Monday, August 23, 2010

Hurd by Numbers

Now that the Mark Hurd Affair has devolved into a tit-for-tat post-mortem between the HP Board and unnamed proxies for Hurd—reaching its Clintonesque nadir last week when the Wall Street Journal actually reported that Hurd himself had let it be known through his ‘camp’ that “This woman and I never had sex”—we thought it worthwhile to return to more concrete means by which to evaluate the worth of the man Larry Ellison ranked right up there with Steve Jobs as far as “reviving HP to its former greatness” goes.

And those means would be strictly this: the numbers.

By the numerical yardstick of Wall Street’s Finest—the analysts we regularly poke fun at in these virtual pages (having been one years ago, we know the game well enough)—the answer to the question of whether Mark Hurd really revived HP “to its former greatness” is an unequivocal “Yes.”

Of course, Wall Street’s numerical yardstick does not necessarily include certain intangible factors that make a company great in the long run—things like corporate culture, employee turnover, new product development, or anything else beyond the realm of what happens outside the stock prices flickering across their Bloomberg terminals.

For it is no secret that the primary number Wall Street cares about is a company’s stock price.

(If you think that’s being too cynical, go back in time and leaf through the so-called “research” reports on Enron, say, or Lucent, or WorldCom, or any of the spectacular mortgage frauds of the housing boom: you will find consistently that, at the end of the day, continued strength in a stock price trumps short-selling reports, skeptical articles in Fortune, and even, in the case of David Einhorn’s 100% accurate prediction that Lehman was doomed to fail without some form of massive restructuring, public speeches defining the exact nature and dollar amounts of a company’s misdeeds.)

And on the basis of stock price, Hurd did indeed very nearly revive HP to its “former greatness.”

HP’s shares nearly tripled during his tenure, not only adding $50 billion in market value to HP shareholders in five short years, but also restoring HP’s stock price to within 20% of its Dot-Com Bubble-era all-time high of $68.

(By way of comparison, Cisco has never gotten back to within 50% of its all-time high.)

Of course, stocks don’t generally increase over a long period of time if revenues and earnings don’t also increase, and, under Hurd, increase those revenues and earnings did: from 2005 to 2009 (using HP’s fiscal year, which ends in October), annual revenues jumped roughly $30 billion—from $87 billion to $115 billion—while operating income grew $6 billion, from $5 billion to $11 billion.

And while we here at NotMakingThisUp pay very little attention to reported earnings per share (it is a number which can be, and frequently is, manipulated via special charges and artificially depressed depreciation charges and low book tax rates), the more relevant net “free cash flow” per share of HP stock, according to our Bloomberg, neatly doubled during Hurd’s tenure, from $2 a share in 2005 to $4 a share in 2009.

Thus, it is no wonder the stock performed as well as it did under Hurd. It is also no wonder that many of Wall Street’s Finest would agree with Larry Ellison that Mark Hurd did “revive HP to its former greatness” (even if they disliked his Michael Ovitz-style severance package).

But did he really?

First let’s look at where that $30 billion increase in annual revenue from 2005 to 2009 came from. We find it came essentially within two business segments: $20 billion from services and $10 billion from notebook computers.

Specifically, HP’s “Services” business grew from $15 billion to $35 billion between 2005 and 2009. At first glance, that would appear to be a good thing, considering that HP sought mightily over the years to emulate the IBM business model of providing lower-margin consulting and outsourcing services to its business customers in order to help spread its own higher-margin hardware and software throughout the business world.

In HP’s case, however, that entire $20 billion revenue increase could be accounted for by EDS, which was doing $22 billion of revenues when HP bought it in 2008.

As for the $10 billion increase in notebook computer sales, from $10 billion to $20 billion between 2005 to 2009—well, notebooks are not the high-margin, proprietary kind of business Hurd sought to emphasize with the likes of his $4.5 billion Mercury Interactive acquisition in 2006.

