Monday, October 06, 2014

Understanding the HP split

HP is splitting itself into "enterprise" and "consumer" companies. Why the split? Isn't the goal of big companies to get bigger? Well, no, that's just the cynical view of companies. The actual goal is to deliver value to stockholders. Splitting delivers value in two ways. The first is that it "exposes" the underlying business. The second is that it avoids dis-economies of scale.

Conglomerates like GE (General Electric) have a problem. While some businesses do well and grow, other businesses fail and shrink. You can't buy stock in the individual components of GE's business you think are growing, you have to take all or none. GE Medical has been growing fast, but you can't invest in it individually.

Thus, big companies frequently spin out such companies, either to divest themselves of the dead weight that isn't growing, or conversely, to let a growing part of these business to fly free without being held back by the deadweight. The fast growing parts of a business aren't inherently better. They tend to also be riskier, meaning that while their stock may surge, they have equal probability of going bankrupt soon.

We can see how this philosophy worked in the case of HP's previous spinoff of "Agilent", the test-and-measurement business that was the origins of HP.

Test-and-measurement is a boring product category. Thus, since the spinoff, Agilent has closely tracked the S&P 500. The HP computer business was the exciting business with growth potential, which has done better, although with more volatility. The thing to note here is that if you average the two stock prices together, then investors wanting high-risk growth stocks would've gotten a smaller return. That's why HP divested itself of Agilent -- it freed itself of the deadweight.

The second reason to split is dis-economies of scale. Larger is not better The biggest problem is the corporate brand. What does the "HP" brand stand for? On one hand, the brand is trying to service enterprise market where the brand is wants to stand for "boring reliability". On the other hand, the brand is trying to service the consumer market where HP wants to compete with Apple for "cool awesomesauce". Trying to be both weakens the brand in both markets.

Thus, the real goal of the split is to free the brand. HP has a big presence in the home market with its printers and laptops. Freeing the brand means HP can start selling other consumer products, such as tablets and phones, with exciting HPness, without being offending it's enterprise customers. Conversely, the new "Hewlett-Packard Enterprise" and become even more stodgy and boring.

The stock jumped 6% today, because investors are betting on the future shares. When the split happens, they'll receive one share in each business to replace an existing share. Investors wanting steady growth will immediately sell the consumer share. Investors wanting high-risk/high-return stock will likewise dump the stodgy enterprise share.

CEO Meg Whitman is staying with the enterprise business. It's not that this is the better company. Instead, it's because the consumer market fighting against Apple is for younger, more energetic CEOs.

By the way, as an investor, I'd dump the consumer stock. Its printer ink business is a cash cow, but I don't think they know how to compete against Apple and achieve growth. Several years from now, they still won't be the luxury brand demanding high margins that everyone wants, but still will be the boring/cheap brand they are today.

No comments: