The Hewlett-Packard (HPQ) story is well-known, another piece of vintage Americana, Bill and Dave starting off in a garage, with $540, flipping a coin to see whose name went first. It was about inventiveness. When I turn on my computer, it displays the HP logo, with the imperative "invent" underneath. Of course when Steve Wozniak, an employee at the time, offered them the first Apple (AAPL), they turned it down.
Here's how Meg Whitman sees the company, from her letter to shareholders in the 2011 Annual Report:
Over the long term, I expect HP to be a GDP-type growth company that can grow revenue inline with or better than our markets, expand earnings faster than revenue, and produce consistent cash flow. We intend to deploy a balanced capital allocation strategy, investing in our businesses through a combination of capital expenditures and acquisitions, and returning cash to stockholders through a mix of share repurchases and dividends.
There is no mention of R&D or inventiveness in the letter, just a rather bland mission statement about managing a portfolio of businesses.
In the financial statements, R&D expenditures come in at $3.3 billion, or 2.6% of revenue. Net income is $5.3 billion, or 4.2%. R&D expenses are very material, when compared with what is reaching the bottom line. Is R&D and investment, or an expense? What happened to the imperative - invent?
Assessing R&D Performance
It's always difficult for an investor to quantify the value added to a company by its R&D expenditures. One of the few companies that communicate clearly on the issue is 3M (MMM). From a recent presentation (pdf):
(click to enlarge)
The point is, 3M is making an effort to quantify R&D results by looking at new products as a percentage of sales, and it is communicating the results to shareholders.
3M's R&D expense is 5.3% of revenue, and its net income is 14.5%. The thinking here would be that when R&D is well spent, margins and/or growth will be higher. HP's margins are fairly thin, compared with the amount spent on R&D.
A Competitor's Opinion
Considering the source, the criticism should be given considerable weight. HP will be a better performer if Whitman fixes the problem.
Part of HP's former iconic stature derived from its focus on inventiveness. An investment thesis that relies on regaining that level of prestige is unrealistic.
Ken Fisher, in his early book, "Super Stocks," did some thinking on PRR, or price-to-research ratio. His take, R&D is a commodity, and gets its value from marketing. From the book:
Avoid the lure of supposed research magic. There's no magic in engineering. The real key to what a company will get out of its research lies in marketing. Once you determine marketing capability, valuing research becomes a relatively easy thing to do.
Apple has put a lot of pressure on the PC business, by developing the tablet as an alternative to traditional PCs and laptops. Steve Jobs had a vision of what would sell, and he pushed engineering to develop the product accordingly.
Fisher advocated buying "smokestack" industries, or those producing commodity products, at a P/S ratio of 0.4 to 0.8, buying at the low end of the range and selling toward the high end. HP is trading at a P/S ratio of 0.3, vs. a 5-year average of 0.9.
Producers of commodity products don't need a lot of R&D. Whitman should either axe the R&D expense or take a very close look at the interface between R&D and the customer. Does the company know what the customer wants, and is R&D focused on meeting those needs? There's value there, whether it takes the form of potential expense reductions or products that are differentiated and command higher margins.
From the 8-K:
On May 23, 2012, the HP Board of Directors approved a restructuring plan designed to simplify business processes, accelerate innovation and deliver better results for customers, employees and stockholders. HP expects that the restructuring plan will be implemented through the end of HP's 2014 fiscal year and will include changes to the company's workforce as well as cost savings from supply chain optimization, stock keeping unit and platform rationalization, real estate consolidation, go-to-market strategy simplification and business process improvements.
As part of the restructuring plan, HP expects approximately 27,000 employees, or approximately 8% of the company's workforce as of October 31, 2011, to exit the company by the end of fiscal 2014, with a portion of those employees exiting the company as part of a voluntary early retirement program for U.S. employees whose combined age and years of service exceed certain levels. The total number of employees ultimately affected will be impacted by the number of employees that opt to participate in the early retirement program. The changes to HP's workforce will vary by country, based on local legal requirements and consultations with employee works councils and other employee representatives, as appropriate.In connection with the restructuring plan, HP expects to record aggregate pre-tax charges of approximately $3.5 billion through the end of HP's 2014 fiscal year beginning in the third quarter of HP's 2012 fiscal year. Of that amount, HP expects approximately $3.0 billion to relate to the workforce reductions and approximately $0.5 billion to relate to other items, including data center and real estate consolidation. HP expects approximately $2.7 billion of those aggregate pre-tax charges to result in cash expenditures during the term of the plan. HP expects to amend its U.S. pension plans to facilitate the funding of a portion of the cash expenditures using available U.S. pension plan assets.
Here's Whitman, on the restructuring, from the 2Q earnings conference call transcript:
Over time, some of the savings will drop to the bottom line, but the majority will be reinvested using a disciplined, data-driven process to prioritize organic opportunities across the business. Return on investment will be evaluated on an ongoing basis and the investments will be calibrated accordingly. We'll be investing to drive leadership in the 3 strategic pillars of Cloud, security and Information Management. And in each of our businesses, we'll make investments to stay ahead of customer expectations and market trends.
In our PC and printing businesses, we'll be focused on design, engineering, quality and generating demand and desire with our customers. In Services, we're improving processes and building out capabilities in Cloud, security and information. We'll also be strengthening our industry practices, as well as our service quality and innovation. In Software, we'll be investing to speed development across security, information and management infrastructure for both on-premise IT and in the Cloud, with a key focus on Software-as-a-Service offering. This will include the extension of Vertica and Autonomy across our entire portfolio. For example, deploying them in our document workflow solutions and in building out our Information Management practice and services. And in ESSN, we'll invest to drive R&D and innovation in our core businesses of Server, Storage and Networking.
In this discussion, Whitman demonstrates awareness of the need to invest in R&D and innovation, and the relation to customer expectations, in contrast to the quote in the shareholder letter.
With the stock trading in the $19 area, using P/S and a midpoint on Fisher's 0.4 to 0.8 range, shares are potentially worth $37, assuming Whitman stabilizes HP as a producer of commodity products. If HP emerges as an innovator, with growth and margins enhanced accordingly, $60 per share would be possible. Either outcome would result in generous returns from today's prices.
The restructuring is a two-year process, and the results will become clear sometime after that process has been completed.
I'm long HP, and nursing a sizable unrealized loss. I plan to hold and monitor, tracking the progress of restructuring and innovation.