Below I will describe why Hewlett Packard is now an attractive long-term buying opportunity with a sufficient margin of safety, and why their unique ability to offer end-to-end IT solutions should keep them relevant for many years. While this might not be an unrecognized special situation, I believe the media and many investors are extremely short-term focused , causing them to dwell on past negatives like management’s indecisiveness rather than the breadth of HP’s products and services, HP’s leading market share within each segment, and most importantly, the firm’s future free cash flow and earnings power.
First I will examine HP’s market share within each of their main segments.
Personal Systems Group
From the latest 10K dated 10/31/11:
“The Personal Systems Group (PSG) provides commercial personal computers (“PCs”), consumer PCs, workstations, calculators, and other related accessories, software and services for the commercial and consumer markets.”
Recent obvious concerns:
Has management’s indecisiveness with regard to spinning off the PC unit hurt market share?
Will tablets eliminate the use for PCs completely?
Not according to data from Gartner:
Preliminary Worldwide PC Vendor Unit Shipment Estimates for 3Q11 (Units)
|Company||Market Share Q3 ’11||Market Share Q3 ’10||Year-over-Year Shipment Growth|
Industry Shipment Growth Year-over-Year = 3.2%
Source: Gartner (October 2011)
Additional Comments below:
“In the U.S., PC shipments totaled 17.8 million units in the third quarter of 2011, a 1.1 percent increase from the third quarter of 2010. The U.S. PC market experienced year-over-year growth for the first time in three quarters.
HP showed strong growth in the U.S. PC market, as shipments increased 15.1 percent in the third quarter, and its market share totaled 28.9 percent (see Table 2). Despite the potential spinoff of its PC business, HP executives' efforts to give the appearance of "business as usual" seemed to work in the quarter.
Dell's performance was below the industry average in most regions, as the company faced intensified competition in the professional space, where Dell has been traditionally strong.
Dell struggled as shipments declined 7.2 percent in the third quarter of 2011. "Dell's issue has been balancing profitability and market share gain, a difficult task in a PC industry where high volumes and low margins are the norm," Ms. Kitagawa said.”
With regard to the EMEA market:
“In the third quarter of 2011, HP regained the No. 1 position from Acer and grew its market share by 1.1 percentage points year-on-year. HP managed the impact of separating its PC division better than we had expected.”
PC demand since 2006 plus Gartner’s estimates for calendar year 2011:
The data shows that despite some cannibalization from tablets and a slow growth economy globally, PC unit shipments still grew not only during a very difficult period the last few years, but also year-over-year. If PC shipments still grew during a sluggish economy, which includes arguably the worst recession since the Great Depression, they are still likely to grow moderately when more rapid economic growth returns. Although tablets can replace certain tasks performed on a PC, such as surfing the net and checking email, PCs will still be relevant because they provide far more functionality for enterprises than tablets.
And with all the concern over HP losing market share, the data shows the strength of a strong brand name, as HP increased its market share across the globe year-over-year. As the number 1 provider of PCs globally, HP sold nearly 4 million units more in Q3 of ’11 than its closest competitor Lenovo. Fears of Dell capturing market share from HP are completely unfounded. Despite the controversy since the summer, the latest numbers show HP is executing better than Dell in the PC space.
Gartner released Q4 PC data after this article was submitted to VIC. It appears the lack of direction with regard to the PC unit from the former CEO severely hurt HP’s PC sales during the last quarter of 2011. Although HP remained the top provider of PC shipments in the United States and the world, the company’s market share fell from 17.9% in 2010 to 17.2% in 2011 and its year-over-year shipments declined 3.5% compared with a 0.5% increase for the industry.
Having examined many reviews of HP products and its customer service, it appears to be of equal quality to Dell and other companies. Some users think HP’s support is better than Dell’s, due to HP’s customer service having more of a US presence.
I think it will take some time for HP to rebuild its brand, but it is certainly possible given its long established history within the industry and because the new CEO has committed to ensuring the PC unit remains part of the company.
