Thursday, August 23, 2012

HP Third Quarter Report: Lost at Sea

Hewlett-Packard has now attracted a larger, quality stable of value oriented investors, and that's a good thing.  Dodge and Cox, which has upped its stake, is no longer alone: Fidelity, Vanguard, BlackRock, and GMO have sizable positions.  

As a prelude to looking at the quarter, I wanted to review some thoughts from Jim Chanos, founder of Kynikos Associates on HP. Jim made these points about "value traps" in a June 2012 presentation at VALUEx Vail. In a nutshell, here are bullet points   taken from his slide along with some additional text. Remember that these remarks reflect his vantage point as of June 2012.

  • HPQ metrics, relative to its history and to its industry peers, suggest that it is a value stock.  Forward P/E of 5.2x, forward EV/EBIT of 5.6x.  FCF yield of 10.7%, using LTM FCF before share buybacks and acquisitions.
  • Share buybacks and dividends of $6.3 billion in LTM are equal to 162% of FCF.
  • Growth through acquisitions has not paid off. This is characteristic, Jim says, of value traps. $36.9 billion spent on acquisitions since 2007, equal to 82% of FCF. Despite the acquisitions, LTM cash from operations is 7% less that it was in 2007.
  • Value destroying actions were reflected in Compaq impairment, EDS restructurings, Palm write-off, and Autonomy revenue implosion. 
  • HPQ's businesses are struggling.
  • Lack of strategy, as evidenced from 3 CEOs since 2006. 
Characteristics of value traps, according to Jim Chanos, include: a stock looking cheap according to management's metrics, a marquis management or a board comprised of famous investors, cyclical products or dependency on one product line, and hindsight driving expectations.  The latter point is a very interesting one in the case of Hewlett-Packard, which clearly Jim Chanos feels is probably not a 'value stock.'

In some convoluted sense, HP was seen as "beating expectations" by reporting non-GAAP adjusted, diluted EPS of $1.00, a sequential improvement over the April quarter's adjusted, diluted EPS of $0.98, and versus adjusted, diluted EPS of $1.10 for the prior year period.  Somehow, this was better than expectations, although the basis of the analyst estimates are never very clear, and they're not very good modelers anyway.

Management has tried to set expectations as low as possible, and they have the convoluted slop of non-GAAP adjustments, which clearly elude many of the analysts before the announcements. 

As a long-time equity analyst myself, I certainly understand the utility that non-GAAP adjustments provide by improving comparability between EPS numbers. However, they sometimes obscure the underlying economics of the business.  I do get nervous when these adjustments are habitually overused for long periods. Here is an excerpt from a footnote to one of the company's own reconciliation slides:

"Impairment of goodwill and purchased intangible assets doesn't affect cash. It does represent the loss of value in these assets over time.  Expense associated with the loss in value is not in non-GAAP measures and doesn't reflect the full economic effect of the loss in value of these assets."
The value destruction from acquisitions continues to reverberate, as the company took an absolutely astonishing $9.2 billion charge in the July quarter for impairment of goodwill and purchased intangible assets relating to the EDS acquisition. On a diluted EPS basis, the charge was a $4.66 hit to reported GAAP earnings per share.  Heavy restructuring charges in the quarter were a $0.91 hit to reported GAAP earnings per share in the third quarter.

Looking at the balance sheet, there are no alarm bells going off, but it has been subject to stress, looking from October 31, 2011 to July 31, 2012.  In this period, long-term debt has increased by $1.5 billion, reflecting both the Autonomy acquisition and aggressive share repurchases. (On a 'net debt' basis, the CFO talked about a $1.5 billion reduction in 'net debt' over the same period) Standard and Poors noted this when they downgraded the corporate credit ratings in November 2011:

The downgrade reflects liquidity and financial flexibility that have been
reduced by more aggressive financial policies, including the use of leverage
to fund the recent $10.2 billion (net) Autonomy acquisition,” said Standard and Poor’s credit analyst Martha Toll-Reed, “and annual share repurchases well in excess of discretionary cash flow"
Stockholders' equity over the same period has declined by $7.0 billion.  No amount of non-GAAP reconciliations can diminish the fundamental challenges facing HP's portfolio of businesses looking forward, as well as the legacy burden on the organization from its "drunken sailor" acquisition spree over the past several years.

The CEO's tone on this call was much more subdued than at the beginning of her tenure.  Then, Whitman made references to having run this playbook before.  Now, the CEO talks about Enterprise Services being in "a multi-year, non-linear turnaround," whatever that means. Whitman also referred to "plate tectonics" moving the industry, and she talked about adjusting the portfolio. 

This portfolio adjustment is just what Cisco has been doing for a few years.  HP will find itself late in the game for a meaningful portfolio reallocation and refocusing. I believe that the CEO herself acknowledged this when she referred to revenue and near-term results "being challenged."  Overall, Whitman's tone is much more sober, as she now understands what she is up against, both inside and outside the company. 

The Personal Systems group's revenues, 28% of the corporate portfolio, declined by 10% y/y, to $8.6 billion. Total units sold in the PSG declined by 10%.  Operating income was $409 million, for a margin of 4.7%, a decline of 120 bp in margin y/y.  The revenue decline was across all areas, but notebooks led the way with a 13% decline in revenue and a 12% decline in units.  This story is the same told by retailers like Best Buy and by other manufacturers like Lenovo and Dell.  Consumers are price sensitive, and wary about making a purchase before the scheduled October 26th launch of Windows 8.  Channels were overstocked, and everybody looked to manage inventory, so margin was less important than a sale.  Overall, the consumer business was down 12% and commercial sales were down 9%. 

