HP is a liquid large cap value stock in the middle of a strategic turnaround, which we think has led the market to undervalue its shares.

It’s easy to hate HP. HP’s hardware business, which has traditionally been focused on PCs and printers, is going the way of the dodo bird, as users migrate to tablets and smartphones, and post material online instead of printing it. Likewise HP’s legacy corporate IT systems, which include large, slow servers, are dying off, with revenue run-offs hurting YoY comps; this forces the company to compete with a steady revenue headwind.

This brutal dynamic has not been lost on HP’s board, although their efforts to find the right leader to turn the company around read like a Greek tragedy. HP has had four CEOs in the past decade (not counting 2 interim CEOs), each pursuing a different vision for how to turn around the ailing technology giant.

In light of HP’s deteriorating business, whipsawing strategic agenda and rapidly revolving CEO door, the list of HP’s failed acquisitions is perhaps not surprising: the Compaq ($1.2 bn charge), EDS ($8 bn charge), and Palm ($0.9 bn charge) acquisitions all destroyed shareholder value. In 2011, HP bought Autonomy for $11 bn, only to take $8.8 bn writedown the very next year. Allegations of accounting improprieties at Autonomy are still reverberating in the financial press. These acquisitions, while well intended, clearly have the whiff of desperation.

Meg Whitman has cut fat from the business, laying off tens of thousands and ruthlessly attacking costs, which has contributed to a run-up in the stock in the past year, but you can’t cut forever without cutting into the bone. This could be a company in the midst of its death throes. Or so the argument goes.

This being VIC, we are here to tell you that all is not lost.

The company is very cheap today, with an EBIT yield on TEV of 12.8%, which places it in the cheapest 5% of liquid stocks (which we view as those above approximately a $1.5 billion market cap). Additionally, we believe that the hype surrounding the deterioration of its core business is overblown. We also believe HP is still fundamentally a high quality business, although the market has lost sight of this due to relentless negative publicity. We also think there are reasons to be optimistic about some of the business lines the company is trying to grow.

If HP can meet the ongoing challenge of stabilizing its legacy business while controlling costs and optimizing profitability, and simultaneously innovate and pivot to new technologies and growth to overtake the declining business, the stock represents good value at this price.

Let’s review some highlights of HP’s key business segments:

1) Personal Systems (27.8% of 2013 revenue)

Personal Systems comprises consumer/commercial PCs, workstations, tablets, calculators and the like. This is HP’s largest business segment by revenues, and has traditionally been a mainstay of its business model.

The conventional wisdom is that the PC industry is in a terminal death spiral, with PC shipments falling at rapid rates as tablets and phones take over the world. Consistent with this view, 2013 was the year the bottom dropped out for the PC market. IDC has estimated PC sales declined at a stunning 9.4% rate in 2013, far and away the steepest drop in a single year. But as anyone on VIC knows, you should always question the conventional wisdom.

There is growing sense that the PC markets are “bottoming out,” in the sense that the worst declines are behind us. Indeed, IDC projects a comparatively benign 6.1% decline for 2014, with shallower decline rates going forward. What accounts for this?

In many cases, PCs are simply a more efficient way to work, particularly for U.S. business users. Chances are good you are not currently sitting at your desk working on spreadsheets and word documents on your tablet, or a handheld. After initial steep declines in the installed PC base, as the marginal PC user opted for, say, a tablet, the weak hands from that user group are gone, and the market for traditional business users and other hard-core PC users, who really need and use PCs every day, may help stabilize the U.S. market.

In emerging markets, declines are still expected for PCs, but the portable market is actually projected to grow over the next few years, which is a trend that will help stabilize worldwide markets. IDC projects that worldwide PC shipments will decline by only 0.2% in 2018. So is this truly a bottoming out taking shape?

While it’s only a snapshot in time, HP’s PC group actually grew revenues by 4% in the first quarter, driven by 8% growth in the commercial business. HP’s launch of a new line of commercial PCs and tablets appears to be bearing fruit, and it has also launched a “phablet” (mobile phone/tablet hybrid) product in the Indian market. So it would appear that it is at least possible that HP’s secular headwinds could be abating, and that it is positioning itself appropriately to stave off future declines given evolving market conditions.

