In August, we wrote,
"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."Based on an earlier post, we believe that, to a large extent, the CEO and her management team did what had to be done yesterday. In many prepared remarks and in some small asides, HP was portrayed as an organization in trouble.
Big conclusions for me:
- Spinning off the Personal Systems and Printer Group makes no sense. It was considered, according to the CEO, and customers told her that it would be anathema to them. The forward looking strategy makes no sense with a break-up option on the table.
- Stop the share buybacks. Apart from the dividend, plow any free cash flow into bringing the improvement in the business forward in time from 2015. Actually, looking at the quarterly buyback rates, buybacks have been slowing from 2011 to the present. Stop the financial engineering and use the cash for the businesses. The employees will see the use of cash for the business as confirmation of their commitment to a protracted turnaround.
- Do not even consider any mergers or acquisitions, even though this option appears on the CFO's slide set. Much of the material presented during Analyst Day points to a lack of ability to manage and optimize the current portfolio. An acquisition would defocus the management team, confuse employees, and would break faith with the larger, value-oriented shareholders. The team has enough on its plate, and HP has the elements for a robust product offering for the evolution of customer IT needs.
Expanding on her frequent references to "execution issues," she noted that HP has "too many products, services and geographies." Autonomy has 200 products, for example. HP does business in 114 countries around the world, and yet 80 percent of the revenue is generated in just 14 countries. These points also refer to her characterization of HP's "lack of sharp competitive focus."
Accountability and compensation are not aligned to maximize profits. As an example, the top 200 corporate account executives will not have full profit and loss responsibility for their portfolios until 2013. Up to now, the volume of business written was all that mattered, whether the business was profitable or not. One wonders what any of the previous CEO's were doing when they reviewed the operations.
The CEO also referred to an underinvestment in R+D and in IT systems that support business management. HP has several large professional consulting practices within the business segments. In a professional service practice, there are only four meaningful metrics: rate, margin, utilization and leverage. Yet, the CEO said that HP doesn't have an internal software platform to manage staff engagements on a project level. It was initially decided to defer this kind of purchase until 2014, but she now decided to use some of the enhanced restructuring savings to acquire this software in 2013.
The CEO's presentation was frank, but still optimistic overall. Fiscal 2013 was described as being a period of "broad-based profit decline, but more constrained than in 2012." Fiscal 2014 would be the period of "recovery and expansion." As the typical institutional inevestor would say, "The stock is dead."
The CFO's presentation laid out FY2013 non-GAAP EPS guidance of $3.40-$3.60, which was about 18 percent below the hapless analysts' most recent consensus. The operating margin would decline on a year-over-year basis! The smart phones in the room were probably buzzing with emailed sell instructions to trading desks.
The company's use of acronyms for their businesses and the changing definition of segments are confusing. The big news in the CFO presentation was in "Enterprise Services," a $25 billion business, which the CEO described as being number 2 worldwide in its segment. ES includes Infrastructure Technology Outsourcing (ITO) and the Application and Business Services group (ABS). 2013 revenue was projected to decline by 11-13 percent year-over-year, with operating profit margins of 0-3 percent. Over time, ES was business was characterized as a modest grower, with not a lot of promise for margin expansion.
The revenue loss was largely attributable to the rolloff of four major customers, one of which was likely Commonwealth Bank of Australia, which had a six year contract with the former EDS, now owned by HP under ES. In its last reported quarter, HP took a gargantuan charge to write off the former EDS operation. We made the following observation, based on our reading of HP's own presentations, contained in a footnote,
"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."Analysts get too fixated on dismissing non-cash impairments, immediately going to the non-GAAP number, an economic fiction. The other shoe has now dropped on the former EDS business. There is significant loss in value at Enterprise Services. The company's characterization of the future margin opportunities in the business are not at all encouraging. This business itself might roll off and eventually be shuttered, unless dramatic changes are made.
The most impressive executive, who gave the most lucid and illuminating presentation, was George Kadifa, Executive Vice President of HP Software, a $4-6 billion business, which would be the sixth biggest software company in the world. Mr. Kadifa comes from Silver Lake Partners, where he was an operating partner in the Value Creation Group, after a long career at Oracle. He reports directly to CEO Meg Whitman, which also says something about the importance of his portfolio.
