Hewlett-Packard Hits Bottom, Finds A Shovel

By Stephen D. Simpson, CFA | November 27, 2012 AAA

At the risk of sounding like I want to pile on to Hewlett-Packard's (NYSE:HPQ) misery, this company may become my go-to example for the years to come in the risks of "how much worse can it get?" thinking. I just don't see a lot of strength here in terms of high-quality end-markets, and I question whether the company can position itself for demands of the always-evolving IT world of tomorrow. Though this stock still looks exceedingly cheap, I have absolutely no confidence that this management team can guide the company back or harvest that underlying value.

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A Tough Close to Another Rough Year
Between the reports of companies like IBM (NYSE:IBM), Dell (Nasdaq:DELL), and other IT hardware companies, there was little logical expectation that Hewlett-Packard was going to have a strong quarter. Although the actual reported results weren't really any worse than expected, there was still plenty of bad news to further rattle a frustrated shareholder base.

Revenue fell 7% from last year on an as-reported basis, with a currency-adjusted decline of 4%. Every major unit but software was down as reported, with computers' (Personal Systems) decline of 14% and storage's 13% negative revenue comp pacing the bad news. Printing revenue fell 5%, services was down 6% and consolidated servers/storage/networking fell 9% (with networking up 7%, servers down 7%, and storage down 13%). Software was the bright spot, with revenue up 14% from last year.

All things considered, margins weren't bad. Gross margin improved three points as reported, with a better than one point improvement from the third quarter. Non-GAAP adjusted operating income fell 1% from last year, with operating margin up more than half a point. Printing in particular saw good margins (a five-point year on year improvement), while hardware margins eroded badly.

Autonomy - A Questionable Deal Gets Even Worse
When HP announced a little more than a year ago that it was going to spend more than $10 billion to acquire British software company Autonomy, there were more than a few analysts who thought HP paying a 75% premium was far too much for this enterprise analytics and data management software company. Yes, unstructured data analysis is a big deal, and HP was under pressure to keep up with the cool kids like IBM and Oracle (Nasdaq:ORCL), but it was a pricey deal with a lot of execution risk.

HP hadn't really done much in the following quarters to convince the Street that Autonomy was the right deal (and/or at the right time and for the right price). Now the story is getting even worse.

With fiscal fourth quarter earnings, HP management announced a $8.8 billion writedown of Autonomy and asserted that there were various accounting improprieties and misrepresentations that were unknown to the company at the time of the deal. It's tempting to call "sour grapes" on this, but HP management tied about $5 billion of the writedown to these accounting issues and apparently will look to the courts to try to recover some of that lost value for shareholders.

Disappointingly, current CEO Meg Whitman tried to throw former HP executives Leo Apotheker and Shane Robison under the bus for the Autonomy debacle. While Apotheker certainly deserves plenty of the blame (if CEOs get the credit when things go well, they deserve the blame when things go south), as does Deloitte (the auditor involved), Whitman was on the board at the time and voted for the deal. More to the point, I suspect that had the Autonomy deal gone well and surprised everybody to the upside, she wouldn't be so eager to bring Apotheker's involvement back to people's minds.

Where's The Growth?
I wasn't overly impressed with HP's analyst day back in October, and nothing here has gotten better since then.

I don't think the company's computer business is hopeless, but I doubt either HP or Dell will reclaim the top spot from Lenovo (OTC:LNVGY). Likewise, while the printing business can generate cash flow, that sizable drop in hardware unit sales (20% this quarter) is worrisome. Also worrisome is HP's weak positioning in the evolving mobile device market, be it smartphones or tablets.

I likewise see problems elsewhere in hardware. I don't think the company is really a credible threat to players like EMC (NYSE:EMC) or NetApp (Nasdaq:NTAP), and I think established rivals like Cisco (Nasdaq:CSCO) and IBM are ample threats to the server and networking businesses, to say nothing of the migration to software-defined networking (SDN), an area where Cisco, VMware (NYSE:VMW), and Oracle are already making major investments. Last and not least, I see no particular reason to think that HP's service or software businesses have sustainable competitive advantages.

And, in my opinion, it just gets worse from there. HP is still trying to staunch its bleeding, and it's hard to plan for the future when you're busy trying to plug leaks in the dyke today. What's more, I'm not sure HP can turn to that tried-and-true catch-up strategy in Big Tech of acquisitions - with the embarrassing Autonomy failure still playing out (and 3PAR not really a raging success), I can't imagine shareholders will enthusiastically greet another big acquisition.

The Bottom Line
If HP can grow at all on a long-term basis, these shares are likely substantially undervalued today. But, as in the case of Dell, the near-term problems are so large today that few investors have the courage to bet on that better long-term picture. Consequently, while it's not hard to see potential value in HP shares, the Street is likely going to need to see substantially better execution before believing that this management team can realize that value.

At the time of writing, Stephen D. Simpson owned shares of EMC since September 2012.

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