2) Printing (20.7% of 2013 revenue)

Printing consists of printer hardware, ink and toner supplies, and scanners.

The conventional wisdom suggests that people are printing less text and fewer photos, as the world goes paperless. Nevertheless, worldwide printed pages are stable, and are increasing in emerging markets. Volumes are also increasing for some specific products, such as multifunction printers (e.g., print, copy, scan).

Printing is still essential for business, especially around branding and marketing. For example, direct mail is a heavy user, and print is still an important part of many small business marketing campaigns. Print may be dying long term, but it is by no means in freefall.

HP generates a lot of cash from printing and is still a market leader. It has a well-established brand in consumer and business markets, and has lots of IP that enables it to gain or hold market share across its markets. As everyone knows, printing tends to be a generally good business since once you sell a printer, you earn a high margin annuity on ink cartridges and toner supplies. HP’s economies of scale will enable it to continue to earn profits on ink and toner, and grow share if the market shrinks, and marginal competitors get squeezed out of this commodity market.

HP has seen printer hardware growth for the past two quarters, driven by share gains in Lasers. Multifunction printers have also been showing strength, and IDC estimates the market for MFPs will grow at a CAGR of 1.4% through 2015. Another industry shift is from monochrome to color. Consider that HP’s multifunction color printers grew 25% YoY. HP is finding ways to win at the margin, even in turbulent markets.

Although printing overall is generally a slow growth business, it is growing more rapidly in emerging markets, which grew last year at double digit rates. In particular, the ability to print from a mobile device has driven sales. HP currently offers a plug-in with Samsung smartphones, and this model could be an effective one for the company going forward. IDC projects that around half of all tablet and smartphone owners will be using office printers in 2015.

Another intriguing printing area is 3D printing, which Whitman has said HP intends to enter in mid-2014. Last year, Goldman Sachs named 3D printing as one of 8 creatively destructive technologies that will disrupt existing markets. With potential applications in such diverse fields as health care (hearing aids, joint replacement, dental), aerospace and automotive (engines, equipment), and the consumer, some analysts have projected 20%-30% annual revenue growth. And 3D printing stocks have been marching higher: 3D systems Corp. (Ticker: DDD) and Stratasys Ltd. (Ticker: SSYS) have both roughly doubled in the past year and possess a combined market cap of over $11 billion. Obviously, 2D printing is very different from 3D printing, but if HP can leverage its experience and IP and dip a big toe into this market, it could do good things for the stock.

3) The Enterprise Group (24.5% of 2013 revenue)

The Enterprise Group consists of infrastructure solutions, including servers, storage, networking, and cloud offerings.

The Enterprise Group represents almost a quarter of HP’s revenues, and when you read in the press that HP has to “reinvent” itself, it’s a good bet the Enterprise Group is in the discussion. Recent highlights from the group include:

Servers

HP has lost several key accounts recently, and faces ongoing pressure from continued declines in its legacy commodity server business. As Oracle’s Larry Ellison complained a few years ago, “HP servers are slow, expensive, and have little or no software – that makes them vulnerable to market share.”

Apparently, Whitman took this to heart, as HP has sought to offset this criticism and market trends with Project Moonshot, a line of “software-defined” servers that can customized and optimized for large-scale applications, especially in data centers. The technology uses ARM processors for the same reason they are used in phones and tablets: they have a small footprint, use little energy and don’t generate heat. For any data center, this is a very good thing. The servers are set up in parallel, distributed architecture to facilitate specialized cloud applications including hosting, web serving, or transaction processing.

Some customers have been experimenting with the first generation Moonshot servers, and Whitman claims to be in discussions with dozens of service providers in the Fortune 200 who have shown a lot of interest, but she cautions the since the technology is new it will take time to penetrate the market. While Moonshot is appropriate today only for hyperscale environments, HP hopes that it will eventually be adopted by smaller users in fields such as genomics and financial services.

