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In the history of corporate America, few companies present a more dramatic fall from grace than Hewlett-Packard (NYSE:HPQ). The company has gone from being an icon of Silicon Valley innovation to the technology sector's ugly duckling. In our last article on HP, we examined whether or not there is value left in HP now that the company has written down yet another acquisition; this time the company destroyed $8.8 billion in shareholder value by acquiring Autonomy.

HP CEO Meg Whitman is attempting one of the most ambitious corporate restructurings in history, and so far, investors have not been impressed. And while Meg Whitman still has the confidence of the board, and few, if any observers are calling for her removal, there is a new element in the HP story: the company's withered stock price and market capitalization.

This has created a ripe opportunity for either activist investors or other technology companies to enter the scene, and remove the need for Whitman to turn the company around in its present form. In this article, we will examine the potential endgame scenarios for HP, including an analysis of potential acquirers, as well as the roles that activist investors could play. Unless otherwise noted, financial statistics for HP will be sourced from the company's Q4 2012 earnings release and accompanying presentation.

A Takeover of HP: Taking Control of a Diamond in the Rough

As of the close of trading on November 27, 2012, HP had a market capitalization of just over $24 billion, a dramatic fall from its historical levels. At these levels, HP no longer has the protection of a large market capitalization to block takeover offers. Even with a 25% premium, HP's stock is worth just over $30 billion, a digestible sum for many companies. And if the takeover occurs via a stock deal, there will be more room for a deal.

Some may wonder why any company would bother taking control of HP, given all the turmoil that is going on. The reason that HP holds appeal for potential acquirers is that even with all the turmoil, the company still has leading positions across a variety of markets. The company's printing division continues to print cash, and Meg Whitman is finally reinvigorating HP's R&D departments, bringing back a focus on innovation, not just cost cutting. HP is investing in its cloud computing offerings, and the company's storage and networking products are growing.

In addition, HP's balance sheet is stronger than it appears, giving an acquirer more flexibility in considering a deal. HP is one of the few large scale technology companies that has net debt on its balance sheet. As of the end of the fourth quarter of fiscal 2012, HP has $11.301 billion in cash & equivalents, and debt of $28.436 billion. With $17.135 billion in net debt, HP's balance sheet appears to be too weak for an acquirer to handle. But, much of the debt on HP's balance sheet is not true debt. Rather, it is debt that HP uses in the daily business of HP Financial Services, the company's financing arm.

Excluding this debt, HP has net debt of $5.8 billion. The debt within HP Financial Services is constantly "churned" as HP goes about financing its customers. Furthermore, HP is still projected to generate $5 billion in free cash flow during fiscal 2013. With dividend increases on hold, and buyback activity slowed down, HP is able to focus on rebuilding its balance sheet. Furthermore, if and when HP is acquired, dividend payments will be stopped. Based on its current dividend payout, HP sends $1.04 billion each year to its shareholders, cash that could be retained if and when HP is taken over. Now that it has been established that HP's financial strength is stronger than the headline numbers suggest, who would be willing to take control of this company? In this article, we will examine the 3 potential acquirers that we think would benefit the most from taking control of HP.

Mirror Mirror on the Wall, Who is the Fairest Acquirer of Them All?

Within the technology sector, there are several potential suitors for HP, and we will start with the most obvious, and perhaps the most interesting, at least from a personality point of view: Oracle (NYSE:ORCL).

Oracle: Oracle CEO Larry Ellison would see a deal for HP as a form of karmic justice for the company's ouster of Mark Hurd, now Oracle's president and a close friend of his. Ellison will almost certainly send Hurd to personally remove HP's board and management team if Oracle acquires the company. The questions that need to be answered, however, are the following: why would Oracle want HP, and can it afford it?

For Oracle, HP holds several valuable assets, including a growing networking and storage business. 3Par would give Oracle a foothold in the rapidly growing storage market for less than it would take to acquire NetApp (NASDAQ:NTAP). Furthermore, Oracle would gain control of HP's cloud computing products (and customers), giving it the opportunity to both cross-sell its own software, as well as potentially increase R&D spending, for there will be less need to cut costs, and Oracle is much stronger financially than HP. With increased focus on research & development, Oracle could more effectively build out HP's future products than the company could on its own.

From a financial standpoint, a deal is doable, even if it would be by far the largest deal that Oracle and Larry Ellison have ever attempted. Oracle currently has $16.836 billion in net cash on its balance sheet, and the company has room to lever up to do a deal, as well as issue stock. Oracle investors are, by this point in time, aware that they are invested in a company whose CEO has never shied away from opening his company's wallet for a deal, and so far, the strategy has worked well.

