Saying that Hewlett-Packard's (HPQ) stock has been on the rise in 2013 would be understating matters significantly: its stock is up by nearly 45% in the year-to-date. To put that in perspective, the S&P 500 (SPY) and Dow Jones Industrial Average (DIA), both of which have been having their best years in the past five, have returned 11.7% and 13.1%, respectively. Meanwhile, it is by far the best performing of the 30 components of the Dow; its return is over 150% that of its closest rival, still magical Disney (DIS).
HP's performance in the first trimester means that its return is around 3-1/2 times that of either of the major indices' and is all the more surprising considering that while analysts expect earnings to rise by 8% and 18%, on aggregate, for the S&P 500 and the Dow, HP's earnings are expected to fall by 13.6%.
Odder still, the world's largest PC maker ostensibly suffered a blow when it was reported that PC shipments had fallen by nearly 14% in the first quarter of 2013. Moreover, PC sales are expected to be exceeded by tablets this year.
The buy case for HP has largely been based on the fact that its fortunes in prior years had been so benighted - consider, for instance, the still-ongoing debacle of its acquisition of Autonomy - that it had become cheap relative to its various assets, including its large patent portfolio. Indeed, even with its incredible rise in the year thus far, HP is trading at only 1.7x its book value - a far cry from the 6.3x book value of its peers such as recently bruised IBM (IBM) and Teradata (TDC) - and a 28% discount to the book value of the average S&P 500 company.
What's more, despite its slumping revenue growth and negative trailing earnings, HP continues to pay a dividend whose 2.6% yield is 24% better than the average S&P 500 company's and 73% more than that of its peers.
In that sense, at some point in the last eight months, HP acquired a "value" proposition that its stock has been riding ever since. The fact that it beat estimates by 11-cents a share in its January 2013 fiscal quarter simply reinforced the notion that it had been unfairly battered and that it was poised for a turnaround under CEO Meg Whitman. Indeed, Whitman recently unveiled a new line of "Super-Servers" meant to resuscitate the company's fortunes by providing an attractive, energy-efficient solution for data centers as businesses and consumers migrate more and more of their data to the cloud.
Yet our own view is that the market has taken HP further than its fundamentals warrant. The balance of risks for HP suggests that a failure to deliver on expectations would result in significant downside for the stock. To wit:
1. Earnings Aren't Looking Good. Analysts have HP reporting fiscal second-quarter revenues of 28.15Bn on May 20, a decline of 8.3% from the same period a year earlier. For the whole of fiscal 2013, HP is anticipated to see earnings fall 6%. The magnitude of revenue decline should abate somewhat in the following year: analysts predict that its fiscal 2014 earnings will fall by just 1.7%.
However, this doesn't take away from the fact that earnings for its next five fiscal years are expected to rise by just 0.25% per annum - essentially flat - and at less than a tenth of their average level in the preceding five years. In contrast, its industry is slated to see overall earnings rise by an average of 13.3% a year over the next half-decade even as the S&P 500 sees earnings grow by an average of 9.3% a year in the same span.
Clearly, HP's growth is expected to trail that of its peers considerably and, in such a situation, it's not surprising that its forward price-earnings ratio is 5.8x - more than 11-times less than that of its industry peers and around one-third of the S&P 500's.
What is troublesome for HP is that even its Moonshot server strategy, for all its touted benefits to its potential users such as cloud service and social media providers, is going against the trend where the largest potential users of such systems are looking to build their own devices under open standards, ostensibly to save costs and wean themselves away from the expensive maintenance agreements associated with the servers sold by companies like HP and IBM. Indeed, the Open Compute Project was pioneered by Facebook (FB). In short, Moonshot and its peers may be innovative and cost-effective but the pressure to compete with open solutions could eventually doom the once-hefty margins from this space, making the paradigm more like that of commoditized personal computers.
2. Other Measures Aren't All That Flattering. To be certain, HP does retain a relatively strong balance sheet from its more fecund years - its debt levels, for one, remain low relative to that of its peers. That said, it is no longer as strong as it used to be: its cash ratios are only average and are actually less than that of the typical S&P500 company.
Moreover, HP's margins continue to compress. Its last year's gross margin of 26% is lower than its trailing five-year average of 26.3%. That, in itself, would not be much of a detriment were it not for the fact that its industry's gross margins actually rose in the past 12 months compared with the last half-decade. What's more, HP's margins are already 32% lower than the industry average.
What this means for HP is two-fold. First, to the extent that its cash flow generation is poor, it will be unable to fund the sort of in-house innovation it needs to turn itself around. Indeed, in 2012, HP spent less than 3% of its revenues on R&D.
Second, lower cash will eventually require HP to either cut its dividend or issue more debt to finance its cash requirements. In the long run, such moves would soften its attraction to investors or weaken its balance sheet fundamentals.
All this doesn't even consider the fact that HP just hasn't done all that much with its shareholder's capital. To wit, its average net profit margin of 1.4% over the past five years is merely a sixth of that enjoyed by its industry peers. What's more, its mean return on assets in the past half-decade has been paltry - just 1.2% compared to its industry's 7.4%.
All told, while HP continues to enjoy strong brand recognition and a stable of impressive patents, the fundamentals don't support the recent rise and share price. In addition there hasn't been enough demonstrated by current management - by actual performance or plans - to convince us that a turnaround from its dismal performance is imminent.
We therefore believe this is one to stay away from, and expect a 20% correction in the stock price in the next three months if there is a boarder market sell-off.
Disclaimer: Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.