The relief at Hewlett-Packard Co.'s Palo Alto headquarters was palpable. On Nov. 16, just 96 days removed from its biggest quarterly earnings miss in more than a decade, HP staffers celebrated the company's 2004 fourth-quarter results. The 66-year-old technology giant had rebounded nicely, notching a 27% hike in profits, to $1.1 billion, while sales jumped 8%, to $21.4 billion. The market whooped it up, and HP's stock rose a solid 8% from its 19.68 close in after-hours trading.
But the next day, cheers gave way to sighs. Certainly the company picked up its performance from the disastrous third quarter. But investors were quick to probe the vulnerabilities behind the cheery numbers. They noted that HP continued to lean heavily on its superstar printing business while its mammoth PC and server businesses struggled to eke out profits. More unsettling, much of the profit growth stemmed from cuts in research and development, and from a lower tax rate. Without these savings, HP's profits would have climbed only 10% -- not 27%. Analyst Laura Conigliaro of Goldman, Sachs & Co. (GS) wrote in a Nov. 17 research report that HP's results were "probably not quite as good as they seem on the surface." By the end of the day, all that HP stock had to show for its celebratory quarter was a measly bump of 52 cents.
It has been more than five years since Carleton S. Fiorina hit town with bold plans to reinvent the Silicon Valley icon, and she's still struggling to put the company on the right track. The charismatic chief executive with the million-dollar smile has zealously pursued a bigger-is-better strategy, with hopes of creating a technology world-beater. Thanks largely to its $19 billion acquisition of Compaq Computer in 2002, HP has doubled its sales in the past five years and become a competitor in an unrivaled number of markets, from $100 digital cameras to billion-dollar tech-services deals.
Yet in too many of the businesses, HP is losing steam. Sure, its one champion, the $24 billion printing division, gushes profits. But look beyond that crown jewel, and the rest of HP is an underachiever. In personal computers, it's no match for Dell. And HP is too often outgunned by IBM (IBM) in the global markets for corporate computing. Worse, Fiorina's team faces steep operational challenges as it tries to come to grips with HP's huge stable of businesses. "It requires entirely different strategies to compete with Dell and IBM," says analyst Bill Shope of J.P. Morgan. "Judging by HP's performance, they haven't been able to do either."
Little surprise then that investors spurn HP's stock. Most analysts peg the stand-alone value of its high-flying printing business as slightly less than the entire company's $61 billion market capitalization. That means that the rest of HP's businesses, which generate $56 billion in revenues, are being valued at next to nothing. "We own this stock for the printer business," says Brian Bruce, head of equity at PanAgora Asset Management Inc., which holds about 2 million HP shares. "It's not clear HP has gotten the synergies they expected from the other businesses."
Despite the laments, HP is hardly teetering on the edge of an abyss. Its 2005 profits are expected to reach $4.5 billion, with sales climbing 6%, to $85 billion -- not bad for a technology colossus. Trouble is, HP has earned a reputation for coming up short. Over the past 20 quarters, HP has missed analysts' profit estimates seven times, according to Thomson First Call. Although this is an improvement over its previous 20 quarters, that record still represents twice as many misses as Dell and IBM combined during the same period. "[HP is] trying to do 100 things. It's hard to do everything well," says Joseph Tucci, chief executive of EMC Corp. (EMC), a rival in the storage business.
Can Fiorina finally drive HP to realize its vast potential? BusinessWeek has interviewed more than 100 people, including past and present HP employees, investors, customers, partners, and competitors, to explore the issues and potential solutions. Suggestions abound. Some call for Fiorina to hire an operations ace to manage the company's far-flung divisions and get them working in sync. Others call for the company's PC division to retreat from its global network of retail distributors and to ape Dell's super-efficient direct-sales model. And many opine that HP should gobble up software and tech-services companies to better compete against IBM. The risk? If the company adds to its portfolio without first tackling the operational issues, the already daunting complexity could multiply. "Carly has to prove she can execute and it just hasn't happened yet," says a former HP vice-president who left earlier this year. That view is widely shared by many others interviewed by BusinessWeek.
