This is a post by Wikibon analyst contributor David Cahill who is the president of Diligent Technology.
David talks about HP play to back out of the Autonomy deal. A good read..
This is all a bad dream.
I am willing to give HP a mulligan on this one and assume this is all a bad dream. Judging by the market reaction over the past week, many others are willing to do the same. Since announcing Q3 results and a “strategic transformation”, HP’s stock has declined >20%, erasing more than $12 billion in market value. However, I don’t really care if the market likes this deal or not in the immediate term. In fact, the less the broader market likes it, the more of a buying opportunity it creates for the stock if this strategy makes any sense.
This is what makes analyzing the new direction all the more interesting. In this context, what really matters is whether this is the right move for the long-term value of the company. With this in mind, I have cycled through this whole turn of events multiple times. As hard as I try, I keep coming up with the same conclusion: This is a terrible series of moves.
It’s Not Just Me
One of the more puzzling aspects of this whole situation is that Marc Andreessen, a director on HP’s board and member of it’s Technology Committee that oversees M&A strategy, seems to agree with me. Three days post-deal he writes this piece in the “Wall Street Journal” in an attempt to subtly justify HP’s new direction. What I can’t understand is how someone could possibly pen this this article after endorsing the $11.7 billion acquisition of a roll-up of legacy on-premise software assets.
If Andreessen truly believes that NEW software innovations are eating everyone’s lunch, how can he possibly endorse paying a 10x revenue multiple for Autonomy? If Andreessen truly believes that startup costs and barriers to entry are lowered, then why pay such a premium? If Andreessen truly believes the future is in the cloud, then why buy a company where 67% of its installs, per HP’s comments on the earnings call, are on-premise?
The $117 million Mulligan
Extending HP’s focus up into the application layer is a dangerous exercise with material integration and selling risk. Entering the application arena by acquiring a rollup of well-marketed but legacy software assets, based in a different country, makes even less sense and brings with it real cultural risk. The great news here is that HP doesn’t have to go forward with the strategy. The breakup fee for this deal is only 1% of the offer price. This translates to ~$117 million. HP generates roughly $25m of free cash flow per day. It could make this bad dream disappear in less than 5 days. Over time, this breakup fee will pale in comparison to the capital wasted on seeing this deal through.
NetApp’s leadership calls it sales affinity. One of the primary reasons NetApp maintains such a rigid discipline in M&A is selling affinity. NetApp refuses to acquire outside of its main focus due to the recognition of how difficult it is to get direct sales and channel partners to sell product outside of their core competence. In the case of NetApp, this is storage. In the case of HP’s enterprise business, this is infrastructure. It is servers, storage, and, increasingly, networking. It is not applications. Acquiring Autonomy is recognition of this. In theory Autonomy buys HP the DNA to sell applications. But with the plan to run Autonomy as a separate subsidiary, what then are the synergies to justify such a rich takeout?
HP has consistently struggled to drive real growth out of its own infrastructure software business inside an infrastructure company. Nevertheless, building off the recent Vertica deal, Autonomy brings HP into unstructured data with its search, e-Discovery, Web content management, and email-archiving assets. But while it may seem to make sense laid out on a PowerPoint, in practice the selling efforts between infrastructure and applications are light years apart. Sales reps do not migrate well outside of their comfort zone. Vertica was a stretch in this regard but with a much lower price, less risk, and more strategic potential. Autonomy is a step beyond stretch. One should not underestimate the difference between selling infrastructure hardware and application software. Of course the most frequent acquiring company response to this objection is sales overlay/specialist teams made up of the acquired company’s sales reps. This is a short-lived strategy with a shelf life as long as the retention packages given out with the deal.
Cisco is a real time case study in how challenging it can be to extend into “market adjacencies.” The end result, more often than not, is a net negative, as the core sales force will always retrench to what they know. Once the initial momentum dissipates, and the “overlay” sales force is disbanded, the focus goes with it, resulting in a bunch of sales reps trying to sell a product they care, or know, little about.
EMC is another instructive example here. The huge success of the VMware acquisition has bought it a lot of currency to do other mediocre software deals including Legato, Documentum, and RSA. The further away from storage and infrastructure it gets, the worse the outcome. So while HP’s move into the application layer is bold, the selling risk alone skews the risk/reward against this deal.
