Hewlett-Packard (HPQ) is under attack from investors and competitors alike. HP suffered a 56% share price decline from its early 2010 high (around $54/share), and currently trades at about $23.50/share which is also well beneath where HP exchanged hands during the stock market "generational" low levels seen in March 2009.
Investors must always consider price relative to underlying value, conservatively estimated. Therefore a large decrease in the stock price deserves additional analysis to determine if price has become appreciably less than value and, if so, why. The why is clear for HP, investors are considering:
- Whether the printer and ink business is experiencing a fundamental decline due to a shift towards cloud computing and tablet devices.
- How the incessant turnover at the executive management level will affect the strategic direction of the company.
- If intense competition among all its business lines, particularly in the PC business where Apple (AAPL) is growing market share, will severely impact future cash flow and earnings performance.
- If expensive acquisitions over the past several years will be accretive to earnings, or whether management grossly overpaid for miscalculated bets.
There is no shortage of media and Seeking Alpha commentary discussing the strategic missteps of HP which I won't discuss here. I want to focus on a few items of value that could be being overlooked by investors. When value is ignored, opportunity for value-oriented investors is created.
Price is what you pay, value is what you get. So what are a few items of value that investors obtain when buying fractional interests in HP, but potentially overlooked by the market?
Intangible Asset Amortization
The footnotes (note 5) in the latest 10-Q reveal an interesting piece of information. As a result of HP's acquisitive nature, there is a significant amount of amortization expense that will impact generally accepted account principles ("GAAP") earnings over the next 5 years. Amortization, of course, is a non cash charge and should be added back to cash flows attributable to shareholders. My discounted cash flow ("DCF") analysis from this source yields the following where:
N = Time period, using mid-year convention. Because the footnote does not explicate the exact timing of future amortization expense post-2017, I will use a discount factor of 8.375, which assumes the final $1,392 will be realized during 2020.
PV Factor = 10%. This is a low risk cash flow because it only requires future revenues from which to be offset.
# Shares = Current number of shares outstanding. This will likely be lower later in the amortization period because management is actively buying back shares. For conservatism, I will use the current shares outstanding to get a per share present value of future amortization expense.
Economic substance rather than accounting treatment is more important to equity valuation. Once HP fully amortizes the finite-lived purchased intangibles as required by GAAP, better earnings will result.
Value of Property Plant and Equipment
HP carries Property, Plant and Equipment ("PPE") on its balance sheet at historical cost less depreciation, except for land which is not subject to depreciation expense. As of January 31, 2012, HP reported the following:
Accumulated depreciation makes up 55% of depreciable assets, buildings and equipment. Let's assume that ratio is applied equally to each class of depreciable asset. Buildings, then, are carried on the balance sheet at $3.9 billion. According to HP's fiscal year 2011 10K, the company owns 47% of the 70,000,000 square feet of total space available, or roughly 32,900,000 square feet. Therefore, HP carries its real estate on its books at about $118/square foot which is likely less than its true economic resale value and/or utility.
If we conservatively assume that the true economic value of that real estate is 1.5x its carrying value, there is approximately an additional $1/share in excess value absent from the financial statements, resulting in fair market value of $5.85 billion, or $178/square foot for the real estate.
Other Intangible Assets
In addition to purchased intangible assets which are recorded on the balance sheet, HP possesses over 36,000 patents (some of which were created internally, thus not capitalized), a highly educated workforce and a dynamic supply chain, none of which is captured in the share price except indirectly through the cash flows these intangible assets help to generate. It's difficult, if not impossible, to value these classes of intangible assets, but the drastic decline in HP's share price doesn't require us to. After a steep decline in the share quote to $23.50/share, and hidden value made up of $3.25 in the present value of future non cash amortization expense, $1 in potential additional real estate value and $4/share of cash on HP's books, collectively totaling $8.25/share (or 35% of the share price), a cataclysmic disaster appears to be priced in for HP.
The future is inherently uncertain. The only way to avoid a substantial loss in investment principle is to buy bargain priced investments and to know why they are selling at a discount. I recognize that there are difficulties for HP ahead, some of which probably aren't visible yet, but when sentiment becomes overly pessimistic, and I can identify pockets of value likely ignored by others, I am willing to be a contrarian and purchase those out of favor securities at levels selling at what I believe is temporarily below intrinsic value. After considering those low risk assets described above, let us not forget that HP is still the largest technology company in the world measured by revenue, generating roughly $125 billion in annual sales. HP appears to be currently offering investors a wide margin of safety at current price levels.
Disclosure: I am long HPQ.