THINKING THINGS OVER
Volume I, Number 11 100111
By John L. Chapman, Ph.D. Washington, D.C.
The Hewlett-Packard Company (HPQ) is an iconic brand name in American business history, and one of the 20th century’s greatest business success stories. From humble beginnings in a one car garage in Palo Alto, California in 1939, it has grown to number nine on the Fortune 500 list today, with 320,000 employees and 2010 revenues of $126 billion. The firm is a global leader in personal computers, imaging and printing systems, and enterprise computing, application software, and information technology services.
More important than its scale, however, has been its effect on the global economy: H-P was the origin of what has become an historic provenance of entrepreneurial invention and innovation, branded by a moniker known as Silicon Valley — words that now connote a mindset far more than a mere geographic location. Founders Bill Hewlett and Dave Packard built and embedded within the firm a deep culture that came to be known as “the H-P Way”, and called upon employees to relentlessly pursue invention that could be commercialized even as they pursued excellence in all dealings with customers — and with each other. Outside of IBM (IBM) and the AT&T (T) orbit of companies, no other American corporation can match H-P’s long and consistent record of patents and technological innovation. From a macroeconomic standpoint, there is no question that H-P is one of the progenitors of American greatness and indeed, of our modern civilization.
How sad it is, then, to witness what can only be described as a “spectacle” in recent months that underlies a truly “spectacular” failure in governance. Last week Meg Whitman, former CEO of eBay and 2010 gubernatorial candidate in California, became the firm’s eighth CEO, but fifth since 1999. The firm’s market capitalization stood at $106 billion just 18 months ago, two thirds that of IBM, its largest global competitor; since then its value has declined by over 57% to $44.6 billion today. This figure is, pathetically, now less than one-sixth of IBM’s value, and it has occurred during a year and a half of solid growth in information technology spending around the globe, a key reason why IBM shares are a third higher in this time. H-P’s operating profits have held steady during this period, if not meeting pre-announced growth targets, yet the stock now trades at just over 5X trailing 12-month earnings, compared to IBM’s 14X. For a company which is at once the world’s largest personal computer maker as well as the largest printer provider, it has been a time of stunning reversal. What caused this, what can be done now, and what can we learn from H-P’s recent decline?
Recent Turmoil at Hewlett-Packard
H-P’s troubles began with the sudden departure a year ago of Chairman and CEO Mark Hurd, for “expense-account irregularities”. Mr. Hurd had been the subject of a sexual harassment lawsuit by part time actress and model Jodie Fisher, who had been a contract employee of H-P as a hostess at various customer events. While the suit was settled out of court, and H-P’s Board concluded Mr. Hurd had not committed sexual harassment, there were ethical breaches of conduct to which Mr. Hurd admitted, and he was shown the door along with a severance package of $34.6 million.
H-P’s market capitalization plummeted almost $20 billion immediately in the wake of Hurd’s departure, as investors questioned the move over what are still-undisclosed improprieties. Hurd’s tenure had been a tremendous success at H-P in the preceding five years, as he had eliminated tens of thousands of redundant jobs, shuttered under-performing business units, and absorbed EDS in a dramatic move to expand H-P’s presence in higher-margin enterprise services. During this time H-P’s market value doubled, and it became the leading PC maker in the world at the expense of rival Dell Inc. (DELL).
After two months of deliberations, H-P’s Board hired Leo Apotheker, the former CEO of German software giant SAP AG (SAP). It was a strange pick: Mr. Apotheker had run SAP as a co-CEO for less than two years, and had been the sole CEO for all of seven months. SAP had said Mr. Apotheker left “by mutual agreement”, but nothing is known of the details of the 57-year old’s departure, although there were rising customer complaints about SAP service levels and pricing at the time. In his eleven-month tenure as head of H-P, Mr. Apotheker was, according to internal sources, largely incognito, holding no company-wide meetings, no major public addresses, and met with few customers. After missing earnings targets for three quarters in a row, Mr. Apotheker announced in an August 18 call with analysts that the Company was exiting the small wireless device and tablet business, considering a likely sale or spin-off of its $40 billion PC business (an announcement which caught PC chief Todd Bradley completely unawares), and buying the British software firm Autonomy (LON:AU) for $10 billion, triple its market value before the announcement. H-P’s value declined more than $18 billion in value in the two days surrounding the Autonomy announcement, and Mr. Apotheker was gone a month later.
