Staying Clear Of Hewlett-Packard

 |  About: HP Inc. (HPQ), Includes: DELL, MSFT
by: Valuentum

Legacy hardware OEM Hewlett Packard (NYSE:HPQ) reported strong cash flow for its second quarter Wednesday afternoon even though the business continues to shrink. Revenue declined 10% (9% ex-currency) year-over-year to $27.6 billion, falling short of consensus estimates. Non-GAAP earnings per share declined 11% year-over-year to $0.87, which was actually slightly better than previous guidance as well as consensus expectations. More impressively, operating cash flow was 44% higher compared to the year prior at $3.6 billion, driving free cash flow of $2.8 billion, which the company used to repurchase shares and to boost its quarterly dividend 10% sequentially (to 14.52 cents per share). Click to enlarge

Image Source: HPQ

Although CEO Meg Whitman's turnaround continues to progress at a solid rate, it's impossible to ignore the firm's steady decline in revenue. Revenue has declined for 7 consecutive quarters, but much of this is due to the company eliminating low-margin and unprofitable contracts. Not surprisingly, weak PC sales have been driving much of the overall weakness. Personal Systems declined 20% year-over-year to $7.6 billion, with total units down 21%. Both notebooks and desktops were a disaster, with revenue from the products declining 24% and 19% year-over-year, respectively. Consumer revenue was down 29% from a year ago. Oddly, CEO Meg Whitman seems somewhat optimistic about the company's Personal Systems business going forward, saying:

"…PCs, listen, if we have the right product priced right, the channel still loves HP and they want to sell in our product, whether it's to small businesses, medium-sized businesses, or the enterprise. And frankly having Android products here helps a lot. This $169 Slate helps cover a segment of the market that we didn't have before."

Whitman continues to believe that PCs are necessary for high-powered computing, though we think Microsoft's (NASDAQ:MSFT) Office Suite will be available on iOS in the not-so-distant future. From what we gather, Apple's (NASDAQ:AAPL) iPad mostly dominates the tablet space, and we're not confident that consumers are very receptive to other tablet devices. Adding an Android powered device is likely better than the company's previous mobile experience, but Windows Metro and the iPad are likely to dominate the tablet landscape, in our view, especially when it comes to the enterprise.

While the Personal Systems group remains weak, we were a little discouraged to see the weakness in the higher operating margin Software business. Revenue declined 3% year-over-year to $941 million, though operating profit remained strong at 19.1%. We've long warned that the entry to the enterprise software business (which all of the OEM giants have promised) is harder than it appears. Not only does HP have to compete with Dell (NASDAQ:DELL), but it has to battle it out with Microsoft, Oracle (ORCL) and IBM (NYSE:IBM), among several other firms vying for software revenue dollars. In a still-cautious capital investment environment, there will be plenty of winners and losers. Such intense competition also bids up the price of acquiring smaller firms, and such investment comes with substantial risk (see: Autonomy).

Click to enlarge

Image Source: HPQ

Printing remained a reliable source of earnings during the second quarter, even though revenue fell 1% year-over-year to $6.1 billion. Printing operating profits were 19% higher year-over-year at $958 million as restructuring boosted operating margins. Hardware remains weak, with units declining 11% year-over-year, but printing supplies revenue increased 2% year-over-year. Though primed to decline substantially over the long run, we do not think printing will disappear overnight. It will be crucial that HP allocate the segment's earnings in a value-creative nature while it still manages to generate cash.

On the enterprise front, HP experienced weak performance from both its Enterprise Group and its Enterprise Services. Revenue was down 10% and 8% year-over-year, respectively, though some of the revenue decline in the Services group can be attributed to the firm cutting down on unprofitable accounts. Revenue of $6.8 billion in the Enterprise Group still managed to generate an operating margin of 15.9%. Other than a decent operating margin, it's hard to find many positives from the segment, especially as all categories saw revenue decline year-over-year. With regards to Services, Whitman mentioned that the company signed its largest mega-deal in IT outsourcing since the first quarter of fiscal year 2012, but it was not enough to compensate for eroding prices. We'd like to see some progress on both fronts in the enterprise business to get more excited about its potential.

Admittedly, business performance will be a huge determinant of HP's success going forward, but we think capital management is just as important at this juncture. Given the riskiness of its business model, we appreciate Whitman's commitment to bring net debt to near zero, which we think gives the company additional flexibility. With shares mostly trading at a discount to our fair value estimate for the quarter, we think repurchasing shares was also a solid use of capital. We're also encouraged to see the company reduce working capital, as the firm has aggressively reduced accounts receivable during the year while also reducing inventory and increasing accounts payable. However, these positive working-capital moves can only last so long - the company will need to increase its net income to boost cash generation.

Looking ahead, the firm reiterated its full-year non-GAAP earnings per share outlook of $3.50-$3.60 per share, though its third-quarter guidance came in above consensus estimates of $0.83 at $0.84-$0.87. Given past results, we assume Whitman is taking a page out of the Steve Jobs playbook and issuing conservative guidance to temper expectations. Regardless, we like the company's capital management efforts during the past several quarters, and we see its turnaround progressing. However, revenue continues to fall at a rapid clip, and we think cash flow generation could be constrained once the company can no longer shrink inventory and accounts receivable. Given the stock's current valuation, we remain on the sidelines as we do not see a wide enough margin of safety to justify a position in the portfolio of our Best Ideas Newsletter.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Some of the firms mentioned in this article are included in our actively-managed portfolios.