Tuesday, November 20, 2012

Turnarounds and Turkeys: BBY and HP

The Macy's Thanksgiving Day parade is two days away.Wall Street got an early start trotting out some turkeys with today's earnings announcements: HP and Best Buy led the way, for different reasons.

Best Buy closed down 13 % for the day, but it is up a couple of cents in aftermarket trading.  The fundamentals weren't good, but the reaction of the stock seemed more a continuing plebiscite on the turnaround plan and arbitrageurs playing an offer from Dick Schulze, than it was an evaluation of the results themselves.  

The company's CFO Jim Meuhlbauer, who we were told has been at his post for ten years, allowed a very confusing discussion to ensue about gross margin dollars versus gross margin rates.  He made a remark, and analysts asked questions about what he said; then merchant Mike Vitelli seemingly contradicted what the CFO said.  Finally, the CFO noted that everyone agreed.  Since the 160 basis point compression in the gross margin rate was clearly the concern for analysts modeling the forward rate, this discussion should have been short, sharp and precise.  Instead, I'm sure that it confused analysts.  

The issue came back in a different way in the Q&A when Mr. Muehlbauer was asked to give some thoughts about the biggest drivers between what the analyst said was the 130-150 basis point gross margin rate compression over the past two years. The CFO said that the entire margin compression was due to sales mix, which really makes no sense.  

U.S. same store sales declined by 4%, which was affected by the smaller number of stores in the base due to closings.  Online sales of $431 million in the quarter grew by 10%.  Domestic selling, general and administrative expense grew by 15% y-o-y, but adjusted for the sales force training expenses related to the new product launches and for the absence of Best Buy Mobile profit-sharing payments, they were flat.  Not a great performance by any means, but not the end of the world either.

The international business, which has always been undermanaged, saw same-store sales decline by 5.2%, with European sales increasing, while Canadian and Chinese sales declined. Gross margins in the international business declined by 280 basis points, which clearly needs some explaining.  Selling, general and administrative expense in the overseas portfolio increased by 7%.  Now that Best Buy has a CEO with some  international credentials, this portfolio needs to be rationalized and optimized.  The Chinese market needs to be re-examined.

The company significantly lowered its guidance for the range of FY 2013 FCF to $850 million-$1.05 billion, down from a recently announced range of $1.25- $1.5 billion.  The explanation was lower projected profit levels and higher inventories.  The lower projected profits gets back to the same store sales, the overseas business, the gross profit margin rates, and mix of sales.

An analyst who asked a question about the wisdom of maintaining a $225 million annual dividend, seemed to surprise the CEO, which means he was poorly prepped.  The CFO added no light.  The board hasn't decided was the CEO's answer: not very clear or comforting.  If there were a choice between improving ROIC through higher volume, better margins or asset management, then that is a superior use of cash than dividends in a higher tax environment for investors.  Give investors some guide into how the board and management think about the issue.

The adjusted ROIC was 10.1% versus 10.6%, which not bad, given the weakness in the same store sales, both domestic and foreign.

I was very surprised that no analyst chose to ask for an update on the buyout plans of Dick Schulze's group. It could have easily been asked in a way which simply requested an update of prior public announcements.  The entire group was silent about the elephant in the room.

Bottom line, the results weren't good, but the new CEO has been in place a grand total of eleven weeks.  He has expressed a lot more clarity that the previous CEO did in his entire tenure.  Unfortunately, it was not a well prepared conference call, and the Q&A went off track.

The King Turkey award for the day goes to HP which reported Q4 2012 results that were right down the middle of their guidance, and in some important ways like FCF even better than expectations.  Adjusted EPS for the quarter was $1.16 verus $1.17 in the prior-year period, on the same basis.

The company's revenues were $30 billion in the quarter, down 4% y-o-y in constant currency.  Adjusted gross margins increased were 24.2% up 90 bp y-o-y, despite expected weak results in personal computers, offset by strong revenue and margin growth in software and an unexpected increase in printing margins. Operating cash flow in the quarter of $4.5 billion was 69% ahead of the prior year period, and and FCF was $3.5 billion in the quarter.  What is not to like about this quarter?

Answer: another massive writedown of $8.5 billion for impairment of goodwill and purchased intangible assets from the acquisition of Autonomy.  Some $5 billion of this amount relates to alleged fraudulent accounting at Autonomy prior to the acquisition; the fraudulent practices relate to revenue recognition and to the allocation of costs to expenses versus product costs that made product sales margins look like software transactions.  The fraud allegations have been referred to the SEC and to the UK Serious Fraud Office.

(Before I go on, I want to give a shout out to Jim Chanos, who often writes and speaks at Columbia's Graham and Dodd Institute: you had it pegged perfectly, Jim.)

To his credit, Barclay's analyst Ben Reitzes, with the first question on the call, asked CEO Whitman how she evaluated her own responsibility as a director of HP during the hiring of former CEO Apotheker and for the approval of his proposed acquisition of Autonomy.  Her answer was less than courageous.  All the directors feel really bad!  However, those responsible have been discharged: Apotheker and a VP of strategy.  What a limp fish of an answer.

About a month ago, we wrote about CEO Whitman's need to focus on internal issues and to change over the board of this company.   CEO Whitman should politely suggest to those long-standing directors, all of whom were there for the botched transaction not to stand for renomination by the Nominating Committee.  This company cannot move forward with these same directors in place.  It would be courageous for CEO Whitman to pass on a significant portion of her 2012 incentive pay for her part in the botched acquisition.

There was a period of time when HP insiders talked with pride about being from "the (Silicon) Valley."  All of the directors should be ashamed of themselves.  To say that they relied on audited statements alone is a failure of duty to the corporation and its shareholders.  Forget about suing Deloitte or KPMG: that is a distraction and a waste of money and time.

The "rocket scientist" founder of Autonomy, Mike Lynch, now appears to also be a very savvy promoter.  Another name from the "Valley," Frank Quattrone of Qatalyst Partners seems to have been involved in introducing Lynch to Oracle, ostensibly to talk big data, but really to shop the company. As this ploy was failing, HP was being driven, even against the first instinct of its board, to not only acquire Autonomy, but to pay a fool's price for merchandise passed over by Oracle.Oracle had also hired Mark Hurd.  It's an embarrassing story with a horrible ending for shareholders' equity.

The new CEO is making her impact felt among the rank-and-file and the producers at HP: this is a great thing, which reverses the Mark Hurd era's style and culture. She's definitely on the right track, and people are listening. If she holds herself and her board accountable, the troops will really be galvanized into believing that there really is a new day dawning. With the support of a new, talented and committed board, which also shows its belief in owning shares personally, this may still prove to be a value-creating turnaround.

Even with all the corporate mismanagement around us, we can all find much to be thankful for.  Happy Thanksgiving!

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