As much as Lenovo made noise about gains in its market share, it appears that cementing and increasing its gains in China were more effective than making share gains in North America, Europe and other markets. HP has a future here, but its challenge is how to differentiate itself in a commodity business.  COMPAQ began as a premium, high quality product that became debased from a brand into a commodity offering.

Smartphones and tablets are things which HP is coming into with no consumer share of mind and with little heritage of design innovation.  If the corporate motto is "Invent," they need to start here by launching great products either on the Apple model or on the Google/Android model.

The Services business is 29% of the corporate portfolio at $8.8 billion in revenue, which declined 3% y/y.  Operating income was $959 million, which is a margin of 11.0%, but the margin declined by 270 basis points from the prior year period. The biggest revenue decline in Services came from infrastructure technology outsourcing, which declined by 6% y/y to $3.7 billion.  It's hard to understand the future of this business from the conference call commentary or Q and A. 

Imaging and Printing (IPG) is 20% of corporate revenue at $6 billion, and it declined by 3% y/y.  Operating margins were 15.8% in the fiscal third quarter, an increase of 160 basis points from the prior year period.  Analysts seemed surprised by this performance, probably because they had the operating margins for all businesses declining y/y.  The current margin rate hearkens back to the halcyon days of 3Q-4Q 2010 when the margin was 16-17%. 

The commercial hardware segment within IPG increased revenue by 4% y/y to $1.4 billion, which is 24% of IPG revenues. Commercial hardware units increased by 4%. The CEO mentioned a sale of 10 HP Indigo presses to Consolidated Graphics, Inc., the printer with the largest digital footprint and a committed user of HP products; the new presses list for about $1.5 million each.  The larger digital presses have components which were negatively impacted in last year's third quarter by the Asian tsunami and related parts shortages.  Finally, the CFO said that the company had a better mix of laser printer sales versus deskjet sales in the quarter. 

Consumer printer sales declined 13% to $567 million, with units declining by 23%.  Between commercial and consumer hardware sales in IPG, total units declined by 17%.  Supplies still represent 67% of revenues for the IPG, and supply revenues declined by 3% y/y.  Oddly enough, in IPG, it looks like the consumer printing segment has problems on the hardware side with a confusing array of old and new models, some design flops like the Envy printers, and declining reliability and quality overall.  Consumer resistance to high ink prices is resulting in almost continuous promotions and discounts on ink at major retailers.  The IPG doesn't seem to one of the bigger headaches for the CEO but it too seems directionless.

Enterprise Servers, Storage and Networking (ESSN) saw revenues decline by 4% to $5.1 billion, with 62% of ESSN revenues coming from Industry Standard Servers.  Operating profit margins in ESSN were 10.9%, a rate 200 bp below the margin for the prior year period.  ESSN is the segment CEO Whitman described as being in a multi-year transition. 

Software business revenues of $973 million increased 18% y/y. The operating margin for the software business was 18% of revenue, or $175 million.  The operating margin declined 150 bp y/y.  Support provided 48% of software revenues and increased 16% y/y.  Services were 21% of segment revenues and increased by 65% y/y.  License revenue accounted for 31% of segment sales and grew 2% y/y.  The Software segment is 3% of consolidated revenue and 5.7% of consolidated segment earnings from operations.  It is also difficult to understand the vision for this business.  It is too small to move the corporate needle.

There you have it: a grab bag of products and services sold primarily to businesses but with a large segment of earnings coming from consumer sales, specifically ink.  Leaders are being replaced, and surely the key sales people in some of the larger businesses are probably being lured elsewhere.  The reduction in company headcount is set to be larger than initially announced. 

"Investing" in cloud computing sounds almost as scary as the government's "investing" in education.  With PSG, Services, IPG and ESSN, the future seems driven by the hindsight of historical, normalized profit margins.  With the businesses themselves being transformed by technology and customer demands, this does not seem to be a suitable way to look forward. 

CEO Whitman drew a parallel to IBM in the 1990's. Let's think about that one. Lew Gerstner told students at the Harvard Business School, "
"Transformation of an enterprise begins with a sense of crisis or urgency," he told the students. "No institution will go through fundamental change unless it believes it is in deep trouble and needs to do something different to survive."
The board at IBM knew that the company was in trouble to the extent that it went to a total outsider as their new CEO, someone who understood the mechanics and language of efficiency and cost.  It's unclear whether the HP board really understands anything. At some point, some of the new investors like Dodge and Cox and GMO should get involved in planning for a significant refresh in the HP board for the next proxy season.

HP's portfolio superficially bears more resemblance to Cisco's than it does to IBM's. I guess I end with the same point I've made before: it's almost impossible to understand where HP is going, as opposed to where it was or where it is, because of the sins of the past. 

Aside from looking at metrics relative to HP history or industry comps, it's hard to make a bull case for HP.  This argument sometimes appears as, "It can't get much cheaper."  Investors who got in at $20-25 felt this way, and we disagreed in prior posts. Unless HP as an organization believes it is in trouble and acts that way, as Gerstner says, then it may be a short-term trade from depressed levels, or a value trap.  Time will tell, and it's very early in this story, with no clarity.

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