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Both Hewlett-Packard Company (HPQ) and Dell Inc. (DELL), the two largest global PC makers, have seen a drop in earnings due to the sharp decline in the global PC business. I want to compare how HP has done with some tech giants that I am pretty bullish about like Microsoft Corp (MSFT) and International Business Machines Corp. (IBM). HP hasn't been as successful in transitioning its business the way IBM and MSFT have done.

HP can learn a thing or two from both MSFT and IBM. There will be a lot of web based growth with more people coming online in the future and this will make Bing Search and Microsoft's social media ventures like Socl increase in popularity. HP can either venture into these areas or look to step up its game in sectors that it has a good presence and that can improve its profitability in the future.

HP is still the biggest player in the server business with a 26.9% market share. Dell and Cisco Systems, Inc. (CSCO) had 18.5% and 4.1%, respectively, of the global server market share. Nonetheless, in Q1 2013, HP's server sales fell 14.8% to approximately $2.95B.

Moreover, its Industry Standard Servers business was $12.5B in 2012, the same as the 2010 revenue. I think HP will have to learn from Dell here as its servers and networking segments have actually been growing quite well. Dell has grown its servers and networking revenues from $7.6B to $9.3B in the past three years.

Let us now examine HP using DuPont Analysis and see how it compares to MSFT, IBM and CSCO.

DuPont analysis is named after the U.S. chemical company that created this method of analysis in the 1920s to gain more in-depth knowledge of Return on Equity [ROE]. In DuPont Analysis, the ROE is decomposed into factors that can be further analyzed. These factors are commonly a profitability measure, a turnover measure, and a leverage measure.

Three-Step DuPont

The three-step equation breaks up ROE into three very important components:

ROE = (Net profit margin) * (Asset Turnover) * (Equity multiplier)

These components include:

Operating efficiency - as measured by profit margin.

Asset use efficiency - as measured by total asset turnover.

Financial leverage - as measured by the equity multiplier.

Let me briefly touch on the math here.

Taking the ROE equation: ROE = net income / shareholders' equity and multiplying the equation by (sales / sales), we get:

ROE = (net income / sales) * (sales / shareholder's equity)

We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont equation.

ROE = (net income / sales) * (sales / assets) * (assets / shareholder's equity)

This equation for ROE, breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

ROE

=

Net Profit Margin

×

Asset Turnover

×

Equity Multiplier

Oct 31, 2012

-56.38%

-10.51%

1.11

4.85

Oct 31, 2011

18.31%

5.56%

0.98

3.35

Oct 31, 2010

21.66%

6.95%

1.01

3.08

Oct 31, 2009

18.91%

6.69%

1.00

2.83

Oct 31, 2008

21.39%

7.04%

1.04

2.91

Source: HP Annual Reports

As you can see, the ROE has decreased and it can be attributed to the profitability decline as measured by the Net Profit Margin. The equity multiplier has also increased sharply and these are two very negative signs for HP.

HP's ROE is fairly average, but this is a bit misleading when you take into account the high equity multiplier value. A higher equity multiplier indicates higher financial leverage, which means the company is relying more on debt to finance its assets. HP's equity multiplier values are almost 3 times those of MSFT and CSCO over the last 5 years. But they are lower than IBM's values.

Five-Step DuPont

This is called the Extended DuPont Analysis.

As we have seen:

Net Profit Margin = Net Income / Sales

-10.51% (2012 value) = ($12,650) / $120,357

This can be rewritten using another mathematical identity:

Profit Margin = (Net Income / Sales) = (Net Income / Earnings Before Taxes) * (Earnings Before Taxes(EBT) / Earnings Before Interest and Taxes (EBIT)) * (EBIT / Sales)

Tax Burden = (Net Income / Earnings Before Taxes)

($12,650) / ($11,933) = 106%

Tax Burden is an indication of how much the company is paying in corporate taxes, or how much of the profit is falling to the bottom line. This calculation indicates that as of the most recent fiscal year, HP has kept 106% of every dollar it makes after expenses. This is because it has been losing money.

Interest Burden = (Earnings Before Taxes / Earnings Before Interest and Taxes)

($11,933) / ($11,057) = 107.92%

Interest Expense reduces Net Income and therefore, lowers ROE. HP's interest burden is higher than the industry average.