In light of the latest quarterly PC shipment results, I have lowered my projection for HP PC revenue in fiscal 2012 from a previously forecasted 1% growth rate to a 5% decline.
From the latest 10K:
“Services provide consulting, outsourcing and technology services across infrastructure, applications and business process domains. Services delivers to its clients by leveraging investments in consulting and support professionals, infrastructure technology, applications, standardized methodologies, and global supply and delivery. Our services businesses also create opportunities for us to sell additional hardware and software by offering solutions that encompass both products and services.”
I highlight the last sentence because I feel it is something many pundits are missing. HP is a one stop shop for all Enterprise IT products and services, as they can provide PCs, printers and supplies, copiers, scanners, servers, storage systems, networking, and software. Very few firms, if any, have this ability. It can be argued IBM does because of the firm’s partnership with Lenovo, but even they must rely on another company to provide end-to-end IT solutions. As another example, Dell is a long way from becoming a premier services provider, as evidenced by their thin margins due to heavy reliance on PCs and servers.
HP has a formidable Services segment, trailing only IBM as data from 2010 shows:
2010 Worldwide IT Services Vendors
|Company||2010 Market Share||Year-over-Year Revenue Growth|
Industry Year-over-Year Revenue Growth: 3.1%
Source: Gartner (April 2011)
More commentary from Gartner below:
“Worldwide end-user spending on IT services totaled $793 billion in 2010, a 3.1 percent increase from 2009 revenue of $769 billion, according to Gartner, Inc.
"There is little doubt that the effects of the global recession of 2008 and 2009 are still very much being felt, but the market for IT services bounced back in 2010 after a 5.1 percent revenue decline in 2009," said Kathryn Hale, research vice president at Gartner.
IBM retained its No. 1 market share position in IT services in 2010, with a revenue increase of 2.6 percent returning $56.4 billion in revenue and accounting for 7.1 percent of the market (see Table 1). With arguably the weakest revenue performance in the top five, HP grew its IT services revenue less than $100 million, or 0.3 percent, in 2010.”
While it is concerning in 2010 that HP’s growth was slower than the industry, the firm still remained the #2 provider of IT services in the world. With all the optimism surrounding IBM, although better than HP, IBM’s growth was also slower than the industry. Fears of IBM taking market share from HP are overstated, as unlike the PC industry, market share within the IT Services arena is much less concentrated, as the #1 provider of IT Services globally, IBM has only captured 7% of the market.
For HP in fiscal 2011, year-over-year growth of IT services revenue, although still slow, was faster than in 2010. According to the most recent 10K dated 10/31/11, Services revenue was up approximately 1.2% year-over-year vs. less than 0.5% the previous year (fiscal 2010 revenue versus fiscal 2009). Please note: the differences between Gartner’s numbers and percentages versus HP’s are due either to minor organizational reclassifications on HP’s part or the fact that HP has a different fiscal year, ending October 31st versus Gartner’s calendar year data.
The main question is: Given HP’s recent financial performance and what should be expected in the future, is a 50% decline in share price warranted? The data shows the decline is not warranted, as although still meager, HP’s year-over-year IT services revenue grew at a faster pace in 2011 than in 2010, and other than the recent Q4 PC market share decline, the remaining segments are performing similarly in 2011 as they did in 2010.
Although much of the sluggish growth in HP IT services revenue can be attributed to the effects of the global recession in 2008 and 2009 still lingering, HP must prove they can execute in this area if they seek to grow revenues at a faster pace and capture more market share. The breadth of the firm’s products and services shows they have potential to do so.
Imaging and Printing Group
This is HP’s most dominating unit, and often overlooked.
From the 10K:
“Imaging and Printing Group (IPG) provides consumer and commercial printer hardware, supplies, media and scanning devices. IPG is also focused on imaging solutions in the commercial markets.”
