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Vitaliy Katsenelson
Vitaliy Katsenelson
Articles (126)  | Author's Website |

HP: Grow Up, Already

August 19, 2011 | About:

Anger and frustration are the two emotions pulsing through my veins as I write this. HP, once the symbol of innovation, is being dismantled by its high-pedigreed board and the CEO of the hour (I truly hope his tenure will be measured in hours, not years). I vividly remember the early 2000s, when Carly Fiorina, then CEO of HP, engineered the HP merger with Compaq. She argued that the merger was a must for HP’s future to be bright. Walter Hewlett, the son of one of the founders, was publicly opposed to it, and I remember the drama of the proxy fight, the TV interviews and arguments from both sides, and the finale – Walter Hewlett lost and the merger went through. But it was not the finale, because nine years and two CEOs later HP has announced that the PC business, the one it so desperately wanted just a decade ago, is too hard a business and that it will look for ways to get rid of it. Almost in the same breath HP announced that it will kill WebOS devices, a business it acquired in April 2010 for $1 billion; and management, possibly missing the irony in those two announcements, went ahead and announced another acquisition, which this time will for sure transform the company.

HP will buy Autonomy, a UK software company, for $10 billion. I understand $10 billion doesn’t sound like a lot of money in today’s post-trillion-dollar-bailout world, but it is plenty for HP, especially considering what that money bought. There are many ways to illustrate how expensive and meaningless to HP’s future this acquisition is: $10 billion is about a fifth of HP’s market capitalization, while Autonomous will contribute 0.7% to HP’s revenues, and 2.7% to its earnings; and HP paid 10x revenues and about 25 times earnings.

Leo Apotheker, HP’s CEO, bragged about Autonomy:

“Autonomy has grown its revenues at a compound annual growth rate of approximately 55% and adjusted operating profit at a rate of approximately 83% over the last 5 years.”

Keith Backman, a sell-side analyst from BMO Capital, asked a very pertinent question about Autonomy:

“… metrics that you threw out for Autonomy, particularly on top-line growth, included a lot of acquisitions for Autonomy. What's the organic growth rate that Autonomy has achieved lately?”

Leo did not have an answer, whereupon HP’s stock started to drop. HP had reported an OK quarter, expectations were already low (its stock was at about 6x times 2011 estimates, which remain intact), and Dell had already lowered guidance a day before; so no one was surprised when HP lowered its revenue guidance for 2011 by a few percentage points. Management said that since it will pay for Autonomy from cash on the balance sheet, it will not be buying much of its stock in the near future, and then they mentioned that this acquisition will be accretive. Yes, accretive! Nothing to worry about. This transaction is accretive only for illiterates in economics and those short on common sense.

HP is using cash on the balance sheet to pay for this transaction, and thanks to the Federal Reserve this cash yields zero and thus brings zero income. As long as Autonomy’s income is greater than zero (I am oversimplifying a little) then it will be accretive (at least on a cash basis). However, this assumes that HP’s cost of capital is equal to the return it receives on its cash. Which is not the case, as that would ignore such minor details as the time value of money, inflation, the risk premium (after all, unlike the US government, HP cannot print money and doesn’t have nuclear weapons) and, simply, opportunity cost.

Any investment HP makes today should be compared against an opportunity set that includes its own stock, which at 6x times earnings results in about a 16% yield (cost of capital). In fact, if HP used $10 billion to buy its own stock, its earnings per share and dividend would jump by 16%. Autonomy will not be able to match this return, by a long mile.

I don’t need to have a great imagination to envision another conference call in August 2015, where a new CEO decides that the software business is too difficult, and HP needs to come back to its roots (maybe going back to making calculators) and will spin off the software business into a new company, take an enormous charge, and then maybe announce an acquisition that the same highly pedigreed board will rubber-stamp.

HP’s valuation has not changed that much – the PC business only represents about 16% of operating profit, so even if HP gives it away, earnings power will not decline greatly. HP should still be able to get a decent price for it, as there has got to be a Chinese company out there swimming in US dollars that wants to put them to work before they become worthless. HP’s core businesses, will be slightly impacted by the global economic weakness, but the company should maintain its earnings power largely intact. Autonomy reduced HP’s value by about $3; but with my lack of confidence in management, I’d not buy HP at a P/E higher than 10, which would bring the stock to the mid to high 40s.

HP’s stock sold off not because the company disappointed Wall Street but because Wall Street grew tired of the overpriced “must-have” acquisitions. Wall Street has smartened up and assumed that this acquisition, as with many other “transformative” acquisitions, will do nothing of the sort. And so, today we are faced with a decision: buy, hold, or sell. At 4.6 times earnings HP is not a sell; but considering that the company is still trying to figure out what it wants to be when it grows up, it is hard to add to our holdings of the stock; so unfortunately this company has turned into a hold.

About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).

