HP Breaks Itself Into Back Office And Front Office Halves
They could have called one Hewlett and the other one Packard, but instead, as HP breaks itself into two halves, it is calling the part that sells PCs and printers HP Inc and the one that sells servers, storage, software, and services HP Enterprise.
In a surprise move, Hewlett-Packard has decided to go ahead with an idea that former CEO Leo Apotheker flirted with and that current CEO Meg Whitman initially and repeatedly rejected, and that is breaking the company into the two parts that serve the front office and the back office.
"The turnaround made today possible, and we are operating from a position of strength," Whitman said on a conference call with Wall Street analysts announcing the breakup plan. "We are going to create two companies that are going to win in the marketplace."
The decision to break HP into two comes just after rumors surfaced a few weeks ago that the company was trying to acquire storage juggernaut EMC, which not only has the largest storage array business in the world but which also has a portfolio of security and content management software it has built up over the years as well as an 80 percent stake in server virtualization and cloud software maker VMware. An acquisition of EMC by HP would have cost a fortune, and interestingly, by splitting off the PC and printer business from the enterprise business, HP Enterprise might be in a position to be acquired by EMC. If half of the market capitalization of HP can be attributed to HP Enterprise, then it has a value of about $34 billion. As we go to press, EMC has a market capitalization of $58 billion.
The HP breakup deal comes hot on the heels of Lenovo Group's takeover of IBM's System x division last week, and while the timing could be coincidental, the competitive threat that Lenovo posts to the enterprise business of HP is not to be underestimated. A decade ago, Lenovo bought IBM's also-ran PC business for $1.25 billion and has gradually transformed it into a competitive threat to both HP and Dell in the PC market. And now, Lenovo wants to do the same thing with X86-based systems and related storage and networking as well as with key software assets like Platform Computing middleware and the GPFS parallel file system that it has licensed from IBM as part of its $2.1 billion acquisition of the System x division from Big Blue. The presumption is that Lenovo can become a very low-cost manufacturer of X86 systems from its manufacturing base in China and that it will have an advantage selling in its indigenous and still fast-growing market compared to companies like HP and Dell. The threat posed by Lenovo and other makers of vanity-free systems, storage, and networking is sufficient that HP partnered with Foxconn in April to develop machinery aimed at hyperscale customers. HP has promised to reveal more about the partnership with Foxconn and the machines they are creating this year, but thus far has been tight lipped.
Under the plan announced today before Wall Street opened up for business, and after rumors started circulating around late on Sunday that the breakup was imminent, HP will be distributing shares to existing shareholders for the two entities in a tax-free method. The two entities, HP Enterprise and HP Inc (pun intended on the printer business, we presume), are roughly the same in size and profitability at this point. This was probably the most important factor in determining when to do the split. With the enterprise market having its growth issues and the PC market growing thanks to the sunsetting of Windows XP but probably not on a long-term growth trajectory, this may be the last time that the company's PC business looks this healthy.
The PC and printing business had $57.2 billion in revenues in the trailing four quarters and an operating profit of $5.4 billion, or about 9.4 percent of revenues. The PC side accounts for about 59 percent of those revenues, while printing accounted for the remaining 41 percent. In terms of profits, the PC business showed some modest black ink, but as has been the case for many years, printer ink is the profit engine for the front office part of HP's business. Like Dell, HP missed the boat on smartphones and tablets and the consumer services behind them, ceding these markets to Apple, Samsung, Amazon, Google, and others.
HP Enterprise had sales of $58.4 billion in the trailing four quarter, with an operating profit of $6 billion, which works out to an operating margin of 10.2 percent. The idea behind the acquisition of PC and server volume leader Compaq back in 2001 and IT services giant Electronic Data Systems in 2008 was to create a company that could stand toe-to-toe with IBM and compete for the big systems and services contract that the top companies in the world while also continuing to peddle wares through channel partners to smaller companies. The Enterprise Group in this part of HP makes up about 48 percent of revenues, and the Enterprise Services unit another 39 percent. HP Software brings in 7 percent of sales and HP Financial Services, which mostly does leasing for HP hardware and software, brings in the remaining 6 percent.