Thus, we find that two-thirds of the revenue growth at HP under Hurd came from an acquisition, rather than organic growth, while the remaining one-third came from a decidedly unglamorous, commodity business not much reminiscent of HP’s printing franchise in its prime.

And revenue aside, the HP of 2009 was, in some respects, not much better off than the HP of 2005.

For starters, sales per employee dropped big-time, from $580,000 to $380,000, thanks to the labor-intensive nature of the services business acquired under Hurd.

And gross margins—the best measure of the inherent profitability of a business, and the hardest number to gin up—didn’t budge more than a few basis points during his tenure: from 23.4% to 23.6%, according to our Bloomberg.

Now, it is true that operating margins—which Wall Street’s Finest would no doubt argue reflect the real genius of Mark Hurd, ‘the execution machine’—jumped from a little under 6% to a little under 10% under his tenure.

Nevertheless, one might want to consider some of what it took to achieve that heroic step-function in profitability while sales per employee was collapsing and gross margins were staying put: what it took was layoffs, R&D cuts, and the kind of recurring “one-time” restructure charges that most investors assumed were going to disappear after the Enron, WorldCom and Lucent accounting scandals cast a pall on the use of “Non-GAAP Earnings” and “one-time” charges.

Under Hurd, annual Research & Development spending declined from $3.5 billion to $2.8 billion from 2005 to 2009. Given the rise in sales over that same time period, this resulted in a 40% drop in HP’s R&D ratio—a figure commonly used across Silicon Valley as a shorthand way to measure a firm’s commitment to new product development—from 4% of sales to 2.4% of sales.

As for “one-time” or “non-operating” charges, HP under Hurd took a whole lot of ‘em: by our math, $7.5 billion worth in the 2005-2009 period (not to mention another $2.1 billion taken in the first half of the 2010 fiscal year), including $3 billion of the kind of “restructuring” charges companies incur when doing real things, like lay-offs.

All excluded under "Non-GAAP" accounting.

Consequently, of the roughly $40 billion of operating income HP reported to Wall Street’s Finest during the 2005-2009 period, nearly $8 billion—or 20%—seems to have appeared thanks to the exclusion of costs by means of employing accounting principles which are not generally accepted by accountants.

Now, Hurd supporters, including his fans among Wall Street’s Finest, may well point to the fact that 2009 was not exactly a banner year for business, coming as it did on the heels of the worst financial crisis since the Great Depression.

And they may also point out that, whatever the details as to how it got there, HP’s return on equity rose from 6.4% to nearly 20% under Hurd, while earnings per share (using the HP, Non-GAAP method) jumped from $1.65 to $3.85.

To this, we point out that, also under Hurd, both those measures were inflated by a drop in HP’s effective tax rate, from 32% to 19%.

Also, thanks to share buybacks at high prices and large, intangible-asset-boosting acquisitions, HP’s tangible book value per share declined from a modest $6.04 per share when Hurd arrived to an even more modest $0.15 per share. (Yes, that’s right: HP’s tangible book value, as calculated by our Bloomberg, was almost zero the day Hurd left.)

So “How should we think about this?” to steal a line from Wall Street’s Finest.

How can we frame HP’s results under Hurd, which, on a superficial level go a long way to explain the $50 billion increase in market value from 2005 to 2009, but which, on deeper inspection, point to a host of issues that might well bolster the Board’s decision to say “See ya”?

Let’s look briefly at IBM, the closest “comp” to HP and a company revered by Wall Street’s Finest for its consistent earnings, free cash flow and share buybacks.

For starters, IBM’s recent stock price (at $128 or so) is within shouting distance of 1999’s $139 all-time high. That’s a better recovery from the Dot-Com Bubble than HP or any other large technology company we can think of, aside from Score one for IBM.