Below illustrates HP’s leading position:
Worldwide Hardcopy Peripherals Market, Top 5 Vendor Shares and Year-Over-Year Growth, Third Quarter 2011
|Vendor||Q3 ’11 Market Share||Year-over-Year Revenue Growth|
Industry Year-over-Year Growth: 1.6%
Source: IDC Worldwide Quarterly Hardcopy Peripherals Tracker, December 2011
While HP’s market share is down slightly since last quarter, it has steadily increased the last couple of years, from 40.8% in 2009 to 42.1% in 2010 to almost 43% currently. In addition, HP’s share of t he US market increased to 56.2% in Q3 of ’11 from 54.1% the previous year, as the firm was the only player to grow revenues domestically year-over-year, while all other major players saw a decline in US revenue according to data from IDC.
Based on information in the 10k, it is possible the Japanese earthquake and tsunami slightly hurt market share and margins globally, due to supply chain disruptions. Despite this major event and the effects of the credit crisis still lingering, HP’s imaging and printing division continues to be the industry leader and has performed remarkably well over the last few years.
Enterprise Servers, Storage, and Networking (ESSN)
From the 10K:
“ESSN provides server, storage, and networking products in a number of categories. Our converged Infrastructure portfolio of servers, storage, and networking combined with HP Software’s Cloud Service Automation software suite creates HP’s CloudSystem.”
IDC - Press Release
Top 5 Vendors, Worldwide Total Disk Storage Systems Factory Revenue, Third Quarter of 2011
|Vendor||Q3 ’11 Market Share||Year-over-Year Revenue Growth|
Industry Year-over-Year Revenue Growth: 8.5%
Despite a small loss in market share, HP’s storage revenue grew nicely year-over-year and the firm’s storage system market share remains #2 in the world. As the data shows, this industry appears to have higher barriers to entry compared with IT services, as a huge portion of market share is concentrated among just 5 players who have recently captured more market share from smaller storage providers.
Worldwide: Server Vendor Revenue Estimates, 3Q11 (US Dollars)
|Company||Q3 ’11 Market Share||Q3 ’10 Market Share||Year-over Year Rev Gr.|
Industry Year-over-Year Growth Rate: 5.2%
Source: Gartner (November 2011)
Worldwide: Server Vendor Shipment Estimates, 3Q11 (US Dollars)
|Company||Q3 ’11 Market Share||Q3 ’10 Market Share||YOY Shipment Growth|
Industry YOY Growth: 7.2%
Source: Gartner November 2011
HP remained the worldwide leader in server shipments and held #2 market share in terms of revenue the third quarter of 2011, despite of a year-over-year shipment decline of 3.1 percent . According to Gartner, this decline was driven primarily by drops in HP’s ProLiant brand.
If server demand is examined further the last quarter, while it is concerning HP’s leading ProLiant brand lost market share, it appears the big three, HP, Dell, and IBM, all lost market share to smaller competitors. Thus HP’s recent market share loss does not seem like it is because of lack of execution relative to larger competitors, but because of more competition across the industry in general, as small vendors increased revenue and shipments significantly. This is definitely something investors should monitor closely, but given ProLiant’s stellar reputation over the last 15 years, HP should remain a leading provider of servers for many years to come. Quarterly results can also be volatile, as HP’s year-over-year revenue growth and market share were better during the prior few quarters.
Below is the link to a recent, fairly comprehensive review of HP’s ProLiant DL360 G7, which appears to be favorable:
Although a smaller piece of the firm’s revenue, HP is making progress on the networking front, increasing revenues significantly the last few years. In order to avoid bias, I decided not to use information directly from HP. According to Infonetics Research, HP grew revenues significantly in the enterprise router market so far this year and has taken market share in the Ethernet switch market.
Below is data from an article on telecomengine.com:
Report: Cisco, HP battle in Ethernet switch and enterprise router markets
September 25, 2011
Last week, market research firm Infonetics Research (Campbell, Calif., U.S.A.) released excerpts from its second quarter 2011 Ethernet Switches and Enterprise Routers market share reports. The report indicates that vendors are experiencing flat revenues as a result of the increased competition in the market, with Cisco (San Jose, Calif., U.S.A.) and HP (Palo, Alto, Calif., U.S.A.) in the forefront of the competition.
