Category Archive

HPQ

*revs and EPS better than very weak expectations – like we discussed, sentiment got really washed out

*cash generation of $2.6b is good, but not all kosher – large tax benefit, cap ex down to $214 vs $299 last Q and $430m last yr, and so its still ahead of fears but i’d classify it as neutral and not a positive turn yet. payables actually shrank as they reduced their channel inventory needs

*all revenue segments declined which is still a problem, networking (the low end of enterprise) was only positive

*EPS helped better margins in printing on new commercial printers

*inventories, receivables, and debt all look ok

*yes, they “delivered” again, which does matter at this point.  the cash generation puts $6b in cash flow as a real possibility which keeps value buyers happy – 6x $6b in cash flow at low end gives us $36b mkt cap which is $18-19 for base case

*nothing exciting on first look – its just a distressed story where they are not doing too much worse.

*saw a UBS upgrade, guys will start calling for the turn in enterprise (recall Cisco was “cautiously optimistic”)

*HPQ is going to push the data center story – won’t sell PCs etc…it all makes sense.  we still worry about lots, but in general an improvement would put HPQ on track for $24-26, while it seems fair value is being tracked at $18-19 now based on distressed cash flow, some short covering on earnings pop expected.

some thoughts on the technical outlook below:

• Near term value based on high end of cash flow estimates would be $23-24 at 7x
  • Heavy travel / resistance at $25
• Short interest – Short covering remains a driver – as levels remain elevated
  • Huge spike staring last Feb and peaking in Nov
  • Previous range was 15-33m shares short and a coverage ratio 0.6 to 1.5 days
  • Currently there at 74.6m shares short with a coverage ratio of 4.6 days
    • This is similar to the September 2012 data prior to the earnings miss and analyst day in Oct 2012. The peak was 106m shares and 5 days coverage
• Technicals
  • Reverse head and shoulders bottom runs neckline to $23-25.50
• Moving averages
  • 200d $17.27 (breakout on earnings) vs 50d $16.37 and rising
  • 8d $18.59 / 21d $17.41 – short term technician supports for up-trending market
  • Gap fills – Roughly $17.50 to downside and $22.80 to upside
• Momentum trades
  • Carries you into $21.60 to $22.90 range excluding other patterns and support
  • Bottom of short term range $18
• Investor base
  • Starting in Q3 no tech or growth investor would touch it – it was deep value only, even then we saw some exit in Q4
  • Some deep value and yield seeking/distressed buying in Q4/Q1 based on cash flow after the Q4 debacle
  • Now you are seeing technical traders, closet value buying, but still few tech or growth – this makes the stock more vulnerable to downswings on any disappointment as there is some fresh money in the name for the first time since last fall – but trend is upward to mid $20s

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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.

HP – revenues were lower vs reduced expectations, guidance is lower for Q1 and backend loaded for the FY, which is a lot to ask in a turn around story that has “executed” for two quarters, secular issues remain in core markets… oh, and they are writing down Autonomy by $8.8b.  Yes, that Autonomy that they acquired for $10.2b just last year.  But wait, there’s more – $5.5b is aparently due to fraud.  HP will sue.  Greeeaaaat.   A few thoughts on the write down b/f the numbers… 1) the entire board except Whitworth signed off on the deal, 2) CFO Lesjak warned the board against the deal, stating it was too expensive and not in HPs best interest, 3) HP lead council and others were aware of rumors regarding accounting irregularities at Autonomy but were “reassured” by documents provided by Autonomy management and auditors, 4) Autonomy former CEO Mike Lynch worked for HP from December ’11 until May ‘12 – after he left HP began its investigation and notified regulators but did not announce anything until today..so not only due diligence but two reporting periods of financials before HP had to be told by an insider about the issues.   There is something very wrong about this picture and the shares are being punished for it – we will report more, if relevant, as we learn it but this will take time to shake out.   How much worse can it get?  Not sure, but remain on the sidelines for now.

*revs $29.96 vs $30.4b ; EPS $1.16 vs $1.14; revs down 6.7% (-4.1% ex fx)

*operating margins: PC 3.5% (down), printing 17.5% (up), Services 14.2% (up), ESSN 8.3% (down), Software 27.2% (up)…total 10.4% up 0.7bps y/y and 1.2bps q/q

*FQ1 guide EPS 68-71c vs 85c (whisper 75-80c); maintains FY13 $3.40-3.60, but most were already skeptical…lots of 2H loading in EPS guide for lots of reasons including restructurings, new products, bad contract run offs etc.

