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The HP Split: The Devil Is in the Details

By Adam Levine-Weinberg - Oct 8, 2014 at 3:30PM

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Investors cheered the news that HP will split in two, but this isn't necessarily a great move for long-term shareholders.

On Monday October 6, 2014, Hewlett-Packard (NYSE: HPQ) announced plans to split into two companies next year, confirming reports that leaked out over the weekend. One company, called HP, will maintain the PC and printer businesses. The remainder of the company, including enterprise hardware, services, and software, would be called Hewlett-Packard Enterprise.

HP's printing and PC businesses will be split from the rest of Hewlett-Packard.

This move was particularly interesting, because one of the first things HP CEO Meg Whitman did when she took the job in late 2011 was cancel a plan to spin off the PC business. At the time, she argued that HP was "better together." Now, the company claims it will be better off as two separate entities. What gives?

The goal of a split

Splitting HP into two companies could generate value in two ways. First, splitting into two companies might improve results. Second, investors may value the two halves more highly than the combined company, independent of any performance improvements.

In the first vein, while both halves would still be big (more than $50 billion in annual revenue), they should be easier to manage since they'll have fewer products. Each company's management teams will be able to devote its attention to a smaller set of threats and opportunities.

Having two companies with narrower focuses also makes it easier to align executive and investor interests. In a conglomerate, stock performance depends on lots of factors. If managers in each division receive stock options, they can "free-ride" on the performance of other divisions. The stock price might go up even if their own division performs poorly. In a smaller company, that would be less likely.

A split could also improve HP's valuation independent of its impact on financial results. Today, investors have to buy into the whole HP. That includes some mature businesses that produce strong free cash flow but have minimal growth potential, as well as other businesses that require more investment but could potentially offer higher growth.

Some investors prefer investing in high-yield stocks with strong free cash flow. Others prioritize growth opportunities. HP will fit into the former category, while Hewlett-Packard Enterprise fits more into the latter category. Investors may be willing to pay more in total for the pieces they prefer than they would pay for the whole package.

The cost of being apart

The last proposed split of HP would have left the PC business by itself.

When Meg Whitman canceled HP's plans to spin off the PC business in 2011, she cited $1 billion of potential dis-synergies that would have been lost. Much of that was related to the fact that the PC division would have had to be rebranded, whereas it will now keep the HP name.

However, another potential issue is that HP is currently one of the largest buyers of computing components in the world. This allows it to get favorable pricing. Splitting the PC business from the enterprise hardware business may endanger some of these "purchasing synergies." HP also saves on overhead costs like IT by being a single company.

The last issue is that as a single company with a unified sales force, HP could offer top-to-bottom computing solutions for its customers. After HP splits, it will no longer be able to sell this particular value proposition.

On the company's recent conference call discussing the HP split, CEO Meg Whitman and CFO Cathie Lesjak assured investors that the long-term dis-synergies would be much less than $1 billion. However, they admitted that there will be significant short-term costs, and that the long-term costs probably can't be driven to zero.

Jury is still out

HP executives have provided a compelling rationale for why splitting the company makes a lot more sense now than it did in 2011. In 2011, HP's PC business was starting to come under severe pressure from the tablet revolution. Sales in the PC division fell 3% in FY11, 10% in FY12, and another 10% in FY13. The PC segment margin also fell significantly.

By contrast, PC division sales rose more than 7% through the first three quarters of FY14, while its segment margin has started to improve. In fact, pre-tax earnings for the Printing and Personal Systems Group -- which will become the new HP -- are up 14% year to date. Investors no longer have to worry that this side of the business is about to disappear.

The return of stability in the PC and printing divisions makes a separation more feasible than it was just a few years ago. However, it still may or may not be a good idea for long-term investors. That will depend on the ultimate size of the dis-synergies from splitting, compared to any benefits that greater focus might provide in accelerating HP's turnaround.

In this context, it's worth noting that companies with enterprise-focused product portfolios haven't been doing especially well recently. The enterprise side of HP would arguably be just a weaker version of IBM. Yet IBM has seen organic growth stall out in recent years, and its stock price has barely budged in the last three years. It's not a very compelling model these days.

Foolish final thoughts

Investors sent HP stock up nearly 5% on Monday, following the news that HP would split. This reflects hopes that the two halves of HP will perform better apart, as well as the valuation benefits of offering investors two distinct investment alternatives. However, it will take several years to really know whether HP's decision to split in two was the right call.

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