We don't always get it right. As much as we'd like to think that we do, we don't. There are times when our analysis of a stock and its prospects are just flat out wrong. When that happens, we are upset with ourselves and we always try to go back over our original analysis to see what we did wrong so we don't repeat that same mistake again.
Such is the case with Hewlett-Packard (NYSE ticker: HPQ). We originally purchased shares of Hewlett-Packard, the computer company, in January 2012. At that point in time, we knew that HP still had some recovery ahead of it. The company had just recently named its third CEO in as many years and the last CEO left under embattled circumstances. There was some disarray at the company but the new CEO, Meg Whitman, had a decent track record of having successfully guided eBay for a number of years. Our thesis on the company was that there was some short-term pain ahead but we felt the market was undervaluing a good franchise. The market was pricing the company to shrink about 5% every year until the end of time. There was also a modest dividend yield around 2% annually that we felt offered a bit of a backstop. We felt the company earnings were likely to fall over the coming year as we saw the potential for the new CEO to write off a lot of previous errors - an accounting tactic known as "the kitchen sink". That is, you throw everything bad including the kitchen sink into one particular year and write it all off, showing a tremendous loss for the year. However, this is an accounting trick and the key is that cash flows at the company were - and still are - positive, even with the company potentially showing negative earnings. I know this sounds a bit confusing, but that is the key difference between "earnings" and "cash flow" and one reason we pay much closer attention to cash flow. It is much harder for a company to manipulate cash flow than earnings.
We were not alone in our positive assessment of the company. One outside resource that we often look to for independent analysis of companies is Morningstar. We read their analysis of Hewlett-Packard and they, too, saw positive free cash flow and an undervalued company. In fact, in their assessment, the stock would be fairly valued at $40 per share. We thought that a little too optimistic, but nonetheless were a bit reassured by the confirmation that HP might be undervalued.
Fast forward to the first week in October when the company held an analyst day - a day on which the key executives of the company are made available to equity analysts for question and answer sessions and comments and forecasts are provided. Meg Whitman provided a shocker of a forecast as she guided earnings expectations down dramatically for not only this year but also next year. In fact, she essentially said that HP was not going to be recovering until at least 2016. The stock price plummeted on this news, dropping 13.5% for the day alone. We actually applaud Meg Whitman for her openness and honesty. However that is little consolation for what she didn't say. The day after the analysts meeting, we watched Meg on the CNBC program "Squawk on the Street". She tried to be upbeat, but CNBC commentator Jim Cramer hit the nail on the head. He likened Meg to President Obama and Mitt Romney - politicians who talk a lot but never actually answer any of the questions directly put to them. Even more disturbing was that all Meg could talk about was HP's hardware. In fact, the thing that most excited Meg was the potential roll-out of a new tablet PC to compete with the Apple tablet and a whole host of other tablets already on the market.
While HP does have a significant portion of the PC market, this is a low margin business that faces the prospects of decreasing profitability over time. What HP needs to do is de-emphasize this aspect of the business and concentrate on the one space where they have an advantage and higher profit margins. The one positive to HP's current PC and printer business is that it gives them a foot in the door to companies. What HP needs to be emphasizing is not PC's and printer (hardware) but networking equipment and servers. These are higher margin products that, once established in a firm, tend to be very sticky. That is, once a company has HP networking equipment, they tend to continually upgrade rather than switch completely to a new networking company. Even better, HP has the ability to customize a company's hardware to fit easily with the servers and networks. This segment of HP, which they label as ESSN (enterprise servers, storage and networks), was the fastest growing segment for the past two years. The one segment of the hardware division that was growing over the same time period was workstations, which would connect directly with the ESSN products offered. Given this focus, we were severely disappointed to hear Meg emphasize hardware over what Morningstar labels as 'infrastructure' - the ESSN unit. We tend to believe that Jim Cramer was right when he said the analysts day was essentially HP's "Kodak moment". That is, this is the moment in time when HP begins to become irrelevant just as Kodak has as photography has moved from film to digital and Kodak failed to keep pace with these structural changes.
Given this new development, we are now seeking to exit HP stock that we currently own. We do think that we can exit our position at a better price, so expect to see us writing options against our position. We have already done this once and will continue to do so until we can exit our position. By selling options against our shares, we effectively set a price that we are willing to sell but we take in a premium for giving up any gains above this set price. This premium effectively raises the price that we are selling our stock. For example, if we sell an option with a $14 strike price and take in $0.82 in premium, we are selling our shares for $14.82 in total. We just collect part of the sale early.
In the end, as we look back over our analysis, we do not see that we erred in our thinking about HP. We still see value at the company and we think there is a chance HP could become the money machine that we saw several months ago. However, we are not confident in management's ability to see this value or navigate through the issues ahead to successfully reach that goal. If Meg really believes that HP will take until 2016 to begin their recovery, there is plenty of time for us to revisit the stock at a later date. For now, this is what we would call a "value trap" - and we fell into it completely. Mea culpa.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Clients of Aerie Capital Management are currently long shares of HPQ and short HPQ Nov call options.