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Summary

  • 3.5 (x) cash-flow (ex balance sheet cash).
  • 15% free-cash-flow yield.
  • Missing ingredient remains revenue growth.

Hewlett-Packard (NYSE:HPQ) reports their fiscal Q2 '14 earnings after the close on Thursday, May 22nd, 2014.

Analyst consensus per Thomson Reuters is expecting $0.88 in earnings per share (EPS) on $27.4 billion in revenues, for expected year-over-year growth of 1% in EPS, and a decline of -1% in revenues.

Since the February '14 earnings report, the EPS number has remained the same while the consensus revenue estimate has been revised higher from $27.396 billion to $27.422 billion, or a $26 million bump.

In Q1 '14 reported in February '14, while the quality of the EPS beat was low or less-than-high, in our opinion, HPQ's operating income growth was +7%, the highest in 10 quarters or 2.5 years, or since the July '11 quarter.

Hewlett-Packardestestest
year-over-year growth10/14 q47/14 q34/14 q21/14 q110.13 q47/13 q34/13 q21/13 q110/12 q47/12 q34/12 q21/12 q110/11 q47/11 q34/11 q21/11 q110/10 q4
Net Revenue-2%-1%-1%-1%-3%-8%-10%-6%-7%-5%-3%-7%-3%1%3%4%8%
Cost of Salesn/an/an/a-1%-1%-8%-11%-6%-8%-5%-1%-4%-1%2%1%1%7%
R&Dn/an/an/a2%-20%-7%-4%1%10%5%4%-2%2%9%13%17%16%
S,G&An/an/an/a-3%4%-3%-6%-2%-10%-2%3%8%5%9%12%6%16%
Operating expenses
Operating Incomen/an/an/a7%-16%-16%-13%-13%1%-10%-23%-36%-7%31%25%33%5%
Interest Income/(Expense)n/an/an/a-9%-45%-35%-21%-19%-53%85%220%128%395%-10%-16%11%-39%
Income pre-taxn/an/an/a42%-14%-32%-12%-33%9%-14%-29%-40%-17%34%26%34%7%
Income Tax Expensen/an/an/a20%-14%-41%-10%-34%-3%-16%-30%-41%-2%55%35%48%15%
Net earningsn/an/an/a-11%-14%-30%-13%-12%14%-14%-28%-40%-21%29%24%30%5%
diluted share outstandingn/an/an/a-1%-1%-1%-2%-2%-2%-5%-9%-10%-13%-12%-9%-8%-6%
F/D EPS3%3%1%10%-13%-14%-11%-11%-1%-9%-21%-32%-12%47%36%42%34%

* Source: Thomson Reuters consensus estimate (and actual results) on internal spreadsheet

When you look at HPQ's business by product line, the PC and the Printer Groups are still half of HPQ revenues, and in the February '14 quarter the PC / Printer Group grew revenues 2% for the first positive y/y growth in 5 quarters (per our internal spreadsheet).

HPQ by segment % of total
Revenues10/13 q47/14 q34/14 q21/14 q110.13 q47/13 q34/13 q21/13 q110/12 q47/12 q34/12 q21/12 q110/11 q4
* Personal Systemsn/an/an/a30%29%28%27%29%29%29%31%30%31%
* Printingn/an/an/a21%21%21%22%21%20%20%20%21%20%
Total Printing and PSGn/an/an/a51%50%50%50%50%49%49%51%50%51%
* Servicesn/an/an/a25%20%21%22%21%29%30%21%21%29%
* Enterprise Serversn/an/an/a20%26%25%25%25%17%17%25%24%17%
* Softwaren/an/an/a3%4%4%3%3%4%3%3%3%3%
* HP Financial Servicesn/an/an/a3%3%3%3%3%3%3%3%3%3%
* Corporate Investmentsn/an/an/a1%0%0%0%0%0%0%0%0%0%
Total Segmentsn/an/an/a103%103%103%103%102%103%103%103%102%103%
* Intersegment rev'sn/an/an/a-3%-3%-3%-3%-2%-3%-3%-3%-2%-3%
Total HP Consolidated net revn/an/an/a100%100%100%100%100%100%100%100%100%100%
Operating Income
* Personal Systemsn/an/an/a10%8%9%9%9%9%13%17%16%21%
* Printingn/an/an/a36%35%35%36%38%32%31%26%26%29%
Total Printing and PSGn/an/an/a47%43%44%45%47%41%44%43%42%49%
* Servicesn/an/an/a2%8%7%6%3%37%31%8%5%44%
* Enterprise Serversn/an/an/a37%36%40%41%43%13%18%43%46%26%
* Softwaren/an/an/a5%11%8%7%6%9%6%6%6%10%
* HP Financial Servicesn/an/an/a4%3%4%4%4%3%3%3%3%4%
* Corporate Investmentsn/an/an/a5%-2%-2%-2%-3%-2%-2%-2%-2%-33%
n/an/an/a100%100%100%100%100%100%100%100%100%100%
HPQ segment: y/y growth10/13 q47/14 q34/14 q21/14 q110.13 q47/13 q34/13 q21/13 q110/12 q47/12 q34/12 q21/12 q110/11 q4
Revenues
* Personal Systemsn/an/an/a4%-1%-11%-20%-8%-14%
* Printingn/an/an/a-2%-1%-4%-1%-5%-5%
Total Printing and PSGn/an/an/a2%-1%-8%-12%-7%-11%
* Servicesn/an/an/a18%-34%-33%-8%-7%-6%
* Enterprise Serversn/an/an/a-20%48%32%-10%-4%-9%
* Softwaren/an/an/a-1%-9%1%-3%-2%14%
* HP Financial Servicesn/an/an/a-9%-6%-6%-9%1%1%
* Corporate Investmentsn/an/an/a7100%-62%-74%43%-87%-110%
Total Segmentsn/an/an/a0%-3%-8%-10%-6%-7%
* Intersegment rev'sn/an/an/a52%2%-2%-18%-19%-26%
Total HP Consolidated net revn/an/an/a-1%-3%-8%-10%-6%-7%
Operating Income
* Personal Systemsn/an/an/a25%-16%-44%-54%-51%-47%
* Printingn/an/an/a3%0%-4%19%25%35%
Total Printing and PSGn/an/an/a7%-3%-16%-10%-4%0%
* Servicesn/an/an/a-25%-79%-80%-34%-48%2%
* Enterprise Serversn/an/an/a-7%161%84%-18%-18%-41%
* Softwaren/an/an/a-8%3%15%5%-3%12%
* HP Financial Servicesn/an/an/a0%-2%2%1%11%6%
* Corporate Investmentsn/an/an/a-286%-31%0%17%30%-91%
Totaln/an/an/a6%-9%-16%-14%-13%22%

