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Is Apotheker destroying HP?
Nine months back, B&E had questioned whether Leo Apotheker was the right choice to fill hurd’s shoes at HP (Article Titled, “Wrong person. Wrong place?”). With his recent announcement to restructure HP’s healthy business, the questions are back. Will his bet pay off; or is it a fatal move for HP?
Issue Date - 19/01/2012
A week before former SAP CEO Leo Apotheker was set to assume the corner office at HP’s Palo Alto headquarters (on November 1, 2010), B&E had put forward two forecasts for HP. First, was an adoption of inorganic means to grow in the enterprise space. [Claim #1: “What is inevitable, is that HP under Apotheker will join the battle to capture the enterprise space from the likes of Oracle and IBM. This would call for an expensive acquisition.”] Second, was a tamper with HP’s old order – the hardware business. [Claim #2: “He (Apotheker) has options. The most irresistible one will be not to tamper with HP’s pride – its hardware business – which he will.”] Both became reality on August 16, 2011, when HP announced the purchase of LSE-listed software-maker & cloud-search specialist Autonomy for $11.69 billion and decided to spin-off (and put on sale over the next 12 months) its $40.74 billion-a-year topline earning Personal Systems Group (PSG unit that includes hardware – PCs, tablets & mobility devices).

Many claim that such a prediction would have been easy. Not so. Even as recently as April 2011, Apotheker was heard singing hymns about HP’s webOS and how it would make up for the core OS on all HP PCs shipped post-2012. In fact, it was only on July 1, 2011, that HP’s tablet – the TouchPad – was launched. The company’s announcement to therefore acquire Autonomy and pull the shutters on hardware is a sign that Apotheker was undecided until the first week of August 2011, whether or not he was to adopt enterprise software & services as the sole breadwinner for HP. Now that he has made a public appearance on the subject, question is – will this decision work in favour of HP?

The thoroughly flummoxed stock market thinks otherwise. In the trading session that followed this announcement, the company’s m-cap shrunk by $16 billion – the single-largest fall in a day since the Black Monday crash of 1987 (taking the tally of HP’s value destroyed by Apotheker to $47.52 billion in 10 months; under him HP’s m-cap as on August 29, 2011 had fallen by 47.47% to $51.48 billion). Frankly, the bourses have it rightly calculated. There are reasons.

Forget the risks. Even at face value, the Autonomy purchase is an expensive one. What logic explains the pricing of an entity, whose current revenue equals 1% of your expected annual topline? Even if paying a 75% premium over Autonomy’s closing price on August 15, 2011, is not an indication of the deal being overvalued, then a valuation in excess of 64x of Autonomy’s current P/E and 16x its forward revenue (for FY2011) surely is.

The purchase does carry an upside in the sense that it could provide exposure to HP’s enterprise software business (which currently contributes to 46.51% of its topline; FY2010), as well as a push into the analytics arena. But the opportunity cost renders the deal unappealing. What the Autonomy buy has in store for HP is better understood in the light of revenues that will be lost due to the coupling of this inorganic strategy with the hardware unit sell-off. Competition has lowered profits in the hardware business, but “brave” is the only adjective to describe the sacrifice of a business, where HP is currently the indisputed leader. Financially therefore, it is difficult to imagine a future without the PSG division starting FY2012. The revenues lost? A $73.64 billion sacrifice at the altar of the enterprise software and services gods between just the two years FY2012-FY2013. Not to say that the hardware unit is not faced with greater competitiveness by the day, but to jettison it in a single shot is absurd. What makes us believe that HP’s most recent shot at restructuring (and Apotheker’s attempt to win over his shareholders) is more about hype than hope? Read the numbers.

Post sell-off of the PSG unit, the company stands to lose $400.74 billion in expected revenue earnings over the next 20 years (arrived at using a binomial regression forecast model; R2=0.99; Eq. y = -37.75x2 - 1395x + 42154). In stark contrast, the complimenting move of buying Autonomy – will end up adding $49.03 billion to HP’s topline over the same period. Translation: a loss of more than $350 billion over the next two decades! This comparison especially assumes importance considering the valuation of HP’s hardware business. Based on a review of PC focused peers (Lenovo, Dell, Acer and Asus), HP’s PSG segment could warrant a valuation of 0.3x EV/Sales (or 4.8x EV/EBITDA) multiple, which would put the pure enterprise value of the business at roughly $12 billion – the amount that is being spent on Autonomy to save its service dream. A bad bargain.

The restructuring also brings to surface the inability of HP to keep its head above the water in a world of devices where convergence is the magic word. The company has made clear its intentions to wash its hands off webOS devices. The HP management has confessed that it lacks the innovation and the execution to become an Apple in any decade soon. Come Q4, 2011, and webOS will live no more. The webOS write-off will further put pressure on HP’s cost base.

Many debate that a move away from hardware will help HP’s operating margin (OM). True. But only in percentage terms. If we consider total revenue synergy of $320 million due to the acquisition, HP’s OM will improve from the currently estimated 10.5% to 13.1% in FY2012. But this would be missing the woods for the trees. Besides losing the crown of being the #1 revenue-generating IT company in the world (to IBM), its operating profits will show a decline of $1.46 billion (to $11.68 billion, given the decline in revenue base due to the PSG unit sell-off). What HP is trying at the moment is to become IBM, whose OM stands at a high 20.02%. But given the current economic scenario, when a diversified model is considered the need of the hour given the macroeconomic uncertainties, HP is doing wrong by putting its profitable hardware unit for sale and moving solely to services. Says NY-based Goldman Sachs Analyst Christina Colon to B&E, “The separation of the PSG division from HP comes with risks. A spin-off and sell-out may bring some operational challenges that may not be immediately obvious.” Truth is: at present, HP’s OM is more than double of the industry (diversified computer systems business model) standard, which stands at a 5.12% (source: Capital IQ). HP’s present business model is therefore strong.

What is most surprising about the consumer business spin-off is that it happens at a time when HP’s Enterprise businesses are not having a smooth run. As Vlad Rom, Analyst at Credit Suisse, while talking to B&E from Manhattan, says, “The most pressing concerns, are that of Services margins taking another step down, and the enterprise business being affected by a deteriorating macro outlook. We are lowering EPS estimates for FY2011 & FY2012 respectively. It appears that the transformation in Services will take some time with margins declining further in the near term.” At present, HP is being hit by a range of secular issues facing the business compounded by chances of a macroeconomic downturn. The overall results and near-term outlook from both Goldman and S&P have confirmed the rapid slowing in the Services & Enterprise Server, Storage and Networking (ESSN) units that account for 95.34% of its Enterprise revenues.


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