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Many money managers have a core investment philosophy of avoiding turnaround situations. We take a businessman approach of acquiring securities that are severely undervalued and/or misunderstood, that have the opportunity to improve dramatically over a long-term time horizon, offering the investor the potential for large profit potential and limited downside because of the discount to intrinsic value that the securities are purchased at. Hewlett-Packard (NYSE:HPQ) has all of these characteristics and we have been very fortunate that CEO Meg Whitman has outperformed our most optimistic expectations since taking over for the disastrous Leo Apotheker. By strictly managing capital allocation to pay down debt, strategically investing in the business based on returns on capital, and distributing excess free cash flow to shareholders, HP has made significant strides despite serious macroeconomic headwinds. Clearly, HPQ isn't as attractive as it was when it was trading in the low to mid-teens, but I believe there is 50-75% upside from current levels, as free cash flow stabilizes and starts growing again.

Hewlett-Packard has a wonderful brand that has endured for decades, despite some significant misfires over the last ten years or so, really since the acquisition of Compaq by Carly Fiorina. The company has a wide expanse of different businesses, with some highly profitable with reasonable growth potential, and others that are commodity-like, which are likely to see consistent revenue declines. After the disastrous acquisition of Autonomy and a lack of R&D spending at the expense of Mark Hurd's cost-cutting, among many other huge misfires, the company rightly traded at a very pessimistic valuation in 2012. The keys to a good turnaround are identifying the major problems and strengths, developing a plan to improve, and delivering on the strategy.

Meg Whitman realized that the balance sheet had been weakened materially from acquisitions that didn't achieve the desired returns. She saw that R&D and innovation had been neglected on an organic basis, and the focus on acquisitions to supplement that had deteriorating effects on HP's creative culture. Whitman also saw that it was important to balance business spending designed to maximize returns on capital, with prudent capital allocation where excess free cash flow would be distributed to shareholders' through a mixture of stock buybacks and dividends. Management's plan to address these issues was to focus extensively on reducing the debt load through aggressively funneling free cash flow to right-size the balance sheet. This means refraining from material acquisitions despite a rapidly changing technological environment so that the company could once again be seen as a financially strong entity. Whitman reorganized divisions to improve response times, reduce costs through limiting SKUs and to get everybody on the same page moving forward. Management balanced the aggressive debt reduction with increasing dividends and stock buybacks. This rewarded shareholders that were long-term investors and because the stock buybacks were done at a material discount to intrinsic value, the intrinsic value of the stock increased as a result of them. Most importantly, management has stayed the course and did what it said it would do, despite an environment where many of its peers have been unable to meet expectations.

Rome wasn't built in a day and neither will HP's turnaround be complete in a year, but the seeds have been planted. HP is beginning to innovate again and I believe the company is positioned to pick up market share in many of its businesses. Margins have likely bottomed and any resurgence in Europe, China and global government spending would provide a nice tailwind to the company's financial results. The company's capital allocation strategy is beginning to remind me a little bit of IBM's (NYSE:IBM), which should be the model for large-cap technology companies in low-growth segments of the industry, with a focus on improving margins and shareholder returns. Key to management's execution has been the continued production of free cash flow, well in excess of expectations, which is the rocket fuel for all of the major investments that the company will ultimately need to make to move the business forward. If the company continues on this path, I have no doubt that shareholders' will be richly rewarded even through buying at current valuations, after the substantial appreciation that HPQ has seen year to date.

On May 22nd, HP reported relatively strong financial results. Second quarter non-GAAP diluted earnings per share of $.87 were down 11% YoY, but above the previously provided guidance of $.80 to $.82 per share. GAAP earnings per diluted share in the quarter were $.55, down 31% YoY, but were above the previous guidance of $.38 to .40 per share. Second quarter net revenue was $27.6 billion, which was down 10% YoY. Non-GAAP operating expenses were $4.2 billion, down 5.3% YoY and up 1.5% sequentially, so the company is making progress but there is further to go to really achieve operating leverage. Cash flow from operations of $3.6 billion was up a solid 44% from the prior year period, and the cash conversion cycle was down to 21 days, 7 days better than the prior year. Free cash flow was $2.9 billion in the quarter, up 90% YoY. The company has thus far generated $5 billion in free cash flow over the first half of 2013, which is equivalent to what the company guided to for the entire fiscal year and management has now guided to $7.5 billion in free cash flow for 2013. HP continues to improve its balance sheet through improving the net debt position by $1.8 billion, which marks the 5th straight quarterly reduction of over $1 billion. In addition, the company returned $1.1 billion in cash to shareholders in dividends and stock buybacks. $283MM of this was from the payment of dividends, while $797MM was used to repurchase approximately $36.3MM shares of common stock. HP also increased the quarterly dividend to 14.52 cents per share, which offers a roughly 2.7% yield at a recent closing price of $21.23.

