The breathtaking decline in Hewlett-Packard's (HPQ) stock since April 2010 has surely been a gut-wrenching experience for shareholders. From its April 16, 2010 high of $54.75, the stock fell a bit more than 75% to its recent 52-week low of $13.68. During the same period, the S&P 500 (SPY) was up more than 16%. There has been plenty of debate about whether Hewlett-Packard's woes are temporary or not. Seeking Alpha contributors have also taken part in the debate. For two of the most recent articles, see "Hewlett-Packard: Don't Miss This Turnaround Story" and "Hewlett-Packard Tries To Spin Its Way Out of Trouble."
Based on the company's press release from October 3, 2012, "HP Details Turnaround Strategy, Provides 2013 Outlook," Hewlett-Packard is projecting 2013 earnings per share of $3.40 to $3.60 (non-GAAP) and $2.10 to $2.30 (GAAP). Using the midpoint of those ranges and the recent price per share of $14.40, the stock has a forward P/E of 4.11 or 6.55 depending on your preference of non-GAAP or GAAP earnings. A price-to-earnings ratio in the 4 to 7 range will certainly be viewed by many investors as representing extreme value. But it can be hard to decipher whether an extremely low valuation is simply a reflection of the earnings declines needing time to catch up with equity investors who have anticipated even more future earnings declines (creating a value trap).
When companies are in the midst of earnings declines and attempted turnaround strategies, it becomes very hard to know at what price the bottom in the stock will occur. Nokia (NOK) investors learned this lesson well as the stock continued lower for quite some time after it announced strategic initiatives for turning the company around. But with respect to Nokia, there was a different way to assess its survivability or the potential success of its turnaround strategy. Rather than simply watching the stock or listening to people debate whether the company would survive, it paid (and still does pay) to watch the action in the company's bonds. I think Hewlett-Packard investors would be well-advised to do the same.
Bond investors (especially institutional ones) are trained to carefully consider the prospect for a return of their money, not just a return on their money. Equity investors, on the other hand, usually seem much more focused on the potential return on their investments. The more intense focus on a return on their money raises the risk that equity investors fall victim to value traps. But during the same periods of time that equity investors are most at risk of succumbing to value traps, bond investors are usually focusing on whether the investment makes sense from a potential default perspective. It is for this reason that the price action in a company's bonds can be a valuable thing for equity investors to watch when a stock they own is in freefall.
During the freefall in Nokia's stock, the company's bonds were also plummeting. Bond traders were well ahead of the ratings agencies in terms of anticipating credit downgrades, and the bonds eventually settled in the low-to-mid 70 cents on the dollar range with yields-to-maturity near 10%. Important for investors to watch was the intensity of the bond sell-off and whether the bonds bounced along with the stock. In Nokia's case, at the depths of the sell-off in the stock, equity and options traders were implying an immediate risk to Nokia's survival that the bonds were simply not showing. The bonds were indicating severe stresses, but some of the action in the put options and the intense selling in the stock showed a level of concern that seemed unjustified in the eyes of bond traders. Moody's has a loss given default (LGD) projection of 59% on Nokia's senior unsecured bonds. During the time of the steep equity sell-off, the LGD was 63%. If Nokia was going under any time soon, the bonds would have been trading closer to 40 cents on the dollar.
Before taking a look at Hewlett-Packard's bonds, I'd like to mention another company that also saw its stock suffer horrific losses in 2011 and 2012. Peabody Energy (BTU) is a company from the coal industry that, along with the rest of the industry, has gone through a difficult period over the past year-and-a-half. From its April 4, 2011 high to its July 26, 2012 low, Peabody's stock declined nearly 75%. While that type of decline was not unusual for a coal stock, the strength of the company's bonds during that time was highly unusual.
I consider myself fortunate to have been able to purchase its 9/15/2020 maturing 6.50% coupon note (CUSIP: 704549AH7) during one of the rare days that it traded under par. While the rest of the coal industry saw its bonds look more like Nokia's bonds in terms of price and/or yield, Peabody's bonds showed that fixed income traders were less concerned about the company's survival. It showed that the rough patch for the stock was more of an earnings-and-valuation story rather than a survival story. Of course, that can change in the future, and fixed income investors will need to be on guard for any regulatory changes or changes in worldwide coal demand that could permanently alter the situation for Peabody.
Turning to Hewlett-Packard, its senior unsecured debt is rated A3/BBB+ by Moody's and S&P respectively. The company has a significant amount of debt available for purchase, including the following senior unsecured bonds:
Based on the current prices and yields at which Hewlett-Packard's corporate bonds are trading, the bond market is clearly stating that the company is at least a couple notches overrated. But the bond market is also currently not indicating that the company's future is at risk. The highest yielding bond, maturing 9/15/2041, is currently being offered for 97.75 cents on the dollar with a yield-to-maturity of 6.167%. With a yield of approximately 331 basis points over a comparable Treasury, a two-notch downgrade from Moody's would be the absolute minimum I would expect in order to bring the company more in-line with the market's expectations (and I am being generous with that).
There are plenty of companies in the Baa1 to Baa3 ratings range (lower ratings than HPQ) with yields much lower than Hewlett-Packard's. This is true across various industries, which tells me that Hewlett-Packard's rating is way off. To provide a couple of examples, Cigna's (CI) Baa2/BBB rated 3/15/2041 maturing note (CUSIP: 125509BQ1) has a 4.386% yield-to-call, and Time Warner's (TWX) Baa2/BBB rated 10/15/2041 note (CUSIP: 887317AM7) has a 4.394% yield-to-maturity. Two other examples include Hess' (HES) Baa2/BBB rated 2/15/2041 maturing note (CUSIP: 42809HAD9) yielding 4.35% to maturity and Kroger's (KR) Baa2/BBB rated 4/15/2042 maturing note (CUSIP: 501044CR0) with a yield-to-call of 4.29%.
What do Cigna, Time Warner, Hess, and Kroger have in common? From a business perspective, they don't have very much in common. But from a credit rating and yield perspective, each of those companies' long-term bonds have the same credit ratings and very similar yields. And in each case, the rating is one to two notches lower than Hewlett-Packard's (depending on the rating agency), and the yield is more than 175 basis points lower. I will reiterate that a two-notch downgrade from Moody's, while it may seem harsh to shareholders, really wouldn't even bring it in-line with the bond market's expectations.
Just because Hewlett-Packard is way overrated from a credit perspective does not mean you can't use the bonds to help you determine whether the stock is near a bottom. If the stock bounces hard from today's levels, use the bonds to help confirm the move. Take a look at whether the bonds are stabilizing in price, and perhaps more importantly, whether they are experiencing a narrowing in their spreads to Treasuries. That would be supportive of an upward move in the stock.
Also keep an eye on how the bonds react to a potential future credit downgrade. Moody's currently has Hewlett-Packard under review for downgrade. If and when the downgrade comes, should the bonds shake it off (not just the downgrade itself, but also the language used in the press release), that would be a signal that the bonds have priced in all company-specific news currently anticipated by traders. Last, if you are trying to pick a bottom in the stock, it may be useful to track the spread-to-Treasuries at which some of the longer-dated Hewlett-Packard bonds are trading. As long as the spread keeps widening, it signals downside risks to the stock.
Additional disclosure: I am long Peabody's CUSIP 704549AH7.