The HP Break up
The last decade has not been a good one for Hewlett Packard. During the period, the company has not only seen its core businesses (computers, printers, business services) under assault but it has also had self-inflicted wounds from corporate governance failures and terrible acquisitions. I posted on one of those failed acquisitions (Autonomy) a while back and you can read the post here:
http://aswathdamodaran.blogspot.com/2012/11/hps-deal-from-hell-mark-it-up-and-write.html
Meg Whitman, who made her reputation by building up EBay, joined the board of directors at HP in 2011 and became CEO in September 2011, with the promise that she would turn the company around. Ironically, she was instrumental in rejecting an earlier plan to break up the company, arguing that the company was Òbetter togetherÓ.
In the last three years, Whitman has toiled with mixed results on both the profitability and the stock price front. HPÕs revenues have declined in the last three years and its margins are under pressure:
|
|
2009 |
2010 |
2011 |
2012 |
2013 |
TTM |
|
Revenues |
$114,552 |
$126,033 |
$127,245 |
$120,357 |
$112,298 |
$112,179 |
|
EBITDA |
$15,798 |
$17,736 |
$16,373 |
$14,384 |
$12,754 |
$12,976 |
|
Operating Income |
$11,025 |
$12,916 |
$11,389 |
$9,289 |
$8,143 |
$8,597 |
|
Net Income |
$7,660 |
$8,761 |
$7,074 |
-$12,650 |
$5,113 |
$5,097 |
HPÕs stock price has reflected this turmoil, dropping in 2011 and 2012, before making a recovery in the last year and a half:
You can get HPÕs latest annual report, 10K and 10Q at the links below, as well as a summary of the companyÕs financials over time.
Last annual report: http://www.stern.nyu.edu/~adamodar/pc/blog/HPannual.pdf
Last 10K: http://www.stern.nyu.edu/~adamodar/pc/blog/HP10K.pdf
Last 10Q: http://www.stern.nyu.edu/~adamodar/pc/blog/HP10Q.pdf
Summary: http://www.stern.nyu.edu/~adamodar/pc/blog/HPBloomberg.pdf
In early October, HP announced that it was planning to break itself up into two companies, one containing the computer and printer businesses and the other incorporating business services and its financial arm. The official announcement (or at least presentation) that HP made about the break up is here:
http://h30261.www3.hp.com/phoenix.zhtml?c=71087&p=irol-special
In the presentation, HP provides the broad details of the two businesses:
Note that the combined operating income for the two businesses in the last twelve months ($11.4 billion) exceeds the operating income for HP as a consolidated company ($8.6 billion) by about $2.8 billion. The footnote suggests that this does not include corporate investments (I assume that this refers to unallocated corporate costs).
Before you delve into the HP breakup, it is good to get a big picture perspective on why companies break up and whether these break ups can add value for investors. I have an old post on breakups that sets up the landscape:
http://aswathdamodaran.blogspot.com/2011/09/breaking-up-is-easy-to-do.html
Looking at the HP deal through the lens of the potential reasons for breakups:
1. Market mistakes: It is possible that the market is under valuing HP but it is difficult to argue that this is because the market does not see the value in one of the pieces. The reality is that neither part of HP (business services or computers/printers) has been doing well and that the market is building in the expectation of continuing revenue decline and margin compression.
2. Contaminated parts: Neither part of HP carries toxic attachments that may drag the company down. In fact, the most toxic parts of HP are the acquisitions that it has done in the last five years and breaking up into two businesses is not going to stop that predilection.
3. Efficiency improvements: It is possible that HP has become an inefficient host for these businesses and that breaking up into component parts will increase the value of the businesses. In fact, the company seems to be making this argument implicitly in its presentation, with the $2.8 billion decline in operating expenses (relative to the combined firm). To add some credibility, HP did announce major layoffs (55,000 over the next few years).
4. Simplicity story: Is HP much simpler to value as two businesses than as one? I donÕt think so. The businesses are not vastly different in their risks and cost structures and are more related to each other than independent.
