HP Faces Criticism for Shortchanging Research and Development

Hewlett-Packard is facing sharp criticism from one of its rivals regarding the company’s strategy for investing in research and development.  In a very candid interview with The Wall Street Journal, IBM Chief Executive Samuel Palmisano claimed that HP has little choice but to spend significant sums on acquisitions because former CEO Mark Hurd “cut out all the research and development.”  Mr. Palmisano also criticized HP’s Board of Directors for providing Mr. Hurd  with a generous severance package saying that this was not a good use of shareholder money.

While criticism from a rival should usually be taken with a grain of salt, Mr. Palmisano appears to have a point regarding overall trends in HP’s commitment to R&D in recent years.  From a brief examination of the data over the past decade it is clear that the company has cut R&D spending significantly and it is very possible that this has interfered with the ability of HP engineers to develop products in-house that are now being purchased at steep price tags through acquisitions.  We have been critical of HP’s acquisitions of 3Par and ArcSight based on the high valuations being paid.  Could more R&D spending have allowed HP’s internal resources to develop such technology in-house?

R&D Spending Track Record

In an attempt to come up with some answers regarding the validity of Mr. Palmisano’s comments, we took a “thirty thousand foot” view of HP’s R&D spending track record over the past decade by examining basic data contained in recent 10-K reports.  This article is by no means a comprehensive analysis of HP or an analysis of how the R&D funds were actually used.  Obviously, raw numbers for spending on R&D are not the entire story since funds can be deployed poorly or efficiently.  For now, this is beyond the scope of our analysis.

The exhibit below contains data extracted from recent 10-K filings.  A revenue breakdown is presented along with statistics on R&D spending.  Since HP’s revenue mix has changed in recent years, particularly since the acquisition of EDS in late fiscal year 2008, we calculate R&D spending both as a percentage of total net revenues and as a percentage of product revenues.  Click on the image for a larger view.

We can see that the raw figure for R&D spending steadily increased from $2.6 billion in fiscal 2000 to $3.7 billion in 2003 before remaining roughly constant until fiscal 2008 at an average yearly level of approximately $3.5 billion.  In fiscal 2009, R&D spending was cut to $2.8 billion and it appears that the pace of R&D spending for fiscal 2010 has remained at around $2.8 billion on an annualized basis.

However, looking at the raw figure for R&D spending does not tell the whole story because companies typically determine how much to invest in R&D based on a percentage of revenues.  As the scope and volume of product sales increases, technology companies must typically invest a certain percentage of revenues to remain competitive especially if a larger product portfolio is responsible for the boost in sales.  The exhibit below presents HP’s R&D spending as a percentage of total net revenues and as a percentage of product net revenues.

The chart visually demonstrates that HP has dramatically cut R&D spending as a percentage of both total and product revenues over the past decade.  This trend has continued with further declines in the first nine months of fiscal 2010.  HP was spending over 7 percent of product revenues on R&D in the early years of the last decade.  This has fallen by more than half to 3.5 percent for the first nine months of fiscal 2010.

Short Term Profit Boost … But at What Long Term Cost?

Just as skipping a couple of oil changes will not immediately destroy your car’s engine, cutting R&D spending will not have an immediate impact on a company’s technological position.  In fact, skimping on R&D can boost reported profitability in the early years of such cutbacks since the company’s products will still be competitive and costs will be reduced.  Over time, however, technology companies that fail to invest in R&D will eventually face a decline.  In the case of HP, Mr. Palmisano is suggesting that the company is now paying the piper by being forced into expensive acquisitions made necessary by a lack of internal innovation.

We have not made a case one way or another regarding the efficiency of HP’s research and development program and there is no way to prove that the company could have developed technology in-house that would have made the 3Par and ArcSight acquisitions unnecessary.  However, it is quite clear that both Carly Fiorina and Mark Hurd presided over a gradual decline in HP’s commitment to R&D.  HP shareholders should be asking tough questions regarding the concerns Mr. Palmisano has raised.

Disclosure:  No position.

HP’s Acquisition Binge Continues with $1.5 Billion Cash Offer for ArcSight

Hewlett-Packard’s Board of Directors has yet to name a permanent CEO to replace Mark Hurd but is set to seal the deal on the company’s second major acquisition in less than one month.  According to a press release issued this morning, HP will acquire ArcSight for $43.50 in cash in a $1.5 billion deal.  The transaction is expected to close by year end.

The ArcSight transaction follows HP’s victory in a bidding war for 3Par earlier this month.  In a critical article in late August, we noted that HP’s Board appeared to believe there were “no constraints” in its bid for 3Par.  At the end of the battle, HP agreed to pay $2.4 billion for a company that posted sales of only $194 million in its latest fiscal year and has yet to exhibit any signs of consistent profitability.  By any measure, HP paid a very rich price for 3Par.