Making matters worse
For many reasons it is easy to poke holes in this deal, but the mainstream tech media has this covered. Instead, a more productive exercise is coming up with an alternative solution to HP’s problems. HP has lost its way, which is clear. As I have written previously, it is suffering from an identity crisis by trying to be too many things to too many people. Investors especially are a tricky animal to please. You need to appease them without listening to them. They want short-term execution and long-term vision, all at the same time. Right now HP is falling down on both accounts.
The HP message since Apotheker took over has been about stoking the innovation engine and getting away from the cost-cutting label that defined the Mark Hurd era. However, from the outside this is still a PC, server, and printing company. HP is never going to get full credit for execution in its legacy segments, because these businesses are viewed as old news and boring. However, it is very difficult for any of the non-legacy business lines to be big enough to move the needle. At a >$125 billion in revenue, this is no easy task without some major moves. Following the empire-building transactions of prior regimes, the company is too big and spread too thin. HP needs to restore focus across the company. Spinning off the PC division is recognition of this. However, pulling this off while diversifying into applications and migrating the company’s software center of gravity to Europe will have the exact opposite effect.
Beyond focus, in order to make any real progress, HP needs to stop being so reactive to near-term Street expectations and starting investing with conviction. This is the only way the innovation engine can thrive within HP. HP’s cited reason for exiting the Palm/WebOS business is a glaring example of the impact of this hyper-sensitivity to Wall Street. On the most recent earnings call, HP’s CFO stated, “To make this investment a financial success would require significant investments over next 1-2 years, creating risk without clear returns”
Isn’t this the bet that every single startup makes? Innovating is all about making bets without clear return. The engine in place to foster this behavior at HP is clearly broken. You can’t possibly innovate or disrupt with this mindset at the outset of every emerging venture investment cycle. This is classic Innovator’s Dilemma inertia that separates doing what’s right for the future of the company versus what is aligned with an existing business model and investor base.
Exiting the enterprise innovation pipeline
The consumerization of IT is quickly disrupting the traditional PC footprint within corporate America as tablets, mobile devices and SaaS-based services are offloading the reliance on traditional client-side computing. Given these market dynamics, it makes sense that HP wants to exit the hardware component of this business and focus on the enterprise.
However, recent super-growth start-ups have proven that real inflection points are realized by sneaking into the enterprise from below. The largest opportunities seem to be those that seamlessly bridge between our personal and professional lives. Stemming from their consumer IT experiences, users are demanding better solutions to traditional IT problems. This is why Amazon Web Services, Box.net, Dropbox and Drobo exist. Exiting the PC business to restore focus is the right move. But for HP to exit its only touch-point into some of the most dynamic innovations in the enterprise without a strategy to compete here is a mistake. The good news for HP is it can play in this opportunity with out being in the physical device business (this is where Citrix comes in, more later).
The Deal Sweetener
With Apple crushing the desktop and PC businesses of everyone that gets in its way, is there a worse time to get decent value for a PC business? Even more puzzling is why tell everyone you are selling it ahead of time? I am no Frank Quattrone, but this can’t strengthen HP’s negotiating position in any transaction.
Arguably the highest value asset HP has, and least synergistic with the HP enterprise infrastructure assets (e.g. server, storage, networking) is the printing business. Given its profitability and market leadership, this is also a much more attractive chip to play with than the PC business. I suspect HP will be hard pressed to find a buyer willing to pay what HP believes it’s PC business is worth. The fix here is to add the printer business to the package. Printing, while a great business, is not core to the vision of an enterprise infrastructure provider. Moreover, investors are never going to bid up HP’s stock on the strength of the printing business—so why not leverage this asset to buy something that will add substantial value long term?
Packaging up the PC and printer segments together accomplishes some important things:
- It increases the interested buyer pool, particularly private equity, dramatically.
- It increases cash generation from divestiture.
- It creates much greater strategic focus for the remaining entity.