5. Tax story: I donÕt see one and HP does not claim to have one. If there are tax savings to be had from capital structure refinements, it is again difficult to see the potential. Neither of the new HP companies is likely to be a cash cow and the option of levering up will offer limited value.
In the table below, I do fairly simple (and simplistic) valuations of HP as a consolidated company and the broken up pieces:
Broken up businesses |
Stay-together firm | ||
HP Inc |
HP Enterprises |
Consolidated |
|
| Industry | Computers/Peripherals |
Computer Services |
|
| Beta | 1.33 |
0.96 |
1.12090 |
| Pre-tax cost of debt | 5.00% |
5.00% |
5.00% |
| Tax rate | 25.00% |
25.00% |
25.00% |
| Debt to Capital Ratio | 18.74% |
18.74% |
18.74% |
| Revenues | $58,400.00 |
$57,200.00 |
$112,179.00 |
| Operating Income (EBIT) | $5,400.00 |
$6,000.00 |
$8,597.00 |
| Invested Capital | $30,000.00 |
$20,261.00 |
$50,261.00 |
| Pre-tax return on capital | 18.00% |
29.61% |
17.10% |
| Reinvestment Rate = | 2.50% |
10.50% |
9.15% |
| Length of growth period = | 5 |
5 |
5 |
| Computed Values | HP Inc |
HP Enterprises |
Consolidated |
| Cost of Equity = | 9.82% |
7.73% |
8.65% |
| After-tax cost of debt = | 3.75% |
3.75% |
3.75% |
| Cost of capital = | 8.68% |
6.98% |
7.73% |
| After-tax return on capital = | 13.50% |
22.21% |
12.83% |
| Reinvestment Rate = | 2.50% |
10.50% |
9.15% |
| Expected growth rate= | 0.34% |
2.33% |
1.17% |
| Value of firm | |||
| PV of FCFF in high growth = | $15,634.96 |
$17,657.75 |
$24,357.67 |
| Terminal value = | $57,697.32 |
$72,051.51 |
$96,546.78 |
| Value of operating assets today= | $53,683.35 |
$69,066.49 |
$90,900.70 |
| Cost Savings and other inputs | |||
| The valuations above assume that the difference between the consolidated company's income and the income of the parts is cost savings. | |||
| Assumed cost savings = | $2,803.00 |
||
| What percent of this do you think will actually be saved? | 100.00% |
||
| Value of Breaking up | |||
| Value of broken up businesses | $122,749.84 |
||
| -Value of consolidated firm | $90,900.70 |
||
| - Corporate Costs | $0.00 |
||
| Value change | $31,849.14 |
||
Before you get too excited about the value creation, almost all of the value addition here comes from the upfront assumption that the operating income of the pieces will be $2.8 billion higher than the consolidated companyÕs income. Thus, if you believe that HP has $2.8 billion in annual operating costs that are truly wasteful, the break up will add value, but only if the break up is a prerequisite for the cost cutting to happen.In this final part, that is the question that I explore by looking at what the value increase will be as a function of how much of the $2.8 billion will really be cut and how much is mirage that will manifest at the new HP pieces. To estimate the effect, I considered different estimates of the cost savings and the impact on value. Thus, if there are no cost savings, the value change goes to zero and as the cost savings increase as a percent of $2.8 billion, the value effect of the breakup also increases:
Annual Cost Savings |
Value Change |
$0.00 |
$0.00 |
$500.00 |
$601.00 |
$1,000.00 |
$7,386.00 |
$1,500.00 |
$14,170.00 |
$2,000.00 |
$20,936.00 |
$2,500.00 |
$27,738.00 |
$3,000.00 |
$34,522.00 |
The bottom line: Your assessment of this break up boils down almost entirely to whether you think that there will be cost savings from the break up and how big and lasting they will be. I am skeptical. I think that the company is over estimating its capacity to cut costs, finesse capital structure and grow in the future and I am afraid that it is carrying bad habits with it into the new ventures. I am also unclear about why there has to be a breakup of the company for their cost savings to manifest themselves. If the company is inefficient, why cannot it cut costs as a consolidated company.