Personal Systems continues to really struggle with revenue down 20% YoY and a 3.2% operating margin. Pretax earnings in the segment were $462MM for the 2nd quarter. Commercial revenue declined 14%, while consumer revenue declined 29%. Total units were down by 21% with Desktops units down 18% and Notebooks units down 24%. The company is working with both Microsoft's (NASDAQ:MSFT) Windows 8 and Google's (NASDAQ:GOOG) Android and Chrome platforms to develop tablets and convertibles, which I expect to ultimately drive the division's results moving forward. Intel's upcoming semiconductor innovations should yield lighter and more energy-efficient devices that I believe will help the company pick up market share versus Apple (NASDAQ:AAPL) in the space. While this unit seems to get most of the negative attention for HP, the reality is that it only accounts for about 10% of the company's overall operating income, so I believe this misunderstanding between perceptions and reality is one of the reasons the stock has been so undervalued.

Printing revenue declined 1% YoY but the company has made strides at protecting operating margins, which were 15.8% for the quarter, 2.6% over the prior year. Pretax earnings in the printing segment were $1.911 billion in the quarter. Total hardware units were down 11% YoY, with commercial hardware units down 5% YoY, and consumer hardware units down by 13% YoY. The company has been focusing on the higher value units and has been giving up low-margin market share in the lower value space. HP has been quite innovative in this division with new initiatives like Ink Advantage and the Officejet Pro X, which have helped stabilize the unit in a difficult macroeconomic environment. In the 2nd half of the year, the company is releasing its Instant Ink product, which is a subscription based model that HP hopes will increase usage.

Enterprise Group revenue decreased 10% YoY and posted a 15.9% operating margin. Enterprise Group pretax income was $2.166 billion in the quarter, while Enterprise Services pretax income was $232MM. Application and Business Services revenue decreased by 10% YoY, and IT Outsourcing revenue declined 6% YoY. Most global technology companies are struggling in the Enterprise segment, especially in Europe where demand has been dismal, and where cost-cutting takes much longer than in North America. HP made a management change recently in the division and is in the process of letting unprofitable business run off, so revenue will be pressured over the next year or two. The company highlighted a 10-year, $210MM agreement to support Cambridge University Hospital's Trust in transforming its digital infrastructure, where the clinical staff will have secure, mobile access to test results, medical history and images.

Software revenue was down 3% YoY and achieved a 19.1% operating margin, putting pretax income for the segment at $337MM. Support revenue led the way with revenue up 12%, while license revenue was down 23% and services revenue was down 5% YoY. HP Financial Services revenue was down 9% YoY with a 3% decrease in net portfolio assets and a 24% decrease in financing volume. The Financial Services division posted an operating margin of 11% and pretax income of $198MM.

For the 3d quarter of fiscal year 2013, management guided estimates for non-GAAP diluted EPS to be in the range of $.84 to $.87 and GAAP diluted EPS to be in the range of $.56 to $.59. The non-GAAP guidance excludes after-tax costs of approximately $.28 per share, related primarily to the amortization of intangible assets, restructuring charges and acquisition-related charges. For the full fiscal year, HP estimates non-GAAP diluted EPS to be in the range of $3.50 to $3.60 and GAAP diluted EPS to be in the range of $2.50 to $2.60.

Based on a recent price of $21.24 and 1.935 billion shares outstanding, HPQ has a market capitalization of $41.1 billion. The company has long-term debt of $19.863 billion, which is slightly offset by $13.240 billion and a net debt position of $6.623 billion. The enterprise value is approximately $47.72 billion and it is important to note that if you back out the financial services division, the company's operating net debt position is only $2.9 billion. Based on management's new guidance for $7.5 billion of free cash flow for fiscal year 2013, the free cash flow to enterprise value yield is 15.7%, which is obviously highly attractive assuming that free cash flow doesn't fall off a cliff. I'm extremely impressed with Meg Whitman and CFO Catherine Lesjak's strategy to rebuild the balance sheet after it was severely weakened from the string of disastrous acquisitions, and the company has now shed $9 billion of debt since the peak in the 1st quarter of fiscal 2012. I believe that the business is at a minimum worth in excess of $75 billion on an enterprise value basis, which means that there is at least 55-60% upside. This valuation would simply imply a free cash flow to enterprise yield of 10%, and I believe HPQ can materially grow both free cash flow and more importantly free cash flow per share in the future. I fully expect there to be significant volatility in the stock so a dollar cost averaging strategy is highly advisable.

Source: Hewlett-Packard: Successful Turnarounds 101