Winding Up The HP Conversation: What's Missing

Perhaps the most curious remark made by new CEO Meg Whitman on the recent HP conference call was her characterization of HP as a company that grows at GDP-like rates (it was a bit inaudible on the webcast).  While this kind of remark makes total sense from a longer-term perspective, it isn't what an institutional investor wants to hear.

Trees don't grow to the sky, and to be sure "long term growth rates" of 15% projected by most analysts for S+P 500 growth companies make little financial or economic sense.  Some of my savviest institutional investor customers spent lots of time trying to determine the "earnings power" of potential investments, i.e. what returns could they earn on the assets they had in place if volumes were growing at above-GDP rates, the company had pricing flexibility, and the economic and competitive backdrops were favorable.  For cyclical companies with significant leverage, the turnarounds in EPS were dramatic.

Stephen Penman, Professor of Accounting at the Columbia University Graduate School of Business, recently wrote a book, "Accounting for Value," in which he updates the Graham and Dodd approach made famous in their pioneering work on security analysis. He concludes that most investors overpay for growth and leave no "margin of safety" when they buy a stock.  The "margin of safety" is one of the key tenets of Graham and Dodd's approach.  Warren Buffett, a longstanding student and disciple of Graham and Dodd, recently announced a large equity stake in IBM, and not HP.  One would think that HP would show a reasonable margin of safety at current prices. 

HP was described by some analyts as trying bring expectations down as low as possible.  That's usually a tactic pursued by second rate companies.  Tweedy Browne is a distinguished value shop which has habitually avoided technology stocks.  They recently initiated positions in Google, which doesn't fit traditional value metrics.  However, they argue that given their huge cash flows, and large investments made to date in technological backbones like data centers, incremental revenue growth, acquisitions and entries in adjacent businesses can have large impacts on EPS. 

Their one concern about Google is a cultural one, namely that the management seems intent on changing the world, in their own words, as opposed to always making shareholder-friendly decisions.  HP on the face of things looks like a traditional  technology value stock.

Dodge and Cox, another traditional value shop, has a five percent or better ownership position in HP equity, between the Stock Fund, the Balanced Fund, and the International Stock Fund.  The company has a long standing position in HP bonds through the Income Fund, which has long been overweight corporates.  It looks like the Income Fund recently sold out of HP bonds because of their strong price out performance.  Aside from HP and extensive index fund ownership, we will see in coming months which other value investors may be accumulating shares in HP.

What's missing from HP in our opinion is leadership, both from the board room and from the revolving door of the executive suite.  This is a serious cultural issue, more worrisome than any cultural issue at Google.  It is the same board in place, and a CEO who came from the very same board which made any number of large, foolish decisions.  The IBM turnaround had a clear beginning with Lew Gerstner. It was fortified by Sam Palmisano and is being handed off to Virginia Rometty; the entire process had gravitas, circumspection and strong hands at the tiller.  HP has under performing assets, a portfolio of businesses with no unified vision or mission in the marketplace, low expectations and a new CEO with smaller company experience driving this very large ship.  Without a cultural transformation, it might become a nice short-term trade, when stronger 2H 2012 earnings become visible, but it's a long way from being a great investment yet.