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Summary

  • HPQ reported an underwhelming quarter yesterday with several segments showing revenue declines.
  • Shares are trading for 7 times FCF and 9 times forward earnings.
  • HPQ is being priced like it is dying off when that isn't the case, offering upside potential.

Shares in Hewlett-Packard (NYSE:HPQ) have been an interesting case study in what happens when a business begins to die off. After cresting $50 in 2010, shares plummeted to just above $10 in late 2012 on fears its PC business was going the way of the dodo. Since that time, however, HPQ has shown tremendous resilience and although growth is still a bit of an issue, the company's shares have tripled from their lows and trade at $35 as I write this. So the question for investors is whether or not there is still value in HPQ after the multi-year rally that has left shares in the mid-$30s.

To answer this question, I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at 8 cents of growth annually, and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 7%.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$3.56

$3.72

$3.91

$4.09

$4.28

$4.47

x(1+Forecasted earnings growth)

4.50%

5.10%

4.57%

4.57%

4.57%

4.57%

=Forecasted earnings per share

$3.72

$3.91

$4.09

$4.28

$4.47

$4.68

Equity Book Value Forecasts

Equity book value at beginning of year

$15.03

$18.11

$21.30

$24.59

$27.98

$31.50

Earnings per share

$3.72

$3.91

$4.09

$4.28

$4.47

$4.68

-Dividends per share

$0.64

$0.72

$0.80

$0.88

$0.96

$1.04

=Equity book value at EOY

$15.03

$18.11

$21.30

$24.59

$27.98

$31.50

$35.13

Abnormal earnings

Equity book value at begin of year

$15.03

$18.11

$21.30

$24.59

$27.98

$31.50

x Equity cost of capital

9.50%

9.50%

9.50%

9.50%

9.50%

9.50%

9.50%

=Normal earnings

$1.43

$1.72

$2.02

$2.34

$2.66

$2.99

Forecasted EPS

$3.72

$3.91

$4.09

$4.28

$4.47

$4.68

-Normal earnings

$1.43

$1.72

$2.02

$2.34

$2.66

$2.99

=Abnormal earnings

$2.29

$2.19

$2.07

$1.94

$1.81

$1.68

Valuation

Future abnormal earnings

$2.29

$2.19

$2.07

$1.94

$1.81

$1.68

x discount factor(0.095)

0.913

0.834

0.762

0.696

0.635

0.580

=Abnormal earnings disc to present

$2.09

$1.83

$1.57

$1.35

$1.15

$0.98

Abnormal earnings in year +6

$1.68

Assumed long-term growth rate

3.00%

Value of terminal year

$25.89

Estimated share price

Sum of discounted AE over horizon

$7.99

+PV of terminal year AE

$15.02

=PV of all AE

$23.01

+Current equity book value

$15.03

=Estimated current share price

$38.04

The model computes a fair value of $38, given the inputs I described above, or about $3 higher than shares trade today. So that means HPQ is cheap right?

In a sense, yes, but we also need to understand what we're looking at. First off, the $38 is a fair value and not a price target. Price targets are forward looking; the investor computes estimated EPS and then multiplies that number by some earnings multiple to project a price out into the future. By contrast, the fair value I've shown here is based upon today's price and assumptions. In other words, I've computed a fair value of $38 as the present value of the company's discounted earnings stream, adjusted for dividends, based upon the inputs I described above. This means that HPQ is cheap right now as it has a decent margin of safety to its current fair value.

The company reported fiscal Q3 results yesterday and the results were underwhelming. PC sales rose nicely but the business is low margin. Enterprise services revenue fell another 6%, continuing a free fall that has been persisting for some time now. Software licensing, storage and server revenue also fell and pressured top line growth. The company also guided for in-line Q4 EPS and announced that $582 million was spent on buybacks during the quarter. In other words, this wasn't exactly a quarter to write home about but in the context of where HPQ has come from, it was okay. And besides, we all knew that several of HPQ's businesses are shrinking so that was no surprise.

However, I think that HPQ's expectations are so low that even simply meeting EPS targets should provide some upside to shares. First off, the company is trading for roughly 7 times free cash flow as guided by CFO Lesjak. That is a very low valuation and we aren't talking about wonky GAAP accounting that can be manipulated; this is real money, cash that is flowing into the business over and above its outlays. IBM (NYSE:IBM), for instance, trades for 14 times FCF and while I understand that businesses are different, they aren't different enough to warrant that kind of discrepancy. I like HPQ based just on FCF yield here.

But if we take a look at HPQ's earnings estimates above, analysts aren't expecting much out of the company in the coming years. This is good as it means that HPQ has a very low bar to step over when it comes time to report each quarter and that should make it much easier to show upside surprises and power shares higher. With analysts only expecting ~4% growth and shares trading below the fair value associated with that growth, I reckon shares are pricing in ~1% earnings growth for the foreseeable future. Remember that HPQ repurchased roughly 1% of its shares during the most recent quarter so even if the business never grows again, EPS should be able to keep pace with 2% or 3% growth annually simply on reduced float.

HPQ was a declining business a couple of years ago and while the company still has problems, it has been quite the turnaround story. The company, despite having seen its shares triple, is still trading for only 7 times its FCF and only ~9 times forward earnings. In other words, this company is being priced as though it's going out of business slowly which I do not believe it is. Meg Whitman has shown terrific results since taking the helm and with the company spinning off enormous amounts of cash, management is free to invest in the business or return it to shareholders. HPQ is very cheap and given that expectations are so low, you don't even need the business to grow; you just need it not to die off to make money. I like those odds.

Source: Hewlett-Packard Valued Like It's Going Out Of Business