More than a week ago Jim Chanos showed a comprehensive analysis about Hewlett-Packard (HPQ), and was not exactly good. Everybody knows that the company is at a low ebb, but he went further classifying its stats as a value trap for any potential investor.
The reasons that considered Chanos, manager of the hedge fund Kynikos Associates and famous for his contributions to the bearish stock market, is that HP has grown through a long succession of acquisitions which darkened a large amount of expenses. The tech company has concentrated a lot of money in I+D, which unfortunately, has not produced the expected results.
In other cases we wouldn't, but if Chanos is the messenger who's uncovering frauds and bad companies since its 24, it's better to pay attention.
With data on hand:
When managers show the quarterly earnings to the investment community they give us a fantastical result, based generally, upon fictional numbers. Earnings are calculated as follows: First comes the gross profit; the most realistic amount and is the difference between sales and its costs. Below they deduce all possible approaches: amortizations, depreciations, impairments, etc.. They subtract and sum any kind of amounts. Finally, they apply taxes over the result. The statement can be found within the Income Statement.
Due to frequent makeup of calculations, the new generation of investors has been focused towards a rather more "realistic" statement which shows the real volume of money moved by the company: Cash Flow.
CASH IS THE KING. Cash flow is the more realistic metric to print on paper all the movements done in treasury along a specified period.
Cash flow is divided in three sections: operational cash flows, investment cash flows and financial cash flows. The sum - or difference - of these parts results in an increase or a decrease of the company's cash.
The theory says that operational cash flows are the result of the daily business. Cash comes from sales, via checks or effective. The output goes to suppliers or to pay the salaries. It's pretty simple. The most important thing is a "healthy" operating cash flow and positive. It means that revenue comes from the core activity of the company. If so, the excess may be used to fill holes (indebtedness) or invest in (savings).
In general, financial cash flows are the difference between the inputs from indebtness and the outputs to pay old debts and its interests.
Investment cash flows, however, are the difference between expenditures in capital and gains from some previous investments. They are non-recurring. Not every day a company spend ten millions on a new plant or in a new assembly chain. Although, some do.
Now we return to Hewlett-Packard:
HP, like many other tech companies like Dell (DELL), Microsoft (MSFT) or Oracle (ORCL), have entered into that lovely situation where are diversified enough because of its big corporation status. A lot of fronts, competitors, and products to keep rolling. Sometimes, stuck in a philosophy which made them great in the past, now they cannot find a new Holy Grail to come back in fashion. They can not invent Facebook (FB), Instagram or Zillow. The engineers are concentrated in mantaining a mature business, or their status, but not many have new ideas.
For this reason, executives that haven't got a good quarry prefer to buy new ideas filling checkbooks. So, they become big business in serial acquirers.
HP last year bought 3Com and Palm, and each company has its own market. However, as investment, its expenditure was classified as investment flow. In negative.
This companies, with new products and new markets, were bought with profits and classified directly as HP revenue within Operative Cash Flows. Basically, Hewlett Packard used a fortune to buy these new products, well worth considering as its income.
Unfortunately, the professional analyst may be confused by this misleading results. The analyst or professional investor reads the fundamental operating cash flow and see that Hewlett-Packard had cash increases every year. Does not realize that these benefits have been purchased directly by big investments.
To discover this trick, Financial Shenanigans recommend the ratio: Free Cash Flow after Acquisitions.
Free Cash Flow after Acquisitions = Operating Cash Flows - Capital Expenditures (Capex) - Acquisitions Cash Flows
With data in hand, we found out a lot of hidden losses hidden by a long list of acquisitions. Here are the results:
Disclosure: I am long ORCL.