On Wednesday afternoon, hedge fund manager Jim Chanos made waves by declaring that he was short Hewlett-Packard (HPQ), and outlining his bearish thesis for the company. Chanos called HP "the ultimate value trap" at the Delivering Alpha conference. This revelation briefly sent HP shares down by more than 2% from their early afternoon highs, though the stock subsequently rebounded. It is obvious to any observer that HP faces serious challenges to its business, but these are already more than priced in to the stock today. In fact, HP is likely to outperform the market over the next several years as investors become more comfortable with CEO Meg Whitman's strategy, and particularly as cost cuts begin to pay off.
Chanos' bear thesis appears to be a classic instance of an investor uncritically projecting the past forward. Instead of carefully paying attention to what management is doing today, Chanos seems to be focused on what previous management teams did years ago. Had he given his speech two or three years ago, it would have been very timely. Today, Chanos' thesis is flat-out wrong.
Chanos appears to have two main arguments. First, he claims that HP is in "declining businesses", by which he seems to refer to the PC business. He argues that as the smartphone and tablet markets continue to grow, PCs will become less profitable. Since HP does not seem to be well-positioned to win market share in smartphones and tablets, this is bad news for the company.
What Chanos seems to have forgotten is that the PC business is not particularly important to HP. On this score, Dell (DELL) or Lenovo might be more logical short ideas. While the PC group was HP's largest business segment by revenue as of last quarter, it was the 4th largest in terms of EBIT (earnings before interest and taxes). Ultimately, it's EBIT that counts, and the PC business contributes only 17% of HP's profits. It is well known that PCs are a declining business line, so it is fair to say that the PC business represents an even smaller proportion of HP's value, since PC earnings deserve a lower P/E multiple. As I have noted before, HP faces challenges in several of its other business areas, but the company is already taking steps to turn those around. HP's massive reorganization will deliver significant cost savings while positioning the company to compete more effectively as a provider of higher-margin value added services.
Chanos' second argument is equally unconvincing. He claims that HP has been "hiding its R&D spending through acquisitions". In other words, the company has been under-investing in R&D in order to keep costs down, while overpaying for acquisitions (which do not show up in a P&L statement). This observation is true, as far as it goes. The problem is that HP is already doing exactly what Chanos says it should be doing. Meg Whitman announced early in her tenure at HP that the company would stop making large acquisitions and would deliver cost savings in order to free up more money for organic R&D investment. If Chanos had evidence that HP was deviating from this mindset, his argument would be more compelling. However, Whitman's actions have been consistent since she became CEO last year and suggest that she will continue to work on streamlining the company while investing in innovation.
At the end of the day, investors need to recognize that HP is not Apple (AAPL) and never will be. The two companies are not even competitors in their most profitable lines of business. Apple's success in smartphones, tablets, and PCs will continue to hurt HP's PC business, but the overall impact on HP will be minimal. The move to portable computing represented by the iPhone and iPad will stoke the market for servers, networking equipment, and cloud-based solutions, which are all areas where HP plans to increase its focus. Investors like Chanos who continue to mistake the HP of the past (PC giant) for the HP of the future will miss the opportunity that lies in this stock.