in her response to Reitzes. She responded by stating that,

"Yes, well first of all, the CEO at the time and the Head of Strategy who lead this deal are both gone, Leo Apotheker and Shane Robison. With regard to the Board, you're right. Most of the Board was here and voted for this deal and we feel terribly about that. What I will say is the Board relied on audited financials, audited by Deloitte, not brand X accounting firm but Deloitte and, by the way, during our very extensive due diligence process, we hired KPMG to audit Deloitte, and neither of them saw what we now see after someone came forward to point us in the right direction. That said, obviously, we have not done any big acquisitions and we will review the acquisition process. What I will say is due diligence now reports to our Chief Financial Officer. At the time when I came to the Company, I was surprised to find that due diligence and M&A reported to strategy as opposed to the Chief Financial Officer. I've never seen that before in my career and that's a decision I made right away before I knew any of this. So I understand your point of view and we have made a few changes in that regard but, in the end, you have to rely on audited financials and we did and we will now carry on and as you know, we've reported this to the SEC as well as the Serious Fraud Office and we will take it from here."

Autonomy has now cost HP's investors billions, and naturally, analysts expect that someone at HP has to be held responsible for this. The question now is whether or not Whitman is to be held responsible. And that is a difficult question to answer.

It is true that Whitman voted to purchase Autonomy at its inflated price as a director of HP. But, it is likely that Whitman based her decisions on the financials provided to the board, financials that now appear to be false. In her defense, not one, but two of the world's largest accounting firms appear to have missed the fraud that was occurring at Autonomy. If both Deloitte and KPMG could not uncover the fraud without knowing exactly where to look, how could HP's board, including Whitman, have known that Autonomy's price tag was based on false financials? Diving into the accounting practices of an acquisition target is not the responsibility of the board. Their responsibility is to examine how that target company fits into their strategic vision of where their company is going, and if the deal makes financial sense, based on the financial statements that they are given. In any case, Whitman has overhauled the M&A process at HP, and due diligence teams now report to Cathie Lesjak, not to the company's head of strategy. Whitman has also sent this case to both the SEC and SFO, and HP is preparing lawsuits to recover as much money as it can. But, it should be noted that CFO Cathie Lesjak, long a beacon of stability in the chaos that is HP, was opposed to the Autonomy deal from the beginning, and warned that the board was overpaying. Shouldn't HP's board have listened to their CFO, who, in hindsight, has been proven right about Autonomy? We believe that the question of whether or not Whitman is responsible depends on how much responsibility one believes a company's board of directors has. As an HP director, Whitman is expected to do what is in the best interests of the company and its investors. But, she is expected to rely on the input of the company's management team and advisors, in addition to her own instincts. If HP's CFO says one thing about Autonomy, and KPMG, Deloitte, and HP's other advisors say something else, who should the board listen to? It is a question that we do not think has one simple answer.

Autonomy's former CEO, Mike Lynch, has also weighed in on these allegations, in an interview with the Wall Street Journal. Naturally, Lynch denied that any cover up had occurred, and laid the blame squarely on HP. In a vacuum, his arguments make sense. Lynch stated that,

'I think what has happened here is that they have got themselves in a mess. They did the acquisition of EDS, they had to write that one down. They had to write Palm down. When Autonomy was acquired it was done by a CEO who wanted to get rid of various divisions of that business and lead with software. He was ousted in an internal coup d'etat. From that point Autonomy was at odds with the divisions that were in power. There was a series of mismanagement steps. They lost hundreds of the talented people at Autonomy. They whole management team basically went out of the door. Sadly they are left with the results of having destroyed all that value."

In Lynch's defense, it is true that HP has a pattern of writing down its acquisitions, and that after Autonomy was acquired by HP, much of its senior staff left, leaving Autonomy adrift, and a mountain of goodwill and other assets on HP's balance sheet ripe for a writedown. His charge is that HP is hiding its inept management of Autonomy by accusing Autonomy's old management team of defrauding HP and its investors. Lynch also expressed disbelief at the idea that both Deloitte and KMPG could miss such a fraud. How can 2 of the Big 4 accounting firms both fail to see this, as well as Barclays, which also worked on the deal? Furthermore, Autonomy was a FTSE 100 company that has been audited by Deloitte for years; why has it taken until now for the fraud to be uncovered? With this case now in the hands of the SEC and SFO, only time will tell who is truly right.

Is There Value Left in HP?

HP's stock plunged nearly 12% on the back of its Q4 results and the Autonomy writedown, closing on November 20 at a new 52-week low of $11.71, levels the company's stock last saw over 15 years ago. But, based on the low end of its guidance, HP's shares now trade at 5.58x GAAP fiscal 2013 earnings, and trades at 3.44x non-GAAP fiscal 2013 earnings. With HP's non-GAAP P/E approaching the size of its non-GAAP EPS, does that mean that HP is now too tempting to pass up?

Over the past year, HP has cut net debt from $22.591 billion to $17.135 billion, and HP's stock now yields 4.44%; only Intel (NASDAQ:INTC) has a higher yield (of 4.51%). The company is still returning cash to investors, even as it continues to invest in the business. Operating cash flow of $10.571 billion during fiscal 2012 was down by 16.36% from fiscal 2011, but the vast majority of the decline was due to changes in working capital, as HP elected to pay down liabilities at an accelerated rate, something that was offset by accounts receivable changes. HP's financial state, while certainly not as strong as some of its technology peers, has not reached the point where investors need to be worried about HP's ability to do business.

While HP's stock certainly seems to hold value, the road ahead is uncertain, and HP is far from finished with its attempts to turn the company around. As we stated in our last article on HP, a breakup represents the best option for HP; the scale of the company's restructuring needs may simply be too much for a company of this size to handle. We concluded our last article on HP by stating that we think that there is value in HP, and even with these latest developments, we think that there is still value here. But, we believe that Meg Whitman needs to seriously consider breaking the company apart. As we stated in our last article on HP,

"If Meg Whitman can undo the damage that her predecessors have caused, then HP can be healed. But, Meg Whitman needs to deliver real and tangible results to investors soon, or else she may lose the chance to repair HP in its present form. Ralph Whitworth's agreement with HP expires [compelling him to support HP's board] in November 2013, and it is likely that other activist investors will begin pressuring the company before this agreement expires. Unless Meg Whitman can show investors that HP is on the road to recover, the company may not be able to keep itself in its present form."

With a market capitalization of just over $23 billion, HP is no longer large enough to resist activist investors simply by virtue of its size. Meg Whitman needs to show evidence of tangible progress in fiscal 2013. Otherwise, the pressure on HP to break the company apart (or perhaps even sell it), will begin to mount. We believe that fiscal 2013 will be a transformative year for HP. Either the company will begin to show evidence of a real turnaround in its fundamental performance, or the company will face mounting pressure for a much more dramatic reorganization.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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