By Brian Tracz
Hewlett-Packard (HPQ) finds itself in the middle of a large restructuring effort that is, in large part, meant to be one of the first strong steps after a series of managerial missteps. Hewlett-Packard shares are down 12% year-over-year and trading near their 52-week low. At around $22, shares are down from a 52-week high of $37 and are, in my estimation, underpriced. I believe that HP shares would make an excellent 3-year purchase during its restructuring, though I would urge more caution on shorter-term trading.
A simple glance at the forward P/E tells a compelling valuation story. Apple (AAPL), Microsoft (MSFT), IBM (IBM), and Dell (DELL) have higher forward P/E than Hewlett-Packard. The forward P/E for Hewlett-Packard is estimated at around 5.5, while Dell's multiple hovers around 6.2. The rest have forward P/E of greater than 10. Thus, Hewlett-Packard makes a relatively inexpensive buy against the some of its major competitors.
Management Changes And Earnings Rebound
Hewlett-Packard announced second quarter 2012 revenue of $30.7 billion, topping the Street's expectations by about $800 million. Earnings per share came in at $0.98, well above management's guidance (and the Street's expectations) of $0.91.
That said, revenues for the company are expected to dip by about 3% for this year, and many are anxious about the overall managerial plan for Hewlett-Packard. In all, the company needs to improve margins and fight to compete with the research and development of other companies. The net profit margin of Hewlett-Packard remains around 4.2%, while IBM maintains a 15% net profit margin. Even Dell maintains a better margin at 5.2%.
In my estimation, this reflects Hewlett-Packard's focus on the hardware and manufacturing front over the software front. The company has the practice of outsourcing certain internet technology applications, such as cloud computing. The company has historically been committed to printing and imaging development, as well as accessories and external hardware. This seems to represent an overall lack of focus on the part of past management.
However, the new HP management appears to have realized this as it begins to shift much of the non-core manufacturing aspects of the company to its Personal Systems Group (PSG). In March, for instance, the printing and imaging aspects of Hewlett-Packard's line were relocated to PSG. Indeed, if the company is able to prove the value of its core research and development and to create valuable software for analytics and enterprise servers, I would be in favor of the potential spin-off of PSG into a separate computer manufacturing firm.
To this end, the company is looking to eliminate 8% of its workforce over the next two years, already having dismissed 27,000 employees. The proceeds of these cuts are going to go toward expanded research and development, according to management.
Indeed, management has already introduced its new cloud computing servers. The CloudSystem, Hewlett-Packard's flagship cloud-computing system, is an integrated system of technologies and software that is meant to serve either as a stand-alone system or as an enterprise-level system. Like Apple's overall approach, this system combines software and hardware technology to create a more seamless end-product. I would like to see this approach in more areas of Hewlett-Packard's fleet.
Tablets and Computers
One of the major risks to any assessment of a technology company at the moment is the extent to which tablet computing will displace personal computing. PC revenue was down 3% year-over-year in 2012, though this figure is an improvement over Dell's PC revenue decline. The culprit in both cases: the iPad.
The impending ultrabook push, with the official release of Windows 8 later this year, will be a litmus test for HP and Dell, in addition to other manufacturers, as they attempt to compete with the latest release from Apple on June 11. This release included, as usual, a fleet of new software (iOS6 and OSX) and hardware (MacBook Air and the new MacBook Pro).
Hewlett-Packard needs to make a concerted company-wide effort on the consumer electronics front to regain market share, and soon. Apple's market share of the personal computing market is at a 15-year high at 5.2% worldwide as of the end of 2011.
Financial Strength and Investment Risk
Hewlett-Packard has a rather strong financial profile to back up an undervaluation thesis. The price-to-book ratio of HP is 1.07, which is below the IT sector's lowest quintile value of 1.19. Additionally, the company has a price-to-sales ratio of 0.36, which is below the IT sector's lowest quintile value of 0.78. By both of these metrics, Hewlett-Packard is undervalued according to its underlying assets and sales base. I believe a significant upside over the next two to three years is extremely likely; over the next 18 months, I believe a reliable target of $35 is reasonable.
The risk to this thesis, though, is whether management will execute its plans. With the management shake-ups of late, it is hard to tell how the company will execute its strategy. In September 2011, the board fired former CEO Leo Apotheker one year after his initial appointment. He was replaced by Meg Whitman, the former CEO of eBay. While these were undoubtedly necessary for a rebound, they have not served to increase investor confidence in the company.
Whitman has ensured investors that she will make major changes only after increasing the company's execution on smaller projects. She claimed that the turnaround could take as long as 5 years, likening HP to the position that Starbucks (SBUX) had in 2008 as its CEO Howard Schultz began a similar restructuring.
The company maintains an investment-grade debt rating of BBB+. Though the company currently has a debt-to-capital ratio of 44%, much of this was due to the amount of debt incurred during the acquisition of Autonomy. This acquisition will aid bolstering enterprise data management services and analytics software development, in addition to other specialties. Thus, though the acquisition jumped total debt to $21.8 billion in 2012 for Hewlett-Packard - an increase from $12 billion at the end of the third quarter 2011 - this incurring of debt is part of the company's turn-around strategy. With its strong debt rating, it seems like a good idea to use its borrowing capacities to its advantage.
Value investor Seth Klarman had more than $400 million invested in the stock at the end of March. Activist investor Ralph Whitworth also had nearly $400 million invested in HPQ and he also serves on company's board. A director of the company, J. Raymond Lane, recently made insider purchases totaling nearly $4.5 million. The insider and hedge fund interest in the stock has also sent bullish signals to investors.