The hiring of Ms. Whitman immediately following the Apotheker dismissal culminates actions by a Board of Directors that Reuters has perhaps aptly named a “trainwreck.” Investors are rightly peeved that Apotheker was the third dismissal in five years, and that the full Board did not meet with Apotheker when he was hired a year ago (nor did they all meet with incoming chairman Ray Lane at the time, either). Further, some are incensed that the Board has agreed to purchase a software company for 34X its earnings and 3X its pre-deal market capitalization, when Oracle Corp. (ORCL) recently refused to buy the same company for 40% less, and Microsoft turned away from a deal in 2008 for 70% less.
What Can be Done Now?
Into this maelstrom has stepped Ms. Whitman, former head at eBay. She has announced she supports the general strategy undertaken by Mr. Apotheker but now intends to focus on “better execution”, although she will review the tentative decision to spin out the PC business and make a firm decision by year-end; the Autonomy acquisition that has so incensed some investors may be completed this coming week.
What is clear from the foregoing is that the Board of Directors has failed H-P investors in recent years. It is inexcusable to hire a new CEO without all Board members meeting him or her personally; this is equally true of the new Chairman (now Executive Chairman), Mr. Lane. Further, Autonomy may well be a market leader in the development and corporate exploitation of “unstructured data” (video, email, unformatted documents, and the like), an exciting and growing area for the growing theme of software-as-a-service at the enterprise level; but H-P is clearly overpaying for the company: not only is this suggested by Autonomy’s market value in mid-August (before the August 18 announcement by Mr. Apotheker), or by the benchmarks of Oracle and Microsoft rejecting the company at much lower price points. Indeed, for a firm to pay a multiple of 34X for an asset implies only a 3% return at current run rates, thus pressuring H-P to achieve major sales growth with Autonomy immediately, in order to earn back at least the firm’s cost of capital, which is at least double-digits, any way it is calculated.
Ms. Whitman has thus made her first mistake in agreeing to go through with the Autonomy deal, which cannot be immediately accretive to earnings, as the firm asserts. The PC business may or may not be a candidate for a sale or carve-out: there are equally good reasons to keep the global leader (full line supplier, brand-building, consumer retention, protection of printing business, leverage with tech suppliers) as there are to sell it or carve it out (re-invest PC business’ cash flows in much higher-margin service and enterprise businesses, as IBM did six years ago with its PC business). But the key point here is that the business decision is strategic, complex, and requires expert analysis. Expertise which, unfortunately, H-P’s Board cannot provide.
Indeed, Hewlett-Packard is now such a complex enterprise that, with a Board comprised of 7 newly-elected members in 2011 out of 13 total, there is little chance of effective decision-making on most any aspect of strategy for a period of time which the exigencies of the moment do not afford. Further, this would be true even in the case of a strong Board; H-P’s current Board, however, consists of, for example, one new member who is already resigning by next spring (Dominique Senequier); Pat Russo, the failed former chief of Alcatel-Lucent; Kennedy Thompson, a career banker who has no native experience with high-tech manufacturing; Shumeet Banerji, a career academic and management consultant with no operating experience; and Ray Lane and Meg Whitman themselves, two career software executives now leading a company with a deep historic presence in hardware that has now seen tremendous growth in enterprise services — but neither of whom have had any operating experience with hardware. Looking across the 13-member Board, there is also a huge lack of experience in corporate finance transactions, and thus it is not hard to understand why the Autonomy acquisition, like the value-destroying Compaq deal before it, may well be ill-considered.
It is evidently too late for Ms. Whitman to pull back from Autonomy, but the weakness of this Board cries out for a change of control via private equity (“PE”). A PE-backed deal for H-P, whether a going-private transaction or a PIPE (private investment in public equity), would be historic: the deal would likely trade at $35 per share, a 50% premium to Friday’s close, and a market valuation of $70 billion — easily the largest PE deal of all time. But after the comedy of errors by the H-P Board in recent years, it is the best way to rejuvenate this iconic brand and its technological leadership, and it could happen at a price point amenable to a syndicate of leading PE firms, such as Carlyle Group, KKR, and/or Texas Pacific.
