Recently I have been analyzing several well known large cap tech companies. I have written about many of these companies such as Microsoft (MSFT), Dell (DELL), and Cisco Systems (CSCO) which were darlings of the internet bubble in the early 2000s but have been largely out of favor in recent years. In this article I will evaluate another large tech company which has fallen out of favor - Hewlett Packard Company (HPQ).
I believe that HP is a speculative buy at this time and I don't recommend it for investment.
For those who might not know the company, HP is a leading global provider of various technologies and software. The company employs nearly 350,000 people around the world, and offers a wide range of products and services. HP divides its business into 4 main focus areas:
- Personal computing and other access devices
- Customer services, including infrastructure, business process outsourcing, technology support, integration, and a few others.
- Imaging and printing related products and services
- Enterprise IT infrastructure, including storage, servers, networking, IT management solutions, and security/risk management solutions.
(Source: Company 10-K)
The company has a market cap of $28.45B, and had revenues the past year of $122.5B.
The past few years the HP core business of PC sales has really been under threat. Global PC sales have always been cyclical, but recently they have started to decline more significantly. In Q3 of 2012, Gartner states PC sales have declined 8%. Part of this is due to the upcoming release of Windows 8, and consumers and corporations put off buying PCs until the new operating system comes out. There has also been softness in the PC market recently which some have attributed to increases in smartphone and tablet sales. As Apple (AAPL) has by far the largest market share of tablets this could be having some negative impacts on HP's sales.
I think the biggest story to note here is that the company has had lots of high profile management issues over the past few years which has put a damper on its prospects. The current CEO, Meg Whitman, was hired in September 2011 and became the third CEO in just over 1 year at the company. This has caused a lot of changes in strategic direction and many issues with the integration of EDS, a large IT services firm which was purchased in 2008. Similar to a lot of other large cap tech firms, HP has been trying to move more into higher margin IT services and be less dependent on PC and printer sales, which are lower margin and have relatively mature slow growth markets. However the services division has not been performing well, and this year it expects to have a 32 cents/share negative impact on HP's earnings.
Overall the business prospects at least in the short term are not very bright for HP.
HP - Friendly To Shareholders?
With any potential investment, I always assess how friendly I believe the company management is towards shareholders. Overall I believe this is one of the more attractive points of HP. Here are several summary points:
- HP has an attractive dividend yield of about 3.6%.
- The company repurchase shares of stock consistently. One thing to note though is that the company has purchased significantly less in 2012 than it did in 2011. According to the latest quarterly report, As of July 31st 2012 the company had repurchased 59 million shares, where as in the same period one year earlier it was 245 million shares. With 1.97B shares outstanding, that means this year they have repurchased less than 3%.
- Looking at the 10 year summary, we can see that the company has lowered the outstanding share count from 3.04B in 2002 to 1.97B in 2012 - a reduction of 35%. This is quite impressive.
Does HP Have a Competitive Moat?
Clearly HP is one of the first names that comes to mind when people think of PC makers. The company has for some time held a strong market share in the consumer as well as enterprise PC market.
However their market share has started to decrease in the past few years.
Looking at this table from Wikipedia, we can see that their market share has dropped from as high as 19.3% a few years ago down to 17.2% in 2011:
|Global PC Market Share by Units, Percent. 2006-2011.|
In 2012, it appears HP's market share is deteriorating even further. As mentioned in this Financial Times article, Gartner and IDC have released recent figures which put Lenovo and HP both around 15.9%.
As I've mentioned before in a previous article on Dell, one of the biggest issues I have with the PC and server hardware business in general is that the competitive moat is not very strong. Every few years company's or individuals will buy new hardware, and the most important deciding factor is generally price. This is very different than software, which has a much stronger moat associated with it because of the human factor. Changing software packages could have a lot of complexities for things such as re-training users and integration with other systems.
The company's software and services make up only 31% of revenue as of 2011. Consumer PCs, Enterprise hardware and networking, and printers make up the rest.
In addition to this, the enterprise services division has been poorly managed recently. The division has had 4 leaders in almost as many years, and the EDS business recently took a large $8b writedown. This is hardly the kind of showing you want from a business which should help to offset declining PC sales and margins, and also which should help to improve the competitive moat of the business.
HP Has Increasing Debt Levels
The following table summarizes key balance sheet figures from HP:
|Total Cash (mrq):||9.53B|
|Total Cash Per Share (mrq):||4.85|
|Total Debt (mrq):||29.78B|
|Total Debt/Equity (mrq):||93.04|
|Current Ratio (mrq):||1.12|
|Book Value Per Share (mrq):||16.07|
(Source: Yahoo! Finance)
The debt equity ratio for HP is at 0.93, which is quite high. What I don't like is that the debt has been steadily increasing every year. Long term debt was $5B in 2007, and had risen to $22.5B in 2011. Only 3 years ago the debt to equity was only 0.39.
Although the company has worked to lower costs and streamline operations, the fact remains that high current debt levels leave the company more at risk if the turnaround plan is not working as expected.
Recently HP has lost money with a negative net income. The company has stated recently they expect to achieve $3.40 - $3.60 per share earnings in the upcoming fiscal year. Although this is still unproven, lets for a moment give them the benefit of the doubt and assume they can achieve $3.40. The 26 analysts covering the stock also have a 5 year growth rate of 1.75%.
To be more conservative I will assume they can only achieve 1% growth over 10 years. Using these inputs, I have conducted a simple DCF:
- Current EPS: 3.40
- Earnings Growth Rate over 10 years: 1%
- Growth rate after 10 years: 0%
- Discount Rate: 6%
This gives me an intrinsic value of $61.27/share. Normally, I then would indicate how confident I am in these earnings materializing. In this case, I would say I am no more than 50% confident - there is just too much uncertainty in the company at the moment. Interestingly with HP, even if I was to half the intrinsic value to take into account my uncertainty on the company's prospects, the resulting intrinsic value ($30.63/share) is still more than double the current market price of $14.48. Indeed, with a forward P/E of only 4 and an EV/EBITDA of 3.45, the company is definitely priced very low.
There is no question that HP is very cheaply priced. Any positive earnings (>0%) in the coming few years and the company should theoretically be worth at least double the current market price, according to standard DCF methods as I've shown above. So some could argue that the company is "too cheap to ignore". However my fundamental problem with the company is that its core PC and hardware business is clearly under threat, margins are weak, and mismanagement the past few years has meant that their higher margin services business is not growing to compensate. The company under Meg Whitman has recently announced a 5 year turnaround plan, but it is completely speculative in my opinion as to whether it is successful. This brings into play too much downside risk for my taste.
I therefore do not recommend buying HP at this time. Despite shareholder-friendly actions and a seemingly cheap valuation, there are much better companies out there to invest in. I recommend that value investors looking in the technology sector should seek out companies with stronger competitive moats, better balance sheets, and better long term prospects. They are actually not that hard to find - a couple prominent ones I highlighted recently in other articles are Microsoft and Cisco Systems .
In my mind the decision is clear - why gamble with HP when there are other companies with less risk that can offer better chances of market beating returns?