Hewlett Packard‘s 21st Century Adventures: Stupid Is as Stupid Does

Hewlett Packard and its shareholders have suffered during the first 15 years of this century. I previously highlighted the issues here and here. The underlying problem is an attachment by HP’s CEOs starting with Carly Fiorina and continuing with current CEO Meg Whitman to a doomed attempt by a mature low-growth, hardware-based, old tech conglomerate to regain its growth mojo thru acquisition related consolidation. Back in 2013 I recommended an alternative path to grow old gracefully by managing for cash and returning it to shareholders instead of growth. This is a difficult recommendation for most managers to accept; they seem instinctively opposed to shrinking even when it is the right thing to do. I thought it might be interesting to see how HP has progressed as it approaches the split of its PC and printing business from its services group.

Some of the items I suggested and HP’s reactions are as follows:

1)     Improved Efficiency: lots of cost/job cuts-54,000 with another 30,000 planned. Unfortunately, margins and returns have remained weak as core revenues continue to decline. So “A” for effort but “C” for impact.

2)     Refocus Product Portfolio: still burdened with overly board product lines. Remains a work in process with a grade of “C”.

3)     Improve Focus: the split/spin off of the PC and printer divisions to HP, Inc and the service units to Hewlett Packard Enterprise should improve focus. Additionally, it allows more tailored financial polices-see # 4 and 5 below. Grade “A”.

4)     Improve Balance Sheet: the balance sheet and ratings were weakened by a disastrous series of acquisitions. The company’s net debt position was reduced to “0” prior to the spinoff. Post split, Inc will have a net debt of $2.3B while Enterprise will have $5.5B more cash than debt. Grade “A”.

5)     Improve Capital Discipline (i.e. increase shareholder distributions): dividends have increased, but represent only 13% of free cash flow (FCF) compared to IBM’s over 30%. Post split, however, Inc will payout 50-75% of FCF while Enterprises FCF payout is targeted at 50%. Grade “A”.

6)     Curtail Acquisitions: acquired relatively small Aruba Networks (revenues around $700 Mln) for $2.7B earlier this year. Seems to make strategic sense with manageable integration risk. CEO Whitman recently stated their M&A goal is not to do anything (again?)-sounds like a sensible approach to me. Grade “B”.

Lots of unanswered questions remain for the spun off divisions; overall grade-“A-“ Whitman has done “ok”. My concern is with revenue, margins and returns under pressure as reflected in a stagnating stock price, the HP entities will fall prey to the growth fetish and “do something stupid” again. Initially, Enterprise headed by Whitman will have more financial slack to do something stupid. Let’s hope that HP Inc and Enterprises accept financial reality and maturity by focusing on efficiency and capital disciple instead of growth. Their empires may be smaller, but their shareholders will be richer. Let’s hope the HP entities have fewer future adventures than they had over the first of the 21^st century.

Joe

Mature Tech: Valuation and Pricing Lessons

Apple’s large price drop and the Google’s large price jump occurred within days of each other. They highlight how challenging tech valuation and pricing can be in a normal trading context let alone in an M&A setting. I find it useful to distinguish the different stages of tech firms to understand the economic dynamics. My scheme is as follows:

1)     Seed: idea stage with no established business model or revenues; private market valuation set by handful of optimists of questionable reliability.

2)     Early: established business model and revenues -profits hopefully to follow e.g. Square; price based on relative value compared to “peers”.

3)     Mature: great returns/profits but growth leveling off e.g. Apple and Google; key drivers are growth and returns.

4)     Old: declining returns with limited if any growth e.g. Hewlett Packard and IBM; focus on shareholder distributions and breakup asset values.

Recently, Apple and Google experienced large stock price swings. GOOGLE increased by 16%+ or $65B on July 17 while Apple fell 7% or $60B four days later. Ralph correctly notes stock prices are based on expectations not actual results.

Expectations are frequently based on extrapolations-sometimes sophisticated, but still extrapolations based on beliefs not facts. Once a new signal (which could be information or noise) is received, investors revise their prior beliefs regarding future operating performance-Bayesian updating or learning. Tech firms are inherently volatile given short product life cycles and their uncertain operating environment. Relatively small changes in expected growth rates can have a huge valuation impact.