HP no doubt had hoped for the systems and services approach to yield more profits, but intense competition squeezed the profits out of many hardware product lines. While HP has one of the largest enterprise infrastructure businesses in the world, profits are in software these days and it has not thrown off enough cash from its various businesses to build a software business that can compete with the likes of Microsoft, IBM, and Oracle.
Under the plan that HP announced to Wall Street today, Meg Whitman is taking the helm of HP Enterprise, with Patricia Russo taking the role of chairman of the board. Whitman will be chairman of HP Inc, and Dion Weisler, a former Lenovo executive who was put in charge of HP's PC and printer division in June 2013, will be CEO of the front office half of HP. On the conference call, Whitman said that the management teams were being put in place for the two halves of HP and that a special separation team would manage pulling the companies apart so that each half could continue operating and not have to manage this process as well. The breakup plan is expected to be completed before the end of HP's fiscal 2015 year, which ends in October 2015.
HP's justification for the breakup is that both halves of HP need more agility to compete in their respective markets, and there is all the talk of unlocking shareholder value as you might expect. HP is certainly right that it needs to be more agile, but there is more to it than that and some of the ideas don't add up. For one thing, the current HP has tremendous bargaining power with chip makers like Intel, and this contributes directly to the company's bottom line. By breaking HP into two, each half will have less leverage and it is reasonable to assume that HP's components will get more expensive, thus eating into profits. Moreover, at exactly the time that HP needs to do some big deals to build out its software business, or create its own software stacks, it is splitting its cash stream in two. Cathie Lesjak, HP's CFO, said on the call that the plan was to get the capital structures of both halves of HP more in line with their objectives, with HP Enterprise using cash to fund organic growth as well as acquisitions and share repurchases and HP Inc focusing more on organic growth, dividends, and share repurchases.
What is obvious is that by breaking HP into two pieces, the company has created two companies of almost the same size and profitability that will, once the deal is complete, be a drag on the other. So, for instance, assuming there is intense competition in the PC sector and that printing supplies become less profitable as people move to digital storage, the enterprise half of HP will not suffer from such a potential decline. Similarly, if HP's servers, storage, and switching business come under even more competitive pressure than it is already under, then this will not be a drag on the PC and printing half. The presumption and the story line today, of course, is that both the back office and front office businesses will get leaner and meaner, and therefore more profitable, as they focus and attack their markets. But the breakup is really about positioning the company for when this doesn't happen for one half. It would take better soothsayers than we are to try to guess what may happen years hence with HP Enterprise and HP Inc, but one thing is certain. HP facing stiff competition on all fronts.
In addition to the announcement of the breakup plan, HP said that it was boosting the number of layoffs in its restructuring plan by 5,000 to a total of 55,000 employees. The company had originally had expected for layoffs to be between 45,000 and 50,000 to get its costs in line with revenues. The company said it would take the savings from the incremental layoffs it identified and plow them back into sales, research, and development. As of the end of HP's third quarter of fiscal 2014 ended in July, around 36,000 employees have left the company. HP has also shaved its income projections for fiscal 2014, and now says it expects earnings per share to be in the range of $2.60 and $2.64 this year, down from a projection it made two months ago of $2.75 to $2.79 for the year. Looking ahead to fiscal 2015, HP is projecting earnings per share of $3.23 to $3.43, with savings from the restructuring falling to the bottom line. HP told Wall Street that the combined company should generate between $10 billion and $10.5 billion in cash, with somewhere between $6.5 billion and $7 billion of that being free cash flow. HP expects to return at least half of that cash flow to shareholders through dividends and share repurchases, and says it will also make up for the fact that it did not do that with fiscal 2014's cash.
