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On November 20th, Hewlett-Packard (HPQ) reported ugly 4th quarter earnings that were right in line with a disastrous 2012 campaign. HPQ has been my single worst investment over the last year by a very large margin. It is our process to perform rigorous fundamental analysis, dollar cost average, and unless the facts change on our investment thesis, we are willing to take a 3-5 year time frame. After absorbing HPQ's 4th quarter results, I am walking away still comfortable in holding the position and will be looking to dollar cost average accordingly at these levels. The key to looking at HPQ as an investment is to disassociate the emotional energy that comes with crazy days like today, and look at the value that you are receiving versus the price that you are paying. This process requires more than a cursory knowledge of accounting and financial measures, but I believe that a careful study of the facts points to significant upside with a reasonable margin of safety.

(click to enlarge)Source: HPQ 4th Quarter Earnings Presentation

The noise in the quarter was the result of a non-cash charge for the impairment of goodwill and intangible assets primarily relating from the Autonomy acquisition, which in my estimation can be firmly placed in the Mount Rushmore of disastrous acquisitions. The write down was no surprise to us as the day it was announced we were in disbelief that a CEO and Board of Directors could be so naïve about destroying shareholder value. The reason we held on to HPQ was because we believed that underlying businesses were fundamentally undervalued, and with good management the company could recover nicely. Leo Apotheker paid a mind-blowing multiple for Autonomy, so whatever fraud may or may not have occurred likely pales in comparison to the poor investment principles behind the acquisition. The fact that most board members are still present in the company is worrisome and I believe it is likely that activist investors will look to remove some of them in the near future. Meg Whitman has done a nice job and I want her to stay the course without any acquisitions, and a streamlined focus on reducing debt levels. This most recent debacle comes after the painful and atrocious utilization of capital that was the EDS acquisition that was written down last quarter. In total a whopping $18 billion of goodwill and intangibles has been wiped clean in the last 3 months. While these setbacks are frustrating, it is also important to remember that they occurred under prior management. Whitman's decision making over the past year has been sound given a bad hand, and the price is right on the stock, therefore within this madness we see opportunity.

Net revenue in the quarter was $30 billion in the 4th quarter, down 7% YoY and down 4% in constant currency. Non-GAAP diluted EPS of $1.16 was down 1% YoY and the GAAP loss per share was $3.49. The company generated cash flow from operations of $4.1 billion, up 69% YoY. The company utilized $124MM to buy back stock in the quarter and $260MM to pay dividends. For the full year HPQ generated more than $10.6 billion in cash flow from operations, which management pointed out is more than McDonald's (MCD), Coca-Cola (KO), Disney (DIS), FedEx (FDX), and Visa (V). HPQ generates in excess of $120 billion in annual revenue so any stabilization in margins will lead to significant operating leverage. Non-GAAP gross margins were up 90 bps YoY to 24.2% as services and software is becoming a larger part of the overall business mix. Non-GAAP operating expenses were $4.1 billion, down 5% YoY, while non-GAAP operating margins were up 70 bps to 10.4%. HPQ delivered $3.1 billion in operating profit.

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Most analysts knew the quarter was going to be rough given the environment in the technology sector, and the big noise in the quarter really shouldn't have been such a shock. Don't forget that HPQ dropped 20% the day that now infamous merger, was announced, and yes the company did also threaten to spin off the PC division on that day, but I believe most of the panic was due to the price paid on Autonomy. For fiscal year 2012, HPQ generated a respectable non-GAAP operating profit of $4.05 per share versus a GAAP loss of $6.41. What I'm impressed about with Whitman is that she realizes her number one priority right now is to improve the financial condition of the company and she is accomplishing that goal. In the 4th quarter HPQ reduced net debt by $3 billion and $5.6 billion for the year. When you back out financial services, where assets are receivables as opposed to cash, net debt for the company is only $5.8 billion. That is still not ideal but it is starkly better than the net debt figures that many analysts are quoting, which aren't backing out the financial services business. The company was able to repay so much debt because in this year of huge GAAP losses, the business generated $7.5 billion in free cash flow. Keep in mind that HPQ's non-GAAP earnings aren't the atrocity that's (CRM) are, where stock options represent a huge percentage of GAAP expenses.

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We look at HPQ as distressed investing 101. Whenever we do these types of investments, we are careful not to build a full position right away and we are patient in working to get better prices. HPQ posted a dreary outlook for 2013, where it expects non-GAAP FY earnings of $3.40-$3.60 per share, and $0.68-$0.71 non-GAAP EPS in the 1st quarter. The business usually benefits from seasonality as the year progresses and I believe management is intelligently being rather conservative in this forecast.

