For several years, I avoided purchasing Hewlett Packard (HPQ). Lack of a coherent strategy from management, questionable acquisitions, and a less than pristine balance sheet all kept me away. But when the stock took a 25% loss in two days, I took a long position, feeling the valuation was compelling and margin of safety sufficient. Despite management's mistakes, Hewlett Packard is a much more profitable company than is currently portrayed in the media.
Hewlett’s financial health is much worse than many tech giants such as Microsoft, Intel, and Cisco; three companies with pristine balance sheets and tons of net cash, even adjusting for repatriation. Hewlett is a different story, with slightly negative tangible book value and a net debt position as of 4/30/11 of $10.18 billion. It is also important to look at the quality of Hewlett's receivables, which are a significant portion of its assets. HPQ has revolving trade receivables-based facilities permitting the firm to sell certain trade receivables to third parties. Currently, HPQ's maximum capacity under these programs is approximately 10% of its total accounts plus financing receivables. HPQ records a write-off or specific reserve when a receivable reaches 180 days past due. The majority of receivables are paying in a timely fashion, however investors much watch carefully for significant increases in trade-based receivables capacity and changes in delinquencies and accounts 90 days or more past due.
Hewlett’s saving grace is its consistent free cash flow generation as shown below:
Depreciation and Amortization
Free Cash Flow
Hewlett’s free cash flow has grown from $6 billion in 2006 to nearly $10 billion currently, which is more than enough to meet its obligations, even if their cost of doing business and cost of financing rises. Although management has seem lost recently and spent carelessly on acquisitions, they have bought back a substantial amount of shares with a portion of this free cash flow, which has helped earnings per share growth immensely. If you have been listening to recent headlines, you might think Hewlett’s earnings growth has been terrible. Below tells a different story:
|Diluted Shares Outstanding||2852||2716||2567||2437||2372||2268|
Hewlett’s EPS has nearly doubled the last five years, helped by the tremendous share buyback program, which will most likely be suspended due to the Autonomy acquisition.
Although Hewlett's R & D as a percentage of revenues declined from 2003 on, it is a misconception that lower R & D expenses significantly enhanced profitability. Hewlett reached a peak of $3.65 billion in R & D spending in 2003, and although R & D as a percentage of revenue began to decline after 2003, Hewlett averaged more than $3.5 billion annually in R & D spending from 2004-08. It was only after the credit crisis when R & D spending declined significantly; however was still nearly $3 billion annually in 2009 and 2010, and is on pace to be higher this year. This is not surprising as many companies became cautious after the market crash in the fall of 2008. Even if Hewlett spent $1 billion per year more on R & D after 2003 without the increase benefiting income, they still would have been incredibly profitable, as net income grew from $6.2 billion in 2006 to over $9 billion, based on HPQ's trailing twelve month net income as of 4/30/11.
Below I will break Hewlett into its three main segments and compare its performance against major competitors in order to determine a fair value for the company.
Hewlett’s total Enterprise business has a healthy operating margin, which has grown impressively and is only slightly lower than IBM's:
click to enlarge
Hewlett’s operating margin in its combined enterprise segments has increased significantly, from 9% to over 15% the last five years. IBM’s operating profit margin has grown from 13.1% in 2006 to 17.1% as shown below:
IBM’s EV/EBIT multiple is currently just above 10 as shown below:
|Equity Market Cap||189900|
|Cash and Equivalents||11714|
IBM’s financial position is no better than Hewlett’s as they have a slightly negative tangible book value as well and a similar amount of liquidity and quality of receivables. IBM’s current tangible book value is approximately -$5.7 billion while Hewlett’s is approximately -$4.4 billion. Based on the fact that Hewlett’s financial position is no worse than IBM and Hewlett’s operating margin is only slightly lower, the market should not be valuing IBM at twice the EV/EBIT multiple of Hewlett. HPQ should be given an EV/EBIT multiple only slightly lower than IBM, due to its slightly lower operating margin. At 9x EV/EBIT, HPQ’s Enterprise business, based on an EBIT of $9 billion, would be valued at approximately $81 billion, nearly $20 billion more than its current total enterprise value. Although some adjustments need to be made for other expenses, this essentially means if you bought Hewlett today, you would get the PSG and IPG businesses for free.
