Hey, everyone loves software — it’s not capital-intensive, and there are high margins and a high return on capital. The problem is that HP is not a software company. More than $100 billion of its sales come from hardware: printers, servers, PCs, storage devices and routers. Software represents just 2 percent of sales. Also, the transition would have required more acquisitions with Autonomy-like price tags.
It is hard to tell whether it was the sound of the HP founders spinning in their graves or HP stock sinking 30 percent, to 4.5 times earnings, that tipped the board off that there was something very wrong with this strategy. The messenger was appropriately (if only figuratively) shot — well, Apotheker was paid $13 million not to show up to work anymore — and a new CEO was installed. The board appointed Meg Whitman, ex–EBay CEO, onetime California governor hopeful and HP board member.
Wall Street is not happy with the choice. You hear “HP needs a visionary,” “She is not a techie,” and “She has never run a company of HP’s size.” But Wall Street is wrong. Whitman is a talented and highly respected executive who took EBay, an obscure start-up with barely $4 million in annual sales, and turned it into a $4 billion-in-revenue Internet giant. HP doesn’t need a visionary; it needs a good manager — a mother figure, if you like — who will make the employees feel safe, provide clarity and stop the exodus of talent.
Whitman is also an excellent communicator. She has clarified what Apotheker meant when he talked about a software future: HP will remain primarily a hardware company; it will grow its software business organically by a few billion dollars, mainly to help hardware sales. Hallelujah! HP will decide what to do with its PC business as soon as possible, but the decision will be driven by one factor: maximizing shareholder value.
Whitman’s incentives are properly aligned. Being CEO of one of the U.S.’s largest companies is a win-win proposition: If you succeed, you make a lot of money; if you fail, you still make a lot of money (as her predecessor learned). But Whitman has little interest in money. She is a billionaire. She spent $140 million on her California gubernatorial campaign. She is interested in a new challenge, and if she succeeds, she’ll make a lot of money on 1.9 million HP stock options.
HP, despite being everyone’s most-hated stock, has a great brand and is either No. 1 or a very formidable presence in every business in which it competes. Wall Street doesn’t like its PC business, but PCs are only 15 percent of operating profits.
Of course, Wall Street will not let you forget that HP has had the most dysfunctional board of directors in corporate history. The key is “has had” — nine out of 14 members joined the board in January 2011 and were not involved in previous scandals, nor did they hire Apotheker.
The value of any asset is the present value of its future cash flows, a boring but fundamental truism of investing. But the truism comes with an asterisk — that something semismart will be done with the cash flows. No matter how great the business or how much cash it generates, if management burns cash flows through poor capital allocation, the business will not be valued on free cash flows but on the ashes of its cash flows.
Today, HP is valued on burnt cash flows, and though for a while Wall Street was right, the company doesn’t deserve this method of valuation any longer. Whitman’s most important task is not to do anything dumb with HP’s ample ($10 billion) cash flows. She and the board already have publicly committed to no more expensive acquisitions. The risk of capital destruction has been completely taken off the table. If Wall Street were to value HP on free cash flows, it would realize that today’s price discounts a 10 percent decline in free cash flows over the next ten years. That is an unlikely scenario.
Copyright Institutional Investor
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, click here or read his articles 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 Katsenelson’s Active Value Investing (Wiley, 2007) book.