Will HP Continue to Rally?

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

The recent spike in shares of Hewlett-Packard (NYSE: HPQ) was most likely resulted from the better than expected first quarter financial reports of HP. This rally, however, doesn't mean the company is out of the woods or that HP has recovered from its slowdown. Is the company on the road to recovery? Will HP further rise in the coming months?

HP's CDS Changed Course and Fell

The company’s credit default swap (five years, in USD) has changed course and declined in recent weeks: it has decreased from nearly 371 basis points back in November 2012 to nearly 259 bp as of the beginning of February. This represents a 30% drop from its high point. The current price of 259 means the annual premium is $259 thousand in case of a default of $10 million of debt within the next five years. This premium, however, is still much higher than it was back in 2010.

One of the reasons for the tumble in the CDS price is the recent recovery of the company’s stock price. Nonetheless, HP isn't out of the woods just yet. The market lowered the company's chance of default on its debt, but this chance is still relatively high to the company's chance from back in 2010.  

Low Expectations Lead to Sharp Gains

It seems that the market had very low expectations from this company. This could be among the reasons for the spike in the company's stock in recent weeks. Since the beginning of the year shares of HP sharply rose by almost 39%. So the company didn't perform as bad as many investors and analysts had anticipated in the first quarter of 2013. But the results still showed a drop in revenues: in the first quarter of 2013 the company's revenues fell by 5.6% compared to the same quarter in 2012. Moreover, HP's operating profitability declined from 6.8% in Q1 2012 to 6.2% in Q1 2013. In comparison, a market leader such as Apple (NASDAQ: AAPL) had a much higher profit margin of 31.6% as of the fourth quarter of 2012 and its revenues grew by 17.7% compared to Q4 2011. But this comparison doesn't do justice to HP: a better comparison would be to other computer companies that aren't market leaders such as Dell (NASDAQ: DELL) or Lenovo (NASDAQOTH: LNVGY). In this comparison, HP's situation isn't so dire. Dell's revenues declined in the first quarter of 2013 by 10.7% and its operating profitability was 4.9%. Lenovo, on the other hand, augmented its revenues by 11.8% in the fourth quarter of 2012, but its operating profitability is very low at 2.6%. Let's turn to the future and see if HP will continues to recover.

HP and the Tablet Wars

HP is trying to find its market share in the tablet market and has recently introduced the Slate 7 - an android based tablet. This tablet will be marketed for $169, which will put this tablet in strong competition with the mini iPad by Apple that is sold for $329 or Google's nexus 7, which is priced at $199. This might eventually increase HP's market share in the tablets markets. Will this highly competitive market revive the company's growth in sales? Will it raise its profit margins? 

HP by the Segments

When examining the profit centers of HP, one can notice that there is a wide variation among segments in terms of growth and profit margins. The chart below shows the profitability by segments of HP in the first quarter of 2012 and 2013.

<img src="/media/images/user_13287/hp-profitability-by-segment-feb-2013_large.jpg" />

As seen, Personal Systems segment recorded very low profit margins of 2.7% as of Q1 2013. The new tablet of HP is part of the company's Personal Systems segment. This segment's revenues fell by 7.7% in the last quarter – the sharpest fall in revenues among all other segments. This puts the new tablet in a segment with low profit margins; since it will be sold at a very low price even for other tablets, this could result in another drop in profit margins. So this tablet might eventually raise the company's revenues, but won't necessarily lead to a rise in profit margins.   

HP and R&D

One of the main factors that could revive HP's growth will be if it will keep augmenting its Research and Development. Despite the drop in revenues, the company maintained its R&D budget and spent nearly 2.8% of its revenues on it. In comparison, Apple spent in the fourth quarter 1.9% of its revenues on R&D, Lenovo spent 1.8% on its sales in the third quarter on R&D, and Dell allocated 2.1% of its revenues to R&D in the recent quarter. So HP, in relative terms, is putting a bit more than other computer companies into its R&D. Will it be enough to put HP over the top? In absolute terms, HP is allocating more than double of its resources to R&D than Dell or Lenovo do; HP's R&D provision is roughly 80% of Apple's. So this gives HP a fighting chance to come up with new products that could compete with market leaders.   

Final Thoughts

HP is trying to revive its business and is coming out with new products and new directions. The company still has a long way to go until it will be able to show growth in revenues. I'm not certain if the company's steps will be enough to revive it but perhaps it will come up with new products that will eventfully lead to sustainable growth.

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 Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.

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