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In this article I look at the fundamental value in Hewlett Packard (NYSE:HPQ); with the beating the stock has taken one naturally wonders if it's not become the best value play out there.

I also include Dell (NASDAQ:DELL) in my analysis.

Dell has become a dividend stock and appears very similar to HP in many respects:

• Both HP and Dell are switching business models and now it looks like they are following IBM (NYSE:IBM)
• Both suffered setbacks in their core business line, i.e. the PC market,
• Their stocks trade at historical lows
• Their EV/EBITDA & PEs are very low relative to the sector and to the market at large
• Even though HP and Dell belong to the tech segment, rather known for harboring growth stocks, both actually pay dividends (HP since 1992, Dell since 2012)

Business, operations and sales comps

HP gets $122bb in sales, which is twice the amount for Dell ($60bb). Their market values hold the same ratio, with $34bb for HP and $18bb for Dell. The table below shows the historical revenues and cash flows on HP:

(click to enlarge)HP

Free cash flow has been declining, but still remains high at more than $8bb. The last quarterly number was $2.1bb, which would amount to $8.4bb annualized.

Let us compare these numbers with a benchmark in the sector, IBM. IBM's sales are not as large as HP's, but their free cash flow is twice as high:

(click to enlarge)

However, IBM's market value is $237bb, which is almost 7 times as large as HP's! IBM's valuations capitalize free cash flows roughly 3.5 times more than HP.

Looking at operations and the distribution of business lines, HP appears to be ahead of Dell in terms of switching towards services / corporate clients:

Management: HP vs. Dell

Looking at HP's management, first it is clear that they do not stand the comparison with Dell. HP has seen many changes in the executive suite, and many significant changes in strategy. For example, the spin-off of the PC business was planned in 2011, but later cancelled in 2012.

In addition, HP carried out several expensive acquisitions. In 2011, HP bought software editor "Autonomy" for $10bb, almost 24 times EBITDA. Last quarter , Autonomy's numbers were disappointing, which led to the departure of its CEO and management. Once again this venture acquisition will affect HP's asset value.

Over the last three years HP massively bought back its stock, which (in spite of being an efficient way of distributing cash flow to shareholders) reduced its balance sheet's soundness. In the meantime, the stock lost half of its value.

Dell, in contrast, is quite another story. Michael Dell owns 11% of the company and has been the CEO for the past five years. The acquisitions made by Dell have been smaller, cheaper and have not affected the strength of the balance sheet, relative to HP. Dell's cash is still twice as large as its liabilities.

On the positive side for HP, Meg Whitman (ex-eBay) who has been CEO since the end of 2011, has set clear priorities.

These are: organic growth, a re-org of the group (HP is well known for its lay-offs, being so huge with 350 000 employees), improving the balance sheet and reducing liabilities.

Now we turn to the proper valuation of HP. I use a tool called XlsValuation, which I find quite practical.

1) Historical Valuation Multiples

(click to enlarge)

The original data is from Morningstar.

Price to Book and PE for HP are more volatiles than Dell's, probably because of the increase in liabilities, and the depreciation of assets, which artificially affects profits and stockholder equity.

2) Peer Valuation Multiples

My comps are based on:

• Dell (the closest to HP)
• IBM (what I think HP is converging to in the long run)
• Lenovo (computer maker)
• Lexmark (making printers)

(click to enlarge)

3) Normalized data:

Profits per share: I'm using the estimated non-GAAP profits (not including assets impairment) given by Meg Whitman during the October 2012 presentation.

Revenues: last quarter revenues were lower by 5% relative to the prior year; so assuming that is the trend for the year, I apply a haircut of 5% to last year's revenues in order to project them going forward.

Operational margin: using the non-GAAP operational margin data published last quarter.

Cash and interest-bearing debt: Morningstar last quarter's values.

(click to enlarge)

4) Discount rate

With an estimated PE of 3.6, the overall cost of equity in the event of capital increase, could be estimated to 1 / 3.6 = 27%.

The historical 5-year beta is 0.93. Taking in addition the historical risk free rate at about 4% and the historical equity risk premium at 5.5% we would get an average cost of equity at 9.1%, which is not a reasonable level.

Now let us use Damodaran's bottom-up beta instead. HP has many different divisions, so we will use different betas on the different business lines. With this approach we have to use unlevered betas, each one representative of the business in each sector.

HP debt-free beta: 29%*1.14 (IT services) + 3%*1.18 (Computer software) + 65%*1.33 (Computers/peripherals) + 3%*0,50 (Financial Services) = 1.25.

To this unlevered beta we need to add the effect of leverage naturally. Then we obtain the all-in bottom-up beta.

Beta (liabilities included) HP: 2.25

(click to enlarge)

(click to enlarge)

5) Growth

In the case of Dell, we considered a negative growth rate of 5% per year over five years. HP, being more diversified than Dell, should be less affected by the decline in the PC business.

However HP is having a tough time in the service sector. Meg Whitman mentioned in her recent communications that she was planning a three year restructuring.

We are conservative, and will assume a negative growth of the operational revenues of 10% over the next three years:

(click to enlarge)

6) HP Valuation

We are weighing our three approaches (historical multiples, peer multiples, discounted cash flows) at 20% / 40% / 40%:

(click to enlarge)

Peer multiples and discounted cash flows give a valuation between $33 and $35. The final estimate is around $33, with an implicit PER of 9.5 and an EV/Ebitda of 5.6. HP trades at $14.3, half our estimate!

7) Super investors

According to Dataroma, there are 10 "Super investors" buying HP, and 14 for Dell. Dell had Lou Simpson; HP has Seth Klarman:

(click to enlarge)

8) Conclusions:

HP seems to offer a deeper discount than Dell (Dell trades $9, my estimate: $15-16). HP appears to be less risky than Dell due to its leader position and the greater diversification in its businesses. From a financing standpoint, HP's balance sheet is less attractive than Dells. However with a Free Cash Flow at 8bb, HP is not likely to have financing problems.

Michael Dell protects his investment and his stockholders' investments, which shows through tighter governance, and less strategic mistakes. HP on the other hand is on an improving track now with Meg Whitman.

All things considered, I will buy both HP and Dell!

Disclosure: I am long HPQ, DELL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.