Thinking Things Over July 8, 2012
Volume II, Number 27: Who Should Run HP? An IBMer! Who Should Own HP? Henry Kravis
By John L. Chapman, Ph.D. Canton, Ohio
Hewlett-Packard shares (HPQ) hit a 52-week low last week, and the firm has lost three-fifths of its market value since hitting a secular high just over 16 months ago. Worse, HP is one of the few American companies trading lower since its March 2009 low (down by 27%), and since new CEO Meg Whitman took the helm last September 22, HP shares are trading 12% lower. It’s a rude greeting she did not foresee, but it surely precipitated May’s announcement of 27,000 job cuts. Fortunately the perpetual improvement machine that is American entrepreneurial energy, when wedded to solutions for improvement offered by modern corporate governance, affords a ready answer (private equity in this case).
Shortly after Meg Whitman took the helm at Hewlett-Packard last fall, we wrote a piece suggesting that a going-private transaction, or at least a PIPE deal (private investment in public equity) to strengthen HP’s comatose Board, was the best possible path forward for the great corporate icon of Silicon Valley. Judging from the hate mail we received it was our stupidest idea ever, but having reviewed the company’s performance and competitive situation again here three quarterly earnings reports into the Whitman Era, it has even greater strategic merit now, to our way of thinking. And there’s a lesson in this story for policy-makers, too, if they’d care to apprehend it.
A Short Review: What Is Private Equity, and What Is Its Institutional Role in a Capitalist Economy?
For the uninitiated, the private equity (PE) sector is both an important part of modern finance and a key structural tool for corporate governance, as well as being a vehicle for the activation of entrepreneurial initiatives so important to economic growth and prosperity. Private equity firms are usually partnerships, consisting of investment and operating executives acting as general partners who manage capital raised from institutional limited partners including pension and endowment funds, insurance companies, banks, and the like. The pooled capital from the limited partners is placed in a fund which makes a series of investments in various companies (thereby spreading the risk of the limited partners); these transactions are held for typically 2-7 years, and then exited, with capital returned to the partners on a 20-80 general-limited split after a priority return (say, 8%).
Later-stage private equity (which we refer to here, as opposed to early-stage venture capital) is targeted toward mature, established companies in need of a change in governance, strategy, or operations, and can serve a variety of purposes. Typically it’s used to recapitalize ailing firms that need a change in strategy or asset structure, provide funding for growth and expansion, fund buyouts that in turn pursue consolidating acquisitions to achieve greater economies of scale or scope, or even aid in the actual downsizing and rationalization of a very mature-stage industry suffering from excess capacity. (This latter type of PE investment generates sensational and emotion-laden headlines of, say, the job cutting and subsequent outsourcing that occurs in proverbial one-company steel towns — just such mature-industry transactions pursued by Bain Capital, Mitt Romney’s former firm, have been in the news lately. This caricature gives the impression of cold, ruthless, hard-hearted capitalists exploiting workers, stripping corporate assets for “quick flips”, and leaving desolation in their wake; this is a very false trope that is beyond the scope of our topic here to rebut, but we will only say here that it is better to save 100 jobs in an industry with excess capacity after cutting 100 by streamlining, than to lose all 200 of them to bankruptcy. We’ll take it as an assignment to provide a detailed rebuttal of this thesis at a later date, given Governor Romney’s inarticulate, even incoherent defense of his own career.)
Matching this considerable operating impact of private equity on corporate America is its footprint in the U.S. economy today: some 2600 PE firms now have stakes in more than 15,000 companies that employ more than eight million workers. These funds collectively manage up to $1.5 trillion in equity currently – often investing on behalf of “widows and orphans”, we must add – and affect perhaps up to $3.5 trillion in corporate value, compared to the current market capitalization of NASDAQ and NYSE publicly-traded equity of around $20 trillion. But private equity’s indirect effect on U.S. equity markets and corporate America may be even greater: via a more efficient market for corporate control, the catalyzing of entrepreneurship and creation of knowledge that is useful for producers and all market participants, aligning incentives between owners and managers, improving Board focus and governance, and providing capital for both growth opportunities and the rationalization of industry economics via consolidations or improvements to operating scale and scope, the entire U.S. economy is more flexible, dynamic, adaptive, and efficient. That is to say, more profitable, which in turn induces new job creation and improvement in living standards.
How Private Equity Can and Should be Applied in the Case of Hewlett-Packard
If ever there were a company in need of “major changes in governance, strategy, and operations” – all three, as we’ve argued before – it is HP today. And meaning no disrespect to Ms. Whitman, who nonetheless came to the job with experience that is questionable in its applicability to the current matrix of challenges at HP, the problems there now are too great to be settled by the current leadership and Board. Other than the announced layoffs and reversal of the decision to spin out the $40 billion PC business, Ms. Whitman’s tenure has only served to extend the firm’s strategic drift.
