Hewlett-Packard (HPQ) has been hammered over the last twelve months with the stock down by 35.8%. During the same time period, competitor Dell (DELL) has appreciated by 20%. Despite problems with margins and PC growth, I believe that HP presents one of the most favorable opportunities to take advantage of investor fear. At this point, the downside is relatively low, in my view, as the issues concerning fundamentals have already been factored in. The greatest risk, however, will come from missed earnings, which will be taken more as confirmation of investor suspicion than anything else. This unfortunately will cause management to focus more on the short-term than the long-term.
From a multiples perspective, both companies are nevertheless incredibly cheap. HP trades at 8.7x and 6.4x, past and forward earnings respectively, while its competitor trades at a 8.2x and 7.9x, past and forward earnings respectively. Gross margins are higher at the former: 23.4% versus 18.5%. At the same time, analysts currently rate HP shares a "hold" while Dell receives a "buy" rating.
At the fourth quarter earnings call, HP's new CEO, Meg Whitman, expressed the need to renew investor confidence:
HP has all the components of an outstanding company, but we're not taking full advantage and leveraging these parts to drive the result where the whole is greater than the sum of the parts. We need to be simpler, clearer and more consistent. No more surprises. We need to articulate a clear direction, from business strategy to financial strategy to capital allocation strategy.
While I won't be communicating all the answers today, the executive team is hard at work on this. One thing we do know is that we're getting back to the basics of executing business fundamentals, which, frankly, we struggled with in FY '11.
So what made FY '11 such a challenging year?… We grew revenue 1%, non-GAAP EPS 7% and free cash flow 8%. And we generated $12.6 billion of cash flow from operations. While this was not HP's best annual performance, generating nearly $13 billion of cash flow is a good, healthy result.
Regrettably, Whitman's first quarter as CEO was not marked by a positive change in financial results (although I do not fault her for this). Free cash flow was down significantly, around 25% when taking out the effect of webOS being shut down. Management's focus is on growing EPS and the surest path to this goal is through reforming operations. If opex declines by around 100 basis points, EPS could go up by as much as $0.50. Towards this end, the firm is trimming costs and dismissing an acquisition strategy.
However, I believe that an acquisition of Xerox (XRX) could provide significant value creation for the firm overall (explained here). HP's IPG business is struggling with margins and purchasing a leading business in the field would spread out variable costs and boost EPS in the long-term. Thus far, HP has done well integrating recent actions - with Fortify, 3Par, 3Com, and Arc Sight experiencing double-digit or greater growth. At the same time, I anticipate IPG normalizing better than anticipated. Inventories are likely to improve after no more than half a year, as demand picks up from a trough. Ditto for HDD.
In addition, HP has set the bar very low - providing considerable upside to investors willing to take on obvious risk. I am in favor of how Whitman is leading the company and believe that steering strategy away from a transformative story is in shareholders' best interest. I also believe that raising cash will help de-risk the business and inspire investor entry. Net debt currently stands at $22.6B, representing 40% of market value. Competitor Dell, meanwhile, has a net cash position of $5.6B, representing 18.5% of market value.
Consensus estimates for HP's EPS are that it will decrease by 16.4% to $4.08 in 2012 and then increase by 9.3% and 9.2% in the following two years. Assuming a multiple of 10x - still at the very low end of peers and the market - and a 2013 EPS estimate of $4.34, the rough intrinsic value of the stock could be $43.40. This implies a 52.8% margin of safety - making it what I believe to be an unsuspecting value investment. The media has slammed the stock, creating the opportunity for tremendously high risk-adjusted returns. The Street has done the same, as evidenced by the fact that of the 33 revisions to estimates, all have gone down for a net change of 13.3%.
Consensus estimates for Dell's EPS are that it will increase by 32.7% to $2.11 in 2012, decrease by 4.3% in 2013, and then remain flat in 2014. Assuming a multiple of 11x and a 2013 EPS estimate of $1.96, the rough intrinsic value of the stock could be $21.56. This implies a 35.6% margin of safety - not enough, in my view, to justify an entry due to anemic growth and low R&D to catalyze change. With that said, the company is on the other side of the spectrum from HP, with all but one of the 32 revisions to EPS estimates going up for a net change of 5%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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