Monday, August 22, 2011

Hewlett-Packard (HPQ) Is Still Good Without a PC Business

After the release of it's most recent quarterly earnings, and the conference call that came with it. HP's CEO Leo Apotheker has been under constant strain because of the seemingly ill time proposed acquisition of Autonomy. Investors are getting pessimistic about the future of the company and it reflects in the recent selloff that has hit HP's stock. Maybe is it time to take a break from the unending stream of information and be rational about the real long term potential of this company.

For those not in the know, and Reuters provides a very detailed description, Hewlett-Packard Company (HP), incorporated in 1947, is a provider of products, technologies, software, solutions and services to individual consumers, small- and medium-sized businesses (SMBs) and large enterprises, including customers in the government, health and education sectors. Its operations are organized into seven segments: Services, Enterprise Storage and Servers (ESS), HP Software, the Personal Systems Group (PSG), the Imaging and Printing Group (IPG), HP Financial Services (HPFS), and Corporate Investments. Services, ESS and HP Software are reported collectively as a broader HP Enterprise Business. In April 2010, the Company completed its acquisition of 3Com Corporation. In July 2010, the Company completed the acquisition of Palm, Inc. (Palm), In September 2010, the Company acquired Fortify Software. In September 2010, the Company acquired 3PAR Inc., a global provider of utility storage. In October 2010, the Company acquired ArcSight, Inc., a security and compliance management company. The Company’s offerings include multi-vendor customer services, including infrastructure technology and business process outsourcing, technology support and maintenance, application development and support services and consulting and integration services. It also provides enterprise information technology infrastructure, including enterprise storage and server technology, networking products and solutions, information management software and software that optimizes business technology investments; personal computing and other access devices, and imaging and printing-related products and services. It is interesting to note that, at current prices, the company offers the best long term potential among the components of the Dow Jones Index. 

An unfortunate chains of events leading to a 33%+ decline in the stock price of an established company can only mean two things. For one, it could mean that investors might be thinking that the company has seen it's share of growth and are anticipating that the coming years will see a major drop in the company's earnings. Another more frequent reason might be that investors are overreacting to a series of what they assume to be very bad news for the firm. 

Time will tell which of those two scenarios fits best to reality, but in the meantime, I adhere to a contrarian camp who thinks that HP still has room for even modest growth. Assuming a reasonable P/E ratio of 10, the current price assumes a decrease of HP's earnings of 0.5%% annually over the next 5 years, giving us a 2016 price of 35$. A 8% discount rate would then justify the current 24.45$ at the end of the August 22nd. However, we know that HP has been growing earnings at about 8% a year over the past 10 years, and they went through two recessions over that period. Let's make another assumption and let's say that the acquisition of Autonomy puts some breaks on the growth of HP's earnings and that the company is only able to grow EPS at 5% per annum. We find ourselves with a 2016 price of 48$ per share. 

For the long term investor who is knowledgeable of the tech industry, this must be a great entry price into a company that has rewarded investors with a solid performance in the past 10 years, considering it's seize. With my limited knowledge of this particular industry, I used four different measurements and I came to the conclusion that the current price of HP's stock is overly pessimistic. The earlier stated P/E method gave me a 48$ price tag on shares of HP. 

Interestingly enough, HP has managed to grow it's book value per share over the past 10 years at about 7.5% per year. Assuming they can manage to keep that pace, we end up with a book value of nearly 23$ per share in 2016. At the current depressed Price/Book ratio of 1.6, we end up with a price per share of 38$. 

We can also look at free cash flow per share, which I calculated to have grown about 7% per year over the same period, even if it has been swigging wildly as it can be seen on the above chart. Keeping HP's stock for 5 years and using a 8% discount rate, I ended up with a present value of 49$ per share for HP. Free cash flow per share would end up being about 4$ per share in 2016, If we use a reasonable Price/Free cash flow ratio of 10, we end up with a 2016 price per share of 40$ per share. 

Assuming that my assumptions are not too flawed, it seems to me therefore that the market is being overly bearish on the long term prospects of Hewlett-Packard. Investors are assuming that the current change of strategy will have negative effects on the company, without taking into account that HP might come out of this crisis as a more profitable company. And it will certainly be more profitable if it dumps it's hardware business and stops acquiring companies at absurd premiums to the current price. 

Disclosure: The author has no position in HPQ and does not intend to initiate one in the near future.