Hewlett’s IPG segment also has a healthy operating margin as shown below:
click to enlarge
Hewlett’s margin far exceeds that of Xerox as shown below:
I adjusted EBIT for non-operating investment income and non-operating interest expense, as some financing revenue and costs are part of their business. Xerox’s (XRX) enterprise value and EV/EBIT multiple are shown below:
|Equity Market Cap||10400|
|Cash and Equivalents||1098|
|Equity Investments in Affiliates||1318|
|ST Debt and Current of LT Debt||2197|
|EBIT 2011 Est||1740|
Although laser printers and supplies can be profitable, I will be conservative in my valuation estimate because of the potential cannibalization from digital alternatives and assumption of this segment as a slow growth business. If we value Hewlett’s IPG business at 10x EV/ EBIT, even though its operating margin is significantly higher than Xerox, based on $4.5 billion of operating income, it would command a value of $45 billion.
Lastly, I will compare Hewlett’s PSG segment to Dell. Hewlett’s operating income and margins from its PSG segment are shown below:
click to enlarge
This is clearly Hewlett’s least profitable segment of the three; maybe why management has finally decided to explore spin-off options. Dell’s profit margins are comparable as shown below:
Dell’s (DELL) enterprise value and EV/EBIT multiple are shown below:
|Equity Market Cap||26500|
|Cash and STI||14479|
Because Hewlett and Dell carry similar margins, and I would argue, the same brand name within this segment, they should be valued almost identically. If Hewlett is valued at 4.5x EV/EBIT based on a conservative estimate of $2 billion EBIT, we arrive at a value of $9 billion for the PSG segment. Even if it is assumed Hewlett will lose some market share to Dell, this segment should still command at least an $8 billion valuation. Hewlett’s products are good enough to retain significant market share.
When valuing Hewlett’s three main segments separately we arrive at an Enterprise value of approximately $135 billion ($81 + 45 + 9). Adjusting for net debt of approximately $10 billion, plus a small minority interest, gives us an equity value near $125 billion, over twice Hewlett’s current market value. It is clear the parts are worth more than the sum and a break up of Hewlett might be smart.
When evaluating Hewlett’s fair value as one company we must adjust not only for its financial services segment, which has high single digit margins and a small profit contributing to the bottom line, but also for other costs, as Hewlett’s total projected current year EBIT is approximately $12.75 billion compared with over $15 billion for its three main segments combined. As stated, the lower total EBIT is due to extra costs, much of which are related to corporate expenses and acquisitions.
Hewlett’s Enterprise business contributes approximately 46% of its revenues; its PSG segment approximately 30%; and its IPG segment approximately 21% as of 4/30/11. Other income from its financial services segment and corporate investments is negligible. Pro-rating the % of revenues from its three main segments, I arrive at an EV/EBIT multiple of 7.6 for Hewlett. If we use Hewlett’s current projected EBIT of $12.75 billion, we arrive at an enterprise value of approximately $96.9 billion and an equity value of approximately $86.35 billion after adjusting for net debt of $10.18 billion and a small minority interest. This gives us a fair value of $39.54 per share based on diluted shares outstanding of 2.184 billion as of 4/30/11.
If I value Hewlett using DCF, I arrive at a fair value of $49 per share using fairly conservative segment revenue growth and margin estimates; assuming depreciation/amortization and capital expenditures grow in line with slow revenue growth; and based on a 10% WACC and 2% near-term and terminal growth rate.
With an intrinsic value range of $40-49 per share and a potential break-up value even higher, Hewlett offers significant upside and a sufficient margin of safety at its current price under $25 per share.
Disclosure: I am long HPQ.