Monday, October 1, 2012

Can Dell and Hewlett-Packard's Restructuring Actually Work?

Two tech bellwethers reported this week and it was a pretty grim outlook from both of them. The issues with Dell (NASDAQ: DELL) and Hewlett-Packard (NYSE: HPQ) are not so much their exposure to technology as their exposure to old technology. In other words, far too many of their profit centers appear to be within a structural decline and it is going to take time for them to adjust to the technological changes that are threatening their profitability. Developments like cloud computing, smart phones and tablets have hurt them as they do not have good exposure here. The turnaround challenges for both are significant and there was little in these earnings reports to suggest they are working.

Notebooks and PCs

Not a nice market to be in right now. Dell reported a 9% yearly decline in desktop PC sales and mobility sales were down a whopping 19%. It was a similar story at HP with its notebook sales down 10% and desktop sales declining 9%.

This is not good news for Intel (NASDAQ: INTC) and it is hard to see how this kind of inventory build up at Dell & HP isn’t going to hold back DRAM chip sales in the near term. To add insult to injury HP referred to component chip costs actually going up. A tricky thing when the company is vowing to defend its leading position.

All hopes for 2012 must surely be pinned on Microsoft’s Windows 8, but frankly with each windows upgrade the impact on PC/notebook sales seems to be less pronounced. It is not the operating system (OS) that people care about, but rather the type of device and the apps that run on it. Yet another triumphal release of Windows is hardly going to excite consumers in the way that a new iphone does.

Storage, Servers and Networking

Again, both companies disappointed in each of these product lines. HP’s storage revenues were down 5%. Dell’s were down 13% but its IP storage came in with growth of 6% albeit below the company’s hopes. These sorts of numbers are not unexpected given NetApp’s recent difficulties and lowering of expectations. It is not only that the storage market is weak but EMC (NYSE: EMC) appears to be aggressively taking market share. NetApp and EMC are specialist storage companies, Dell and HP are two struggling companies in need of turnaround. I know who my money would be on in this fight.

It is a similar story with servers. Hopes were pinned on a surge in demand following the release and integration of Intel’s Romley chip. As such, Dell’s servers revenues came in up at a respectable 8%, although slightly weaker than analyst forecasts. HP’s were down a worrying 3%. In fact, the only product line that both showed good growth in both was networking. HP’s networking revenues rose 6% and 5% sequentially and Dell’s were up strongly too. This sheds some light on Cisco’s recent good quarter in routing and networking.

HP’s Challenges

Probably the biggest challenge remains with its traditional core business of printing & imaging. Corporations and individuals are increasingly storing documents electronically and in the cloud. For consumers, you only have to look at the ‘pic fest’ that is Facebook in order to see where this is going.  With regards to fcorporations, a plethora of electronic devices are now being used to store and carry documents. Printing them is often seen as an unnecessary hassle. Throw in the difficulties that HP is having with the Autonomy acquisition and Meg Whitman has a tough job on her hands. It must be hard to take when your core markets are in decline and your acquisitions aren’t going as planned too.

Listening to the conference call, it appears that the emphasis is on cost cuts and employment cutbacks. This will achieve only so much and I would be concerned by the emphasis placed on fighting back in notebooks/PC and with trying to differentiate itself in the troubled printing & imaging sector. History is littered with companies that failed while trying to innovate in declining markets. I note that instead of fighting a losing battle, Lexmark is pulling out of the consumer inkjet business.

Dell’s Strategy

Dell’s position is somewhat more fortuitous and it has been aggressively making acquisitions in order to diversify revenue streams. The Wyse (client cloud computing) deal and the purchase of SonicWALL (unified threat management or UTM and firewalls) are both in higher growth areas of technology. Indeed, Dell pointed out that their pipelines were up 35% sequentially. This suggests that the UTM market is doing well and confirms what market leader Fortinet (NASDAQ: FTNT) recently reported about its strength.

According to Gartner, Fortinet has 19.6% of the market and SonicWALL has 13.3%. Perhaps there is some trading down going on in the mid-market because UTM is traditionally seen as more of an SMB product? In addition, the upcoming acquisition of Quest Software (database management) also makes sense for its storage division.

The Bottom Line

In short, I think Dell’s strategy looks more interesting but neither of these companies is particularly attractive to anyone other than a value investor. It’s easy to criticize HP but it’s also hard to think what else the current management can do. Making acquisitions when your cash flow is falling and you are downsizing staff is a thankless task. Moreover, divesting troubled core operations is not so much like selling the family silver as it is shutting down the mint. If I had to pick one to succeed, it would be Dell.