Friday, December 7, 2012

Hewlett Packard: A Failed Growth Strategy

HP was already a master serial value destroyer before its latest disaster with Autonomy. Consider that since 2006 it spent $38B in ill-fated acquisitions like Autonomy, EDS, Palm, and Compaq of which it has written off $26B. The write-offs exceed HP’s current $23B market value, which in turn, is now less than one third of its 2001 market value. Putting aside Autonomy’s alleged accounting and due diligence issues - there is a clear pattern of inept acquisitions over an extended time period, and under several different management teams. This suggests an institutional strategic flaw at HP, which makes it incapable of doing successful acquisitions. Consequently, the focus of this post is on the strategic issues in HP’s broader growth model. See Aswath Damodaran’s 11/26/12 post on “HP’s Deal from Hell” for an alternative financial review of the Autonomy acquisition on a standalone basis.

HP’s acquisition strategy was based on buying increased earnings through transformational deals. Management would not accept its maturing low growth business profile. Nor would it consider returning excess cash flow to shareholders instead of overpaying for strategic targets. Once a target is deemed strategic by a CEO, it will be supported by endless strategic studies and supporting financial analysis supplied by top named advisors.

The Autonomy deal - priced at 11X revenues, 24X EBITDA, 3X assets, and a 60%+ pre-bid stock price premium - was DOA at close. There was no way it could work, even without the alleged accounting irregularities, except in the eyes of the CEO who proposed the deal and was subsequently fired. A real question is where was the board, including the current CEO who was a board member supporting the deal? Why didn’t it raise questions? They could have chosen to exit up to the day of close by paying the $100mm break-up fee - cheap relative to value loss incurred. Apparently, the board was infected by the same growth delusion as management.

Most likely, the root of the problem was HP’s strategy of buying growth to offset weak core operations. This is based on the mistaken belief that investors value nominal earnings increases. GAAP earnings are an incomplete profitability measure. They ignore the cost of capital needed to generate earnings. Markets do not passively respond to reported earnings with a constant valuation multiple. Rather the multiple changes to reflect the quality of the earnings generated given the level of capital employed. Firms need to distinguish between adding value with residual earnings, and earnings after a capital charge from nominal earnings. Value is created only when asset returns exceed their cost of capital. Expansion with subpar returns may make the corporate kingdom larger, but its citizen shareholders will be poorer.

The pressure to expand is among the greatest threats to effective acquisitions. Expansions consume capital to fund the growth. Capital efficiency, not earnings alone, creates value. A simple example illustrates this fact. Assume you double an investment in a certificate of deposit at the same rate. Earnings will double, but clearly no one should receive a bonus on the increase as the residual income, earnings after the capital charge (the CD rate) for the increased investment, is unchanged. This highlights that simply employing more capital in investments with positive GAAP earnings can always create earnings, but doesn’t necessarily increase value.

Improving returns by making existing operations more efficient and returning excess capital to shareholders has a larger value impact than asset expansion for maturing firms. Despite this fact, growth strategies remain popular as they fit the conventional wisdom that bigger is better. Also, it reflects how management performance is evaluated and rewarded. Unlike most investment proposals, which reflect a capital cost, many performance and incentive systems are largely earnings based. Thus, they can be gamed to favor management through unwarranted expansion. Mature firms like HP should temper their ambitions to fit industry opportunities instead of trying to create opportunities to match their ambitions.

Size matters, but not necessarily in the way many think. Getting bigger can be a means to improving intrinsic value. It is not, however, an end in itself. The paradox of expansion is that increased earnings can be hazardous to shareholder wealth. The preferred near term strategy for a mature firm like HP, is to manage for returns by curtailing expansion, especially large transformational acquisitions, and then give the excess capital back to shareholders.

HP’s board and management should pledge not to acquire anything regardless of size for the next 5 years to stop further write-offs. Moreover, they should consider strategic alternatives. This could include the break-up of its services and software units through spin-offs, divestment or carve-outs.  See Bill George DealBook 11/28/12 “To Save HP, Break It n Two” for a further discussion. Ultimately, this may mean putting HP up for sale to someone who can better utilize its assets. Bad bidders like HP eventually become good targets. That time may have come. HP’s shareholders deserve nothing else. HP illustrates the importance of getting the strategy right before acquiring -as ‘there ain’t no right way to do the wrong thing’.


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