HP's Moat Dries Up

Pete Wahlstrom: Last fall, Hewlett-Packard (HPQ) announced that it will split into two publicly traded companies: HP Inc. and HP Enterprise. As we look forward, we no longer believe that the combined entity benefits from sustainable competitive advantages, and it's unlikely to earn economic profits in excess of WACC [weighted average cost of capital] over the next 10 years.

As a result, we've moved our economic moat rating to none from narrow, although the Morningstar Moat Trend Rating remains at negative. For HP Enterprise, this is a business that sells hardware to enterprises as well as software and maintenance services. These are generally sticky businesses. Network equipment, server arrays, storage arrays, and related software tools are difficult to rip out from an operational data center. IT managers are really reluctant to change; however, we view HP as seeing competitive threats from Chinese white-box manufacturers and, over the long-term, we've grown less comfortable that the company has any sort of sustainable competitive advantage in its enterprise-hardware business.

On the services side, HP is large, at number three in terms of revenue in a very large and fragmented industry. But we think the company operates at a competitive disadvantage relative to focused players such as IBM (IBM) and Accenture (ACN) and top-tier offshore providers.

Switching over to HP Inc., this includes the company's printing and PC businesses. We generally view PCs and printing as commodified businesses, as there are relatively low customer switching costs. It's true that HP is well entrenched with its customers here; however, we are concerned about secular trends toward mobile computing, which represents a significant headwind for the company.

From a valuation perspective, we view HP shares as modestly undervalued but still sitting in 3-star territory. We'd seek a wider margin of safety before investing in the name.