How Hewlett-Packard's Revenue Declines Impact Its Intrinsic Value

| About: HP Inc. (HPQ)
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Hewlett-Packard has a revenue problem.

The company can't cut costs forever, and Wall Street will eventually sour on shares.

Hewlett-Packard posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals.

Hewlett-Packard (NYSE:HPQ) has a problem: revenue growth. The company can only shrink its way to more profits via cost-cutting for a finite period of time. The company's fiscal second-quarter results released Thursday were more of the same: more revenue declines and more job cuts. Hewlett-Packard noted that it will cut as much as 16,000 more jobs than it originally planned. The reality of the situation is that any management team can make cuts. Hewlett-Packard simply needs a better revenue growth strategy, and this should involve making a deal where cost-cutting synergies can be folded into another company that can capitalize on Hewlett Packard's resources to then drive revenue higher as a combined entity. Hewlett-Packard should be talking mergers and acquisitions, as low-quality earnings growth via cost-cutting will inevitably start to lose favor with Wall Street. With that said, let's calculate Hewlett-Packard's cash flow-derived intrinsic value estimate, and run shares through the Valuentum style of investing.

For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolio. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Hewlett-Packard posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. A 6 is better than average, but it still falls below a 9 or 10 (or the equivalent of a "we'd consider buying" rating). Let's dig into the components behind Hewlett-Packard's Valuentum Buying Index score, including its cash flow-derived intrinsic value calculation.

Hewlett-Packard's Investment Considerations

Investment Highlights

  • Hewlett-Packard's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders, with relatively stable operating results for the past few years, a combination we view very positively. We think it is very important for us to state up-front that Hewlett-Packard is a good company. Though we do have some qualms with its lack of revenue growth and its decision to cut costs for profit expansion, on an ROIC basis, the company is generating economic value.
  • Hewlett-Packard is reinventing itself to become a leaner, more effective company. The transition won't be fully completed anytime soon, and the firm has yet to find a solution for its dwindling top line. Printing (20% of sales) continues to decline, despite CEO Meg Whitman's efforts to reignite innovation.
  • Hewlett-Packard has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 6.4% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 45.3%.
  • We aren't excited about the near-term picture at HP. Though cash flow remains robust, it will be sensitive to both secular declines and macroeconomic headwinds. Turnarounds are notoriously underestimated in both difficulty and duration. Revenue is still expected to decline in coming years, but the firm is looking to 3D printing for growth. We're not sure why Hewlett-Packard won't scoop up 3D Systems (NYSE:DDD). It'd be acquiring valuable technology, and the combined entity would help offset revenue declines, if only by a degree. If Hewlett-Packard truly believes that 3D printing is the way of the future, it should roll up the industry now. Becoming just another player will simply destroy industry returns.
  • Though Hewlett-Packard scores well on the Valuentum Dividend Cushion methodology, the firm's turnaround could make the dividend more risky than our projections suggest. We'd still be cautious, and we're not adding it to the Dividend Growth portfolio. There are a whole bunch of companies to choose from that have much better dividend growth prospects. Two of our favorites in big-cap technology include Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT), though the former is using its tremendous cash balance to buy back stock.
  • Hewlett-Packard registers a 6 on the Valuentum Buying Index. We prefer higher-rated firms, ones that we include in the Best Ideas portfolio.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Hewlett-Packard's 3-year historical return on invested capital (without goodwill) is 94%, which is above the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Hewlett-Packard's free cash flow margin has averaged about 8.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at At Hewlett-Packard, cash flow from operations decreased about 41% from levels registered two years ago, while capital expenditures fell about 30% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Hewlett-Packard's shares are worth between $28-$42 each. Shares are trading at $33 each, at the low end of the range. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $35 per share (the midpoint of the range) represents a price-to-earnings (P/E) ratio of about 13.3 times last year's earnings and an implied EV/EBITDA multiple of about 6.2 times last year's EBITDA.

Our valuation model reflects a compound annual revenue growth rate of -1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -3.8%. Revenue declined 1% in the firm's most recent quarter, and we think we're being optimistic by modeling in only a similar pace of revenue declines in coming years. Revenue pressure may intensify as Hewlett-Packard continues to cut its workforce, even if those jobs are tied to lower-margin operations.

Our model reflects a 5-year projected average non-GAAP operating margin of 9.1%, which is above Hewlett-Packard's trailing 3-year average. In this department, we expect the firm to improve margins, as it continues to restructure. We think cost-cutting is rather easy to do, and we don't give management too much credit for simply shrinking. In any case, removing positions, streamlining operations, and targeting efficiency improvements will enhance the operating line, and we're modeling this in.

Beyond year 5, we assume free cash flow will grow at an annual rate of 0.3% for the next 15 years and 3% in perpetuity. For Hewlett-Packard, we use a 9.9% weighted average cost of capital to discount future free cash flows. We think Hewlett-Packard will hold the line in free cash flow generation beyond year 5 (which implies mid-cycle performance, smoothing out the upcycles and down cycles implied during the second phase of the model). The second phase of the model fades return on new invested capital (RONIC) to the firm's cost of capital by the third stage, which is a standard perpetuity function. We think the discount rate applied in the model is appropriate, as it roughly mirrors the median in our coverage.

We understand the critical importance of assessing firms on a relative value basis versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Hewlett-Packard to peers Apple and IBM Corp. (NYSE:IBM), among others. Apple is firing on all cylinders, while IBM continues to face pressure, artificially bolstering earnings per share via share buybacks. Hewlett-Packard is attractive on a P/E basis, but its PEG ratio is in line with the industry median. As such, we're neutral on its relative valuation, despite how little investors are paying for the company's next year's earnings. Note: these are non-GAAP figures.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $35 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Hewlett-Packard. We think the firm is attractive below $28 per share (the green line), but quite expensive above $42 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Hewlett-Packard's fair value at this point in time to be about $35 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Hewlett-Packard's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $47 per share in Year 3 represents our existing fair value per share of $35 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements - non-GAAP

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: AAPL and MSFT are included in the actively-managed portfolios. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.