Breaking Up HP Will Be Great for Investors

After shelving plans to sell off its PC business a few years ago, Hewlett-Packard (HPQ 0.45%) has changed course with the announcement this week that it plans to break itself into two companies. HP will be comprised of the company's printing and PC business, while Hewlett-Packard Enterprise will sell enterprise hardware, software, and services to business customers.

The split makes sense for HP, which has been struggling to grow, allowing each new company to focus on its core business. For HP investors, the split also makes sense, since the total market capitalization of both new companies will likely be higher than that of HP today. This breakup has a very good chance of unlocking value for shareholders, and here's why.

Old vs. New
Here's a breakdown of HP's segment revenue and operating profit during fiscal 2013:

Source: HP  

In terms of revenue, both new companies will be roughly the same size. The segments comprising Hewlett-Packard Enterprise generated more operating profit during fiscal year 2013 at a higher margin, but both companies will earn billions of dollars annually once the separation is complete.

How will this separation create shareholder value? Let's consider HP first. HP will be about the furthest thing from a growth company one can imagine. Printing has been in decline for quite some time, and the business doesn't appear to be stabilizing any time soon, and the PC market, while stronger than it's been in the past few years, is still expected to slowly shrink over time.

But HP's printing business is a cash cow, with operating margins in the mid-to-high teens. The business of selling ink and supplies to buyers of its printing hardware remains a lucrative one for HP, and it will continue to earn HP plenty of money even as it declines.

PCs are much lower margin, but they still contributed about $1 billion in operating profit in 2013. HP is the second-largest PC vendor in the world, and the more focused HP will be better-suited to compete with Lenovo Group (LNVGY 1.16%) in the PC market without being tied to the enterprise business.

While there are some growth prospects for HP, such as 3-D printing, I wouldn't bet on much growth from the company. A valuation for HP similar to that of HP today would seem reasonable, although if HP pays a strong dividend, investors could flock to the stock. HP could easily afford to pay what HP pays today in annual dividends, about $1.2 billion per year, leaving plenty left over for investments in 3-D printing and other areas. If HP becomes a dividend stock, it could very well command a higher valuation.

Enterprise bound
Hewlett-Packard Enterprise will look a lot like IBM, focused solely on enterprise hardware and supporting software and services. IBM got out of the PC game a long time ago, and Hewlett-Packard Enterprise is now making a similar, albeit belated, move.

HP Enterprise likely deserves a higher valuation than HP has today since there is at least some potential for growth. The low-margin PC business will no longer be holding the company back, and the potential to increase the profitability of the enterprise services segment, which has abysmally low margins, could give a nice boost to earnings. Removing the two segments that have tended to decline over the past few years will make it much easier for HP Enterprise to grow revenue, and its higher operating margin compared to HP today could lead to a higher valuation.

HP Enterprise does face some serious threats, however, that could derail the success of the breakup. Lenovo recently closed the deal to buy IBM's x86 server business, and the company is aiming to steal enterprise hardware market share away from HP. This could lead to lower margins in the server business, and that would be detrimental to HP Enterprise's bottom line.

HP Enterprise, though, will be better-suited to deal with the threat once it sheds its consumer-facing parts, and Lenovo will certainly have a more difficult time competing against a company that is solely focused on enterprise customers.

Final thoughts
The move to break up HP makes a lot of sense, and it has the potential to unlock some shareholder value. HP has never been a particularly good dividend stock, but post-split HP will earn more than it knows what to do with, and paying a solid dividend is a good way to make the stock look more attractive despite its lack of growth potential. HP Enterprise, now unburdened by PCs, can focus on protecting its server market share and growing its services business. A higher valuation than HP has today is possible, and I suspect that investors will ultimately benefit from HP's breakup plan.