How does the ArcSight transaction measure up?  According to Value Line, ArcSight posted sales of $181.4 million in its latest fiscal year which ended on April 30.  The company is profitable with net income of $28.4 million in the latest fiscal year.  ArcSight provides high end security management solutions which have been in greater demand in recent months due to concerns regarding high profile hacking attacks.  According to the press release, HP intends to use ArcSight’s technology to further expand the range of offerings to corporate clients looking for turnkey solutions:

“HP’s acquisition of ArcSight will enable the creation of a new type of security solution, one that serves the modern enterprise,” said Tom Reilly, President & CEO, ArcSight. “By combining ArcSight’s Enterprise Threat and Risk Management Platform with HP’s breadth of application development and operations management solutions, HP will be able to offer an integrated security platform that delivers broader visibility, deeper context, and faster remediation of enterprise wide security and risk related events. In a world where perimeter security is no longer enough, businesses need this holistic approach to securing their networks, applications and sensitive data.”

We cannot comment on ArcSight’s business or valuation in any detail and it is possible that the company has breakthrough technologies that will allow HP to justify the purchase price.  However, by any conventional valuation measure, the price tag is extremely high.  We also know that ArcSight has been actively trying to sell the company over the past several weeks.  If prospects for growth are so explosive, it is fair to question why ArcSight’s management would be so eager to sell.

As we wrote over the weekend, technology companies seem to be allergic to the concept of returning cash to shareholders and prefer to hoard cash to retain flexibility to pursue deals.  Regardless of the merits of the 3Par and ArcSight deals, it is highly dubious for a company without a permanent CEO to engage in transactions at speculative valuations.  The incoming CEO will have no accountability for the performance of these acquisitions.  While in theory the Board of Directors can be held accountable, the reality is that any failures will simply be glossed over.

Disclosure:  No position.

Technology CEOs View Dividends as Sign of Defeat

Few examples in stock market history more clearly illustrate the risks of buying into “hopes and dreams” than the technology bubble of the late 1990s and early 2000s.  Companies with no earnings and nonsensical business plans eventually ceased to exist and are now long forgotten.  However, most of the well known technology firms from 2000 continue to exist today and have tested business models that generate consistent profitability.  However, investors are so disillusioned that valuations have plummeted.  This raises the question:  Are technology companies now “value stocks” that should pay large dividends?

The question of technology firms’ “payout problem” was the subject of an article this weekend in Barron’s.  Andrew Bary makes many of the familiar points regarding the valuation of companies such as Hewlett-Packard, Microsoft, Intel, and other former high fliers that now trade in value territory based on earnings multiples.  We recently published a favorable article regarding Microsoft making some similar points.  Barron’s points out that few technology companies are paying significant dividends. Intel’s 3.5 percent payout is an exception and Microsoft also pays a modest dividend of 2.2 percent but clearly the potential for much larger dividends exists.

Why Hoard Cash?  Look at the Incentives…

Why are technology CEOs so reluctant to pay dividends and prefer to pile up huge amounts of cash on the balance sheet?  The motivation behind cash hoarding for technology firms seems to fall into two categories.  First, technology CEOs have a mindset in which talk of growth is paramount.  Analysts expect this focus and “growth” investors will abandon a company that admits limits to growth by paying dividends.  Second, compensation plans for technology CEOs usually rely heavily on options with a fixed exercise price.  Paying large dividends reduces the intrinsic value of the options because cash is exiting the business.  Additionally, CEOs may believe that a permanent revaluation of the company as a slow growing “value” stock could prohibit multiple expansion that will increase the value of options.

However, the reality may be quite different in terms of how the market reacts to higher payouts.  Many investors are legitimately afraid of high levels of cash on the balance sheet due to  concerns that expensive acquisitions may be pursued.  HP’s acquisition of 3Par is the latest example.  Paying a larger percentage of free cash flow to investors could provide reassurance and also would impose discipline on management.

Barron’s also accurately points out that some investors will be attracted to technology companies based on larger payouts.  The incoming group of income oriented investors could very well make up for the exit of investors seeking “growth”.  As Warren Buffett and others have often said, the distinction between “growth” and “value” investing is a  false one to begin with.  Ultimately, management should retain earnings only when the prospect of internal reinvestment or acquisition exceeds a hurdle rate that is higher than what investors could achieve for themselves if they take possession of the excess cash.

Look at Share Ownership, not Option Holdings

While it is impossible to predict which technology companies will increase payouts going forward, one clue could involve the level of stock ownership by management.  If the CEO has a large ownership interest, as opposed to merely holding a large number of options, he or she would benefit from distribution of the cash just like other shareholders.  When Microsoft instituted a regular dividend in 2004 and paid a one-time special dividend of $3.00, many observers believed that this was due to Bill Gates and Steve Ballmer’s large ownership position in the company.

With the dividend tax set to increase in 2011, it would not be surprising to see special dividends paid out later this year.  Companies with high levels of insider ownership are much more likely to make such a move.

Disclosure:  The author of this article owns shares of Microsoft Corporation.