By Rom Badilla, CFA
Since Hewlett-Packard (HPQ) CEO Meg Whitman provided earnings guidance for 2013 in early October, investors with disappointment on their minds have targeted and attacked anything related to the company. The stock has tumbled by a staggering 22.8 percent from October 2 through yesterday. Similarly, yields on HPQ bonds have increased in a time where U.S. Treasury rates have either stayed the same or for longer maturities, have fallen. While the announcement is upsetting for stockholders, the fact is that the outlook should be sufficiently constructive from a credit perspective.
In particular, management's goal of improving the company's credit profile via debt reduction should be a strong positive for bond holders. The company hopes to return to a mid-single A credit rating from its current low A3/BBB+ rating by Moody's/S&P (Watch Negative by Moody's) over the course of the next several years. Furthermore and despite the competitive challenges the company faces across all of its business segments, the credit fundamentals suggest that HPQ bonds are cheap and are a relative value opportunity, especially when compared with debt issued by other Technology companies of similar investment grade ratings.
On October 3, 2012 at HPQ's turnaround strategy meeting with security analysts, CFO Cathie Lesjak provided the outlook of the company for 2013. While the company provided non-GAAP earnings per share guidance in the range of $3.40 to $3.60 which fell short of the average analyst's expectations of just above $4.00 per share, the management team stressed its priority of debt reduction and repairing its balance sheet in the next several years. The hope is to ultimately reduce its cost of capital by improving its credit rating one notch. In particular, Lesjak said at the analyst meeting:
Now, I've highlighted the importance of rebuilding the balance sheet. Let's look at the progress we've made. You can see that over the last several years we've utilized our free cash flow largely for M&A and share repurchases. This has driven our net debt position down below where a mid single A credit-rated company would be. As I mentioned, we have made progress this year by reducing operating company net debt positions by over $2.5 billion, but we have more work to do, and we expect it could take a couple more years before we are where we need to be.
That said, it remains to be seen if they continue down this path of paying down its debt. However, the fact is that this is a priority for management and is vital for the company's turnaround. Any expected declines in earnings in 2013 should be offset by any significant debt reductions. This in turn should be good for bond investors.
Another thing to consider is the credit profile of HPQ on a relative basis. From a fundamental standpoint, HPQ has better credit metrics in comparison with another technology investment grade company, Xerox Corporation (XRX) which is rated lower at Baa2/BBB-.
The amount of net debt relative to its profitability ratio for HPQ is better than XRX. The Net Debt to EBITDA ratio which is represented as a multiple, measures how easily debt can be repaid using a company's cash flow. EBITDA which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is one measure of profitability. An easy way to interpret this ratio is to say that a company that has a ratio of '2x' would mean that it would take two years' worth of cash flow to repay its debt. So, a lower multiple is better.
In the case of HPQ, the company has a Net Debt to EBITDA ratio of 1.48x while XRX is at 2.81x when using earnings over the past 12 months.
Along the same lines, HPQ has a lower debt burden in relation to its size than XRX. HPQ sports a Net Debt as a percentage of Shareholder Equity of 63.2% versus 66.6% from XRX.
Given these credit metrics, it is easy to assume that XRX bonds would trade at a higher yield than HPQ. However, that is not the case which provides investors a relative value opportunity in terms of yield.
HPQ bonds are trading at a higher yield to XRX bonds with similar characteristics. According to Trade Monster's Bond Trading Center, HPQ 4.65% Coupon Maturing on December 9, 2021 (CUSIP 428236BV4) is currently trading at a dollar price of $99.67 which translates to a yield to maturity of 4.69%. Comparatively, XRX 4.50% Coupon Maturing on May 15, 2021 (CUSIP 984121CD3) can be purchased at a dollar price of $106.14 which equates to a yield of 3.65%. So by investing in HPQ, an investor can pick up an additional 104 basis points based off of today's levels while assuming similar risks.
For investors who do not want to take on that much interest rate risk by extending with a longer maturity but would like to capture some carry, the short end of the yield curve provides some opportunities. An investor can capture 3.16% on a yield to maturity basis by owning HPQ 2.60% Coupon Maturing on September 15, 2017 (CUSIP 428236BW2) at a dollar price of $97.52. This is a 101 basis point pickup over XRX 2.95% Coupon Maturing on March 15, 2017 (CUSIP 984121CF8) which at a $103.29 dollar price is yielding 2.15%.
All of the aforementioned bonds were highlighted by finding the best yield given the dollar price. Some bonds yielded higher but at a cost of a higher dollar premium.
Furthermore, keep in mind that corporate bonds trade over-the-counter. So, prices and yields can vary depending on the broker you use. The best suggestion is to use a broker that offers the most visibility and price transparency for the corporate bond market. This can be achieved by comparing the price to buy and the sale price (aka bid-ask spread). The closer the differential usually means the better the liquidity.
As always, every bond investor should perform their own due diligence when making their investment decisions.