HP acknowledges the need for more financial consistency. However the company points out that since the merger, its cumulative quarterly sales and profits are slightly ahead of cumulative analyst estimates.
Investors aren't impressed, and the drumbeat on Wall Street is growing for a far simpler solution: break the company up. The CEO staunchly resists the idea. The board continues to discuss such a move, say former and current insiders, but directors support Fiorina's commitment to hold the company together. While Fiorina declined several requests for interviews for this story, she has said in numerous public statements that such a move "destroys shareholder value." Still, the calls to split apart the consumer and corporate businesses, or to sell off the printer division, are bound to grow and spread if she fails to light a fire under HP's underperformers.
The breakup options could certainly appeal to beleaguered investors. One of the most vocal proponents of a sell-off, analyst Steven Milunovich of Merrill Lynch & Co. (MER), calculates that the total value of HP's businesses could increase by 25% to 45% if it were split into printing and nonprinting operations. The idea is that the printing business, which would probably retain the HP name, could expand its market and partner with HP's computing rivals, including IBM and Dell -- once it was unhitched from the computer company.
And managers of the computing company, with its divisions in software, PCs, servers, and tech services, would have to beaver away madly to make profits. No longer subsidized by the printer division, they would have no choice but to perform. Merrill calculates that the spin-off would create $15 billion to $27 billion in incremental value. Those numbers get shareholders' attention. "I would like them to spin off the printer business," says Kenneth A. Smith, senior portfolio manager at Munder Capital Management, which owns about 2.9 million HP shares.
For now, Fiorina continues to bank on bulk. She contends that HP's breadth pays off in added sales and lower costs. Consumers and corporations, for example, often shop for both printers and computers at the same time. So selling one fuels sales of the other. And HP does reap cost savings from its scale. After the Compaq merger, the company wrung $3.5 billion in annual expenses out of its operations, in part by squeezing components suppliers for lower prices.
Bucking calls for a spin-off has paid dividends for technology titans in the past. That formula certainly worked for IBM. In the mid '90s, legions of analysts, eager to unlock value inside Big Blue, urged IBM CEO Louis V. Gerstner to sell off the company's mainframe division. But Gerstner resisted their calls. Instead, he plowed cash flow from mainframes into growth businesses for IBM, including the Internet. Taking a page from his book, Fiorina could attempt to patch the soft spots in her computing arsenal with proceeds from the printer business.
Fiorina insists that HP needs the broadest reach possible to capitalize on her vision of technology's future. A long-time executive at telecom giant AT&T (T) and later at its spin-off, Lucent Technologies (LU), Fiorina has become a leading evangelist for the converged digital world. In passionate speeches, she describes how the continuing Information Revolution will transform corporations and electrify entertainment, with the whole world becoming "digital and mobile and virtual and personal." And she has assembled a giant corporation vast enough to hawk its wares on nearly every path and byway of the digital universe. Far broader than Dell or IBM, HP spans consumer and corporate markets. It makes everything from calculators and cameras to supercomputers, and competes with Sony (SNE), Canon, Samsung, EDS (EDS), just about everyone in tech. "We think we have a unique opportunity," Fiorina said during a speech in August, "because we have leadership positions and intellectual property at every stage of the value chain."
Indeed, rather than break apart HP's existing businesses, Fiorina may look to beef them up. Even as she accelerates the cost-cutting measures, including new layoffs, another substantial acquisition remains a possibility, particularly in software or services. Several former and current insiders say HP pondered a deal for Veritas Software Corp. (VRTS), a leader in storage, although it is not clear if any discussions ensued. Another target, say analysts, could be Capgemini's U.S. operations, which the struggling French consultancy is said to be shopping around. Capgemini, however, denies its U.S. operations are for sale. Veritas declined to comment. HP has said it would not rule out additional acquisitions.
