After Hewlett-Packard (HPQ) and top PC competitor Dell (DELL) provided lackluster guidance during Q2 earnings season last month, HP's stock went into a tailspin, dropping from $20 to below $17 in just over a week. However, the shares have since bounced more than 7% off their lows to a Tuesday close of $17.95. It is too early to call a definite bottom for the stock, but I think that HP shares have stabilized at this point and could beat the market between now and year end if the company displays decent execution.
Last month, I suggested that HP's dip could be a buying opportunity. However, with HP having made solid gains this week while the market has been roughly flat, investors who were previously worried about deteriorating technicals may be more comfortable jumping in. The key catalyst to HP's gains on Monday and Tuesday was a statement in the company's 10-Q (p. 17) that HP would be reducing headcount by 29,000 as part of its global restructuring. This is somewhat higher than the company's initial estimate of 27,000 job cuts as part of the restructuring. The extra 2000 layoffs could save HP roughly $200 million annually by the end of the reorganization in 2014.
I think that the increase in expected savings shows that HP's management team is very focused on trimming the organization's fat. We will almost certainly learn that the additional cuts are in the PPS (printing and personal systems) and services divisions. This reflects management's commitment to putting HP's capital into the projects that will generate the highest returns. Thus, while a UBS analyst suggested last month that HP's PC business might be "smart apart" from the rest of HP, the PC business actually provides a good return on invested capital. The recent alignment of the PC and printer divisions is expected to generate efficiencies for HP, which will further boost the company's returns in the PC business. While PC revenue has dropped over the past year, I expect this to stabilize and improve over the next year as we approach Microsoft's (MSFT) end of Windows XP support in early 2014.
By contrast, the services business consists of a lot of low margin, labor intensive outsourcing activity. Meg Whitman has decisively concluded that this business requires too much investment for minimal rewards. Investors seem to be worried about HP's stagnant top line, but this is in large part the result of pursuing margins over revenue. HP's "IT Outsourcing" revenue was down 6% in Q3 (accounting for almost the entire drop in the services division), as HP deliberately passed on low margin contracts. By cutting headcount, HP will be able to more than offset this lost revenue with lower costs.
It's natural for investors to link declining revenue to declining competitiveness, but in the services business, this is not what's happening. In this sense HP's transformation is similar to what happened at IBM (IBM) in the previous decade. IBM's projected 2012 revenue of $105 billion is the result of a 1% CAGR (compound annual growth rate) over the past 8 years. However, profits and the share price have exploded over that time period, as IBM traded unprofitable revenue for high-margin revenue. As HP's recent investments in R&D for products related to cloud computing and big data analytics pay off, I expect a similar trend. Revenue growth should resume, albeit at a modest rate, and the margin profile will be much higher.
With the iPhone 5 rollout on Wednesday, all eyes in the tech world are on Apple (AAPL). By contrast, HP's inability to create a successful smartphone or tablet makes the company seem very unattractive to many investors. However, the consumer product space is not HP's core business. While having a top selling tablet would be nice for HP, it is not necessary for the company to be successful. Even much more valuable companies like Google (GOOG) and Amazon (AMZN) are unable (or unwilling) to produce a tablet at a profit. Investors who look beyond the more visible PC business will see good progress in the areas where HP really makes its money. HP's bright future in the enterprise space is the reason why I think HP is finally ready to reward shareholders.
Disclosure: I am long HPQ.
Additional disclosure: I am also short AMZN.