HP: Past Mistakes And Future Relevancy

  • Stock buyback policy and its impact on the firm.
  • HP undertook some of the biggest M&A follies in the past decade.
  • The splitting up of HP into two entities marks the start of a new chapter.
HP stock analysis

Hewlett-Packard (NYSE:HPQ) has had a roller coaster ride in the past decade. It is one of the ‘Old Techs’ which has struggled to find a strong foothold with the changing winds in the technology market. A huge part of this blame has to be shouldered by the previous managements who didn’t pursue new developments aggressively. Although it has a long list of major mistakes, the one that stands out the share buyback policy followed by the company.

Currently there are divergent views within the investing world regarding the share buyback usage by HP management. Some of the biggest names like Warren Buffett have favored share buyback as an ideal tool to return excess cash to shareholders. However the opposing school of thought says that the management of a company should pay attention to the products and services offered by them and should not play the part of an investor. Also there have been examples like HP where the share buyback ended up destroying the capital of the company as the purchases were made at high price levels. Besides this, another reason for opposing share buyback is that it allows the top executives to manage the price of the stock. If their own compensation is linked to the stock price it would create a conflict of interest where they are more interested in short term stock increases instead of long term viability and growth of the company.

HP stock price and stock buyback
Figure 1: Stock price movements charted along with the stock buybacks of HP

We can see that most of the buybacks before the financial meltdown of 2008-09 were wrongly timed and were made at high price levels. Similarly from 2010-2012 major stock buyback program was initiated which also coincided with the zenith of the stock price. Since 2004 the company has spent over $44 billion in stock buyback whereas the total market cap of HP went below $25 billion in 2012!! Along with $9 billion which the company paid in dividends from 2004 the total capital invested in this comes to a staggering $53 billion. This capital could have been used for increasing the R&D investments and pursuing other technological breakthrough which would have given the firm a long lasting product pipeline and higher margins.

The company has also made some ludicrous M&A for which it paid heavy amounts and the overall benefits have been marginal at best. The first was the merger of Compaq and HP. It ended up mixing the profitable printing/imaging business with the low margin PC business. Although HP was able to gain the No. 1 spot in PC sales the deal did not help in improving the long term margin for the company. Once IBM (NYSE:IBM) sold its PC division to Lenovo in 2005 the profit margins in this business segment were further squeezed.

Next came the $14 billion acquisition of EDS in 2008. Even this acquisition did not go far enough in giving any sustainable profit margin for HP. EDS was already pinned down by low cost competition and this reduced any future possibility of improving the margins. It was renamed to HP Enterprise Services in September, 2009 and got revenue of $23.52 billion in fiscal 2013 with a non-GAAP operating profit of only $0.68 billion.

The last acquisition surpassed all earlier follies. It acquired British software firm Autonomy for $11 billion. Within a year HP had to write the deal down by an astounding $8.8 billion. Collectively these three acquisitions cost HP over $50 billion!! This has come at the expense of its investments in R&D. It has fallen behind in the R&D investments in comparison to other competitors.

HP and IBM R&D to revenue
Figure 2: Comparison of R&D expense to revenue for IBM and HP.

In this entire saga of one of the biggest Old Tech firms there has been a major twist in the past few weeks. Hewlett-Packard announced plans to split into two companies. One company would handle its PC and printing division and will be called HP. The remaining will take care of its enterprise hardware, software and services business and will be called Hewlett-Packard Enterprise. Although the jury is still out on how this split will work out for HP but there seems to be good strategic benefits in this move. Both the firms will have approximately $58 billion of revenue and it will allow greater freedom for either firm to work on their future plans. This has also been lauded by Wall Street as it will untangle the diverse business divisions and help in correct valuation for both the firms.

The PC sales have bottomed out after falling for the past 3 years and have shown modest growth in the first two quarters. The printing division is a cash cow which has a profit margin in mid-teens. Although it does not have a major growth potential barring a surprise market demand for its 3-D printing, it still brings healthy revenue and cash flow. This would also turn the Hewlett-Packard Enterprise into a smaller version of IBM. Although IBM has been struggling for the past few quarters a smaller, more agile and newly formed company like Hewlett-Packard Enterprise can surely spring a few surprises.

Going forward the company will have to tread carefully and avoid the follies of the past. IBM recently moved out of x86 server business by selling it to Lenovo. This category will surely see heavy competition in the future. Lenovo can upset this market in the way it did with the PC business. Lenovo will have a market share of 10% which gives enough room for growth. In this deal HP is the final loser as it is the market leader with over 25% of market share and over 40% of its operating margin was due to this segment.

Both the divisions, HP and Hewlett-Packard Enterprise, will be having a decent cash flow in the near future. This can be used for increasing the future product pipeline or acquiring small startups which can provide a head start in a particular business segment. It would be ideal if the company does not go for further stock buybacks or heavy dividends which would only lead to squandering the much needed dry powder for future expansion.

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