Investors are upset that Hewlett-Packard (HPQ) has been unable to quickly address its multiple operational challenges. Secular trends are undermining the company's core business of PCs and printers. At the same time, company-specific issues are denting margins in the more profitable services business. While IBM (IBM) keeps rolling along at all-time highs (the company raised earnings guidance again this week even though revenue was lower than expected), HP is struggling to keep customers without offering big discounts.
In spite of all these challenges, HP's valuation is far too low at current levels. Investors with a medium-long term focus should attain market beating returns over the next few years. This is true for a number of reasons. First, commentary regarding the end of PCs has become severely exaggerated. Supply constraints from the Thailand floods and customer uncertainty regarding HP's possible spinoff of its PC division depressed HP sales last fall. Last week's reports from Gartner and ISI indicated that HP recovered all of its lost market share in Q1 2012. This represented a year-over-year gain in total unit sales, as HP retook market share it had lost to Dell (DELL) and others. PCs are no longer a growth industry, but I expect this business to remain consistently profitable for HP. The PC business will also likely see a boost from the release of Windows 8 this fall, which may spark a new upgrade cycle.
I also expect the merger of HP's PC and printer divisions to yield significant cost-cutting possibilities, which will boost the margins for the new Printing and Personal Systems Division. It's possible that HP will also be able to increase sales by more effective cross-marketing, but I see this as less likely.
However, the PC/printer merger news dwarfed the rest of HP's reorganization announcement, which was probably more significant for a potential turnaround. HP will be streamlining sales and marketing across the company. At least in theory, this should allow the company to better communicate with customers and understand their needs.
I believe this is the first step in Meg Whitman's plan to turn around the services business and begin providing better value-added services. Whitman has signaled that this turnaround will take years, not months. While investors often focus on the short-term, those with a longer term horizon should be happy that HP's management recognizes the challenges they face and are taking strong action to improve the company's performance.
Valuation-wise, while I don't agree with Takeover Analyst's $42 fair value calculation, I agree that HP's DCF (discounted cash flow) stream supports a much higher valuation for HP, barring a disaster scenario that is unlikely to materialize. HP is probably worth $35 today, which values the company at less than 9 times analyst estimates for this fiscal year. If the company can provide evidence that its turnaround efforts are making progress, then a figure above $40 might become more reasonable. Investors who are willing to wait a year or two for the HP turnaround to take effect will be able to capitalize on the market's current pessimism regarding HP.
Disclosure: I am long HPQ.