Monday, December 3, 2012

Hewlett-Packard, "Goodwill," and Investing

Much has been written recently about Hewlett-Packard, once an esteemed leader in the technology sector.  Not only has the company (and its stock) suffered from reports of a huge shift in customer preference toward smart phones and table computers and away from personal computers and printers (Hewlett's most important products).  On top of that, Hewlett recently shocked investors by writing down nearly 90% of the value of its acquisition last year of Autonomy, a British software company.

Hewlett paid $11 billion to buy Autonomy in an attempt to shift its emphasis away from the obsolescent business of personal computers and printers.  Investors were stunned and frustrated by the huge premium HP paid, a price nearly twice what another reported bidder considered the value of Autonomy.  That was bad enough for investors, but last week Hewlett wrote down $8.8 billion of the $11 billion acquisition.  This was the latest example of the generally poor record of major corporate acquisitions that are later written down--or completely written off.

When a company buys another at a premium to the accounting value of its net assets (assets minus liabilities), the difference is put on the acquiring company's books as "goodwill."  Companies such as Procter & Gamble that have grown over the years by acquiring other companies (and products with valuable brand names) have large amounts of goodwill listed among their assets on the balance sheet.  In those cases, the brand value of, say, Gillette razor blades is considerable.  Such brands have maintained or even increased their value over time.  An investor in such a business would justifiably pay for the imbedded goodwill of such key products.

But for a business such as technology, with its risk of rapid obsolescence, it is dubious to pay a high premium.  Hewlett had already stumbled with its acquisition of Electronic Data Systems several years back.  EDS, a former subsidiary of General Motors, was heavily dependent on business from GM, and when GM struggled in recent years, so did EDS.    Such write downs of poor acquisitions result in a reduction of stockholders' equity, or book value.  

I pay attention to a company's book value, or more important, its tangible book value (after deducting goodwill and other intangible assets).  For a company with valuable brand names such as Apple or Coca-Cola, tangible book value might be considered irrelevant in assessing the true value of the business.  But for companies in other sectors with hard assets, or businesses with commodity-like assets like many technology companies, I would not pay a large premium over tangible book value.

In general, the record of large corporate acquisitions is mixed, at best.  I generally prefer a company whose management does not make large acquisitions that dilute the investment of existing shareholders (by issuing large amounts of additional shares of stock to pay for the acquisition).  Managers who behave like owners, rather than highly-paid consultants looking for a quick payout, are better.

The poor decisions at Hewlett were made under the prior CEO, though most the board of directors that approved the deals is still there.  So, it is hard to have confidence in management today.  

Yet, the stock has declined 53% over the past year and 74% over the past five years.  Its price/earnings ratio is now 3.9.  Though it has substantial debt, its cash generation is considerable.  With its total stock market capitalization now down to $25 billion, could it be attractive for takeover by a private equity firm?  Or is it at least now sufficiently undervalued to offer a "margin of safety" in buying the stock?  I'm not ready to go that far, but the stock is worth a closer look at this point for its valuation and 4% dividend yield.

Steve Lehman

HPQ:  $13

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