* Source: internal spreadsheet

The Enterprise Server Group, which varies between 20% - 25% of total revenues, has seen some decent growth until last quarter which could also be somewhat seasonal. I've wondered, given the fact that Dell is now a private company, how that will change the competitive landscape in the enterprise server business. Does the fact that Dell is now private make them a more rational or irrational competitor ? My first guess is that - given Dell doesn't have to sweat quarterly results and worry about the stock price - that means Dell can make longer-term and rational decisions around the business. That is a big assumption though, and it doesn't account for other competitors.

Valuation:

The most compelling metric for a bullish outlook on HPQ however comes from scrutinizing the cash-flow statement:

HPQ cash-flow analysis10/14 q47/14 q34/14 q21/14 q110/13 q47/13 q34/13 q21/13 q110/12 q47/12 q34/12 q21/12 q110/11 q47/11 q34/11 q21/11 q110/10 q47/10 q3
Cash from operationsn/an/an/a$2,990$2,816$2,674$3,556$2,562$4,059$2,846$2,473$1,193$2,400$3,207$3,962$3,070$3,151$3,273
Cash from investingn/an/an/a($217)($944)($661)($554)($644)($610)($825)($1,267)($751)($11,466)($911)($1,219)($363)($5,066)($2,353)
Cash from financingn/an/an/a$1,229($2,960)($2,002)($2,351)($630)($1,657)($823)($1,008)($372)$4,156($2,081)$61($3,702)($1,874)($333)
Net change in cashn/an/an/a$4,002($1,088)$11$651$1,288$1,792$1,198$198$70($4,910)$215$2,804($995)($3,789)$587

Cash from operations

n/an/an/a$2,990$2,816$2,674$3,556$2,562$4,059$2,846$2,473$1,193$2,400$3,207$3,962$3,070$3,151$3,273
Capex (excl acquisitions)n/an/an/a($997)($919)($880)($767)($633)($870)($870)($1,080)($883)($1,385)($1,128)($1,100)($926)($1,232)($1,130)
Free-cash-flown/an/an/a$1,993$1,897$1,794$2,789$1,929$3,189$1,976$1,393$310$1,015$2,079$2,862$2,144$1,919$2,143

4q trailing CFO

n/an/an/a$12,036$11,608$12,851$13,023$11,940$10,571$8,912$9,273$10,762$12,639$13,390$13,456$12,585$11,922$12,204
yoy growthn/an/an/a1%10%44%40%11%-16%-33%-31%-14%6%10%

4q trailing capex

n/an/an/a$3,563$3,199$3,150$3,140$3,453$3,703$4,218$4,476$4,496$4,539$4,386$4,388$4,238$4,133$3,847
y/y growthn/an/an/a3%-14%-25%-30%-23%-18%-4%2%6%10%14%

4q trailing FCF

n/an/an/a$8,473$8,409$9,701$9,883$8,487$6,868$4,694$4,797$6,266$8,100$9,004$9,068$8,347$7,789$8,357
yoy growthn/an/an/a0%22%107%106%35%-15%-48%-47%-25%4%8%

