Seeking Alpha
Long/short equity, value, debt, base metals
Profile| Send Message|
( followers)  

Introduction

I'm usually not a big fan of multi-billion dollar market cap blue chip companies, but I think Hewlett-Packard (NYSE:HPQ) has what it takes to make people very happy over the next 3-6 years. I'll have a brief look at the freshly-reported Q3 numbers. Then I'll immediately move over to some theoretic calculations wherein I will prove why the share buybacks can generate strong returns for shareholders in the longer term, and why I decided to initiate a long position in Hewlett-Packard.

Even if the company's revenues show no growth (which triggered a double-digit drop in the share price), the dividend will eventually be increased because right now, the company is only paying 17.7% of its cash flow as dividend. In this article I'll show how a strategy of share buybacks and dividend increases could move HPQ into the category of high dividend payers just like Garmin (GRMN), which has a dividend yield of 4.4%.

The Q3 financial results

I won't be repeating the Q3 financial results as other authors and the mainstream media have already provided sufficient angles to look at the company's operational results.

Hewlett-Packard generated $27.2B in revenues, which resulted in a net profit of $1.4B or $0.72/share. This was much better than the second quarter when the company only had a net profit of $1.1B. Net earnings for the first 9 months of its financial year were $3.7B, and the company seems to be on track to make $4.5B in profit this year.

I would however like to draw your attention to the company's underlying cash flow as this is my main argument to consider Hewlett-Packard as an excellent buy, IF the management team continues to reward its shareholders.

Cash Flow Generation

In the first 9 months of this year, Hewlett-Packard generated $2B in free cash flow after paying $821M in dividends, repurchasing $1.05B worth of shares and retiring $3.4B in debt. This means the company generated $7.1B in cash flow before rewarding its shareholders, and $5.1B if we exclude the switch from 'accounts receivable' to cash. I'm estimating the company will generate $6.5B in free cash flow this year, and if the company uses this cash flow wisely its shareholders are in for a fun ride.

How this cash flow stream will affect shareholders

The company has a consistent track record of retiring debt, buying its own shares for cancellation and to pay a dividend to its shareholders, as you can see in the numbers for the first 9 months of its financial year.

In this paragraph, I'll make a theoretical calculation how the company's share structure and dividend policy might change over the next three years, and how this will affect shareholders. I'll prove that even without revenue growth, Hewlett-Packard could be a tremendous buying opportunity if the management team does what it should do. In this theoretical assumption I'll start with a $6.2B cash flow generation for Y1, $5.9B in Y2 and $5.75B in Y3, so I even allow for continuous cost and margin pressure.

FY 2014. Starting point: 1.925B shares.

In Year 1, HP should generate approximately $6.2B in free cash flow. Assuming the company adds $1B to its balance sheet and retires $2B of debt, the company has $3.2B to spend on share buybacks and dividends. At the current dividend rate of $0.60/year, Hewlett-Packard is expected to have a cash outflow of $1.2B, meaning the company could spend $2B on share buybacks. This would allow the company to buy back 75 million shares at an average price of $26.65/share.

FY 2015. Starting point: 1.85B shares

Assuming the company generates $5.9B in free cash flow (which would be 10% less than the previous financial year and puts a conservative angle on this calculation) and adds $0.9B to its balance sheet now, the company has to divide $5B between debt repayment, share purchases and dividends. Assuming a same debt retirement and dividend rate, the company would be able to repurchase $1.8B worth of shares. Assuming an average price of $24/share, HP would be able to cancel 75M shares.

Keep in mind the dividend per share increases to $0.65/annum from $0.60/year thanks to the reduced share count. This dividend will increase further to $0.68 per year if the company can cancel an additional 75M shares.

FY 2016. Starting point 1.775B shares

In this year I'm assuming a debt retirement stop, as it would make more sense to increase the dividend and reduce the share count even further. That is, if the share price is attractive enough to buy and cancel its own shares.

My starting point was a $5.75B free cash flow generation for Year 3. As the company already added $1.9B in cash to its balance sheet in the previous two years, I'm assuming a slowdown in adding cash to the balance sheet to just $250M, with the balance being used for a large buyback campaign.

Under this assumption, the company would be able to spend $5.5B on share buybacks and dividends. I'm hoping for a large buyback program of $3B, which would allow Hewlett-Packard to cancel 110M shares using an average share price of $27/share. This would reduce the share count after year 3 to 1.665 billion shares. As the company will have strengthened its balance sheet, it would make sense to announce a huge increase in dividend payments to $2B per year, which would mean an annual dividend of $1.20/share, which would result in a dividend yield of 5.36% based on the current share price.

FY 2017+

If the company can keep its free cash flow stable at $5.5B per annum, a dividend payment of $2B per year would absorb just 36% of its free cash flow so a (much) higher dividend would definitely be sustainable, especially because retiring debt will reduce the interest payments and have a further positive effect on the free cash flow of $30M per $1B of retired debt (based on a 3% interest rate on HP's debt).

Investment Thesis

This article was a theoretical calculation about how powerful the company's share buybacks could be in the long run. By attributing just 30% of its expected free cash flow per year to share buybacks, the company will be able to reduce its share count by almost 14%, which will have an immediate impact on the free cash flow per share. As per my assumptions, if after 3 years the company would decide to use about 35% of its free cash flow to pay dividends to its shareholders, Hewlett Packard would have a dividend yield of in excess of 5% at today's share price. If some activists step up the plate and force the company to pay 50% of its cash flow as dividend, HPQ would have a dividend yield of 7.4% based on the current share price.

I realize this article is based on just assumptions, but it's a fact less than 18% of today's free cash flow is used to pay dividends. I am convinced Hewlett-Packard will experience sufficient shareholder pressure to increase its dividend, and am therefore adding Hewlett-Packard shares to my portfolio with a 5-year investment horizon.

I think the Put 17 January options at an option premium of $0.44 look interesting, as well as the Put 20 November at an option premium of $0.60.

Source: Hewlett-Packard Is A Cash Cow And Will Be A Dividend Play Down The Road