Hewlett Packard: What Happens When A Good Business And Bad Management Collide

Sep.17.12 | About: HP Inc. (HPQ)

Hewlett Packard (NYSE:HPQ) shares have performed terribly this year, declining from a high of about $30 per share to their current $18 range, an almost 50% decline, in the span of six months.

Hewlett Packard 1 year Chart (source: barcharts.org):

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Indeed, as can be seen in the more long-range chart of 25 years below, HPQ stock has recently been testing lows not seen since 2003, and before that, the late '90s. In addition, the share count has declined since that time, and earnings have increased, so perhaps HPQ, today, is cheaper than it has been (on, for example, a price-earnings ratio basis) in the last 20 or so years.

Hewlett Packard 25 Year Chart (source: barcharts.org):

Click to enlarge

The obvious question investors typically ask in such a situation: are the shares a bargain and therefore suitable for purchase as an investment? As this article will attempt to show, the answer to that question is unclear. On the one hand, HPQ has a portfolio of enviable businesses; on the other, they are ruled by a management that has made questionable business and capital allocation decisions.

Hewlett Packard's Portfolio of Businesses:

Here is a cross-section of HPQ's lines of business from its most recent 10Q:

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Although there was much disappointment and concern over recent declines in sales (perhaps rightly so), overall this is a portfolio of extremely robust, highly profitable businesses. Of the five non-financial business segments, four have operating margins in excess of 10%. Hewlett Packard Software has operating margins in excess of 20%. Further, many of the businesses in the Hewlett Packard portfolio have strong leadership positions in their fields, with easily recognizable brand names and strong customer awareness. From this picture, it is my belief that despite the recent sales declines, which can perhaps be attributed to horrendous economic conditions around the globe, especially in the United States and Europe, these businesses will probably continue to achieve high rates of profitability.

Hewlett Packard's Management:

Now from the above segment, we have seen essentially that HPQ's management has been bestowed a plethora of riches - high performing businesses that also throw off lots of cash. Many of these businesses also do not require substantial capital investment, as depreciation expense usually equals or exceeds capital expenditures. The question is, has HPQ's management used that capital, the riches bestowed upon it, wisely? The answer is almost certainly no.

1) Overpriced Acquisitions:

In 2011 and 2010 alone, HPQ's management paid $10.48 billion and $8.1 billion for aquisitions, respectively, for a total of almost $20 billion. Compare this to HPQ's current $35.7 billion value according to market capitalization! Indeed, the management could have purchased more than half of Hewlett Packard for the price paid to acquire these businesses.

Did these acquisitions substantially impact either HPQ's sales or earnings? In fiscal 2008, HPQ had $91.7 billion of sales and $8.3 billion of earnings; in fiscal 2011, HPQ had $84.5 billion of sales and $7.1 billion of earnings. So the acquisitions failed to add substantially, or at all, to HPQ earnings. This alone is a fairly egregious, and a somewhat alarming misallocation of resources that leads any potential investor to question this management and ask why they pursued such behavior in the past, and whether this behavior will persist in the future?

In addition, the acquisitions were financed primarily by long-term debt, resulting in an increase in long-term debt from $18 billion in 2008 to more than $30 billion in 2011, hampering HPQ's future financial flexibility.

2) Questionable Share Repurchase Tactics:

HPQ's board has a habit of repurchasing shares at or near 52 week highs. Although the company repurchased $10.1 billion, $11.0 billion, and $5.1 billion worth of stock in fiscal years 2011, 2010, and 2009, they did so at an average price of $43.20 dollars per share in 2011 (issued and outstanding share count decreased from 2204 million shares to 1991 million shares in 2011 - 213 million shares; cash proceeds from stock issuances totalled $896 million while cash paid for repurchases totalled 10.1 billion, for net cash outflow of $9.20 billion).

Repurchases in prior years were made at similarly high prices. Two further items of note regarding share repurchases:

First, the price is so high, in part, because HPQ issues shares as compensation at below-market prices. For instance, in 2011, HPQ issued about 45 million shares for proceeds of about $900 million; at $20 per share, that price is about half that of the shares it repurchased.

Second, although HPQ management incurred debt to repurchase shares at high prices, lately (with a much lower stock price) they've been opting to increase the amount of cash going to dividends and to repurchase debt, and reduced the portion of cash going to share repurchases!

Although there are probably other areas of concern with respect to management behavior, these seem to be particularly questionable.

Conclusion: Are HPQ Shares a Buy?

Although HPQ has strong business fundamentals and a compelling valuation, uncertainty about management's future behavior results in a puzzle regarding whether the shares are a buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.