Sales Margin = (EBIT / Sales)

($11,057) / $120,357 = -9.19%

Sales Margin is yet another way of looking at how profitable each dollar of revenue is after deducting operating expenses but before deducting interest and taxes. The sales margin and the net profit margin are lower than that of Microsoft.

So again, putting the three ratios together, we get:

Net Profit Margin = Tax Burden * Interest Burden * Sales Margin

-10.51% = 106% * 107.92% * -9.19%

And finally, the complete Extended DuPont Analysis:

ROE[1] = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Sales) * (Sales / Assets) * (Assets / Equity)

-56.38% = [($12,650) / ($11,933)] * [($11,933) / ($11,057)] * [($11,057) / $120,357] * [$120,357 / $108,768] * [$108,768 / $22,436)

ROE = Tax Burden * Interest Burden * Sales Margin * Asset Turnover * Equity Multiplier

[1] Values are for 2012

ROE

=

Tax Burden

×

Interest Burden

×

Sales Margin

×

Asset Turnover

×

Equity Multiplier

Oct 31, 2012

-56.38%

106%

107.92%

-9.19%

1.11

4.85

Oct 31, 2011

18.31%

78.76%

92.82%

7.49%

0.98

3.35

Oct 31, 2010

21.66%

79.83%

95.60%

9.04%

1.01

3.08

Oct 31, 2009

18.91%

81.36%

100%

8.74%

1.00

2.83

Oct 31, 2008

21.39%

79.53%

95.73%

9.24%

1.04

2.91

The ROE has decreased and it can be attributed to the profitability decline as measured by the Sales Margin.

Three-Step Net Profit Margin

You can take your analysis further by taking individual components of the DuPont Identity and breaking them down to gain additional insight.

Net Profit Margin

=

Tax Burden

×

Interest Burden

×

Sales Margin

Oct 31, 2012

-10.51%

106%

107.92%

-9.20%

Oct 31, 2011

5.56%

78.76%

92.82%

7.49%

Oct 31, 2010

6.95%

79.83%

95.60%

9.04%

Oct 31, 2009

6.69%

81.36%

100%

8.74%

Oct 31, 2008

7.04%

79.53%

95.73%

9.24%

I hope you get the idea by now. It can be clearly seen that the Sales Margin has had the biggest impact on the Net Profit Margin and its decline from 2011 to 2012.

Concluding Thoughts: Negative figures for 2012 are troubling

Investors are always on the lookout for companies that generate profits more efficiently than their rivals. ROE is a key indicator that signifies to investors that a firm is a profit creator and not a profit burner. A DuPont analysis helps in painting a true picture about the ROE value obtained. It was a very helpful exercise indeed to perform the Extended DuPont Analysis on HP going back over time to see how the trends have been going with the individual components over time.

The other thing that was very useful was to compare HP with IBM, CSCO and MSFT. MSFT looks better than IBM, CSCO and HP in the DuPont Analysis and I think MSFT is better positioned for the future. It is agreed that we are in a dying PC market. Gartner has reported that global PC shipments in Q1 2013 have fallen to levels not seen since Q2 2009. Microsoft has been unable to make inroads into the highly competitive mobile arena with Apple Inc. (AAPL) and Google Inc. (GOOG) being the front-runners. Furthermore, Microsoft is still trying to shed its old-fashioned image in this technology era that is basically dominated by touch and social. But it is a monopoly with its Windows product and that is all that really matters.

As for IBM, it has continued to be very innovative with its Blue Gene supercomputing program winning the National Medal of Technology and Innovation in 2009. IBM looks to be the industry leader in IT services and computer software for the foreseeable future with some big acquisitions made already.

Hewlett-Packard could be a value play on the turnaround long promised by CEO Meg Whitman. However, the high intangible assets on the balance sheet make me not too excited about HP right now.

HP is in the process of restructuring itself after a bad acquisition. Nearly $8.8B was wiped out of the PC maker's equity as a result of the Autonomy acquisition. The issues with HP don't stop there. There is also the $35B in goodwill and intangible assets that could be further written down in the future. HP's negative tangible book value is at -$11.5B and the Palo Alto, CA based firm has just $23.5B in equity. This seems like a good time to short the stock as I fully expect the stock price to dive further in the coming months.

Note: All materials are sourced from Morningstar and MSN Money.

Source: Why I Don't Love HP In 2013