Hewlett-Packard: A Lesson in Destroying Shareholder Value

Is Hewlett-Packard (HPQ, Financial) a value investment or a value trap?


HP was covered in the value idea contest in June and many things have changed since then. You can read the previous analysis here.


A brief review of HP's business is in order. Let us have a look.





1. Valuation


Let's look at how crazy the valuation of HP is. Ackman in a recent interview about HP said, “I have the fairly quaint notion that the value of anything is the present value of the cash you can take out of the business over its life.”





The FCF of HPQ stands at $9 billion in TTM. The FCF is the cash which is used to repay interest, debt and reward shareholders. Assume that HPQ returns all this cash to the shareholders. Then, with a 20% discount and -20% growth in FCF, this is worth:





If we continue this, then we will arrive at $27 billion. Per share this adds 12. With book value of $17, HP is cheap even in this extreme scenario. It is selling at a $24, which is a 17.2% discount to the value we calculated ($29 a share). Even if HP wastes 20% of its cash flow every year, it is cheap by almost 17%!


2 Shareholder Return





If we forget about all the mumbo-jumbo analysts tell us, companies can return money to the shareholders in only three ways

1. Dividends - HP has consistently paid $0.32 a share since 2001. HP was selling for around $23 a share in 2001. This is a 14% return on this price.
2. Earning growth - HP has grown its earning phenomenally. HPs per share EPS has grown from $0.21 to $3.61. This is a growth rate of 33% annualized. This is phenomenal. This is quite a rare achievement.
3. Change in price multiples - Increased price multiples increase the share price more and vice versa. HP has gone from a P/E multiple of 64.1 to 5.8, P/B ratio of 2.9 to 1.3, P/S ratio of 0.9 to 0.4 and P/CF ratio of 15.8 to 4.1.

If we put all of this together, we see that HP has performed quite badly in the last decade. The overall return has been only due to the dividends, which comes to be 2.28% every year.


The majority of growth in the earnings of HP has been gobbled up by the dropping price multiples. At the current multiple of P/E 6, the market is pricing HP for a negative growth of the order of magnitude of around 20%.


3 Profitability and Growth


Let us look at the revenue and the margin trend of HPQ.








[u]HPQ has been able to maintain stable margins across the board. In fact, even though the gross margins are in a downward trend, the operating and the net margins have improved quite a bit. HPQ has gone for significant cost cutting measures and the numbers reflect that.The revenue of HPQ has gone from $45 billion to $128 billion in the last decade. This is a 11% growth rate in the last 10 years. The growth rate in the last year was 10%.The EPS growth rate has been ever more impressive because of the cost cutting measures. HPQ has clocked in a growth of 17.52% last year and the 3-, 5- and 10-year average growth rates are 11%, 35% and 7% respectively.The FCF has gone from $1 billion to $9 billion in the TTM. That is a 24% increase on average.[/list]


4 Debt





5 Cash Flow


Cash flow is the measure of the cash that the company generates. The more consistently the company generates cash, the more consistent the dividend and growth it can achieve. Let's look at the cash flow data of HPQ.







[u]The capital expenditure has remained in line with the sales. The FCF as percentage of sales seems to be in a downward trend since 2008. Also, the FCF as percentage of net income is in a downward trend.HPQ is taking on debt.It has no immediate liquidity problems, although the cash situation is deteriorating.HP has been buying outstanding shares.[/list]


In short, HP is

• valued for negative growth of the order of 20%
• has taken on a lot of debt in the recent years
• and is being hated by the market.

The question to ask now is, who is responsible?


Meet HPs board of directors and to some extent its CEOs. Here is a small tutorial on how to destroy shareholder value.

• HP canned Mark Hurd in 2010 who was arguably a very good CEO for HP. During Hurd's reign, HP put in an awesome display by cutting cost and substantially growing earnings. The reason for the departure was minor accounting irregularities and a sexual harassment charge that was not in violation with HPs sexual harassment policy but it “violated the standards of business conduct of HP.” Bravo! To add insult to injury, the board did not fire Mark and so ended up paying him $34.2 million. In short, they lost a very good CEO who was immediately picked up by rival Oracle (ORCL, Financial) and paid him a lot of money as a severance package. Larry Ellison, the CEO of Oracle, said, “The HP board just made the worst personnel decision since the idiots at Apple (AAPL, Financial) fired Steve Jobs.”
• HP hired a software guy, Leo Apothekar, the former CEO of SAP AG (SAP, Financial). After firing him in less than a year it seems that most of the board had not even met him, let alone interviewed him for the job, before hiring him. One of the board members said, “I admit it was highly unusual, but we were just too exhausted from all the infighting.” Seriously? Wow!
• HP hired the former eBay (EBAY) CEO Meg Whitman to do the job now. She claims that HP needs a strong leader to show them the way. I don’t know if Whitman can achieve this, coming from managing a company like EBAY (HP is by far a different beast). But one thing is for sure, the board has done more than enough on its part to destroy shareholder value.
• Among HP's board are people like Ken Thompson, the former CEO of Wachovia, who some say singlehandedly ran the bank into the ground. Another member is Patricia Russo, the former CEO of Lucent, which has been one of the best companies in destroying shareholder wealth.

