The history of American business is filled with stories of fallen angels rising again, and once-loved leaders turning to dust. Hewlett-Packard (HPQ) was the Silicon Valley pioneer but it lost its way through a flurry of multi-billion dollar acquisitions, which have been abject failures, and the loss of the innovative culture that had made the company what it was in the glory days. We at T&T Capital Management have written up the company before and are firm believers that the distressed stock price augurs well for strong future returns for investors, despite the obvious hurdles that the company is facing. In technology, innovation is nearly impossible to predict and looking at past creativity as a prelude to the future can be a costly mistake. I took the time recently to read The HP Way, written by David Packard, to more fully understand the history of the company. While the book was written prior to the purchase of Compaq and other subsequent acquisitions that destroyed shareholder value, it became very clear that at some point after the book was published, the company lost sight of the drive to innovate and create, which had enabled it to become one of the great American success stories of the 20th century.
HPQ is different now and while it is far too early to fully assess Meg Whitman's tenure as CEO, I firmly believe that she understands that HPQ needs to be, and more importantly is capable of being one of the leading innovators across the IT landscape. An example of this is HPQ's first commercial product from its Moonshot program that was produced out of the iconic HP Labs, which HPQ says will transform the server category by consuming 89% less energy, 94% less space, and 63% less costs than the traditional x86 server environment. Another example is the Officejet Pro X printer, which prints exactly the same speed and quality as laser printers, at half the cost. These are the type of transformative innovations that historically have separated Hewlett-Packard from its peers, and this $100 billion in sales company still has the capacity to do so. The process will take time but Whitman is taking the right steps by reducing debt, ramping up R&D spending, and streamlining the company towards the products and services where HPQ can add real value, as opposed to just chasing sales without regards to margin or the strategic fit. For example, the Enterprise Services division is letting four large contracts roll off because they don't fit with the margin or strategic profile that HP is seeking. Over time, these incremental steps to improve the operations of the business can help HPQ regain its lost luster.
One of the money managers that I most admire is Bruce Berkowitz of the Fairholme Funds. One of his slogans that I really take to heart when analyzing investments is to "follow the cash flows." At TTCM, HPQ was our biggest loser in 2012, and I can tell you that there were people who thought I was crazy to invest in such a company given the obvious industry headwinds. This forced me to re-read numerous 10-Ks and quarterly reports where I attempted to blow up my investment thesis. The thing that kept me excited about HPQ, ultimately inspiring me to increase our investments in the company was that HPQ generates prodigious free cash flows. I estimate that its normalized free cash flows are between $7-$10 billion per annum, and while most market participants seem to wrongly associate HPQ as being only a consumer-led business, the reality is that HPQ has one of the best mixes of hardware, software and cloud services across the Enterprise. HPQ's diversified revenue mix give the company the capacity to improve its operations, and the number one negative the company has faced over the last decade, has been a management that paid silly multiples to buy companies for "strategic value." Everyone wants the hottest technologies but when you overpay by the margin that Hewlett-Packard did, there is little hope of success. Because the infamous Apotheker era, burdened the company with quite a bit of debt, the company was really forced to focus on cutting fat, and using free cash flow intelligently to pay down debt while still maintaining capital returns to shareholders.
While I'll be the first to admit that an IBM (IBM), Google (GOOG), or Apple (AAPL) have vastly superior competitive positions, it is essential to weigh the price paid versus the value received. I'm not saying those other companies are expensive, but HPQ trades at less than 5 times expected 2013 non-GAAP earnings, and unlike a company like Apple, there is little doubt that HPQ's earnings are cyclically depressed. When Meg Whitman originally got the CEO position, I was very dismayed and slightly uneducated about her history. I believe that she has really improved over time and I don't disagree with any of her major moves thus far. I believe HPQ would be silly to exit the PC or Printer businesses because they both are extremely cash generative, and are absolutely essential to assisting in sales of the potentially lucrative service offerings. In addition, valuations are so low for PC and Printer makers that the value of the discounted cash flows far exceeds any realizations that could occur through a sale. I think it is funny that so many people have come out of the woodwork to show their dismay regarding Michael Dell's offer for Dell (DELL), and I would bet that a lot of them aren't invested in HPQ despite a better business mix, and I believe an even better valuation. The big write downs are over and expectations are so low that as long as HPQ doesn't deviate from Whitman's strategy, I see very little downside for the long-term investor, and I believe the stock could double over a 3-5 year period.