Pulling all of this off could be as critical to Fiorina as it is to HP. The 50-year-old chief executive has told colleagues who were interviewed by BusinessWeek that she is interested in going into politics at some point. Her public support of President George W. Bush and her work on California Governor Arnold Schwarzenegger's transition team have led to open speculation inside HP that Fiorina is positioning herself for an Administration appointment or a run for the U.S. Senate -- perhaps a 2006 race against Democratic Senator Dianne Feinstein. She demonstrated her political skills by pushing through the Compaq acquisition, the largest deal in computer history, over fervent and well-funded opposition. And her quick integration of the two companies exceeded even the expectations of her supporters. But if her turnaround at HP continues to stall, her political prospects could grow dimmer by the quarter. Fiorina would not discuss her political ambitions with BusinessWeek, but at a November meeting with her senior staffers she addressed the swirling rumors and promised to stay at HP.
Fiorina carries the solid fourth-quarter results into a widely anticipated analysts' day in Boston on Dec. 7. This eases the pressure for her to take dramatic action. But as Goldman's Conigliaro suggests, the latest numbers merit a second look. During the period, HP's tax rate fell to 15%, down from 19% a year earlier. In addition, research and development fell to 4% of sales, down from 4.6% the year before. This pumped up profits. Investors who are excited about a sustained, profitable growth spurt from HP should be wary. "You can't simply keep cutting R&D and the tax rate to boost profits," says analyst Richard Chu of SG Cowen Securities Corp.
HP acknowledges the point. Robert P. Wayman, the company's chief financial officer, said in a Nov. 16 conference call with investors that the decline in the tax rate was primarily a result of the favorable resolution of a state tax audit and that the tax rate would probably rise to 20% in the coming year. HP officials have said in the past that they expect R&D spending to decline, because of the elimination of redundancies from the Compaq merger and its efforts to place fewer, more focused research bets.
As analysts comb through HP's fourth-quarter numbers, other questions arise. During the period, the amount of money that HP was owed for its products -- the accounts receivable -- surged by $1.8 billion, to $10.2 billion. That caused the amount of HP equipment that retailers and other partners have in stock, but haven't paid for yet, to climb in October to the equivalent of 43 days of sales, up from 40 days in the previous quarter. It's the highest level since 2002. Some experts suggest that this may be a sign that HP is burnishing its results. "[It raises] questions about end-of-quarter sales, particularly into the channel," wrote Goldman's Conigliaro in her Nov. 17 report. HP defends the increase, however, saying that it shipped extra units to support several product launches.
Still, HP suffers from poor positioning. In its PC business, HP runs two systems that often operate at odds with each other. One is a direct-sales, build-to-order model to compete with Dell, which carries virtually no inventory. The other is HP's traditional, higher-inventory model for units that it ships through its sales partners. Operating in both worlds leaves HP doubly exposed. It fails to match Dell's scale and efficiency in the direct system.
Yet if the company pushes more business into direct sales, it risks angering thousands of HP's traditional retailers and resellers. And HP needs their help to sell its printers and ink. A break-up would help to resolve this dilemma, freeing the computer division to adopt the Dell approach. For now, though, HP keeps both systems intact -- and in the process loses ground in PCs. Following the Compaq merger, HP briefly rose to the No. 1 in PCs. But the company has slipped to No. 2, with 15.7% share, behind Dell, which has an 18.3% share. Operating margins in 2004 were a meager 0.9%, miles behind Dell's 8.8% margins.
HP also appears overmatched in its scrum with IBM. Led by CEO Samuel J. Palmisano, Big Blue has put together a more lucrative array of corporate computing products. They span everything from software to servers to chips, and they generate overall 11% operating margins. By comparison, HP's non-printing businesses managed operating margins of 3% in 2004. The disparity is especially clear in the profit-rich software business. In IBM's third quarter, ended in September, its software biz generated $3.6 billion and operating margins of 25%. HP, by contrast, notched $277 million in software sales for its fourth-quarter, ended in October, posting a small operating loss.
