Turnaround opportunities often arise when companies experience a decline in fundamentals, which then leads to falling earnings and, usually, slowing top-line growth rates. Investors should note whether any such decline in fundamentals has been a result of weak leadership or management's strategic blunders and poor execution. If so, the appointment of a new management team to clean up the mess might become an excellent catalyst for increased profitability and solid returns in the short term.
One such turnaround opportunity might just be Hewlett-Packard (NYSE:HPQ). The company has already made some cost-cutting changes under new CEO Mark Hurd, including plans to trim 14,500 jobs, a move that will improve HP's operating leverage and should lead to bottom-line profitability and a boost to its stock. Over the long term, however, HP will need to find ways to boost top-line growth. Without that, its potential for sustained returns is somewhat limited.
Meet the new boss
Hurd used to head up NCR (NYSE:NCR), a diversified global IT company, where he achieved a successful turnaround effort ahead of schedule. The turnaround, pulled off largely through cost-cutting, improved NCR's margins. Operating leverage and margins got an additional boost from subsequent revenue growth, which also began to appear ahead of schedule.
Hurd has begun making similar changes at HP, and the company's stock price is beginning to reflect it. As of Aug. 19, the stock was up nearly 8% since its earnings call three days earlier. Hurd is a competent manager, and his experience should help HP improve, particularly in its struggling enterprise business, which provides servers, storage, and software for large enterprises.
HP's Aug. 16 earnings report showed revenue of $20.8 billion and EPS of $0.36 -- both ahead of expectations. The company delivered revenue growth of 10% -- the same as Dell (NASDAQ:DELL), which had reported the previous week. And, sure enough, HP showed glimmers of improvement in the enterprise business, with improvements in sales of servers and storage sales. The company's operating margin improved from 3.5% to 4.4% year on year, no doubt assisted by Hurd's cost-cutting.
Over the long term, however, I doubt that HP will enter the ranks of leading hardware companies. It will need to do far more, both strategically and tactically, to move from mediocre company to industry leader. It's spread too thin from trying to compete in too many areas. A more cohesive, selectively focused strategy could better leverage HP's resources and deliver more robust results. Alas, it seems as though HP will continue to operate as a diversified, multi-product/multi-market company rather than a more streamlined organization.
Time to shake things up
Here's some of what HP still needs to achieve:
- A leaner and clear business strategy.
- A more unified company culture.
- Increased visibility in senior management accountability.
- Considerably better execution, particularly in the enterprise business.
- Significantly more cost cuts (including layoffs and spinning out) to improve operating leverage.
- A sales focus driven by specific end markets.
Hurd's abilities aside, I'd rather have seen HP promote from within. Its corporate culture is already indistinct, and because he's an outsider, Hurd will need more time to learn the inner workings of the company, which could hinder progress on HP's road to recovery. I can't help thinking that Vyomesh Joshi, the head of HP's lucrative printing and imaging business, might have been a better choice. But the fact that HP once again didn't promote from within (Carly Fiorina was an outsider, too) suggests that its management bench isn't very deep.
Unclear company cultureUnlike many commentators, I always thought that Fiorina was the right person at the time for HP. The company had been struggling with its Internet strategy, and shortly after she arrived, she (appropriately) put an end to a lot of vendor finance deals for dot-coms. Her right-on rationale: "HP isn't a bank." She then went on to more tightly focus the company's strategy. In an earlier article, I suggested that companies such as Sun Microsystems (NASDAQ:SUNW) probably wished they had done the same. Sun bled red from the dot-com bust, and it's likely continuing to bleed in areas such as amortized debt.
My one criticism of Fiorina is that she brought an AT&T/Lucent Technologies (NYSE:LU) hierarchical management style to a culture that had traditionally thrived under a more egalitarian system. I fully recognize that this more structured style may well have been necessary, considering the size and breadth of the post-merger HP entity. But it's not a style conducive to the type of innovation that flourished during the old days of HP.
Remember, HP is the only American company ever to have won the Deming award in Japan for quality. Now, the company has de-emphasized R&D, outsourced almost all of its manufacturing, and has become an assembler of someone else's parts with margins that are fixed. The "HP Way" appears long gone, thanks to a focus on outsourcing and paranoia about diversity programs and other nonsense. The new "way" seems to be more about spin. I can't help thinking that the real spinning is going on in Dave Packard's grave.
HP desperately needs to restructure if it wants to regain its focus. More R&D within an open environment might lead to a return to the old ways that worked so well for so long.
Enterprisebusiness needs a shot in the arm
Whether Hurd can turn around HP's enterprise business remains to be seen. The sector is a shambles, plagued by poor execution, weak sales, dreadful customer service, and an unfocused marketing message. Furthermore, IBM (NYSE:IBM) is a formidable competitor in this realm. I'm not very confident of HP's ability in the long term to regain lost ground and market share in this sector. Success in the enterprise categories (in particular, servers) is key to driving top-line growth as well as incremental revenue and profit in other segments such as storage, software, and services. Consequently, HP runs the risk of continuing to lose share to more focused, higher-quality enterprise manufacturers, such as Motley Fool Stock Advisor recommendation Dell (NASDAQ:DELL) in PCs and IBM in servers.
It's unlikely that HP's printing and imaging business -- its premier franchise -- can offset an ongoing weakness in enterprise. Although HP continues to be a leader in printing, the merger with Compaq transformed that sector from being HP's largest and most profitable business unit into a much smaller overall contributor to the total numbers.
It doesn't help that Hurd takes over as demand continues to remain relatively weak across most of HP's product segments. Although HP has significant technology assets and a solid stream of revenue from both its printing and supplies segments, these positives appear to be virtually offset by ongoing pressure from increased competition, commoditization, ongoing execution challenges, and lack of strategic focus. The company also faces a number of operating risks, the biggest of which is price pressure from Dell and IBM in the aforementioned market segments. Even the potential strengthening of the U.S. dollar could have an impact on HP's international business.
A turnaround stock?
Since Hurd's arrival, HP's stock has appreciated by around 16%. The company has many features of a "good" turnaround, but turnarounds tend to be shorter plays (one to two years) than true value plays (three years plus). Unless HP can generate top-line growth in the high single digits, I don't see a long-term buy-and-hold opportunity here. But as a 12- to 18-month investment, I like it. I can see it trading up to the $30 range.
HP has the potential to simplify its strategy, improve margins through cost cuts, win back some market share, and boost its enterprise business (although this would be its toughest challenge). And all of those moves -- which Hurd is capable of achieving -- should be positive for the stock in the short term.
Philip Durellalways loves a good turnaround play. To see his latest picks, why not take a free trial of our Motley Fool Inside Value newsletter?
Fool contributor Melanie Hollands does not own shares in any company mentioned.