Visit Vitaliy Katsenelson's Website

Rating: 4.3/5 (41 votes)


Hschacht - 5 years ago    Report SPAM
The company is a mess. Possibly the worst board of directors on Earth, but I'm sure I'll think of a worse one in a minute. All that said, $7 billion in fcf in the last 9 months shows you that even these idiots can't destroy HP. I have never owned the stock professionally until today. The spin-off/sale is stupid. The acquisition is even worse. They need to hire a CEO who promises to neither buy nor sell but simply to start paying out all fcf in the form of a dividend. Market value would probably jump to $80 billion in a week.
Cm1750 - 5 years ago    Report SPAM
This is the danger of buying a stock based on a "cheap" valuation.

What competitive advantage does HP have? That's right - none. AAPL drove them out of two businesses. Add a bad CEO and incompetent board and you have all the makings of a value trap.

Chances are a massive share buyback would have created more value for shareholders. CEOs always love doing transformative deals when many of these deals are only good for their investment bankers.

Tonyg34 - 5 years ago    Report SPAM
Mr. Schacht:

I will refer you to your own article entitled, "Dell: A Value Trap?"

This seems like a very similar situation to me; a company transforming itself from a maker of commodity boxes into an enterprise solutions provider to look more like IBM. Same problems, different day.

Batbeer2 premium member - 5 years ago
>> In fact, if HP used $10 billion to buy its own stock, its earnings per share and dividend would jump by 16%. Autonomy will not be able to match this return, by a long mile.

I haven't looked at the company in earnest but I agree, these transactions don't add value. Having said that, they did actually spend 5-10B per annum in recent years buying back stock....

1) Book value per share has almost tripled in 10 years.

2) Return on equity is now > 20%. This wasn't the case in 2000-2003.

3) Revenue has almost tripled while SG&A has doubled.

4) They've retained about 35B of earnings to create a company that produces 10B of FCF.

I've seen worse, much worse.

Hschacht - 5 years ago    Report SPAM
Thanks, Tony. I have thought about that comparison a lot. Dell is different. Nobody is going to change the tone there with Mr. Dell at the helm. Given the disaster at HP, I think the situation will change. Also the price at HP is much lower. Some of my best investments have been in companies with awful mgts... when they leave and actions change, it is a major catalyst.

But I am amazed by how many people keep pointing out the obvious... HP is a mess. We know that. It is in the news every minute and in the stock price too. You would think that value investors would try for some second level thinking here... at some price is HP worth a look?

I mean they have $30 billion in sales a QUARTER... and they net nearly $2 billion a quarter... is that worth something? Some number above zero?

I say yes... and one last difference with Dell... they are far more beholden to the PC business... the spinoff/sale/shutdown of the PC division will not change the above numbers much. Not so at Dell.
Tonyg34 - 5 years ago    Report SPAM
H. Schacht

thanks for clarifying that point. I also agree that HP is not ultimately beholden to the PC business and that the stock is pretty silly cheap at the moment. Just wanted to highlight that I had seen this line of reasoning from your previous post and that you ultimately walked away from that position due to management and wanted to see if you had a different angle on this one.

My take is that IBM is the next CSCO. CSCO originated as the vertically integrated player and then smaller players came in and focused on only one aspect of the chain. I think the same thing can happen to IBM as HPQ, ORCL, DELL and others get in the services game.

Does anyone have a tech industry professional's insights on the effect of ORCL no longer provides support for its software used in HP servers that run on INTC chips. This seems like a big blow to HPQ's server business.

the stock trades at a 5 multiple and 14% FCF yield. Totally worth the risks.

Praveen Chawla
Praveen Chawla premium member - 5 years ago
I agree with above two commentators. HPQ lost 10 Billion market cap in one day, The drop in value more than compensates for the Autonomy buy even if turns out to be a big fat rotten egg.

With a earnings yield of 17.2 % and a Cash return on 15% - at present this is a screaming buy. I hope the PC unit is spun off under the compaq name - so shareholders can benefit directly rather than getting a knocked down priced from an Asian manufacturer.
Hschacht - 5 years ago    Report SPAM
The other benefit of a spin-off vs a sale? Sale proceeds would be cash that goes into the hands of this idiot management to allocate! A spin-off is a separate asset that falls into the accounts of shareholders. What are the odds the management of the "new" Compaq is as dumb as their masters at HQ?

I actually think the operating folks at HP are quite good... one wonders how you can get this many bad directors and CEOs in a row. You have to work hard to look this bad.

And yet, my phone doesn't ring. Wonder why? I might even reinstate my membership in the NACD.
Dafjev - 5 years ago    Report SPAM

Thanks for writing what so many of us are thinking. The question is what can we do as shareholders to make this simple change in attitude happen and get rid of this idiot CEO? It would probably require getting rid of most of the board as well...they need to be publicly criticized in a way that touches their public image...people like Meg Whtiman would be hit hard by a public embarrasment and it might force them into action.
Aagold - 5 years ago    Report SPAM

You said,

"Anger and frustration are the two emotions pulsing through my veins as I write this."

I couldn't agree more. That's how I feel as well.

However, while I agree that the Autonomy acqusition has to be one of the most overpriced I've ever heard of, I think the larger blunder is how HP management is handling the PC business. By announcing that they'd like to get out of the business, but that it's going to take 12-18 months for them to figure out how to do that, they're basically destroying that business. Who's going to want to buy a PC from HP now? I wonder how their sales looked the day after the announcement compared to the day before. That blunder really just astounds me...

- aagold

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