Apple, although it had a great quarter, gave revenue guidance that shook investor growth expectations. Specifically, concerns over iPhone, iPad, iWatch and the next “big thing” caused investors to markdown growth estimates. It is still a great firm but was priced too high based on new growth estimates. This raises another issue-will Apple’s management try regain its growth “mojo” through expensive unfocused new product R&D and acquisitions? Remember they have a huge $200B+ cash pile and could do lots of damage. Hopefully activists like Icahn will keep pressuring them to return more cash to shareholders. Interesting to see how their management reacts. The record of aging tech firms refusing to age gracefully like HP is not a happy one.

Google benefited from a “twofer”. They had a better than expected second quarter. They also provided information on improving growth prospects for mobile ads. Equally important, their new CFO provided comforting words on expense and capital discipline. The problem with maturing tech is the discipline to manage the transition from high growth to more modest growth. Managing the transition has an important impact on expectations. Whether Google’s management can deliver on these raised expectations remains to be seen. If they disappoint then expect a subsequent large downward pricing adjustment.

My take is mature tech firms are fraught with agency cost issues which make them difficult to value. They will try to fight the transition to slower growth and try to manufacture growth through undisciplined capital allocation at the expense of returns and value. New management teams unburdened by legacy culture will be needed to avoid Microsoft-Nokia type M&A misadventures.

J                                                                                                

Forgive Them (Not)-They Do Not Know What They Do: Hewlett Packard Again

Hewlett Packard’s (HP) Autonomy acquisition is back in the news again. I previously covered this tale of woe back in 2012. HP was the target of lawsuits following the botched acquisition. The terms of a recently settled suit are pretty interesting. How HP missed “accounting irregularities” so large that they were forced to write-down $8B of the $11B acquisition soon after the close has always puzzled me.

As part of the settlement HP agreed to establish an M&A related risk committee to incorporate the views of the investment, finance and technology committees - now there is a novel thought (get other points of view). Also, they will require their due diligence teams to be better trained - you mean they have to know what they are doing? My God, now they decide to better handle M&A risk and due diligence more than three years after the disastrous Autonomy deal! What were they doing before that deal and since it closed? To be fair this is probably legalese - form over substance.

What I find especially appalling is that the current CEO, Meg Whitman, was one the board members who approved the deal over the objections of HP’s CFO - so much for accountability! You don’t need enhanced risk committees and better due diligence to know that it is a BIG-BIG-BIG red flag if the CFO objects to a deal. Some other less obvious indicators include:

1)     Pressure to grow: looking to cover up weak core operations with a large acquisition is always troublesome as was the case here.

2)     Transformation: big acquisitions away from your core rarely end up well.

3)     Over Priced: the CFO objected, inter alia, that the deal was massively over priced at 11X sales v comparables at 3X.

4)     Dissenting views ignored: like the CFO’s.

5)     Weak Due Diligence: everyone knew the answer the then CEO wanted and no one was going to stand in the way-at least not if they liked their job.

The incident is another example of a board rubber stamping the CEO’s wishes. Of course boards cannot run the firm. This does not excuse boards from exercising some minimum of oversight and basic judgment. This is critical when the board’s CEO selection track record is weak - as it was with HP prior to Autonomy with substantial CEO turnover. CEOs are frequently selected based on luck not skill. A CEO candidate who has a “successful” track record is deemed skillful, when in fact he could have been simply lucky. Such CEO candidates are frequently over confident AKA decisive. Thus, absent a strong board they are prone to behavioral errors in an acquisition setting.

J

Warren Buffett and Conglomerates

Berkshire Hathaway is a difficult to understand conglomerate with a collection of unrelated businesses ranging from candy to insurance. Conglomerates suffer a well deserved discount from their pure play peers. Consulting firms like BCG and Marakon estimate the discount as high as 10% in normal times. The discount is based on the following factors:

1)     Poor focus leading to inefficiencies including: a) high head office overhead; b) cross subsidies from cash positive SBUs to cash deficient units; and c) poor capital allocation decisions. Conglomerates mimic capital markets, but on a less efficient basis.

2)     Weak Fit: conglomerates are usually not the best owners of all their SBUs. Managers must not only manage well enough to earn their cost of capital; they also earn more than an alternative owner who can extract synergies from related operations.

