Few companies in recent memory have destroyed shareholder value at the level that Hewlett-Packard Co. (HPQ) has over the last several years. While the company's problems had been growing for some time, things got far worse at the very end of Mark Hurd's reign and the dismal regime of former SAP CEO Leo Apotheker. The rash decisions to purchase Palm, spin off and then not spin off the PC division, invest in and then curtail the tablet business, and the absolutely horrendous acquisition of Autonomy offer a perfect case study on how to throw tens of billions of dollars of shareholder value down the drain. We started buying HPQ when it was trading around 7 times earnings, but unfortunately that was before things really started going downhill, so we have been digging down deep into the numbers to determine what the next step should be.
HPQ is trading at about $17.56, so the market capitalization is roughly $35 billion. The company has $24 billion in long-term debt and another $16.6 billion in long-term liabilities, which is slightly offset by $9.5 billion in cash. This brings the adjusted enterprise value to roughly $66.1 billion. Adjusted EBITDA is roughly $15-$16 billion depending on what adjustments you are willing to make, giving the stock an EV/EBITDA multiple of just over 4. While this seems very cheap at first glance, if earnings continue to decline, it may ultimately prove expensive. Even if the company were to only earn non-GAAP earnings per share of $4.00 in fiscal year 2012, the P/E multiple would be a measly 4.39 times, therefore the earnings yield is 22.8%. Regardless of what popular opinion is at the moment regarding HPQ, it is essential to understand that the price being paid virtually assumes earnings are likely to drop by 50% and stay at that level, and to me, this is exceptionally unlikely.
Hewlett-Packard reported earnings on August 22nd that were weak as expected. The GAAP loss per share was $4.49 driven largely by a disgraceful $10.8 billion write down of intangible assets. Sadly, we think it is just a matter of time before most of the intangibles of the Autonomy deal are written off as well so we ascribe very little value to the intangible assets of HPQ, despite the company's storied name and history. Non-GAAP diluted earnings per share were $1.00, down 9% YoY. Overall revenues were down 5%, or 2% in constant currency. The Personal Systems Group (PSG) revenue was down 10% YoY with a 4.7% operating margin. PSG is likely HPQ and Dell Inc's (DELL) worst business, but is an essential component of each company's operations to keep cost of goods sold low and to maximize the efficiency of the supply chain. Imaging and Printing Group (IPG) revenue declined 3% YoY with a 15.8% operating margin. Both businesses saw greater declines on the consumer side as many buyers are waiting for Windows 8 to come out, and there is clearly a shift towards tablets which is impacting the sales of notebooks in particular.
Services revenue declined 3% YoY and had an 11% operating margin. Enterprise Servers, Storage and Networking (ESSN) revenue declined 4% YoY with a 10.9% operating margin. Software revenue grew 18% YoY with an 18% operating margin, including the results of Autonomy. HP Financial Services revenue was flat and the unit posted a 10.4% operating margin. HPQ disappointed by lowering guidance for fiscal year 2012 for non-GAAP EPS of $4.05 to $4.07 per share which was down slightly. In the quarter, HPQ generated $2.8 billion in cash flow from operations and still managed a solid $2.1 billion in free cash flow.
Despite HPQ's struggles, the company's consolidated non-GAAP operating margin was a decent 9.2%. HPQ is further along in the shift to a services focused business model than Dell is which we profiled yesterday. This is a company that generates around $125 billion of revenue, so even at an 8% operating margin, the company would have operating income of $10 billion.
(click to enlarge)As can be seen in the table above from HPQ's earnings release, every one of the company's businesses outside of PSG and obviously corporate investments has non-GAAP operating margins in excess of 10%. This is despite dismal macroeconomic headwinds, which are crimping demand on a global basis. The Services businesses of HPQ are certainly not broken, and CEO Meg Whitman is aggressively cutting the fat and focusing on boosting margins from here. The Services businesses actually warrant a much higher valuation than the PSG division due to the longer-term and recurring nature of services contracts, and the higher switching costs. Like Dell, HPQ has a vertically integrated set of offerings and the company as a whole is focusing far more on the corporate side of things as opposed to the consumer. Often media reports on both companies tend to emphasize the decline in the consumer businesses without even discussing the radical shifts in business plans that these companies are in the midst of.
3PAR was an expensive acquisition, but it has worked out quite well; the business grew 60% in the 3rd quarter. HP Networking saw revenue growth of 10% YoY, and Whitman has enhanced the focus on R&D where HP Labs has 50 patent-pending innovations. Software revenue was up 18%, and HPQ's offerings have improved allowing them to be more competitive for larger deals. Early in Whitman's tenure, she tackled the IPG business and decided to merge that with PSG. This has stabilized margins and is driving cost reductions between the two businesses. PSG and IPG are tremendous cash flow producing businesses that don't offer exciting growth opportunities, but HPQ should be able to leverage the cash into expanding its more attractive businesses without having to rely on taking on additional debt to do so. Whitman recently made a management change in Enterprise Services to implement aggressive changes more quickly than the prior management team was willing to do. The company expects 11,500 employees to leave the company in fiscal year 2012, and over the next couple of years the cost savings from these moves should flow through the bottom line.
Capital allocation has been an albatross for Hewlett-Packard ever since the company's ill-fated acquisition of Compaq. The recent acquisition of Autonomy could turn out to be just as bad, but Meg Whitman shouldn't be blamed for the Board of Directors' and Leo Apotheker's complete neglect of acting in the best interests of shareholders. In the quarter, HPQ bought back 16.5 MM shares of stock and the share count is down 5% YoY. The company still has $9.3 billion remaining in the authorized share repurchase plan, and while we'd love to see the company take advantage of that, we'd prefer to see the majority of free cash flow going towards reducing debt levels. As earnings improve, we believe HPQ could reduce the share count by 3-5% per year which would be nicely accretive to earnings. The stock currently yields about 2.56%, so the investor is getting paid adequately to wait for the turnaround in performance. Meg Whitman has made clear that large acquisitions are a thing of the past, and I'd expect to see R&D spending increased which could boost employee morale. This appears to be much needed.
The restructuring work for HPQ and Meg Whitman will be difficult but fortunately the business is decent, and the price is based on extremely low probability assumptions. For the shareholder to make money from current levels, the company simply must perform adequately and not blow money on acquisitions. We believe HPQ could conservatively grow earnings per share by approximately 6% over the next decade with the inclusion of share buybacks. Using a more conservative $4.00 per share earnings base, we show how EPS should develop over the next decade.
We don't need to do a discounted cash flow calculation to establish that this is exceptionally cheap relative to the earnings that this company is likely to produce. For the investor that doesn't care about looking stupid over the short-term or owning a business that isn't currently popular with consensus opinion, HPQ offers the opportunity to make a lot of money. Even under the extremely pessimistic and unrealistic possibility that earnings would decline by 3% a year from the $4.00 base number, the current valuation still makes for a compelling value.
It seems likely that the future will be better than the recent past and we feel that Meg Whitman is performing well. The fact that so many people are so outrageously negative on HPQ means that even fairly patient investors have sold their stock, so any catalyst towards improvement should allow the stock to rally. Based on these facts, we are comfortable dollar cost averaging into the stock with the mentality that we are willing to wait 3-5 years to potentially double our money.