If that was the only problem with HP, I would have been happy. HP seems to be behaving like a patient with bi-polar disorder in the last year. Let us look at the contradicting things it has been doing these days:

• HP bought Palm for $1.2 billion or ($5.7 a share). Before, this Palm was a heavily indebted company which was unable to compete in the market. HP wanted to use webOS to build its own ecosystem like iOS and Android. On July 1, 2011, HP unveiled HP Touchpad, bringing webOS on a tablet device. Due to lackluster sales, HP started selling Touchpad for $99. The new CEO Leo wanted to shift HP away from the low-margin PC business to the high-margin enterprise software business (surprise, he was CEO of SAP!). The board was not happy with the decision of spinning out the PC business. Most prominently the chairman Ray Lane said "We have no intention of getting out of the PC business. Why would we get out of a $43 billion PC business that is No. 1?" Without the PSG, HP would lose a lot of bargaining power from its suppliers as well as customers. Shifting into enterprise software from PC will need HP to create a new brand identity. IBM was able to pull it off by selling its PC division to Lenovo, but will HP be able to do it? Whatever happens, this move will take a lot of time and waste a lot of money in the process. HP's board is not even sure if this is a good deal and hence fired Leo and replaced him with Meg. Meg has said that she will decide about the spin-off by the end of October. But I am positive that this will not come to pass. In the meantime, the employees remain rudderless.
• Leo’s parting gift to HP was the acquisition of Autonomy — UK’s largest software maker. Autonomy had a sales of $949 million! The price HP paid was 10 times the sales. The value of something lies in the eyes of the beholder, but let's see if this was a good use of cash for HP. HP announced that it will be putting off its share repurchases because of this deal. If HP would have bought its shares with the $10 billion it is using to acquire Autonomy at the current depressed levels, and used the generated FCF to buy shares too, it would end up buying all outstanding shares in five to six years. This will create some serious returns for the shareholder! To put the overpayment in perspective, the cash represents 20% of the current market cap of $50 billion but the Autonomy’s sales represent only 0.7% ($929 million/$126 billion) of its revenue. If HP only used the $10 billion cash to buy back its stocks then this would have increased EPS and dividend by almost 15%. Autonomy will never be able to increase either EPS or dividend by that much. That is some serious overpayment.
• This is not the first time HP has overpaid for a company. HP paid $2.3 billion for 3Par, after a bidding war that erupted for the company between HP and Dell (DELL, Financial). Dell walked out of the deal and 3Par paid $92 million to Dell in termination fees. HP ended up paying a price that was 11 times its earning and 3 times its market cap!

Only time will tell if HP will be able to recover or not, but history does not favor companies with bad management and directionless employees. In a recent interview, Bill Ackman says the following about HP:

We have gotten over the last several months probably at least five or six calls from the largest shareholders of Hewlett-Packard begging us to take a stake in the company and be a proactive shareholder. I think that what we focus on is that we try to find a business that we can predict what it’s going to look like over a very long period of time. I have the fairly quaint notion that the value of anything is the present value of the cash you can take out of the business over its life.


The problem is that HP is in a number of businesses where I think it’s very difficult to predict what the business is going to look like five years from now, let alone over the many, many years of a discounted cash flow calculation you need to figure out what the business is worth. The problem you’ve had is that it looks cheap, but the future of the PC industry is a very difficult business to handicap. It’s incredibly competitive. I think the announcement of their intention to spin part of the business off perhaps has damaged the brand and it is a big, complicated mess. One of the things I learned a lot earlier in my career is to do a calculation which I call return on invested brain damage, which is before I make an investment which requires brain damage, or a lot of work and energy, I figure out how much money I can make. The higher the brain damage, the higher the profit has to be to justify it.


I was actually at HP yesterday for a meeting unrelated to their core business and it was just depressing walking around. The morale of the employees going from an outstanding company to one where they don’t understand the direction of the business.

The bottom line:


HP has not gone so far that it cannot recover. The journey will no doubt be long and arduous. At the current moment watching from the sidelines is a safe bet. I have already bought HP at $38 for a $4000 worth which is down almost 40% now. I will wait until things get better before doubling down.