Time To Take A New Look At Hewlett-Packard Shares: A Contrarian Call

| About: HP Inc. (HPQ)

It was not that long ago that Hewlett-Packard (NYSE:HPQ) stock in the mid-teens would seem a steal. At around $14.50 per share, the stock seems priced as a bargain. Based on out-year consensus, it trades at a paltry 0.26x revenue and 4.2x earnings. Even once we adjust for its hefty indebtedness, it is still cheap. Its enterprise-value-to-revenue ratio is just 0.41x, and to EBITDA it is an alluring 1.3x. And its free cash flow yield is a robust 15.0%. Indeed, some early and patient money is flowing back into the stock: It is up 10% since we started this analysis. That said, the sell-side view is negative with most analysts modeling an ongoing decline, and sentiment toward the stock remains poor.

All of this has us wondering, then, if this in fact is a good time to consider HP shares, at least for patient deep value investors. Yes, problems abound at the company and the current restructuring program has been mapped over five years. But the stock is incredibly cheap and likely more than prices in this mess. The first whiff of some breath, the first murmur of some heart beat, investors will realize HP is not moribund, but the $110+ billion troubled titan it has become. In a flash, the stock could easily be $18 per share (up 25%) and still very cheap (0.32x consensus out-year revenue on market capitalization, 0.47x on Enterprise Value, with a trailing Free Cash Flow yield of 13.1%). And a good portion of deep value owners at $18 per share will think they are just getting started. Timing this event is difficult, but it will happen at some point (I'm guessing) in the year ahead.

The fact is, HP remains the leading global vendor of PCs, Printers and x86 Servers. There are indeed significant issues across this offering, though the company has clearly begun to address them. (More on this below.) Indeed, with a decent Tablet offering, its robust and tuned channel could move a considerable volume of this product as well. Its software business has greater critical mass than ever. And right-sized and focused, its troubled services business could very well begin to prosper. Moreover, management seems cogent, focused and-importantly-committed to under-promising.

So yes, in my view, for Value investors at least, it is time to take a close look at HP shares. That said, the company's performance over the last 18 to 24 months has been turbulent, due to a series of destructive actions taken by management. It is thus necessary to review this recent history to determine if conditions have changed enough to allow improved performance. Finally, the fact that management induced these negative circumstances suggests there have been lapses in Corporate Governance at the company, And it is necessary to confirm that these conditions have changed as well. So let us roll up our sleeves and take a close look.

Much has happened at HP over the past two years and a great deal has been written about it. So I will limit our discussion to the essentials. However, much of what went wrong and how it might be changed can be understood in two sets of press releases from the company, those that accompanied the fiscal Third-Quarter earnings release in 2011, and a subsequent set that were issued in conjunction with the Analyst Day and Fiscal Fourth-quarter earnings release last month. Yes, one undoes the other in a sense, to the extent these circumstances can be reversed. But the Value Investor's decision to buy the shares can at least start with these telling snapshots.

A Turn for the Worse

Key to the enfeeblement of HP were actions implemented by CEO Léo Apotheker (former co-CEO of SAP) with the fiscal third quarter earnings release of 2011. In two, somewhat contradictory releases, the company announced the following transformative actions: 1) the decision to divest the PC business (30% of revenues), which was in fact hedged as the intent to consider options for the business; 2) the intention to close down the WebOS business, along the associated Tablet and Handset product lines, in the wake of an initial stumbled offering; and, 3) the acquisition of Autonomy, a highly acquisitive Enterprise Software company, for ~$10 billion, or roughly 11x revenues.

Investors' consternation was surely reflected in the company's market capitalization, which immediately fell by about 25%. In our view, each action betrayed severe lapses in the Corporate Development oversight process, as very obvious negative consequences were likely to arise with each action. Yes, PCs were a highly competitive, high-volume/low-margin business, relative to the profit margins offered by Enterprise Software. Yet the loss of purchasing power offered to HP by its leadership positions in the PC and x86 Server markets would be awfully hard to offset, as would the marketing and channel synergies offered by these business and the commercial and consumer printing businesses as well. Taken together, these computing and imaging businesses contribute about two thirds of HP's revenues; PCs alone are nearly a third. They are not highly profitable businesses, but high volume businesses rarely are as customers typically have strong buying power.

