I’m an ex-auditor and when I see moves like HP’s planned split into two entities, I still get a little pissed off. At least from the numbers, this looks like a great short-term bump to HP’s valuation, but a horrid idea for long-term investors, employees and customers. The costs of the merger are now approaching $3B (the enterprise unit only made $1.6B in profit last year), and the long-term dis-synergy has a sustained $200M+ adverse impact on both of the resulting firms. To add insult to injury, the enterprise unit is only walking away with $.5B of the debt, leaving the massive majority of existing and new debt (about $22B) to the PC/Printing company which, because it is saddled with printing, was going to struggle with profit growth anyway. Yes, it will distract for a time any further drifts to unprofitability, which can now be blamed on the split, but the result will be massively weaker than the current troubled firm.
When CEO Meg Whitman said she was going to turn HP around, I doubt anyone realized she meant toward an even worse direction.
Dis-synergy is a new term and I’m kind of fascinated with its use. I also believe the $450M estimate for this is likely significantly understated; experience teaches me that when a firm wants to do something, it tends to aggressively play down the problems with that path. We saw Carly Fiorina do this with the Compaq acquisition, which I covered extensively at the time. That eventually set up her firing from the firm.
But just like there are financial advantages to a merger, which allows a combined entity to share and reduce total costs, there are disadvantages to a break up. All your common services like HR, accounting, finance, investor care, legal, operations, facilities, supply chain, vendor management, etc. now have to be duplicated in both firms. And often, the number of employees required by each of the new firms is pretty close to what the combined firm used largely because, with automated tools, once you get to a certain level you can add a lot of additional load without a lot of additional people.
One big area is in component discounts. The PC unit generates the volume and the Enterprise unit gets lower prices. While the PC unit should, because its volumes are relatively massive, be able to hold its pricing, the enterprise unit should eventually see a sharp increase in its costs, which can only be passed on to sole source customers (suggesting that you sure don’t want to be a sole source from HP Enterprise once this deal is done).
As noted, the Enterprise unit starts with a relatively low $.5B in debt and a $1.6b in net profit, reduced by half the “dis-synergy” to $1.2B in profit. However, that is at the current $55B revenue rate. That’s about 2 percent net profit on revenue. That is a tiny buffer and doesn’t take into account the competitive problems that will result from this split. In any blended PC deal, the new company will not as easily be able to bid on locking them out of some or all of this business. That is one of the big reasons PCs and servers came together in the first place; firms that had both would work to set up RFPs that included both components and thus lock out any firm that didn’t have that product breadth.
If, like in most companies, a significant part of the near $3B estimated cost for the split is a sustaining cost, then that reduced $.2B profit could easily drop to become a loss, forcing yet another downsizing. There isn’t that much left of HP to downsize, given a long history of doing large layoffs across a variety of CEOs over the last decade. So with the Enterprise group, you have an entity that is in sharp decline in terms of revenue (down from $61B in 2012 to $55B in 2014), has a tiny margin to work with, and faces a high probability that it’ll quickly drop into a loss.
The PC group, in comparison, is doing really well, with 6.6 percent growth year over year and $1.2B in earnings on $34B in revenue, or nearly 4 percent profit. Unfortunately, this is offset by the Printing group, which is losing revenue at the rate of nearly 4 percent per year but making a whopping $4B+ in earnings on $23B in revenue, or around 16 percent profit. In terms of cash generation, both in total and as a percentage of revenue, the Printing unit is a like a money machine. The problem for it is the trend. Now in debt, HP shows a massive $20B, down $2B from 2013, and added to this will be much of the $3B separation cost, and the Enterprise half of the firm is just taking $.5B. That leaves the PC/Printer company with a whopping $22B (approximately) to pay off. Current interest run rate is about $600B for the combined company and with interest rates likely to increase, this places this entire debt load on the HP Inc. plus the load of having to pay off the principal currently running at around $2B a year. This should take the current $5B+ a year and basically cut it in half.
Now as we move more and more aggressively away from paper, the printing side of this unit is likely to lose revenue faster and those combined bids that the Enterprise unit will lose, the PC/Printer unit will lose also. So while this unit has far more margin to play with, the massive debt load cuts into that number sharply, leaving thin margins that faster printer revenue declines could eat up quickly, and the PC segment, regardless of how well HP has done (and it has actually done rather well in PCs), isn’t strong enough to make up the difference by itself.
With this side of the firm, you get decent initial profits, but likely very sharp annual declines, unless the Printer side of the firm finds new revenue opportunities (which exist in areas like vinyl wraps and coverings, and 3D printing), but HP has failed to take full advantage of these.
Wrapping Up: So you get…
So you start with one sick company that is massively underperforming the S&P index and wave the magic wand and end up with two companies, with most of the same people, products and capabilities, with an extra $3B in debt spread across half the revenue, an extra $.5B in costs and inefficiencies, and access to less existing RFPs, so a potentially significantly smaller total available market for the firm. Oh, and it is highly likely that these negative numbers are understated to make the deal look better on paper. In other words, this is likely as good as it gets and we really aren’t even talking about the revenue lost from just the customer confusion and collective competitor FUD that often results from a deal like this. It is no wonder VP Bill Veghte is running for the hills.
Other than some likely hidden executive incentives and some potential short-term stock benefits resulting from possible overvaluations, I honestly can’t figure out how anyone can think this is a good thing. They’ve even locked the employees down so they can’t vote with their feet, but while I’d be tempted to move to the PC/Printer unit because it’s generating much more cash, that massive debt coupled with possible increasing interest rates would scare the crap out of me.
So I can’t answer the question I opened with. This move looks insane to me.
Rob Enderle is President and Principal Analyst of the Enderle Group, a forward-looking emerging technology advisory firm. With over 30 years’ experience in emerging technologies, he has provided regional and global companies with guidance in how to better target customer needs; create new business opportunities; anticipate technology changes; select vendors and products; and present their products in the best possible light. Rob covers the technology industry broadly. Before founding the Enderle Group, Rob was the Senior Research Fellow for Forrester Research and the Giga Information Group, and held senior positions at IBM and ROLM. Follow Rob on Twitter @enderle, on Facebook and on Google+