No Kodak Moment for Hewlett-Packard

Investment mistakes usually fall into one of three categories: analysis, behavior or bad luck. In October 2011, after the shares of Hewlett-Packard Co. had been halved from about $48 earlier that year, I made a case for the stock. That was a mistake. There was no bad luck. I made several errors in my analysis. In this column I want to drill down into my mistakes and provide a new analysis of what is still an attractive investment.

In 2011 I got three things wrong about HP: printers, services and culture. To better understand the company, it’s helpful to use an analytical framework based on two companies in different time periods: computer maker IBM Corp.circa 1993 and film giant Eastman Kodak Co. since 2006.

Kodak was responsible for pioneering work in digital photography as early as the 1970s. In the ’90s, when digital photography was introduced commercially, Kodak’s 35mm film sales at first continued to grow, as digital cameras were an expensive novelty. But as digital cameras got better and cheaper, and thus more popular, sales of 35mm film started to decline. If you were a value investor analyzing Kodak, the stock would have appeared cheap on past earnings. And if you assumed that Kodak’s cash flows would gradually decline years into the future, you’d have been dead wrong. Kodak turned into the value trap of all value traps. Once digital cameras went mainstream, Kodak’s sales went off a steep cliff, falling from $13 billion in 2006 to $5 billion today. Cameras are replaced every few years, and the cost savings from not buying expensive film any longer were substantial. Also, the new digital cameras were simpler, and the learning curve was not steep.

I challenge you to find a single roll of 35mm film at your local grocery or drugstore. You might look on the same shelf that has the eight-track tapes and vinyl records. There is absolutely no reason for 35mm film to exist in the digital world.

If the HP of today is Kodak in 2006, then value investors like me who dare to discount its future cash flows (even if they are declining) are fools. But I’ll argue that for the most part, with the exception of a few of its businesses, HP is IBM in 1993, not Kodak in 2006.

In 1993, IBM was in trouble. Its stock was trading in the low teens, down from the high of nearly $44 hit in 1987. Its bread-and-butter high-margin mainframes were being attacked by cheaper Japanese competitors Hitachi and Fujitsu. Mainframe sales were down almost 30 percent in 1993. Though mainframe sales were only about 20 percent of total sales, they were the core of IBM’s business; they drove revenues for maintenance, software and services. If mainframe sales disappeared, so would the bulk of IBM’s other revenue.

Cheaper and better products from direct competitors were only part of the problem. The computing landscape was drastically changing, as PCs powered by Wintel (Microsoft Corp.’s Windows software and Intel Corp.’s chips) threatened mainframe dominance. Suddenly, a much smaller and cheaper box that did not require a forklift to install and a clean room to live in was replacing a lot of mainframe functionality. IBM came out with what many believed to be a superior product to Wintel PCs — the Power­PC, with its own processor and operating system, OS/2— but the company was still losing the PC war.

The media were very negative on IBM, and rightly so. A Fortune article from the period had this to say: “IBM’s difficulties include overdependence on high-margin mainframes, when computing power has become a desktop commodity; .. . emphasis on hardware, when software and services are ever more important; and an inability to get quickly to market with the new machines that periodically remake the industry.”

Ironically, a Fortune piece in May 1994 described how HP was “positively thriving” at the expense of IBM: “Over the past decade, HP has quadrupled in size, created $10 billion in shareholder value, and transformed itself from an also-ran No. 7 among U.S. computer makers to a strong and profitable No. 2. It eclipsed DEC [Digital Equipment Corp.] last year.”

This is my favorite part: “No one thinks HP will succumb to the malaise that got its rivals. While IBM has long stood for mainframe computers and DEC for minis, the products with which HP is synonymous — pocket calculators and computer printers — are in little danger of becoming obsolete.”

