HP: $8 Billion Charge Great For Investors?

| About: HP Inc. (HPQ)

Hewlett-Packard (NYSE:HPQ) announced that it is raising its third quarter forecast. The company also said that it expects to write down $8 billion worth of its enterprise-services business and shuffling management at the top of the division. It further added that it is eliminating 27,000 jobs, mostly coming from the enterprise service division. Following the write-down, it will replace John Visentin as the head of enterprise services. The company will bring on board Mike Nefkens and Jean-Jacques to head the unit.

The decision to write-down implies the declining value of Electronic Data Systems. It acquired the company for $13.9 billion in 2008. Former Hewlett-Packard CEO Mark Hurd expected that the marriage of HP and Electronic Data Systems will produce one of the market's leading outsourcing providers, with the ability to complete lifecycle capabilities in healthcare, government, manufacturing, financial services and other industries. But, it failed with this campaign as rivals Wipro (NYSE:WIT) and Tata Consultancy were able to handle IT outsourcing more efficiently than Electronic Data Systems. Wipro has maintained its operating margins of 17% and has returns on equity of 21%. This is despite the fact that most IT outsourcing players have low single digit margins and returns on equity.

This should be seen as a positive move from Hewlett-Packard CEO Meg Whitman. Whitman is definitely leading the company toward higher margins. I also see this as part of its multi-year restructuring process. As announced earlier, the restructuring will generate annualized savings of around $3 to $3.5 billion. These cost savings will be reinvested back into the company's strategic focus areas: cloud computing, big data and security. The company also said that it will invest into other segments that offer attractive growth potential.

It seems that Whitman is working hard to reverse Hewlett-Packard's missteps over the last decade. According to research firm Baird, the company spent $67 billion on acquisitions since 2001. This is twice the company's current market capitalization of $38.27 billion. This only goes to show that previous management has done a poor job managing its resources very well. Its acquisition strategy worked very well for the small companies they acquired. But it failed to integrate the larger ones. Unfortunately, these acquisitions were costly and quickly destroyed shareholders' wealth.

For example, the company acquired Palm for $1.2 billion. It envisioned Palm's mobile operating system, WebOS as an ideal platform for the company's mobile strategy. A year after the Palm acquisition, it decided to close its webOS devices as it could not compete with Apple's (NASDAQ:AAPL) iPhone and Google's (NASDAQ:GOOG) Android.

In the case of Electronic Data Systems, the segment has been slow to innovate. It failed at keeping up with its rivals. This also resulted in the company accepting lower-priced contracts, putting a squeeze on its margins. Moving forward, I expect to see Meg Whitman to focus on higher margin contracts.

The $8 Billion Charge: Short-Term Pain, Long-Term Gain

The recent acquisition blunders highlighted the company's lack of direction from management shuffles. Over the last three years, there were also three top management changes. This resulted in different mindsets and strategies for the company. The impact is also obvious if one would assess its historical financial performance. For the last 5 years, it has grown its revenues by 6% a year. This translates to operating margins of 7% to 8% and return on equity of 17% to 21%. For the fiscal year 2011, operating margin is at 7.6% and return on equity of 17.89%. This is at the lower end of the historical range.

In contrast, Google has successfully implemented its acquisition strategy. Google's notable acquisitions have translated to incremental cash flow for the company. Over its 14-year history as a company, it has spent $22 billion in acquisitions of more than 100 companies. The result is astounding. Revenues have grown by 29% for the last 5 years. This translated to operating margins of 31% to 35% and returns on equity of 18% to 20%. Given the strong track record of Google, I would not be surprised if these figures will be higher in the future.

Even IBM (NYSE:IBM) has better prospects. It has also successfully integrated its acquisitions into the company. It has grown its revenues by 3% a year. This translated to operating margins of 17% to 19% and returns on equity of 65% to 73%. Since IBM has making traction in the enterprise market, I expect figures to remain steady through the next fiscal years.

Whitman's decision to write-down $8 billion of its enterprise service business is actually a good sign. Despite being a famous active dealmaker herself, Whitman has spent more time cost-cutting than deal-making. I believe that the era of focus for Hewlett-Packard has arrived. For the next 5 years, analysts expect the company to grow its earnings by 4% a year. This may appear so low considering the annual savings of around $3 billion to $4 billion a year.

Valuations: Break-up as Catalysts?

The stock is currently trading at 7.5 times earnings and 90% of book value. It also carries a dividend yield of 2.5%. For the last 5 years, the company has average price earnings ratio of 13.1 times.

Its peers are trading higher. Microsoft (NASDAQ:MSFT) is valued at 15 times earnings and 3.8 times book value. IBM trades at 14.5 times earnings and 11.1 times book value. It also carries a dividend yield of 1.60%. Also Apple trades at 14 times earnings and 5.2 times book value.

It seems that the market is clearly discounting its ability to turn around its operations. I believe that one of the key catalysts is breaking up the company. Based on the recent UBS report, a potential break-up of its consumer and business divisions would make perfect sense. I believe this would complement Whitman's plan to focus on its three key areas. It will also convince the market that there is a solid plan to turn things around. I expect that this won't happen unless there is an activist like Carl Icahn or Bill Ackman to push Whitman. For now, the market will continue to wait on the sidelines.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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