Tuesday, December 31, 2013

Year-End Thinking About HP and the Tech Giants

The conference call is over.  The questions have been asked, and the voluminous slide sets are online with all the granular non-GAAP financials in place.  I know that it's a dull document, but there's nothing like sitting down with the 10-K and penciling through the document, looking at three years of results side-by-side. Before doing that, I like to read through the risk factors for any nuggets, and I like to read through the analysis of goodwill and intangibles discussion.  These tell me a lot about any concerns about the future that are not reflected in the historical results.

After some reconciliation to the past presentations and my notes , I came away with a more sober view of HP's challenges in 2014 than that which I held post the fourth quarter conference call.

CEO Meg Whitman was right from her earliest presentations, viz. this is definitely going to be a multi-year turnaround.  This company clearly was incredibly badly managed for a long time before her taking the reins, and unfortunately the Autonomy acquisition was not only insanely expensive, but it has cost valuable management time and somewhat circumscribed options.

The restructuring program's scale and management's focus on executing it on plan was really the only option, and its benefits can be seen in FY 2013 selling, general and administrative expense being $300 million lower than the FY 2011 level as reported. However, looking at the multi-year project, this is the 'easy' part, and I don't mean to be cavalier and it's all relative.

Even though the company's share price has had a nice one year run, the 10-K's three year stock price performance chart shows that it has clearly under performed the SandP 500 and the SandP 500 Information Technology Index by a wide margin.  So, there's still a long, long way to go.

Breaking up the company, which was the long standing refrain for a while, clearly would have resulted in nothing but a destructive fire sale, and that is clearer than ever when one looks at the seven reporting segments over the three year history.

Personal Systems has seen its operating margin decline from 6 percent in FY 2011 to 3 percent in FY 2013, but its revenue loss over the same period is over $7 billion.  Although the company has been chastised for being late to the tablet wars, if this segment can right itself there is tremendous opportunity.

One of the industry's leading low cost competitors, Acer has just seen the departure of three key senior executives, the head of global commercial business operations, its chief technology officer, and its GM of Chinese smartphone operations.  So, low cost production and decent form factor design alone aren't enough to succeed.  If HP can get the right leaders in place for Personal Systems, it could take advantage of its strong position in the corporate market as well as a stable position in the consumer market.

By contrast, the Printing business trimmed its year-over-year revenue decline to 1% in constant currency for FY 2013, while its operating margin of 16.3% is 130 basis points above the FY 2011 level.

Looking at the commercial segments, Enterprise Group and Enterprise Services the company has some tricky waters to navigate, and the risk section of the 10-K talks about about the commoditization of the x86 server products, while at the same time talking about a product transition to the Itanium platform that needs more software development by partners to support user requirements.

The Enterprise Group has seen its segment operating margin decline from 20% in FY 2011 to 15.3% in FY 2013, a 470 basis point decline, which is substantially larger than the margin rate declines in Personal Systems or Printing over the same periods.  I suspect that industry conditions and the product line transition may have negative revenue and margin implications for FY 2014.  The cautions in the risk section and the three year profile might suggest a year of treading water.

The Enterprise Services segment saw revenues decline 7% in constant currency in FY 2013, which was the biggest decline among the seven segments right behind Personal Systems.  Operating margins collapsed to 3% in FY 2013 from 7% in FY 2011.  This business needs some tough love.  Together, Enterprise Group and Enterprise Services comprise 46% of consolidated net revenue and about 45% of segment operating profit excluding Corporate.

While I have no doubt that HP will remain a critical vendor to large scale enterprises, the product line transitions, margin pressures and extended corporate buying cycles will probably put pressure on FY 2014 results.

The Software segment seems to bear the scars of the Autonomy acquisition, which I also noted in listening to the head of the business and comparing his tone from coming on board to his tone after the recent fourth quarter.  He sounds a bit worn out and frustrated.

Software revenue grew from $3,367 million in FY 2011 to $4,060 million in FY 2012 with some benefit from Autonomy, but it declined by 3% in constant currency to $3,913 million in FY 2013.  There has been a discussion about the inability of HP managers to replicate the sales cycles of pre-acquisition Autonomy.

The good news is that despite the revenue decline, segment operating margins in Software increased year-over-year to 22% in FY 13, an increase of about 200 basis points.  The bad news is that because Autonomy has been such an expensive debacle, HP probably needs to make more software acquisitions in the future in order to press its advantage as the herd of corporate IT suppliers gets thinned a bit, in the future.

Research and development expenditures have been flat for the three year period at just over $3 billion.Without knowing what kinds of projects comprise this spend, one wonders if buying innovation through acquisitions is cheaper than building innovation in-house.  No one ever asks this question on a conference call, and I've never read it addressed in an analyst report.

Finally, returning cash to shareholders is the tech industry shibboleth of the day for CEOs.  HP has spoken about a goal of returning fifty percent of  FCF to investors through buybacks and dividends.  I've never understood what is sacred about a number like 50%.  I know that Cisco hews to this self-imposed metric.

HP is running at about 30-38% of FCF, defined as CFO minus Cap Exp from the CF statements.  With the stock where it is, i.e. fairly valued, I would suggest stopping the buybacks and seeing if there are areas where it could be deployed internally to build more for the future.  What are HP Labs doing?

Acquisitions, according to the financial press, will require higher control premia.  Social media shouldn't be the metric for jumping to this conclusion.  Technology that will feed into the corporate and consumer computing environments needs market presence and distribution, which smaller companies cannot build without time and a lot of expense.  Acquisitions, especially for an entity like HP, are very risky for shareholders.

The Land of the Tech Giants

Cisco and Microsoft have advantages over HP in managing their respective corporate makeovers.  Both have fortress balance sheets and legacy business like routers and switches and Office software that can throw off cash even if their volumes and margin structures have to be ridden down over time.

HP's consolidated gross margin rate, even with a lot of blocking and tackling in sourcing and in asset management. has been flat over the three years at 23%. There is no cash cow hidden among the seven segments.

HP's balance sheet has been improved from its cratered complexion some time ago, but it isn't exactly pristine.

IBM has extremely strong market presence in multiple markets, financial capacity, and opportunities in super computing which are the bailiwick of very few players.

Making money on HP from here in 2014 won't be the easy money of 2013, but it should be an interesting evolution during the year.

Happy New Year!

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