The new HP identity that results from this transaction is an enterprise infrastructure company with relevant assets across server, storage, networking, infrastructure software, and services. In the process, HP can rake in a stockpile of cash to go hunting for additional strategic assets aligned with this vision. Finally, the resulting entity is a much cleaner asset for investors to get their heads around without constantly being distracted by the PC and printer divisions.
A Valuation Exercise
Using trailing-twelve-month (TTM) enterprise-value-to-revenue (EV/R) and enterprise-value-to-EBIT (EV/EBIT) multiples for Lexmark (the most comparable printing pure play), suggest HP’s printer business is worth somewhere in the range of $10.5-14.5 billion. This is a very conservative starting point. You can easily argue HP deserves a premium to the Lexmark multiple given share leadership, superior revenue growth, and margin profiles. The current Lexmark multiple is also discounted along with the broader market given recessionary concerns. Leaning towards the high-end of the valuation range, the implied printer business valuation is ~$14 billion.
For the PC business, finding directly comparable companies is much more difficult. In May of 2005 when IBM spun out its money-losing PC business to Lenovo, it received only a ~0.175x multiple (or $1.75 billion) on $10 billion of revenue. So while HP’s PSG unit is more profitable ($2.34 billion in TTM EBIT), the market conditions for PCs are clearly worse. Taking all of these factors into consideration, along with potential acquirers’ likely payback requirements, implies HP’s PC business is likely worth somewhere in the range of 0.20x revenue. At a $40 billion revenue run rate this implies a valuation of $8.0 billion
The Case for Citrix
Staring at $22 billion in potential cash inflows from divesting PC’s and printing, HP can’t stand still. Looking out across the tech landscape, there is no asset more synergistic with HP’s infrastructure story and it’s hybrid cloud strategy than the combination of HP and Citrix. As I wrote off the Synergy event earlier this year, Citrix has legit offerings across virtual desktop, cloud, networking, and SaaS. There is very little overlap between the two portfolios, in fact they actually compliment each other extremely well and make HP far more competitive against key competition (e.g. Cisco, IBM, EMC) in the process. The recent acquisition of Cloud.com is also a much-needed asset for HP to weave a legitimate hybrid cloud story with its own IP. As one of Cloud.com’s marquee customers, Zynga, has said publicly, you can’t get any more hybrid-cloud than this. The Xen IP also allows HP to marginalize the VMware stronghold on virtualization. Most importantly, with Citrix, HP doesn’t need to worry about being in the tablet or desktop business anymore. Leveraging Citrix’s Receiver and desktop virtualization portfolio, HP can play across all PC’s, tablets, and edge devices without owning any of them. Citrix is the bridge between the consumer and enterprise domains. As the lines continue to blur here, this is an increasingly strategic control point. Adding Citrix to the HP portfolio creates a full-fledged device to data center story that few can match.
Adding it all up
Looking at the Citrix valuation and baking in a few different acquisition premium scenarios implies an enterprise value in the range of $12.5 to $15.0 billion. A healthy 40% control premium over today’s market value implies a valuation of $13 billion. All in, here is the math required to get from here to there:
- Autonomy breakup fee $117m
- IPG Division Implied Valuation $14 billion
- PSG Division Implied Valuation $8 billion
- Citrix Systems Implied Valuation $13 billion
- Net Cash Inflow/Outflow to HP = +$8.83 billion
The End Result
It has been a tough week for HP, with $10 billion out the door to Autonomy and $10 billion lost in vanishing market cap, a total of $20 billion in capital destruction in 5 business days. The market cap component is a sunk cost, the only way to get that back is to execute. HP needs to define a clear identity and direction. Investors will reward focus and growth out of HP. The integration, selling, and cultural risk that comes with the Automomy deal are far too much to take on at this point. In contrast, if it trades out the PC & printing divisions for Citrix and $8 billion in cash, HP will have significantly upgraded the focus, growth profile, and strategic reach of the company without stretching outside of its core competence.
While this revised thesis may sound logical on paper, the strategic shift would obviously require a lot of execution. However, HP needs bold and concentrated moves to get where it needs to go. Now is the time to ignore investors, double down on focus, and walk away from Autonomy. The rest will take care of itself. And when the strategic pivot is announced, I will gladly be the one to write a thought piece in the “Wall Street Journal” to justify HP’s new new direction.