No better example of this could be offered than the already-epic failure of the Autonomy deal. Indeed as we predicted last fall, the acquisition of the British software maker and purveyor of cloud connectivity for 34X its earnings and 3X its pre-deal market capitalization, which Ms. Whitman could have insisted be dropped, appears to have been a disaster. As her first test of combat, the extent of this failure, in which over a quarter of its workforce have quit in frustration and its founding CEO has been fired for lackluster sales, is telling:
HP did not break out the Autonomy revenues, the overall software division saw second-quarter revenues rise just $173m from the same period last year, which was before the Autonomy deal. Given that Autonomy had quarterly revenues of around $250m before it was acquired, this implies a significant slowdown at either Autonomy or HP’s other software operations…..
[In addition to the founding CEO being fired], ….[a]ccording to people close to the company, Steve Chamberlain, chief finance officer, Sushovan Hussein, president and head of sales, Pete Menell, chief technology officer, Andy Kanter, chief operating officer, Nicole Eagan, chief marketing officer and Martina King, head of virtual reality project Aurasma, had all left in the last few weeks. Autonomy’s head of legal, several regional sales chiefs, and a large number of developers have also left.
More broadly, HP posted $127 billion in revenue in 2011, and net income of $5.8 billion (IBM, by comparison, had just under $107 billion in top line sales and $15.9 billion net). Yet although HP is the world’s largest technology company, it is now only 18% of IBM’s market capitalization (compared to two thirds that of IBM just two years ago; HP trades at roughly half the range of IBM’s and Apple’s earnings multiples). In describing its strategic intent, developed in 2011 by a failed and departed CEO who preceded Ms. Whitman (Leo Apotheker, the architect of the Autonomy disaster that he did not survive to see), HP asserts that it
brings together a portfolio that spans printing, personal computing, software, services and IT infrastructure at the convergence of the cloud and connectivity, creating seamless, secure, context-aware experiences for a connected world.
Here, alas, is the beginning of the problem’s definition. The translation of the foregoing is that HP is going to be all things to all people, both enterprise customers and consumers. That is a recipe for the torching of investors’ free cash flow, and it is a black mark against Ms. Whitman that she has not moved to gain a more focused clarity for HP moving forward, a problem Carly Fiorina also never solved (again, as a useful contrast, IBM serves only enterprise customers with a very focused mission on the application of technology to enhance their customers’ competitiveness in an interconnected world; such clarity affects the firm’s culture, strategy, and all employee mindsets in a beneficial way. IBM is also [externally] customer-focused in organization, whereas HP is [internally] product-line focused).
HP in fact faces a host of challenges that Ms. Whitman has not provided direction on so far, either, that private equity is uniquely positioned to ameliorate:
(1) Mix of businesses, and growth. Whitman has definitively decided – for now – to keep the $40 billion PC for investment, let alone a rationale for remaining in a line of business. Again, HP has considerable assets: the firm is the world’s largest full-line provider of information technology products and software services and solutions, serving both consumer and business segments. And no one can match Hewlett-Packard’s breadth: in addition to PC’s, the firm’s server, printing solutions, networking and storage products, IT management services, and software, consulting and outsourcing services are all multi-billion dollar businesses. Following Jack Welch’s famous dictum, Hewlett-Packard does indeed have high market share across its business lines.
And yet its sales are stagnant, having grown just 1% in 2011, with the same forecast for the next two years, and profits are declining, as is return on capital. Can HP be all things to all people? Where is future growth coming from? Was the PC reversal even a good idea, when that product segment is clearly in its late stages of maturity while the industry moves on to more integrated and mobile form-factors? (Again as useful contrast, IBM exited the PC business years ago).
(2) Entry into new business segments. Sadly, as sclerotic as are some of H-P’s business units, it has largely missed the current high-growth areas of computing and information technology. HP Labs has invested billions and worked on cloud/ubiquitous/always-on mobile services for more than 12 years, but has little to show for its efforts commercially now. While Apple transformed itself, HP, starting from a far superior competitive position and greater breadth of technological and marketing assets worldwide, has no tablet or mobile hand-held offerings at all any longer (after killing the Jornada, HP invested heavily to compete with Apple and announced the HP Touchpad in July 2011; it lasted 49 days before former CEO Apotheker announced its death). Where will the company be placing its entrepreneurial bets moving forward?