As the media were writing IBM’s obituary, IBM stock must have been a dream for short-sellers, especially if they shorted it in the $20s, $30s or $40s. Considering the articles mentioned above, I can imagine how easy it was to make the case that IBM, which at the time had more than $20 billion of net debt and 300,000 people working for it, would go to zero.

But in 1993, IBM did the unthinkable: It hired a former McKinsey & Co.consultant whose last gig had been running a food and tobacco company, RJR Nabisco, who knew nothing about technology. One of the first and most important decisions Louis Gerstner had to make was whether to follow through with a breakup of the company or keep it together. Previous management had already set a plan in motion to break IBM into several pieces, and consultants were already working on naming the divisions to be spun off.

If this story sounds eerily familiar, it should: HP — yes, the company that was in “little danger of becoming obsolete” — is going through similar pains today.

Not unlike Gerstner, HP CEO Meg Whitman inherited a significant decision about whether to break up her company’s largest division, PCs, or keep it. Wall Street loves to hate ex-consultants (they probably hate them in advance, as consultants are bound at some point to turn into politicians). Just as Gerstner was ex-McKinsey, Whitman was ex-Bain & Co.. Predictably, the pundits criticized her for being an ex-consultant and lacking relevant experience.

This brings me to the first mistake I made: culture. Similarly to HP today, in the early ’90s, IBM was riding the coattails of its past success and saddled with a dysfunctional corporate culture in which the individual divisions were engaged in constant turf wars with one another. IBM was slow and bureaucratic. Its human resources systems were antiquated and inflexible — if employees wanted to transfer from one division to another, they had to be fired and rehired.

In the case of HP, I underestimated how much its culture had been gutted by its past few CEOs. I apologize in advance for using this analogy, but HP reminds me of a talented kid whose parents passed away, who then went through several abusive foster parents. The good news is, the kid has finally found a great and caring guardian, but the question is, how irreparable is the damage done by the previous foster parents?

HP employees have been demoralized by cost cuts and acquisition integration.Endless layoffs haven’t helped morale. But HP was inefficient; it had too many people working for it. The layoffs will eventually end. IBM went through layoffs too: By 1994, Gerstner had reduced IBM’s workforce to 219,000. As I have written before, HP needs a good parent, not a visionary. Whitman is just that. Like Gerst­ner, she is trying to gradually change the corporate culture. She moved all executives from corner offices into cubicles; she sits in a cubicle too.

Whitman took a page out of Steve Jobs’s playbook and is trying to refocus the company on fewer products. For instance, HP made a mind-boggling 2,100 types of laser printer in 2012. Whitman will cut that number in half by the end of this year and probably even more in the future. HP needs a lot more focusing.

(A side note: When I wrote my first article on HP in October 2011, I tried to buy a new PC from the company’s website. The website was a mess, offering too many choices, and after 20 minutes I gave up and bought a PC from Dell.Recently, I was looking for a computer for my father, and HP’s website had been simplified and become easy to use.)

Historically, HP’s PC and printer businesses had different sales forces despite sharing the same customer base; Whitman is combining them. The company also favored investing in external research and development through expensive acquisitions that destroyed an enormous amount of value. Whitman is reversing this. She is putting more money into R&D and has largely ruled out acquisitions for the foreseeable future.

It is clear now that the company that was the founding father of Silicon Valley was turned by its three previous CEOs into a sorry empire of dozens of misguided and misintegrated acquisitions, which could barely function as one unit. Being large has its advantages, and one of them is buying power, but HP did not capitalize on this. For example, there are 1,500 HP decision makers around the world buying media. Whitman is fixing that too.

My second analytical mistake was to underestimate the problems in HP’s printer business, which will significantly decline over the next five years. The bulk of the decline will not occur in business printers and supplies (laser printer toner) but in consumer printers and, more important, consumer ink. Business demand for printing has not dramatically changed over the past five years. You see it in Xerox Corp.’s numbers: Black-and-white is declining a few percentage points a year, while color is offsetting it with mid-single-digit growth.Computer and tablet screens strain our eyes, so printing and reading on paper, though archaic, is a habit that will take a long time to die. Also, when we print at work, our employer is paying for the ink and paper, and because we are spending someone else’s money, there is little motivation to change our antiquated and costly habit.

