Hewlett-Packard (HPQ) is on track for resurgence in 2013-though it may be brief. Hewlett-Packard might even be one of the biggest winners of 2013 after being the biggest loser in 2012. But do not expect a turn around like the one Bank of America saw in 2012.
Does this mean the company will build its position as one of the dominant players in the information technology industry in 2013? Not a chance. In fact, its position will continue to deteriorate.
I wrote about this in my post: "You Should Sell Hewlett-Packard." It's worth a quick look.
So how does one explain this paradox? Surely the potential of a resurgence of this magnitude goes hand-in-hand with some measure of perennial dominance, right?
In this article, I want to explain how Hewlett-Packard, one of the most storied companies in Silicon Valley, is on the brink of becoming a parochial relic. This fall from grace, however, will not occur like an image of destruction from Thomas Cole's "Course of Empire," which was swift and absolute. But rather, this fall will reflect what the evolutionary biologist Stephen Jay Gould called, "punctuated evolution," which is an incremental change punctuated by sudden abrupt change.
Moreover, I want to take a look at the company's valuation and lay out an argument for why I think $20 per share is a fair target price for the company in 2013. Additionally, I want to explain why Hewlett-Packard's competition will continue to erode the company's market share in its most crucial areas.
Hewlett-Packard from a Historical Perspective
There are three reasons why Hewlett-Packard's fall as one of the most dominant information technology companies will be incremental as well as abrupt and absolute.
First, companies rise and fall on the proclivities of the stock market, whereas world powers rise and fall on the proclivities of the bond market - both of which are often based on opposing psychological foundations, and often times, opposing investment strategies.
Consider Habsburg Spain, Bourbon France, Ottoman Turkey and the British Empire. Each of these world powers fell once interest payments on their debt rose to a point at which the bond vigilantes abruptly revolted, regardless of debt-to-GDP ratios or the percentage of debt held internally versus externally. Companies across industries, however, historically have not met their downfall based on any one single factor. Each fall can only be determined on a case-by-case basis, and therefore creates more contradictions in the marketplace.
Second, the cloud computing revolution will not happen in a single stroke. Consider any historical revolution. Did the French Revolution end with the fall of the Bastille? Or did the Russian Revolution throw off the shackles of the 19th century on the first day? Of course they did not.
Revolutions in business occur the same way as they occur in history. As Polybius argued, and historical research shows, all historical revolutions occur because there is an imbalance between the government, the wealthy citizens and the "average" citizens. The same happens when there is an imbalance between executives, shareholders and consumers. Consumers will not switch away their computers for tablets and smartphones over the course of a weekend, and they will not all exit from Hewlett-Packard in one weekend. This change will occur incrementally with sudden abrupt changes as a plethora of variables occur, few of which cannot be quantified.
Third, I believe that Meg Whitman, Hewlett-Packard's CEO, has strategically undervalued the company throughout 2012 so that she can claim her strategy in 2013 is working despite not doing anything to help the long-term trajectory of the company. This is a common turn-around move by CEOs. Just consider the most recent $8.8 billion write-down of Autonomy acquisition, which has plunged the company's stock price. By pursing this tactic, the market has overreacted and pushed the company's share price below its true economic value.
Hewlett-Packard from a Financial Perspective
There has been much talk of late that Hewlett-Packard is woefully undervalued. Is it? Yes, but not as much as some are claiming. The company will not return to $40 a share again. It simply does not have high enough EBIDTA margins to achieve that level. As the company showed in its recent 10-K, even when revenue declines from one year to the next, the cost of products is the only cost of goods sold that declines in relation to revenue.
My target price for Hewlett Packard is $20 per share. Sure, euphoria at some point in 2013 will send the stock higher, but despondency will be waiting around the corner to bring the price back to the harsh reality that the company will never be able to bridge the gap between the distant fantasy of being a dominant player in the information technology industry and the cold reality of being but a shadow of its former self.
Assuming the company returns to 2011 revenue levels in 2013, which is a huge, ostensible assumption, the company's free cash flow will remain around the $8 billion mark, assuming consistent margins throughout the income statement - which have historically remained constant. This free cash flow level, however, has been dropping since 2008, when the company had over $11 billion in free cash flow. Moreover, as was disclosed by The Wall Street Journal, as free cash flow has decreased, the percentage of those cash flows that is contributed by receivables sold (factoring) has increased from 35% in 2011 to nearly two-thirds of the company's free cash flow in 2012.
