Prior to Hewlett-Packard's (HPQ) analyst day last month, I wrote that due to low expectations amongst analysts and the investment community, investors should consider buying HP before the meeting. At the time, I thought that HP would be able to maintain EPS above $4 in FY13 despite the weak global economy, secular declines in some of HP's businesses, and planned increases in HP's R&D spending. As it turned out, this was a bad recommendation; HP has dropped from around $17 before the analyst day to a recent trading range near $14.
While cost cuts are coming through as quickly as I expected, revenue is dropping faster than expected. At the analyst day, HP's leadership team laid out a turnaround plan for each business unit, but in the near term, the company is expecting revenue declines in every major business except software. (The full Seeking Alpha transcript of the analyst meeting is here.) In HP's troubled enterprise services division, management guided to an 11-13% revenue decline and a virtual evaporation of profit in FY13, as margins fall to 0%-3%. The overall result was that HP is forecasting non-GAAP EPS of $3.40-$3.60 for FY13. This figure may be somewhat conservative, as HP raised its FY12 guidance modestly during the year, but EPS will still fall well short of $4. Additionally, whereas HP used share repurchases to boost EPS in recent years, the management team reaffirmed the priority of debt reduction in capital allocation decisions.
Even analysts who were previously optimistic about HP's turnaround prospects abandoned their defense of the company. For example, Shaw Wu of Sterne Agee (who had previously held a $31 price target) cut his rating to neutral and his price target to $15. At the time, Wu wrote, "We are at a loss in identifying positive catalysts within a reasonable investment horizon and fear for further downside surprises as we believe the headwinds the company faces are likely structural and secular in nature."
Obviously, if HP is indeed beset by "structural issues" that it cannot overcome, then the stock should be avoided. Apple (AAPL) has clearly won the mind-share game with the iPhone and iPad, cannibalizing PC sales, while also impacting HP's industry-leading printing business. HP's long-running feud with Oracle (ORCL) over software development for servers running Intel's (INTC) Itanium chips has more or less destroyed sales of HP's Business Critical Systems. Meanwhile, HP's services business is heavily skewed towards low-margin offerings, and as a result, profitability has declined severely in that business.
However, in the analyst day presentations, HP detailed numerous initiatives designed to prevent further revenue declines and boost future earnings. In all likelihood, some of these programs will not meet their objectives. However, given the level of detail that HP provided about its turnaround plans for each division, I am confident that the company as a whole will rebound towards the middle of the decade. HP discussed a number of promising programs (all discussed in the transcript and press release cited above).
In the printing and personal systems business, HP is looking to capitalize on the mobile revolution with a business-oriented tablet running Microsoft's (MSFT) new Windows 8 OS. HP's first move into the tablet arena (the ill-fated TouchPad running WebOS) was a disaster because the company tried to compete directly with Apple in the consumer arena. The new tablet is likely to perform much better and win big orders from business customers who need access to legacy Windows applications. Meanwhile, HP's Ink Advantage program is fixing the broken "razor/razor blades" model in printing. Instead of selling hardware at a loss and then trying to sell ink at a big mark-up (which provides a big opening for third-party ink suppliers), HP saw success in test markets by increasing hardware prices while lowering the cost of ink refills. In the servers business, revenue declines in Business Critical Systems due to the Oracle dispute will taper off as the Itanium servers are gradually phased out. Meanwhile, HP is taking the lead in designing ultra low-power servers running ARM (ARMH) based processors (as well as Intel's low-power Atom processors) through Project Moonshot. In the services business, HP is finally integrating its recent database and analytics acquisitions (Autonomy and Vertica) in order to provide integrated solutions to customers. This should drive growth in higher-margin segments going forward.
Thus, while HP faces execution risks, there are numerous signs that the company is creating innovative products again and can reassert leadership in the enterprise segment (but not on the consumer side). I think that HP's low price targets and poor analyst ratings are largely the result of the long-term nature of its turnaround. In the comment quoted above, Shaw Wu suggested that there were no obvious catalysts "within a reasonable investment horizon." Richard Kugele of Needham & Co. made a similar comment, stating that while CEO Meg Whitman has laid out a sensible turnaround plan, "Nevertheless, we cannot expect investors to hang on for a possible turnaround four to five years from now, nor do we recommend that they do so."
For long-term investors, a genuine turnaround that does not fully take hold for 4-5 years could still provide market-beating returns. The unwillingness of most investors to wait that long creates opportunities for those who are more patient. Moreover, clear signs of progress in each business should be visible by the end of FY14, which is just two years away. If HP's turnaround is successful, the company's FY17 results are likely to see revenue around $120 billion (similar to FY12 revenue) but margins higher at around 10-11%, leading to EPS of $5 or more depending on tax rates. At a conservative 9X multiple, that supports a 2017 price target of $45 for HP, more than triple the current price. In the meantime, long-term investors can enjoy a roughly 3.7% dividend yield. Therefore, while investors with a shorter time horizon should possibly avoid HP, I still rate the stock as a buy for long-term investors.