Hewlett-Packard and the Mirror of Erised

By Asit Sharma - July 20, 2012 | Tickers: AAPL, DELL, HPQ, IBM, MCD | 0 Comments

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Because of its history and its mammoth, diversified footprint in the technology sector, Hewlett-Packard (NYSE: HPQ) has occupied a soft spot the size of a solar flare in the investing community's heart for quite some time. This week noted short seller Jim Chanos sought to puncture the complacency surrounding HP's prospects, citing, among other problems, the opaqueness of the company's true R&D expense due to acquisitions. CEO Meg Whitman wrote a different narrative in late May when she introduced a multi-year restructuring plan. Which story is closer to the truth? When in doubt over a stock's direction, you can do worse than to start with the balance sheet. To borrow a sage observation from the hardwood: ball don't lie.        

Buying Defensive Interval

HP's restructuring plan will reduce headcount by 27,000 employees, or nearly 8% of its total workforce, by the end of fiscal 2014. Whitman and CFO Catherine Lesjak explained during the HP's Q2 2012 earnings call that the cash generated from the restructuring would be funneled into initiatives spurring innovation and organic growth. To quote Whitman directly: " ...some of the savings will drop to the bottom line, but the majority will be reinvested using a disciplined, data-driven process to prioritize organic opportunities across the business."

The company's claim that it is using the proceeds from its massive layoff for investment in "organic opportunities" is disingenuous. HP simply does not have the resources to continue absorbing both overall sales declines and acquisitions that don't accrete to the bottom line. The cash savings to a considerable extent are already spoken for. The company's balance sheet reveals an anemic current ratio of 1.16 as of Q2 2012, and a debt to equity ratio of 0.72. What it is really doing is buying defensive interval. The defensive interval is a ratio which is simple in concept: divide current assets by average daily operating expenses. The ratio is expressed in days, and answers the following question: for how many days can the current assets at hand pay for the company's daily operating expense? 

Let's crunch HP's recent defensive interval ratio. If we were calculating this ratio from the finance department of HP, we would use real-time numbers. Calculating this ratio based on GAAP financial statements is not quite as fine-tuned, but still produces a reasonable picture of liquidity (and operational health). HP's current assets from its latest balance sheet stand at $49.6 billion. For expenses, we turn to HP's most recent annual income statement (this gives a more accurate view of average expenses than a single quarter). We'll pick up cost of revenues plus general administrative expenses, without regard to noncash items such as depreciation/amortization and interest expense. We won't consider "Other Income / Expense" items, tax obligations, etc.  From the latest annual income statement, we find that expenses totaled $110.5 billion for the year. 

Dividing our expense number of $110.5 billion by 365 days, and dividing current assets by that result, we find that HP's defensive interval ratio expressed as 164 days.

For comparison, I've added in some peers of HP: Apple (NASDAQ: AAPL), Dell (NASDAQ: DELL), and IBM (NYSE: IBM):

At 164 days with which it could conceivably operate off its current assets, HP finds itself lumped together with Dell in playing poor defense. The company has a looming burden that will impair its ability to lengthen out its defensive interval -- its debt. In the last fiscal year, HP inflated its total debt outstanding from $22.3 billion to $30.6 billion -- a prodigious increase of 37%. Part of this debt binge was utilized to acquire Autonomy Software at a 60% premium for $10.3 billion. Initial results for Autonomy have been disappointing.

It should be sobering for HP's management that after so significantly altering its capital structure in 2011, two ratings agencies promptly lowered the company's long-term debt ratings in December of last year. Fitch and Standard & Poors both downgraded HP's long-term debt rating, from A+ to A and A1 to BBB+, respectively. In addition, Moody's changed its credit outlook for HP to negative on October 11, 2011.

Per the debt schedules reported in HP's last annual report (October 31st, 2011), the company has nearly $21 billion of debt coming due in the next three years, inclusive of lease obligations. Its ability to refinance this debt at favorable rates is questionable (and credit ratings downgrades do not assist the endeavor). Margins are declining in nearly every category, and net income for the trailing twelve months ended 4/30/2012 have dropped precipitously, from $9.2 billion trailing at the beginning of the period (April 2011) to $5.2 billion. Add to this picture an ill-advised share repurchase program that has consumed $21.2 billion of cold hard cash over the last two years, with another $10.8 billion authorized at the end of 2011, and the credit agencies' skepticism appears well-justified.