IBM’s revenues, meanwhile, grew more modestly than the $30 billion increase at HP under Hurd—by a mere $5 billion on a $91billion base. And while IBM made no EDS-type $22 billion revenue-enhancing acquisitions during the period, it did, as did HP, consummate many small deals (the biggest being Cognos in 2008, which added almost $1 billion in sales) to boost revenue. Score one for HP.

As for gross margin, however, IBM started well above HP’s at 40% in 2005 and rose even higher, to 45.7% in 2009, thanks to IBM's focus on adding software while HP was adding services and notebook computer revenue. Score two for IBM.

Bringing things down to operating income, we find that IBM plays similar games as HP, removing charges and “one-time” items from “reported operating income”…but nowhere near of the same magnitude. Thus, despite an already-quite profitable mix of business, IBM managed to increase its reported operating margin from 10% in 2005 to 18% in 2009. Score three for IBM.

IBM’s return on equity, like HP’s, jumped—from a healthy 24% in 2005 to an absurd 74% in 2009, thanks to share buybacks and the ensuing decline in equity. And while IBM likewise reduced its book tax rate (from 35% to 26%), the boost to reported earnings and return on equity was less than HP’s. Score four for IBM.

So, again, did Mark Hurd “revive HP to its former greatness,” as Larry Ellison claims?

Far be it for anyone to argue with a man who has created more value for more people—investors and businesses alike—than maybe anybody except Steve Jobs.

And it is true that today’s HP is nothing like the HP that Mark Hurd took over. In 2005, HP’s great printer franchise generated two-thirds of operating income, while the rest came from a mix of computers, storage and services; by 2009, that ratio was turned on its head: printers were a bit over one-third of operating income, and the remaining two-thirds came from services (nearly half of operating income) and a mix of PCs, storage, and servers.

Yet while HP’s new line of printers (which can print from a file emailed from anything without printing capability, like, oh, an iPad) developed under Hurd will no doubt fortify that longstanding razor/razor-blade franchise, the rest of HP, as reconstituted by him, consists of a large, low-margin service business; a large, low-margin notebook computer business; and a handful of more proprietary product lines that don’t move the needle too much.

At the end of the day, then, the HP Board may well have been looking at more than a faulty expense account report and the potential distraction of a drawn-out tabloid-feeding legal drama.

They may have been looking at the numbers, too.

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Quints said...

I'm not entirely convinced that Hurd deserved to be ridden out of town on a rail based on financial performance. You raise excellent points aboutn non-GAAP earnings, but I also think about the fact that HP had to do something drastic or they would be the next Xerox, except with printers instead of copiers. At least he dodged or postponed that. It seemed that Fiorina would not have.

eeeeeekonjohn said...

Having recently purchased a Palm Pre (which I love), it seems like picking up Palm's webOS (the phone was developed under an ex-Apple employee) I am really hopeful that HP doesn't blow it with webOS. Their lack of apps (c'mon, gimme Hipstamatic, please!) leaves it hamstrung at this point, but there does seem to be a few fanatics out there. Hope they make it work.

Abhishek Thakur said...

Very well put together!

It indeed looks more like the board had decided that Hurd was past his sell-by date. He had cut all the costs (and more) and done acquiring revenues (EDS et al). For HP, the time had now come to start concentrating on the organic growth and concentrate increasingly on services business- things that require good employee morale and greater individual ownership and initiative. Hurd was increasingly not looking the person who could get all this done.
(I'm an ex-HPite, btw)

Anonymous said...

Hey Jeff, how come you are always making fun at Wall Street analysts, nevertheless you read them everyday (otherwise you wouldnt be making fun at their buy/sell calls)?
Good post, by the way.

najdorf said...

Jeff: I always thought there was something a little fishy about HP, but you've analyzed it more thoroughly than anyone else I've seen. Thanks for the long-term, real-accounting perspective.

quints: As an investor, I don't care whether HP management gets to keep running a large company - I care whether they earn an adequate return on my capital. To the extent that they were headed the way of Xerox, the right thing to do would have been to run the printer business for cashflow and distribute the proceeds to shareholders. If shareholders want to invest in a services business, they can buy a piece of one in the public market at a much cheaper price than what HP paid for EDS. Unless you think HP has services expertise or synergy between businesses that adds value, why would you want your management to buy a new line of business at a premium price rather than returning cash?