On February 21st, Hewlett-Packard reported first quarter earnings that exceeded expectations. 1st quarter non-GAAP diluted earnings per share of $.82, were down 11% YoY, but were above the previous outlook of $.68-$.71. 1st quarter GAAP diluted earnings per share was $.63, down 14% from the prior year, but above the previous outlook for $.34 to $.37 per share. Net revenue in the quarter was down 6% YoY to $28.4 billion, and down 4% when adjusted for the effects of currency. HPQ produced $2.6 billion of cash flow from operations, which was up 115% YoY. $2.1 billion of free cash flow was generated in the quarter, highlighting the underlying profitability of HPQ's business mix. Hewlett-Packard continued returning capital to shareholders, having spent $511MM in the quarter on dividends and buybacks. HPQ's non-GAAP operating margin in the quarter was down to 7.9% from 8.6% last year, while GAAP operating margins were reduced by 60 basis points to 6.2%. Non-GAAP earnings information excludes after-tax costs of $373MM, or $.19 per diluted share, related to the amortization of purchased intangible assets, restructuring charges and acquisition-related charges. Revenue in the Americas was down 3% YoY to $12.8 billion, revenue in EMEA was down 11% and 9% in constant currency to $10.3 billion, and revenue in Asia-Pacific was up 1% to $5.2 billion. Non-GAAP gross margin was down 190 basis points due to seasonal revenue declines in enterprise services outpacing expense reductions, and printing margin declined due to the sales mix. Whitman has been working to aggressively cut costs, and in the quarter, non-GAAP operating expenses were $4.1 billion, down 1.4% YoY, and 1% sequentially. These cost cuts should be more evident moving forward, as a lot of costs were front loaded so that savings could be achieved later.
HPQ is intelligently guiding conservatively into 2013. The company estimates 2nd quarter non-GAAP diluted EPS to be in the range of $.80 to $.82 and GAAP diluted EPS to be in the range of $.38 to $.40. The 2nd quarter non-GAAP diluted EPS estimates exclude after-tax costs of approximately $.42 per share, related primarily to the amortization of purchased intangible assets, in addition to restructuring and acquisition-related charges. For the full-year 2013, HPQ is targeting non-GAAP diluted EPS to be in the range of $3.40 to $3.60. GAAP diluted EPS should be in the range of $2.30 to $2.50, and non-GAAP diluted EPS estimates exclude after-tax costs of approximately $1.10 related to intangibles and those same charges.
In the 1st quarter, HPQ paid a $.132 per share dividend that resulted in cash usage of $258MM, and the company also bought back 19.2MM shares of stock for roughly $253MM. That equates to an average price of $13.17 and is an exceptional utilization of cash. Shares outstanding were down to 1.956 billion from 1.964 billion on October 31st, and 1,998 at the same time last year. I really respect that Meg Whitman hasn't frozen from allocating capital in the smartest way possible just to cave in to all the calls for the company to cut its debt, as a balanced approach should create the greatest amount of shareholder value over the long-term. Even more importantly, HPQ continues to improve its net debt situation by reducing it by more than $1 billion in the quarter to $4.7 billion, and this marks the 4th consecutive quarter where the company has been able to reduce net debt.
In the Personal Systems group, revenue was down 8% YoY and the operating margin was 2.7%. Most of the pressure came from the Consumer, which declined by 13%, while Commercial revenue decreased by 4%. Total units were down 5% with Desktop units up 10%, and Notebooks units down 14%. HPQ gained some traction with its Windows 8 roll-out, gaining 1.4 points of market share in PC's YoY, including 4.6 points in the U.S. Printing revenue declined 5% YoY with an operating margin of 16.1%, which was up 3.9% YoY, driven by new innovation and models. Total hardware units were down 11% YoY with the consumer leading the way down once again. The Enterprise Group revenue was down by 4% YoY and the operating margin was 15.5%. Networking revenue was up 4%, Industry Standard Servers revenue was down 3%, Business Critical Systems revenue was down 24%, Storage revenue was down 13% and Technology Services revenue was down 1% YoY. Enterprise Services revenue declined 7% YoY with a 1.3% operating margin, and the company forecasts a 0-3% margin for the full year for this beleaguered unit, which is now under new management. Application and Business Services revenue was down 9% YoY, and IT Outsourcing revenue was down 6% YoY. Software revenue declined by 2% YoY with an attractive 17% operating margin. Support revenue was up 11% while license revenue was down 16%, and services revenue was down 8% YoY. HP Financial Services revenue grew 1% YoY as a 1% increase in net portfolio assets was offset by a 25% decrease in financing volume, contributing to a 10.6% operating margin.
HPQ represents the type of well-financed business that has remarkable long-term relationships with its clients, and is also trading at a huge discount to any reasonable assessment of intrinsic value that we absolutely love. If Whitman and management continue with an astute capital allocation plan, shareholders should do quite well due to the ridiculously high free cash flow yield available at the current price. If HPQ can continue to build on its momentum in innovation and capture a reasonable market share in the various form-factors beyond traditional P.C.'s than I believe the stock could more than double over time. Rome wasn't built in a day and I don't expect HPQ to become IBM, but thanks to the peculiar and fanatical moods swings of "Mr. Market," I don't need it to, in order to make very attractive investment returns. The beauty of investing is that time will tell the tale and I plan on continuing to buy on dips, until something fundamentally changes my mind about the company and management.