On Tuesday November 26, 2013, Hewlett-Packard (HPQ) reported its 2013 4th quarter results and had numbers that beat analysts' estimates. The following day its stock price was well rewarded as it soared 9% higher. HPQ's CEO Meg Whitman on the company's conference call, (read the transcript on Seeking Alpha by going here), reported the following:
"In Q4, we brought our cash conversion cycle down to 17 days and delivered free cash flow of $2 billion. For the full year, we delivered more than $9 billion of free cash flow, well above our most recent outlook of about $8 billion."
Hearing this news, I thought it would be timely to put Hewlett-Packard through my free cash flow analysis and determine how an investor should proceed.
This analysis will use the following six free cash flow ratios:
- Price to Mycroft Free Cash Flow
- Mycroft/Michaelis Growth Rate
- Free Cash Flow Payout Ratio
- Free Cash Flow Reinvestment Rate
Those new to this analysis can find an introduction by going here that will explain in detail how each of these ratios is calculated. When used together, these unique ratios will generate a quantitative picture of a company's underlying fundamentals, including strengths and weaknesses.
The "2014 Mycroft Free Cash Flow Per Share" estimate, shown in the table above, is generated by taking the trailing twelve months (TTM) free cash flow result for Hewlett-Packard and then adding my Mycroft Michaelis Growth Rate into the equation in order to generate forward-looking estimates for 2014. That growth rate is generated by using my FROIC ratio (Free Cash Flow Return on Invested Capital). Basically FROIC tells us how efficient operations are as it zeros in on how much free cash flow is generated for every $1 of total capital employed. Hewlett-Packard has a FROIC of 20%, which means that for every $100 of invested capital, the company generates $20 in free cash flow. Now my Mycroft/Michaelis Ratio takes that 20% and multiplies it by the firm's free cash flow reinvestment rate. The reinvestment rate that I use is a free cash flow reinvestment rate instead of the standard one used by analysts that simply uses net income:
Free Cash Flow Reinvestment Rate = 100% - (Free Cash Flow Payout Ratio).
Free Cash Flow Reinvestment Rate = 100% - (Total Dividend/Total Free Cash Flow).
By replacing net income in the payout and reinvestment ratios with free cash flow, I am thus able to make my analysis more precise by incorporating capital spending (Cap Ex) into the equation.
Therefore, from this we can determine that Hewlett-Packard has a reinvestment rate of 88% and went on to use 12% of its free cash flow to pay out its dividend. Thus by taking 20% (FROIC) x 88% = 17.60%. From there we add the dividend yield of 2.3% and we have a Mycroft/Michaelis growth rate of 17.60% + 2.3% = 19.90% (rounded off to 20%).
Hewlett-Packard's Mycroft Free Cash Flow per share of $6.07 was generated by taking its TTM free cash flow per share and multiplying it by (100% + 20% or 1.20). Once we have our result, we then take its current market price of $27.35 and divide it by $6.07 and get a Price to Mycroft Free Cash Flow result of 4.50. I consider a Price to Mycroft Free Cash Flow per share result of less than 15 to be good for purchase, and anything under 7.5 to be excellent.
The higher you go above 15, the more overvalued a company becomes. I use a Price to Mycroft Free Cash Flow per share result of 22.5 as my sell price, and 45 as my short price.
An appropriately priced stock should trade around a Price to Mycroft Free Cash Flow per share result of 15. This benchmark result was determined by backtesting.
Buy (opinion) = A Price to Mycroft Free Cash Flow per share result of less than 7.5 is considered excellent (50% below the initial Hold level), and anything under 15 is attractive.
The result I give as my Buy opinion in the table above uses a Price to Mycroft Free Cash Flow per share result of 7.5.
Hold (opinion) = 15 to 22.5 (I use 15 in the table).
Sell (opinion) = 22.5 or higher (50% above the initial Hold level). (I use 22.5 in the table).
Short (opinion) = 45 or greater. The Price to Mycroft Free Cash Flow per share result of 45 was determined by going back to the peak of the market (in the year 2000) and averaging the Price to Free Cash Flow per share results for the key players at that time. (I use 45 in the table).
The CapFlow ratio result that you see in our first table above is an original ratio I created in order to tell me how much Capital Spending is used as a percentage of Cash Flow. A result of less than 33% is considered ideal and with Hewlett-Packard coming in at 25%, means that 75% of the company's cash flow is actually free cash flow and can be used for such things as buying back stock.
In conclusion, with a Price to Mycroft Free Cash Flow per share of just 4.50, Hewlett-Packard from a quantitative point of view is clearly a bargain right now. However, it is always important to remember that whenever you find a company whose stock trades below its buy price, it is especially important that you do further analysis to try and determine why the stock is trading so cheaply. Stocks that trade this low usually get there for a good reason. For example, a good company may trade so cheaply because investors have had such a negative outlook on its stock for an extended period of time and that they may need further convincing before they become believers again. This is what I believe is currently happening with Hewlett-Packard.
The best way I have found to bring further analysis into the equation is by consulting the "15 Points" outlined by Philip A. Fisher (the idol of Warren Buffett and father of qualitative analysis) in his book "Common Stocks and Uncommon Profits." Here are those points:
- Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
- Does the management have a determination to continue to develop products or processes that will still further increase total sales potential when the growth potential of currently attractive product lines have largely been exploited?
- How effective are the company's research and development efforts in relation to its size?
- Does the company have an above-average sales organization?
- Does the company have a worthwhile profit margin?
- What is the company doing to maintain or improve profit margins?
- Does the company have outstanding labor and personnel relations?
- Does the company have outstanding executive relations?
- Does the company have depth to its management?
- How good are the company's cost analysis and accounting controls?
- Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company will be in relation to its competition?
- Does the company have a short-range or long-range outlook in regard to profits?
- In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
- Does the management talk freely to investors about its affairs when things are going well but clam up when troubles or disappointments occur?
- Does the company have a management of unquestionable integrity?
Hewlett-Packard, under the leadership of Meg Whitman, passes many of these points. However, my biggest concern is with Fisher's point number seven, in that Management is very close to completing a 26,000 workforce reduction. It has been my experience as a qualitative analyst that when so many worker reductions occur in such a short period of time, it has a definite effect on the morale of those workers who remain. I prefer to invest in companies that are hiring and not reducing their workforce (Apple (AAPL) for example) as this fact clearly shows that the company is growing and has not reported better results due to cost reductions. Cost reductions in the end are transitory and are either done to correct past mistakes or are just done to improve short-term results, in order to make the analysts who cover the stock happy.
So Far CEO Meg Whitman has done exactly what she said she would do since taking over the CEO role, and is now three years into her original five year turnaround plan. I have a lot of faith in Meg Whitman's skill as a manager and Hewlett-Packard's board of directors made a good move in hiring her as CEO as she is a person of unquestionable integrity. I reached this conclusion by following her career closely for the past two decades and by being an eBay (EBAY) shareholder while she was at the helm. Therefore using Fisher's "15 points" as our guide, I suggest that a potential investor in Hewlett-Packard remain on the sidelines for now and wait for further signs that the company is actually growing and has products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years. When investing the most important thing one should look for is consistency. One quarter of strong performance may mean nothing, but two or three in a row, and you have the makings of a great investment.