Thursday, October 18, 2012

Comparing IBM and HP Recent Quarters

IBM's third quarter earnings announcement was characterized by the New York Times, as "mixed and somewhat unsettling."  Actually, it shouldn't have been too unsettling as IBM has missed its  revenue guidance for the past five quarters. This quarter also represents the first quarter in which the new CEO Virginia Rometty is putting her stamp on the style of the presentation, which was more cautious and spoke of the same macro headwinds referred to in the HP conference call.

The quarter reported against the background of the bold 2015 Road Map When a reader looks at the revenue growth rates over the period 2010-2015, especially for the base business excluding acquisitions, one sees the same GDP-type growth rates referred to by HP CEO Meg Whitman in their recent conference call.  For instance, IBM projects the CAGR of major market revenue, in constant currency, over the Road Map period as being 2%. Growth markets, which for IBM means ex-North America and developed Europe, are expected to increase revenue at 8% per annum in constant currency over the same period.  HP by contrast seems to have its OUS business more heavily exposed to the European Union, which is why CEO Whitman was so cautious about European macro headwinds.  IBM's global brand and reach has been built out over a longer time to a wider portfolio of nations.

IBM said that $20 billion of acquisitions will add revenue growth of 2% per annum to the company over 2010-2015.  HP, by contrast, will be hamstrung by its repeated history of disastrous acquisitions under the three past CEO's.

In the important areas of business analytics and cloud computing/data centers, HP and IBM look somewhat comparable in their presence and growth opportunities.  Today, IBM put out an industry press release announcing the launch of several new products in the data security field, aimed specifically at big data users who are concerned about data encryption, usability and security.  This makes it very clear, when taken together with the HP call, why Autonomy, though bungled from the outset, was a critical acquisition for HP to complete in order to stay competitive in cloud computing/data centers and analytics.

Where IBM leaves HP behind is in the services area, where IBM competes with Accenture at the top of the food chain.  HP is not yet in that category, but getting there would make a big difference to an HP profit turnaround.  IBM characterizes its services businesses as having gross margins in excess of 35% and pre-tax operating margins of 20%.

IBM enterprise software and middleware represent 44% of 2011 revenue.  The company says that only 40% of the operating profit from software comes through transactions for systems and hardware, meaning that it has a strong annuity component.  Again, this reinforces for us the importance of the new software CEO at HP and his reporting directly to CEO Whitman.

One thing which seems sub-optimal to me about IBM's 2015 Road Map is the preponderant contribution of share buybacks and dividends in the historic and expected future total return to shareholders.  IBM is not exactly a screaming buy, and it hasn't been since the stock's exceptional 2011 performance. I would aim to increase the dividend yield, take the foot off the buyback pedal, and look to selectively reinvest in the growth businesses.

CEO Meg Whitman, according to my notes, said in their conference call, "I believe in creative destruction." Of course, this is Hayek's term, but it is also the title of a business book by two McKinsey consultants. I pulled a dusty copy off my bookshelf, and I believe that Whitman's reference was to this book. Many of the case studies in the book are technology companies, from Storage Tech to IBM.

If CEO Whitman believes in the Hayek concept, then when will she start that process for the HP portfolio?  The new PSG, now that it includes printers and personal computers, could be sold much as IBM did decades ago; values are rock bottom, and the company has claimed buying synergies which argue against selling this business.  IBM has shown that having some hardware system sales does help software and consulting sales too.  So, the jury's out on this one.

The other candidate is the old EDS business, which has been sharply written down.  This might very well be a place to begin the creative destruction, but in the short run CEO Whitman's focus has to be on cultural change, operational efficiency and repairing the balance sheet.

The reports of both companies show how difficult it is to consistently generate above GDP revenue growth, ex-currency, in this tepid recovery, now almost three years old, from the financial crisis.

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