The closure of the WebOS handset and Tablet businesses has been problematic for other reasons. First, it was a peremptory reversal of a differentiated Tablet strategy implemented by Apotheker's predecessor Mark Hurd with the prior-year acquisition of the Palm WebOS in 2010 for $1.2 billion. It was intended to extend HP's franchise into the cellular handset and Tablet markets. Given HP's strong consumer franchise and brand, it was an obvious thing to do. Admittedly, the business's first Tablet offering under HP had faltered unceremoniously, introduced as it was into the market with little support and (we suspect) executive oversight. But its closure deprived HP, as a leading purveyor of consumer technology, with no alternative offering in what has been a burgeoning market. And though only iPads enjoyed any success at the time, the market has since admitted other differentiated, Android-based alternatives. This remains a severe deficiency, given HP's strong position in consumer Notebook PCs. Clearly, whatever the outcome for HP's Personal Systems Group, it should have retained this business to pursue iterative and improved products.

Apotheker's third major announcement with these releases was also controversial. First, this proposed acquisition of Autonomy was very expensive, at over 10x revenues. High-growth, high-quality enterprise software companies typically command valuations in the range of 3x to 5x revenues. Second, Autonomy was a bit of a roll-up with a good number of detractors, having come together from a lengthy series of sizable acquisitions. And given reporting practices, the actual state of existing and acquired businesses was generally unclear, both to analysts and, as it happens, auditors (see below). At least, this was our individual impression and we were not inclined to do additional work given past experiences with such companies. As we argued in this forum at the time ("Meg Whitman Assumes the Helm"), we felt that HP should reverse the acquisition, though the companies had somehow negotiated an absurdly high break-up fee. In any event, the acquisition went forward and the company is even more heavily leveraged as a result.

The striking thing about each of these initiatives is that they betray a lack of thorough consideration the Board of Directors typically expects in implementing such transformative actions. In most companies of size, strategic initiatives are developed and initiated in an iterative process overseen by a Corporate Development that typically reports to the CFO but engages directly with the CEO and Board. The pros and cons of a fairly obvious transformative action such as exiting the PC business are typically well understood and articulated at least among the Group, and surely with any C- or Board-level individual so interested. Here, it seems not to have been the case. Similarly, the decision to terminate Tablet development seems sheer folly, given the company's leading notebook position. Taking on so much debt to fund the Autonomy deal is equally questionable, as it has constrained the company's financing capacity, and strategic flexibility in a year of dramatic market change. So what are we to think?

Charting a Path out of this Dark Valley

It is striking that one CEO could damage so much so quickly in so large a company. Surely a factor was the fact much of this historically fractious board was new and the Chairman, Ray Lane, was as deeply grounded in, and apparently limited by, his experience in Enterprise Software as Apotheker himself. But in my experience, it is possible for a CEO with sufficient haste, appealing initiatives, and attractive slide-ware, to induce negative change with a sympathetic board. In any event, as is said: "what is done, is done." In short order, with his mistakes now obvious to all, Apotheker was out, and newly appointed board member Meg Whitman in as CEO. At this juncture, it is the response of the Board and the Ms. Whitman to this crisis that is more relevant. And for this we turn to the second set of releases.

The negative effects of Apotheker's initiatives have reverberated across the past year. The Personal Systems Group revenue growth has reversed, as customers' commitment to the ostensibly abandoned business wavered. The fundamentals of the PC market have weakened as well, of course, as Tablets have proliferated and differentiated form factors have emerged (Kindles, Nooks, the Nexus, Surface RT and Pro, convertible and separable Ultrabooks). But HP under Whitman has initiated what appears to be a deliberate, thorough and very protracted turnaround of the company and its many businesses. The undertaking is vast in scale and time frame, but this allows for a process that is dynamic and measured, a process that can be fine-tuned as HP's markets, currently subject to dramatic change, evolve. Let us take a closer look.

Whitman's Plan

If Apotheker's tenure as CEO was characterized by hasty change and apparent floundering, Whitman's thus far has been a model of careful deliberation. The newly articulated strategy, presented to analysts in early October, came nearly a year after she assumed the post and betrays a careful analysis of HP's major segments and their many businesses. Importantly, it was preceded by a major multi-year restructuring program announced in May that is intended to both focus and right-size individual businesses to potential revenue opportunities.

