Analyzing the Bull Case of Hewlett-Packard

Anindya is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The time has come to break up Hewlett-Packard (NYSE: HPQ) into parts. That’s the view of UBS analyst Steve Milunovich. He says that a sum-of-the-parts analysis finds the company is worth north of $20 a share.

“That valuation assumes that HP’s businesses are independent, which are not,” he writes. “We believe this fallacy of independence explains the gap between intrinsic and realized value. The burden of corporate management, systems, and brand erosion argue that improving unit results isn’t sufficient -- we believe HP should break up.”

In the last few weeks, the stock has rebounded nicely. Is this shift in momentum for real? That's hard to say. Hewlett-Packard's stock has been hurt by a number of strategic mistakes. Deals like Autonomy, Electronic Data Systems, Palm, and others built on the $17.6 billion purchase of Compaq a decade ago wasted the company's resources and talent. All of these point to a company that’s dysfunctional.

Immediate Fix: Splitting Up the Company

Fiduciary Trust sold its Hewlett-Packard stake several years ago when the investment firm began losing confidence in the company’s leadership, according to Chief Investment Officer Michael Mullaney.

“It’s absolutely dirt cheap,” Mullaney, who helps manage $9.5 billion in Boston, said in an interview. “If they want to try to fix it immediately, it would be by splitting up the company. That’s exactly what they have to do.”

Hewlett-Packard needs to overhaul its board, because some of the current members are responsible for approving the Autonomy acquisition, and then split the company in two. The personal computer and printer businesses could be spun off together or sold to a buyer such as an Asian computer maker like Taiwan’s Acer or Asustek Computer. The printer business, the stronger of the two, could help entice an acquirer and get a better price.

The $33 billion company, valued at more than $100 billion as recently as 2011, could boost its stock price to more than $20 by separating itself into two companies focused on consumers and business clients. By breaking up PCs and printers, Hewlett-Packard can reinvest that cash into the enterprise unit to enhance its software used for data centers.

Hewlett-Packard’s Reinvesting Ability

With the company failing to capitalize on a boom in demand for smartphones, tablets, and cloud computing, third quarter revenue has fallen short of expectations. Hewlett-Packard posted third quarter results that saw EPS beating estimates despite lower order renewals and large write-downs. The restructuring initiatives of Meg Whitman will likely result in continued weakness and write-downs, as the company focuses on core operations to find its next major growth driver.

But that doesn’t mean Hewlett-Packard is financially a weak company. The question is would it be a good idea to accumulate the stock that’s dirt cheap due to this weakness? Hewlett-Packard’s Enterprise Value to Free Cash Flow ratio is impressive and currently stands at 6.823, which is in-line with Dell’s (NASDAQ: DELL) 6.472, but better than International Business Machines’s (NYSE: IBM) 14.84. Enterprise Value to Free Cash Flow compares the total valuation of the company inclusive of debt with its ability to generate cash flow. It's the inverse of the Free Cash Flow Yield. The lower the ratio, the faster a company can generate cash to reinvest in its business or pay for acquisitions. 

<img src="http://media.ycharts.com/charts/e923766408fdf15a6c145d364fa21b55.png" />

HPQ EV / Free Cash Flow TTM Data by YCharts

Hewlett-Packard’s Relative Strength

The company is still a revenue generating machine. Its quarterly revenue per share is growing by 41.55%, compared to Dell’s 10.69% and IBM's is 24.03%. 

<img src="http://media.ycharts.com/charts/f383c03d0da07852930e0f3dfabccfc7.png" />

HPQ Revenue Per Share Quarterly Data by YCharts

Hewlett-Packard has a free cash flow yield of 22.41% with a rebounding FCF curve. Free cash flow yield standardizes the free cash flow per share a company is expected to earn against its market price per share. The ratio is calculated by taking the free cash flow per share divided by the share price. The lower the ratio, the less attractive the investment is and vice versa. Hewlett-Packard’s relatively high FCF yield indicates that the company’s strong cash position is favorable for investment. 

<img src="http://media.ycharts.com/charts/c9bc25355b0e3f1ba6ea9f10245a566e.png" />

HPQ Data by YCharts

Server Sales Seeing Temporary Recovery

Worldwide server demand has been slowing since large businesses are now choosing to make their own servers and data centers. However, the former powerhouse data-center server makers Hewlett-Packard, IBM and Dell have seen a modest recovery in server sales since the second quarter of 2012. IDC believes that server demand will continue to improve following a number of critical product refreshes which will continue to be announced. But nobody expects the server market to stage a dramatic turnaround anytime soon.

Demand for x86 servers started improving since the second quarter of 2012 with Hewlett-Packard leading the market, following Dell and IBM. The blade server market continued its solid growth in 2012. Overall, bladed servers, including x86, EPIC, and RISC blades, accounted for a record high revenue. More than 90% of all blade revenue is driven by x86-based blades, which now represent 22.1% of all x86 server revenue. Hewlett-Packard maintained the number 1 spot in the server blade market in 2012 following IBM in the second place. Cisco and Dell rounded out the top 4.

The Bottom Line

Long-term investors should start accumulating the stock in dips, if they believe in Meg Whitman's turnaround plan. The plan is based on three strategic initiatives:

  • Paying down the company's debt before it becomes unmanageable
  • Shifting from an external to an internal innovation model, a policy which has worked for other tech companies like Apple and Microsoft
  • Opening up the company's operating system WebOS to the applications development community

But if the plan fails to revive the company? Don’t worry, splitting up the company might then be the only solution to turn it around. And that could also be a great bet!


Anindya7 has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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