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Another Perspective


PREOCCUPY WALL STREET

IBM has almost always been a darling of Wall Street.  It is Big Blue, the bluest of the blue chips.  This year IBM shares have risen more than any of the other 29 components of the Dow Jones Industrial Average; they currently sell for about 13 times earnings.  Hewlett-Packard is also a DJII component.  It has significantly higher revenue than IBM.  For the past five years it has grown faster, too.  It sells a larger number of servers than Big Blue.  But its name is mud on Wall Street.  HP's price/earnings ratio is half that of IBM.  How come?

Looking strictly at the numbers, some of the financial facts seem to justify investors' sentiments while others simply do not.  For instance, IBM's financial reports peg the company's gross profit margin somewhere north of 46 percent.  HP, by contrast, reports gross profits margins of 24 to 34 percent, basically half that of IBM.  Similarly, IBM's net profit is about 15 percent, while HP's is in the vicinity of 7 percent.  To a considerable extent, IBM's higher profit margins come from its huge software business.  Software at IBM reports pre-tax net margins in the mid-30s.  HP sells software, too, but its software revenue is tiny compared to IBM's and even smaller when compared to HP's total revenue, which is 25 percent greater than IBM's.  HP's pre-tax margin in software is just under 20 percent, a little more than half of the kind of profitability IBM has managed to achieve.

In services, however, the comparisons are not so painful to HP fans.  HP gets about 20 percent of its revenue from services, while IBM gets more than 50 percent of its revenue from services.  HP says its pre-tax profit in services run about 13.5 percent; IBM's is 14.5 about percent.  So, at well under half IBM's size, HP's services business (which became large when HP acquired EDS and thus gets quite a bit of intake from the IBM mainframe services market) really ought to be acceptable to if not loved by investors .  .  .  if HP can get it to grow.  Like IBM, HP is finding that competition in services from Asian players is pretty stiff and that the quality of services provided by the kind of Asian firms IBM and HP run into on bids for large contracts is quite high.  IBM and HP may say they are at the top of the league when it comes to computing services, but the services business has evolved in a way that has all the big players sharing in the same global talent pool.  The deep end of that pool is in IIT (India Institutes of Technology) territory.

When it comes to hardware, IBM and HP are markedly different.  They are both in the server business, but HP's market strength is in small and mid-size boxes.  IBM, of course, is the leader in large machines based on Power technology (or Power's fraternal twin, the mainframe).  IBM has a substantial trade in X86 iron and well regarded products, but once you look at that segment IBM's shipment volume is in third place after not only HP but also Dell.  (Dell, half the size of HP and therefore more than half IBM's size, has financial ratios, particularly the important net profit margin, that generally fall between those of IBM and HP.)

If you look at HP's share price, which has been in the toilet for what seems like years, you might guess that there is some obvious measure of corporate success where HP falls short .  .  .  and where IBM displays its prowess and glory.  Market capitalization, the total value of a company's outstanding shares, is one gauge of investor sentiment, and, if you notice how often it gets mentioned in articles about business, it's arguably the best measure of money's mindshare, if money can be said to have a mind.

Apple, which Wall Street loves nearly twice as much as it loves IBM, if market capitalization is love, has a market cap in the vicinity of $400 billion.  IBM's is a bit more than half that.  HP's market cap is less than a quarter of IBM's, between $40 billion and $50 billion, making it a company with roughly a tenth the worth (in the opinion of shareholders, anyway) of Apple.  Dell's total share value is maybe three-fifths that of HP.  If the purchase didn't move the price, Apple could buy Dell with the $28 billion or so in cash it has on hand.  (Google, not a direct competitor of these firms but a technology company that's on every investor's mind at all times, is sitting on something like $40 billion in cash.)

Sometimes it seems as if a company's share price (and therefore its market cap) will rise if a firm is growing and fall if it is shrinking or even growing more slowly than its rivals.  Well, since companies publish their revenue figures and anyone with an HP-12C or a spreadsheet program can quickly derive a straight line that shoots through the data points, the easy-to-compute revenue growth rate is abundantly used to justify a company's share price.  But try to justify this: IBM, as I keep saying, is hotter on Wall Street that the Hollywood starlets gracing the protest campground.  How fast has the company grown the past five years? How about 9 percent per year? That's pretty good compared to, say, individuals' average earnings or housing prices.  But it's just plain crap compared to the way Apple has been growing for the past half decade, which is at a rate of 15 percent per year compounded.  HP has been growing at 11 percent a year, way faster than IBM, and Dell has been growing at the same pace.

So even though pundits are trying to explain how the PC business on which HP depends for sales of client machines and, indirectly, for sales of printers (which by itself is a bigger business than IBM's total sales of servers, storage and other hardware), is just a dying trade, mortally wounded by iGizmos and Androids and so forth, that's one of those widely accepted ideas that turns out to be mainly horse manure.  Yes the PC business is rough right now but right in PCs turns out to be slow growth not no growth (for the aggregate, as some players may actually have been unable to keep up the pace).  And HP, talking about spinning off PCs as some kind of financial caper that must have seemed cute and clever to Apotheker before his defenestration, did itself no good making all kinds of crazy talk.

It might turn out that an HP breakup is a good idea and if so a company that deals with its customers selling stuff used at the client end of the wire or wireless could possibly want different rules than a company that sells to corporations not people.  Corporations buy servers and glass house equipment and, increasingly, cloud stuff and all kinds of exotic services.  IBM hates people as customers and loves corporations.  That has been clear since it sold off the Selectric and made PCs so awful that more than a dozen clone makers were able to kick its big blue butt, while Apple became a power mainly because of the way it poked fun at IBM.  Anyway, as I've said, it's possible that HP's owners would be better off holding shares in two companies, HP-that-likes-people and HP-that-likes-corporations.

Still, right now, with Western Civilization circling the economic drain and the IT world persuaded that its salvation will come from tablets and smartphones, IBM and HP both really only need one thing: Stuff that sells.  Neither has yet understood the insight of Steve Jobs, who won't be giving out any more clues now that he has been repackaged in his diePod.  Jobs visited Xerox PARC and other places where nerds were kings and saw precisely what the world needed: Machines that keep engineers' fingers busy so they don't pick their noses so much.

Wall Street seems to believe IBM has that kind of brilliance and HP does not.  I can't spot much evidence either way.  Is Wall Street money smart money? Maybe.  But it never was before.

— Hesh Wiener October 2011


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