Last Wednesday, Hewlett Packard (HPQ) reported a record loss of $8.9 billion. Investors quickly dumped the stock, which had broken above $20 last week, so that it dropped to a new 52-week low under $17 in morning trade on Tuesday. However, investors have overreacted to this news. HP certainly faces ongoing weaknesses in several of its major business areas, but it still deserves a modest earnings multiple of 7x based on its position as one of the leading players in the tech industry. At that valuation, the company should be trading at $28-$29 (more than 60% ahead of the current price).
Before I move on to my analysis of HP's earnings, I want to briefly explain the logic behind my earnings multiple target. A company with stable net income over the long-term deserves an earnings multiple of 8X-10X, all else equal. (At 10X, if it devoted 100% of earnings to a share buyback, the share count would sink by 10% a year, increasing earnings by 10% and yielding a PEG of 1). While HP's adjusted earnings declined from last year to this year, I expect the current cost cutting plan to keep net income flat or better over the next several years. However, since the company has net debt (cash+short term investments+long term investments-gross debt) of nearly $10 billion, I will deduct that amount from the company's valuation. The result is a target valuation between just under 7X and just under 9X. I will use the low end due to the market's current skepticism about HP's ability to maintain its earnings. That said, even though analyst sentiment on HP has soured of late, the average estimate for FY 13 still stands at $4.21, somewhat ahead of this year's earnings.
While management was very cautious in talking about the outlook for next quarter, nothing in the earnings announcement justified the selloff in HP shares that followed. There are three potential explanations that come to mind, but each is a red herring, in my opinion. First, investors may have been spooked by the size of the writedown and the resulting loss (even though they knew it was coming). Second, investors may be worried that there is no end in sight to the PPS (printing and personal systems) division's troubles. Third, it is possible that management's discussion of the competitive environment led some investors to believe that HP's turnaround will ultimately fail, because the company is too far behind competitors like IBM (IBM).
With regard to the first potential explanation, it is true that HP's record loss made big headlines last week. However, since investors knew it was coming, it's unlikely that the earnings announcement alone caused the stock to move lower. Furthermore, the losses reported were paper losses from the writedown of goodwill. They reflect the fact that HP's services and PC units have been performing poorly, something that investors have been well aware of over the past year or two. HP's management specifically stated, "We do not expect this goodwill impairment charge to result in any future cash expenditures or otherwise affect the ongoing business or financial performance of the Services segment." (See Cathie Lesjak's comments on the Q3 HP earnings call). Aside from the big writedown and the restructuring charge associated with HP's early retirement program, HP earned a profit of $1/share (slightly ahead of analyst estimates). The writedown has no effect on future earnings, and the early retirement program will actually boost future earnings. Thus, there was nothing in the Q3 earnings itself to justify dumping HP shares.
The second explanation (weakness in PCs and printers) has some more merit to it. HP saw its PC market share slip last quarter as it lost some ground to Lenovo. Meanwhile, sales in the printer division apparently dropped off near the end of last quarter. While inventory was down from the previous quarter, the slow selling rate meant that weeks of supply went up. (See Meg Whitman's answer to Toni Sacconaghi of Sanford Bernstein in the earnings transcript: link above.) None of this is really news; it's just the continuation of a slow downward trend in PCs and printers. Most of HP's competitors in these two businesses are in just as much (or more) trouble. On the PC front, Dell (DELL) dramatically slashed its full year earnings outlook last week. The company does not expect the late October release of Windows 8 to do much to revive PC sales. On the printer side, Lexmark (LXK) announced Tuesday morning that it plans to exit the inkjet business entirely, through a sale of its inkjet technology, if possible.
Relative weakness in the PC and printer industries simply reinforces what investors should already know; these are no longer growth areas. However, they can still be steady cash cows for years to come. The whole purpose of HP's decision to merge the two divisions is that it will cut costs, thus allowing HP to adopt more competitive pricing while maintaining margins. Furthermore, there may be some cross-selling efficiencies from the merger that would ultimately boost sales. On the PC side, another factor that investors are overlooking in the midst of their panic is that Microsoft (MSFT) ends support of Windows XP and Office 2003 on April 8, 2014. As of last month, Windows XP was still the most popular operating system in the world, with over 40% market share. Some users may simply opt to upgrade the OS on those machines. Some may be redundant, or will be replaced with tablets. Some users may keep their XP systems even after the end of support. But there will still be a vast number of new PCs sold over the next year and a half to replace systems currently running Windows XP. Due to the economic climate, many consumers and businesses may be delaying purchases today, but the end of XP support will ultimately force their hands. I therefore expect to see a pickup in PC sales beginning this fall and accelerating through 2013.
The third potential explanation for HP's post-earnings dive is concern that HP's turnaround is too little, too late. This is ultimately the biggest risk for HP, because it is impossible to know for sure whether the company's new focus on R&D for cloud, big data, analytics, etc. will result in successful products. However, HP still has a well known and valuable brand, and has a massive list of clients who like working with HP. These assets give it as good a chance as anybody to win in the corporate sector. As Meg Whitman has outlined, maintaining strong hardware businesses can be a competitive strength vis-a-vis IBM in the long run.
At its current bargain-basement valuation, I'm quite willing to roll the dice on a successful comeback by HP. As Shaw Wu of Sterne Agee noted last week, HP is still generating strong cash flow, which is money that will ultimately go into shareholders' pockets, in part through HP's solid dividend (currently yielding over 3%). The "old HP", as described by Jim Chanos, constantly threw money down the toilet through bad acquisitions, leading to the company's current troubles. However, as I wrote last month, I am satisfied with management's promise to lay off big acquisitions in the future. I have seen no reason to doubt Meg Whitman, thus far, and I think patient investors will be well rewarded by HP over the next 2-3 years.