Hewlett-Packard Co. (HPQ) is down almost 24% year-to-date, while the Dow Jones Industrial Average is up almost 8% in the same period. In this article, I will analyze Hewlett-Packard, determine why its relative performance is poor, offer insights by contrasting Hewlett-Packard with industry peers, and present my opinion on the efficacy of investing in this company in advance of its quarter three earnings call due later this month.
Hewlett-Packard has a market cap of almost $39 billion and trades around $20 per share. Its price to earnings ratio stands at 7.66 and its price to earnings growth ratio of 1.15 is encouraging. Hewlett-Packard's price to book is a very desirable 0.93, countered by a weak return on equity of 12.52%. Quarterly year-over-year revenue and earnings growth are reported at -3% and -30.9%, respectively. For a more balanced view, I turned to the income statements, which also show a year-over-year decline in performance, but not as dramatic as that reflected by the quarterly. Fiscal year-end 2011 total revenues actually exceed those of 2010 about 1%, but cost of revenue increased, wiping out the gain. Year-over-year net earnings declined 0.8%.
These figures, while more palatable than the quarterly year-over-year results, are directionally wrong. Moving to indicators of financial strength, we find that the debt to equity ratio is also on the wrong side of ideal, posted at 72.24. However, operating and levered free cash flows are strong. The current ratio is a very acceptable 1.16. Hewlett-Packard pays shareholders a dividend yielding 2.5%, against an arguably sustainable payout ratio of 18%. On the plus side, from a discounted cash flow perspective, the company is undervalued almost 230% and on the basis of book value, undervalued about 100%. This begs the question, "Why are share prices declining?"
Current CEO Meg Whitman has been at Hewlett-Packard since late September 2011. The upcoming third quarter earnings results will represent her first full quarter since taking the reins. Unlike U.S. Presidents, she will be held fully accountable for results. If track records are any indication, the company's results are likely to be an improvement. Whitman has had a string of successful gigs, not the least of which is represented by the stellar results she achieved as CEO of eBay (EBAY). In her 10-year stint with eBay, she took the company from $4 million in annual revenue to $8 billion. If she does only half as well with Hewlett-Packard, shareholders are in for a treat.
In fairness to former management, Whitman was not exactly handed a lemon. Hewlett-Packard has consistently delivered an excellent cash return on invested capital, an acceptable - if not stellar - return on equity, consistent profitability, and positive free cash flow for the past 10 years.
Hewlett-Packard's fundamentals are largely positive; however, share prices began to slip in late February 2011 and have slipped continuously since, with the most dramatic drops coinciding with earnings calls. Clearly, Hewlett-Packard needs to demonstrate its ability to create organic growth of revenue and earnings. Only this will win over investors and, I would argue, this is the most important task facing Meg Whitman in the coming months. This is why quarter three results are critical to the reversal of this trend.
Whitman has taken some bold steps in reorganizing the company, combining the printer and personal computer segments into a single division, with staff reductions of 8% (about 27,000) and a gutsy $8 billion write down in the value of its technology services business. The consequence of these bold moves, short term, will likely be one of the worst quarters for earnings in Hewlett-Packard's history; however, there are already indications that investors are heartened by the leadership Whitman is demonstrating. The stock hit its 52-week low in early August and has been making an incremental comeback since.
In my view, this is a good entry point for the long-term investor. I believe investing now provides an excellent opportunity for an investor to maximize return as stock prices continue to rebound on the positive changes Whitman is bringing to the table.
Hewlett-Packard has some formidable competition by way of IBM (IBM) and Dell (DELL). Dell, quite obviously, challenges Hewlett-Packard in the personal computing arena, while IBM is the greatest threat to Hewlett-Packard's technology services business. As the chart demonstrates, Dell is the weak sister and, in my view, the most likely to lose market share to a revitalized Hewlett-Packard. IBM, on the other hand, is a robust competitor with deeper pockets. Whitman must find a way to ensure that her company not only holds the block of business it now enjoys, but positions the company to grow its technology services segment in the shadow of big blue. The $8-billion dollar write down is a start.
Dell's fundamentals are virtually interchangeable with those of Hewlett-Packard. The exceptions are: price to book - where Hewlett-Packard has a clear advantage, return on equity - where the nod must go to Dell, and debt to equity - where Hewlett-Packard enjoys the advantage. Oh yes, Dell pays no dividend.
IBM, alternatively, has great fundamentals, but is a far less nimble company than either Dell or Hewlett-Packard. This is the one advantage Whitman can best exploit as she moves the company into the good graces of investors. For the reasons I have cited, Hewlett-Packard is the right play at the right time, with the right leadership in the person of Meg Whitman.