Meanwhile, Data Centers are big business. If the cloud was a country, it would be approximately the 5^th largest consumer of energy on the planet. Whitman has said that if the need for servers continues to grow, the market could need 10 million new servers over the next few years. IDC has forecasted the so-called “ultra-dense” server market to grow at double-digit rates, so if Moonshot gains traction in the cloud, HP would benefit.

Predictably, however, the competition is fierce. Big gorillas like Google and Facebook may be focused on the Open Compute initiative, which shares IP for data centers. So while the jury may still be out on Moonshot, at least HP has a viable horse in this important race.

Storage

While HP has legacy problems in its storage business similar to those in its server business, the company has a hit in its 3Par storage product line, which is a flash-optimized system allowing rapid access to stored data. The technology has been especially successful in the mid-tier storage market. According to Stiefel Nicolaus, 3Par is now HP’s largest storage contributor, having recently overtaken HP’s traditional storage business. HP expects converged storage (mostly 3Par) revenues to increase at a 2%-3% CAGR through 2016.

4) Enterprise Services (20.4% of 2013 revenue)

Enterprise Services involves HP’s technology consulting and support services.

Enterprise Services is also under pressure due to account runoff, and had a poor performance in Q1 (although it is a seasonal business). A lot of this business segment revenue relates to HP’s 2009 acquisition of Electronic Data Systems, whose business included outsourcing, and data center management. Whitman has commented that services take longer to turn around than transaction businesses, since service business may require cultural change and incremental progress, whereas a transaction business can be turned around more quickly through cost cutting, layoffs, or new technology.

Within Enterprise Services, the advances are being made around the cloud, Big Data, mobility and security. HP wants to move to a “new style of IT,” which provides strategic services, and goes beyond traditional outsourcing and simple modernizing of business applications.

5) Software (3.4% of 2013 revenue)

HP’s software is a small component of HP revenues, but has very high margins, and good growth prospects. HP’s efforts are primarily focused on its integration of two acquisitions: Vertica, a big data analytics specialist, with Autonomy, an information processor. The integration allows more efficient use of customers’ unstructured data, allowing it to be monetized. For example, companies can mine Tweets or Likes to modify their products or services. This concept has been extended to a big data analytics platform called HAVEn, which drives decision making in areas where machine data and human information overlap. Applications include capacity planning, healthcare analytics, and security.

Part of HP’s challenge is to move away from traditional licensed, “on-premise” software, and towards emerging software-as-a-service (SaaS) models, which are cloud-based and can be run in a web browser. Gartner predicts SaaS will be a $22 billion market by 2015, up from $14 billion in 2012. HP’s SaaS revenues were up 6% in Q1. While the trend towards SaaS may hurt HP’s profitability in the near term, as defections hurt its traditional licensing business, if they can play catchup on SaaS, the market is large and growing.

FRANCHISE VALUE

HP is huge portfolio of diverse businesses, with overlapping legacy and new business lines, and due to this the company is very difficult to model in a granular way. Rather than insert a model and debate line items, we therefore now turn to some big-picture statistical characteristics which we think are good indicators of HP’s franchise value.

MARGIN STABILITY

“The single most important decision in evaluating a business is pricing power.” – Warren Buffett

A high quality business with a franchise is able to raise or maintain prices, and continue earning profits, without sacrificing demand for its products. Note that HP has maintained its strong gross margins in a narrow range of between 22.9% and 24.6% over the past 8 years, which represents a full business cycle:

TTM 23.2%

2013 23.3%

2012 22.9%

2011 24.2%

2010 23.5%

2009 23.9%

2008 24.6%

2007 24.4%

We believe the stability and consistency of HP’s margins is a signal that the firm’s underlying business has economic moat-like characteristics and demonstrates it has pricing power in its markets. This may have something to do with HP’s strong brand, which it has developed steadily over many years and many customers, and across many products; today HP’s brand is well known worldwide, across a range of technology offerings and it is one that people trust.  Because consumers and businesses trust the brand, they are willing to pay more for HP products than for its competitors’ products, giving the firm pricing power, and enabling it to maintain highly stable margins over time. 

