Hewlett Packard (HPQ), hit by a secular decline in its mainstay business of personal computers, huge missteps by a dysfunctional board, two years of abysmal leadership and overpriced acquisitions -- has reached a price which is a great opportunity to buy and hold for the next two to three years.
HP operates in seven segments below:
Year end Oct 2011
( $ Bn)
% of Total Revenue
% of operating profits
Imaging & Printing
Servers, Storage Networks
Sources: SEC Filings
* - Personal Services Group
At $ 24, I strongly believe that the market is punishing HP too heavily for its past missteps and not paying enough for the service and software parts of the business, which account for 30% of its revenues and 42% of its operating profits.
The Bull Case
Retaining PSG (Personal Services Group) was a good idea
This is a declining business, with too many substitutes for the PC and customers migrating to cellphones tablets. However, I believe HP's decision to keep the PC business is a good one and as the market leader, it does add an important layer as a one stop provider for all computing services. I also believe it can stay on top -- the 15% revenue drop in Q1, 2012 caused by a disk drive shortage in Thailand was quickly reversed when HP recovered the market share it lost in Q1.
Expanding Services and Software
With HP's wide business customer base, I expect these two segments to continue to grow and add significantly to revenues and operating margins. Recent trends suggest that large businesses prefer customized computing solutions - a large part of IBM's success is attributed to this strength. HP has a solid array of products and services that meet these demands - computing, hardware, licensing, storage, printing and cloud services to compete effectively with the likes of IBM, (IBM) Oracle (ORCL) and Dell (DELL). I think its product breadth is a huge advantage.
Continuing leadership in Imaging and Printing
As the market leader in this segment, HP's printing business has a higher operating margin than its services business. I also don't see a risk of obsolescence -- as more printing and sharing of photos shift online, reducing demand for toners and printers, HP's imaging group has carved significant niches in this business to keep up with migrating customers.
Servers, Storage and Network
This group actually managed to increase prices in 2011 in a fiercely competitive segment, primarily on the strength of its technology.
Avoiding further missteps
In 2011, HP's debt ballooned to 58% from 38% of its equity last year and it also saw its credit ratings. That gives me hope that HP will reform out of compulsion -- It simply doesn't have that much left to squander on costly acquisitions!
The Bear Case
The PSG segment will continue to bleed (at an operating margin of 5.9%, this segment needs to be subsidized by the others) as almost all the growth in personal computing has come from the Mobile and Tablet segments, where HP has little significance.
Services are not a panacea and HP had to lower prices last year to retain customers - this too is a fiercely competitive segment, and competitors usually catch up with each other fast on product or service differentiation.
There have been no significant improvements with its board of directors in spite of all its mistakes; it continues to be as dysfunctional as before.
Services & Software share of revenue %
Market Cap $ Bn
Sales TTM $ Bn
Market Cap / Sales %
Sources: SEC Filings
With only 20% of revenues from software and services, Dell commands a 24% premium over HP and Lenovo with no software or service revenue is priced almost as much as HP -- the market is willing to pay $48 Bn for HP's hardware business but nothing for the rest.
Of course, IBM with 45% operating margins is in a different league and comparisons with it would be meaningless. In my opinion, HP's problems of the past two years are fully discounted at a price of $24 and I would recommend buying it for a 50% gain over the next two to three years.