Thursday, May 19, 2005

HP: When Less is More

Hewlett-Packard’s new CEO is facing intense pressure to share his plans for how to improve HP’s operations. Mark Hurd, who took over from Carly Fiorina last month, is facing investors unhappy about a lagging stock price and a loss of market share in key markets.

Under Fiorina, HP attempted to become a technology powerhouse competing in vastly different markets, from personal computers, printers, digital cameras, and big business servers, to consulting, software, and online services. Sometimes it seems as though there’s no part of the technology market that HP is not involved in. In fact, HP describes itself (in its most recent annual report) as:

“a leading global provider of products, technologies, solutions and services to individual consumers and businesses. Our offerings span information technology (‘‘IT’’) infrastructure and storage, personal computing and other access devices, multi-vendor services including maintenance, consulting and integration and outsourcing, and imaging and printing.”

In other word, it thinks of itself as everything to everyone. This has caused HP to lose focus and stray away from its core competency – it’s imaging division, which includes printers, scanners, and digital cameras. HP’s imaging division accounts for 70% of the firm’s profits, despite accounting for only 30% of HP’s revenue. This cash cow is now feeling some heat from a rapidly growing Lexmark and an aggressive market entry by the usual suspect, Dell. The growing competition is reflected in the reported operating profits in printing, which fell 14.5 percent from a year ago. And HP faces even more challenges ahead, from firms like from Kodak, which is widely expected to enter the printer market next year.

One of Fiorina’s most controversial moves was the Compaq merger, a move that never produced the anticipated results of putting HP in a better competitive position vis-à-vis Dell and IBM. Competition was fierce as Dell entered the market with a skimming strategy that was successful in stealing market share from a thinly spread HP. Dell’s lower cost structure posed a difficult situation for HP. It was faced with two options: 1) lower its price and start a price war with a much more efficient competitor, while losing margins or 2) relinquish market share and let Dell take the lead. Fiorina chose not lower its low-end PC prices and as expected, lost significant market share in the PC category. Furthermore, HP announced that it would focus on the profitability of its PC division - in other words, that it had settled for being second to Dell. As stated in the FT earlier this year, “HP is stuck in some commoditizing markets as neither the low-cost producer nor a successful innovator.” Analyst Andew Neff of Bear Stearns sums it up well in this article when he says: “The strategy is unclear when you compare to other companies. What is it that ties everything together? IBM is in software and services, Dell is the low-cost vendor, EMC is storage, HP is: Fill in the blank."

Hurd, the new CEO, was heralded in the last week for HP’s favorable second quarter results (most of which occurred before he took the helm). However, he has not announced how it plans to continue growing and sustaining its large scope of offerings. As Mark Stahlman, an analyst with Caris & Co said, investors are most interested in the longer-term plan that will provide a cure for HP’s fundamental issues-- "Investors want to know what he will do in order to accelerate growth.”

Some commentators have suggested that HP buy Gateway in order to obtain scale in the PC business, but this would be a mistake. HP’s problem isn’t that it needs greater economies of scale to compete with Dell – and even if that was the problem, Gateway’s $3.5 billion in revenues would do little to address this issue. Rather, HP needs to recognize that the skills required to succeed in the PC business have changed over the past decade, and that they are very different from HP’s core competencies. HP is a R&D focused organization and spends close to 5% of revenues on R&D – in contrast to Dell’s less than 1%. PCs are a commodity business, and Dell’s cost-focused model is simply much more suited to this business than HP’s. Rather than fighting a defensive battle against Dell, HP should face up to reality, and recognize that it can’t compete in the PC business. Similarly, HP should also recognize that it won’t be successful in the Enterprise Storage and Servers business. HP can’t compete with more focused companies like EMC, Network Appliance, and Sun – as evidenced by its anemic 1% profit margins on this business.

HP needs to refocus its strategy around its core imaging business, and divest everything else. This is a growth business where HP’s R&D skills can pay real dividends in the form of competitive advantage. HP’s recent purchase of online photo site Snapfish is a good start, but appears to be little more than an afterthought to the company’s current strategy. Divesting its other businesses will allow HP to focus on imaging and the growth opportunities it presents. HP should at a minimum sell or spin off the PC business and enterprise storage/server divisions, but it should also seriously consider selling its services division – there’s simple no strategic fit with the imaging business.

Analysts estimate that the parts of a split up HP would be worth 25-50% more than the firm is today. Spinning off the PC and enterprise business into a separate company - like it did with Agilent in 1999 - would likely also improve these divisions’ operational performance. As division managers are freed from the HP bureaucracy, we believe that improved operating results would make the true long term value of splitting up the company even higher.

Let’s just hope Mark Hurd agrees.

Veronica Herrero, Sophia Kamberos and Chris Rodskog


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