Tuesday, December 18, 2012

HP Ends 2012: Hope to Anger to Apathy

Jim Chanos had a clear thesis on HP which he made public in mid-2012, and the market proved him correct.

On the long side, HP was able to generate a lot of hope among value investors, such as Dodge and Cox.  Dodge and Cox has been overweight technology for years, as their portfolio manager and Assistant Director of Research David Hoeft explains in the linked video.  As of September 30, 2012, the Dodge and Cox Growth Fund alone owned 64.5 million shares worth $1.1 billion, or an average of $16.78 per share.   The firm's total position was 142 million shares at 9/30/2012! Today, the stock closed at $14.53.

In talking about how they evaluate technology, David talks about the importance of management, the long-term growth prospects, and the margin opportunities.  I wonder which management he's referring to, as the position was developed over a long period of time.  Their interest has spanned Hurd, Apotheker, and Whitman, at least. He then talks about using traditional valuation metrics to give a point of entry, with a traditional margin of safety.

Later in the talk, David refers to HP as an "older" technology holding, which he lumps with Dell.  He contrasts this with "more innovative" technology companies like Google, NetApps, Adobe, and curiously, eBay.  Perhaps their comfort with HP's CEO change to Meg Whitman was because they admired her work at eBay.

David pooh-poohs the consensus "death of the PC" world view, saying that it is priced into the stock.  He suggests that the portfolio of non-PC businesses within HP is much more valuable that the market is giving credit for in the share price.

He then makes a very curious statement, namely that companies like Intel and HP have "said" that 70% of their incremental growth in the next 3-5 years will come from emerging markets.  I haven't understood that to be the expectation of HP management from anything they've said in 2012.  It also doesn't seem obvious which businesses in the portfolio might provide this kind of incremental contribution.

It certainly wouldn't come from the PC, tablet, SmartPhone, or printing businesses because HP is so late to the game in mobile devices and printing faces other Asian-based challengers.

Going back to the Analyst Day and the subsequent disappointments, downward revisions, and the fiasco with Autonomy, sell-side analysts got blindsided and got angry.  Analyst Shaw Wu reduced his rating to "Sell" and made the incendiary statement that on a tangible book value basis, the equity was worth -$2 per share.  Talk about anger, and it was all the company's fault for how they handled disclosures.

At this point, though, analysts who suggest that the company is worth $20 per share sold for parts must be doing a 'back of the napkin' calculation.  If that were true at cyclically low valuations for much of HP's portfolio, then HP must be worth much more as a continuing business, given a modicum of astute management and a global economic rebound. The talk about creating a hive of independent public companies from HP is nothing but an investment banker's pipe dream.

There are real, nagging questions about the board and the financial acumen inside of HP.  Think about their own statements for how HP looks at share buy backs.  According to the CFO's presentation, the company buys back shares only when:

  • There are ample funds available while building financial strength and investing for the long-term;
  • HP shares trade at a significant discount to conservative calculations of the intrinsic value of the shares;
  • No higher ROI opportunity exists.  
Now, think about this time profile for quarterly share buybacks:
FY 2010= $11.1 billion
FY 2011= $7.6 billion
FY12 1Q=$1.6 billion ;  2Q=$800 million ; 3Q=$365 million and 4Q=100 million.

When the company's credit rating was downgraded, the rating agency made reference to the profligacy of share buybacks and their limits on the company's financial flexibility.  It is incomprehensible how under any set of reasonable, conservative inputs, a defensible model could have generated significant discounts to  intrinsic value for three years.  The board and the CFO must accept accountability for this gross mismanagement of funds.  

Meanwhile, the commercial printer line, it was later admitted, hadn't had a model refresh in seven years.  Surely, this would have been a better investment of funds into the basic business than financial engineering and buying back shares.  

The next 10-K, proxy, audit opinion and Section 404 certifications of internal controls need to be carefully examined to see if the company has learned anything from the last three years of mismanagement. 

We leave this story for 2012 as we began.  Unless this company does a major refresh of its board membership, internal controls and processes, financial acumen, and shareholder communications, then 2013 will be another year of Wall Street apathy towards HP shares.  That would be a shame for the organization, its employees and customers.  

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