Hewlett-Packard (HPQ) is in the news again. This time not only for the recent earnings announcement made on May 23rd, but also for mass lay-offs of up to 27,000 workers slated for later in the year and into 2014. HP reported stronger than expected profits and revenue for the quarter and also updated their outlook for the remainder of the year by raising their fiscal year earnings outlook. I believe that HP has tremendous upside potential for a value investor and that these recent events are a sign that the company is undergoing a long-awaited turnaround. I rarely bet against the greatest value investor in history, but I believe the bet by Berkshire Hathaway (BRK.A) on IBM (IBM) will underperform a purchase of Hewlett Packard over the next five years.
Recent Events
HP is one of the largest and best known global technology firms, with a portfolio of businesses that spans personal computing, printing, software, services and IT infrastructure. On May 23rd, the company released its second quarter results for 2012. Net revenues were $30.7 billion for the quarter, down 3% year-over-year. Net earnings were down 28% year-over-year at $1.9 billion, yet the decline was not as poor as the previous quarter which saw earnings drop 44%. Earnings per share (diluted EPS) were down to $0.80 from $1.05, a 24% drop year-over-year, but again not as severe as the previous quarter which saw a 38% drop in diluted EPS. These figures still don't look very impressive yet may signal that Meg Whitman and her team are turning around the large ship that is HP. EPS for two quarters in a row has now been above the previously provided outlook.
HP reported that all geographic regions were either flat or saw a decline in sales year to date. The Americas, which includes the U.S., Canada and Latin America was flat for the year, while sales in Asia-Pacific was down 1% and down in Europe, the Middle East and Africa (EMEA) by 7% year-over-year. Declines in the EMEA region were not totally unexpected due to the on-going uncertainty in eurozone economies as well as social upheaval in Northern Africa. To put this foreign impact into perspective, the United States accounts for 34% of revenues, while the remaining 66% comes from overseas. From a business division perspective, 4 of HP's 6 divisions had flat or declining sales year to date.
HP faces direct competition from Cisco (CSCO), which is considered the leader in enterprise networking solutions. Personal Systems Group (PSG), which consists of laptops and desktops, was flat year to date, perhaps not surprising with the prevalence of tablet computers coming in the market, ala the iPad from Apple (AAPL). Imaging and Printing which were recently merged into one business group saw sales decline 10%. Additionally, Xerox (XRX) has launched a series of pithy television commercials touting their expertise in business printing and support. For the first time, Xerox reported that their services business now makes up as much as half of their overall revenue. HP will need to be mindful of this competitor but also has the potential to dominate the printing business for business customers just as they do in the PC market. Lastly among the divisions, the Enterprise Services, Storages and Networking division was down 6%. The two divisions which saw an increase in revenues year-to-date were Software and HP Financial Services, however these two divisions only make up 6% of overall revenue.
On a bright note, HP increased their 2012 fiscal year earnings outlook from (non-GAAP) $4 per share to $4.05-4.10 per share. The change in estimates was due largely to the expected savings that the restructuring plan will generate. As a part of this restricting plan, HP plans to reduce headcount by 9,000 employees in 2012 and reduce up to a total of 27,000 jobs by the end of 2014. The headcount reductions are welcome, but investors would likely have been better awarded had more of the reductions occurred in 2012 and 2013. These headcount reductions are expected to translate into $3 billion to $3.5 billion in savings annually, but the value impact will not be fully felt until 2015.
During the investor call last Thursday, HP did not specify how much of the $3 billion in savings would be reinvested back into the business, however alluded that a more disciplined approach toward managing return on invested capital would be used in the future. I took this commentary as a prediction that Hewlett Packard is likely to refrain from headline grabbing acquisitions.
Valuation
HP generates a steady stream of cash from operations. Operating cash flows are $10.8 billion over the last 12 months. The company has pursued expensive and value destroying acquisitions, such as the $12 billion purchase of Autonomy, with the hopes that they would lead to deeper margins. CEO Meg Whitman seems to have different ideas. Instead it seems that Ms. Whitman wants to ensure the company is a leaner and more focused enterprise. To do this she is focusing on cutting costs and leaning out the business in order to be more focused on its customers.
The real question is if the company is not going to waste its operating cash flow on poor acquisitions then how much of this weakening cash flow stream will be available to equity investors. HP had approximately $30 billion of short and long-term debt in late March. Using a simple amortization of ten years, this reduces the available cash flow to $7.7 billion. HP remains a research focused company and investment costs are going to remain high. For the sake of argument, assume that the $4.5 billion spent over the last year remains constant going forward. This provides a rough estimate of cash flow available to common equity of $3.3 billion over the last 12 months. Even after applying a conservative discounting to this cash flow stream an investor is looking at a stock worth between $30 and $35 a share. Previously, I had estimated values closer to $40 a share, but given the length of time that the restructuring plan will take, I have reduced my estimates back to reflect the long horizon.
Conclusion
CEO Meg Whitman took over the reins of the company in September 2011, and already she has made strategic changes to the company and one can expect to see more down the road. The recent announcement of upcoming workforce reductions are not completely unexpected but also most likely the right move for the future success of the business. These layoffs shed light on how effective the "old HP" and its management was and how efficient the "new HP" must become.
I expect to see additional strategic changes, such as the integration of the printing and imaging business both in the intermediate term as well as further in the future. HP must now stave off these declines in revenue by business unit as well as regional area. I believe there is a lot of upside potential in HP over the coming years, but the risk remains high as well. At the low end I believe the stock is worth at least $30 a share and at the high end $35 a share. I feel comfortable with a 30% margin of safety from the mid-point of $32.50 which translates into a target purchase price of less than $22.75. HP recently traded for below $22 a share, and I would recommend HP to investors with the risk appetite and time horizon to appreciate this turnaround story. Based on my research, I expect to see a 30% hike in share price by next summer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
