In a recent article on value stock and value traps, I highlighted 5 characteristics of value traps from a presentation by legendary short seller Jim Chanos.
- Cyclical and/or overly dependent on one product
- Hindsight drives expectations
- Marquis management and/or famous investor(s)
- Appears cheap using management's metric
- Accounting issues
A value trap doesn't have to have all of those five points, but several do show up most of the time and my opinion is that Hewlett Packard (HPQ) fits the description.
Before you go on, here is a very detailed 10 page fundamental stock analysis report you can follow as a companion to this article.
The "Value" Story of Hewlett Packard
- 3.86% yield
- P/B of 0.85
- P/FCF of 5.75
- EV/EBIT of 8.8
FCF has been positive for over 10 years and now that Meg Whitman is CEO, she has laid out a long term plan to right the HP ship.
The Value "Trap" Story of Hewlett Packard
Although the point about positive FCF comes up regularly, it is in decline due to the increase in capital expenditures as well as the increasing number of acquisitions.
In fiscal 2011, $10.4b was spend on acquisitions and $8b in 2010. This has not translated to either earnings or FCF.
As much as the above numbers show how cheap Hewlett Packard has become, I have learned the hard way that cheap can get cheaper.
One of the easiest points to check is declining gross margins. Although it has stayed around the 24% range for much of the past 5 years, it will likely drop to the 22% range at the end of this fiscal year.
The once strong balance sheet is taking on new debt and is now at its highest levels at 20.5%.
The Piotroski score, which is a grading system based on positive accounting trends, only scores a 5. Not bad, but not great.
click to enlarge images
Going through some quality checks from my Old School Value stock analysis spreadsheets, the business scores a 7/20, financial score is a 9/20 and earnings predictability gets a 8/20.
All three sections score below average as you can see below.
Hindsight Drives Expectations
I've been a victim of hindsight and it looks like Hewlett Packard is offering exactly that.
Compared to its historical performance, the current valuations are very cheap. The question is whether Hewlett Packard can return to its "norm".
With mobile devices eating up sales and gaining market share, and its printer, IT services and server businesses seeing declines, there is a long way to go before it can match what it did until 2010.
If I were to perform some valuations with expected numbers and target growth rates, I can easily get $40 as a target price.
But when I make adjustments to reflect some headwinds, my optimistic estimate is $16.
Keep in mind that this scenario is where Hewlett Packard will continue to grow cash flow. There is a good chance that growth could be negative for a few years too.
But even if the target price is $16, the margin of safety is too narrow to offset the business uncertainty. A much bigger margin of safety is required.
Marquis Management and/or Famous Investor(s)
"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact". - Warren Buffett
Meg Whitman may now be the CEO, but even rockstar CEO's cannot right every ship.
Placing too much trust and hope into management is a sure way of losing money. I've been there.
The financial numbers will always tell the final story and has to match with what is being said by management otherwise it is a big red flag.
Other famous investors such as Seth Klarman and Michael Price bought Hewlett Packard and are down considerably and there are any more gurus buying this company.
They probably know more than I do, but I'd rather be safe than sorry on this one.