At times, HP's push for synergies has gotten in the way, say customers and insiders. Take storage. After buying Compaq's market-leading storage unit, HP integrated it into its enterprise group, which also includes servers and software. Along the way, HP laid off scores of storage-sales specialists in favor of sales reps with a broad knowledge of HP offerings. Key storage execs followed them out the door. In short order, competitors such as EMC Corp. (EMC) began to nab customers from HP. Storage revenues dropped 5% in 2003 and a further 7% in 2004. Even loyal HP customers, such as grocery company Indoff Inc., bolted for EMC when buying storage gear earlier this year. Says Shawn Faulkingham, Indoff's chief information officer: "I was looking for bang for the buck, and HP didn't have it in this case." Although HP recognizes the error and is hiring back storage specialists, it cautions that a turnaround in storage could take time.
Other customers have even more serious complaints. For instance, HP has developed customized Web sites for customers where they can place and manage orders. However, these sites, dubbed B2B (for business-to-business) by the company, have frequently cratered -- erasing accounts, losing orders, and shipping the wrong products, according to former sales managers, customers, and internal sales memorandums that were obtained by BusinessWeek. In one such memo, written back in February, 2004, an HP sales representative complained to his superiors about the disappearance of 70 customers from the B2B systems: "I can't even explain how many relationships...have been burned with this new site." HP has no comment on the B2B issue.
Similar woes have hamstrung HP's efforts to take on IBM in large corporate computing deals. Eight former employees and executives, who all departed within the past year, say that the technology supporting HP's corporate-computing sales -- from order administration systems to customer databases -- remains a patchwork of overlapping and poorly fitting systems despite recent efforts at improvement. HP sales reps laboring within this regime spend only 30% to 35% of their working time with customers and partners, compared with 55% to 60% at well-run organizations, former sales executives say. "I would stress how difficult it is to do business inside HP," says Paul Gerrard, HP's former vice-president for enterprise sales for the central U.S., who left the company in June and now runs sales at a tech company in Colorado. "There are terrible inefficiencies in the system."
To pull off a big sales deal at HP these days often requires delicate diplomacy. Putting together a package involving servers, printers, and software, a sales rep has to hammer out an agreement with each division. If one unit is concerned about financial targets, and unwilling to bend its price, the whole deal can fall through. The company lacks an effective process to resolve conflicts. Fiorina herself helps broker some deals, but she has time only for the biggest accounts, say former execs. "It's the tier-two deals that fall through the cracks," says a former sales vice-president.
These management tangles have fueled calls within HP for hiring a cracker-jack operations chief. Fiorina has categorically ruled out hiring a chief operating officer, saying that a strong CEO should keep a grip on operations. Yet as BusinessWeek previously reported, HP is quietly seeking a top manager to run all non-printing operations. Sources close to the search, including an HP insider, say that the recruitment effort is continuing. Many investors and analysts view Fiorina as an inspiring speaker and salesperson, but either lacking the skills or stretched too thin to solve HP's grueling operations challenges.
If Fiorina continues to struggle, pressure is sure to mount for her to spin off the printing and imaging division. The unit, spearheaded by Executive Vice-President Vyomesh Joshi, spans everything from printers and ink to digital cameras. It boosted its sales by 7% in 2004, to $24.2 billion. And it's a cash geyser, providing 76% of HP's operating profits, derived from just 30% of total sales. Investors clearly love it. Analysts speculate that freedom from broad corporate management could goose the printer group's performance. And they argue that separating from the printing division could protect HP from its most dangerous long-term threat in the printing business, Dell.
