Next time you go to Wal-Mart (NYSE:WMT), you might find an unsuspecting item in the $5 bargain bin. It isn't a CD. It isn't a DVD. No, instead, it is an HP (HPQ). Hewlett-Packard is fantastically undervalued even assuming high discount rates, anemic growth, and virtually no future in perpetuity. The bears have overwhelmed the stock and completely neglected its powerful brand, excellent management, and historical trends in the industry.
While it is hard, if not impossible, to establish a sustainable advantage in technology, the opposite is equally true: any startup, let alone a mature company with existing customers, can explode revenues with the next breakthrough. For this reason, and those mentioned above, HP will generate high risk-adjusted returns.
First, let's begin with an assumption about the top-line. For the sake of proving my point, I model a very low per annum growth rate of 0.5% over the next half decade or so. Bear in mind that HP finished FY2011 with a 1% growth. This decelerated from 10% growth in the preceding year. Even still, 0.5% annual growth is, frankly, absurdly low.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 76.3% of revenue versus 10.2% for SG&A, 2.5% for R&D, and 3.4% for capex. Taxes are estimated at 21% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital. I expect this to hover around -1.5% over the explicitly projected time period.
Taking a perpetual growth rate of 1% (which means the company basically has no future) and discounting backwards by a WACC of 10% yields a fair value figure of $42.17 for just north of 70% upside. HP had $8.1B in free cash flow last year. That means that the stock trades at just 6x free cash flow. Put differently, the free cash flow yield is a stellar 16.7%!
All of this falls, however, within the context of a great deal of skepticism:
Given some of the challenges of the last year, we've been working hard to set the right tone, calm the waters and reassure our stakeholders that HP is the same reliable company that they've known and admired for decades…
So what have I found? Certainly, I found some skepticism. But I have also found that we have incredible support.
The skepticism is, in part, warranted:
[W]e met our guidance and delivered non-GAAP diluted earnings per share of $0.92 and revenue of $30 billion. Frankly, it was a tough quarter, and every business had its challenges. In PSG, the hard drive shortage and continuing difficulties in China contributed to a revenue decline of 15% year-over-year. With the supply challenges, we focused on profitability rather than market share and did a good job of delivering an operating margin of 5.2%.
Investors would be wise to then think like a contrarian. From a multiples perspective, HP is also cheap. It trades at just 8.7x and 5.6x past and forward earnings versus 15.9x and 12.6x for IBM and even 8.7x and 7.5x for Dell. If HP were to miss 2013 EPS expectations by 9.5% and trade 7x (lower than Dell's forward multiple!), the stock would still appreciate by 13.3%. A multiple of 9x and a conservative 2013 EPS of $4.35 would put the stock right where my DCF model predicts.
Consensus estimates for IBM's EPS forecast that it will grow by 11.2% to $14.94 in 2012 and then by 10.4% and 8.1% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $16.23, the stock would hit $227.22 for 9.5% upside. To put that into perspective, consider that the (1) the 14x multiple was nearly twice what I gave HP in the 13.3% upside bear case. Moreover, (2) the $16.23 EPS for IBM is merely conservative versus a $4 EPS for HP, which is absurdly low. Despite these stark contrasts, HP is still more undervalued than IBM. And yet IBM is the stock that Warren Buffett decided to back!
Dell has a similarly precarious future as HP. Consensus estimates for Dell's EPS forecast that it will stay flat at around $2.15 over the next three years. Assuming a multiple of 7.5x and a conservative 2013 EPS of $2.15, the stock is more or less fairly valued. If there was a stock to be contrarian about, it would thus be HP. That is not to say that Dell is overvalued. By contrast, I think that it is undervalued. A multiple higher than 9x would send the shares skyward. But HP requires even less of a multiple to yield the same return.