Still Hot on HP

 | Oct 18, 2013 | 11:00 AM EDT
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In the past few months, we have been recommending that investors build a position in Hewlett-Packard (HPQ). After a great run in the first half of 2013, the stock has been in a correction mode since August. It recently bottomed below $21, on concerns that the turnaround, driven by CEO Meg Whitman, was beginning to derail. Analysts and investors had feared that the company would lower guidance at its Oct. 9 investor day.

To many investors' relief, the company guided 2014 earnings to a range of $3.55-$3.75 a share vs. the consensus of $3.63. Many feared that management would undercut the consensus by 10-15 cents a share. The stock rallied close to 9% on this positive news.

We think this is the beginning of the company's next leg up, even in light of the weak Q3 technology performance that was highlighted by IBM's (IBM) revenue disappointment on Wednesday. The weakness in the emerging markets that affected IBM is less of an issue for HPQ and was already factored into the outlook it gave last week.

Most of the news presented at the meeting still highlighted a mixed and struggling environment for HPQ's core business units. Personal systems (PCs) are expected to decline more than 5% for the upcoming year. Enterprise computing also has operating headwinds related to declining legacy Unix server and tape/disc storage products. Enterprise services is also struggling with contract run-offs and lack of new contract signings. (Both of these areas are vulnerable to cloud computing overhang questions, such as highlighted by IBM's just-announced revenue miss.)

Taken together, the overall top line for HPQ will likely decline moderately in the upcoming year. 

Balancing these headwinds will be solid operating performance in printing, software and financial services. Additionally, Hewlett-Packard will also be benefiting from significant cost-reduction actions. Management expects to end 2014 with 33,000 fewer heads and operating costs lower by $1.9 billion. Profit should hold steady and margin should expand slightly, even in this challenging environment. 

Management also talked about enhancing shareholder value in the upcoming year.  The company expects to pay out 50% of the projected $6 billion to $6.5 billion in free cash flow to shareholders via dividends and share repurchases. Finally, investors will begin to see a much-awaited improving attitude to shareholders after many years of disappointment.    

There are now several reasons to own the stock: management's renewed focus on shareholder value, the stock's rock-bottom valuation (it ranks as the cheapest stock in the S&P 500 on a trailing and projected P/E basis), HPQ's return to having a premier balance sheet and a bottoming business. HPQ is still a large and vital player in the computer markets with more than $100 billion in revenues and close to $7 billion in annual net income. The firm still has the top position in printing and commercial computing devices and a significant market presence in services, software and storage. These product and service lines are deeply entrenched at many of the world's largest corporations, governments and non-profit agencies and are not easy to replace.   

HPQ also sells at a screamingly low level of valuation at 6.4x 2014's EPS estimate of $3.65 a share. It should not take too much effort for the shares to trade at 8-9x earnings based on any inkling of a sustained turnaround. 

While last week's analyst day didn't yet point to such a sustainable turnaround, many people walked away with the sense that Meg Whitman is making many inroads to improving the company.

We are increasingly comfortable that HPQ is healing a number of self-inflicted wounds from the past few years. In addition, while many areas of their business are not in a growth mode, their most challenged segment -- PCs and printers -- will ultimately bottom out and provide a significant revenue, earnings and cash flow stream for years to come.

Bottom line, at 6.4x earnings there is a lot of room for HPQ to rally once the perception that HPQ is in permanent decline begins to ease.

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volatility is quite low here, and we could see some downsides here in the short term. ...



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