There are 3 obstacles to a potential Oracle-HP deal. The first is HP's PC business and the company's overall margins (a linked issue). In the fourth quarter of 2012, HP's overall operating margin was 10.39% (on a pro forma basis). Oracle's operating margin in its latest quarter was 35.19%. Given the fact that HP's revenue is more than triple that of Oracle, a takeover of HP would severely weaken Oracle's operating margins, even if it would lead to growth in operating income and earnings per share.

Much of HP's weakness in operating margins stems from its PC division, which has an operating margin of just 4.78%. HP's printing division, on the other hand, has a margin of 14.64%, and HP's software division has a margin of 20.37%, much more in line with Oracle's own margins. It is unlikely that Oracle would acquire HP with its PC division; Oracle is not a consumer facing company and it has little reason to enter that business. HP would need to spin off its PC business before a deal with Oracle can be completed.

The second obstacle is potential anti-trust concerns. HP and Oracle both have strong positions in servers, and the Justice Department may not be too keen on the merger of these two companies and its potential effects on server competition. HP and Oracle would need to present a compelling case as to why their merger would not stifle competition in the market.

The third obstacle is HP chairman Ray Lane. Lane was pushed out from the presidency of Oracle by Larry Ellison, and it is unlikely that he would ever support a deal to hand control of HP to his former boss, no matter what terms Larry Ellison and Oracle were to propose (the idea of being fired twice in one lifetime by the same person could be too much for Ray Lane). Oracle would likely have to initiate a hostile takeover to take control of HP, and while Larry Ellison has proven that he can win such battles, they take time, and are often complex affairs.

Dell: At first glance, Dell (NASDAQ:DELL) seems like an illogical acquirer of HP. After all, HP is more than twice the size of Dell, at least based on their last quarter's sales ($29.959 billion for HP, and $13.721 billion for Dell). A takeover of HP by Dell could, in reality, be the reverse, for HP could quite possibly overwhelm Dell. Investors may be aghast at the idea of merging two of the world's largest PC makers. After all, what would that do for Dell, which is trying to diversify away from PCs? While a Dell-HP deal seams like a poor idea on the surface, the financials tell a different story.

Dell has made no secret of its desire to diversify away from the PC business. In its latest quarter, PCs (desktop and mobility) accounted for 50% of Dell's revenue. At HP, PCs are just 29.06% of revenue. And unlike Dell's PC business, HP's is still profitable, posting pre-tax income of $309 million in Q4 2012. In its last quarter, Dell's consumer PC business lost $65 million. At HP's PCs contribute just over 9% of the company's pre-tax income. Despite its status as one of the world's largest PC manufacturers, the vast majority of HP's profits are made in businesses outside of the PC market. Dell, which has been spending billions on takeovers in its attempt to diversify away from the PC business, could go a long way in its attempts to do so by buying one of the world's largest PC makers.

Dell could gain control of valuable assets such as 3Par, HP's cloud computing products, and its networking & serve business, markets that Dell wishes to have a meaningful presence in. Furthermore, the combination of HP and Dell's PC business could give the combined company more scale, as well as leverage over suppliers. A combined HP & Dell would generate, based on the combined results of their latest quarters, 35.15% of their revenue from the PC market, 15% less than Dell's current levels. From a profitability standpoint, PCs would generate just 5.63% of the combined company's profits, making PCs a minor part of Dell's bottom line.

If Dell did indeed want to acquire HP, could it finance such a deal? Dell ended its last quarter with $5.146 billion in net cash, a far cry from the tens of billions needed to take control of HP. But, like HP, Dell's debt levels, as reported on its balance sheet, include debt used in its financial services business. Like HP, Dell uses this debt to operate this business, not provide funding for Dell as a whole. Dell does have room to leverage itself up to finance at least a portion of a deal for HP; it could use HP's own free cash flow to pay off this debt as quickly as possible.

Furthermore, over $1 billion in cash will be freed up if HP no longer has to pay dividends. Dell will likely have to issue stock to finance a deal for HP. But, if we were Dell investors, we would support such a move. A takeover of HP would bring a host of valuable assets to Dell and increased diversity in both revenue and earnings. As for anti-trust issues, we believe that they could be addressed fairly easily. The PC market does not lack competition. Consumers are free to choose from a myriad of different PC manufacturers, and a combined Dell and HP, despite becoming the largest PC manufacturer, would control just 26% of the market (based on the latest data from Gartner), hardly levels considered to be monopolistic.

The enterprise side of the business would face more anti-trust scrutiny, but Dell has less of a leadership position in this area than Oracle, and perhaps some minor divestments could appease regulators. The upside potential of acquiring even some of HP's non-PC business could still be a worthwhile opportunity for Dell to pursue.