FREE CASH FLOW

Whatever you may think of all the controversy surrounding the company’s core markets, board room antics and turnaround strategy, HP is unquestionably a strong and consistent generator of free cash flow. Below are HP’s FCF totals for the past 8 years:

TTM $8,473

2013 $8,484

2012 $6,266

2011 $8,347

2010 $10,972

2009 $9,335

2008 $9,891

2007 $6,658

8-Year FCF Total: $68,426

When we measure these past 8 years of free cash flow against HP’s Total Assets of $105,676, we get 64.8%, which is better than approximately 80% of our liquid market (as defined above). HP has demonstrated its ongoing ability to generate cash on its investments over a full business cycle. On this measure (trailing 8 yr. FCF/Assets), HP beats out some notable cash generators in technology, including Google, Honeywell, NVIDIA, and Brocade.

RETURNS ON CAPITAL

HP has also demonstrated an ability to earn respectable returns on capital (which we define as: EBIT*(1-tax rate)/BV debt + BV equity – cash):

TTM 10.6%

2013 (25.0%)

2012 8.4%

2011 14.7%

2010 13.9%

2009 13.4%

2008 17.3%

2007 14.9%

The 8-year geometric mean of HP’s ROC is 7.6%, which is close to average for the market for liquid stocks (as defined above). We think HP’s historical returns on capital can be reasonably incorporated into forecasts of future returns across all the projects the firm has on its books.

FINANCIAL STRENGTH

HP is profitable, and earned a 5.0% ROA, which is above its 8-year geometric return on assets of 4.4%. The company is increased both ROA and FCF/Assets versus the prior year, which indicates more efficient use of its assets, and positive trends in the underlying business. The company also has TTM FCF of $8,473 million versus TTM net income of $5,306, indicating low accruals, a cleaned up balance sheet, and low likelihood of earnings manipulation.  

HP’s leverage (when scaled by assets) declined in the past year; net debt is now below pre-Autonomy levels. HP was also a net repurchaser of equity in the past year. At recent analysts meeting, HP committed to returning 50% of free cash flow to shareholders. We think that is pretty shareholder friendly. In Q1, HP repurchased $565 million of stock, and paid $278 million in dividends.

NEAR TERM INSTABILITY OF COMPETITION

An interesting feature of HP’s current competitive landscape is that there is some instability and uncertainty among several large competitors. IBM announced plans to sell its x86 server business to Lenovo, which boosts its share in the server market, making it suddenly relevant in the enterprise business. Still, U.S. customers may shy away from doing business with a Chinese firm that is partially government-owned, and whose PC products were banned by several western intelligence agencies last year. Dell is also going private, and assuming perhaps $15 billion of new debt. That kind of leverage has a way of scaring customers, especially if client support suffers; it can also impact employee morale, as huge layoffs are threatened. By contrast, HP may look like comparatively stable, and create near-term opportunity for HP, whose channel partners may prefer HP’s comparative consistency.

CONCLUSION

HP is a complex business, with a lot of legacy businesses that are going away and many new businesses the company hopes will supplant these declines and lead to growth going forward. Unquestionably, the company faces many threats to its core business, but the turnaround seems to be going reasonably well. The PC market may be bottoming out. Printing is still generating cash, and the company has repositioned well. Moonshot may reinvigorate the server business, and help the company succeed in the cloud. HP’s 3Par looks like a strong storage model going forward. The enterprise service business is turning around. In software, the company is embracing big data and a SaaS model. Whitman deserves credit for a good job thus far.

And today the company is clearly cheap, with an EBIT yield on TEV of 12.8%. It also shows strong signs of being a good business with franchise characteristics, including stable margins, a high rate of FCF generation, decent returns on capital and on assets, and positive trends in financial strength, including increasing returns on assets and reduced leverage; the company is also returning a lot of cash to shareholders.

In light of the success of the turnaround, favorable market dynamics relative to perceptions, positive developments in the business, and strong financial quality metrics, we think that on balance, HP represents a good value investment here.