I have the same objection to Intel-McAfee, Berkshire-Burlington, etc. There's simply no reason to pay a huge premium over market price when you have no means to make the company worth more inside your corporation than it was worth outside of it.

Jeff Matthews said...

Anonymous asks, reasonably, why we read Wall Street's Finest in the first place. The reason is that it's one way of keeping track of what's going on in the world.

Yes, there's a lot of nonsense in these daily missives. In fact, most of the daily research pieces constitute a half page of harmless, fact-free commentary on earnings or a company meeting, followed by many as 5 pages of legal disclaimers.

But there are good analysts and interesting stuff out there too, and you learn to sift and find it.

The stuff we make fun of tends to be from analysts we've learned, over time, to only read for amusement.


gvtucker said...

Well, I'm another buy side investor, and I still read Wall St analyst reports, but I do so solely for the data they provide. They do make excellent data aggregators.

Now that doesn't make them worth a whole heck of a lot of money, of course. Fortunately, I don't pay them very much. I wonder how long Morgan Stanley, Goldman Sachs, et al will continue to pay them well more than they're worth?

Colin P said...

At some point in your sell-side career, did you voice a similar opinion and immediately get fired or disciplined? Even though you were probably right in what you said.

Jeff Matthews said...

Colin P asks if we ever voiced "a similar opinion" in our Wall Street career. Funny he should ask.

As a very junior number cruncher in the energy research group of a very large Wall Street firm, I drafted a report on 18 small oil and gas producers not long after the oil collapse in the early 1980s, when the stocks were all down 60-80% from their highs, but still trading in the $10-$20 area, mainly on hope that things would go back to the way they'd been.

The conclusion of the report was that 1/3 of the companies were healthy, 1/3 were on the edge, and 1/3 were bankruptcy or restructuring candidates.

There was nothing--zero--in the report that was brilliant or insightful: it was strictly by the numbers, and the numbers were terrible. (It was like writing a report on eToys and WebVan in early 2000 when they were at $15 or $20 saying they were going to zero.)

Unfortunately, some of the companies were clients of the firm: in my youthful enthusiasm I had neglected this fact.

Not surprisingly the report got watered down (if not axed--I don't recall ever seeing it in print) and I soon left for different pastures.

And I am not making that up.


Gordon said...

Similar story to yours, Jeff--back in the late 80's, I wrote a report about a few industrial names, and unfortunately, the numbers I was given couldn't quite justify the prices that the market was paying at the time. I didn't think anything of it, and wrote the report that needed to be written given what the numbers were.

A senior analyst gave the report back to me, and told me to rewrite the report because there were a couple of banking clients that were listed in the report. In my youthful ignorance, I didn't get the hint. I thought he was talking about my writing. I rewrote the report and kept the same numbers and conclusion. I turned it back in.

The senior analyst called me into the office and asked me why the numbers weren't higher. I told him that the numbers weren't higher because the numbers really weren't higher. The senior analyst told me to make those numbers higher. I finally figured out what he meant, but I wasn't just ignorant in my youth, I was obstinate, too. I took the report off his desk, put them on top of his bookcase (close to the ceiling) and told that the numbers were about five feet higher now.

The next day I was a junior analyst in a different industry. Looking back, I am amazed that I wasn't fired.

Anonymous said...

Shareholders could only wish that HP board actually exams the numbers. But again, how can Hurd be paid so handsomely if the board had done their job in the first place.

Anonymous said...

In your IBM/hp revenue compare, you should note that IBM grew revenuevwhile divesting the think pad and hard drive businesses. So, I think you need to score revenue for IBM too.