Hewlett-Packard (HPQ)

Our latest microcap idea is a little company called Hewlett Packard (HPQ).  We believe that HPQ is currently significantly undervalued at current price levels and that its strong business franchise, modest valuation, strong management team, and excellent long-term prospects make it an excellent investment amid a deflating credit bubble and slowing global economy.  HPQ trades at 5.7x LTM EBITDA, 7.2x LTM EBIT, 9.5x FY08 (ended Oct 31) non GAAP EPS of $3.63, and 9x FY09 non GAAP EPS guidance of $3.88 to $4.03 (just recently given by management).  HPQ also trades at about 7x to 8x free cash flow.  These ratios are far below the multiples where HPQ has traded in more stable environments (welcome to the club).  We think they are attractive for a business that was able to grow both non GAAP EBIT and EPS over 20% year to date in 2008 (although we clearly expect these growth rates to slow in F09 given global macro conditions).  HPQ will give a more detailed update on Q4 and F08 results on Monday.    

The multiples above do not pro forma the EDS acquisition (discussed further below) which was completed on August 26, 2008.  The EDS acquisition will enlarge significantly HPQ’s services segment, more than doubling its revenues.  HPQ management has said the acquisition will be accretive to non GAAP EPS in year one.  HPQ management made a point of noting that F09 guidance incorporates the current market conditions (economic and currency) into recent guidance numbers.  So far Hurd and his team have consistently beaten their guidance numbers quarter after quarter.

CEO Mark Hurd came to HPQ in April 2005 after a very successful experience at NCR, a technology company specializing in point of sale terminals and ATMs, where NCR’s operating performance improved sharply and its stock price tripled while he was CEO from 2003 to 2005.  In our opinion Hurd executes, drives efficiencies, and strategizes about as well as any executive we have come across.  Since he arrived at HPQ non GAAP EBIT is up over 150%, shares outstanding are down over 15%, and the balance sheet has remained extremely strong.

Free cash flow

HPQ generates very substantial amounts of free cash flow and is trading at about 7x to 8x LTM free cash flow.  LTM cash from operations is close to $15 billion as compared to LTM capital expenditures of $2.8 billion, resulting in LTM free cash flow (as we define it) of $12.2 billion or $4.96 per share.  Based on today’s $35 share price this results in a free cash flow yield of 14% on the equity.  Excluding working capital, LTM cash from operations is about $14 billion, resulting in FCF per share of $4.37 or about a 13% FCF yield.  We find this very cheap for a company of this quality even in today’s bombed out environment.  

HPQ’s balance sheet is extremely strong and was actually in a net cash position of $5 billion prior to the EDS acquisition, although it has since borrowed to complete the purchase of EDS in August 2008.  While the EDS purchase has added debt to HPQ’s balance sheet, EDS is also bringing along a substantial amount of incremental cash flow: EDS’ LTM cash from operations was close to $2 billion versus LTM capital expenditures of about $800 million. 

Our optimism for HPQ is not only its strong revenue and earnings growth to date in a difficult economy but we also believe that HPQ under Hurd’s leadership will be very effective at deploying its prodigious cash flow into highly accretive acquisitions.  Therefore, we believe there could be several years of additional earnings growth in this situation as various under-managed IT assets gradually find their way into HPQ’s quite capable hands.  HPQ has a highly diversified business model across both geographies (about 65% of revenues come from international markets) and business segments (HPQ has dominant positions in printers, personal computers, servers, services, software, and other areas).

Business Segments

HPQ’s business franchise is probably well known to VIC members but just a short review.  Key operating segments and their contributions are as follows:  Imaging and Printing Group (LTM revenues of $29.5 billion and LTM operating earnings of $4.4 billion), Personal Systems Group (LTM revenues of $41.3 billion and LTM operating earnings of $2.4 billion), Enterprise Storage and Servers (LTM revenues of $19.5 billion and LTM operating income of $2.4 billion), HP Services (LTM revenues of $18.2 billion and LTM operating earnings of $2.1 billion), and HP Software (LTM revenues of $2.7 billion and LTM operating income of $0.5 billion).