The consumer printer business will die at a much faster rate. Consumers have used ink-jet printers for kids’ homework and photos. Though kids still print homework (at least for now), with tablets, cell phones and Facebook, photo printing is on a dramatic decline.

HP’s consumer printer business model was simple: The company sold ink-jet printers at a very small profit (or maybe a loss) but made a killing by charging high prices for ink. It was a great business, but the previous management milked the ink cow too hard — they raised prices for ink to the point of destroying already-fickle demand. The current management has been slowly rectifying this in emerging markets, where HP has raised prices for ink-jet printers but lowered prices for ink and toner, but it cannot reverse the trend. HP doesn’t disclose it, but by my estimate, ink for consumer printers is two thirds of HP’s printer-supply business, and it is on the way to meeting its maker, fast.

HP’s consumer printer business looks just like Kodak’s 35mm business, and its rate of decline is likely to accelerate significantly in coming years. In my latest analysis I shrink consumer printing profitability by two thirds in three years — but more on that later.

My third mistake had to do with services. The bulk of the service business is Electronic Data Systems, which HP acquired under Mark Hurd’s leadership for $12 billion in 2008. I did not realize how grossly mismanaged HP’s service business was. How grossly? In 2012, HP wrote down $8 billion of the EDS purchase price as its margins collapsed to almost nothing.

Though on the surface it seemed like EDS was a good fit, and it still may be, HP, as a company that invents and makes stuff, simply did not know how to run a more mundane service business. The service business in general doesn’t face any significant secular headwinds — Accenture and Affiliated Computer Services (owned by Xerox) are prospering — but to make the numbers and please Wall Street, HP starved this business for investment and seriously mismanaged it.The margins in the service business are unlikely to recover to the artificially high levels under Hurd, but considering that they are at 1 percent today, the bar for success has been set very low.

I do not put the acquisition of Autonomy or the deterioration of the PC business on my mistakes list. Considering that HP stock dropped more than 20 percent on the announcement of the disastrous $11 billion acquisition, I assumed that the market had already priced in a complete write-down of Autonomy.

When you read the headlines, it sounds as if HP is dangling from a thread, just a few months away from bankruptcy. It isn’t. During its “horrible” 2012, when sales were down 6 percent, HP generated more than $5 billion of free cash flow and its net debt fell to $5 billion ($10 billion if you count its underfunded pension plan).

In my original article about HP, I thought it had earnings power of more than $5 a share. I was wrong. Though the services business will probably recover in a year or two, albeit to lower margins than I expected, the decline in the printer business will only accelerate. My base-case HP earnings power is somewhere between $3.50 and $4 a share.

However, more important, even after I tried to smother each of HP’s businesses with a pillow — I assumed that profitability and revenue growth of each business would decline, profitability of the printer business would drop by 80 percent, and the PC business would earn only half of what it earned in 2012 — I still got earnings power of $2.50 or so.

Wall Street has a very short memory, and at some point HP will lose its stigma (just like IBM did). If the market grants it a price-earnings ratio of 12 — not a shabby number — then, based on my worst-case earnings, HP will trade at $30, and by my base-case earnings, the stock will double from its current level to $40 to $50 a share.

I can only imagine how toxic IBM’s stock was in 1993. You had to be able to admit to your clients that you owned a has-been that had lost its way, that had just taken $3.4 billion in charges (that was real money then). IBM’s stock fluctuated, stagnated and then skyrocketed. IBM’s mainframe business, though challenged by PCs, is still around today. HP will likely be no different — it will be around for a long time. Will its sales decline further next year? Possibly. Will they fall off a cliff, like 35mm film? Unlikely.

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