A few days ago, I wrote an article about why Hewlett-Packard (HPQ) should be thrown out of the Dow. Well, I got quite a few daggers thrown at me. In this article, I shall examine HP's business under ex-ex-CEO Mark Hurd and what happened since he had been fired.
HP is composed of six major business groups, soon to be five when IPG merges with PSG under new CEO Meg Whitman:
- Enterprise Storage and Servers - "ESS"
- Services - "HPS"
- HP Software
- Imaging and Printing Group - "IPG"
- Personal Systems Group - "PSG"
- HP Financial Services - "HPFS"
The following pie chart shows the percentages of each branch's revenue and operating income as a percentage of HP. Personal computers ("PSG") and printing ("IPG") account for 50% of HP's revenue and 41% of its operating income. But the products represented by these two groups are both at declining stage in their respective product cycle. Hence they are the least important groups for HP's future.
To get out of the current conundrum, HP has to push for growth in storage and servers ("ESS") and services ("HPS"), currently accounting for 45% of the revenue and 52% of the operating income. Using the BCG growth-share matrix, one can easily see HP's dire situation:
Enterprise server and storage
It has no "star", the high growth, high market share business. Service and storage represent the fast growing sector in IT business, but HP doesn't have a large market share (which makes these two groups "problem children"). Its "cash cow" and "dog", the slow growth business, are about to merge together. Successful companies such as IBM (IBM), Oracle (ORCL), or Google (GOOG) have majority of their businesses as either "star" or "cash cow". Sometimes they nurture a "problem child" if it shows promise. In history, Jack Welch, the ex-CEO of GE (GE), was extremely successful at making sure that GE only had "stars" and "cash cows" by acquiring emerging stars and splitting off businesses that do not perform up to par. That's the direction HP has to head towards. Among its peers, only Dell (DELL) is in a similar, perhaps worse trouble than HP.
How was HP doing during and after Mark Hurd (2005-2010)? The following two charts illustrate the revenue and operating income of each of HP's groups from 2005 to 2011.
Mark Hurd did a great job growing HP's service branch (HPS: green line) but was moving slowly on enterprise server and storage (ESS: redline). Since his ousting, however, HP has lost momentum even in the previously quick-growing service group. Something went terribly wrong. During the first quarter of 2012, HP's business was dropping at an alarming rate across board except for software, which saw expansion because of the Autonomy acquisition (The financial services group is not a core part of HP's business). That is why HP's stock was beaten down so badly during the past year. The following income table from HP's most recent quarterly report shows the dismal image.
HP will soon see some one-time charges and layoffs because of the merger between PSG and IPG groups. It should also lead to cost saving in the future. But that is not the most important part. The most important change at HP is the new board, and the new celebrity CEO who has the power to make drastic changes. The chaos caused by ex-CEO Leo Apotheker seems to be finally coming to an end. This will create a stable environment for both HP's employees and its clients.
Under this scenario, is there value in HP's stock? The answer is yes. Here's why.
In 2011, HP has an operating cash flow of $12,639 million. If we use a pessimistic projection of 40% drop in operating cash flow in the whole year of 2012, just like the past quarter, HP will have $7,583 million projected annual cash flow. Adopting a historical price / cash flow ratio of 7.4 over the past three years, HP's projected market value is $56 billion, or about 25% higher than the current level. In other words, the market is pricing HP as if it were to experience more than 50% drop in operating cash flow.
But there is reason to be optimistic. The drop in ESS group's recent quarter revenue can be partially attributed hard drive the supply problem caused by severe flood in Thailand late last year. The drop in services was mainly because of decline in demand of short term projects, likely caused by the chaos under Leo Apotheker. These are both one-time events. So I believe the current value reflects too pessimistic an expectation. Simply by stabilizing its business, HP's stock should recover 25% from its current price. It perhaps still needs some more time before anyone can read whether Meg Whitman is able to pull off a big turnaround.
The verdict: HP seems very close to see the end of recent chaos. It is almost at a point to buy.