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Following last week’s put action in HPQ and DELL today – the “the PC story is washed out” meme is in full swing.  Now traders will begin with the activist investor shtick   Ralph Whitmore of Relatinoal is already on the board at HPQ.  He doesn’t own a huge stake, but agreed to not sell until 2014 in order to get on the board.  Just for reference; our current range is $18-19 with a “buyout / split” worth mid $20s today.  Fundamentally, there are no long only guys touching it… the moves now are deep value guys and traders taking a scalp.  Its a matter of no more sellers right now…  technically it reclaimed the 50 d moving average (with 200d MA above at $19) and short interest remains high.  Other enterprise companies point to a weak but not worsening Q4 – so a more rapid deterioration in HP is possible vs. expectations  but not likely given the carnage of last month. 

  • Recent launch of cloud initiate and issues with public outages at Amazon and Google may help prove HPs case for private / public hybrids… but also Cisco’s, IBM, EMC and others.
  • Investor sentiment may be close to a bottom…from and email to a colleague
    • This does not mean the company is no longer a value trap – but simply that a) long only tech investors are no longer involved and will not be until fundamentals show positive signs; b) individual investors are scared out of the name.  The remaining investors are nearly all deep value players.  This has led to a large volume of “top pick for 2013” and other bottom finishing calls.  We agree that sentiment is washed out and this normally sets the table for sharp rallies.  However, this does not eliminate the risk of HP being a value trap.  We are very concerned about the issues facing HP and view the risk of a decline in core business for 2013 is very real.  Expectations are low as cash flow guidance deteriorated, but as long as it remains above $5b for the year we see a fall only to $12-13 as possible even with low sentiment – with sharp upside given its underowned status. 

As the HP turnaround drags on the question becomes

1) how much will business be impacted by scandal and perception

2) how large will the impact of secular issues facing printing and PCs be

3) how much cash flow can they produce without damaging investment

Investor sentiment is washed out… no tech or growth investor will touch it.. even deep value players are beginning to think twice.  As I’ve written, I am no fan of HP and its sprawling business model and need to heavily invest in its future  – an issue for protecting its cash flow.  However, as it hovers around $14, up from under $12 following earnings and the Autonomy debacle, we reach a stage where the incremental downside requires serious degradation in the business. Recent quarters suggest cash flow near $4b on the downside, assuming little to no improvement in inventory management and working capital, and a continued decline in core business… which values the company at ~$24b in or $12.30… more realistically the number is $5-6b or greater next year (given all the levers) and at a more reasonable multiple it yields a stock of closer to $18-19 per share.  Any stabilization in end markets, macro improvement, or actual improvement by HP would push it closer the the sum-of-parts value (including conglomerate discount of $23-24 per share.

The one red flag we will be watching is the make up of the cash flow – if they are cutting capex and extending payables its a big negative.  If however, they continue to get their inventory issues under control – they will see a $500m-$1b positive impact, and the front end loading of restructuring costs should help the cash flow toward the second half.

Earnings of $3-3.50 and cash flow of $5+b should be enough to keep the shorts at bay and deep value in the name.

Given the secular issues we are not positive on the company – but have to respect that the pendulum of fear and negativity has swing too far.  Path of least resistance is likely up from here.