FCF Yield

FCF as % of market capn/an/an/a15%16%18%23%26%26%13%

4q trailing net income

n/an/an/a$6,472$6,652$6,974$7,557$7,808$8,035$7,763$8,072$8,840$10,038$10,567
CFO as % of net incomen/an/an/a186%175%184%172%153%132%115%115%122%126%127%
FCF as % of net incomen/an/an/a131%126%139%131%109%85%60%59%71%81%85%
dividendsn/an/an/a$278$284$280$283$258$252$252$252$252$211$211$211$211$193.0$193.0
share repurchasesn/an/an/a$565$479$3$797$253$125$498$498$498$2,529$2,529$2,529$2,529$2,760$2,760
total capital returnedn/an/an/a$843$763$283$1,080$511$377$750$750$750$2,740$2,740$2,740$2,740$2,953$2,953
4q trailing dividendn/an/an/a$1,125$1,105$1,073$1,045$1,014$1,008$967$926$885$844$826$808$790$772$771
4q trailing share repo'sn/an/an/a$1,844$1,532$1,178$1,673$1,374$1,619$4,023$6,054$8,085$10,116$10,347$10,578$10,809$11,040$9,565
4q trailing total capital returnedn/an/an/a$2,969$2,637$2,251$2,718$2,388$2,627$4,990$6,980$8,970$10,960$11,173$11,386$11,599$11,812$10,336
Capital retn'd as % of FCFn/an/an/a35%31%23%28%28%38%106%146%143%135%124%126%139%152%124%

Stock issuance under comp plans

n/an/an/a$83$55
% of share repon/an/an/a15%22%

Source: internal spreadsheet

Although the above data looks rather "crowded", there are a couple of items that jump out:

1.) HPQ has a "free-cash-flow yield" as of the February '14 quarter of 15% (free-cash-flow as % of market cap). There aren't too many bonds today that you can buy with a 13% "yield" that are BBB rated;

2.) Cash-flow coverage and free-cash-flow coverage of net income has been steadily improving, which, pari passu, means that the quality of HPQ's earnings have improved over the last three years;

3.) HPQ is returning just 35% of its free-cash-flow to shareholders, so once HPQ's revenues start to grow again, I could see the Board distributing more free-cash via dividends and buyback to shareholders;

The issue for HPQ remains revenue growth: over the next three fiscal years, per the Thomson Reuters consensus, HPQ revenues are expected to decline 1%, but still generating an average EPS growth rate of 4%.

If Meg and the management team can restore HPQ to just low to mid-single digits positive growth rates over the next 3 - 5 years, $4 per share in core EPS is easily sustainable, and maybe more, since the consensus 2016 EPS today is $4.14, under current assumptions.

Trading at less than 10 (x) the fiscal 2014 EPOS estimate of $3.71, HPQ still remains undervalued in our opinion.

Our internal intrinsic value model values HPQ at $37.50 after the February '14 earnings report, and assumes no revenue growth. Morningstar's more conservative, discounted cash-flow model, assigns a perceived intrinsic value on HPQ of $26, which I personally think is too low.

Split the difference, and HPQ looks fairly valued at this point at $32 - $33 per share, but that is before the substantial return of free-cash that could occur, and without any revenue growth whatsoever.

Personally, I'm still table-pounding bullish on the stock, primarily because I have high regard for Meg Whitman as CEO, and do think she has done a great job stabilizing the company, and will now drive a 2nd, "growth-oriented" phase for the company, and due to cash-flow generation, and the potential for higher dividends, share repurchases and such.

Some think HPQ will buy a 3D printing company, which could squash HPQ's upside if it isn't done right. With HPQ's current p.e at 8 (x) earnings, and the 3D printing space trading at much higher valuations, you would think it would have to be a heavily-dilutive deal to HPQ shareholders, if a deal were done today.

To conclude, with just low to mid single digit revenue growth, I do think HPQ could generate core EPS between $4 to $5 per share, depending on what happens around it. We think Meg has done a fabulous job of stabilizing the company, and generating substantial cash-flow, which gives her and the management team many options, most of them favorable for shareholders.

Our low cost-basis on HPQ's stock in one value-oriented client's account is $14.40 from December of 2012. We acquired the bulk of our position between $20 - $25 per share in mid 2013.

We would add more share from $28 to $30 on a decent pullback, and with no surprises around fundamentals.

Normally, with cash-flow valuations of 3.5 (x) cash-flow (ex cash) and 5 (x) free-cash-flow (ex-cash) you wonder if you have a "value trap" on your hands as an investor.

The one missing ingredient is revenue growth, but if Meg and the management team can continue on the improvement track that is starting to bear fruit, I think it will happen.

The analyst consensus could start to reflect positive revenue growth for fiscal 2015, by the end of this year, given the trends in the numbers.

Although our earnings model doesn't have it yet, a patient investor could see $40 - $45 per share in next few years. The wild card would be a transforming acquisition that is temporarily dilutive.

Here, and here e some of our earlier articles on HPQ. Our theme is consistent: the cash-flow valuations remain mouth-watering, we just need a little growth.

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.