This month marks 30 years since the personal computer was first introduced to the world – since 1981, companies like HP, IBM, and Apple, among many others, have helped to pioneer one of the most influential industries of our time.  And somewhat ironically, as the personal computer celebrates 30 years this month, HP revealed that it is seeking to exit the PC industry that for years it has helped to shape.

During HP’s recent earnings release, the company announced that its Board had approved the “exploration of strategic alternatives for its Personal Systems Group (PSG),” including “a full or partial separation of PSG from HP through a spin-off or other transaction.”

So much for the whole “cooler than Apple” thing.

Reading through the press release I was shocked that HP, the world’s largest maker of PCs, was thinking of dropping its PC business.  I think we all were.  HP’s strategic decision to drop its PSG segment would effectively shrink it by a third in terms of revenue, though it would certainly have a favorable impact on operating margins over time and drive the company’s continued transition to services.

Yet, as I digested the HP press release it became far more surprising how and when it happened, rather than that it happened.

Following the ousting of former CEO Mark Hurd and the hire of SAP’er Leo Apotheker, the tech company narrowed its focus on stronger sectors such as services, storage, and software.  During Hurd’s era, HP began its transition to services, but the executive’s legacy is better defined by his cost cutting efforts.  HP and Apotheker’s vision today is to drive growth and profitability, and ultimately shareholder returns, by moving into services, while primarily targeting the vendor’s legacy hardware businesses for cost reductions.  Despite Apotheker’s assurances just one quarter ago that the company was committed to PCs, citing the segment’s very high return on capital and “great cash flow”, it was clear that it didn’t fit into the enterprise-focused, tech solutions, IBM-ish framework HP was molding itself around.

While the PC business does provide “great cash flow”, with PSG earning $567 million in the last quarter, it’s much less attractive when you consider it took $9.6 billion in revenue to generate that cash.  This small operating margin is a product of fierce competition within the PC market, while pressure from tablets and smartphones threaten to trim the traditional PC’s growth even further.

Over the years, as the PC industry consolidated and commoditized, major vendors such as HP and Dell tended to compete more on the basis of cost rather than innovation.  Component and device manufacturing moved almost entirely offshore, software or “bloatware” was more often bundled to help subsidize aggressive pricing, and corners were cut on components and throughout the manufacturing process.  And despite all of this, the PSG’s operating margins were driven to levels below the auto industry (7.3%) and even consumer foods (6.7%), and far below the level of profitability that Mr. Apotheker and his services-oriented executive team would view as acceptable.  Last quarter, HP’s PSG posted the smallest operating margin of any division in the company at 5.9%, while Storage (13%), Services (13.5%), and Software (19.4%) continue to lead the company on its path to greater profitability.  It should also be noted that while PSG revenues shrunk by 3% on year, HP’s Storage (7%), Services (4%), and Software (20%) segments all grew.  With its 14.7 percent profit margin, the IPG is quite secure, even if the profits it generates are used to fund HP’s services expansion.

In addition to competitive forces within the PC segment, the advent of “post-PC” devices has made the traditional PC even less vital in many consumer and business applications, as tablets and smartphones can now run applications that were too demanding just a few years ago.  Businesses and consumers have grasped the iPad’s, er, tablet’s worth, and forecasts call for shipments to reach nearly 250 million units by 2015.

Apotheker admitted that the “tablet threat is real” in the company’s recent earnings call, following a press release stating that HP  would pull its TouchPad tablet just weeks after it launched with much fanfare, but a disappointing reception from both consumers and pundits.  webOS and the TouchPad was supposed to be HP’s response to Apple’s iOS ecosystem, a way for the company to build a web of interconnected devices, and a way to ultimately drive incremental purchases across all of the vendor’s computing and communication devices.  Unfortunately, what HP did not realize is that an ecosystem cannot simply be bought and assembled; it takes a long-term commitment and the development of an extremely popular platform to grow an ecosystem naturally.

While it is hard not to view dropping the TouchPad after two months as impulsive, the decision underscores HP’s commitment to exiting all aspects of the PC market, regardless of an individual segment’s growth potential.  The move also highlights the level of importance that HP placed on the TouchPad’s role in its over-arching ecosystem strategy, as HP apparently did not see a future for its PC unit that was not based around a webOS core.  It is very likely that if the TouchPad proved successful and HP was able to realize its ecosystem goals, the inherent brand loyalty that would come with this achievement would have allowed the vendor to shift PSG’s focus back to innovation, allowing it to raise prices, and achieve profits that could possibly rival Apple’s hardware unit.

Obviously, HP’s decision to explore a spinoff or sale of PSG presents a huge opportunity for a buyer, similar to the opportunity Lenovo seized with its acquisition of IBM‘s PC business six years ago.  Companies throughout the world, and particularly Asia, are certainly considering HP’s business right now for its many intangibles as well as its hardware revenues.  While margins are tight and competition is high, Asian companies like Lenovo and Samsung could benefit from the purchase of HP’s PC business by expanding their channel distribution opportunities and reducing costs through greater economies of scale.

As the global leader in the personal computer industry, HP’s PC segments have a significant foothold in the retail, e-commerce, and commercial channels.  In the US retail channel, HP is the most dominant player in the desktop and notebook segments, accounting for 48 and 31 percent of retail shelf placements on a weighted basis.  HP also utilizes a massive direct and IT VAR sales force to target its public and enterprise accounts.  With the uncertainty created by HP’s announcement of a possible spinoff of the PSG, there is a big opportunity for HP’s competitors to build new sales relationships with resellers seeking to balance their product offerings.

However painful it seems right now for HP, its shareholders, resellers, and perhaps even its customers, the move to break away from the PC market can be seen as justifiable, especially in the eyes of HP’s services-focused leadership.  The PSG division’s margins are small, growth is nonexistent, competition among PC vendors continues to increase, and tablet growth threatens to cannibalize PC sales.  All the while HP has already proven that it can make money as a solutions-based business, where growth is still abundant and margins are much more attractive.

While it trims HP down substantially, the sale or spinoff of its PC business will help the company direct its focus upmarket to services, storage, and software, where more attractive annuity revenue streams are found.  These business segments have proven to be very profitable for other tech companies like IBM and Cisco, both of which also ditched their consumer product lines.  In fact, Cisco just shut down its Consumer Products Division in April, which was highlighted by the popular FlipVideo line of digital camcorders.

In the end, HP’s expected departure from the PC business is bittersweet.  Another company outside of the US will likely carry on the hardware business, while HP moves unequivocally towards its goal of becoming a major player in the services arena.  Whether or not they can succeed remains to be seen, but the company has the right resources, the talent, and the leadership to make a go of it.  Let’s just hope they are more patient with future services projects than they were with webOS.

Written by: Keenan Thomson, Market Analyst