It's been little more than a year since Hewlett-Packard (NYSE: HPQ) suddenly ousted then-CEO Mark Hurd and sparked an immediate sell-off in the company's stock. In February, HP issued a disappointing outlook and the stock began a fresh round of underperformance relative to both the market and competitors IBM (NYSE: IBM), Dell (Nasdaq: DELL), and Apple (Nasdaq: AAPL).
Next Thursday, the company again reports earnings. With a P/E ratio of 7.6 and a dividend yield of 1.6%, it's time to ask what you believe: Is HP a great value or a value trap?
The "PC is dead" trade
The raging success of Apple's iPad tablet is elevating "the PC is dead" to conventional wisdom. That's helped push stocks of PC-related companies to single-digit P/E ratios. Intel (Nasdaq: INTC) has a P/E ratio of 9.3 and offers a whopping 4.1% dividend yield. Microsoft (Nasdaq: MSFT) has a P/E ratio of 9.1 and offers an S&P 500 index-beating 2.6% dividend yield.
So part of the knock against HP is its position as the world's largest PC vendor. But while HP's PC division accounts for 32% of revenue, it accounts for only 13% of operating profit. HP's enterprise businesses -- servers, storage, networking, services, and software -- account for 56% of operating profit. The printer business accounts for 28%.
That's not to say the fortunes of HP's PC business don't matter. It's to say the fortunes of the company's enterprise and printer businesses matter far more.
From growth stock to turnaround
HP officially has transitioned from growth stock to aspiring turnaround. It confessed last May to having underinvested. Mark Hurd, known for his cost-cutting skills, took a good thing too far. Catch-up spending is expected to be a drag on earnings growth for an extended period.
Additional near-term concerns include supply-chain disruptions because of the tragedy in Japan, which highlighted HP's dependence on Canon for printer supplies. Weakness in consumer spending and the company's missteps in China are hurting its PC business.
My vote: value trap
Let's take a look at HP's outlook, keeping its profit mix in mind. It's a huge company in a maturing industry, so growth is a challenge. That said, within tech there are still growth areas. Here are several I'm watching:
- Mobile.
- The cloud.
- Business analytics/big data.
- Emerging markets outgrowing developed markets.
So how is HP doing in these areas? In mobile, it spent $1.2 billion to acquire Palm in hopes of beefing up its smartphone and tablet offerings. Earlier this year, management expressed optimism that its then-unreleased TouchPad tablet would help improve the PC division's growth and earnings. But little more than a month after the TouchPad's July 1 launch, it was widely available with instant discounts of $100 -- including at HP's online store. That can't bode well for HP's margins on the product, given that it was priced to compete with the iPad. Apple CEO Steve Jobs has said his company is pricing aggressively.
What about the cloud? HP says it's now putting a big emphasis on cloud computing. Ditto with business analytics. During Hewlett-Packard's March 2011 investor summit CFO Cathie Lesjak said the company is "skating to where the puck will be," though she thought investors weren't giving it due credit. I think investors realize there are a number of competitors between HP and "where the puck will be." HP may be skating to the right place, but it's behind in a fast-moving industry.
At least there are emerging markets. Management cited PCs in China as a reason it expects improved performance later this year. Its China PC business has seen sequential improvement lately but is probably still down significantly from last year. I also question whether HP's and Dell's PC businesses are tech enough to succeed in emerging markets.
In its most recent quarter, BRIC countries accounted for 12% of HP's revenue. In contrast, IBM's CFO stated last month that he remains "confident that growth markets will approach 30 percent of IBM's geographic revenue in 2015, and drive half of IBM's revenue growth, with strong margin performance." To be fair, IBM's definition of growth markets extends beyond BRIC countries. Nonetheless, the CFO's comment indicates that IBM established a beachhead in emerging markets early enough to be generating meaningful and profitable revenue now instead of investing for growth. In short, that puck is heading for IBM. (The same is true of the business-analytics puck.)
Can HP catch up? Not if its software aspirations are any guide. The company has been saying for years that it planned to grow its software business into a larger share of its mix. No doubt HP has been eyeing IBM's software business, which accounts for about 24% of revenue and a whopping 44% of pre-tax profit at Big Blue. At HP, software now accounts for about 3% of revenue and 5% of operating profit. It has improved, but not enough to be called a real success.
Foolish takeaway
The problem with turnarounds is that they so rarely turn. And for now, nothing I see suggests that HP is about to turn. It looks like a value trap rather than a good value. The undervalued tech stocks I'm looking to pick up in this market's bargain bin are first-choice Intel and second-choice Microsoft … two of the biggest victims of the "PC is dead" thesis. IBM and Apple are tech greats I'm looking to buy on the dip.
What do you think -- is HP a good value or a value trap? We're likely to learn more from its earnings release next Thursday. To help you keep an eye on the situation, The Motley Fool recently introduced a free My Watchlist feature. You can get up-to-date news and analysis by adding these companies to your Watchlist now:
