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                                                                                                

First Mover Advantages and Disadvantages

In Joe's last post The Price is Right he questioned the pricing of Uber, noting:

"Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. "

Indeed, in a paper two colleagues and I published in the Review of Financial Studies, we do  find that the first acquiring firm in an industry after a long dormant period without acquisition activity earns abnormally positive returns.  We are quite skeptical of the first mover - or low hanging fruit argument, however, noting:

"Cottrell and Sick (2001), and Schnaars (1994) examine first-mover advantages and disadvantages, noting numerous cases in which the imitator ultimately gains the advantage over the first mover. Examples from the software industry include the success of the VHS tape format over Betamax, IBM following Apple, and Excel following VisiCalc. Cottrell and Sick (2001) also note the phenomena in the motorcycle industry with Yamaha, Kawasaki, and Suzuki successfully following Harley Davidson, and the Indian and European models."

The question is whether Uber can maintain a sustainable comparative advantage.  It's an open question, but my instincts align with Joes.  

All the best,

Ralph


References

Cottrell, T., and G. Sick. 2001. First-Mover (Dis)advantage and Real Options. Journal of Applied Corporate Finance 14: 41-51.
Schnaars, S. 1994. Managing Imitation Strategies: How Later Entrants Seize Markets From Pioneers. The Free Press, New York.

Choose Wisely

I am fascinated with the technology industry-not because of the technology itself, but the pace of industry change. Company life cycles are measured in years compared to decades in other industries. The half life of T (The competitive advantage period) is frequently less than 5 years. This allows us to observe and study how firms are handling maturity. The basic choice is to grow old gracefully by curtailing investments and returning excess cash to shareholders, or try to spend your way back growth.

This was best put by Google’s Larry Page FT who stated his firm, although still growing, risks irrelevancy if it is unable to keep pace with market developments. He hinted at setting up a holding company structure to make diversifying bets (acquisitions) like Warren Buffett’s Berkshire Hathaway. Firms like IBM and Microsoft have chosen to age gracefully and return cash to shareholders who are then free to find the next tech generation of winners. Others, such as Facebook, are seeking transformational M&A to retain their growth status. The problem firms like Google and Facebook who chose to fight aging is they risk an arms race with other cash rich tech competitors battling for supremacy in an evolving digital environment. This leads to ill advised over priced transactions like Hewlett Packard experienced in its 14 year computer adventure which it recently decided to end thru a spin-off of its disparate divisions.

Tech firms considering reinventing themselves by acquiring should consider the following:

1)     What is strategic motivation? Growth alone should be a consequence of strategy not a strategy itself. What competitive advantage in terms of products, technology, market extension, pricing power, or cost advantages are to be gained?

2)     Are there alternatives to acquiring (i.e. internal development)?

3)     Can you identify appropriate targets? These include targets that can exploit market developments-quickly and efficiently scale operations. You acquire firms not technology.

4)     Can you acquire at a reasonable price (i.e. not overpay relative to value)?

It is difficult to value early stage or rapidly growing targets, which often lack an intrinsic value. Rather, their price is determined by what buyers are willing to pay based on current, potentially overheated, market conditions. The lack of an intrinsic value anchor makes such transactions prone to be over priced. Buffett believes firms lacking an intrinsic value are worth only what some other buyer is willing to pay for them. Hence he believes they are speculative and not long term investments. This is the reason he avoids tech firms now just as he did during the 1990s dotcom boom.

You can inject an element of discipline thru a reverse engineering process. This involves solving for the level of sales and profits needed in 5-10 years to justify the offer price. Keep in mind the caveats. First growth requires investments (CAPEX, R&D and working capital). This investment reduces free cash flows and ultimate value. Second time is not your friend. The more distant the cash flows either initially planned or due to delays, the lower the value. See my previous post applying this approach to the Facebook-Whatsapp Acquisition. Whatsapp reported 1H14 sales of around $15mm and a loss of $235mm. They claim the potential still remains, but realization is delayed. The potential growth needed is huge and preliminary results are not encouraging.

J

Responding to Low T

The T in question is the Competitive Advantage Period and not testosterone. It is time in which a firm can invest at returns exceeding its cost of capital. T, or moat as used by Warren Buffett, is the driving factor underlying tech firm high valuation multiples. It is based on strategic barriers including technology, First Mover Advantages and regulation. (Also, see our previous post: Find your sustainable competitive advantage.)

It has a dramatic valuation impact as it declines when firms or industries mature. T eventually fades for most industries as they experience Regression to the Mean due to competitive forces such as new entrants and substitutes. Firms like Apple can have several years of remaining T; whereas, firms like Hewlett Packard’s T is largely gone. This fact is reflected in their widely differing valuation multiples. In fact, you can view T as the number of years a firm has before it undergoes a fundamental corporate change like a LBO, recapitalization or sale.

The current flurry of tech related deals presents insights into how firms are handling the rapid changes in T. These firms are based upon rapidly changing technology life cycles, which can be measured in terms of dog years. Firms can respond this development in two distinct manners. The first is to accept and mature gracefully and increase shareholder distributions as IBM has done. 

Alternatively, you could try to adapt by either developing new products like Apple or acquiring new products and technologies as is Facebook –see Crisis. The acquisition approach is to be distinguished from weak acquirers such as Hewlett Packard seeking to hide declining performance.

Tech firms like Google are investing in strategies which just happen to be executed thru acquisitions. Unlike Cisco which pioneered this strategy, these new transactions are much larger. 

The transactions have two objectives. The first is to acquire skills and technologies faster and cheaper than could be internally developed. The second to pick technology winners early and help them develop early as Facebook is doing with its Oculus Acquisition. In these efforts Real Option Valuation is used to supplement traditional Discounted Cash Flow analysis.

There are many risks involved with the acquisition approach. For example can you the right targets? Can you properly execute the transactions? Can you grow the acquired technology fast enough and large enough? How will your competitors respond?

The jury is still out on how this plays out. It is fascinating to watch.

J