IBM: IBM, like Oracle, has a thirst for acquisitions, but a deal for HP would be in a league of its own for "Big Blue." But, it could be doable. Despite posting over $5 billion less revenue than HP in its latest quarter ($27.747 billion versus $29.959 billion), IBM's market capitalization is almost 9 times greater than HP, due to the company's stability and credibility. HP has solid positions in many markets that IBM wishes to expand into further, and we believe that IBM could spark a renaissance within HP's research & development department in a way that few other companies can.

Any deal for HP involving IBM would have to include a spinoff of HP's PC business. IBM has already been in that business, and it has shown no desire to return to the PC market. We feel that IBM could find a number of buyers for HP's PC business. Lenovo, which bought IBM's PC business in 2005, may very well be interested to buy another PC business from IBM. We think that national security concerns (which would manifest themselves in the form of a CFIUS review), can be addressed. HP already makes many of its PCs in China, and Lenovo has shown that it has no issues with maintaining a presence in the United States.

In fact, the company is planning to start manufacturing some PCs in the United States by early 2013. It is likely that Lenovo would keep HP's U.S. operations intact in a deal for its PC division. Other potential suitors for HP's PC operations include Asus, Acer, or Toshiba. It is unlikely that Dell would be willing to acquire only HP's PC business, as that would, on its own, do nothing to help the company in its quest to diversify away from the PC market.

From a financial standpoint, IBM can afford to do a deal for HP, even if the headline numbers suggest otherwise. IBM ended its latest quarter with $16.407 billion in net debt. But, like Dell and HP, IBM has billions of debt tied up in its financing business, IBM Global Financing. IBM has just $7.4 billion in corporate-level debt, which would give it a net cash position of $9.86 billion when Global Financing debt is excluded. In any case, we doubt that the markets would challenge IBM if it were to increase leverage to acquire HP. IBM is rated AA- by S&P, and Aa3 by Moody's.

Furthermore, any debt used to fund a takeover of HP could be paid down quickly with HP's free cash flow, which could improve from current guidance if IBM's culture of discipline is added onto HP's core business. IBM could also issue stock to finance a portion of an HP takeover. IBM has a great deal of credibility in the markets, and we doubt that there are many HP investors who would turn down shares of IBM (IBM could also buy back those shares using HP's free cash flow, or pause its own dividend increases to repurchase shares at an accelerated rate). Furthermore, the spinoff of HP's PC business could also help fund a deal for the company. Even if it brings in only a few billion dollars, it could provide IBM with a decent percentage of the funding needed to take control of HP.

The biggest roadblock to an IBM-HP deal are anti-trust concerns. Together, HP and IBM would occupy a leading position in markets such as servers and storage, and the Justice Department may see competition issues. Like Oracle, IBM would need to present a compelling case as to why a combined HP and IBM do not present a threat to competition. Concessions may include spinoffs of HP's assets and business lines, which should not be a challenge for IBM to do. There are any number of technology companies that would be interested in a piece of HP's business, such as EMC or Cisco (NASDAQ:CSCO). Without the PC division, there is still enough left in HP to make a deal worthwhile, even with some potential concessions (though the scope of any potential concessions could alter IBM's feelings on a potential deal).

Conclusions

To her credit, Meg Whitman is attempting one of the most complex corporate restructurings in history. It is unlikely that any CEO could fix the problems of the 10th-largest company in the Fortune 500 in the span of 14 months (Whitman became CEO in September 2011). However, there are slivers of progress. HP's pro forma margins rose in Q4 2012 to 10.4%, up 70 basis points from a year ago and 1.2% from Q3 2012, and the company is once again investing in research and development. R&D spending rose by 9.65% in HP's latest quarter to $909 million, a sign that Whitman and her executive team realize that HP must do more than simply cut costs to regain a leadership position in the technology sector. However, Meg Whitman may not get the chance to finish the job of rebuilding HP.

HP's market capitalization has shrunk to just over $24 billion, based on its closing price of $12.36 on November 27, 2012. At this level, HP is no longer large enough to withstand a takeover if it materializes due to size alone. And Oracle, Dell, and IBM (as well as other companies), likely recognize the fact that despite HP's very public problems, there is a valuable business under the surface. HP is competitive in several key markets, and at some point, the company may become too tempting to other large technology companies to ignore. Unless Whitman delivers more tangible proof of progress at HP over the course of 2013, the opportunity to fix the company could be taken away from her.

We have added HP to our watch list, but are waiting for Q1 2013 earnings before committing to an investment in HP. And while we do believe that investors should buy into HP only if they believe in the company's fundamental progress and turnaround, we do think that the downside potential at these levels is limited. If HP's stock falls much further, takeover speculation is likely to intensify. And in our view, such speculation is warranted. There is value locked within HP, and at some point, other companies may very well begin looking to see if they can be the ones to unlock that value.

Source: The End Game At Hewlett-Packard: Analyzing The Company's Takeover Prospects

Additional disclosure: We hold shares of IBM via the Fidelity Growth Company Fund.