Hewlett Packard Company (HPQ) is a diversified producer of technology solutions. The firm's valuations declined substantially as PC sales slumped. Also, the server business is struggling in this macro environment. That said, there are a few bright spots within the company, such as Services, Software and a portion of Storage.
With that in mind and following the recent slump in the share price, is now a good time to accumulate shares of HP?
Based on my valuation models, the answer is yes. The market is discounting negative growth for the company, but negative growth should turn positive within the next 2-4 years. Further, the firm is trading at a steep discount to its peers in the industry based on the market's pricing of growth expectations. The market believes Dell (DELL) and Lenovo (OTCPK:LNVGY) have positive growth prospects. HP is substantially larger than those firms and has a tremendous scale advantage. So if those firms have positive growth prospects, HP should have positive growth prospects as well.
I think investors should be accumulating shares of HP at the current level. I estimate the intrinsic value as $33.50.
Some of the readers may already know all of this, but there may be some new information or perspective. In terms of the competitive dynamics of the PC industry, substitute products in the form of smartphones and tablets have decreased demand for traditional computer equipment. That comes following an environment where PC industry suppliers, such as Microsoft (MSFT), Western Digital (WDC) and Intel (INTC), had substantial bargaining power. Further, competition becomes increasingly fierce as the future industry profitability began to decline and as PCs became more commodity like. Generally, consumer switching costs were low and even though consumers were fragmented, they increasingly gained bargaining power. Lastly, new entrants into the PC industry, such as Lenovo, began to take market share from established companies such as HP and Dell. As a consequence of the aforementioned, the PC industry began to transition from a mature industry to an industry in decline, which is apparent in HP's PC operating segment results.
That said, I'm going to analyze three technology firms: HP, Dell and Lenovo. HP is the largest of the PC manufacturers analyzed on a consolidated basis. Dell is the second largest followed by Lenovo. Scale positively impacted profitability as the larger the company the more profitable it is. On the other hand, Lenovo has been able to increase sales while Dell's and HP's top lines are trending in the wrong direction.
HP's revenue is generated from a mix of products and services. Without going into too much detail, HP is a well diversified company. About 35% of HP's revenue comes from the U.S.; no other country represents more than 10% of total consolidated net revenue. Looking at the PPE, it seems as though a significant amount of HP's revenue is generated in developed countries. Thus, HP is at the forefront of the product lifecycle curve.
Dell is well diversified; it is building out its services platform. The company primarily serves large enterprises and public sectors clients - consumers account for the smallest portion of revenue. Dell is primarily a U.S. company, but 50% of net revenue is generated in foreign countries.
Lenovo's results benefit from its geographic exposure; the company generates over 70% of its revenue from developing markets. Lenovo has clearly benefited from its strong position in China, the world's second largest market. Its product mix of notebook and desktop computers wouldn't fare as well in developed markets but, because of its position in developing markets, Lenovo hasn't faced the headwinds from the mobile revolution (developing markets are behind developed markets in the product lifecycle). Further, Lenovo benefits from its strong position in the enterprise market.
I'm not going to analyze information that we already or should already know. That said, it is surprising how well Lenovo has done with desktop and laptop computers. The company may be adversely impacted in FY 14-FY 16. My assumption is that increases in Lenovo tablet and smartphone sales will only partially offset weakness in PCs. From that perspective, Dell and HP have weathered the storm that may be heading for Lenovo. Further, HP's scale should give it a competitive advantage for the foreseeable future.
HP has about 5 times more productive capacity than Dell, and Lenovo has about one-third the productive capacity of Dell based on net PPE. Lenovo does generate a considerable amount of revenue per net PPE, which is a measure of efficiency, but HP's scale should help it maintain a competitive advantage in the long run.
Obviously HP spends the most on R&D development on an absolute basis, but HP should also continue to benefit from high relative R&D expenditure. Said differently, HP is investing in maintaining its competitive edge. I'm surprised that Lenovo isn't allocating more capital to product testing and development.