These numbers paint a bleak picture for Hewlett-Packard's valuation. In the company's defense, however, its debt levels are manageable and have started moving in the right direction. Hewlett-Packard's total debt increased from $8 billion in 2007 to $31 billion in 2011. In 2012, however, the company began paying off this debt, as it dropped by $3 billion in 2012. This debt reduction has helped its overall valuation-albeit not by much.
Assuming a 9% WACC, 2% growth rate of the economy and an EBITDA of around 8% of revenue through the terminal year, I calculated Hewlett-Packard's per share value at $31. This valuation is a bit high, which is why I would take discounts for concentration in free cash flows. Hewlett-Packard's decline in free cash flows will only continue to grow and the cloud computing revolution continues to change the information technology industry.
Hewlett-Packard Versus the Competition
Now comes the real devastating part for Hewlett-Packard. As each day passes, Hewlett-Packard's position in almost every area of business is diminishing. There are three primary areas that are key to Hewlett-Packard's growth over the foreseeable future. In three out of the four areas, the company is losing market share.
First, the company continues to make excellent printers. Canon (CAJ), its primary competitor, has not been able to gain substantial market share against Hewlett-Packard over the past three years. Going forward, Hewlett-Packard will continue to do well with its printers and to beat Canon in quality and market share.
Second, the company makes good computers. Lenovo (LNGVY), however, has surpassed H-P in market share dominance and will continue to do so. Since 2010, Lenovo has continued to grow at an impressive rate. Since the company bought the computer division from International Business Machine (IBM), it has produced consistently increasing revenue margins each year. Hewlett-Packard, however, will continue to remain relatively well-positioned in this market. Lenovo will dominate because of the relationship it maintains with businesses that have historically used IBM computers and the customer service they offer those businesses. Moreover, Dell, Inc. (DELL) will continue to fall flat on its face. Dell, which has not seen any substantial revenue growth since 2009, will face more pressure as the personal computer market continues to shrink.
Third, Hewlett-Packard has no chance of ever producing a tablet or smartphone that will gain any substantial market share. Put aside the company's failures in the past and consider the competitive landscape. Apple, Inc. (AAPL) continues to dominate these markets with the iPhone and the iPad. Both of these product lines show resilience in the face of an extremely competitive market with fickle consumers. Moreover, the iPad mini has not cut into the iPad sales, making it an ideal complement to Apple's larger tablet.
The company is able to stay on the vanguard of constant changes in this market. Samsung Electronics has done extremely well with its smartphones. For the fifth straight quarter it has reported record earnings with its Galaxy S III and the Galaxy Note II. All this is occurring despite the release of Apple's iPad mini and iPhone 5. Additionally, Google, Inc. (GOOG) has been developing a strikingly slick tablet that is expected to compete fiercely with the iPad. And if Google's developments are not enough, Sony (SNE) recently unveiled its "super" smartphone at the consumer electronics show in Las Vegas. The company hopes to cut into the market share positions that Apple and Samsung have built up, which is why it acquired Ericsson. All of these shifts are occurring while Hewlett-Packard, a company that plans to focus on hardware, according to Meg Whitman, will be sitting on the sidelines in 2013.
Fourth, Hewlett-Packard's software defined networking (SDN) is impressive, but will not maintain any dominant market position against Cisco, Inc. (CSCO). Cisco's recent acquisition of Meraki was a power play that sealed its future in this business. I wrote about Cisco's incredible acquisition strategies in "Cisco's Meraki Acquisition Will Post Gains 'For Years To Come'" and in "4 Reasons Cisco Will be the #1 IT Company." Cisco's recent transformation with the changing marketplace will be nearly on par with IBM's transformation years ago. Hewlett Packard should be taking notes, not planning its second-tier survival.
I want to be clear: Hewlett-Packard will see a short-term rise in 2013. The company is currently undervalued. A good target price for the company based on my assumptions is $20, with a maximum of $25 if "emotional buying" kicks in and also depending on how much of a discount must be taken for free cash flow concentration over the next three years.
However, as the company moves into 2014 and beyond, the large historical forces of the cloud computing revolution will take over, and the company's imminent fall will follow. This fall, however, will be punctuated by sudden abrupt changes due to the inherent nature of market psychology and the course of changes in the information technology sector. Moreover, this fall will be like that of the world powers I listed before. The British Empire certainly did not cease to exist. But it was not the power it was in 1763, either.
A similar narrative is unfolding in Silicon Valley. Hewlett-Packard has failed for a decade to increase shareholder returns. These investors are growing weary. Moreover, consumers continue to move away from Hewlett-Packard's products. This amalgamation has the makings of a bleak future for the company. That is why H-P won't go above $20.
In 2013, Hewlett Packard better prepare for what is coming. If not, then these predictions are generous.