Is the Hewlett-Packard Company Turnaround on Track?

Hewlett-Packard (HPQ -0.46%) is in the midst of what CEO Meg Whitman has described as a five-year turnaround plan. Part of this plan entails investing in incremental research and development to refresh HP's product portfolio. However, the key component for boosting HP's earnings power is a significant cost-cutting program.

However, HP's workforce restructuring has ballooned in size since it was first announced two years ago. Initially, HP planned to reduce its headcount by approximately 27,000 by the end of FY14. That job cut figure has been revised higher multiple times and now encompasses up to 50,000 employees. Does this mean that HP's turnaround plan is a failure?

HP has eliminated tens of thousands of positions in the last few years.

I don't think so. Other major IT players like Cisco Systems (CSCO -0.50%) have similar ongoing restructuring programs. This is just an indication of the fact that IT is a fast-moving industry where long-range planning can only go so far. HP's turnaround appears to be on track to return the company to earnings per share growth starting this year.

Serial restructuring?
HP announced that it would eliminate 27,000 positions in May 2012, but it took just a few months for the company to increase its job cut estimate. A quarterly SEC filing from September of that year revealed that HP planned to eliminate 29,000 positions by the end of October 2014.

Soon thereafter, HP began stating that the total number of job cuts could vary from its estimate by up to 15%. HP confirmed late last year that it would eliminate 34,000 positions (which is actually 17% more than 29,000). Around the same time, CFO Cathie Lesjak told investors that there might be incremental cost-cutting opportunities.

This ultimately led to HP's announcement last week that it will eliminate an additional 11,000-16,000 positions on top of the 34,000 job cuts already confirmed. This change will extend HP's restructuring plan to the end of FY15.

Bears believe HP is leaning too heavily on restructuring to survive. Some bears accuse HP of "serial restructuring" -- in other words, restructuring is a never-ending process, but the costs are being excluded from adjusted EPS as if they are "one-time" events. Others simply believe that HP's earnings power will drop off when it finally winds down its restructuring program.

A necessary evil
Some of the bears' criticisms are fair. HP's management has admitted that even when the current restructuring program is done, some parts of the company will continue to shed employees from time to time to boost efficiency. However, those future job eliminations (if they come) will not be treated as one-time costs. If HP follows through on this promise, it will take the wind out of the sails of "serial restructuring" critics.

Furthermore, HP is not the only company to keep raising job cut targets as new information on the enterprise IT landscape comes to light. Cisco Systems began restructuring back in 2011. It announced major job cuts that year and in 2013, along with some smaller cuts along the way. Cisco's cuts are similar to those at HP in terms of the total percentage reduction of its workforce.

In the past few quarters, Cisco's revenue declines have actually outpaced those of HP. As a result, the company has barely been able to keep EPS at the flat line, whereas HP has finally returned to earnings growth. Nevertheless, many analysts appear to be much more bullish about Cisco than HP.

It's all about cash flow
In my opinion, the one thing that settles this argument in favor of HP bulls is cash flow. It's true that HP can manipulate adjusted EPS figures by classifying certain expenses as "restructuring" costs. However, it can't fake how much cash is coming in the door -- or going out.

Last year, HP produced $11.6 billion of operating cash flow and approximately $8.4 billion of free cash flow despite the costs of its restructuring activities. At the midpoint of FY14, HP was not far off that pace, having produced year-to-date free cash flow of more than $4 billion. That money can be used for things like dividends, share buybacks, and debt reduction.

Based on HP's recent cash flow run rate, shares trade for less than eight times free cash flow. That's an extremely low valuation, especially if HP can increase free cash flow through additional cost cuts or reducing restructuring expenses. HP's turnaround is not finished yet, but there's no reason to doubt its chances of success at this point.