Hewlett-Packard (HPQ: Charts, News, Offers) has been looming large in the headlines this week, following CEO Mark Hurd’s abrupt resignation last Friday after a sexual harassment probe into his relationship with an employee revealed falsified expense accounts concealing an extramarital affair. Hurd had been instrumental in the restructuring and rebirth of HP, cutting costs and increasing margins drastically, doubling the share price in the past five years. In his absence, CFO Catyhie Lesjak has taken the reins as interim CEO until a suitable replacement can be found. Investors remain divided on the future of HP without Mark Hurd. Some have likened the removal of Hurd to Apple’s nearly fatal decision to oust Steve Jobs back in 1985, while others believe that HP is still on track to fulfill its full year revenue forecast. Indeed, upon the announcement of Hurd’s departure, HP unexpectedly revised its full-year EPS outlook from 4.45-4.50 to 4.49-4.51, in a thinly veiled attempt to pacify shareholders. As if the Hurd scandal wasn’t enough, new allegations of bribery in Russia totaling 10.9 million to secure a contract have further sullied the company’s reputation. Is there any hope for this once bright tech beacon amid a PR nightmare?
For many years prior to Hurd’s ascension, HP was tangled in a web of low margins and over-diversification. Since 2005, Hurd increased margins from 4% to nearly 9% at one point. He followed IBM’s (IBM: Charts, News, Offers) example and shifted much of its focus towards higher margin software and IT services, which now make up 31% of HP’s revenue model. 68% of HP’s gross revenue still comes from hardware – 54% from personal computers and imaging/printing devices, and 14% from enterprise storage and servers. Its recent 13.9 billion, 3-year acquisition of EDS (Electronic Data Systems) is expected to boost its storage/servers division significantly, making it the second largest corporate storage provider after IBM. Also worth noting is the recent $1 billion acquisition of struggling smartphone maker Palm for a 23% premium, despite the company failing to turn a profit since 2008. This shows HP’s desperation to enter the lucrative smartphone market, even if it means starting late and handicapped. Of these aforementioned divisions, the imaging division, which includes printers, scanners and print cartridges, is the most profitable. The imaging hardware is sold at either a loss or a very thin margin, while the replacement cartridges are sold at 50% margin, and provide HP with its cash cow, earning over 50% of the company’s net profits.
HP’s decision to enter the smartphone arena with an already fragmented business model may prove to be distracting, unnecessary and costly. Critics have already pointed out that the Palm brand is practically worthless and quickly becoming a footnote in the fast moving mobile world. Others have predicted that HP would strip the Palm name and mine its technology in order to release a new HP branded smartphone quickly. HP had previously used Windows Mobile in its previously unsuccessful iPaq handsets, and now also owns Palm’s WebOS. Neither would be a viable choice to enter a market dominated by Apple’s (AAPL: Charts, News, Offers) iPhone, Research in Motion’s (RIMM: Charts, News, Offers) Blackberry, and a slew of Google (GOOG: Charts, News, Offers) Android powered devices which include HTC, Samsung, Motorola and Sony Ericcson. It would take a gentle hand to guide HP into the smartphone game without incurring massive initial losses and decrease the margins that Hurd had so shrewdly increased.
Due to the fact that HP’s focus is so broad, there are multiple competitors on several fronts, which would take skillful maneuvering, on the level of Mark Hurd, to counter. On the personal and corporate computer front, Dell (DELL: Charts, News, Offers) is its closest competitor, though it has lower net profit margins (2%) than HP (7%). On the IT services and software front, IBM is the biggest threat, with significantly higher net margins (14%) than HP. However, HP’s profit engine is its imaging division, where it faces a whole different group of rivals – Lexmark, Canon, Samsung, Xerox and Epson. Against these companies, HP holds a commanding 45% of the market. There is, however, a new threat of office mega-stores such as Office Depot (ODP: Charts, News, Offers) and Staples (SPLS: Charts, News, Offers) selling their own generic brand print cartridges that are compatible with HP devices. This is a serious threat to HP as much of its bottom line depends on the sale of print cartridges.
As HP’s share price sinks, there are many purely technical factors that make it an attractive long-term investment. The trailing P/E is only 11.4 and the forward P/E is 8.06. The PEG ratio has fallen to .98, and it rests right above the 52-week low of 39.95. There is also a small 0.08 quarterly dividend to boot. Hewlett Packard is a strong brand with a healthy heart generating plenty of cash, and it won’t go under anytime soon.
The new CEO will have to be as focused as Hurd was on maximizing HP’s comparatively small margins, cutting costs further, and streamlining HP’s fragmented business model and insuring the absorption of EDS and Palm go smoothly. Many analysts believe the stock could go either way at this moment, and with pessimistic uncertainty thick in the air regarding Hurd’s replacement and the outcome of the current DOJ bribery probe, it may be prudent to step back and set HPQ on a watchlist for now and see what happens.
Other News About HPQ
Hewlett-Packard directors sued over CEO Hurd exit
US Department of Justice Asks Hewlett-Packard Co. to Provide Internal Records for Bribery Investigation
Hewlett-Packard Dropped To A New Low For The Year