There is no shortage of the amount of prose written eulogizing the valuation of HP stock (HPQ). To be sure, the stock is trading at an attractive valuation. A P/E ratio just about 8.6, and a price to book of 1.23 for a large cap stock definitely makes you stop and take a look. Given the amount of corporate upheavals the company has recently gone through, a low stock price is not a surprise. The question is, whether the stock is a good buy at this time or not.
A Change in Business Strategy?
HP built its reputation on the “HP-Way” with focus on employees and a commitment to build products to improve humanity. This was reflected in the engineering and R&D oriented culture at HP for a long time and helped HP innovate and stay ahead of the technological trends. However, in recent times, this focus on R&D has faded, with HP scrambling to play catch up to its competition through acquisitions. Consider HP’s R&D expenditure: HP spent close to 6% of its revenues on R&D in 2002. in 2011, R&D expenditure was down to 2.5%.
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In recent times Hewlett Packard has sought to remake itself in the mould of IBM by adding complementary services and building up capabilities in the areas that it lacked. It bought out Autonomy last year for $10.3 Billion so it can compete in the Cloud computing and business analytic services, along with Amazon and IBM. Its acquisition of EDS for $14 B in 2008 is still fresh when HP tried to bulk up its software services business. With acquisition of 3Com, HP tried to position itself in the networking segment. Its PC business and even its bread and butter printer/ink business has suffered in recent times and HP has actually lost market share in virtually all the segments that it competes in. The top level management turnover has not helped stabilize the situation either.
Instead of building on its strengths, HP has tried to increase its heft through acquisitions.
The Balance Sheet is a Mess
I will be candid here and call a spade a spade. Of the total assets of $126.6 B, a full 43% ($54.6 B) is goodwill and intangibles, which gives HP a negative Tangible Book Value of ($15.5 B). True that Business Week finds HP as the 11th most valuable brand in the world, and certainly that has value. However, goodwill in the amount of $44.6 B represents the premium HP shelled out during its various acquisitions. The end result of all these “competence building” acquisition? A declining market share in all its business units as reported for Q1 2012.
The fallacy of looking at the Price to Book ratio becomes clear in HP’s case. A P/B of 1.2 maybe attractive for a large cap but a negative tangible book value torpedoes any balance sheet based valuation argument, especially, as I argue below, with a moat that is getting skinnier by the day.
Price to earnings multiple is low but a declining top line and bottom line does not engender much confidence that an improvement in this multiple may actually be due to increased value of the business.
It Used to Have a Moat
The point is that with the reduced R&D focus, and emphasis on growing its top line by getting into low margin businesses in the past, HP has let its “moat” erode. The moat was built around innovation, quality and superior engineering, which has been replaced with cookie cutter products and chasing existing markets with entrenched competition. HP also became overly reliant on its printer/ink business and lost its focus on continuous innovation. This moat erosion is plain to see in the reduced margins in the recent years (2002 gross margin = 30%, 2011 gross margin = 26%). The company is trying to work its way into a higher margin cloud competing business but as a late entrant to this market, it is unlikely to enjoy the same penetration and margins as the incumbents.
Can the Current Management Turn it Around?
Carly Fiorina was a disaster. Other CEOs in the interim failed to arrest the decline. Can Meg Whitman succeed in returning HP to its former position in the market? This is the big question.
My personal opinion is that Meg will prove that she is not the transformational leader that HP needs at this time. Some one like Lou Gerstner at IBM or Jobs at Apple. HP needs to return to its core and Meg is really an outsider, both to HP and also to a tech company with significant hardware based revenues. Unless a clear vision and strategy is articulated, I expect the stock to remain at its current level of valuation.
In other words, while HP maybe on the cusp of mounting a great turnaround, there is little evidence of it actually in progress. One can buy HPQ stock based on hope and promise, but with other better valued stocks one can buy, why bother?