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Using a Value Line Report: HP Wants to be IBM
Hewlett-Packard (HPQ – Free Value Line Report on Hewlett-Packard) took investors on a roller coaster ride before it reported fiscal third-quarter results. The stock, which had been down as much as 8% early in the day, surged nearly 14% after reports that it was considering spinning off or selling its personal computer operations only to end the day off 6%. The next morning, after the company had reported and confirmed its intention to leave the computer making business the shares fell some 23%.
Value Line analyst Theresa Brophy provided an analysis of the situation in a Supplementary Report for subscribers as the events were taking place, including a proposed purchase of U.K. enterprise software provider Autonomy. (Non-subscribers can read this special update on HP for free.)
The plan to explore strategic alternatives for the personal computer business, including a spinoff or sale, and the proposed acquisition of Autonomy are both part of a bigger picture at HP. Management intends to sharpen the company’s focus on its strong printing hardware, software, and services operations; concentrate on the enterprise, government, and commercial markets; and invest in rapidly growing areas, like cloud computing and analytics. For anyone who has watched the technology space in recent years, these moves should sound very familiar. IBM (IBM – Free Value Line Report on IBM) made similar decisions not too long ago, including selling its computer-making business to Lenovo.
Still, evaluating options for the personal computer business, which had sales of $9.6 billion in the July interim, is expected to take 12-18 months. And although Autonomy is a very profitable company, with gross margins in the high 80% area, the acquisition, which is expected to be completed by the end of calendar 2011, will be expensive, at over ten times revenue. It is interesting that the market has, effectively, cheered on IBM while it seems to be sending a vote of no confidence to HP. The divergence in the price performance of both stocks (which can be seen in their respective Graphs) is clear evidence of this.
This brings two questions to mind. Is HP moving in the proper direction? And, if it is, can the company pull it off?
The recession might offer some insight into the answer to the first question. As the historically portion of the Statistical Array shows, IBM’s earnings didn’t miss a beat during the recent recession, shown on the Graph by the gray vertical bar. Although sales were lower in 2009 than they were in 2008, the company was able to adjust its services focused businesses to protect profit margins—something that would be more difficult with a capital-intensive computer-fabricating business. Hewlett-Packard, on the other hand, saw both sales and earnings falter.
The horrific catastrophes in Japan are also evidence of the differing prospects of the two companies. HP’s results were severely hurt by the disaster because of decreased product sales and higher shipping costs, while IBM’s mostly service-oriented business wasn’t really affected. In fact, Brophy describes the IBM’s Japanese business as being mostly annuity-like.
It appears clear that shifting to a model similar to the one used by IBM is not a bad decision. That leaves the second question, can HP pull it off?
Although most think of IBM as one of an elite group of technology companies based on size, performance, and corporate legacy, HP is also in that group. The vaunted “HP Way” has been used to describe the company’s highly successful corporate culture. The corporation is most likely capable of such a shift from a cultural perspective if it puts its mind to it. That said, some might highlight the important role of hardware in HP’s past—a valid point—but IBM’s hardware was no less dominant in its past.
Financially, interestingly enough, the company appears to be in at least equal, if not better, shape than IBM. For example, as the Capital Structure boxes on the two reports show, HP’s debt makes up 26% of its capital structure, while IBM’s debt is nearly half of its capital structure (note that a portion of IBM’s debt is related to providing financing to its customers). This is despite the fact that HP’s business is far more capital intensive. That said, HPs numbers don’t yet include the Autonomy purchase, which is a part of the planned shift.
Also, the two companies have similar amounts of cash on their balance sheets, as can be seen in the Current Position box, despite the fact that IBM is over twice as large—IBM’s market capitalization is about $200 billion versus HP’s more modest $70 billion. Keeping that in mind, however, IBM pays out about twice as much of its earnings in dividends as HP (21% in 2010 versus HP’s 9%). This is largely because HP kept its dividend largely unchanged for years, unlike IBM, which has a long history of increases. HP recently increased its dividend to $0.12 per share per quarter, shown in the Quarterly Dividend box, but Brophy’s projections, shown to the right of the Statistical Array, call for HP to maintain a lower payout ratio over the next three to five years despite shifting to a new dividend policy.
So, it appears that HP is, in some ways, in better financial shape than IBM. It would seem that the company has the ability, both financially and culturally, to make this shift. This suggests that any pullback in HP shares, particularly one as glaring as the near 30% drop in under 24 hours, creates a possible good entry point for long-term investors. That said, the company’s 3- to 5-year earnings and stock price appreciation potential aren't as well defined as they are at IBM, and the company's shift probably will be a protracted and uncertain process. So, more adventuresome investors willing to go along for what might be long ride might want to keep an eye on HP. Those who are risk averse might want to take a look at IBM, which has already made the hard choices Hewlett-Packard is currently staring at.
At the time of this article's writing, the authors did not have positions in any of the companies mentioned.