Would A Smaller HP Be A Better HP?

By Stephen D. Simpson, CFA | July 07, 2011 AAA

Summer is the time for idle rumors and speculation around the market, mainly because there's so little real news out there that nobody will be too hard on any new idea that floats by (hey, at least it's something to talk about). Prior to the Fourth of July holiday, the markets were briefly abuzz with the idea that Hewlett-Packard (NYSE:HPQ) should bow to pressure and split up some of its operations. Although it is probably not too likely (CEOs like to run bigger businesses, not smaller), it is an idea that is still worth exploring.

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Everything Old is New Again
This latest round of "how to make HP better" chatter is reportedly coming from a consortium of private equity groups (Blackstone (NYSE:BX), KKR (NYSE:KKR) and TPG Capital). While specifics are lacking, this group has noted the relatively poor valuation on HP's stock and suggested that the company could benefited from a strict diet - getting rid of the PC business and perhaps the printing unit as well.

Investors should realize, though, that this is not the first (or the likely the last) time such a move has been suggested. Journalists and commentators penned plenty of pieces in the wake of former CEO's Hurd messy departure that suggested HP should take that opportunity to become leaner and more focused. Going back even further, Merrill Lynch analyst Steven Milunovich penned a note in 2004 that recommended HP split in two, creating a consumer-focused company and a business/enterprise-focused company.

The Logic to the Move
Honestly, it's hard to fault the idea of getting rid of the PC business. Selling PCs used to be a real growth opportunity for the likes of HP and Dell (Nasdaq:DELL), but this business has devolved into a cyclical commodity slog where margins are thin and consumer loyalty extends no further than the last breakdown or whatever is featured and on sale at Best Buy (NYSE:BBY) or Costco (Nasdaq:COST). Even granting that it does not take much R&D to stay competitive in PCs, it difficult to see how keeping the HP PC business helps the company - jettisoning PCs certainly did IBM (NYSE:IBM) no harm.

Looking at HP's imaging and printing business is a little trickier. This business has solid margins and a very strong market share against rivals like Lexmark (NYSE:LXK) and Canon (NYSE:CAJ). Here too, though, growth is challenging - periodically somebody invents a new mousetrap that pushes imaging/printing ahead, but for the most part it's a slow-growth replacement/upgrade market. On the flip side, this is a business that produces good returns on capital and solid cash flow - it is more difficult to make the case that HP will be better and stronger without its printing business as this cash flow can underwrite a lot of R&D in other parts of the business.

Time to Jettison the Consumer Biz?
Notwithstanding the uncanny success of Apple (Nasdaq:AAPL) as a consumer tech company, targeting consumers does not seem to be a great success strategy for larger American tech companies. Microsoft (Nasdaq:MSFT) has yet to become rich from the Xbox; neither Motorola (NYSE:MMI) nor Research In Motion (Nasdaq:RIMM) have captured and held their market in phones; and nobody cares anymore if Intel (Nasdaq:INTC) is inside.

With that in mind, it probably makes a fair bit of sense for HP to consider Milunovich's advice from seven years ago. The PC business is holding back HP's growth and margins and reviews of products like the TouchPad suggest that the company is no threat to Apple or Samsung in phones or tablets.

Better then to sell or spin off these consumer-focused businesses and focus on growth opportunities in the corporate/enterprise space. Enterprises continue to produce, process and consume data at mind-boggling rates and there is significant money-making potential there. What's more, jettisoning the low-growth businesses (particularly those with little prospect of future growth) would likely help the stock's valuation - tech investors love growth above all else and it does not matter how much quality there is to HP's earnings if there is no growth.

The Bottom Line
The good news for HP shareholders is that the stock's current valuation presupposes very little improvement. At these prices, even absent growth, investors can afford to be patient and wait for the stock market to realize the inherent value at HP. How that value comes to light will be the story of the next couple of years - will management slim down and refocus on real growth or will external forces (like private equity investors) take matters into their own hands, buy these cheap shares, and do what must be done to bring HP's performance in line with its potential? (For related reading, also take a look at Could Your Company Be A Target For Activist Investors?)

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