More than a quick fix
Does Hewlett-Packard’s future look like Kodak or Xerox? Both American companies once led peers in their respective industries and technologies. Today one is muddling along, the other bust. The smart money is divided on whether HP, Silicon Valley’s formerly stalwart icon, can return to glory under Chief Executive Meg Whitman. Tech history, however, suggests the bears have the upper hand in this debate.
HP has both savvy supporters, like Relational Investors boss Ralph Whitworth, and detractors, including short-seller James Chanos of Kynikos. Both camps seem to agree the company, now on chief executive number four in three years, wasted tens of billions of dollars on bad acquisitions and missed a handful of key technological transitions. The main point of difference between the longs and shorts is whether there’s value to be extracted from HP’s assets or the group is in an unrecoverable downward spin.
For the past decade, HP relied on takeovers rather than research and development to power growth. That didn’t work. Spending half as much as IBM as a proportion of sales on developing new products flattered margins, but has left the company behind the curve on understanding how customers access information and use technology.
Where HP’s programmable calculators were once the device of choice for engineers of all stripes, the company is a minor player in today’s tablet and smartphone markets. Not only did HP neglect a huge opportunity – more smartphones are now sold annually than PCs – but this switch now threatens one of HP’s biggest businesses. Tablet sales are rapidly cannibalizing PC sales.
Attempting to fill these gaps by buying other companies has proven disastrous for investors, because HP routinely overpaid. Even under its last CEO before Whitman, the group – egged on by software-obsessed board member Marc Andreessen – shelled out an inexplicably large $12 billion for UK-based Autonomy. Other acquisitions simply didn’t deliver. Cellphone maker Palm has since largely vanished into the HP abyss.
Overall, HP made over $60 billion of deals in the past decade, leaving the once cash-rich firm saddled with about $20 billion of net debt. That’s more than 50 percent of the company’s equity market capitalization of $33 billion.
HP’s stumbles provided an opening for activist investor Whitworth, who is now a board member. His firm owns less than 2 percent of the stock. With HP trading near five-year lows, there is plenty of support among institutional investors for the sorts of remedies he successfully pushed at struggling companies such as Genzyme, Home Depot and Waste Management. Those include not chasing growth and M&A if the result is capital destruction, returning cash to investors, increasing investment in select areas, and selling businesses if a buyer will pay a premium.
And HP looks extraordinarily cheap. It trades at 4.4 times estimated 2012 earnings, which is roughly a third of the S&P 500 average multiple. The bull case espoused by Whitworth and others is that turning HP into merely an average company could raise this multiple, sending HP’s stock soaring. Unfortunately, good management alone isn’t sufficient in the technology world.
“There’s never been a big tech company turned around by the fifth CEO on the job,” Cisco Chief Executive John Chambers told Reuters Breakingviews this week. In an industry where innovation moves at warp speed, profit and market share accrue rapidly to leaders. As Chambers puts it: “Meg Whitman has been dealt a tough hand, and I like competing against it.”
By missing so many technological shifts, HP risks repeating the travails of Xerox, the copier-maker that was renowned for pioneering innovation but failed to capitalize on its inventions in the marketplace and nearly went under a decade ago. Or worse, HP’s reliance on products that risk becoming obsolete could make it another Kodak. The former global market leader in photography went bankrupt in January.
That may seem far-fetched. HP’s cash flow looks robust at the moment. The danger is it could shrink quickly in coming quarters, as sales at its PC, IT services, printing and enterprise servers, storage and networking divisions are all falling. These businesses make up more than 90 percent of the company’s sales.
The number of PCs sold worldwide next year should be flat, according to estimates from investment bank Evercore. Because prices of gadgets steadily decline, that’s a recipe for falling sales. Moreover, people using tablets and phones print out fewer documents than on PCs. That could mean HP’s cash cow business of selling printers and ink – this area provides more than a quarter of corporate profit – could also suffer steady decay.
Arresting this decline will be difficult. In the past, HP would have countered by going shopping. Whitman, who hasn’t done any big deals, recently said that the company intends to develop a portfolio of mobile devices. But with HP’s track record it is hard to see that initiative generating an acceptable return on capital.
That’s particularly true if HP has less financial wiggle room than commonly thought. The company’s free cash flow (cash from operations minus capital expenditure) was about $5 billion over the past 12 months. That suggests plenty of room to pay the roughly $800 million of interest due annually on its debt, distribute $1 billion of dividends and bump up R&D substantially, even if sales continue to fall.
But HP has also sold increasing amounts of accounts receivables – transactions which can flatter cash flow – including $3.1 billion over the past nine months. If revenue continues to shrink it may not be long before unpleasant choices, such as reducing dividends or slashing capital expenditures further, may be in order. Given the risks, it’s easier to see how HP could lose more of its $33 billion in market cap than increase it. The bears look to be better positioned for HP’s future than the bulls.