Hewlett-Packard (HPQ) was one of the worst performing stocks in 2012. The shares dropped from $30 to a low of $11.35 and recovered slightly towards the end of the year. It currently trades at $17. The share price reflects the mismanagement of the last few years. The $18 billion goodwill and intangible asset write-off in the Services segment and for the acquisition of Autonomy confirmed the general opinion that HP overpaid for acquisitions. As a result GAAP full year EPS came in at a negative $6.41. A bad performing company can still be a worthwhile investment as long as the price is low enough with a sufficient margin of safety. For me HP falls in that category. There are a few reasons why I think an investment will pay off over a 3 to 5 year time horizon. Let's take closer look at the 2012 10-K to get a better understanding of the current status.
The negative $6.41 EPS was driven by the $18 billion write-off. This was a one-time, non-cash charge of more than $9 a share. If you exclude this and look at the non-GAAP EPS, then you see this coming in at $4.05. With a declining PC market and competitive pressure in the printing, services and server space, this is not a bad result.
The company is taking actions to improve profitability. In May 2012 HP announced a multi-year restructuring that will touch every part of the company with the objective to create a more streamlined business. Critical part of the restructuring is a workforce reduction of 27,000 employees. This is expected to reduce cost with $3 to $3.5 billion in 2015 ($1.50 to $1.75 in operating savings per share). Other actions are focused on optimizing the supply chain, reducing the number of SKUs and platforms. According to the comments of Meg Whitman on the Q4 earnings call the restructuring is on track. These actions will depress earnings in 2013 and 2014 as the company expects to take $1.8 billion in pre-tax restructuring charges. If executed well, the savings going into 2015 are promising and will increase margins.
HP is making progress on improving the balance sheet. The cash position increased with $2.2 billion to $11.3 billion. The net-cash position (cash - debt) currently stands at a negative $16.4 billion. This looks worse than it in reality is. Financing done through the financial services business is included in the overall debt number. Exclude this and you get a net-cash position of $5.8 billion negative. With a free cash flow of more than $7 billion a year, HP should be able to get close to a positive net cash position in 2013. Inventory as percentage of total assets remained stable at around 5.8%. I am comfortable in the progress the company is making in cleaning up the balance sheet.
The cash flow statement shows that HP still generated more than $10.5 billion in operating cash flow and $7.5 billion in free cash flow. There are however a few items to keep an eye on. Around 12% of the operating cash flow was generated through accounts and financing receivables. Investment in P&E was substantial lower (22.5% less) than the depreciation and amortization (compared to 10 to 15% in the years before). Although focus was on restoring the balance sheet, HP was still able to distribute $2.6 billion back to the shareholders by buying back $1.6 billion in stock (2% of outstanding float) and $1 billion in dividends.
HP's future depends on stabilizing and improving its 6 main divisions: Personal Systems; Printing; Services; Enterprise Servers, Storage and Networking; Software; HP Financial Services. A lot of focus is on the Personal System group and the impact of tablets and mobile devices on its future earnings. With $35 billion in sales it is the biggest revenue generator. However, it is only number 4 in operating profit ($1.7 out of $12 billion in 2012). More critical is the stabilization of the Services, Printing, and Enterprise Servers, Storage and Networking groups. The software group is still relatively small from a sales perspective; its significance for the future is in the high (21%) operating margins.
Graph 1: Operating Earnings
Another way of looking at this is by taking the operating earnings per share per group for 2012 (calculation excludes the cost at a corporate level, like restructuring charges, write-offs, interest, …). I am taking 1998 million as the outstanding share counts for this calculation.
|Division||Op Profit per Share|
|Personal Systems Group||$0.85|
|Imaging and Printing Group||$1.79|
|Enterprise Server, Storage and Networking||$1.07|
|HP Financials Services||$0.19|
Above view is a good indication that even if HP wouldn't sell a single PC anymore it would still have 5 other divisions, out of which 3 are market leaders, generating significant earnings.
The guidance the company put out for 2013 is $3.40 to $3.60 in non-GAAP earnings and $2.10 to $2.30 in GAAP earnings per share. This should not be very challenging to achieve. Let's take the following conservative assumptions:
- Personal System Group: $21 billion in sales ($14 billion less than 2012), with a stabilized operating margin of 5%
- Printing group: last 10 year minimal sales and operating margin
- Services: Stabilized sales and 2011 operating margin
- Enterprise Server, storage and networking: last 5 year average sales and operating margin
- Software: 2012 results
- HP Financial Services 2012 results
- Corporate cost in line with the 2011 and 2012 reported numbers.
|Segment||Sales||Operating Margin||Operating Income|
|Imaging and Printing||22,569||13.6%||3062|
|Enterprise Server, Storage and Networking||19,512||12.3%||2408|
|HP Financials Services||3,819||9.7%||370|
|Unallocated Corporate Cost||790|
|Earnings before Taxes||8,798|
|Earnings after taxes||6,774|
The non-GAAP earnings per share would be around $3.40, in line with the company guidance. Add in the $1.8 billion in restructuring cost and you get close to the $2.10 to $2.30 guidance for GAAP EPS. I consider this a conservative estimate. If the economy doesn't fall off a cliff then the different businesses should be able to do better than projected above. Cost at a corporate level like amortization and interest should be lower after the write-offs and debt reductions of last year. I expect non-GAAP earnings to come in higher than the $3.60 upper limit of the earnings guidance.
HP has another $9 billion left in its authorized share buy-back program. I expect investor sentiment to remain negative during 2013, keeping downward pressure on the stock price. This should give the company opportunity to further reduce the share count with 2 to 3% without impacting its efforts to further strengthen the balance sheet.
If HP is able to make $3.60 in earnings in a transition year, then it should be possible to make more than $4 per share in 2015. With a P/E ratio of 10 to 15, it would give a share price between $40 and $60. My investment thesis is essentially a bet that Meg Whitman will stabilize the company and improve profitability in the services group. The situation is clearly challenging. It will not be easy to turn it around. The good news is that she has a lot of pieces to work with. With a stock price of $17 a share, HP is too cheap to ignore.