The restructuring program is expected to generate $3.0 to $3.5 billion in annualized savings from an 8% reduction-in-force, implemented across the organization over a 30 month period stretching to year-end 2014. It is to be supplemented by a rationalization in SKUs and Platforms (most obviously needed in the Computing and Printing hardware businesses), as well as more general business process and supply-chain optimization programs.

Importantly, the savings generated over time by the restructuring are to be reinvested both in both R&D and Marketing and Sales, as well as in boosting the technology capabilities of individual business segments. This provides a great segue to the strategic initiatives announced at the October Analyst meeting. Its presentations were handily summarized by the first of three releases noted above, which also include the earnings release on November 20th and the Autonomy write-down announcement of the same date. We will integrate a discussion of all three releases to determine to what extent the state and strategies of HP's businesses justifies an investment in the share at this juncture.

We just noted the two-and-a-half year restructuring program intended to realign the company's cost structure and to provide the investment capacity to address strategic opportunities by business unit. With the analyst presentation Whitman provided additional detail, describing a five-year plan that commences with the restructuring and culminates with a steady-state HP, with industry leading margins, growing revenue in line with GDP and profit at a higher rate. CFO Cathie Lesjack additionally provided a fiscal 2013 earnings target of $3.40 to $3.60 per share and gave a long term commitment to pay down debt and observe fiscal discipline as the company re-enters a growth phase in coming years.

As we move through the individual business segments, we see that each faces significant challenges, many of which have either arisen from, or been exacerbated by, the company's recent turmoil. Opportunities abound as well, however, once a turnaround has been implemented. Notably, HP's business segments, once disparate and autonomous, are more obviously organized in larger units, most obviously with the combination of the PC and Printing businesses. Similarly, Enterprise Hardware and Software, while independent segments, are more clearly targeting common customers and technology opportunities.

A unique set of challenges weighs on the Printing and Personal Systems segment, which generated 50% of total revenue ($60.1 billion) in fiscal 2012 (down 9% from the previous year). The PC business, slated by Apotheker for divestiture as we noted, comprises 60% of segment revenue; it experienced a 14% decline in revenue in the fiscal fourth quarter with weakness in both its commercial and consumer businesses. Marco-economic pressure and competition from the iPad and other tablets were both at play. The Printing business (40% of segment revenues) declined a less sizable 5%; consumer and commercial hardware declined 14% and 13%, respectively, though steady sales of supplies (~2/3's the business) largely offset the declines.

Going forward, the company plans to rationalize SKUs in both printing and PC businesses by 25%-30% over the next two fiscal years. It is also rationalizing its selling and supply chain functions to better focus on, and cater to, customer demand. Presently, it is looking to serve both slow- and no-growth businesses while actively competing in higher growth hybrid notebook and commercial Tablet markets. A raft of sleek new products is set to go. They include the HP ElitePad 900, running Windows 8 Pro with an Intel Atom processor. And there is an explicit focus on elegant industrial design. Thus far absent is a Consumer Tablet offering.

HP's Enterprise Hardware and Software businesses remain as independent segments, though a commonality of markets is evident in the company's Cloud and Big Data strategic thrusts. The former, variously termed The Enterprise Group or Enterprise Servers, Storage and Networking (ESSN), produced $20.5 billion in revenues in fiscal 2012 and $2.1 billion in operating profit (both 17% of total with an operating margin of 10.4%). The segment derives ~60% of its revenue from Industry Standard Servers-x86-based servers-an increasingly competitive market that the company has consistently led. HP is also the market leader as well in Blade computing (with multiple server blades per rack) and is likely to maintain leadership moves to ever denser computing platforms. With Project Moonshot, HP has been the first to move towards Hyperscale computing, in which low power ARM and Atom based processors allow even denser server architectures. HP posits that by 2015, ARM- and Atom-based servers will command 15% of the market. And it has just announced that it has such systems (with the code-name "Gemini" using Intel's 6W S1200 Atom processor) already under customer evaluation.