Financial Performance Forecast
HP is becoming more of a services company. I expect that trend to continue in the near future. Services is a more stable, higher margin business than Personal Systems. While still a relatively small portion of revenue, I expect the Software segment to become a larger portion of revenue over time. Software is a higher margin business than Personal Systems.
Lenovo is primarily a notebook computer company, but it is becoming more of a mobile internet and digital home company. That is a trend that I expect to continue. Looking forward, there could be some weakness in the Desktop Computer and Notebook Computer segments, which together comprise over 80% of revenue.
Dell is becoming more of a services, server and networking company. I expect that trend to continue. Mobility and desktop PCs are becoming a smaller portion of the business, but new competitive offers may help revive revenue from the Mobility segment. That said, Dell should continue to face revenue headwinds from the Mobility and Desktop PCs segments.
Earlier in the year, I forecasted HP's revenue coming in at about $110 billion during fiscal 2013. HP's revenue is on pace to be roughly in line with my revenue projection. That said, I think fiscal 2014 revenue will decline at a slower rate than fiscal 2013 revenue as new products gain traction. Also, the services business may contribute revenue growth during fiscal 2014. I expect fiscal 2014 revenue of $104.5 billion.
Dell's revenue may continue to face headwinds from the PC and Mobility segments, but some of that weakness could be offset by new product launches. The Services and the Severs and Networking segments will be key determinants of fiscal 2014 and fiscal 2015 revenue. The Servers and Networking segment could face some headwinds. That said, for now, I'm forecasting roughly flat revenue during fiscal 2014 and fiscal 2015.
Lenovo's revenue grew at a double digit pace during the last fiscal year completed. That is a pace that I think will slow to the mid-single digits during fiscal 2014. Further, I think fiscal 2015 revenue could be flat relative to fiscal 2014 revenue. I expect slowing and/or declining sales of desktop and notebook computers. Sales of mobile solutions should offset some of the decline of notebooks and desktops.
I think all three companies will reduce expenses as a percentage of revenue. Consequently, I'm forecasting the net income margins to expand. I'm looking for HP to have a net income margin of 5% in fiscal 2014. Lenovo could have a net income margin of 2.5%, and Dell could have a net income margin of 1.5%. Lenovo is forecasted to overtake Dell in terms of profitability, which is a consequence of expense management. We'll see how much of the financial performance forecast is factored into the valuations.
I'm going to use two models to value the common equity shares of Dell, HP and Lenovo. The first model will estimate what the market thinks of the company's ability to reinvest future earnings. The second model is a multiplier model. At the end, I will draw a conclusion based on relative valuations.
After the recent increase in the share price, the market continues to price in negative growth for HP. Two possible explanations are that the value could reflect an expectation that management's investment policy would destroy value or the stock price could have lost contact with fundamentals. The market is pricing in growth for Dell and Lenovo. I'm leaning towards the interpretation that HP's stock price has lost contact with the fundamentals. HP remains undervalued by the market. At $37 per share, HP would be trading in line with its peers.
I'm going to use a few multiplier models to value the common equity shares. Using the historic HP multiplier ratios, HP's intrinsic value is $29.68. HP is substantially undervalued. Relative to the S&P 500, HP is undervalued. Longer term, HP's growth prospects are probably better than the market's growth prospects. On a time series basis, HP is trading off its recent peak valuation. The multiplier models suggest HP is undervalued.
Valuation is more art than science, but the models that I used are appropriate for the company being valued. Discounting the market's future growth expectations is more precise than some other valuation metrics. In this case, HP is ramping several new products that will be highly competitive in the market. I especially like the addition of Google Chrome OS offerings. Lastly, HP's past shouldn't be that dissimilar from its future that the historic multiplier model valuations become inappropriate to value the common equity shares.
The models suggest HP is undervalued. I have confidence in the estimates of intrinsic value. The mid point of the two valuation models is roughly $33.50. The recent dip in the share price is a buying opportunity.