Peter Lynch once said that "The real key to making money in stocks is not to get scared out of them." This goes for when stocks are selling-off irrationally, and it also stands for when stocks have appreciated rapidly, but still have the potential for considerable upside. The trader mentality that pervades Wall Street is filled with dogma, such as stop-losses to avoid sharp mark to market declines in price, and profit-taking just because a stock has increased in value. While these "rules of thumb" seem logical, they completely ignore the value investing principles of buying businesses when they trade at deep discounts to intrinsic value, and selling when the stocks trade closer to that intrinsic value, or if a better opportunity comes around. Hewlett-Packard (HPQ) has been on both sides of the equation, as its businesses face tremendous short-term and long-term pressures causing the stock to trade incredibly cheaply based on historical valuations. Since hitting the lows, the stock has rebounded quite strongly in 2013 as CEO Meg Whitman's strong capital allocation and efficiency measures have greatly improved the financial condition of the company. While investors that bought HPQ in the teens might be tempted to sell, I'd suggest holding on to the stock, as I believe that there is considerable upside from current prices when the general economy improves.
When Meg Whitman took over as CEO of Hewlett-Packard, the company was burdened by a heavy debt load after the disastrous Autonomy acquisition, and the business had been starved of R&D investment, meaning the pipeline was extremely limited. Of course it doesn't help that the technology industry is also in the midst of a radical change in the PC industry towards mobile computing, and a shift towards software as a service, which is challenging HPQ's hardware businesses. HPQ is truly a global business, and problems in Europe and Asia, combined with reduced government investment, have added fuel to all of these other headwinds. Many analysts, including myself, doubted that Meg Whitman was the right choice for this restructuring.
Fortunately for HPQ shareholders, Meg Whitman has mostly made all of the right moves with a very weak hand. The company has aggressively paid down debt, reducing the leverage ratios drastically, assisted by robust free cash flow generation. The company has dramatically improved its cash conversion cycle and has managed to return capital to shareholders via dividends and stock buybacks, all the while reducing the debt-load. Management has instituted cost cuts and personnel changes designed to streamline various businesses. R&D expenditures have trended upwards, helping the company to develop some attractive and potentially disruptive technologies such as project Moonshot. While many of HPQ's businesses are declining, over time an increasing percentage of the business will be the faster growing initiatives, which will ultimately return the company on the path of profitable growth. Because the company is in better financial condition, management can intertwine small and strategic acquisitions to its internal investment programs to increase its competitive position.
On August 21st, HPQ reported 3rd quarter earnings and guidance that disappointed the Wall Street consensus. Third quarter net revenue of $27.2 billion was down 8% YoY, and 7% when adjusted for the effects of currency. 46% of revenues came from the Americas, while 35% and 19% of revenues came from EMEA and APJ, respectively. Non-GAAP diluted earnings per share of $0.86 were down 14% from the prior year. GAAP diluted earnings per share of $0.71 were up from a GAAP diluted loss per share of $4.49 in the prior year period. The company generated $2.7 billion of cash flow from operations, which was down 6% YoY, while free cash flow of $2 billion was down 2%. HPQ continued to reward shareholders by returning $283MM in the form of dividends and share repurchases. Impressively, HPQ continued to reduce its net debt position by $1.7 billion in the quarter to $1.2 billion, which marks the 6th consecutive quarterly reduction in excess of $1 billion. Net debt is now below pre-Autonomy levels and will soon be zero, despite all of the hysteria that pervaded the company's financial position over the last year and a half when media pundits were acting like the company was in dire straits due to near-term debt maturities.
The 3rd quarter showed declines in just about all of HPQ's business divisions. The Printing division had revenues of $5.803 billion, which were off 4%. The unit still generated $908MM of non-GAAP operating income at a margin of 15.6%. The beleaguered Personal Systems business had revenues of $7.704 billion, which were down 11% YoY. The unit posted non-GAAP operating income of $228MM at a 3.0% non-GAAP operating margin. The Enterprise Group performed adequately with revenues of $6.786 billion, which were off 9% YoY. The group churned out $1.033 billion of non-GAAP operating income at a non-GAAP margin of 15.2%. In Enterprise Services, the company had revenues of $5.843 billion, which were down 9% YoY. The group posted anemic profits of $192MM at a 3.3% non-GAAP operating margin. The Software division continues to be a source of relative strength with revenues growing 1% YoY to $982MM. The division generated non-GAAP operating income of $201MM at a 20.5% non-GAAP operating margin. Lastly, HP Financial Services had revenues of $879MM, which were down 6% YoY. The unit had non-GAAP operating income of $99MM at a non-GAAP operating margin of 11.3%.
HPQ updated its guidance for full year fiscal 2013 non-GAAP earnings per share to be in the range of $3.53 to $3.57, while GAAP earnings per share should be in the range of $2.67 to $2.71. The company expects to generate about $8 billion of free cash flow on the year, which is well above the expectations the company had coming into the year. One of the big headlines from the earnings call was that CEO Meg Whitman no longer believes fiscal year 2014 revenue growth is likely for the company, which is a more negative tone than she displayed earlier in the year. There is no doubt that the company and the industry is facing revolutionary forces from the shift to different form-factors and cloud computing, while the global economy is struggling across the board. Europe and Asia are big markets for HPQ so it is unrealistic to expect growth until we see a little more stabilization in those geographies. The key is that the company is taking the right steps to improve its financial condition, and its competitive position over time. HPQ can't control the overall economy but it can improve its own performance, and Meg Whitman has instituted real and tangible positive changes.
Based on 1.948 billion diluted shares outstanding and a recent price of $22.02, HPQ has a market capitalization of approximately $42.9 billion. With about $1.2 billion of net debt, HPQ has an Enterprise Value around $44.1 billion. Even after the significant increase in the stock price over the last year, HPQ's 2013 estimated free cash flow of $8 billion means that the free cash flow to enterprise value yield is an astounding 18.6%. Now this would be even more compelling if the company was expected to grow the top and bottom lines in 2014, but I believe that bolstered by newer technologies and operational improvements, revenues and profits will be increasing over the next several years. You shouldn't buy HPQ because you bullish on an individual quarter or even a fiscal year, but instead the company is an attractive investment because the business can be purchased at a significant discount to its intrinsic value. This is attractive for many reasons, not the least that there is very limited downside, which provides a tremendous margin of safety, and then if the company does begin to grow again there could easily be 50-75% upside to the stock.
I'd certainly suggest buying the stock at current prices, but I'd also take advantage of the implied risk premiums by selling some put options. The January 2015 $22 puts can be sold for about $4.10 per contract. This means that assuming the stock trades above $22 at expiration, the investor will realize a profit of $410 per contract, on a maximum risk of $1,790. This equates to a 23% return on the maximum risk in a little over a year's time. The worst case scenario is that if the stock trades below $22 at expiration, you will end up owning 100 shares per contract at a breakeven price of $17.90. This is an 18.7% discount to the current price and you'd have all of the upside or downside potential from that level. I believe that this strategy makes what already is an attractive risk/reward scenario into a no-brainer if you believe like I do, that HPQ can once again return to growth within the next several years.