Hewlett-Packard: No Longer Distressed Investing, Upside Remains

| About: HP Inc. (HPQ)

Going into 2013, few companies were as hated as Hewlett-Packard (NYSE:HPQ) after a period of record write-downs, reflecting horrendous capital allocation and declining financial performance. Through the leadership of CEO Meg Whitman, the company has radically improved the balance sheet and is greatly enhancing the efficiency at which HPQ's businesses are operating at. The stock has had a huge year, despite the headwinds that have been facing the majority of the company's operating units. While the stock is clearly not the bargain it was a year ago at this time, I believe that the company is still in the early stages of what could be a multi-year turnaround, which should lead to significant appreciation in the stock.

When market participants and analysts were writing HPQ's obituary, we were buying the stock and selling puts. The key aspect of the investment was understanding that Hewlett-Packard generates prodigious cash flows, which can be deployed to reduce debt, buy back stock and reinvest in the business. Therefore, the balance sheet issues were likely to be temporary in nature and merely reflected market noise. In addition, Meg Whitman had already stated that the company would avoid large acquisitions, which greatly reduced the risks of another Autonomy, EDS or Palm disaster. Many analysts thought that the company's fiscal 2013 forecast of $8 billion in free cash flow was aggressive, but the company ended up beating that forecast by a billion, despite a very poor environment for Enterprise spending.

Further stock appreciation will require better business fundamentals and execution, combined with solid capital allocation. HPQ has to invest successfully in R&D to move higher up the value spectrum in many of its key businesses, which should ultimately bolster margins. The PC business will continue to generate declining revenues and headlines, but improvement in the services business would likely have a much larger impact on long-term profitability. I'm not certain that Hewlett-Packard can sustainably pick up market share versus its competition, but I do believe that the reward to risk ratio in the stock is quite high due to the cheap valuation. I also feel very strongly that Meg Whitman has done an excellent job as CEO and I believe that she is improving on the execution of the company. The bigger issue is that many of HPQ's businesses are in declining segments of the technology industry such as PCs, ink printers and on-premises servers.

It is encouraging that the company is still seeing strong growth from 3Par and the project Moonshot seems like an exciting project, but robust revenues from it are likely going to take a while to develop. I was happy that Meg Whitman mentioned that she would be inclined to invest organically in the 3-D printing market, as opposed to buying one of the incumbents at what I perceive to be outrageous valuations in the publicly traded markets. HPQ continues to drive down costs commensurately with the decline in the prospects of some of the legacy businesses, but the long-term success of the business will be reliant on innovation.

On November 26th, HPQ reported relatively strong 4th quarter and fiscal 2013 financial results. 4th quarter non-GAAP diluted earnings per share of $1.01 were down 13% YoY, while 4th quarter GAAP diluted net earnings per share of $0.73 were up from a GAAP diluted net loss per share of $3.49 in the prior year period due to write-downs. Non-GAAP diluted net EPS exclude after-tax costs of $545MM and $.28 per diluted share, respectively, related to restructuring charges, the amortization of intangible assets and acquisition-related charges. Fourth quarter net revenue of $29.1 billion was down 3% YoY and down 1% when adjusted for the effects of currency. Fourth quarter cash flow from operations of $2.8 billion was down 31% from the prior year period. The non-GAAP operating margin was 9%, down from 10.4% in the year ago period.

The company returned $763MM to shareholders in the form of dividends and share repurchases in the 4th quarter, while improving the operating company net debt position by $1.3 billion to an operating company net cash position in the 4th quarter. This actually marked the 7th consecutive quarterly improvement of over $1 billion to the net cash position, which is quite astonishing when various media constituents were questioning the financial viability of the company 12-18 months ago.

For fiscal 2013, HPQ generated non-GAAP diluted net earnings per share of $3.56 and GAAP diluted earnings per share of $2.62, on revenue of $112.3 billion, which was down 7% from the prior year and down 5% when adjusted for the effects of currency. Fiscal 2013 non-GAAP net earnings and non-GAAP diluted net EPS exclude after-tax costs of $1.8 billion and $0.94 per diluted share, respectively, related to the amortization of intangible assets, restructuring charges and acquisition-related charges. Cash flow from operations improved to $11.6 billion in fiscal 2013 from $10.6 billion the prior year. Free cash flow for the year was in excess of $9 billion, which was extremely impressive considering the company only guided to generate $8 billion of operating cash flow in the beginning of the year. The company generated $6.9 billion in non-GAAP net earnings in 2013, down from $8 billion the prior year, while the non-GAAP operating margin dipped to 8.5% from 9.3% in fiscal 2012.

