Monday, September 2, 2013

Schumpeter’s Ghost and Hewlett-Packard (HPQ)

Joseph Schumpeter is known as the prophet of innovation who coined the term Creative_destruction. Firms and industries go thru life cycles. As they age, the value of their business portfolio and growth prospects change. This is especially true for tech firms with rapid product cycles subject to becoming commoditized. Competition, usually from smaller more innovative competitors, erodes their competitive advantage period (CAP), what Warren Buffett calls “the moat”. The result is a decline in the excess return over the firm’s cost of capital, and a decrease in value.

Some firms attempt to reinvent themselves by searching for new growth engines either organically or thru acquisitions. Unfortunately, their size and resulting bureaucracy complicate this effort. Their ability to innovate slows and they are unable to maintain their competitive position. This is true not only for tech firms, but for firms in general, albeit at a slower pace. For example, the average life for a firm on the S&P 500 has fallen to less than 20 years. At this pace, 75% of the S&P 500 firms will be replaced over the next 20 years.

Some firms are unwilling to accept these facts. They feel if they just try harder they can overcome the odds and recapture their growth. The problem, however, goes beyond management-it is structural. Firms failing to recognize this fact often embark upon misguided growth initiatives, especially acquisitions, and destroy shareholder value. I am afraid this is happening again at HPQ under Meg Whitman.

HPQ reported disappointing 3Q13 results last week with sales off 8 % Third Quarter. This raises questions concerning the sustainability of their turnaround efforts. The stock dropped over 12% on the announcement. Year to date stock performance, however, had been excellent, up over 70%. Disturbingly, Whitman stated a return to acquisitions was being considered to increase growth. Keep in mind HPQ’s disastrous acquisition track record resulting in $20B+ in recent write-offs alone Merger Prof. Unfortunately Steven Ballmer’s recent “resignation” at Microsoft for sluggish performance may reinforce HP’s misguided acquisition related growth initiatives.

Returns, not growth, should be the objective at HPQ at the current point in its life cycle. HP’s current CAP is close to zero and its return spread over its WACC on new investments is probably negative. The focus should be:

1)     Efficiency: achieve world class returns thru cost improvements. You cannot grow off a weak base.
2)     Refocus Product and SBU Portfolio: profitability is hampered by uneven performance from complex operations. Thus, exit businesses where HP is no longer the best owner. HPQ’s diverse businesses tie up capital and incur needless costs.
3)     Dividends: continue to return excess funds from operations and divestments to shareholders via dividends and share repurchases. There is nothing wrong at becoming a cash-cow dividend play.
4)     Reconsider Debt Reduction: do not retire too much debt as that reduces the interest tax shield. Additionally, it leaves management with too much financial flexibility, which can lead them to waste money on questionable activities like acquisitions.
5)     Explore Strategic Alternatives: this could include finding a partner for part or all or part of the firm to capitalize on the break-up value of the firm. Another is a breakup-up via spinoffs into 2 or more independent companies. This would release the units from the corporate bureaucracy, and allow them to become innovative again.

Growth alone does not necessarily lead to increased shareholder value. HP is a big bureaucratic firm, which complicates successful growth efforts. Trying to hide from Schumpeter’s ghost with ill advised growth, especially acquisition based growth given HPQ’s track record, is unlikely to succeed. Sometimes as Kenny Rodgers noted “you have to know when to hold them and know when to fold them”. That time may be approaching for HPQ. For the sake of HPQ’s long suffering shareholders let us hope that Meg Whitman has the wisdom to chose wisely this time.


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