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Hewlett-Packard Co.'s (HPQ) Chief Executive Officer Meg Whitman believes that by making changes to her struggling computer company, she can boost revenues and its industry ranking. The company's PC sales have dropped, while its top competitors' sales have increased. Hewlett-Packard is hoping that recent changes will give it a fresh start. Some analysts believe that the worst is over for the company and it can only go up from here.

Investors, however, should not be so exuberant. Instead, they should be skeptical of a turnaround that has yet to materialize. Investors should look for a discount on a firm that is headed in new directions and whose existing sales are in decline.

Changing Plans

Whitman is revising Hewlett-Packard's existing strategy, instead of throwing it out. The CEO believes that the best way to improve the company's status is to create new products that are tailored to its corporate clients. She is changing her company through product improvements and tactical launches.

Whitman's moving into the business-focused tablet market is one small, tactical move to dominate a small market. Whitman is avoiding direct competition with Apple's (AAPL) iPad in the consumer space. This is probably wise. Instead, Hewlett-Packard is looking to focus on business applications in order to side-step Apple.

Whitman is also cutting jobs to decrease expenses and salvage earnings. The company predicts that job cuts would save $3.5 billion a year.

These small tactical changes may not be enough. An analyst at Mizuho Securities, Abhey Lamba, said, "They need to restructure the firm…All in, 80 percent of their business could decline."

The firm is too big and unwieldy. Consider Whitman's new emphasis on cloud computing. She would like to offer customers business solutions that combine networking, data storage and server computers in the same device. Ideally, customers would buy a license and receive a box they could plug in to launch cloud computing. Whitman is championing this new focus on big businesses customers to help increase revenue. It's not a bad idea.

The problem is that Hewlett-Packard is a complex combination of many different business units and acquisitions. They don't always work together smoothly, but instead can act as isolated silos with independent interests. One complaint from existing cloud computing customers was that the software was under the control of different business units inside Hewlett-Packard.

The company is now focusing on revising its systems in order to make them more convenient for its clients. Whitman even created a new internal division to help integrate different cloud-related products. This sort of overlay of more administrators is a reactive approach to the core malady of business silos. Whitman needs to accept that the patient needs surgery, not more layers of bandages.

Hewlett-Packard no longer wants to be considered a provider of low-cost servers. Instead, management believes that the cost of the servers should increase with new revisions. Some say that the prices could reach as high as a few hundred thousand dollars. Ultimately, customers are expected to pay the price of stapling together disparate products.

Valuation

Meg clearly has her work cut out for her: she is trying to revive a company that has incurred losses for consecutive quarters. As stock investors, we must make sure that the stock price reflects the difficulties that lie ahead. Hewlett-Packard should trade at a deep discount relative to its competitors and to the stock market as a whole. If Hewlett-Packard is pricey, it's clear that investors should stay away.

Ticker

Company

P/E

P/S

P/B

P/FCF

AAPL

Apple

15.68

4.2

5.6

15

HPQ

Hewlett-Packard

NA

0.27

1.06

9.07

IBM

International Business Machines

15.09

2.23

11.58

19.58

MSFT

Microsoft

14.88

3.38

3.76

10.88

Hewlett-Packard is trading at dramatically lower price-to-sales and price-to-book multiples than Microsoft, IBM, or Apple.

However, the question remains: value investment or value trap?

Checking for Value Traps

Jim Chanos analyzed Hewlett-Packard as a short candidate. He noted that Hewlett-Packard, like many computer companies, has been damaged by the Apple-led movement from personal computers to mobile devices. Chanos is concerned that Hewlett-Packard will go on a spending spree to acquire other companies in desperate attempts to acquire lost market share. Value investors can use this pattern of behavior to diagnose value traps.

There is an accounting issue that arises from acquisitions. Research and development spending is typically expensed immediately according to US GAAP (Generally Accepted Accounting Principles), but is largely capitalized in an acquisition. This salient point would allow firms that engage in acquisitions to keep earnings free from R&D expense.

Companies that internally develop their brands and technology would be at a disadvantage vis-à-vis accounting rules, since their earnings would be lower after expensing research and development costs. (Apple, for example, does not have an explicit acquisitions cash flow item, while all the other firms on our list today do.) Their assets would also fail to recognize uncapitalized intellectual property. Worse yet, cash payments for acquisitions are not usually deducted when computing free cash flows.

Value investors who don't pay attention to this would fall prey to inflated valuation multiples for serial acquirers. Companies that buy R&D instead of doing it in-house would have lower price-to-earnings ratios, lower price-to-book ratios, and lower price-to-free cash flow ratios.

Therefore, investors should pay careful attention to acquisition expenditures and free cash flow adjusted for acquisition payments. Net acquisition cash flows were subtracted from free cash flow below:

Free Cash Flow

2007

2008

2009

2010

2011

IBM

11459

14641

17326

15364

15738

Hewlett-Packard

6575

11601

9684

7789

8100

Microsoft

15532

18430

15918

22096

24639

Apple

4484

8397

8946

16474

30077

Acquisition Cash Flow, Net

2007

2008

2009

2010

2011

IBM

-699

-6242

-793

-5867

-1797

Hewlett-Packard

-6793

-11248

-391

-7977

-10391

Microsoft

-1150

-8053

-868

-245

-71

Apple

Adjusted Free Cash Flow

2007

2008

2009

2010

2011

IBM

10760

8399

16533

9497

13941

Hewlett-Packard

-218

353

9293

-188

-2291

Microsoft

14382

10377

15050

21851

24568

Apple

4484

8397

8946

16474

30077

These numbers for adjusted free cash flow after acquisitions highlight how IBM, Microsoft, and Apple are cash-generating juggernauts. Hewlett-Packard has a history of sporadic cash inflows and outflows after taking into account acquisitions.

Conclusion

Hewlett-Packard is cheap, but it is cheap for a reason. To properly heed Mr. Chanos' warning, investors must have extra assurance that Hewlett-Packard will not binge on desperate acquisitions. Investors should steer clear of HPQ shares until Meg Whitman's turnaround becomes a reality without relying heavily on mergers and acquisitions. Instead, investors should consider Microsoft that trades at attractive at current valuations and is currently profitable. It has a history of healthier cash outflows after acquisitions than Hewlett-Packard.

Please read the article disclaimer.

Source: Hewlett-Packard: Wait For The Turnaround