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The company has seen some strategic changes ever since the change of guard to Leo Apotheker, from Michael Hurd, as the new CEO of the company, a little over eight months ago. Unlike the previous CEO, Apotheker went on to raise the packages of the employees, and raised the R&D expenditures in the company, to bring the focus back to push the thrust in raising the contributions out of the services segment, with a focus on high growth “Cloud” segment, impact of which is slowly being felt at Hewlett Packard now. HP also committed to build webOS into a leading connectivity platform. As the world's No. 1 maker of PCs and printers, HP has the potential to deliver 100 million webOS-enabled devices a year into the marketplace, and HP plans to use that scale along with leading development tools to build a robust developer community that is eager to access every segment of the market and every corner of the globe.
The company continues to show strong growth in the commercial PSG segment, where Hewlett Packard is capitalizing on the growth of the emerging economies of China and India.
While the consumer PSG segment continues to show an almost flat performance, the imaging and printing group improved by a healthy 7% in the past quarter ended January 2011.
HP is following the steps bold of IBM (IBM)
Unlike the past, when Hewlett Packard was earlier known as a giant and a leader in the hardware segment, the sales mix of the company indicates that its focus is to slowly establish itself as a complete technology solutions company, which is less dependent on the hardware business. This is almost in line with IBM’s strategy, which managed to achieve similar goals close to one decade back, when IBM sacrificed revenue for margin, largely giving HP the lead in the revenues but taking a vastly more profitable position in exchange, by capturing some of the high margin segments from software services and networking. Such efforts have now translated into the fact that IBM’s software unit now represents a solid over 40% of their business and is one of the major areas of emphasis for the company. Since then, IBM has not looked back to become an extremely strong producer of free cash flows, as a tangible result of its shift into high margin businesses from low margin hardware, and a massive shift in its cost structure and balance sheet management.
HP, following the acquisition of the EDS business and subsequent to the focus shown towards capturing the potential in “Cloud Computing,” is also on its way to achieving similar goals, albeit at a slower pace. However, considering that IBM’s valuations have noticed a strong uptrend subsequent to the diversification and de-risk strategy adopted by the company, has now become far more expensive, with little scope to show further improvement.
This is unlike HP, which is still in the transition stage of achieving similar changes, objectives and leaves holding healthy potential to attract investors for further value addition, as it continues to de-risk its business mix from hardware business alone, where it was prominent till recently. Thus, while IBM (IBM) already commands a P/E valuation of close to 14.8 times its EPS for TTM at $170.58, I strongly believe that HP holds the momentum to make its way towards higher valuation, from a modest 10.3 times P/E that it commands now, subsequent to some of the clouds coming for few months after the resignation of Michael Hurd last year under controversial circumstances, which brought a knee-jerk fall in the HP valuations.
HP-Where it stands now
HP reported balanced growth in all regions, with an encouraging growth of 11% in the BRIC countries. Revenue from the Americas grew 6%, EMEA was flat, and Asia Pacific grew 7%. HP ended the quarter with $10 billion in gross cash. During the quarter, it repurchased shares for $2.3 billion and paid dividends of $175 million. The company’s stock, however, continues to hover around $40.30, commanding a P/E of 10.3 times its EPS, and a market capitalization of $87.36 billion.
Financials
In the quarter ended January 31 of this year, Net revenue for HP of $32.3 billion was up 4% from the prior-year period, both as reported and in constant currency. GAAP diluted earnings per share (EPS) was $1.17, up 26% from $0.93 in the prior-year period. Non-GAAP diluted EPS was $1.36, up 27% from $1.07 in the prior-year period. Non-GAAP financial information excludes after-tax costs of approximately $0.19 per share and $0.14 per share in the first quarter of fiscal 2011 and 2010, respectively, related primarily to the amortization of purchased intangibles, restructuring charges and acquisition-related charges. [i]HP's financial strength is well reflected in the fact that it was able to generate $3.1 billion in cash flow from operations, up 28% year-over-year in the quarter ended January 2011.[/-] Inventory ended the quarter at $6.7 billion, with days of inventory flat year over year at 25 days. Accounts receivable of $16.6 billion was up 4 days year over year. Accounts payable ended the quarter at $13.5 billion, down one day from the prior-year period. HP's dividend payment of $0.08 per share in the first quarter resulted in cash usage of $175 million. HP also utilized $2.3 billion of cash during the quarter to repurchase approximately 54 million shares of common stock in the open market.
Valuation well below HPQ averages. The most interesting valuation factor.
The point that I find most compelling in HPQ opportunity is the fact that every essential fundamental multiple is strongly undervalued in comparison to what HPQ traded in the last 7 years. This gives us an interesting room for improvement and an ample margin of safety.
a) P/E and EPS growth
In this chart we can see how EPS increased more than 250% from 2005 to 2010 but HPQ P/E decreased dramatically. That multiple is trading in the bottom range from the past 7 years and is nowadays trading near the lows of 2009. Assuming that HPQ P/E goes to 12, which is not expensive, the stock could trade at 48.
b) P/S and Revenue per share growth
Here we can see how deeply undervalued is HPQ P/S in comparison to what HPQ traded from 2006 to mid 2008. Here we can see the discrepancy between revenue growth and P/S. While sales increased considerably, HPQ sales multiples contracted. As it happens in the P/E, this multiple is close to the lows of 2009. Assuming a fair P/S multiple of 1, the stock could be trading at 55.
c) P/FCF and cash flow per share
This multiple is much closer to HPQ averages in the past years but it could have some room to improvement to a P/FCF multiple of 14, which was the number that HPQ traded in 2010. If that happens, HPQ could have a price of 51.
d) EV/T12M EBITDA
This chart shows clearly how far away HPQ is fundamentally trading from the past years. In fact, HPQ is one of the leading tech stocks that is currently trading in the most conservative. Assuming it goes to seven, which is far below HPQ seven-year average and a multiple that HPQ had before Hurd resignation, the stock could trade at 52.
e) P/BV and BV per share
This is the multiple that is trading most in line with HPQ in past years, but it is in the bottom from March 2009. HPQ got a three P/BV multiple in the end of 2009 to mid-2010 and nowadays it is close to two, which was the P/BV HPQ had in the last 2008 crisis. I think that if HPQ trades at a fair multiple of three, the stock could go to 55.
This charts show us that HPQ has an interesting room for improvement in its valuation, considering the multiples the company had in the past seven years. We are not assuming multiples in the high end, just a small appreciation to what HPQ traded in the past years. Assuming the stock gets the fair multiples I wrote above, we get an average price of $52.5, which gives us a 30% margin of safety from current prices.
Conclusion
I expect consistent efforts from management's side to ensure that it is able to move smoothly towards a high-margin software services company, without disturbing the leadership in the hardware segments which it already enjoys in a majority of emerging countries. The impetus is likely to follow from emerging countries itself, where HP is well positioned already to capture further growth. Though the entire process may be slow and steady, a smooth transition over the next year is likely to open up strong avenues for HP to capture stronger profitability and high growth, and also command a much higher valuation of at least 25% from current levels.
To sum up, HPQ offers investors the following key points:
- A diversified worldwide leader in tech.
- Competitive moat in printers and strong competitive position in other segments.
- Strong fundamentals and cash flow generation.
- Very compelling valuation with 30% margin of safety assuming conservative fair valuation of $52 USD.
- Management committed to pay attention to high margin businesses such as software and cloud computing.
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