I write a lot about value traps: companies that look like good value on paper, but with far less margin of safety than a quick inspection shows. Less than a year ago, shares of tech giant Hewlett-Packard were in the gutter. After being valued at over $120 billion in 2010, the market gave HP’s market cap a beating. Not surprisingly, the hiring of new CEO Meg Whitman in late 2011 did little to stop the decline, with the stock hitting a low a little over a year later.
Since that low, the stock has rebounded some, more than doubling before disappointing earnings and guidance caused a steep sell-off in late August. With the company still valued well below its peak, one might think HP currently offers a value opportunity. Indeed, it has a PE of 6, an acceptable debt/equity ratio of 1.1, and it’s generating $8.5 billion in free cash flow. If we dig a bit deeper, however, things don’t look as pretty.
If HP could maintain business and keep growth above 3%, it would provide a margin of safety at today’s prices above 50%. There is, however, reason to believe that HP business will actually contract in the future. HP is split into five groups, and as you can see from the following table, nearly all of them are shrinking:[table “” not found /]
The first group, printing and personal systems, is the largest contributor to earnings and makes up about half of the total revenue. Although it would seem like the printing division, which includes both printing hardware and supplies, should be in a total free-fall, unit sales were actually up in the third quarter. Commercial hardware units rose by 12% year over year, with consumer units jumping by 2%. Revenue from supplies was down, leading to the overall decline, since supplies make up two-thirds of the total printing revenue, but the picture is not as grim as I had expected.
About 40% of the total non-GAAP operating income came from printing, and the stability of the printing operating margin is encouraging. The operating margin has remained around 15-16% for the past few years, with minimal fluctuations. One thing benefiting HP is that there is an implicit barrier to entry into the printing business. No company in its right mind would try to compete with the big players in a permanently declining industry, giving HP and its current competitors the ability to extract high-margin profits. Although printing revenue will likely continue to decline, profits from the business shouldn’t fall much faster than revenue.
The other part of the group, personal systems, includes desktops, laptops, and workstations. This business has terrible profit margins and is stuck in decline as the PC market contracts. HP should have gotten out of the PC market years ago, much like IBM.
The enterprise group includes servers, storage, and networking. This division is responsible for 45% of the total operating profit, making the declining revenue and margin concerning. Operating margin has fallen from around 20% at the end of 2011 to 15% today, and the trend shows no sign of reversing any time soon. A big shift is occurring in the server market, with companies and organizations increasingly outsourcing their computing to the cloud. Proprietary servers are becoming decreasingly relevant, and HP’s most profitable division will likely suffer in the coming years. Profits derived from servers are going to dry up far faster than profits derived from printing.
The enterprise-services group, which includes IT outsourcing, has both shrinking revenue and PC-like margins. HP is betting on new cloud services within this group, which are growing quickly, but the segment as a whole will continue to weaken until these new services gain traction.
Software is the only group which grew in the quarter, although barely. Operating margin is high at 20.5%, but because the group is so small it contributes about as much to total operating profit as PCs contribute.
One encouraging trend for HP is its decreasing debt. Net debt has dropped from $19.5 billion a year ago to $11 billion today, a significant improvement.
Including this net debt, HP’s enterprise value after the post-earnings decline is roughly $54.5 billion. The company expects free cash flow of about $8 billion this year, putting the EV/FCF ratio at about 6.8.
If HP could maintain its current level of profitability going forward, it would be a great value. But, unfortunately, that does not appear to be the case. The units that make up the bulk of HP’s profits are declining, and it will likely take years before the company can turn the corner.
The HP turnaround is a multiyear process that, if successful, will not be complete any time soon. Revenue will continue to decline, taking profits with it, and this makes buying the stock right now a more risky proposition than it first appears. That said, I’ll keep my eye on HP in the coming years, and if there are signs of a turnaround, it become a very good value opportunity.