Personal Systems Group (PSG) is the leading provider of PC’s in the world based on unit volume shipped and annual revenue.  Like the broader PC market PSG continues to experience a shift toward mobile products such as notebooks.  Imaging and Printing (IPG) is the leading imaging and printing systems provider in the world for consumer and commercial printer hardware, printing supplies, and scanning devices.  IPG is driven significantly by its supplies business which represents the high margin ink sales used with its printers.  Enterprise Storage and Servers (ESS) provides a broad portfolio of storage and server solutions to optimize product solutions required by different customers including both enterprise and SMB markets.  HP Services provides a portfolio of multi-vendor IT services including technology services, consulting and integration and outsourcing services and collaborates with the ESS and HP Software groups.  HP Software provides a suite of Business Technology Optimization (BTO) software solutions that allow customers to manage and automate their IT infrastructure, operations, applications, IT services and business processes under the OpenView brand.

Geographically HPQ is highly diversified across the globe with over 65% of LTM revenues coming from outside the U.S.  During F07 revenues by region were as follows: U.S. 33%, Canada/Latin America 9%; EMEA 41%; Asia Pacific 17%.  F07 revenue growth by region was as follows: Americas (U.S. and Canada/Latin America) + 10%; EMEA +16%; and Asia Pacific +18%.

Share repurchases

Since Mark Hurd’s arrival in April 2005, HPQ’s free cash flow and strong balance sheet have supported a huge amount of share repurchases.  For 9mos 2008 HPQ had repurchased $7.7 billion of its shares, on top of $10.9 billion in F07 and $7.8 billion in F06, and $3.5 billion in F05. Most recently, HPQ authorized an additional $8 billion of share repurchases in September 2008.  Even against HPQ’s mega-market cap of $85 billion (at $35 per share price), these share buybacks are substantial numbers ($22 billion in 3.5 years).  What is even more impressive is that, even after all these share repurchases, prior to the EDS acquisition in August 2008, HPQ’s most recent balance sheet was actually in a net cash position ($14.8 billion cash position versus $10.3 billion of debt).  While near term share repurchases may be somewhat muted as HPQ rapidly pays down the debt associated with EDS, we expect them to steadily continue to be a major lever to drive shareholder value under Mark Hurd’s leadership.

Since Hurd arrived in April 2005, the company’s share count has declined from 2.910 million as of the 10/31/04 10K to 2.449 million as of the 7/31/08 10Q while non GAAP EBIT has increased from $4.4 billion for F04 to $9.6 billion for F08, and the company’s balance sheet remained in a net cash position over this entire period.  Management has sharply reduced shares outstanding, sharply increased operating earnings, and has accomplished this while maintaining a very conservative balance sheet position.

Acquisitions

In addition to share repurchases HPQ management has very successfully allocated capital into strategic acquisitions.  Hurd is moving HPQ towards IBM’s model and has made several successful acquisitions of software and services businesses over the past couple years, with the largest and most recent being the acquisition of EDS.  During F07 HPQ acquired several software companies, including Mercury Interactive, Bristol Technologies, SPI Dynamics, and Opsware which added transaction monitoring, applications security testing, and data center automation capabilities to the BTO portfolio.

EDS Acquisition

We believe EDS will end up being a very successful acquisition for HPQ.  HPQ is combining EDS’ services business with its existing HPQ services business to become one of the largest players in the services industry.  HPQ has announced it will cut about 24,600 jobs.  The market reacted very negatively to announce of this acquisition initially due to concerns EDS slower growth rate would dilute HPQ’s earnings growth.  HPQ paid about $14 billion for EDS which had LTM revenue of $22.5 billion and LTM cash from operations of $2.0 billion and LTM capital expenditures of about $0.8 billion.  HPQ financed the EDS purchase from its cash position and a debt offering.  Management has said it expects HPQ to return to a net cash position (total cash exceeds total debt) within 12 to 15 months after closing the acquisition of EDS.  The EDS acquisition clearly adds a lot of incremental cash flow to HPQ, even before considering the synergistic cost reductions, which are quite substantial.  HPQ management has said they expect to drive towards about $2.5 billion of annual savings with total net ultimate run rate level of cost savings of about $1.8 billion (about $500 million achieved in F09).  These savings will come from headcount reductions, IT, real estate, procurement, etc. with a portion reinvested back into market competitiveness and sales force hiring, etc.  Once again, we point out Hurd has an excellent track record of rationalizing costs and reinvesting savings back into revenue driving activities such as larger and more effective sales forces.