Negative Tangible Book Value

One additional weakness clamors for notice on the balance sheet. HP's book value after subtracting goodwill and intangible assets -- its tangible book value -- is an abysmal negative $13 billion. Acquisitions tend to build goodwill on a company's balance sheet, but in a perfect world, earnings from mergers find their way to the equity portion of the balance sheet, leaving positive book value. When a company overpays for another company, and is stuck with meager or negative returns from the acquired entity, the result is similar to what's happened at HP: tangible equity is drained, leaving a mirage of balance sheet health.

If you include goodwill and intangible assets, HP's book value of $41.7 billion dwarfs many historically well run organizations. Take McDonald's (NYSE: MCD), with a book value of $14.7 Billion. On a gross book value basis is would appear to be much less valuable than HP. Remove goodwill and intangible assets, and the picture is much clearer: McDonald's with a  tangible book value of $11.9 billion, is worth nearly $25 billion more than HP in readily convertible assets over liabilities.

To put $13 billion of negative tangible book value in context, I'd like to direct your attention to some interesting rankings from YCharts. If you're a shareholder and have a heart condition, consider yourself properly warned:  

I'm pained to see a company once so fiscally sound leading all three of these categories in negative value.

Why There Is No Simple Solution

HP is comprised of seven business segments, of which six supply significant revenue to the company. Below is a table of those six (the Corporate Investments segment is excluded), with recent non-GAAP operating margins as reported by HP for Q2 2012: 

It's deceptively easy to look at these margins, examine the total revenues contributed by each group, and prescribe a fix for HP. If you follow news and commentary for the company as I do, there appears to be no end of prescription. Most of the proposals advocate dismantling one group or another; trading out older economy PC manufacturing (i.e. the Personal Systems Group) for cloud and big data opportunities (Software, Services). Unfortunately, the segments themselves are comprised of multiple business units with a surprisingly diversified distribution of revenue. I've taken data for all business units for the first half of HP's 2012 fiscal year, and sorted them in Excel so that you can play armchair quarterback with me:

The problem, and perhaps the opportunity for HP, is that revenues are unevenly distributed when one looks at business units rather than segments alone. The Personal Systems Group may only produce a margin of 5.5%, but Notebooks as a unit trumps all other units in revenue. Of the various units in the Personal Systems Group, Notebooks probably makes the most sense to keep -- perhaps the other units in this segment could be wound down or spun off. Software enjoys a lofty margin of 17.7%, yet its revenue is meager compared to other units. To articulate this differently, there are parts of every HP segment that are worth keeping. This complicates a scenario in which HP spins off an entire segment. Willing buyers of any HP segment will discount the spin-off if valuable units are retained by HP. Whitman, a pragmatist who previously ran a company that was able to grow organically, may be attempting to escape the claws of this conundrum by sharpening up each segment's profits while choosing which units to put out of their misery.

The Mirror

Harry Potter fans will recall a poignant scene from Harry Potter and the Sorcerer's Stone. In this book, the orphaned wizard steps in front of a magical mirror and sees himself surrounded by his murdered parents and other departed family members, all smiling warmly back at him. The Mirror of Erised reflects the deepest desire of one's heart ("Erised" is "desire" spelled backwards). HP's deepest desire is to experience organic growth through innovation once again. When it looks in the mirror of Erised, it sees a rejuvenated company plowing profits and cash into growth opportunities, utterly dominating tech industry segments as of days gone by. This is a worthy future vision or aspiration. But without first ensuring the long-term viability of this tottering behemoth, allocating billions to innovation will be as effective as the squandered billions spent on acquisitions and share buybacks during the last decade. Sometimes the hardest person to be truthful to is yourself. For the present, HP must pass by a rather mundane full-length wardrobe every morning, and check its current reflection, warts and all. 

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