Private equity ownership can confer benefits to corporate investee targets facing challenges in governance, strategy, operations, and M&A-driven or organic growth; Hewlett-Packard now has issues to address in all these areas. The firm’s Board is ill-suited to address the urgent questions that must be immediately resolved, and indeed, the core strategy itself is open to question given the unknown fate of the PC business. The tech sector is both consolidating and expanding in kaleidoscopic manner given new “cloud” and wireless technologies and service offerings; again, there is no Board-level expertise in place to review H-P’s options and act decisively. One of the hallmarks of private equity is the propensity to install strong, focused, and expert Boards who cross all decisions with three crucial success factors: (1) sound capital-allocation optimizing, along with (2) deep industry and technical domain expertise, and (3) excellence in operations. In recent years the Hewlett-Packard Board has been deficient in all three areas.
One of the other outstanding features of private equity governance is its ability to eliminate conflicts of interest between owners and managers, and at H-P, this has been a glaring problem in recent years. Mr. Apotheker may well have pursued the Autonomy deal for many of the same reasons Carly Fiorina, H-P’s head from 2000-2005, pursued a $20 billion acquisition of Compaq in 2002: buying that firm, which had lost $700 million the prior year and was in deep trouble, was not optimal for H-P shareholders, but it was for Ms. Fiorina herself, in terms of both multi-million bonus payout, and prestige (the HP-CPQ deal was at the time the largest merger in tech sector history). For Mr. Apotheker, doing the deal with Autonomy in leading edge enterprise data mining and decision support — currently a “sexy” part of the software world – was a headline-grabber, but the price point, at a premium 200% above pre-deal value and 80% post- announcement, is tantamount to a torching of free cash flow. Again, it is a serious error on Ms. Whitman’s part that she did not demand a renegotiation of the deal at a lower transaction value — and poor negotiating on the part of H-P’s Board that they so overpaid for a too-willing seller (as Oracle’s Larry Ellison has now informed us).
Lessons from the Poor Board Governance at Hewlett-Packard
On behalf of H-P’s beleaguered shareholders, one hopes that Meg Whitman understands the value of corporate renewal that can occur in companies through private equity ownership and governance. The vastness of HP’s portfolio of assets, combined with the myriad different directions it may now take strategically, impel a focused and judicious review of the firm end-to-end, and a de facto restructuring, that only private equity can best effect. For one of the big lessons of H-P’s travails in recent years is how costly a poor, unknowledgeable, and one may even dare say lackadaisical Board can be, to shareholders and hard-working employees who have suffered from the recent gyrations.
And there are lessons as well, both retrospective and prospective, for elected officials and even President Obama, in HP’s challenges of late. Even very smart, for-profit economic agents can make huge errors in everything from management to risky capital investments. Far better for risky capital allocation decisions — both of the human and the financial kind — to occur in the private sector, where those who own the assets in question either reap the rewards for their risky decisions, or suffer the penalties in case of loss. Seen in this way, it is almost criminal for the US government — or the State of Texas, under Governor Rick Perry – to invest in private-sector companies by risking taxpayer dollars, and rewarding crony supporters while foisting losses on the public. A vibrant capital market, that encompasses both private and public equity components, is far better-suited to assess risk and return vis-a-vis the uncertain future; fortunately, the brutal whip of for-profit competitive markets quickly punishes error, and thus induces correct placement of capital over time by forcing correction to eliminate losses. And this process is, therefore, at root one of wealth creation via creative destruction; indeed, this IS what Joseph Schumpeter meant, precisely, by use of that oxymoronic term. Feedback from both profits and losses induces correct (and correcting) behavior over time; this leads to the accumulation of both useful knowledge and wealth itself. This process cannot of course occur in government-directed investment — as evinced by this year’s $8 billion dollar loss at the US Postal Service in spite of a monopoly on first-class mail delivery in this country.
And finally, for Mr. Obama, one hopes that he comes to see the folly of raising the capital gains rate on private equity from 15% to 35-40%. It is precisely the favorable rate that has permitted the solid return potential on risky capital investment, that in turn has drawn hundreds of billions of risk capital into private equity and venture capital in the last 30 years. To eliminate this in order to punish “MILLIONaires and BILLIONaires”, and “corporate jet owners”, is to completely mis-apprehend the crucial process of capital formation from the vantage point of investor-entrepreneurs. Hewlett-Packard needs to be recapitalized and reinvigorated; it would be a shame if government policy impedes the process, one sure to create new and defend existing jobs, in the months ahead.
Disclosure: Alhambra Partners owns no HPQ in any of its portfolios. Alhambra does have current long positions in IBM.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at firstname.lastname@example.org.
Click here to sign up for our free weekly e-newsletter.