(3) Cost structure, organization, and growth. HP just announced the 27,000 layoffs across all its business units, with various restructurings in its operating divisions. This will help the bottom line, but will it help the top? HP has alternated in terms of its structure between customer-focused and solution-focused organization structures, and is back to the latter at the moment. But many sales and product consultants are now departing, at a time when big customers already had an array of HP people covering their account. And the on, off, and on-again disposition of the PC business did not help matters in 2011, likely sowing confusion for months moving forward about the entire company. In terms of fundamental questions of organizational architecture, how competitive and nimble can HP be moving forward?
(4) Debt and ability to grow. Hewlett-Packard is now saddled with $26 billion in long term debt, which is two-thirds of its market capitalization; the comparable figure at IBM is 15%. Does HP have the capital and flexibility needed to fuel marketing and technology initiatives to break out of its close-to-zero growth? Further, more than a third of its revenues come from its hefty presence in Europe. How will a 3-4 year recession there affect its cash flow and nimbleness?
Our Recommendation: Henry Kravis, Steve Mills is a half-hour away in Armonk
The list of challenges described here seems almost insurmountable, and leaves out perhaps the biggest concern of all: hanging over all of it is a Board of Directors legendary for its incompetence in the past (so much so that Silicon Valley icon Tom Perkins quit in disgust in 2006), and even now having 7 of its 13 Directors appointed last year – complementing Ms. Whitman’s and Executive Chairman Ray Lane’s untried tenures and lack of knowledge about the firm. This alone is cause for a change in governance to private equity-backed leadership.
But the strength of HP’s history, enduring assets and global brand, coupled with stable cash flow and estimated earnings of more than $4 per share both in 2012 and ’13, afford the wherewithal to engender a strong turnaround if just such new owners and leadership can be found.
In our view, a going-private deal led by the likes of private equity revolutionary Henry Kravis would electrify the industry (if not the entire business world, which sorely needs good news about lively animal spirits engaged in risk-taking now) and certainly re-energize HP. Mr. Kravis knows better than anyone that the right leader could sort through the myriad array of problems listed above, and sort through the options to chart a viable course to re-invigorate HP and draw it toward a better destiny. Who is an example of the CEO we’d like to see team up with KKR? Our view of the best choice in the world, and certainly the prototype of who should have the top job at HP now, is Steve Mills, currently IBM’s Senior Vice President and Group Executive – Software & Systems. Mr. Mills has had an uber-successful career at IBM and only age prevented him from getting the CEO nod over Ginny Rometty there last year (Mills is 61). He understands the IT sector and its likely evolution in this era of hyper-connectivity and demand for always-on infrastructure better than anyone alive, and has also lived through a complex industrial transformation of a moribund, down-and-out company (which IBM was in the early 90s) needing to re-focus its strategy and reconfigure assets on a global basis.
A going-private deal would be welcomed by HP’s institutional and retail share-holders alike, and would likely be valued in the $55 billion range, making it the biggest such transaction ever, if it happened. But a syndicate led by Mr. Kravis could strike the deal, and perhaps obtain buy-in of current shareholders in a rights offering to help lessen the demands for initial cash outlays. The emergence of a first-rate CEO with 40 years’ of industry experience, and one who would not need superfluous media-savvy skills in a PE-backed deal that allows for unperturbed focus on reconfiguring the firm’s assets for optimal value moving forward, would in turn spark renewed commitment to excellence in HP’s senior operating ranks, as well as the now deeply-tormented – and perhaps even frightened – workforce.
We understand the likelihood of such a transaction is small. But consider this an open letter we’ll forward to Messrs. Kravis and Mills, as the long period of mediocrity and underperformance of one of America’s storied companies is hurtful to watch. The logic of a going-private deal at HP is compelling, and backed by the right investors and world-class CEO – and the great team he would no doubt form to lead with him – HP could surely regain its footing. A period under private control would allow for the necessary changes to be considered and pursued, away from the glare of public discussion and Sarbanes-Oxley tentacles. Indeed it is this very situation of corporate stultification for which private equity, as an institutional agent of change, is tailor made.
Epilogue: A Final Note for Policymakers
One major reason the possibility of a going-private buyout of HP is so remote, more than lack of debt financing, is the daunting size of the transaction and its global scale. This alone adds significant risk for any investor seeking to undertake the change in ownership that could effectuate needed transformation within HP. But is it not worth it to society at large to allow for such possible corporate resurrections to occur? If so, the dramatic increase in taxation of carried interest on private equity transactions, in line with scheduled hikes in capital gains rates next year, acts as a major impediment to even casual consideration of the merits and potential of such a transaction.
We’ll leave any conclusions to the reader, but merely note here the dulling effects of such a big tax hike on risk appetite for transactions that could lead to great societal gains and new innovations.
DISCLOSURE: Alhambra Partners has no ownership stake or position in Hewlett-Packard (HPQ). Alhambra has net long positions in IBM (IBM).
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at email@example.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.
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