*Printing -5%; services -6%; enterprise hardware -9%, software +14%… all decelerations except software which was very weak for the previous two quarters

*PC -12% (both Desktop and Notebooks -12%); commercial PC -13%, consumer -16%…PC oper margin fell to 3.5% from 4.7%… this is why next years EPS numbers are too high

*Printing -5%, supplies -1%, commercial hardware -13%, consumer hardware -14%; hardware units -22%

*Americas -6% y/y, EMEA -8%, APac -4%

*taking $8.8b charge related to $10.2b Autonomy acquisition; suing Autonomy and founder Mike Lynch for $5b on pre-merger misrepresentations; HPQ contacted the SEC in May after Lynch’s firing…Deloitte reviewed financials, KPMG reviewed due diligence…multi year issue, SEC then civil charges

*cash flow oper $4.1b; gross cash $11.8b; net cash $-16.4b; net cash ex fin svcs $-5.8b; cap ex only $299 vs $325m last Q and 585m last year

*weaker seasonality in 1H, stronger 2H… but not due to actual business, more the rolling of restructurings, changes, bad contracts

*conf call was unexciting… continued references to better 2H of FY13 will leave many concerned about forecasts; cash flow was better – though printing margins seem too high and cap ex was reduced.

Hewlett Packard (HPQ)

November 12, 2012

Price: $13.45 / Mkt Cap: $26.3b

Div Yld: 3.9%

Recent News:

HP held a disappointing analyst day last month where they lowered guidance for FY13 (which we still think is a stretch), and highlighted the drawn out recovery picture (FY15/16). The strategy reinforced efforts aimed at product segments where HP already leads but are facing secular declines.  HP stated they are a hardware and infrastructure company.  Most have been hoping for a more software, cloud, and services model.  Enterprise services will take a major hit in FY13, and, along with all other business lines recover in FY14 and beyond.

*FY13 EPS guidance of $3.40-3.60vs expectations of $4.  Enterprise Services will see a $0.29-$0.35 EPS drop on an 11%-13% revenue decline, and enterprise hardware a $0.05-$0.12 drop. Software and printing earnings are expected to grow, and PC earnings are seen as flat to slightly down.  Restructuring adds 80c of which 15c will be reinvested. Cash flow from operations $8.5b with $3.5b in cap ex, netting $5b in FCF.  We are highly skeptical of PC earnings staying flat and growth in printing.

FY14 is the transition year, new products coming online in late 2013 based on current investments and a revamped enterprise services unit.  FY15 and beyond the target model is a GDP grower with EPS faster and FCF above $6b.  Will keep dividend, but share repurchases only to offset stock option dilution until debt levels paid down. They need to maintain their debt rating to continue low cost vendor financing.

Thesis:

I do feel that HP did a fair job of setting expectations properly that a) this will take years and b) there ARE major issues that they are working on – including years of neglect on integrated cost structures and technology sharing etc.  However, I was disappointed at the focus on segments that will remain highly competitive and face secular declines and the aggressive estimates.  HP is using the costs savings next year to massage the EPS number and mask serious degradation in margins.  At its current size and scale, even with the planned cuts, and product segment maturity, HP is likely to continue to be a value trap.  Companies that face secular declines in their core markets rarely recover and in this case it’s not just secular, HP is also late on trends and is facing stiff competition both on quality and price.  Companies like Nokia, RIMM, Xerox, and Kodak are modern examples of this scenario.  IBM remains the one classic turnaround story, the exception rather than the rule.  Cisco has stabilized and nearly turned the corner, and really hasn’t seen true degradation in its core market yet.  Free cash flow is falling faster than revenues since 2009 and the dual mandate of cutting costs while investing is difficult to achieve.   We view current upside at $18-19 based on sum of the parts with downside of $10-12 (or lower).  This assumes cash flow does not collapse – not unprecedented, nor impossible given the rapid deceleration we are seeing in PC sales.  On a normalized basis you will find arguments for the return to $24-26 but this will only happen, macro improvements aside, if secular trends abate and management executes on its strategy, which we do not see as a high probability.  HP has the classic set up of a value trap and we remain on the sidelines, but acknowledge that a firm this large has lots of areas to cut costs and bundle and unbundle product sales.  HP’s main asset vs. past tech failures is its sprawling product and geographic diversity – a near term problem with complexity and cost, but may just save them.

Review:

Currently, HP views itself as hardware and infrastructure company, with great software and services capabilities and an ability to deliver on a global scale.  From an integration perspective, they are correct that they are the only true branded, vertically integrated tech company; everyone else solves this problem through best of breed JVs or partnerships.  Its personal computing assets compete with the likes of Dell, Lenovo, Acer and Asustek, while its printing segment sees challenges from Lexmark, Canon, Xerox, Ricoh and Samsung.  The services business is more akin to IBM or ACN, but also outsourcing companies like Cognizant.  On the integrated hardware, software and services basis, they face Cisco and Oracle.  These are the benchmark companies, along with some best of breed companies like EMC, we think of in regard to HP’s aggregate valuation.

