The Bull Case For Hewlett-Packard

Dec.14.12 | About: HP Inc. (HPQ)

In my previous article on Hewlett-Packard (NYSE:HPQ), I made the bear case for the stock. The main points covered were the massive write downs of $10.8 and $8.8 billion which occurred in Q3 and Q4 this year and the decline in revenues HP is experiencing in certain key business segments (PCs, Printers, and Servers). While these issues are important and should definitely be taken into account, HP does offer some reasons to own its stock. I will take a look into some of the reasons why some may find value in HP.

One reason to be bullish about HP is when one looks at its fiscal 2013 outlook.

For the full year fiscal 2013, HP estimates a non-GAAP diluted EPS to be in the range of $3.40 to $3.60 and GAAP diluted EPS to be in the range of $2.10 to $2.30, in line with HP's previously communicated outlook.
Full year fiscal 2013 non-GAAP diluted EPS estimates exclude after-tax costs of approximately $1.30 per share, related primarily to the amortization of purchased intangible assets, restructuring charges and acquisition-related charges.

We can see that, at its core, HP still has a very profitable business. Using the midpoint 2013 FY GAAP EPS and the current price of $14.53, we arrive at a P/ E ratio of 6.6. Earnings per share data is often filled with non cash charges. To get a better look at HP's profitability, a look at its cash flow data is needed. Below is a chart of HPs cash flows since Q1 2008:

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We can see that HP has been consistently able to generate large amounts of cash. The average quarterly cash flow generated by HP has been over $3 billion. For FY 2012, HP generated about $10.5 billion in free cash flow. While HP has not always used this cash in a wise manner (see Autonomy) it has put some of it to good use. Since 2008, HP has bought back almost 700 million of its shares, as shown by the chart below:

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HP has reduced its share count from 2655 million to 1964 million. This is a reduction of about 26%. If we combine these two metrics and look at FCF per share over the last 5 years, we can see how it has held steady thanks to the lower share count:

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HP currently offers a dividend of $0.132 per quarter. This amount leads to an annualized yield of 3.65%. HP is more than able to afford this yield thanks to its healthy cash flow. Dividend payments are currently around $260 million per quarter. The dividend payout ratio is only 10% of FY 2012 cash flow.

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My current opinion on HP is mixed. On the one hand, I see its massive FCF and low dividend payout. HP could in theory easily double or triple its dividend. But, this is unlikely. HP loaded itself with debt when it bought Autonomy. In 2012, it has already reduced its debt load by $3 billion. A similar reduction in debt is likely for 2013. HP also needs to reinvest in its core PC and printing business. These segments provide a large percentage amount of HP earnings.

Though HP cannot stop the secular decline of the PC, it should be focused on keeping its market share intact. HP cannot afford another debacle like Autonomy. Instead, it should focus on debt reduction and revenue stabilization. Interest expense for FY 2012 will reach about $900 million. This is a sharp difference from 2008, when it generated about $100 million in interest income.

Even though the valuation of HP is low and it does generate healthy cash flows, I would avoid the stock. The current dividend is not at all compelling compared to its peers. While HP does have over $11.3 billion in cash, management has been more than happy in the past to spend it on dubious acquisitions. HP also has over $35 billion of goodwill on its balance sheet. This is a ticking time bomb in my opinion.

What would happen to the share price if HP needed to take another large impairment charge? One particular charge HP may need to take is with the server segment. It bought Electronic Data Systems back in May 2008. This acquisition increased HP's goodwill by nearly $14 billion. With goodwill at 125% of its market cap, any impairment charges could have a major impact on HP's share price.

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.