Salvaging Gold From the PC Junkyard

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

When a car, toaster, microwave or any other piece of equipment becomes obsolete, we discard it and it ends up in the junk yard. These discarded items can have two destinies: either they are picked up by users who see value in them, or they are scrapped.

The stock market and investors behave in a similar fashion. When an industry reaches its maturity and growth starts to slow down, the ones who fail to keep up, apart from a few dividend paying stocks, are discarded.  However, once in a while investors are too hasty in writing off a stock. They focus more on rumors, macro weakness and industry specific ailments, rather than the stock’s value.

From the scrap of the PC industry, investors can salvage Hewlett Packard, (NYSE: HPQ) for significant returns. Yes, the PC and printing segments are doing badly, but they contribute only 50% to revenues and very little to earnings. The company has shown solid business performance despite the Autonomy crisis and has rosy outlook for 2013. Therefore, I believe at these levels HP has a lot of value and smart investors can buy it on scrap price.

The situation

In a previous article, I discussed the adverse effect of the accelerated rise in popularity of handheld devices on the PC industry. The transition in computing to handheld devices has accelerated the industry’s march to maturity and almost annihilated the PC stocks, once the darling of the stock market.

Sadly for HP investors, handheld popularity has had a two-pronged negative effect. Not only has HP’s PC segment suffered, but its printer segment has also become an antique shop because the printed page has largely been replaced by tablets and phablets. Not long ago, HP was the largest PC and printer manufacturer in the world and enjoyed sky high valuation, but right now the stock is in a sorry state. 

Last quarter

HP took a 12% hit after the company announced its fourth quarter results. The company beat analyst expectations of $1.14 and reported an EPS of $1.16; approximately a 2% beat. It missed the average revenue estimates of $30.4 billion and reported revenues of $30 billion; a 7% decline YoY. The non-GAAP operating margin was solid at 10.4%, an increase of 70bps YoY.

A positive from the quarter was the $4.1 billion in cash flow from operations). The free cash flows during the quarter were $3.5 billion, translating to approximately $1.8 per share. This improvement in FCF was partially due to reduced inventory levels and increased payables. Share repurchases of $124 and reduction of debt from $9.1 billion to $5.8 billion were the key offsetting factors.

The stock plummeted 12% after the company announced its results. The stock dip can be blamed on the $8.5 billion goodwill impairment related to the Autonomy fiasco. HP had acquired Autonomy last year for a whopping $11.1 billion.

Outlook

Surprisingly for investors, HP maintained its FY2013 guidance. The market was expecting EPS of $3.52 for the year, and the company gave EPS guidance of $3.40 - $3.60 for the year and first quarter EPS guidance of $0.68-$0.71 (versus consensus $0.85). HP CEO Meg Whitman and CFO Cathie Lesjak defended the guidance in the conference call

Management expects the second half of the year to ensure their $3.40 to $3.60 estimates. The primary factor behind the second-half comeback is the restructuring efforts aimed at reducing expenses. Another reason behind the low guidance for the first half is HP’s expectation that during the first half, printer and service margins would contract.

The big question remains the revitalization of the PC business (which contributes 30% to revenues) by the release of Microsoft's (NASDAQ: MSFT)Windows 8. The industry was expecting that the Windows 8 launch would trigger a refresh cycle and improve overall PC demand. However HP maintained that they expect the PC consumer market to remain slow. Microsoft’s new OS has received positive reviews and I believe will positively affect PC sales. In my opinion, hybrids such as HP’s Ultrabook are the future of desktop computing and will receive a positive consumer response.

Segments

The company faces headwinds in its printer business which contributes around 20% to its total revenues. The PC business (30% contribution) should see upsides due to the Windows 8 impact. The current quarter will give a better idea of the future of this industry.

The real sign of worry for HP investors is the 9% decline YoY in Enterprise Hardware Revenue. This is a high-margin segment that can significantly hurt the bottom line. Companies such as IBM (NYSE: IBM) and Cisco (NASDAQ: CSCO) are focusing on the enterprise segment to drive growth. The increased competition, especially from Cisco, has seriously hurt HP’s enterprise segment.

Table 1: HP segments revenue contribution

<table> <tbody> <tr> <td> <p>Segment</p> </td> <td> <p>% Contribution to Revenues 2012</p> </td> </tr> <tr> <td> <p>Imaging and Printing</p> </td> <td> <p>20%</p> </td> </tr> <tr> <td> <p>Personal Systems</p> </td> <td> <p>30%</p> </td> </tr> <tr> <td> <p>Enterprise Systems</p> </td> <td> <p>17%</p> </td> </tr> <tr> <td> <p>HP Software</p> </td> <td> <p>3%</p> </td> </tr> <tr> <td> <p>HP Services</p> </td> <td> <p>29%</p> </td> </tr> <tr> <td> <p>HP Financial Services</p> </td> <td> <p>3%</p> </td> </tr> </tbody> </table>

Valuations

During 2012, the company distributed approximately $2.6 billion to shareholders through buybacks and dividends. HP currently offers a 4.5% dividend yield, which is 80% above industry average. The stock is trading at a forward p/e of 4.35x, which is below the industry p/e of 18x.  HP is currently trading at a 10% premium to its mean sell-side target price.

If we break down the company into segments and do a basic sum-of parts analysis, we can get a better picture of HP’s valuations. The first item is the $11 billion cash hoard, which comes to around $5.6 per share. If we totally discount the Printing and Personal Systems segments, we're left with around 50% of revenues from the remaining 4 segments. Salesforce.com, Oracle, IBM, Cisco, Red Hat and Accenture compete with HP for this 50%. The average P/s of these companies is 4.5x and 2.5x if we remove the very high P/s of Red Hat and Salesforce.com. Next year, the combined revenue from these four segments is expected to be approximately $60 billion or $30 per share. Using the 2.5x multiple, we can calculate a target price of $75, for these four segments alone.

Conclusion

As can be seen from the discussion above, the company had a pretty decent quarter and has maintained its outlook for the next year. Thus there are no immediate concerns about the business model collapsing. The investors have reacted adversely to the Autonomy probe and the falling demand of PC and printers. As the revenue break down above shows, only 50% of the company’s total revenue comes for these segments. According to the valuations shown above, HP is trading at very cheap valuations. The investors are correctly punishing HP for poor performance of its printing & PC business and sorry state of its acquisitions, but highly discounting its other 4 segments. I believe the stock has been overly punished and, in 2013, investors are going to realize this value and HP will soar.


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