Hewlett-Packard (HPQ) is a Value Trap

Thursday, September 09, 2010

HP logoWhen a large, entrenched company stumbles into a storm equity holders tend to sell first and think later. The clear worry is that problems like those seen at BP (BP) or Toyota Motors (TM) excalate where initial reports do not seem horrible but as the news flow picks up and all the details come to light, storied brands can be tarnished in one fell swoop. The value crowd circles these stories like hawks contemplating whether the market has overreacted and trying to determine if the price to intrinsic value differential offers a high enough margin of safety to venture in.

Shares of HPQ are now down 24% year-to-date and have many investors itching to buy. There is good cause to consider buying. HP has a strong presence in the high margin printing business representing 21% of FY09 revenues. Almost half of Hewlett's revenues come from the Enterprise Business divisions: Enterprise Storage and Servers, Services and HP Software. HPQ maintains a dominant global and US position in the personal computer market with 20% of the worldwide market and 27% of the US market. Yet, this low margin business only represents 12% of FY09 earnings.

HP has a seemingly attractive valuation with shares trading at just 11 times trailing earnings. The company has $6 in cash per share and a long-term debt-to-equity ratio of just 0.29. HP's PEG is just over 1.0 given an anticipated 10% growth rate going forward. Yet, three recent events leave me sour on the company.

1. The resignation of CEO Mark Hurd was a major loss

The company did not necessarily make a mistake by getting rid of Hurd given his "profound lack of judgment that seriously undermined his credibility and damaged his effectiveness in leading HP" according to the General Counsel. Apparently Hurd had an inappropriate relationship with a contractor and he expensed many meals and travels over a two-year period. Dropping him may have been the right move but it's a major blow to the management of the company.

Shares dropped 9.3% after the resignation was announced and rightly so. The management of a company cannot be understated in its importance in achieving long-term growth. The hardware computer market is fierce with tight margins and often the only separating factor is strategic vision and great business execution. These components are only accomplished by the people a company retains.

Hurd took the reins in mid-2005 and oversaw years of growth executing an aggressive acquisition strategy that propelled the company into leading spots in several categories and expanded margins. Particularly in PCs, Hurd stepped in at a time when Dell was running over the competition in the personal PC market. Hurd was able to turn things around by refocusing the retail strategy and exploiting Dell's weakness of only online sales. In short order, HP crushed this online build-to-order model and claimed the dominant position in PCs sales. Dell has been floundering ever since.

Jeff Matthews outlined Hurd's accomplishments succinctly:
  • HP’s shares nearly tripled during his tenure, not only adding $50 billion in market value to HP shareholders in five short years, but also restoring HP’s stock price to within 20% of its Dot-Com Bubble-era all-time high of $68.
  • From 2005 to 2009 (using HP’s fiscal year, which ends in October), annual revenues jumped roughly $30 billion—from $87 billion to $115 billion—while operating income grew $6 billion, from $5 billion to $11 billion.
Admittedly, Matthews also argues that "two-thirds of the revenue growth at HP under Hurd came from an acquisition, rather than organic growth, while the remaining one-third came from a decidedly unglamorous, commodity business not much reminiscent of HP’s printing franchise in its prime." The hard numbers may present a more glowing picture than reality but it's hard to argue with the shareholder value Hurd created. And should an reader identify with Matthews' other poignant arguments against Hurd, there is even less of a reason to buy shares in my mind.

2. HP's wild bidding war for 3Par was foolish

HP has now suffered from the classic problem of the Winner's Curse which by winning the bidding war has vastly overpaid for 3Par. Wade Slome over at Investing Caffeine has an excellent post outlining this very problem. He says it better than I can so you should check out his article but I'll highlight two keys points:
  • HP paid $33 per share, or $2.4 billion, to top Dell (DELL), more than triple the price 3Par (PAR) was trading just 21 days ago (< $10 per share).
  • HP paid a price valuing 3Par at 125 times 2011 earnings.
While many investors are very quickly recognizing the power of cloud computing and hardware makers like Dell and HP see it as a crucial strategic business line going forward, recklessly overpaying to acquire a small company like 3Par, even if you have the ability to without jeopardizing the firm, is foolish.

3. Suing Hurd is a distraction and shows a lack of leadership

Felix Salmon asks "Why is HP suing Hurd?" and it's the right question to be asking. The lawsuit, on its face, is completely ridiculous and a total waste of time. Felix sums it up much better than I can:
...Suing its former CEO certainly isn’t going to move the needle financially. And it’s going to take up a large amount of the valuable time not only of HP’s executives but of HP’s board members too... ...There’s nothing approaching a noncompete in Hurd’s separation agreement, and HP’s demands that HP be allowed to control all future actions of its ex-employee in perpetuity are simply laughable. It even wants a Special Master appointed “to provide a monthly verified statement of compliance that Defendents have not used or disclosed any of HP’s trade secrets and confidential information”. That kind of invasion, in the absence of any evidence that Hurd has actually done anything wrong, is downright unconstitutional, unless Hurd agreed to it as part of his separation agreement. Which he certainly did not.
HP seems to be a ship without a rudder at this point. Losing Hurd was damaging and Oracle's quick hiring of him demonstrates Hurd's leadership prowess. While HP has undertaken an acquisition strategy for the last five years, the 3Par bidding war went way too far. While $2.4 billion is a relatively small amount for a large firm with a nearly $15 billion in cash, it is unlikely that it ends up creating shareholder value and perhaps patience and in-house development or finding a less sought-after firm would have been better decisions. Finally, the lawsuit against Hurd is a final straw showing a total lack of leadership.

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: No relevant position.
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