Hewlett
Packard is in a difficult position. The firm faces increasingly fierce
competition across its portfolio as it works through a protracted
turnaround of its enterprise services business. We believe that HP has
strong enough assets to stabilize its business, but the firm's earnings
power and competitive position have deteriorated. We expect HP to manage
through its current challenges, but investors should be prepared for
occasional setbacks and should temper their expectations for future
growth.
We separate HP into three distinct groups, each with fundamentally
different growth and margin prospects: printers and personal computers,
enterprise software and infrastructure, and services. Printers and
personal computers, the largest of these segments, accounts for more
than 40% of HP's operating income and roughly half of revenue. HP is the
leader in both markets, and we believe that the firm will generate
substantial cash flow from PCs and printers even as both come under
increasing competitive and secular pressures. While neither business
benefits from a defensible competitive advantage, printers and PCs
remain important to HP's overall success in the traditional enterprise
and commercial markets, in our view. HP's large commercial installed
base provides the firm incremental opportunities to sell its
stickier--and higher-margin--infrastructure products and software tools
into the enterprise. More important to HP now, however, is the solid
cash generation that we believe printers and PCs can consistently
provide over the next several quarters as the firm strengthens its
balance sheet.
HP separates its enterprise software and infrastructure businesses
into distinct business units, but these businesses naturally fit
together. The infrastructure business, which consists primarily of
servers, storage arrays, networking equipment and related maintenance
services, accounts for more than 40% of the firm's operating income. HP
is the industry leader in x86 servers and maintains substantial market
share in storage and switches. Customers face reasonably high switching
costs when considering a change to their storage and core network
infrastructure, and status quo is the default option for these systems.
Additionally, HP owns valuable intellectual property utilized in its
storage arrays and networking equipment, and we believe that HP earns
gross margins above 50% from these products. Server virtualization has
lowered customer switching costs substantially for x86-based servers,
but we believe that HP still generates economic profits selling x86
servers as a result of the firm's scale, an attractive razor/blade
business model for its chassis-based systems, and through related sales
of software management tools and maintenance subscriptions.
HP's $4 billion software portfolio is small relative to the firm's
overall revenue and operating income. Still, HP holds leading and
defensible positions in IT infrastructure management software, security
and business analytics, and we believe that the firm's software
portfolio increases the stickiness of its enterprise relationships.
Combined, HP's enterprise hardware and software businesses account for
nearly 50% of the firm's overall operating profit, and we think that
this collection of businesses holds a durable competitive advantage and
is key to the firm's future success. While cloud computing, a terminal
decline in HP's business critical servers, and increasing competitive
pressures from traditional hardware vendors will pressure gross margin
and revenue growth over the next several years, we think HP can adapt
its enterprise product portfolio to effectively negotiate these
challenges.
Finally, HP runs a massive services organization as a result of its
2008 acquisition of EDS. This business accounts for 20% of revenue, but
will generate little to no operating profit in fiscal 2013 due to
mismanagement and increasing competition. IT services firms can possess
competitive advantages, depending on portfolio mix, but HP's services
business is sprawling and complex and the firm is at a competitive
disadvantage versus more focused players, like IBM, Accenture, and
best-in-class offshore providers. In addition to competitive pressure,
services firms generally face secular headwinds caused by cloud
computing. Given these pressures, we believe that HP should sell or spin
out its services business in order to alleviate management distractions
and eliminate the temptation to over-allocate scarce corporate
resources to a turnaround that may never materialize. Were HP to shed
its services organization, the firm could once again be viewed as a
friendly supplier by the IT service providers who may in turn be more
likely to recommend HP's high-margin infrastructure offerings to their
clients.
We
have lowered our fair value estimate to $17 per share from $20, as we
have significantly reduced our revenue and operating profit forecasts
across HP's businesses.
We expect revenue to fall from $120 billion in fiscal 2012 to $100
billion in 2016. This forecast is based on our expectations for
upper-single-digit annualized revenue declines in PCs, printers, and
enterprise services; this will be partially offset by low-single-digit
growth in enterprise infrastructure and related services and
upper-single-digit revenue growth in software.
Assuming our revenue forecast plays out, HP should experience
consolidated gross margin improvement despite ongoing pricing pressure
across most of its businesses. Software, storage, networking, and
related maintenance services should experience moderate growth and we
estimate that these categories carry significantly higher gross margins
than PCs, x86 servers and enterprise services, which should shrink over
time. The net result is a 160-basis-point improvement in consolidated
gross margin during the next five years. Still, the higher gross margin
products also require significant ongoing investments in product
development, sales, and marketing; we expect HP's fixed costs to grow
over time despite management's ongoing efforts to rein in costs. The
combination of rising operating expenses and declining revenue should
lead to operating margin contraction, and we model HP's long-run
operating margin to settle in at about 6% in steady-state.
We currently model capital expenditures to remain roughly flat at
about $3.5 billion-$3.8 billion per year during the next five years, but
we would not be surprised to see capital spending come in lower than
our current forecast depending on how aggressive of a restructuring plan
management ultimately chooses to pursue. Finally, we model $8.5 billion
in acquisitions from fiscal 2013 through fiscal 2016, which shaves
about $4 per share from our fair value estimate. While HP's top priority
is to fix existing operations and strengthen its balance sheet, we
think the company will have to continue to make targeted acquisitions in
software, security, networking, and storage in order to remain
competitive.
HP
faces material threats in several of its divisions. PCs are
undifferentiated, and discount notebooks, virtualization, and a general
shift to the cloud from processing and storing data locally threaten to
compress already challenged margins. A similar phenomenon is occurring
in printing, as single-function devices become commodities. HP has good
technology and is pushing into higher-end printers, but a successful
transition is not guaranteed. The market for server technologies remains
a stronghold for HP, but renewed interest from Cisco, Dell, and even
Oracle raises concern. Failure to capture significant share in storage,
networking, and servers could leave HP's server business vulnerable.
Management & Stewardship
Meg
Whitman was appointed CEO in September 2011, replacing Leo Apotheker
after less than a year at helm. As part of the change, Ray Lane has
taken on additional responsibility, becoming executive chairman. The new
management team brings a focus on operating HP's existing businesses, a
sharp reversal from the previous regime's goal of transforming the firm
via software acquisitions. Helping with the new strategy, HP enjoys a
deep bench of management talent that should be able to keep each of HP's
business units on track.
Though we are growing more comfortable with the new regime's
strategy, HP has been plagued by poor capital allocation decisions in
recent years. Share repurchases averaging nearly $10 billion a year were
egregious, considering the firm's balance sheet. The $11 billion
Autonomy acquisition cannot be viewed as anything but destructive to
shareholder value without some extremely optimistic projections.
Furthermore, turmoil at the board level has led from one scandal to the
next, creating instability and a lack of accountability for HP's recent
performance. We believe the new management team is on the right track,
but more evidence that HP is making capital allocation decisions that
are to the benefit of shareholders is needed before we change our view
on the firm's stewardship practices.
Overview
HP's
financial health has deteriorated in recent years due
to unnecessarily aggressive acquisitions and share repurchases. The
company's $29.5 billion debt load seems manageable, however, and the
firm holds approximately $9.5 billion in cash and equivalents on hand.
Profile:
Hewlett-Packard
manufactures and sells information technology products and services to
businesses and consumers worldwide. Services accounts for about 20% of
revenue, enterprise hardware, software and related services accounts for
about 25%, printers and PCs account for 50%, and the remainder comes
from financing.
No comments:
Post a Comment