Barron's published an interesting article on Hewlett-Packard (NYSE:HPQ) this weekend and highlighting the wonderful job Meg Whitman has done to turn the company around. According to Barron's, the stock has 20% upside over the next year and is selling at a substantial discount to its long-term value and relative to peers. The chart below was taken from the Barron's article, but if you want to read the rest of the article, (Click Here) you will need a subscription.
Hewlett-Packard has had just 5.1% annualized earnings growth over the last 15 years and the stock is at levels it was at in 2001. Despite two recessions and a drop in the stock price from $54.75 to $11.35, HPQ continued to pay a dividend. That alone seems quite impressive. The stock currently has a dividend yield of just 1.9%, which is in the middle of the peer group.
- Xerox (NYSE:XRX): 2.05%
- IBM (NYSE:IBM):1.98%
- Western Digital (NASDAQ:WDC):1.22%
- Cisco Systems (NASDAQ:CSCO):3.08%
- Oracle (NYSE:ORCL):1.2%
- Microsoft (NASDAQ:MSFT):2.56%
According to expected earnings growth and a normalized PE ratio, the stock can potentially reach $50+ by the end of the year. If that is the case, Barron's 20% upside seems conservative.
Barron's also touched on the high level of cash flow being generated by the company.
By carefully managing inventory and keeping capital spending in check, the company has generated an impressive amount of free cash-more than $15 billion in its past two fiscal years, equal to about a quarter of the company's stock market value.
Since earnings can be influenced by many non-cash items, I wanted to look further into how HPQ would be valued if based on cash flow and cash flow growth prospects.
It looks like cash flows have remained range bound over the last 5 years despite a drop in the stock price from $54 to $11.35. It looks to me like the drop in price is extremely overdone.
Based on cash flows, the stock might be trading above $60 per share, making the Barron's number look even more conservative.
After an expected decline in cash flows in 2014, cash flows are expected to increase by an annualized rate of 8.4% through 2019, implying a price of $107.85 by October 2019 and a total return of 24.9%.
This seems too good to be true, so I had to delve further and expand the analysis. According to the 10 analysts reported by Morningstar.com, earnings for 2014 are expected to be $3.80 per share in 2014 and $3.86 in 2015.
If we apply a price multiple of 8.7 as reported by Barron's to the $3.86 per share, then the expected price is just above $33. Nothing to write home about. But if multiple expansion does occur and the stock begins to trade more in line with its peers, we're back to our optimistic forecast of 20%+ upside. For example, let's assume a relative average PE multiple of 10 for the peer group. Applying a 10 multiple to $3.86 earnings gives you a price of $38.60, an 18% increase (in line with Barron's forecast).
In my opinion, this seems more reasonable. Even though cash flow is the biggest driver of economic value creation and earnings can sometimes be misleading, I don't think the market has or will value HPQ at the potential levels calculated using cash flow growth.
It's more reasonable for earnings to grow at a rate of 3-5% and for the multiple expansion to increase gradually as the company proves that it deserves a higher multiple. This will only occur when it is clear that revenues will stop declining and are poised to grow.
For the time being, I would apply a multiple of just 9.5 to earnings of $3.86 to arrive at a price of $36.67. Not bad but not a 20% increase.
At the moment I just don't think HPQ warrants a comparable multiple to its peers. It's trading at a discount for a reason, albeit, with good progress made to turning its business around. It's had a great run over the last year, but now it needs to show me the money in the form of revenue growth.
Disclosure: I am long CSCO, ORCL. 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.