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It is clear that there are substantial and structural pressure impacting the PC and Notebook markets, and it is evident in the dismal performance on HPQ's Personal Systems numbers. HPQ is still number one globally although Lenovo is coming on strong. From looking at numbers across the technology space, it seems clear that IT budgets are thin amidst the global uncertainty. With Microsoft's (MSFT) recent introduction of Windows 8, I believe you'll see a gradual improvement in the PC space, primarily in the corporate world. I also believe that Windows 8 gives both HPQ and Dell (DELL) an avenue to enhance their tablet and Ultrabook offerings. It will take time, but many businesses like that run Microsoft Word and Office, will want to keep their operating systems uniform. I'm already seeing more commoditization in the tablet industry, and while that will ultimately be detrimental to the industry as a whole, I believe HPQ can benefit as the margins are higher than PC margins over the short-term, and there is no reason the company shouldn't be able to compete given its infrastructure and distribution. I'm not calling for them to knock of Apple (AAPL) but it doesn't need to in order to make the unit more profitable. The consumer business will continue to be difficult, but fortunately the PC business has significant variable costs, which can be dialed down in times of weak demand, as evidenced by the unit's ability to sustain profits. The Printing business had a nice quarter but management guided that margins are likely to be lower as hedging and inventory management issues aren't likely to be as favorable. The Printing business will continue to be a bastion of profits, and HPQ is gaining market share as competitors retrench. It is not a growth business, but by focusing on higher end printers with better long-term margins, HPQ should continue to lead and innovate.

Services and ESSN have been difficult for just about everybody in the tech space. HPQ has been and will continue to increase R&D to get more and more competitive, but they won some nice deals with General Motors (GM) and Procter & Gamble (PG), which have attractive recurring revenue streams. When I look at fiscal year 2012 for HPQ and back out the restructuring and write down charges, I'm left thinking it really could have been much worse. In the 4th quarter non-GAAP operating margins were 10.4% and I believe the company can achieve 8-10% non-GAAP operating margins over a cycle, as Whitman's changes are fully implemented. On $120 billion of annual revenue it is not hard to see how much leverage there is to ramp up profitability and free cash flow. The other good news, if you want to call it that, is that there just isn't that much more the company can write off. The fat has been removed and I believe the fundamentals of the business will begin to shine through. I look at the PC and Printing businesses like newspaper companies in that they are in a structural decline, but still generate strong profits and cash flows over the cycle. It doesn't make sense to spin them off because the value is not nearly as high as the cash flows they can produce. Down the line I believe HPQ should be open to exit most consumer facing businesses so it can focus on the Enterprise. The ESSN, Services and Software businesses have the potential to grow, particularly as the economy improves globally. Europe is a huge headwind and I believe we are close to the bottom of their tech spending cycle, and Asia and the Americas should improve nicely. Looking 2-3 years out I think the future looks okay, and as the company retires its debt it can continue to retire shares at discounted prices.

At $11.71 HPQ has a market cap of $20.3 billion and offers a dividend yield of about 4.3%. This is a business that generated $7.5 billion in free cash flow in the last 12 months, and should produce at minimum $5 billion next year. Whitman could potentially have company in an even net debt situation by end of fiscal year 2013, while still executing mild stock buybacks. Most of HPQ's cost cutting efforts are labor related, and much of this is occurring outside of the United States where it can take 12-18 months to execute the initiatives due to different employment laws. The beginning of next year will be rough, but as those cost cuts run through, profitability will ramp up over the next several years. The stock trades at a staggeringly low 3.44 times the bottom end of the $3.40-$3.60 2013 non-GAAP EPS estimates; those represent trough earnings in my estimation. The big write downs should be at their last stages. I'd like to see activist investors get on this board of directors to ensure that Whitman has the support to avoid unattractive acquisitions. The entire focus should be on building shareholder value.

On November 20th, we at T&T Capital Management (TTCM) sold some January $10 2014 puts for $1.40. These puts would return 16% on the maximum risk of $8.60 in the likely event that they expire worthless, and at worst you'll own the stock at $8.60. The same pessimism most market participants have about this sort of investing is why it works. There are a million reasons to not own HPQ, and many of them are emotionally related. Therefore we are able to partake in a time arbitrage, by being willing to except short-term mark-to-market losses, as we bridge the gap to a year or two out, when the company's earnings should ramp up considerably. We are following the cash flow instead of the headline numbers. Our investment thesis will prove to be wrong if the company makes expensive acquisitions, the services business doesn't improve with a better economy, or the printing business falls much more quickly than we expect. I believe the current valuation can handle one of these things occurring but two or three of them could be devastating. Time will tell what happens.

Source: Hewlett-Packard: Distressed Investing 101