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Transform, More Like Deform

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Business transformation strategies look great on paper, but results often come up short when applied to the real world.  The two major U.S. computer manufacturers, Hewlett-Packard (NYSE: HPQ) and Dell (NASDAQ: DELL), have been trying to change and diversify into high-margin services businesses for a number of years, as their core businesses mature and foreign competition intensifies.  The desire to speed the process often results in overpaying for businesses or overlooking warning signs, as evidenced by HP’s recent disclosure of an $8.8 billion goodwill write-down from their 2011 purchase of Autonomy.

An Uphill Climb

Despite a high level of acquisition activity, HP’s revenues only grew by 1.7% over the past four fiscal years, and adjusted operating income fell 5.5% during the time period.  The company has not been able to overcome weakness in the computer and printer businesses, which still composes roughly 49% of HP’s revenues.  In the latest fiscal year, HP reported revenues and adjusted operating income of $120.4 billion and $11.1 billion, decreases of 5.4% and 19.0%, respectively, over the prior year period.  Increases in the company’s software business were offset by declines in sales of notebook and desktop computers, as well as weak outsourcing services revenues.  While gross margins were flat versus the prior year period, adjusted operating margins declined to their lowest level of the past five years as the higher administrative and professional costs of the company’s services businesses have not been met with corresponding business growth.  HP continues to generate substantial operating cash flows, $10.6 billion in FY2012, but investors have questioned management’s decisions, with its stock market value down by over 50% in the past twelve months.

Meanwhile, Dell has pursued a similar growth strategy, with overall disappointing results.  The company has likewise moved into the services and software segments, including billion dollar purchases of Perot Systems in 2009 and Quest Software in 2012.  However, revenues only grew 1.5% over the past four fiscal years, as roughly 54% of the Dell’s revenues are still tied to the underperforming personal computing segment.  In its latest fiscal year, the company reported revenues and adjusted operating income of $62.1 billion and $5.1 billion, increases of 0.9% and 23.8%, respectively, over the prior year period.  Gross and operating margins increased versus the prior period, as high margin enterprise server sales and outsourcing services growth offset weakness in the core personal computing market.  In 2013, results have continued to be disappointing, as notebook and desktop sales have suffered from declining volumes and generally lower prices.  For the six months ended July 2012, Dell reported revenues and adjusted operating income of $28.9 billion and $2.1 billion, decreases of 5.8% and 21.1%, respectively, over the prior year period.  Clearly, Dell is still a work in process.

Follow the Leader

Where should investors go to find long term returns in the IT services market?  They should look no further than IBM (NYSE: IBM), the industry leader.  The company is the result of an internal transformation that was initiated in the 90's under former CEO Lou Gerstner and his successor Sam Palmisano.  IBM wisely shed its hardware business long ago, and it is now a provider of IT infrastructure, business process outsourcing, and consulting services in 170 countries worldwide.

While IBM has engaged in acquisitions, such as the billion dollar purchases of Netezza and Sterling Commerce in 2010, its purchases complement existing businesses rather than trying to transform the company.  During its latest fiscal year, IBM reported revenues and adjusted operating income of $106.9 billion and $21.6 billion, increases of 7.1% and 8.8%, respectively, over the prior year period.  The company reported revenue increases across its business groups and benefited from its geographic reach, with double digit growth in China, India, and Russia.  In addition, operating margins were higher versus the prior year, as the company targeted higher margin business segments, including business analytics and cloud computing.

In 2012, IBM has continued to generate solid results despite economic challenges in many of its markets.  Through the first nine months of the year, the company reported a decline in revenues of 2.9% to $75.0 billion, while adjusted operating income increased 6.1% to $15.1 billion.  Despite the uncertain operating environment, it generated operating cash flows of $13.2 billion, which it is using to invest in R&D and reduce outstanding shares.  These actions will likely increase shareholder value in the future and make the company a core holding for investors.

rghanley has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines. Motley Fool newsletter services recommend Dell and International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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