"Ethernet switch buyers are in the driver's seat right now, as vendors are fiercely competing for their business,” says Matthias Machowinski, directing analyst for enterprise networks and video at Infonetics Research. “While the battle is mostly playing out between Cisco and HP, other vendors are caught in the crossfire, with declining ASPs being one side effect. In the switch market, we expect this to result in stagnating revenue despite robust demand in 2011."
Specifically, vendors Cisco and HP had steady revenue market shares from 1Q11 to 2Q11, but Cisco's share is down more than 3 points from a year ago, while HP is up by over 2 points.
In the enterprise router marker, sales grew 6% sequentially in 2Q11, to $843 million worldwide; while unit shipments grew 11%. Vendors with sequential increases in global enterprise router revenue in 2Q11 include: Cisco, up 3%; HP, up 26%; Juniper, up 14%; and OneAccess, up 40%
From the 10K:
“HP Software provides enterprise IT management software, information management solutions, and security intelligence/risk management solutions.”
Software is also a smaller piece of the firm’s revenue, which was obviously the reasoning behind the Autonomy acquisition, as the firm realized it must broaden its software portfolio to stay competitive. In addition, software carries higher operating margins than other segments, especially PCs. Although HP clearly overpaid for Autonomy, based on Autonomy’s net income, growth rates, etc, by broadening its enterprise software offerings, HP has arguably made its lineup of products and services more attractive to many enterprise clients.
While it is hard to grow revenues and market share in each segment every quarter, the above data shows HP should remain a significant provider of IT products and services to enterprises and consumers over the next decade.
Below I estimate net income and free cash flow for the fiscal year ending October 31, 2012, as well as HP’s financial position, in order to determine an appropriate value for the company.
The PSG segment generated revenue of 39.574 billion and an operating margin of 5.9% during the fiscal year ended 10/31/11. For valuation purposes I will assume a 5% year-over-year decline in revenue and a lower five year average operating margin of 5.3%, which reflects not only the highly commoditized and competitive landscape of the industry, but also the slow growth global economy, as well as HP’s poor results during Q4 2011 as referenced above.
The Imaging and Printing group generated revenue of 25.783 billion and an operating margin of 15.4%, during the fiscal year ended 10/31/11. According to the latest 10K, the margin was affected due to “increased logistics costs and supply chain constraints in LaserJet printers as a result of the Japan earthquake and tsunami.” The margin the first half of the year was 17%, which is consistent with the past couple of years. For valuation purposes I will assume revenue growth of 1% and a 16.25% operating margin, the five year average operating margin, as margins should improve barring another catastrophic event.
The IT Services segment generated revenue of 35.954 billion and an operating margin of 14.3% for the fiscal year ended 10/31/11, down from margins of nearly 16% the previous fiscal year. Like my I & P assumptions, I will assume 1% revenue growth. I will also assume the margin remains lower at 14.3% due to rate concessions as stated in the most recent 10K. It is hard to believe margins will contract much more, as this margin assumption is the same as fiscal year 2009, which included the impact of the Great Recession.
The Enterprise Storage, Servers, and Networking segment generated revenue of 22.241 billion, revenue growth of over 9%, and an operating margin of 13.6% the last fiscal year ended 10/31/11. I will assume 5% revenue growth and a slightly lower margin of 13.5% to reflect new competition in the server arena from smaller players.
HP Software generated revenues of 3.217 billion the last fiscal year, revenue growth of nearly 18%, and an operating margin of 21.6%. This does not include much Autonomy revenue, as Autonomy was just recently consolidated as of the beginning of October 2011. I will assume revenue ex Autonomy grows 15% and Software operating margin ex Autonomy is 20%. Pro-rating Autonomy’s 6 month results as of July 31, 2011, their last reported quarter, they would have generated $932 billion of revenue for the full fiscal year had they continued to be separate from HP, and operating margins north of 40%. With regard to the revenue attributable to Autonomy, I will assume growth of approximately 7.5% on this pro-rated amount and an operating margin of 40%, which are slightly worse than Autonomy’s results within the quarters reported prior to consolidation. This equates to $1 billion of revenue from Autonomy and operating income of $400 million.
