When does one plus one equal 3?  In the bizarre math of Wall Street, a corporate spin-off or split can be the fuel needed to fire up a stock.  Although these break ups have no impact on total earnings investors will often assign a higher valuation to a pure growth or an authentic income stock instead of a hybrid.  With Hewlett’s break up, investors will get an income and a growth stock. In a widely anticipated move, Hewlett Packard (HPQ) will split its stock into two independently traded companies effective November 1st.  

One company will be named Hewlett Packard Enterprise.  All of Hewlett’s server sales, consulting, storage, software, cloud and networking business will be included here.  Current CEO Meg Whitman will be running the show for this company which is expected to be the future growth vehicle for Hewlett.

The other company will be called Hewlett Packard Inc. (more appropriately it would be named Hewlett Packard Ink).  Hewlett’s traditional ink, printer and personal computer business will be housed here. This company will be structured to appeal to income investors.  Hewlett Packard Inc. will take on a smaller portion of the parent company’s debt and promises to return 50-75% of free cash flow to investors in the form of dividends or stock repurchases.

Going forward the growth and income strategy of each new company should be more apparent.  For example Hewlett’s recent purchase of fast growing Aruba was not large enough to impact overall numbers. Yet when combined with the broken off Hewlett Packard Enterprise’s smaller revenue base, Aruba’s quickly accelerating revenue growth should be evident.

Income investors in Hewlett Packard Inc. need not fret that cash flow destined for dividends or share repurchases will be spent on research or new acquisitions.  Although the “old” Hewlett could feed research and development with the profits thrown off by its mature printing and PC business, it left income investors wary of how dependable their dividends might be.

Usually Smart Tech Investor stocks demonstrate the ability to “innograte”, to pull in new technology either via acquisitions or research and development and weave those new tricks into the company’s current portfolio of services or products.  This split will allow both divisions to improve their innogration record.

The parent company has a mixed record on successful innogration, mostly due to the size of some of its acquisitions. The first was its $25 billion purchase of Compaq computer in 2002.  This was followed by the $14 billion purchase of EDS in 2008.  While both of these purchases introduced new product lines, Hewlett languished from the bloated cost structure that both acquisitions brought with them.  Hewlett’s new smaller divisions will be able to prosper without feeling compelled to make huge acquisitions.

Ironically, Compaq and EDS both provided the building blocks for Hewlett’s new tracking stocks.  Compaq brought the laptop and desktop business, a low margin but complementary product line to Hewlett’s printers and the basis for Hewlett Packard Inc.

EDS, the IT services and consulting company founded by prior presidential hopeful Ross Perot, helped Hewlett configure the world class enterprise service business that will be encapsulated in Hewlett Packard Enterprise.  

While Hewlett management had already taken the axe to the particularly fat headcount at EDS, the company recently announced that another 30,000 positions in HP Enterprise would be eliminated in the near future. These cuts would help the company reduce operating expenses by $2 billion annually.

While years of layoffs at Hewlett have damaged employee morale, the company promises this will be the last wave of firings.  CEO Whitman is wisely using this significant corporate event as an opportunity to clear the decks and start each company off with a whittled down cost structure.

Hewlett’s stock has been pummeled since last winter and is down 34% year to date due to its inability to grow revenue or earnings.  The mature printer and PC business offers little growth prospects but robust cash flow.  The enterprise business has been hamstrung by the abundance of low cost cloud based server options offered by Amazon, Microsoft and Google but has the potential to grow with new product offerings.

The good news for Hewlett is that while significant growth may be elusive, investor expectations have been battered down so much that the company has begun to beat them.  In fact, Hewlett’s stock jumped to almost $30 when it reported a drop in earnings on August 20th.  Despite the decline, earnings beat analysts’ estimates, a critical ingredient for a rising stock price.  

The company unveiled operating targets for each of its new divisions at its September analysts’ day.  Guidance for earnings and cash flow for fiscal 2016 are within analysts’ targets.

While there may be a short term flushing out of the stock post spin off as income and growth investors sell the portion of Hewlett that does not fit their portfolio mission. However we do know that comparable stocks for both divisions trade at much higher valuations than the overall company receives.  Lenovo and Cannon, hardware companies with similar business models to Hewlett Packard Inc. trade for average PEs of 13 and EMC and Cisco, companies focused on enterprise hardware and software similar to Hewlett Packard Enterprise trade for average PEs of 11. Hewlett trades for a ridiculously low PE of 7 times 2016 estimates and offers investors a 2.6% yield.

Financial engineering alone will not be enough to resurrect Hewlett’s business into the cutting edge company that two Stanford grads first imagined in 1939 when they started the company in a garage.  However, a leaner cost structure and two companies with clear strategies should increase shareholder value.

For now we are watching HPQ with a wary eye, but given its increasing Smart Tech Rating score we may add it to our Investments portfolio if we see confirmation that this move will pan out. Stay tuned.