Less than a year ago, shares of tech giant Hewlett-Packard (HPQ +2.71%) were in the gutter. After being valued at over $120 billion in 2010, the market left HP for dead, dragging its market capitalization down substantially. The hiring of new CEO Meg Whitman, former CEO of eBay, 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 strongly, 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, does HP offer value for investors? Or is the company set for a slow, painful decline?
A disturbing trend
Included in HP's recent earnings presentation was the record of revenue growth over the past three years:
Of course, what matters for investors is the next three years and beyond, and for that we need to know where HP makes its money.
HP is split into five groups, and as you can see from the following table, nearly all of them are shrinking:
HP groups
| $in millions | Q3 Net Revenue | Growth y/y% | Non-GAAP OP $ | Non-GAAP OP % of rev |
|---|---|---|---|---|
| Printing | $5,803 | -4% | $908 | 15.6% |
| Personal Systems | $7,704 | -11% | $228 | 3% |
| Printing & Personal Systems Group | $13,507 | -8% | $1,136 | 8.4% |
| Enterprise Group | $6,786 | -9% | $1,033 | 15.2% |
| Enterprise Services | $5,843 | -9% | $192 | 3.3% |
| Software | $982 | 1% | $201 | 20.5% |
| HP Financial Services | $879 | -6% | $99 | 11.3% |
| Total HP | $27,226 | -8% | $2,296 | 8.4% |
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 International Business Machines (IBM 0.48%) did.
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.
This shift to the cloud also threatens IBM, which dodged one bullet by selling its PC business to Lenovo in 2004. Earlier this year, IBM was in talks to sell part of its server business to Lenovo as well, but those talks broke down. Servers are increasingly becoming a commodity, and weak hardware sales led to disappointing earnings for IBM earlier this year.
IBM derives most of its revenue from software and services, though, so the threat is not nearly as large as it is for HP. IBM's transition into a software and services company is the model for the HP transition, but so far progress has been slow.
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. Services and software are supposed to be the future of HP, but so far they offer little hope.
Competitor Xerox (XRX +0.00%) has actually done a better job of transitioning into a services company than HP has done. Best known for its photocopiers and printers, Xerox now derives more than half of its revenue from services. In the most recent quarter, Xerox grew services revenue by 5% year-over-year with an operating margin of 10.2%. These are numbers that HP can only dream of.
One area of Xerox's business which is particularly strong is health care solutions. Xerox works directly with 31 states and Washington, DC, providing services such as fraud and abuse prevention and to analytics and reporting. Xerox's services are used by over 1,500 hospitals, and a full two-thirds of insured patients in the United States are served by Xerox.
As the Affordable Care Act becomes fully implemented, with its penalty for being uninsured, the number of U.S. citizens with health insurance should rise considerably over the next few years. With Xerox's significant presence in the health care industry it stands to reason that the company will benefit from this development.
Deceptively cheap
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 there's any chance of the company turning 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 unappealing.
The bottom line
HP would need to look outrageously cheap for me to have any interest in the stock, and right now it's not cheap enough. Trying to predict how far the profits will fall is not a game that one shouldn’t play, especially when one cannot ascertain where growth is going to come from.