These forces underlie the wave of proposed spinoffs by firms such as Hewlett Packard, EBay and Yahoo.  Yet Warren Buffett claims Berkshire’s collection of businesses are worth more under their corporate umbrella than as standalone entities. He bases this on the following:

1)     He can move capital efficiently and on a tax efficient basis among the various units. This is premised on his being a better capital allocator than capital markets. This may be true for him, but probably questionable for other mere mortals.

2)     Spinoffs are frowned upon as the “spin-or” does not receive any premium. There is no premium, however, because, the “spin-or’s” shareholder still own the spun SBU just is a different form.

3)     Berkshire has very low overhead-at least for now.

Well, how can you dispute his success? The success, however, has some question marks associated with it. Consider:

1)     Buffett used to measure Berkshire’s by the growth in book value per share compared to the S&P 500. Unfortunately, Berkshire’s performance by that measure has lagged the S&P index for 5 of the last 6 years. Consequently, he switched metrics to comparing Berkshire market value changes compared to the S&P index.

2)     He justifies the change as better reflecting the significant change in his business model from owning minority positions in liquid public securities (70%+  of business 20 years ago) to owning and operating large business today (70%+ of the current business now).

Perhaps, the conglomerate curse is catching up with Berkshire as it marches down the conglomerate path. Buffett’s superior individual skills may slow the onset of “conglomeratism”. Nonetheless, I doubt that even the Oracle can stave off its effects forever. That may be why he saw it necessary to explain why the conglomerate model makes sense for Berkshire in his annual shareholder letter this year.

Berkshire is unlikely to spin-off any divisions while Buffett remains CEO. My guess is that the pressure to break-up will mount once he gone. It seems that the advantages of the conglomerate model are more evident to those who run them, than to customers, employees and investors.

J

Audacity of Hope: Halliburton - Baker Hughes Acquisition

The energy sector is under immense pressure due the collapse in oil prices. This will drive M&A activity as firms seek to adjust. Halliburton, the oil services industry  #2, made a $35B Bid for Baker Hughes, the #3 player, in an attempt to close the operating and valuation gap with industry leader Schlumberger. It represents a large, richly priced and risky transaction.

Ordinarily, the buyer’s price falls following a bid reflecting investor concerns with the deal such as being over priced. Usually, the pro forma value of the combined entity, however, increases. In the Halliburton situation, the combined value actually fell. It reflects both a 10%+ drop in Halliburton’ stock price and Baker Hughes trading at $66 p/s compared to the $78 p/s offer price-which illustrates investor concern with the deal’s large antitrust hurdles.

My issues with acquisition are as follows:

1)     Size: the target is almost the same size as the acquirer. This raises integration issues.

2)     Premium: the 50%. My belief is anything over 40% for a major transaction is difficult to justify.

3)     Shareholder Value at Risk (SVaR): SVaR, combination of premium and size, is huge making this a potential “bet-your-company” type of deal. Halliburton’s management is risking 50% of its shareholders’ pre bid value on this deal.

4)     Antitrust Risk: Halliburton will pay Baker Hughes a $3.5B breakup fee if the deals fails to obtain antitrust approval. This is a significant issue given the combination of the industry’s #2 and #3 firms. Some estimate divestments representing $7.5B of sales may be needed to obtain approval.

5)     Consideration: the deal is 25% cash. Halliburton is using its stock, which trades near its 52 week low, to fund the remaining 75%. The use of potentially depressed under valued stock constitutes another source of over payment.

6)     Synergies: the estimated $2B in cost cuts exceed what observers had estimated-especially in a down market. Projections should reflect reality. Here, I wonder if reality is not being reshaped to fit the projections.

The deal is being justified as strategic, and it may well be. Nonetheless, it must still make financial sense. I am reminded of my former boss who used to say “strategic” is a code word for “over priced”.

Halliburton must have been influenced by President Obama’s book-The Audacity of Hope”. Hope, however, is never a good M&A strategy. Hewlett Packard is the current poster boy of bad acquisitions. I think Halliburton is making a strong move for that dubious honor with the Baker Hughes transaction. No wonder why their shareholders are so concerned.

J

PS  We will not publish Thursday in observance of the American Thanksgiving Holiday.  To all of our friends worldwide, we wish you peace and happiness with your families.