At current levels, HP represents a classic value trap.  It appears attractive as a long term play for free cash flow following harsh write offs, strategic investment and management changes to capitalize on a global brand. The theory is that as investors eventually move past the wait and see stage with the new CEO and strategy they will reward HP with a higher multiple.  Our main issue with this is that HP’s current product portfolio requires large scale investment to fend off secular declines while its balance sheet and dividend continue to demand cost cuts and lower cap ex.  We see HP as a potential to reach $18-19 on the basis of sum of the parts – assuming stabilization in fundamentals, but to unlock more value and higher multiples requires an improvement in end markets and fundamentals. Also, HP has reiterated it does not wish to break-up.  This is weighed against the very real possibility (and our forecast) that secular headwinds drive cash flows from PCs and printers lower in the coming years.

Yes, HP still has valuable franchises in tech – but those are current values, not future.  Our main fears are: 1) PCs and printers are in secular decline, not cyclical; 2) services are leveraged to low value segments and need reinvestment and organizational changes; 3) software acquisition integration issues; 4) data center servers and networking are very competitive and will see continued pressure.

Pros:

• Company is making needed changes and investments in expanded sales coverage and product R&D.   Services for one will be reorganized and under a different reporting structure to capitalize on the fact that  higher margin services is underrepresented as a percentage of revenues at 14% vs. peers at ~20%.  This will take years to play out but is the logical move.
• Estimates are that only 50% of HPs enterprise clients are on support services vs. 75% plus for peers
• HP offers a complete set of server, storage, networking, and computing products on industry standard software and components – a solid position for the ongoing data center overhaul and enterprise computing shift.  The issue is that competition is increasing rapidly in this space.
• Management has been relatively straightforward in setting a reasonable timeline for a return to growth 2015/16
• Plans to continue to pay dividend and fund share buybacks in order to offset dilution.

Cons:

• PC and printer businesses face secular declines.  Gains in emerging markets are offset by losses in developed markets.  In addition, HPs strategy of maintaining pricing discipline on PCs is causing rapid share loss to more price aggressive Asian vendors.  Lastly, the tablet market is cannibalizing notebooks and in some cases desktops at an alarming rate.  In printing, HP is attempting two changes; 1) pricing hardware higher and supplies lower; 2) managed print services.  Both ideas may help improve printing volumes, but will not help margins.  In addition, the tablet and cloud movements hurt printing, a double loss for HP.
• HP has correctly admitted that they will need a tablet and mobile strategy going forward.  They will begin selling Windows 8 tablet this year, but have no discernible mobile strategy.  The tablet offering is focused on the enterprise and is dependent on the success of Windows 8.  The Palm WebOS they purchased has been shelved and sent to the open source community.
• Acquisitions since 2010 include 3Par, Palm, Arcsight, and Autonomy – four distinct business lines to incorporate – all key to strategy moving forward.  Execution is proving to be difficult.  Only 3Par is performing.  Autonomy has been reorganized, lost its founder and CEO and saw negative license growth.
• Going forward, we are concerned with the ability to meet both cost cuts and spending increases after this initial restructuring.  If cap ex remains, and declines continue free cash flow may be impaired.  If cap ex declines to save cash flow, competiveness will by impaired.  HP also has an underfunded pension.  Cash flow stabilization is the key to the investment profile.
• HP competes in several different verticals.  In general, they are under spending and under earning.  They currently spend less than companies like IBM but earn lower returns.  However, in the PC and Printing segments where they lead, they have higher than average margins but face secular headwinds. We see a long difficult transition of the margin structure which may end lower than the current expectations.    In addition, the services segment will continue to be weighed down by contracts that include PCs, printers and commodity servers as loss leaders to the contracts.

Valuation: 

Despite a leading position, HPs exposure to the commodity PC and printer markets, as well as the uncertainty of the services restructuring and the new strategy (focus on hardware and infrastructure) have it trading ~3.9x 2013 P/E.  We feel this is justified given the sliding revenue and secular (and macro headwinds).  The company’s EPS forecast is massaged by the massive restructuring, and revenues will deteriorate in 2013. Many will anticipate slight growth in 2014 (on easy comps alone), but we are not as certain.  We will monitor EBITDA, free cash flow and cap ex as these are the key items.   Metrics to focus on are EV/Sales and Price to FCF.

On a sum of the part basis, we think HPQ is worth close to $18-19 utilizing FCF and EV/EBITDA which are most appropriate.  Using other metrics like P/E and P/S will yield higher price targets – but the use of P/E is inappropriate at this time given the restructuring impact and P/S vs EV/S does not work due to the large amount of debt held by HP (particularly vs. comps).