Hewlett-Packard Company (HPQ) announced this past Wednesday that fiscal Q2 earnings slipped, although shares jumped after hours on an earnings beat as well as an upward revision on current-quarter guidance. HPQ has a problem: two of its primary markets, PCs and printers, accounting for approximately half its revenues, are in secular decline. The situation in the PC market is particularly dire. As tablet and smartphone sales have surged, the PC market has gone into freefall, with shipments down 13.9% YoY in 1Q13, according to IDC. Likewise, the market for printers is shrinking. Additionally, the company has had four CEOs in the past decade, each pursuing a different restructuring vision. With a whipsawing strategic agenda, and market headwinds like these, it's easy to be skeptical that yet another turnaround effort will work.
Yet today HPQ is showing statistical signs it is a high quality business. The company is organized into seven business segments with potential, and which are suitable for a variety of potential strategies: 1) Personal Systems (PCs, workstations and calculators) 2) Printing (printer hardware) 3) Services (infrastructure and technology consulting) 4) Enterprise Servers, Storage and Networking (enterprise computing, storage hardware and cloud technologies) 5) Software (information and IT management) 6) HP Financial Services (leasing, financing) and 7) Corporate Investments (business incubation projects).
Will HPQ be successfully turned around under Meg Whitman? Only time will tell, but regardless, the company is statistically cheap today, with an EBIT yield on TEV of 14.13%, which places it in the cheapest 5% of all stocks in our screening universe. HPQ merits a closer look.
In a well-known piece of Silicon Valley lore that inspired generations of high-tech startups, HPQ was founded in 1939 by Bill Hewlett and Dave Packard in a garage in Palo Alto. Next the firm pioneered the HP Way, an ethos that placed value on people, and included such employee-friendly features as flex time, profit sharing, and generous personnel policies that engendered loyalty and spurred creativity and innovation.
HPQ's fertile culture led to the development of numerous highly successful products, including a pocket calculator that replaced the slide rule (eventually evolving into the HP 12-C financial calculator used by generations of MBAs), the desktop laser printer and, of course, desktop and laptop PCs, of which HPQ is today the leading vendor worldwide. The HPQ story can be interpreted as a cultural story that created a brand.
And what a brand. While HPQ's culture was established over many generations of workers in the technology industry, hand in hand with the evolution of that culture, HPQ's brand steadily developed over many years and many customers, and across many products; today HPQ's brand is well known worldwide, across a range of technology offerings and is one that people trust. Because consumers and businesses trust the brand, they are willing to pay more for HPQ products than for its competitors' products, giving the firm pricing power across its product lines, and enabling it to maintain highly stable margins over time. Note that HPQ has maintained its gross margins in a narrow range of between 22.9% and 24.6% over the past 8 years, and in terms of overall margin strength this places it in the 86th percentile of our screening universe.
The sheer scale of HPQ provides it leverage with large component suppliers (e.g., Intel (INTC), Seagate (STX)), who supply items such as hard drives and silicon chips for the company's PCs. This bargaining power, driven by its industry leading position in PCs, creates supply chain synergies across its businesses, allowing HPQ to obtain favorable terms for similar components required for its storage, enterprise servers, networking gear and other products. The resulting lower per-unit cost structure consistently frees up operating cash flow, and this is reflected in the company's consistent generation of positive free cash flow over long time frames. Consider that over the past 8 years, the company has earned a free cash flow / total assets return of 61.1%, placing it in the 77th percentile of our screening universe.
While HPQ's consistent margin strength and rates of historical free cash flow are strong statistical indicators that it has an economic moat, the firm also has normalized (8-year, geometric mean) return on assets of 4.2%, ranking in the 38th percentile of our universe, as well as a normalized (8-year, geometric mean) return on capital of 7.1%, which is in the 44th percentile. These aren't spectacular numbers but they are respectable, and when we combine them with HPQ's stronger margin strength and free cash flow statistics and take an average across our franchise metrics, we find that HPQ ranks in the 61st percentile of our screening universe for overall franchise strength.
Although HPQ is currently unprofitable, having taken a recent $8.8bn charge on accounting improprieties associated with its acquisition of Autonomy, the company is generating positive free cash flow, with a FCF / assets return of 7.8%. Obviously, HPQ's cash flow therefore exceeded its net income, indicating that the company is not currently using accruals, which would be a statistical red flag. Overall, we give the company two out of a possible three points with respect to our profitability metrics.
Turning to our stability measures, our next component of financial strength, HPQ's leverage (when scaled by assets) declined, and this earns the company a point. Additionally, HPQ's current ratio increased by 1.3%, signaling increased liquidity, and ability to meet near-term creditor demands; this earns another statistical point. HPQ was also a net repurchaser of equity, when equity is scaled by assets, and wins a point here as well. HPQ achieves a perfect three out of a possible three points for its stability.
