EDS, Y-E-S. COMS? N.O., HPQ!

Has Hewlett-Packard (NYSE: HPQ  ) lost its mind?

Late yesterday evening, after cooler heads had called it a day and headed home for some quiet time with the spouse and kids, the PC giant announced what is, quite possibly, its dumbest move yet: buying 3Com (NYSE: COMS  ) .

I know, I know. I'm supposed to be in favor of HP's acquisition spree. Last summer, I praised Mark Hurd's decision to gobble up EDS, a move that promised to leapfrog Accenture (NYSE: ACN  ) in worldwide IT market share, not to mention making HP a true force to be reckoned with, second only to IBM (NYSE: IBM  ) . But this week's news isn't a case of HP getting bigger and badder. This time, HP's just getting bloated and worse.

Consider: When HP bought EDS, which had lower margins than HP's service division's margins, it already had deep experience and a proven ability to post strong margins in IT consulting. This lent every confidence that HP could improve the new business and reap great gains as it brought "EDS's" profit margins up to snuff.

Not so with 3Com. Here we have a hardware maker like HP, but one that earns less than one-quarter of HP's 9.2% operating margin, achieves barely one-fifth of HP's returns on equity, and isn't even growing as fast as HP's expected 10.7% five-year growth rate.

Maybe this would be a good idea if HP were getting 3Com for a bargain price, but that's simply not the case. When HP bought EDS last year, it paid roughly 60% of its own price-to-sales ratio to capture its prize. This time, HP is shelling out a net $2.7 billion for 3Com -- a ratio of 2.1 times sales, when HP's own shares command only 1 times sales. This time, HP is overpaying for an inferior product.

Now, I know what you're going to say: "But Rich, Cisco (Nasdaq: CSCO  ) threw down the gauntlet when it stepped into the server market! HP has to retaliate by threatening Cisco with a credible rival in networking."

But the key word there is "credible." Can anyone honestly argue that 3Com is a worthy opponent to Cisco? Cisco's more than 25 times as big as 3Com by sales, and earns a profit margin five times as large. Maybe a combined HP-3Com can upset Brocade (Nasdaq: BRCD  ) , but I don't expect giants like Cisco or Juniper (Nasdaq: JNPR  ) to lose any sleep over this deal.

Foolish takeaway
HP buying 3Com isn't a threat to Cisco. It's an exercise in diworsification, plain and simple. Make no mistake: HP shareholders will rue the day HP logged on to 3Com.

Fool contributor Rich Smith does not own shares of any company named above. Accenture is a Motley Fool Inside Value recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (8)

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  • Report this Comment On November 12, 2009, at 12:54 PM, bikealot wrote:

    A couple years ago Mark Hurd had strong desires to get into home networking. He initiated programs to go after that market and the products were canceled prior to hitting the market. I suspect this is another attempt at going after the home market while also expanding on their enterprise networking business.

  • Report this Comment On November 12, 2009, at 3:36 PM, takeout2002 wrote:

    ...this assessment is dead wrong...it's, at best, a rear-view mirror judgement that frames it's value based on performance in a worst downturn in 25 years. Make no mistake - this acquisition puts HP in the driver's seat in the highest growth market (China), in the highest margin business (networking), with a next century China-resident R&D workforce & cost structure. They have essentially leap-frogged Cisco in development capacity with a cost structure Cisco cannot touch. Have a look at the H3C portfolio - matches Cisco feature-for-feature with much lower prices and lower power consumption. This is going to hurt Cisco in their bread/butter high margin 'core' businesses. Overpaid? on the contrary...this will look the bargain of the century in two years time.

  • Report this Comment On November 12, 2009, at 8:14 PM, swlaaggie wrote:

    All the 3Com metrics you provided are applicable only under 3Com management. Hurd has proven that he can effectively digest acquisitions, cut out the fat, and effectively harvest the point of the acquisition. As such, why is it fair to look at any metric that is more tied to management effectiveness than the merit of the source of revenue under more competent management?

    3Com revenues come down the middle of the plate where HP has chosen to grow. I agree that 3Com was dysfunctional at best but their technology has never been credibly questioned. This same technology should be complementary to HP.

    Add the points that takeout2002 mentioned and I'm not sure this isn't a hands down winner of an acquisition.

  • Report this Comment On November 13, 2009, at 12:05 AM, sodapops wrote:

    Ciscos greatness has been built on high margin business. Those high margins are about to evaporate.

    Ciscos entry into the server market will will bring them into competition with the likes of HP and Dell in a low margin market HP and Dell are used to competing in. HP is now making it clear that Ciscos margins on networking gear are going to disappear as it becomes as commoditized as the server market is

    HP is the strongest competitor in this market, they have been trouncing dell for years. They have learned to compete in the low margin market.

    How will Cisco fair in the low margin game? Only time will tell.

  • Report this Comment On November 13, 2009, at 6:06 PM, LTInvestorJim wrote:

    The analysis is way too simplistic. $2.7B? HP generates that much cash in less than a quarter. This is all about the battle for the data center. If having this capability helps HP win more HW/services deals, especially in China, it's money well spent. Low operating margins at COMS? Hurd will definitely fix that.

  • Report this Comment On November 13, 2009, at 7:05 PM, TMFDitty wrote:

    Thanks for the feedback, everyone. I see there's a lot of optimism over HP out there... Now we'll sit back and see if Mr. Hurd can justify it.

    Foolish best,

    TMFDitty

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