HPQ management has indicated that there is very limited overlap in relationships between top HPQ services accounts and top EDS services accounts.  They have also indicated that HPQ’s share of wallet with enterprise customers is much higher in all its segments (Services, Software, Enterprise, TSG) with accounts that have an outsourced services relationship.  The pro forma company (HPQ + EDS) has combined revenue of about $135 billion, combined operating profit of about $12 billion, and, importantly, combined spending of about $123 billion.  The last category, combined spending is important, since this represents a large base of costs that HPQ’s management team can focus on rationalizing, as they have repeated done.

Recent operating results

For F07 HPQ’s net revenue was $104.3 billion, up 14% or 10% in local currencies.  F07 non GAAP operating profit was $9.6 billion, up 30% and non GAAP EPS was $2.93 per share, up 23% versus $2.38 prior year.  During F07 HPQ generated $10.4 billion of cash from operations.

HPQ posted another strong quarter for Q3 2008 with revenue up 10% to $28.0 billion, non GAAP operating profit up 20% to $2.7 billion, and non GAAP EPS up 25% to 86 cents versus 71 cents prior year.  Non GAAP results basically exclude non cash and non recurring type charges.

For 9 months F08, HPQ net revenues grew 12% to $84.8 billion versus $76.0 billion prior year, 9 months non GAAP operating income grew 24% to $8.4 billion versus $6.8 billion prior year,  and 9 months non GAAP diluted EPS grew 26% to $2.60 versus $2.07 prior year.

Further Thoughts

We think investors who purchase HPQ at these types of free cash flow yields should do well over time.  While we expect revenue and profit growth will be somewhat muted over the next year due to the recession we think a large part of the HPQ story will be expense optimization which should help offset some of the revenue slowdown.  We think Hurd is exceptionally good at rationalizing cost structures and we think EDS will give him substantial further opportunities to do so.  We believe HPQ has a high quality global franchise with very significant long term upside potential from these price levels.

We think the market will ultimately put a much higher multiple of earnings and free cash flows on this high quality business and management team.  We don’t know when this will happen but we are pretty confident that it ultimately will and feel like we are waiting in a high quality investment which is continuing to grow even in a difficult environment.  Further, we believe the company’s strategic growth plan into higher margin software and services businesses (a la IBM) is another positive which is creating incremental shareholder value. 

HPQ management under Hurd is extremely focused on optimizing costs.  In fact, management presents F07 revenue of $104.3 billion and subtracts F07 operating profit of $9.6 billion to derive what it calls spending of $94.7 billion.  This spending are the expenses which management is constantly focused on reducing or optimizing.  While times are tough we think management’s exceptional cost cutting abilities should help continue to improve operating margins even as revenue growth slows.  Also HPQ has a large portion of its revenue and earnings base in recurring type business segments which should hold up well in a tough environment. 

We have watched Mark Hurd operate since joining HPQ in March 2005 and have been very impressed with both his operational execution and strategic acquisition decisions.  We believe he is an excellent allocator of capital to drive shareholder value and we think there is significant upside in how he effectively utilizes HPQ’s strong free cash flows and strong balance sheet to enhance shareholder value both through intelligent strategic acquisitions and execution on the synergies these acquisitions offer to HPQ. 

Conclusion

Where does all this leave us?  In our view, we could reasonably see HPQ trading at 15x to 16x F10 EPS of $4.25 (we think this EPS number could be conservative) or close to $65 to $70 per share over the next 18 to 24 months.  This would be almost a double from current prices.  Furthermore, we believe this is one of those investment where intrinsic value could continue to grow substantially over a long period of time, as HPQ has a very strong and diversified product and service portfolio which is being sold into a highly diversified geographic footprint which should have excellent long term growth opportunities.  We think HPQ could be an attractive compounding machine over the next three to five years.  Clearly it won’t be a straight line but we think investors at today’s prices should do well.

Segment Information