Recent operating improvements
Next we review the company's recent operating improvements across several key statistical metrics. Return on assets decreased versus a year ago, which is statistically undesirable, and we withhold a point. Return of FCF on assets, however, increased versus a year ago, and thus we award a point, as more free cash flow per unit of assets is statistically associated with undervaluation. HPQ's gross margins also increased YoY, which earns the company another financial strength point. Finally, HPQ's asset turnover ratio (revenues / assets) increased versus the prior year, indicating a more efficient use of the company's assets. Overall, the company scores three out of a possible four points in connection with its recent operating improvements.
On our various Financial Strength metrics, HPQ scores a solid 8 out of a possible 10 points overall. HPQ is generating free cash flow, and is not using accruals. The company appears stable, as it has declining leverage, increased liquidity, and is repurchasing stock. The company is also showing some recent operating improvements, including improvements in free cash flow, margins, and asset turnover. A big question mark is obviously the company's negative net income. A human analyst could attempt to assess whether carrying value exceeds fair value in other reporting units, which could lead to additional goodwill accounting charges in the future.
HPQ is a statistically cheap company, with an EBIT / TEV yield of 14.13%, but there are plausible reasons to believe it should be cheap. For example, as discussed, the company derives approximately half of its revenues from PCs and printers, which are markets that are contracting rapidly, possibly at double digit rates going forward. There has been CEO, board, and executive turnover at the company, leading to inconsistent strategic choices. It is for these reasons that many argue that the prospects for a successful turnaround are bleak. There are reasons to believe, however, that the company represents good value at this price.
Certainly on a qualitative basis, as discussed earlier, the HPQ brand is a valuable one, and the company's scale creates some supply chain cost advantages. In addition to these, there are additional aspects of HPQ's business that may contribute to the durability of its economic moat.
Another factor at play for certain segments of HPQ's business is customer switching costs. Consider the company's leading share of the worldwide market for printers. HPQ manufactures and distributes a wide range of printers, and while this market is in decline, the installed base of HPQ printers, which are durable and long-lasting, both discourages new market entrants and creates a follow-on stream of high-margin supplies such as ink and toner.
Another moat-like feature for HPQ is its sizeable patent portfolio, consisting of more than 37,000 patents. A large portion of these relate to printing technologies and electronic devices, and many accompanied various acquisitions over the years, such as HPQ's purchase of Palm and 3Com. HPQ's patents are valuable in several ways: they can protect cash flows of existing products, they can be developed as new products, or they can be licensed or sold. In each case, the company's existing or potential competitive advantage is protected by the patent.
These factors, and others, likely contribute to the statistical signs we observe that HPQ possesses an economic moat. These signs include a high degree of margin stability and strong free cash flow generation over long time frames.
We have also observed, via the company's Financial Strength score, that statistically one might argue the company is already succeeding in its turnaround efforts. It's growing free cash flow returns on assets, increasing margins, reducing debt, repurchasing stock, and increasing near-term liquidity. In short, it is demonstrating many signs you might expect to see in a turnaround.
While HPQ's existing businesses would seem to offer elements of an economic moat, and its financial strength appears strong statistically, perhaps going forward the more intriguing question is: where is the company going? If the turnaround effort works, then HPQ at today's price is almost certainly cheap. Let's consider some current strategies and potential outcomes.
An intriguing recent strategic theme for HPQ is its pursuit of the big game of the internet: large-scale social-media, mobile, and e-commerce sites that are populating data centers with huge server farms that can meet growing demand for a variety of "big data" services such as search, photos, videos, and cloud computing. In response to this demand, HPQ has launched Project Moonshot, which involves small footprint, high-performance, ultra low-power enterprise servers.
This is perhaps a natural step in the evolution of a diversified technology business that is trying to identify value associated with its collective whole that is greater than the sum of its parts. If HPQ can establish a significant foothold in future data center infrastructure, it could use this positioning to offer other products to customers. But is Moonshot the key strategy, and the one that will be the turnaround catalyst? Or might the solution be new developments in HPQ's Cloud Services that would enable it to leverage the full breadth of its technology offerings?
Perhaps these issues beg a broader question facing HPQ: is there some unifying theme that would allow HPQ to combine its various available component pieces to create a superior unified technology offering?
HPQ's new COO has talked about a "soup-to-nuts" offering, whereby HPQ might become a single vendor that can provide an integrated offering, or "technology stack," which would extend from the hardware involved in storage, enterprise servers, cloud systems, through networking components, and operating systems, all tied together by software and support. Perhaps this will ultimately be the theme on which the turnaround effort succeeds.
Obviously, even if you are a technology expert instead of a quantitative investor, it is difficult to see how the future will evolve. Regardless, if one of these turnaround scenarios succeeds, an investment in HPQ today will likely prove to be financially satisfactory. Yet today, HPQ is priced for continued market share erosion and a failed turnaround.
Taking a step back, you as an investor can pay an extremely cheap price today for exposure to the optionality embedded in this asymmetric bet: heads you win big on a successful HPQ turnaround, tails you won't lose much while you wait, since HPQ is positioned to sustain its competitive advantages, while its financial stability will enable it to weather market and business adversity.