Sunday, October 19, 2014

Will HP's Split-up Help Stock Values?

Does separating the company into two equal parts create more value than a consolidated whole?
As the third quarter, 2014, ended and before companies had a chance to announce earnings, HP slipped through to report it plans to split the company --literally (based on revenues) into two equal parts:  One half, to be called HP Enterprise, will focus on a corporate client base (cloud computing, business software, business services and data storage).  The other will focus on consumers who purchase personal computers and printers.  Right down the middle.

HP is a $100 billion-dollar company, enormous by most measures. The split-up (accomplished by spinning off the personal-computer business to current shareholders) will result in two $50 billion businesses, each still large enough to appear on Fortune 500-type lists. (HP will present a stock -like dividend to shareholders and allow the market to re-value what remains. They, along with their expensive banking advisers, hope the sum of the parts will be greater than the historical whole.)

Does the split (or spin-off) make sense? Was this a surprise?  Was this a maneuver it pondered for years, but CEO Meg Whitman now dares to do it?  Or did shareholder activists push for a financial-engineering move to help boost stock values? Corporate-finance experts:  What achieves maximum shareholder value--spinning off the perceived valuable parts of a global giant or accumulating diverse, well-run businesses to achieve the advantages of diversity?

The 1960's marked a finance period when investment gurus claimed equity values surge by building conglomerates (via mergers and acquisitions). (Think ITT, as the business-school's classic example.)

In current times, investing activists argue equity values rise because of focused management: Companies, they reason, increase equity values (and boost stock prices) by getting leaner, more nimble, and more targeted toward few product lines.  Company management is less distracted, corporate strategy is simple, costs are better controlled, and resources (human and funding) are less constrained.

If it isn't a subject already, HP's mishaps in management strategy and management misdirection and its misguided efforts to go head-to-head with any formidable competitor could be seminal business-school cases in corporate strategy. Whitman, after her renowned tenure at eBay and foiled attempts in politics, swooped in to try to salvage the company or at least restore some of its prominence.

With competition getting more fierce and with a fickle customer base always drifting to the latest new thing, Whitman may have been boxed into making this latest move.

In the eyes of equity investors, HP has slipped, recovered, stumbled, and been revived intermittently for years, but question marks still shroud its long-term outlook.

Its financial performance, nonetheless, has been laudable and overlooked by the fuss over strategy and competition.  Yes, total revenues have reached a plateau (with occasional slippage), and it absorbed giant losses as it restructured itself in the last few years.  As big as it is and as much as some project that competition and technology evolution will puncture it into non-existence, its track record for generating sound returns on equity and managing costs consistently is satisfactory.  (ROE in 2013 = 19%, and the company is on pace to generate  ROE = 16% in 2014.). The company didn't have to break up to return to profitability, because earnings exist and cost margins have been stable.

Its balance sheet is fragile, because about a third of it (over $50 billion) includes intangibles and it needs the debt that's piled on. (That intangible overload, which includes "goodwill" arising from a chain of flimsy acquisitions, leads to reported negative tangible equity; hence, liabilities exceed assets that can be touched, felt and presumably sold. Debt burden, which might be normal, in most financial situations is exacerbated with the existence of such negative tangible equity.)

Fortunately debt doesn't swallow the balance sheet too much, and stable (if not growing) cash flow from business activity keep debt investors comfortable.  (Ratings agencies haven't been harsh--BBB+/A---although they too have criticized management strategy in years past.)

But equity investors want the promise of growth.  They want to see sales increasing in leaps and bounds for indefinite periods. And they want to see returns on equity creeping toward 20%. The combination of impressive, boundless growth in sales, earnings, and ROE leads to big gains in stock price.

The split-up, they argue, is the best way to reach those big gains. Conglomerates contend big combinations of business result in cost synergies and economies of scale.  HP advisers and its board will try to show that dividing the company into two parts will give the company a chance to rationalize and reduce costs and clarify strategy.  The market, they claim, will know what HP Enterprise wants to be and do. The market will understand, they hope, that HP (the consumer side) will need to (and will successfully) figure out what it wants to be.

Another view? Institutional investors and activists prefer investments in two companies--one with stagnating prospects and one with growth possibilities--than an investment in one company with an uncertain, unstable outlook or the possibility of arm dragging down the other.

What poses a challenge in achieving those gains after the division?

1.  As the two entities polish their strategies and introduce products and services that can compete capably, how will costs be divided? Will they be divided fairly or divided in a way to give one a value boost more quickly than the other?

2.  CEO Whitman will have senior presiding roles in both entities.  Will management attention be even more stretched and pulled apart than it is already?

3.  That fragile, awkward balance sheet:  Which entity will accept the burden? Will deal-structurers decide to present HP, the consumer side, the gift of a sturdy, sound balance sheet with positive tangible capital and manageable debt burden?  Will HP Enterprise bear the burden of a capital structure with far more debt than its sister (or cousin?) company?

Dividing the company into two fairly equal parts sounds straightforward. But creating sturdy balance sheets for both and manageable cost structures (as one is extracted from the other) will be formidable tasks--enough to possibly postpone the scheduled late 2015 spin-off.

And enough to give investing activists enough time to develop or discover the next value-creating equity trend.

Tracy Williams

See also:

CFN:  Merger Mania, Boom Times Ahead?  2013
CFN:  What Will 2014 Bring?  
CFN:  Why is Dell Going Private?  2013

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