HP Financial Services, which provides a broad range of value-added financial life cycle management services that enhance HP’s products and services, has generated consistent revenue growth the last couple of years and improving margins. I will assume revenue growth of 10% and margins of 9%, which is a margin close to the 3 year average.
HP Corporate Investments had an operating loss of $1.6 billion last year, however almost 50% of that was attributable to the winding down of the Web OS business. Thus I will assume a loss of only $900 million this year. Web OS has received positive reviews as an open source system, thus there is still a small chance HP will have success monetizing it in the future.
Based on these assumptions, HP’s operating income this year should be over $15 billion as shown below:
|Revenue||Operating Margin||Op Income|
|Imaging and Printing||26041||16.25%||4232|
|Software ex Autonomy||3700||20.0%||740|
|Total Operating Income||15116|
It would be a mistake to value HP based on the 15 plus billion $ number above because there are other expenses that must be taken into account. Below is an estimate of non-operating expenses and a brief explanation:
$400 million of unallocated corporate costs – consistent with the past few years
$100 million of acquisition related costs – takes into account possible costs related to Autonomy and other acquisitions. These costs should be lower than previous years, as the new CEO Whitman stated HP will not pursue any major acquisitions in the near term.
$600 million of Stock Based Compensation – consistent with prior years
$650 million of restructuring costs – common for HP annually and although they may be lower in the future this is still a year of transition. As the latest 10k states: “We may continue to engage in restructuring actions”
$1.885 billion of amortization of intangible assets – estimate from latest 10k
$1 billion of interest expense – should be higher than roughly $700 million last year due to a greater amount of debt and lower interest income. Last year net interest expense was approximately 6% of the beginning year net debt balance. If the same number is used this year, interest expense would be approximately $1.35 billion. However, Whitman has stated that fiscal 2012 will also be a year of “balance sheet reparation.” I assume $1 billion because HP is likely to pay down debt given Whitman’s comments. Although HP’s higher net interest expense needs to be addressed, even an interest expense of $1.35 billion can easily be handled due to HP’s consistent free cash flow from operations.
Thus I arrive at income before taxes of $10.531 billion.
HP’s effective tax rate last year was 21.2%. Based on the fact that significant revenue will be from abroad in lower taxed jurisdictions, and HP is unlikely to incur as many unfavorable non-deductible items as they did in fiscal 2011, such as impairment of goodwill, a tax rate of 20% seems reasonable, which is what I will assume for fiscal 2012.
And I arrive at Net Income of $8.424 billion.
Based on the latest press release there are 2.005 billion diluted shares outstanding. However, before simply dividing my estimated net income into diluted shares outstanding I would like to take into consideration some other things before completing my valuation.
Although HP has consistently repurchased shares in the past, because 2012 is likely to be a year of balance sheet reparation, share repurchases are unlikely until 2013, which is when Whitman said HP will again focus on adding shareholder value through dividend increases and repurchases.
According to the latest 10K, there were 95.54 million exercisable options under $50.00 per share, yet only 34 million shares from employee stock plans were included in diluted shares outstanding, some of which may not only be options but also performance-based restricted stock units, restricted stock units, or restricted stock. Thus I will use a share count of 2.1 billion rather than 2.005 billion to value the company, which I believe more accurately reflects fully diluted shares at my target fair value. To use the treasury stock method formula for each type of share-based compensation would be more accurate, but it would be difficult to calculate precisely and very time consuming, thus an estimation is appropriate.
HP currently has $22,970 of net debt if you take cash plus investments minus interest bearing liabilities minus a small minority interest. This is up considerably the past year due to the expensive $11 billion Autonomy acquisition. Although it was a cash acquisition, it was essentially debt financed, as HP’s net debt increased by approximately the same amount as the purchase price for Autonomy. The good thing about this pricey acquisition, other than the broadening of HP’s software portfolio, is because HP generates so much free cash flow, they will be able to pay down debt and eventually get themselves into the same financial position they were before the acquisition and still benefit from the improved earnings power from Autonomy.