ESSN's other businesses are smaller. The Storage business (18% of segment revenues) targets mainly mid-range network and direct attached implementations, forming a nice complement to the server business. Two offerings in particular show promise: 3Par (acquired in 2010, its largest platform) and its StoreOnce secure backup device, both of which are gaining share. The Business Critical Systems unit (8% of revenue), comprising legacy Unix and other systems, has been under pressure for years, exacerbated most recently with the Itanium dispute with Oracle. Its revenue was down 25% year to year in the most recent quarter. The networking business (12% of revenue) rounds out the segment and offers growth as well. Much of the unit's business stems from 3Com, which HP acquired in 2009.

HP's Software business is entirely focused on the Enterprise, with fiscal 2012 revenues of $4.1 billion (3% of total). Once focused mainly on HP's Unix platform, the segment has expanded in recent years through a series of acquisitions, including Mercury Interactive, Peregrine, Opsware, Tipping Point, and (most recently) Autonomy. Now the 6th largest software company, it is focused on IT and Cloud Management, Security, Big Data Analytics, and Meaning-based computing. As noted above, the Autonomy acquisition (for $10.3 billion) has left HP excessively leveraged, though HP's strong cash flow should allow it to pay down debt fairly quickly. Once it does, the company is likely to resume building out this segment with incremental acquisitions.

The Autonomy acquisition continues to be controversial. With the most recent earnings release, HP announced an $8.8 billion impairment of Autonomy's assets, reversing much of the goodwill created by the transaction's high valuation. The company asserted that $5 billion of the charge stemmed from accounting irregularities and misrepresentations that had escaped detection by the auditors who were involved in the due diligence process. The irregularities were apparently well hidden and only came to light when a senior Autonomy executive identified them to HP management. They appear brazen and include booking hardware revenue as software license sales; accounting for 10% to 15% of Autonomy's revenue, this misallocation surely distorted margins as the products' costs were booked as an operating expense. In addition, Autonomy is accused of booking revenue on unsold license transaction through resellers. HP has turned matters over to US and UK government entities. More relevant to the analysis, the acquired products remain as key additions to the Software Segments offering. It was only the valuation that was defective.

Of HP's segments, the Services segment seems to have the greatest challenges. While HP has leadership positions in PCs, Printers and Servers, and has built a sizable Software business through acquisition, the services business remains a work in process. It contributed revenues of $34.9 billion in fiscal 2012 (29% of total revenues) and generated an operating margin of 11.7%. Boosted in a major way with the late 2009 acquisition of EDS for $13.9 billion, the company has struggled to generate growth and keep its human assets sufficiently utilized. In increasingly competitive markets, it has entered a number of low profit contracts, and it is experiencing significant trouble with others.

With the fiscal third-quarter earnings, the company recording after-tax asset charges of $10.8 billion, which included goodwill impairment of $8.0 billion on Services alone. Management intends to focus on higher value services and improved delivery to achieve a business model that generates growth of 3% to 5% annually with an operating margin of 7% to 9%. It will be tough out of the gate, however. Due to issues with four major accounts, and the need to exit lower value engagements, revenues have been guided down by 11% to 13%, with operating margins at 0% to 3%. It will be a multi-year turnaround. That said, the Services segment is ranked as a leader by Gartner, Forrester, and IDC; with better oversight and management, it should return to growth once the turnaround has been effected.

A Good Buy for Early Value Investors

Since the departure of Mark Hurd, HP has experienced significant duress across most of its major businesses. This in turn has led to declining revenue, a severely depressed stock valuation, and uniformly negative sentiment. Indeed, its PE looks more like a Market Cap to Revenue multiple and it is trading at a discount to its distributors. So even absent a consideration of its fundamentals, the stock seems a compelling buy. Yes, we are early in the recovery and the revenue outlook in the year ahead is negative. But management seems committed to "getting it right" and is not afraid of effecting change over a broad time frame. So at some point, clearly, the stock is going to strike many investors as a compelling buy. It is hard to know what will trigger this impression. But once investors realize things are getting better, not worse, the stock will be heading up out of the 'teens and only the early buyers will have benefited. Yes, with so much wrong at the company, it will seem too early for many investors. But if you like that first leg up, it is time to take a close look at these shares. At some point in the next two to four quarters, this stock is likely to pop up.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.