Can Hewlett-Packard Ink You Some Profits?
Hewlett-Packard (HPQ) is a name almost everybody knows. Like Apple (AAPL), the company was founded by two engineering whizzes (Bill Hewlett and Dave Packard) in a Northern California garage, and has grown to today be one of the largest companies in the world, with 2010 revenues of $126 billion and a market capitalization of nearly $80 billion. This tech giant has recently fallen deeply out of favor, and today, with a 15.4% earnings yield and a P/E ratio under 9, sells at one of its cheapest valuations ever. Do the business results and outlook justify such a dirt-cheap stock price, or is HP a bargain big-cap Magic Formula stock worth buying today? Let's take a look.
This is such a gigantic company that it is difficult to get a grasp around the business. The largest revenue producer (32% of total) is the Personal Systems Group (PSG), which sells HP, Compaq, and Palm branded laptops, desktops, mobile phones, and other computing equipment. It is also HP's least profitable business at just a 5.7% operating margin, driving only about 13% of overall profits. Services account for 27% of sales, and 36% of earnings - the company's biggest cash cow, largely built around the purchase of EDS in 2008. The company's well-known Imaging and Printing products produce 20% of revenues and 28% of earnings. Enterprise Servers and Storage, consisting of equipment for the data centers behind the cloud computing movement, account for 15% of sales at a 13.8% margin. Software offerings and financial services (financing) rounds out the portfolio.
There are definitely things to like about HP. As sales continue to move towards higher-margin services and data center equipment, combined with cost-cutting under former CEO Mark Hurd, the firm's corporate operating margin has shot up nicely, from just 8% in 2006 to 11.7% in the past 12 months. This trend should continue over the longer-term, as these businesses continue to out-grow the legacy PSG group. The general move towards data center-centric computing has been gaining steam in the business world for some time and is starting to see some consumer level uptake, as well. This bodes well for HP's Services and Enterprise segments. The printing division continues to perform well, also, given HP's huge install base and the emergence of digital commercial publishing.
On the other side of the coin, there are legitimate concerns. The large tech hardware behemoths are all fighting for a piece of the services and enterprise server/storage market. Cisco (CSCO) has started selling servers, Dell (DELL) is a formidable competitor on almost all fronts, and firms like Oracle (ORCL), with strong software assets, can leverage those to move customers onto their own hardware platforms (one reason behind Oracle's purchase of Sun Microsystems). HP has a weak software portfolio. This is an area that new management will likely address, because proprietary software is the most effective way to lock customers into your hardware. One only needs to look at Apple's ongoing success to see this phenomenon on the consumer side. It is even more important in the business world.
There are a few other more acute concerns on HP. First, CEO Leo Apotheker has had a bumpy start, already having to reduce guidance twice in the span of 9 months. In such a competitive industry, HP cannot afford to have anything less than top-notch management. Secondly, HP's balance sheet is quite a bit uglier than its primary competitors. A big 2010 shopping spree in which HP spent almost $8 billion on acquisitions has saddled the company with nearly $23 billion in total debt, offset by under $13 billion in cash. While the company is not in any financial danger, they don't have the flexibility that Dell, Cisco, or Oracle have.
Nevertheless, these are not the kind of risks the company hasn't faced before. They have always operated in competitive conditions, from PC wars with IBM (IBM), Dell, and Gateway to printer wars with Lexmark (LXK) and Canon (CAJ). I certainly don't see these concerns being a valid reason to drive the valuation down to its lowest levels in recent memory. The stock has averaged a 10.7% earnings yield over the past 3 years through a major recession! The valuation is nearly 40% under historical norms right now. That disconnect, combined with *growing* revenues, margins, profits, and aggressive share buybacks (average 5% reduction last 5 years) makes the current stock price difficult to justify.
Modeling very meager earnings growth and a valuation closer to historical norms, I value HP at about $60 a share. That is a massive upside of 67% to current share prices in the mid-30's. That kind of upside on such a large, stable, competitively advantaged company doesn't come along every day. This is a strong Magic Formula choice for your portfolio.
Disclosure: Steve owns DELL