To get an idea of how much debt HP can pay off or cash that will be added to the balance sheet within the next year, we need to determine free cash flow for fiscal 2012.
Starting with Net Income of $8.424 billion, I will adjust accordingly with comments:
Add Depreciation and Amortization of $5.271 billion – represents 4% of revenues, consistent with past years
Add Stock Based Comp of $600 million – a reasonable estimate
Add non-cash restructuring charges of $650 million – a reasonable estimate
Subtract $120 million for excess tax benefits from stock based comp – based on a 20% tax rate
Subtract $4.612 billion of Cap Ex – represents 3.5% of revenues. Depreciation is slightly higher than Cap Ex due to amortization of intangible assets
Subtract $1 billion for restructuring costs incurred– although many aspects of working capital vary, this is one that is consistent.
Based on these assumptions, HPQ should generate approximately $9.213 billion of free cash flow after all interest expense and cap ex. There could be an additional cash infusion from reductions to PPE but since this is not a certainty I will not assume so in my calculation. The only other adjustment I will make is for the cash dividends HP pays. I will assume a similar amount to last year’s $844 million, as HP is not likely to meaningfully hike the dividend much until 2013 while it focuses on balance sheet reparation. Thus HP is likely to have a net debt improvement of roughly $8 billion when the next fiscal year ends, assuming $800-900 million of dividends are paid and some extra cash is used for misc. expenses.
I will value HP using a normal market multiple of 15x earnings, which is consistent with the average P/E ratio of the firm the past five years, and adjust for their net debt position:
Net Income Fiscal 2012 Estimate - $8,424
Diluted Shares Outstanding – 2,100
Earnings Per Share - $4.01
Fair Value of Operating Business @ 15x Earnings = $60.15
Net Debt at end of fiscal 2012 - $15,000 (Approximately $8 Billion less than 2011, whether cash increases or debt decreases)
Net Debt Per Share $7.14
Fair Value at end of fiscal 2012 - $53.01
A more conservative measure would be to also subtract pension liabilities unrelated to the operating business.
According to the latest 10k, total pension liabilities/post-retirement benefits were $4.853 billion. This equates to $2.31 per share. Adjusted for net debt and pension liabilities, the fair value of HPQ is $50.70 per share, or approximately 12.6x my estimate of fiscal 2012 earnings. This strikes me as reasonable, given HP’s past five year average earnings multiple of 15x, consistent free cash flow generation, and mediocre but potentially improving financial position.
Research and development expense is likely to be slightly higher this year according to Whitman, as the firm will focus more on innovating internally rather than large acquisitions. It is hard to know whether this will add value or not, but given HP’s resources, smart increases to R & D are likely to be beneficial long-term.
Debt maturities are not likely to be a concern, as HP is likely to pay down debt this year, and maturities are disbursed fairly evenly over the next decade plus.
Receivables are a significant % of assets, thus default rates should be examined. Given HP’s consistently low default rate of receivables, the quality of receivables is not much of a concern. HP ‘s allowance for doubtful accounts for financing receivables is determined by identified exposures such as customer default and bankruptcy, as well as historical credit losses and portfolio delinquencies. The allowance for doubtful accounts for accounts receivable is approximately 2.6% of total accounts receivable down from 2.8% the previous year. For financing receivables, the allowance for doubtful accounts is 4.1% down from 4.7% the previous year. These numbers have been fairly steady over time.
Given the estimated payments for the U.S and non-U.S. pension plans as well as post retirement benefits, although there is a total pension/post-retirement benefits shortfall of approximately $4.85 billion, this is not much of a concern. The fair value of the U.S pension plan is over $10.66 billion and annual payments are expected to be approximately $500 million the next few years. The non-U.S. pension has a fair value over $13 billion and annual payments the next few years are also expected to be in the $500 million range. Other post-retirement benefits are negligible.
No major catalyst. HP’s value is just “too cheap to ignore.”