Why Undervalued HP Is a Potential Two-Bagger Stock

By Alvin Gonzales - September 13, 2012 | Tickers: AAPL, DELL, EBAY, HPQ, MSFT | 0 Comments

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“Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.” – Peter Lynch

It is amazing that Hewlett-Packard (NYSE: HPQ) is still standing. The company, which was led by terrible management for over a decade, has withstood the continuous squandering of company money on horrible acquisitions. On HP’s investor relations site, the company has listed 63 acquisitions since Q1 of year 2000 (the list does not include minor acquisitions). The cost of nine of its biggest acquisitions amounts to a whopping $63.05 billion.

In addition, HP has recently written down its purchase of Palm, EDS, and Compaq by $885 million, $8 billion, and $1.2 billion, respectively. Furthermore, the wind down of webOS has cost HP an extra $755 million. The irony is that HP’s market cap is only $35.38 billion. Nevertheless, HP is actually still a very strong company. According to IDC, HP is number one in computers, number one in printers, and number one in servers.

Looking at the last twelve months, HP’s performance has been subpar, culminating with a huge loss of $8.9 billion in Q3. However, for the last twelve months, adding back impairment, restructuring, and wind down of business charges, HP had a non-GAAP net income of about $6.3 billion and an EPS of about $3.20.

In addition, while HP has neglected its R&D, it still spends a lot more money on it than many of its competitors. In 2011, HP spent $3.3 billion. In contrast, Apple (NASDAQ: AAPL), Dell (NASDAQ: DELL), Lenovo, and Acer spent $2.4 billion, $856 million, $453 million, and $38.4 million, respectively. The following table shows R&D spending for the last five years.

The thing to understand here is that HP does not need an extraordinarily good leader to fix the company. Fundamentally, the company still generates billions in profits. HP just needs someone who will resist the urge to waste money on bad acquisitions, fix the balance sheet, and invest more money on R&D. Basically, former eBay (NASDAQ: EBAY) CEO Meg Whitman is probably enough to right the ship and unleash the company’s value.

At eBay, Whitman grew a small company with a few million dollars of revenue in 1998 to big a company with $8 billion of revenue in 2007. Whether Whitman rode on the coattails of eBay or not does not really matter. Whitman is also often criticized for eBay’s $3.1 billion acquisition of Skype. While it was not a good acquisition, it was still profitable overall. Also, Whitman’s $3.1 billion acquisition pales in comparison to HP’s acquisitions of Compaq, EDS, and Autonomy. Her acquisition mindset is a huge improvement over Apotheker, Hurd, and Fiorina.

Additionally, Whitman kept eBay’s balance sheet very clean. From 2005 to 2007, eBay had zero long-term debt. On the years eBay did have long-term debt, the debt was only a few million dollars. Also, Whitman boosted product development spending as a percentage of revenue from 2% in 1997 to 5% in 1998 and kept it consistently above 7% in the following years. At HP, Whitman has already started to boost R&D spending and cut down debt, albeit by small amounts.

Looking forward, Microsoft (NASDAQ: MSFT) plans on releasing Windows 8 in October. This should provide a huge boost to HP and the rest of the PC industry because Microsoft has integrated a UI (Metro) designed for touch-screen use into Windows 8. Thus, if touch-screen PCs take off, it will likely result in mass upgrades to touch-enabled laptops and desktops. Since there are over one billion PCs in use worldwide, the potential upgrade profits are huge. HP stands to benefit the most because it is number one in PCs. Additionally, Windows 8 allows PC OEMs to build touch-friendly Windows tablets. HP plans to release touch-enabled laptops (Spectre XT and ENVY TouchSmart Ultrabooks), all-in-one touch-enabled PCs (ENVY TouchSmart 23 and 20), and a Windows 8 Pro tablet hybrid (HP Envy x2).

Currently, HP has a negative tangible book value of about $6.50 per share. Using discounted cash flow (DCF) analysis, the previously calculated trailing twelve months non-GAAP EPS of $3.20, the negative tangible book value, and assuming perpetuity, HP is worth about $25.50 per share. Additionally, HP has done a good job of reducing its number of shares over the years. Thus, if HP can get back to $8 billion in net income (the level it was in 2008), HP’s EPS would go up to around $4.00 and the DCF value of the company would be about $33.55. Throw in the big possibility of Windows 8 ushering in the era of touch-screen PCs and HP turns into a legit potential two-bagger stock.

Overall, HP is a strong company and has a lot more value than what it is currently selling for in the market. The company just needs a CEO who will not waste money on bad acquisitions. Thus, the real key to unlocking HP’s value rests on Meg Whitman keeping her promise of avoiding big acquisitions. HP has huge upside potential.

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