Aug

22

Anger and frustration are the two emotions pulsing through my veins as I write this. HP, once the symbol of innovation, is being dismantled by its high-pedigreed board and the CEO of the hour (I truly hope his tenure will be measured in hours, not years). I vividly remember the early 2000s, when Carly Fiorina, then CEO of HP, engineered the HP merger with Compaq. She argued that the merger was a must for HP's future to be bright. Walter Hewlett, the son of one of the founders, was publicly opposed to it, and I remember the drama of the proxy fight, the TV interviews and arguments from both sides, and the finale -– Walter Hewlett lost and the merger went through. But it was not the finale, because nine years and two CEOs later HP has announced that the PC business, the one it so desperately wanted just a decade ago, is too hard a business and that it will look for ways to get rid of it. Almost in the same breath HP announced that it will kill WebOS devices, a business it acquired in April 2010 for $1 billion; and management, possibly missing the irony in those two announcements, went ahead and announced another acquisition, which this time will for sure transform the company.

HP will buy Autonomy, a UK software company, for $10 billion. I understand $10 billion doesn't sound like a lot of money in today's post-trillion-dollar-bailout world, but it is plenty for HP, especially considering what that money bought. There are many ways to illustrate how expensive and meaningless to HP's future this acquisition is: $10 billion is about a fifth of HP's market capitalization, while Autonomous will contribute 0.7% to HP's revenues, and 2.7% to its earnings; and HP paid 10x revenues and about 25 times earnings.

Leo Apotheker, HP's CEO, bragged about Autonomy:

"Autonomy has grown its revenues at a compound annual growth rate of approximately 55% and adjusted operating profit at a rate of approximately 83% over the last 5 years."

Keith Backman, a sell-side analyst from BMO Capital, asked a very pertinent question about Autonomy:

"… metrics that you threw out for Autonomy, particularly on top-line growth, included a lot of acquisitions for Autonomy. What's the organic growth rate that Autonomy has achieved lately?"

Leo did not have an answer, whereupon HP's stock started to drop. HP had reported an OK quarter, expectations were already low (its stock was at about 6x times 2011 estimates, which remain intact), and Dell had already lowered guidance a day before; so no one was surprised when HP lowered its revenue guidance for 2011 by a few percentage points. Management said that since it will pay for Autonomy from cash on the balance sheet, it will not be buying much of its stock in the near future, and then they mentioned that this acquisition will be accretive. Yes, accretive! Nothing to worry about. This transaction is accretive only for illiterates in economics and those short on common sense.

HP is using cash on the balance sheet to pay for this transaction, and thanks to the Federal Reserve this cash yields zero and thus brings zero income. As long as Autonomy's income is greater than zero (I am oversimplifying a little) then it will be accretive (at least on a cash basis). However, this assumes that HP's cost of capital is equal to the return it receives on its cash. Which is not the case, as that would ignore such minor details as the time value of money, inflation, the risk premium (after all, unlike the US government, HP cannot print money and doesn't have nuclear weapons) and, simply, opportunity cost.

Any investment HP makes today should be compared against an opportunity set that includes its own stock, which at 6x times earnings results in about a 16% yield (cost of capital). In fact, if HP used $10 billion to buy its own stock, its earnings per share and dividend would jump by 16%. Autonomy will not be able to match this return, by a long mile.

I don't need to have a great imagination to envision another conference call in August 2015, where a new CEO decides that the software business is too difficult, and HP needs to come back to its roots (maybe going back to making calculators) and will spin off the software business into a new company, take an enormous charge, and then maybe announce an acquisition that the same highly pedigreed board will rubber-stamp.

HP's valuation has not changed that much – the PC business only represents about 16% of operating profit, so even if HP gives it away, earnings power will not decline greatly. HP should still be able to get a decent price for it, as there has got to be a Chinese company out there swimming in US dollars that wants to put them to work before they become worthless. HP's core businesses, will be slightly impacted by the global economic weakness, but the company should maintain its earnings power largely intact. Autonomy reduced HP's value by about $3; but with my lack of confidence in management, I'd not buy HP at a P/E higher than 10, which would bring the stock to the mid to high 40s.

 HP's stock sold off not because the company disappointed Wall Street but because Wall Street grew tired of the overpriced "must-have" acquisitions. Wall Street has smartened up and assumed that this acquisition, as with many other "transformative" acquisitions, will do nothing of the sort. And so, today we are faced with a decision: buy, hold, or sell. At 4.6 times earnings HP is not a sell; but considering that the company is still trying to figure out what it wants to be when it grows up, it is hard to add to our holdings of the stock; so unfortunately this company has turned into a hold.

Stefan Jovanovich writes: 

There is another perspective. HP, like National Semi and so many of the other "original" Silicon Valley companies, was - at heart - a defense contractor. Its instruments were sold to and used by other defense contractors; and the HP Way was dependent on the steady stream of direct and indirect payments from Washington. The HP Cringely knew began to die when the Berlin Wall came down. What is interesting is that this was the same time when new generation of "tech" companies started up that had no experience with government Purchase Orders and purchasing requirements. The question to be asked is how far has Microsoft gone down the road towards being the next HP, only this time the graphics being generated come not from oscilloscopes but from Power Point, etc. One of the many reasons to admire the MRD ("mad" Russian duo) is that, given a choice between competing with MSFT and AAPL, they chose AAPL, even though "everybody knows" that was the wrong decision. Of course, you want to have governments and corporations with large headcounts as your primary customer base.


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