Sunday, August 25, 2013

HP's Separation Anxiety: Take A Deep Breath

A friend of mine who is a globally traveled, senior tech industry executive and problem solver asked me this question, "How did HP do in its most recent quarter?."  The best answer I could give him was. "That depends on what you're looking at."

Overall, the quarter ending 7/31/13 was greeted by Wall Street sending the stock down 12% on the day: a pretty strong reaction.  But, putting it in perspective this left the stock's YTD run up at over 66% versus the prior day's number of 78%. This is still an extraordinarily robust gain, no matter how an investor looks at it.

GAAP revenue was down 8%, and down 7% on a constant currency basis.  Clearly this was a disappointment to the CEO, and a brave face couldn't disguise that it took some air out of her best positive face.

Total Personal Systems sales were down 11%, but really this shouldn't have been a surprise in direction, but perhaps in degree; industry reports on PC shipments and other anecdotal information intra-quarter would have suggested that it was going to be a tough quarter.  Notebook sales were down 16% in dollars, 14% in units and 2% in price.  Desktops were down 10% in sales, 9% in units and 1% in price.  Given the bad timing for the release of Windows 8.1, the notebook retail channel is probably congested with stale product. Pricing didn't collapse, but the fourth quarter might not be pretty either. Again, none of this is new.

Total Printing sales were down 4% y/y, with consumer hardware sales flat.  Overall, not a real negative surprise.

The real stinkers in the quarter from the revenue perspective were the Enterprise Group and Enterprise Services.  Again, the CEO made reference to the Enterprise Group's go-to-market issues which were clearly not something she expected with a mature product offering and long-serving executives.  ISS revenues were down 11%, but again this shouldn't have been much of a surprise since Dell's quarter showed a phenomenon, namely that industry standard servers are commodity products whose scale, cost, energy performance and computing power per rack will make them dinosaurs in an industry transition.  Overall, Enterprise Group revenue of $6.786 billion were down 9% y/y, with the higher margin Technology Services business declining 7% also. The Enterprise Group's operating margin had compressed sharply in the fiscal first quarter, and with continuing sales declines, this business needs to get its act together, but it's not exactly rocket science to determine what needs to be done.

The Enterprise Services Group, a business which we don't think is critical to HP's future in the current configuration, declined 9% y/y with the fading BPO business declining 7% and the Application and Services Business declining 11%.  This business carries a 3.3% operating margin which is comparable to that of the PC business, and yet this ESG gets no discussion on the investor calls.. We've said it before: HP can't be Accenture or IBM in this business, and it doesn't need to be in order to succeed.

So, to this point, the answer to my friend's question would be "It was a lousy quarter."  GAAP diluted EPS was $0.71 versus ($4.49), but clearly this isn't a useful comparison and it meant nothing to a trader reading the headline.  Adding back $0.15 per share for amortization of purchased intangibles, restructuring charges and acquisition-related charges, third quarter Non-GAAP diluted EPS was $0.86 versus $1.00 in the prior year period, on a comparable basis; the prior year period had $5.57 per share in charges for the same categories. Without the promised and delivered cost cutting, the comparison would have been much worse because of the revenue shortfalls discussed above.  The non-GAAP operating margin in the quarter was 8%, a 100 bp decline over the prior year period margin, despite an 8% decline in net revenue.

Cash flow from operations surprised most analysts to the upside with $2.7 billion in CFO, declining 6% y/y; total cash returned to shareholders is something we liked because of the $253 million returned in the fiscal third quarter, only $3 million came from share repurchases and $250 from dividends.  Altogether, looking at Non-GAAP EPS, CFO, funds returned to shareholders and paydown of debt it was really a solid quarter of financial performance.

Here are some bullet points from the Wall Street Journal's discordant story, "H-P's Separation Anxiety"

  • Meg Whitman is shuffling deck chairs;
  • Her strategy could "still sink Hewlett-Packard;"
  • Ceding market share in order to maximize profitability "seems misguided."  
  • The company seems as "strategically moribund and unmanageable as ever."
  • Lenovo could be a strategic bidder.
  • Dell is "cutting price on its gear so that it can grab customers who then sign higher-margin service contracts."  
  • Bernstein analyst says the company is worth 50% more than its "current" price being sold for parts.
Let's start from the most trivial points first.  The same analyst who called the stock more undervalued than any stock he'd ever seen at $12 and stayed neutral as it ran away, and in January 2013 his sum-of-parts guesstimate was $29 per share.  Well, it's $22.40 today, with about $0.26 per share also having been returned to shareholders in the interim period.  This is beating the bushes for a deal and just self-serving. 