PC juggernaut Dell got into the printer business two years ago by reselling Lexmark International Inc.'s (LXK) printers under its own brand name. Since then, Dell has grabbed 13% of the U.S. inkjet market, according to researcher IDC. But why is Dell in printers, a low-margin business for resellers? One primary reason is because HP is using the cash from its printing business to fund the computer division that competes with Dell. "There's a profit pool that some of our competitors are using to subsidize the PC and server business," Kevin B. Rollins, Dell's CEO, told BusinessWeek as Dell plunged into the business in 2002. "That's something we have to go after."
Although it's unlikely Dell would exit the printer business if HP spun off its printer operation, Dell would have much less incentive to push punishing price wars, making life easier for the stand-alone HP printing business. And conceivably rivals such as IBM and Dell could resell HP's equipment or license its technology. "If HP separated their businesses today, and the imaging and printing business was its own entity, I would bet we would be partners because they're a source of technology," says Tim Peters, vice-president for imaging and printing at Dell.
The argument for printer independence has to sound familiar to Fiorina. She was a top exec at AT&T when it decided to spin off its equipment arm in 1996. The primary reason was to enable the division to sell more gear to AT&T's competitors, including SBC Communications Inc. (SBC) and BellSouth Corp. (BLS). The spin-off, dubbed Lucent, initially became a high-flying success, and Fiorina basked in its glow. After 8% revenue growth in 1995, the company averaged more than 15% growth during its first three years on its own, before swooning during the telecom industry's downturn.
HP's corporate computing businesses, though far less attractive, could also benefit from standing on their own. Although investors are valuing the nonprinting operations at next to nothing now, these units, most of them run by Executive Vice-President Ann M. Livermore, generated $1.4 billion in operating profit in 2004. Merrill Lynch's Milunovich and others figure that the businesses, if they were independent, could be worth $18 billion to $21 billion. That calculation is based on applying the same operating margin multiple bestowed on IBM, minus a 20% discount, since Big Blue is considered to be better run and touts higher-end tech services. Still, Milunovich predicts that without the protection of the cash-cow printing business, managers would respond to acute pressure to revamp its sales, upgrade tech systems, and jettison flagging businesses.
Despite the execution woes, Fiorina is open to acquisitions. Her best bet for boosting enterprise profits is in software. She has $13 billion in cash -- plenty to bulk up the software business, much as storage hardware maker EMC has done during the past two years. Promising targets: two leaders in systems management software, Veritas and Mercury Interactive, could sweeten HP profits. In its most recent quarter, Veritas posted operating margins of 25%, compared with the 2.6% operating margins for HP's enterprise business in its fourth quarter.
HP's services division also needs a lift. With $14 billion in revenues, this group helps corporate customers manage and stitch together new information systems. Yet HP struggles in services against IBM, whose service division is three times bigger. While more than 60% of HP's services business comes from low-end, slow-growing customer support and maintenance, IBM boasts richer contracts. Some 70% of Big Blue's service revenues come from business consulting and strategic outsourcing, the kinds of high-margin deals that put IBM consultants into the corner office. No single acquisition will put HP on an equal footing with Big Blue. A purchase of Capgemini's U.S. operations, valued at about $1 billion, would give Fiorina more of a chance to compete with IBM in this arena. IBM strengthened its high-end consulting services through the $3.5 billion purchase of PricewaterhouseCoopers Consulting in 2002 -- a purchase Fiorina says she nixed at a lower price.
As Fiorina completes a half-decade atop HP, the excitement of the early years has faded. The charismatic and determined CEO who set out to build a titan has now assumed a defensive posture and is working to keep her creation in one piece. For success, she must tackle HP's stubborn operational glitches. This will require every ounce of her guile, passion, and boldness. But at this point, her choices are stark: The only way to defend the sprawling HP she has built is to fix it. Until she does, the calls for the breakup of a Silicon Valley icon will only grow louder (JPM).
By Ben Elgin With John Cady in New York and Andrew Park in Dallas