CEO Meg Whitman faces a tall order in trying to steer under-performing technology titan Hewlett-Packard (HPQ). The company's stock is down 44% over the past twelve months. In May, management announced plans for a broad, multi-year restructuring effort aimed at streamlining processes, focusing on innovation, and of course reducing costs (annual savings of $3 to $3.5 billion are expected to be realized by fiscal 2014). In July, famed short-seller Jim Chanos of Kynikos Associates termed Hewlett Packard "the ultimate value trap".
A look at the market's view of the company reveals just why this restructuring is so badly needed, and why Jim Chanos may have the right idea about the future direction of HP.
Among its major competitors, Hewlett-Packard appears to be the least focused. The company is constantly branching out from its diminishing area of strength, which was originally printers, into adjacent markets that it either does not understand, like consulting. The company is also unable to capitalize on consumer enthusiasm for smartphones and tablets.
- Accenture (ACN) is far stronger in the type systems integration consulting that HP plays at but has failed to dominate. And with revenue less than 20% that of HP ($28.9 billion vs. $122.5 billion), Accenture has a market capitalization nearly 50% higher ($42.9 billion vs. $28.7 billion).
- Cisco (CSCO) highlights the benefits of staying focused. While the company has branched out from its core router products, its gross margins of 61% should evoke envy and shame in the management ranks of Hewlett-Packard, which is currently struggling with gross margins of only 23%.
- Dell (DELL) is a competitor that is also losing its footing, but it appears to be managing its declining fortunes better than HP. With gross and operating margins extremely similar to HP, Dell has managed positive TTM net income, illustrating the value of not looking to M&A to solve underlying problems at a company.
- IBM (IBM) is likely what every HPQ executive wishes Hewlett Packard could be. A storied technology company that has successfully reinvented itself and is now a strong competitor in hardware, software and services, IBM is a goliath with nearly $105 billion in sales. Unlike HP, however, IBM has managed to utilize its massive scale to generate impressive financial results, with gross margins of 48% and operating margins of 20%. For these reasons it is no surprise that IBM, with nearly $20 billion less in sales than HP, has a market capitalization over 7.5x its larger but weaker competitor.
A Failed M&A Strategy
Hewlett-Packard has embarked on an aggressive round of acquisitions, which Jim Chanos has termed "stealth R&D". Unfortunately it appears that management is either a poor judge of the upside in its acquisition targets, or blind to the challenges of realizing that upside within Hewlett-Packard.
Since January 2008, Hewlett-Packard has closed six acquisitions of over $1 billion each. These six acquisitions represented a cumulative deal value of nearly $33 billion, or 15% more than the current market capitalization of Hewlett Packard as a whole. This is value destruction on a massive scale.
The purchase of software company Autonomy, in 2011, is only the latest mega deal. The $11 billion acquisition of this software company represented an attempt by HPQ to buy its way into a stronger position in software and services, effectively conceding low margins in hardware.
A Value-Destroying Behemoth
Hewlett Packard management needs to look in the mirror and understand what it is and what it is not. The company is spread too thin, and the signs of overstretch are clear.
- Profitability measures are weak when viewed in isolation, and extremely troubling when viewed in comparison with key competitors.
- Indebtedness is rising, with net borrowings up $14.3 billion over the past two years. Debt to equity is now 0.79x, vs. 0.39x only two years ago. Additionally, the higher proportion of short term debt increases the likelihood of a negative shock to profitability if interest rates should increase substantially.
- Cash flow is moving in the wrong direction, with a cumulative cash burn of $5.2 billion over the past two years.
- The cash conversion cycle has ballooned from 14 to 26 days in only two years.
- Cumulative valuation allowances on gross deferred tax assets of $17.5 billion since fiscal 2009 indicate a weak profitability outlook.
Hewlett Packard is a large company, but not a well-managed one. Its Services Division alone is nearly 20% larger than Accenture and has similar operating margins, suggesting that the market is valuing HPQ at considerably less than the sum of its parts. Instead of working to tweak the current structure of the company, management should seek to blow it up and allow shareholders to reap the value of a series of smaller, focused companies not wedded to a value-destroying view of size as a valid end goal.
The "value trap" that Jim Chanos refers to is the tendency of "cheap" companies to continue to get "cheaper" as the underlying rot prevents management from making the changes necessary to drive gains for shareholders. Hewlett Packard is a giant, but it is a feeble giant seeking to carve out a niche against competitors against whom it has few or no discernible advantages. In light of the company's troubles, and its inability to utilize its scale as a competitive weapon, this looks like a company with considerably more downside than upside in the near term.