Shares of Hewlett-Packard (NYSE:HPQ) added another 2% yesterday after JPMorgan Chase upgraded shares to a buy with a $35 price target. This upgrade is the very definition of coming late to the party as HPQ has been a top performer in 2013, gaining over 93%. Still, JPMorgan believes enough upside remains to buy shares here. Is this a case where it's better late than never? I think so and believe their $35 price target may actually be underestimating Hewlett-Packard's fair value.
JPMorgan's optimism is rooted in multiple expansion and a stabilization of the business. Hewlett-Packard should be able to earn $3.70-$3.80 in 2014. At a 9.5x multiple, shares would be at $35, and in no way is that a particularly aggressive multiple. JPMorgan is looking for the company to generate free cash flow of $8 billion next year, which would be a tremendous upside surprise as management is looking for $6.0-$6.5 billion in free cash flow. Management got to this estimate by forecasting $9-$9.5 billion in operating cash flow and about $3 billion in capital expenditures. I tend to think the company will generate closer to $10-$10.5 billion in operating cash flow, and taking them on their word when it comes to cap-ex, get free cash flow of $7 billion. Even if you valued HPQ at only 9x my free cash flow estimate, shares have another 20% of upside from here.
Investors essentially have to ask themselves whether they are willing to pay about 9-10x earnings for Hewlett-Packard; if yes, the stock has 25-35% of upside. The answer to this question is rooted about what you believe the future of HPQ is. If you continue to think its overall business is in irreversible secular decline on its way to irrelevancy, then 9x is too expensive. If instead you see mild degradation and eventual stabilization as well as some growth in new enterprise service offerings that the company is investing in, 9-10x is fair if not cheap. Based on the company's improving performance under CEO Meg Whitman, I think it is clear the company is stabilizing, which is why I see the stock marching higher next year.
It is popular to say the PC is dead, and while its best days are likely behind it, reports of its death are greatly exaggerated. While tablets and smartphones make it less essential, PCs still have capabilities that other offerings lack, especially on the enterprise side. We are seeing consumer demand fall a lot faster than enterprise because their technical requirements are on average lower. Let's look at the past quarter (available here).
PC revenues were down 2% with commercial revenues up 4% and consumer revenues down 10%. This is indicative of the trend mentioned above. On the back of enterprise, total units were up 3%, which suggests a mildly lower average selling price. The consumer market will continue to decline, but enterprise will be a stabilizing force. I also expect HP to gain enterprise share from Dell in 2014. After Dell's LBO, that company faces an extreme debt burden and interest payments that eliminate much of its financial flexibility. HP can use Dell's financial weakness as an opportunity to undercut the firm on price to gain share in enterprise. The beauty of this strategy is that once HPQ wins PC contracts, it can expand its foothold in more profitable areas like printing, networking, and so on.
HP's printing unit continues to perform well with units sold actually increasing. This company's legacy businesses may not be engines of growth, but they are no longer anchors weighing the firm down. If HP is able to get into 3-D printing, which is still uncertain, upside for this unit could be even higher. At the same time, HP's forward looking enterprise service unit now accounts for 26% of sales with servers, networking, and storage showing solid gains. Meg Whitman is slowly transitioning this company for growth over the next decade. Obviously, challenges remain, and that is why shares are not trading at 15x earnings, but with nascent growth and stabilizing legacy business, I believe a 10x multiple is certainly fair.
Meg Whitman has also repaired the balance sheet, and the operating company now has a net cash position. With its free cash flow generation, the company is poised to step up its returns to shareholders. I would expect continued increases to the dividend, which yields 2.12%. I would expect another 10% increase in early 2014 to about $0.16. With its free cash flow, HP can also double the buyback to about $4.5-$5 billion, enough to repurchase 9% of the float at current prices. Given the low valuation currently, this action would be very accretive to EPS growth and long-term returns.
On the whole, while JPMorgan may have waited too long to upgrade shares of Hewlett-Packard, I strongly agree with the call. HP's legacy business is stabilizing, and there is a path for the company to return to overall growth in 2015. With $3.75 in earnings power next year, I believe shares of HP are extremely compelling here and should reach $37-$40 in 2014, meaning they have another 34.5% of upside from here. While they may not double again, that is still a pretty solid return. HPQ is one of the best tech stocks for 2014.