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Mr. Abbate says "Bet on Horses"

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September 23, 2010 – Comments (0) | RELATED TICKERS: HPQ , IBM , AAPL

Bet on the Horse, Not the Jockey   by: Tony Abbate August 19, 2010  | about: HPQ    

 

The recent departure of CEO Mark Hurd from Hewlett Packard (HPQ) reminds me of one of my favorite quotes by Warren Buffett:

"I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will."

Regardless of who succeeds Mark Hurd, if you look at Hewlett Packard’s businesses, I think anyone can run them successfully. In other words, it is the horse and not the jockey that should allow the company to do well. This is evident by its consistent operating margins and high returns on capital. Below are the two metrics over the last decade:

 


Op Inc

Year

Margin

ROIC

2000

8.4%

56.5%

2001

5.1%

28.8%

2002

4.3%

33.4%

2003

6.2%

67.2%

2004

6.3%

70.7%

2005

5.7%

80.1%

2006

7.4%

186.7%

2007

8.9%

253.0%

2008

9.1%

556.7%

2009

8.8%

296.2%

Another thing I like about Hewlett Packard’s business is that its mix has been moving from Hardware towards Services. Below is the percentage each business represents since 2003:

Earnings From Operations by Business Type

Year

Service

Hardware

2009

54.8%

45.2%

2008

44.3%

55.7%

2007

39.9%

60.1%

2006

37.2%

62.8%

2005

31.8%

68.2%

2004

24.3%

75.7%

2003

23.9%

76.1%

The Service business is more attractive than the Hardware business as it has higher operating margins, is less capital intensive, generates higher returns on capital and tends to be associated with a predictable revenue stream of long-term contracts.

What I like most about Hewlett Packard is that the stock price is very attractive. As of its close on August 17, it sold at 11.6 times trailing twelve month earnings. If I take the trailing twelve month free cash flow for HPQ and divided it by its current Enterprise Value, I get a yield of 10.4%. Both of these metrics are very attractive.

My favorite analysis of a company is, “What would someone pay if they acquired it?” In the case of Hewlett Packard, let’s keep it simple. About half of HPQ’s earnings are service oriented and half is manufacturing. Over the past 15 years, the average manufacturing company has been acquired at an EV/EBITDA multiple of 8. Since 2002, after the tech bubble burst, the average software and service company has been acquired at an average EV/EBITDA multiple of 14.0. If we take the average of these two multiples, we get an estimated intrinsic value or Enterprise Value to EBITDA multiple of 11.

The chart below illustrates HPQ’s EV/EBITDA multiple vs. its stock price over the last 20 years. If you look at the history of where the stock has traded and the history of M&A activity in this sector, It is not unreasonable for the company to trade at an 11 EV/EBITDA multiple.

 

If we apply an EV/EBITDA multiple of 11 to HPQ’s, I get a fair value estimate of $75.71. In case my estimate is too high, I always lower it by ten percent. Hence, my target price for the stock is $68.13. Historically, the company has rarely traded below an EV/EBITDA multiple of 5.0. I use this as the potential downside risk for HPQ which implies a price of $33.60.

At its current price, I think HPQ is very attractive on a risk-reward basis. My estimated upside is 66.9%. My estimated downside is 17.7%. One of my favorite measures before buying a stock is to compare its upside to downside. The upside-to-downside ratio for HPQ is 3.8. This is almost akin to someone asking you if you would be willing to take a bet on the toss of a coin. If it comes up heads, you pay $10. If it comes up tails, you collect $38.

For patient investors, I think HPQ offers a great opportunity for an annualized double digit return over the next 3 to 5 years. Odds are the stock should hold up well if we enter a turbulent market environment over the next 12 months. HPQ is the type of investment I love: attractive upside and minimal downside. Remember the key to successful investing is limiting your loses when you are wrong.

Disclosure: The author and clients of Granite Value Capital are long Hewlett Packard (HPQ)

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