Hewlett-Packard too Cheap to Ignore

 | Sep 16, 2013 | 2:30 PM EDT
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While there is short- and intermediate-term uncertainty about the outlook for a number of businesses within Hewlett-Packard (HPQ), we believe the company will prosper and return to a slow-growth revenue and earnings mode. The stock is too cheap to ignore, and we are confident that the company is making significant progress in its turnaround. Even during this unsettled period, the company is earning a lot of money and has very favorable cash flow characteristics.

We initially recommended HPQ at higher price levels in June with the idea that we would start a position at that time and fill it out if the stock sold off. We believe the recent pullback creates that opportunity and we would add to the position here.

While many paint the outlook for the entire company with the broad brush of a challenged PC market, HPQ is not that monolithic and is not without strengths. Clearly, its desktop and laptop PC sales are suffering from the onslaught of tablets and smartphones. But we think that PCs will continue to have a place in businesses and homes and are far from dead, as their capability to create content cannot easily be replicated by the newer devices. Importantly, management is emphasizing profit over revenue here, as the economics of profit-margin improvement outweigh trying to gain market share in a shrinking market. Similarly, printers have probably peaked but still they fulfill a need; in this case, high-margin ink sales will continue even as demand for additional new devices slows.

On the other hand, servers, IT services and software have better outlooks and are not under the same secular pressures as the PC and printing segments. These businesses have better and more sustainable prospects for growth and returns.

This is the core of HPQ's turnaround: manage the challenged segments for cash and drive for growth in the enterprise businesses while tightly managing expenses. Early reports of CEO Meg Whitman's plan are generally positive, indicating that the turnaround is progressing within management's expectations.

HPQ's financial characteristics are what really make the stock compelling. At the current price, HPQ trades at only 6.2x fiscal 2013 earnings, the lowest multiple of any S&P 500 stock. Earnings should be stable in the $3.55 per share range for this year and next. The company has done an outstanding job managing the business for cash, with free cash flow expected to be $8 billion this year, or more than $4 per share. As a result, the balance sheet has been totally cleaned up, and the company should end the year with no net debt (except for that contained within the financial services subsidiary).

The recovery and turnaround at Hewlett-Packard is a long-term proposition, but the initial progress is encouraging. The stock is up more than 50% this year, though down 20% from recent highs. Our investment thesis is intact, and combined with HPQ's bargain valuation, it makes for a persuasive case. Some sell-side estimates of the company's sum-of-the-parts value is in the $33 range; our intrinsic value work suggests a similar range for the fair price of the stock. The hoped-for stock price concession is upon us, and we recommend taking another leg into the stock now.

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