Description

This is a bit of a contrarian play but the combination of extreme negativity and strong free cash flow make HPQ a compelling idea. The merger of Hewlett and Compaq was universally panned and nearly overturned by shareholders in a particularly public fight.

We now have an entity with a franchise product line that is merging during the bottom of the industry cycle. In addition, the industry has been consolidated with only two players that can now provide end-to-end solutions in the data center. However, the thesis surrounding the investment is based purely on Hewlett continuing to sell ink and provide services and not on getting the integration with Compaq right.

The company is organized into 4 segments, Imaging and Printing, Personal Systems (PC?s), Enerprise (Servers, Software & Storage), and Services. HPQ currently has an Enterprise Value of $46.5 Billion.

Share Price $17
Shares Out 3,031
Market Cap $51.5 Billion

Net Cash $5 Billion
Ent. Value $46.5 Billion

Given today?s price, investors are paying for Hewlett?s Imaging and Printing Division and Services Division and getting the rest of the business for almost nothing.

Hewlett?s franchise printer business has leading market share in laserjets, inkjets, and multi-function devices. Computing has become more distributed leading to 3 beneficial outcomes for printer companies:

1. More people get more distributed content and like it in paper form
2. This content is increasing rich and requires more ink
3. The content is increasingly in color

HPQ?s Printer business had almost $20 Billion in revenues in fiscal 2001 (Ending Oct 31) and historically low operating margins of 9.6%. (Operating margins in the first half of fiscal 2002 were 15.1% on $10 Billion in revs). Going forward the company is projecting 12% operating margins and 10% growth for this unit.

Given their franchise position and great razor, razor blade model, I have confidence in the 12% Operating margin forecast but think the double digit growth could be difficult ? especially in the near-term. Using 5% growth off a $20 B base for fiscal ?03 gives you $21 Billion in revenue. A 12% operating margin assumption yields $2.5 Billion in Operating Earnings. Due to the high visibility in earnings, (with over half of revenues from supplies) and outstanding margins and returns on assets in this business I will use a 12x multiple on operating earnings to get a segment value of $30 Billion.

The Services business is also high margin but lacks the growth of the Printer division. HPQ will conservatively have $13 Billion in Revenues in fiscal 2003 with average historical operating margins of 13%. Given the low growth but high margins in this business I have used a 7X multiple on operating earnings of $1.7 Billion to get a segment value of $11.8 Billion.

This leaves the rest of Hewlett Packard, a $20 Billion PC business and a $18 Billion Server business being valued at $4.7 Billion or .12x Sales. Now clearly the PC business has lost money in the past year and is losing share to Dell. The Server business is also under fire from Dell, Sun and IBM; however, I would argue that they are worth more than the market is valuing them.

In PC?s, Hewlett made money in the Consumer segment and Compaq made money in Corporate. Management has stated that there is tremendous overlap in these groups and plans to shut down instead of integrate overlapping products. For example, Compaq?s handheld, the iPaq will carry on while HP?s legacy Journada division will be shuttered. While the short-term outlook for PC?s may be dim, every desktop will continue to have one and they will be upgraded at some point. The new HP will enjoy some scale benefits from the merger though I would expect Dell to demand the same concessions.

In Server?s, the Company has kept the dominant Compaq NT server brand and shut HP?s NT effort. Compaq is the leader in non-stop Unix from the Tandem days and HP?s own Unix flavor commands over 20% of the market. Since mission critical applications will continue to be run on Unix and it is difficult to change providers, HP will share the Unix data center oligopoly with Sun and IBM. The Compaq storage business is also very strong in deploying storage area networks and has taken share from EMC in disk arrays. The server division has more operating leverage than the PC division and will benefit from an upturn in overall IT spending.

Hewlett has many near-term challenges but its strong free cash flow ? over $1 Billion per quarter, and franchise position in printers will help it stem the tide in PC?s and Servers. There is value hidden in the new HP and it may take a while to uncover it but in the mean time you have an investment with a healthy balance sheet and strong cash generation capabilities.

Given the soft IT spending environment and integration challenges I have put a $22 target price on HPQ (29% upside) based on 16.5x fiscal 2003 management guidence of $1.33 or .8x fiscal ?03 sales.

Catalyst

1. Recognition by investors of the strong free cash generation by the Printing and Imaging division and Services division.
2. Compelling valuation if management is within a standard deviation of publicly stated guidence and on sum of the parts valuation.