For the 1st quarter of fiscal 2013, HP estimates non-GAAP diluted net EPS to be in the range of $0.82 to $0.86 and GAAP diluted net EPS to be in the range of $0.60 to $0.64. First quarter fiscal 2014 non-GAAP diluted net EPS estimates excluded after-tax costs of approximately $0.22 per share, related primarily to the amortization of intangible assets and restructuring charges. For fiscal 2014, HP estimates non-GAAP diluted net EPS to be in the range of $3.55 to $3.75 and GAAP diluted net EPS to be in the range of $2.85 to $3.05. Fiscal 2014 non-GAAP diluted net EPS estimates exclude after-tax costs of approximately $0.70 per share, related primarily to the amortization of intangible assets and restructuring charges.

Fourth quarter fiscal 2013 segment results

· Personal Systems revenue was down 2% year over year with a 3.0% operating margin. Commercial revenue increased 4% and Consumer revenue declined 10%. Total units were up 2% with Desktops units down 5% and Notebooks units up 3%.

· Printing revenue was down 1% year over year with a 17.7% operating margin. Total hardware units were up 6% with Commercial hardware units up 9% and Consumer hardware units up 4%. Supplies revenue was down 4%.

· Enterprise Group revenue was up 2% year over year with a 14.5% operating margin. Networking revenue was up 3%, Industry Standard Servers revenue was up 10%, Business Critical Systems revenue was down 17%, Storage revenue was up 1% and Technology Services revenue was down 6%.

· Enterprise Services revenue declined 9% year over year with a 4.4% operating margin. Application and Business Services revenue was down 10%, and Infrastructure Technology Outsourcing revenue declined 9%.

· Software revenue was down 9% year over year with a 30.8% operating margin. Support revenue was up 4%, license revenue was down 24%, professional services revenue was down 13% and software-as-a-service ("SaaS") revenue was up 15%.

· HP Financial Services revenue was down 6% year over year with a 5% decrease in net portfolio assets and a 3% decrease in financing volume. The business delivered an operating margin of 11.2%.

Source: HPQ 4th quarter 2013 News Release

Based on 1.94 billion diluted shares outstanding and a recent price of $27.55 (after the 9% increase on Wednesday) HPQ has a market capitalization of roughly $53.44 billion. The debt position at the operating company is close to neutral, so the enterprise value is pretty close to the market cap now. In fiscal 2013, the company generated $9 billion in free cash flow equating to a free cash flow to enterprise value of approximately 16.8%. The forward P/E is still below 10 on the low end of the company's guidance. It is clear to me that the market is expecting a long-term degradation in HPQ's earnings and I believe there is a time arbitrage opportunity for investors willing to bet that Whitman will actually be able to improve the fundamentals of the business, ultimately growing profitability. HPQ is still a $100 billion revenue company that can compete in the Enterprise but profitability should be hampered over the short-term because the company must ramp up its investments.

Predicting to what degree HPQ succeeds is beyond my circle of competence in the technology field, but the price of the stock and the odds of success give HPQ at least 30-40% upside potential from here. I've been pleased with capital allocation under Whitman and it will be nice to see the amount of shares outstanding continue to decline. Acquisitions are certainly going to pick up in my opinion, so it is essential that the company avoids the large and overpriced acquisitions that plague HPQ's recent history.

For investors who are already long the stock at cheaper levels and want to increase their exposure, or are looking at establishing a new position, it might not be a bad idea to utilize strategy of selling cash-secured puts. Based on current prices, the January 2016 $27 puts can be sold for $5.30 per contract. This equates to a 24.4% return on the maximum risk of $2,170, or roughly 11.45% annualized. When you factor in the enhancement to the margin of safety that it provides, put selling can be an effective way to utilize a disciplined process in procuring a more attractive entry-price. One last bit of potential upside that I'd mention is that there is a real possibility that Dell will struggle under its increased debt burden. HPQ's margins were down this year and quarter and I believe that the company is lowering prices to boost market share. A weaker Dell could provide a nice tailwind to some of HPQ's legacy businesses and with so much pessimism priced in, any good news can propel HPQ higher.

Disclosure: I am long HPQ. 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.