HP Software counts 94 percent of the Fortune 100 companies among its customers. It is #1 or #2 in its Enterpise Software segments. I tried to put together some information from several slides with perhaps different bases, but I believe that this is correct to an order of magnitude:
- In IT Management, HP pioneered an industry standard product, HP OpenView;
- In Cloud Management, HP pioneered two leading products, HP Service Virtualization and HP Cloud Service Application. Togther IT Management and Cloud Management represent about $3.4 billion in revenue. So, to the question "What is HP doing in the cloud?" it appears that the answer is "pretty substantial business."
- Enterprise Security features well known industry products like "HP Enterprise View," and "HP Data Protector" and there is about $500 miilion in revenue in this business.
- Big Data Analysis is comprised of the Vertica brand in HP, some $40 million.
- Meaning-based Computing is essentially Autonomy, and this business would seem to be over $900 million in revenue. This suggests that some of the initial rapid deterioration in the Autonomy business was arrested.
This business should grow at 2-3x the GDP growth rate with 20 percent or better operating margins. He also mentioned the notion of embedding additinal software-driven functionality into HP hardware, like printers.
His view of evolving IT spend was very interesting to hear. IT spend, Kadifa says, will migrate away from the CIO, to include the Chief Marketing Officer, the Chief Information Security Officer, and the Chief Compliance Officer. He might have added the Chief Risk Management Officer, particularly for financial institutions. He reckons that the addressable market opportunity for a suite of products aimed at marketing, information, security, data analysis and compliance is around $54 billion. If he is correct, the operating margins should be well north of 20 percent. He gave an example of one engagement with McKesson that related to the filling of electronic prescriptions, which is an issue that a number of smaller companies are rapidly trying to address.
Autonomy, he said, is operationally in a start-up mode. Their sales model was not scalable, and the basic back office product development machine was also not scalable. I suspect it was HP scrutiny on the Wild West nature of Autonomy's operating culture which generated the negative comments about "HP bureaucracy." His experience with Oracle and his experience as an operating executive in Silver Lake's portfolio companies gives George Kadifa the credibility to carry out what he says will be a two year process of readying Autonomy to be a much larger player in its segments.
I've expressed reservations about the way in which the IT buyers might handle a move to either private or public cloud computing. HP made an interesting presentation in which they talked about the different approaches to taking a company's computing functions to the cloud.
- The DIY approach: this would involve the individual purchase of best-of-breed, open architecture components in a vendor-agnostic approach. All the integration and testing would be handled in-house. While theoretically possible and economically low-cost, it is deemed too risky for most CIO's. I would say, fair enough.
- Single Vendor: a CIO would not be criticized, especially if the vendor were an industry bellwether. However, the customer would be compromising with some components, and it would be lower risk than DIY but higher cost.
- Paid Integrator: this could cover a DIY approach, but using an external paid integrator, who might also help with component selection. If the component selection or system performance were faulty, the customer would have problems assigning responsibility for fixing the problem.
- "Integrated by design." This would the HP approach to market. Build individual components designed to work in a system for particular applications and working environments. The components would all be open architecture and have a services overlay, with the service areas chosen by the customer.
The cloud was referred to as "another form of oursourcing," which was an interesting definition. Cisco CEO John Chambers expressed his opinion about HP's future in a migration to cloud computing with disruptive technologies. Some HP executives opined on their competition and they noted that Cisco, VM Ware, and IBM each had technology, margin, or solution limitations. HP seems well positioned because of its diverse portfolio to significantly grow its $4-6 billion cloud computing business.
As we've said many times before, value stocks sometimes become "better" values before they generate returns. The jury is still out on HP, and a stock holder could earn a 3.7% dividend yield while waiting for earnings to grow, assuming that there are no more suprises, which is not guaranteed.
The Analyst Day was a good start towards putting mangement's cards on the table, introducing the new management and operational teams, and putting some numbers on the profile of the turnaround. Investors do have better information on which to do their research and to make a decision.