Whitman's HP Restructuring Prone to 'Autonomous' Writedowns

NEW YORK ( TheStreet) -- Hewlett-Packard's ( HPQ) history of mistimed deals and major writedowns may not be over yet.

For a company that saw surprisingly good performance from its core PC and hardware businesses in the second quarter, as well as a forecasting a stronger than expected $1 per share profit in third quarter earnings, investor excitement about HP isn't where you might expect.

That's because writedowns continue to be front and center for HP investors as the company prepares to report fiscal third quarter earnings on Aug. 22: the world's largest PC maker announced on Wednesday a $8 billion writedown related to its $13 billion plus acquisition of business services and hardware giant EDS in 2008.

Underperformance and billions in writedowns overwhelmed the company's infamous 2001 acquisition of Compaq. Meanwhile, smaller M&A like its $1.2 billion deal for tablet maker Palm have been written off in HP's so-far tortured plans to diversify from PCs.

With HP now having spent its "last" mega-deal dollars on British software giant Autonomy, the acquisition will either complete a deal-dud trifecta or serve as proof of HP's successful move into IBM ( IBM) and Accenture ( ACN)-like territory of data and software services. Autonomy -- HP's third largest acquisition ever at $11.7 billion -- is a key but uncertain piece of new chief executive Meg Whitman's restructuring efforts at the computer-making giant.

Upcoming earnings will be a defining test for Whitman after she restructured HP's software unit to bring Autonomy closer to existing operations and ousted celebrated Autonomy founder Mike Lynch in the process. In second quarter earnings, HP's Autonomy overhaul and far weaker than expected results at the data analytics specialist came as a big hitch to the company's strategy, in a quarter dominated by strong hardware sales and a plan to cut 27,000 workers.

Whitman replaced former Autonomy chief Lynch with Bill Veghte, HP's chief strategy officer, in a move to bolster the unit's performance. Whitman cited Autonomy's poor results as reason to remove Lynch and further integrate the software specialist within HP's global sales force, where the business could scale faster.

"Autonomy had a very disappointing license revenue quarter with a significant decline year-over-year resulting in a shortfall to our expectations," said Whitman on HP's earnings call in May. Still, Whitman was optimistic about Autonomy, highlighting its cloud offerings, which had a "flood" of large sale leads and is expected to scale against HP's much larger existing operations.

Overall, HP's software license growth fell to 7% in the second quarter from 12% in the first, while the unit's operating margins dropped to 17.7% from nearly 20%. "When you try to go from $40 million to $400 million to $1 billion to $2 billion, boy it takes -- it's a whole different ball game," Whitman said in May of the unit's weak Autonomy's-based results and its importance.

When HP first took control of Autonomy it planned to run the company independently, keeping Lynch, who founded the firm in 1996, at the helm. The drastic management change for Autonomy, a maker of software analytics that search unstructured data like emails, phone calls and social media, was a troubling sign for investors worried about whether HP will get a bang for its buck on the acquisition.

Under new Autonomy head Veghte, HP will try to better tie the software specialist to the company's existing services, server storage, networking businesses and its sales force, in an "organizational structure to support a $1 billion company," according to Whitman.

Whitman's closer alignment of Autonomy with core HP, and an overall restructuring and simplification of HP mirrors the decade-ago turnaround of IBM that took shape through a strategy to quickly integrate acquisitions.

The question is whether HP will ever attain success in its transformation efforts, as doubters mount.

On Tuesday, UBS analyst Steven Milunovich said HP has so far assembled a mediocre set of assets that's unlikely to pull business from entrenched enterprise players IBM and EMC ( EMC).

"HP lacks the pure enterprise focus of IBM and EMC yet will have trouble competing for consumers without strong tablet and phone businesses like Apple and Samsung," wrote Milunovich in an initiation of HP shares with a sell rating and a $16 price target.

"We question whether HP is 'better together' and that it might be 'smart to be apart,' specifically spinning off printers and PCs," he added.

The key for third quarter earnings, and HP's overall strategy, may well hinge on an Autonomy-fueled revival of double digit year-over-year software growth and improving margins, as the company's hardware sensitive businesses like PCs stabilizes.

In May, Jefferies analyst Peter Misek said that the company's future stock gains hinge on improving performance at Autonomy.

The analyst wrote in a summation of second quarter earnings that HP's investment in IT and cloud services -- such as its Autonomy acquisition -- will offset declining PC and server sales. "We believe HP is one of a handful of players that has or is close to having the components of a full stack (i.e., software, storage, networking, services)," wrote Misek.

Were Whitman's restructuring efforts to work, Misek calculates that cross selling opportunities from Autonomy could lift HP's 2012 earnings per share to $4.20 from a base case of $4.07. Such improvements would warrant a $40 share price because HP's price-to-earnings multiple could rise to 9.5 times 2012 earnings from a base case of 7.5x.

But as Whitman acknowledged on HP's May earnings call, there is the prospect of continued below-expectation performance. In a downside scenario, Misek says that EPS could fall to $4 if Autonomy synergies "take longer to realize," potentially leading shares down to $20 on a falling PE multiple to 5x.

Already, Autonomy has been at the nexus of a radical nine months of change at HP. In August, former HP CEO Leo Apotheker bought Autonomy in a bet it could supplant waning earnings from HP's top-selling computers division. Apotheker was fired shortly after cutting the deal and planning a spinoff of HP's PC-making unit. However, Whitman stuck with the acquisition after joining the company as CEO in September.

In a decisive call, Whitman retained the PC unit but cast high expectations on the benefits of Autonomy. HP chairman Ray Lane said in September that Autonomy's software and analytics revenue could grow from present levels of $1 billion to $5 billion or even $10 billion. "Hopefully, we'll see a bigger software portfolio and we'll see more value-added services at HP, but we have $120 billion of hardware business that we care dearly about," said Lane in September.

Since then, HP has enacted other turnaround efforts under Whitman, including a merger of its PC and printers divisions in a move to cut costs.

On Wednesday, when HP said it expects third-quarter earnings of approximately $1 a share -- compared to its prior outlook of 94 cents to 97 cents a share -- initial stock gains nearing 10% were cooled by the company's non-cash pretax charge of $8 billion for the impairment of goodwill within its enterprise services segment, highlighted by EDS. HP also replaced enterprise services head John Visentin, with Mike Nefkens, a senior vice president of the unit's in Europe, the Middle East and Africa operations.

In afternoon trading, HP shares rose by over 2% to $19.33 on its better than expected earnings guidance. Shares are still down nearly 25% year-to-date and nearly 40% in the past year.

"Though management changes will likely help drive HP's strategic vision to increase profitability in the Services segment, we believe it will likely take multiple quarters to turnaround the business segment," wrote Wells Fargo analyst Maynard Um, in a note to clients.

HP also updated the amount of the third-quarter pretax charge related to the layoffs announced in May, estimating a charge of $1.5 billion to $1.7 billion, up from its prior forecast of roughly $1 billion. The cuts equate to roughly 8% of HP's workforce by 2014, with 9,000 expected to leave this year, and is expected to save up to $3.5 billion by the end of 2014.

Whitman has had autonomy in laying out a broad restructuring plan, but it's the potential for an "autonomous" writedown on HP's transformation efforts that continues to weigh on shares.

For more on tech sector M&A and turnaround efforts, see why a BMC Software ( BMC) deal is caught between a cloud boom and tech gloom.

Interested in more on HP? See TheStreet Ratings' report card for this stock.

Check out our new tech blog, Tech Trends.

-- Written by Antoine Gara in New York

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