Dell: well there's certainly an industry leader worth emulating.  If they were cutting prices to grab customers, then that explained their most recent, horrendous quarter on all counts.  The CEO himself, in a totally disingenuous way, has said that he can't take the measures he needs to take to fix his business while all the financial dirty laundry is public.  Is there any evidence that Dell landed major service contracts from giving away gear?  That's a one-time only deal anyway, if it were true.  Trivial point two is laughable.

Lenovo a bidder?  Not likely, unless the Chinese government were to write the checks.  Even in that case, the announcement would crater the HP credit rating, hit the IGC bond holders--who are, in some cases, also equity holders--, and it would rile the U.S. Government and CIOs around the world.  Talk about uncertainty: if you thought the Dell process was a mess, this one would be a value destroying debacle. 

Picking up on the last point, the CEO in her opening plenary statement to Discover 2012 in front of 15,000 participants and 120 Chief Information Officers, said "You want us to win."  We've made this point before, namely that the CIOs want to have at least one or two viable global players who can sell and service platform agnostic solutions, as opposed to shilling appliances and applications separately. 

Remember when G.E. was the global darling of the financial press in Jack Welch's hey day?  Their corporate slogan was "We want to be #1 or #2 in every business we're in, otherwise G.E. will get out of that business." Well, according to Meg Whitman at Discover 2012, HP is #1 or #2 in every business in which it competes.  Now this clearly can't line up with the reporting segments, but I think that you get the idea.  HP has global distribution, presence, and scale that mimics the customers who will need to served in an IT industry that is going to shed many of the go-to-market practices of the past thirty years.  

So, what are the questions and some of the substantive issues at this point in the incipient turnaround?
First, the current strategy has been vetted and belongs to the board; it is not Meg Whitman's strategy any longer.  This is certainly more than can be said for those of Mark Hurd and Leo Apotheker, who did things that the board learned about by reading the newspaper.  It's a nuts and bolts, fundamental strategy of sizing the cost structure to the future business, and as such it's a marathon not a sprint. 

The CEO made a telling comment at Discover 2012, "It's hard to kill founder's DNA."  She was trying to portray the DNA of the founders as being in customer service.  I don't think that's what the business historians would say was the legacy of the founders. One element of their culture was clearly innovation.

CEO Whitman makes proud reference to the work of HP Labs, which is their equivalent of the iconic Bell Labs of the old ATT.  In an environment where the IT customer can't keep up with the future evolution of the industry, credible global players have to do this for the customers.  The CEO has refreshed HP Labs, but she has also said that they need to speed up the transition from a lab idea to a commercial product.  I would guess that the HP Moosnhot server platform is probably one such innovation, but there have to be more and they must be produced on a faster cycle.

The structure and culture of the company has become sprawling and ossified.  The CEO clearly has been giving unprecedented access to employees deep within the senior ranks through different communications media, and this takes time but it has impacted morale for the better.  To switch again would be deadly.  

The one valuable discussion that took place on the third quarter conference call was one about the to-date almost exclusive reliance on HP veterans to lead all the businesses, with the exception of Software.  This seemed to catch the CEO a bit by surprise, and she thoughtfully stated that she had looked to insiders for their knowledge and presence with customers, but that it was something to consider.  I do think that this is something to consider, and what looks like shuffling of deck chairs could be a prelude to more fundamental leadership changes, from which the company's strategy would benefit. 

The issue of Autonomy should be addressed once and for all. If the U.K. Office of Serious Fraud has yet to opine on Autonomy's numbers, it suggests that perhaps there was nothing there.  In her 2012 remarks to Discover, the CEO says that the company is "100 percent committed to Autonomy and Vertica" for products, technology and innovation.  She made specific references to Autonomy capabilities in new products.  If this is so, it's time to tell shareholders that a lot of remarks were made in the heat of the moment, perhaps driven by board members trying to save face and that the company has moved on.  

The final point: the new board members are promising, but an entire board that reflects the cloud, mobility and big data--the essence of the future HP---would be a boon to the CEO and for shareholders.

P.S. Another company in Redmond, WA announced earnings and an executive change.  Now this one should be drawing a lot more attention than it has.  More later.

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