Friday, July 24, 2015

Tech's Four Horsemen: A Midyear Checkup

Some of our leading, bellwether technology companies--Cisco, HP, IBM and Microsoft--have reported earnings recently, and although I have parsed them and listened to the basically uninspiring conference calls, the Four Horsemen all stand at the same crossroads, between reinvigoration or a secular irrelevance.

Notice that I avoid the word "reinvention," as I haven't seen organizations of the sizes of the four ever doing that; the word has become a cliche in financial lingo.  Lew Gerstner didn't "reinvent" IBM; he pruned the portfolio, changed players and shook up a staid culture, all of which together reinvigorated a sclerotic organization.

All of the organizations share one common fault: their boards and executive managements all misunderstood and underestimated the nature of the changing demands of their CIO customers and the rapidity with which their customers were being called on to respond to larger business issues, and not just technology issues as in the past.  They all missed the boat, and there are a lot of sharp people populating these behemoths.

Satya Nadella's remarks during his overview to his earnings call presentation referred to the "market transformation" that was hitting Microsoft, which he summarized as being comprising mobile computing and the cloud.  IBM and HP also talk about "big data," in addition to mobile and the cloud. John Chambers and his team intone about the "Internet of Things."

So, if the five year average revenue growth rates for IBM and HP are -0.6% and -0.5% respectively (according to Morningstar), then why are these companies furiously reacting rather than leading and innovating?  Cisco's revenue growth was 5.5%, and Microsoft's was 8.2% over the same period, but acquisitions and a virtual monopoly in a core business fortuitously helped these two companies perform respectably on the top line.

However, it is Microsoft CEO Satya Nadella who says that his company must undergo a "transformation" which will translate the market transformation into a "growth opportunity" in revenue, earnings and market capitalization.

With the recent CEO change at Cisco and with the relatively predictable character of their financial performance, I really don't have much insight into where this company is going, although with a median operating margin of 22%, healthy interest coverage of 18x, and relatively low debt-to-capitalization, it is positioned well to do something meaningful to reinvigorate a somewhat plodding, methodical story.

HP is creating a buzz for itself by splitting into two companies. HP Enterprise is their corporate IT facing business, the "growth company."  However, it's a very curious thing reading their red herring. Nowhere in the stated advantages of the split is there any reference to improving their ability and agility in serving their CIO customers better!

There are plenty of references to capital market issues, e.g. more strategic focus, better capital allocation, an optimal capital structure, and giving investors a growth company which should be valued better than a more diffuse portfolio.  Serving the customer should always come ahead of serving the shareholder, because without gaining more customers and increasing their retention and lifetime value, there will no source for rewarding the shareholders except financial engineering, up to a point.

For the six months to April 30th, HPE had revenue of $25.6 billion, down 6.4% from the prior-year period, with operating income of $1.2 billion, a 4.5% margin.  The Enterprise Group's revenue of $13.5 billion was relatively flat to a year-ago, and its operating income margin was 15.1%.  The Enterprise Services group had a woeful OI margin of 3.3%, and its issues are longstanding; the Software business revenue of $1.8 billion is far too small to drive the boat, and its operating margin of 17.9% is below par for the industry.  The successful reinvigoration of this company is by no means a slam dunk, and former CFO Cathy Lesjak, the voice of reason on Autonomy, has gone over to the former printer business.

IBM continue to attract the interest of legendary value investor Warren Buffett.  This aside, there is something really wrong at this company.  Writers at Forbes have cannily gone back to the career of retired CEO Sam Palmisano.  Thirteen consecutive quarters of revenue declines for a company of this size and pedigree ought to have generated board members handing in their resignations; it's inexcusable and unbelievable.

Mr. Palmisano's success came as a rainmaking salesman, but unfortunately that way of selling to the largely ignored, relatively lazy CIO has gone forever.  The nature of the sell has changed, and the customer, with some skin in the game for business success, is now asking questions and looking for value and partnership rather than new hardware and modest software updates.  Mr. Palmisano transformed his salesman's passions about quota records into a slavish focus on Wall Street numbers, hence the dreaded "Road Map."

Instead of returning all that money robotically to shareholders with declining revenues, acquisitions like SoftLayer should have been the focus much earlier.  The sales culture and organizational comfort have all got to change.  This late into the game, it won't be easy unless there are big, uncomfortable changes, which might make a somnolent board uncomfortable.  Gradualism has brought IBM's P/E to 10.3 according to Morningstar.  Warren Buffet has always said he is not interested in a mediocre company at a great price.  Does he own a great company at a great price? Only time will tell, along with a whole new attitude within Big Blue, and a new way of coming to market and making technical sales.

When IBM lost the CIA cloud contract assignment to Amazon Web Services, it was a big wake up call that even with a significant portfolio of federal government business, Big Blue lost a marquee contract to a relative upstart with better customer service, technical support, and hourly unit pricing. The company learned from this error and fixed many holes in its offering by acquiring SoftLayer.

Ending our review where we started, with Microsoft, we still wonder as we have since 2012's Microsoft Reboot post, if this company can reinvigorate itself with a portfolio serving two distinct markets--corporate and consumer--with one historically dysfunctional culture.  The consumer franchises should be extremely valuable to a different kind of company.  Despite its relatively high valuation metrics, Microsoft high returns, befitting of a software company, may be justified.  Its median operating margin is 33.2% according to Morningstar.  A true "transformation" of Microsoft in its current form seems very difficult, and some bloggers suggest that shareholder ValuAct has been lobbying for a split-up of the company.  This split-up would have all to do with core competencies, technical and engineering knowledge, versus understanding of gamers and the entertainment industry and what these actors want in terms of content and delivery models. Don't get me started on Windows Phone!

CEO Satya Nadella sounded a little frustrated on the company's most recent conference call, and he seemed to want to impose his stamp on every response to a question, a contrast to his more nuanced answers in the past, where he let his CFO take the lead.

We were very positive about Surface when it was a greenfield development project inside Microsoft, and indeed it sales more than doubled in the recent quarter, year-over-year, to $888 million. What's more the incremental gross profit contribution compared to the prior year was $1.33 billion.  When the company puts its mind to computing and making people more productive, that's more in its wheelhouse than are gaming and consumer entertainment.  Overall, there may have been some disappointment it Microsoft's most recent quarter, but there is lots of potential to unlock significant value if there can be a real cultural shift within this long dysfunctional organization.  Another wait and see.

No comments: