by Grady Burkett, CFA (Analyst at Morningstar)
Hewlett Packard is in a difficult position. The firm faces increasingly fierce competition across its portfolio as it works through a protracted turnaround of its enterprise services business. We believe that HP has strong enough assets to stabilize its business, but the firm's earnings power and competitive position have deteriorated. We expect HP to manage through its current challenges, but investors should be prepared for occasional setbacks and should temper their expectations for future growth.We separate HP into three distinct groups, each with fundamentally different growth and margin prospects: printers and personal computers, enterprise software and infrastructure, and services. Printers and personal computers, the largest of these segments, accounts for more than 40% of HP's operating income and roughly half of revenue. HP is the leader in both markets, and we believe that the firm will generate substantial cash flow from PCs and printers even as both come under increasing competitive and secular pressures. While neither business benefits from a defensible competitive advantage, printers and PCs remain important to HP's overall success in the traditional enterprise and commercial markets, in our view. HP's large commercial installed base provides the firm incremental opportunities to sell its stickier--and higher-margin--infrastructure products and software tools into the enterprise. More important to HP now, however, is the solid cash generation that we believe printers and PCs can consistently provide over the next several quarters as the firm strengthens its balance sheet.
HP separates its enterprise software and infrastructure businesses into distinct business units, but these businesses naturally fit together. The infrastructure business, which consists primarily of servers, storage arrays, networking equipment and related maintenance services, accounts for more than 40% of the firm's operating income. HP is the industry leader in x86 servers and maintains substantial market share in storage and switches. Customers face reasonably high switching costs when considering a change to their storage and core network infrastructure, and status quo is the default option for these systems. Additionally, HP owns valuable intellectual property utilized in its storage arrays and networking equipment, and we believe that HP earns gross margins above 50% from these products. Server virtualization has lowered customer switching costs substantially for x86-based servers, but we believe that HP still generates economic profits selling x86 servers as a result of the firm's scale, an attractive razor/blade business model for its chassis-based systems, and through related sales of software management tools and maintenance subscriptions.
HP's $4 billion software portfolio is small relative to the firm's overall revenue and operating income. Still, HP holds leading and defensible positions in IT infrastructure management software, security and business analytics, and we believe that the firm's software portfolio increases the stickiness of its enterprise relationships. Combined, HP's enterprise hardware and software businesses account for nearly 50% of the firm's overall operating profit, and we think that this collection of businesses holds a durable competitive advantage and is key to the firm's future success. While cloud computing, a terminal decline in HP's business critical servers, and increasing competitive pressures from traditional hardware vendors will pressure gross margin and revenue growth over the next several years, we think HP can adapt its enterprise product portfolio to effectively negotiate these challenges.
Finally, HP runs a massive services organization as a result of its 2008 acquisition of EDS. This business accounts for 20% of revenue, but will generate little to no operating profit in fiscal 2013 due to mismanagement and increasing competition. IT services firms can possess competitive advantages, depending on portfolio mix, but HP's services business is sprawling and complex and the firm is at a competitive disadvantage versus more focused players, like IBM, Accenture, and best-in-class offshore providers. In addition to competitive pressure, services firms generally face secular headwinds caused by cloud computing. Given these pressures, we believe that HP should sell or spin out its services business in order to alleviate management distractions and eliminate the temptation to over-allocate scarce corporate resources to a turnaround that may never materialize. Were HP to shed its services organization, the firm could once again be viewed as a friendly supplier by the IT service providers who may in turn be more likely to recommend HP's high-margin infrastructure offerings to their clients.
Valuation
We have lowered our fair value estimate to $17 per share from $20, as we have significantly reduced our revenue and operating profit forecasts across HP's businesses.
We expect revenue to fall from $120 billion in fiscal 2012 to $100 billion in 2016. This forecast is based on our expectations for upper-single-digit annualized revenue declines in PCs, printers, and enterprise services; this will be partially offset by low-single-digit growth in enterprise infrastructure and related services and upper-single-digit revenue growth in software.
Assuming our revenue forecast plays out, HP should experience consolidated gross margin improvement despite ongoing pricing pressure across most of its businesses. Software, storage, networking, and related maintenance services should experience moderate growth and we estimate that these categories carry significantly higher gross margins than PCs, x86 servers and enterprise services, which should shrink over time. The net result is a 160-basis-point improvement in consolidated gross margin during the next five years. Still, the higher gross margin products also require significant ongoing investments in product development, sales, and marketing; we expect HP's fixed costs to grow over time despite management's ongoing efforts to rein in costs. The combination of rising operating expenses and declining revenue should lead to operating margin contraction, and we model HP's long-run operating margin to settle in at about 6% in steady-state.
We currently model capital expenditures to remain roughly flat at about $3.5 billion-$3.8 billion per year during the next five years, but we would not be surprised to see capital spending come in lower than our current forecast depending on how aggressive of a restructuring plan management ultimately chooses to pursue. Finally, we model $8.5 billion in acquisitions from fiscal 2013 through fiscal 2016, which shaves about $4 per share from our fair value estimate. While HP's top priority is to fix existing operations and strengthen its balance sheet, we think the company will have to continue to make targeted acquisitions in software, security, networking, and storage in order to remain competitive.
Risk
HP faces material threats in several of its divisions. PCs are undifferentiated, and discount notebooks, virtualization, and a general shift to the cloud from processing and storing data locally threaten to compress already challenged margins. A similar phenomenon is occurring in printing, as single-function devices become commodities. HP has good technology and is pushing into higher-end printers, but a successful transition is not guaranteed. The market for server technologies remains a stronghold for HP, but renewed interest from Cisco, Dell, and even Oracle raises concern. Failure to capture significant share in storage, networking, and servers could leave HP's server business vulnerable.
Management & Stewardship
Meg Whitman was appointed CEO in September 2011, replacing Leo Apotheker after less than a year at helm. As part of the change, Ray Lane has taken on additional responsibility, becoming executive chairman. The new management team brings a focus on operating HP's existing businesses, a sharp reversal from the previous regime's goal of transforming the firm via software acquisitions. Helping with the new strategy, HP enjoys a deep bench of management talent that should be able to keep each of HP's business units on track.
Though we are growing more comfortable with the new regime's strategy, HP has been plagued by poor capital allocation decisions in recent years. Share repurchases averaging nearly $10 billion a year were egregious, considering the firm's balance sheet. The $11 billion Autonomy acquisition cannot be viewed as anything but destructive to shareholder value without some extremely optimistic projections. Furthermore, turmoil at the board level has led from one scandal to the next, creating instability and a lack of accountability for HP's recent performance. We believe the new management team is on the right track, but more evidence that HP is making capital allocation decisions that are to the benefit of shareholders is needed before we change our view on the firm's stewardship practices.
Overview
Financial Health:
HP's financial health has deteriorated in recent years due to unnecessarily aggressive acquisitions and share repurchases. The company's $29.5 billion debt load seems manageable, however, and the firm holds approximately $9.5 billion in cash and equivalents on hand.
Profile:
Hewlett-Packard manufactures and sells information technology products and services to businesses and consumers worldwide. Services accounts for about 20% of revenue, enterprise hardware, software and related services accounts for about 25%, printers and PCs account for 50%, and the remainder comes from financing.
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