Don't Sleep on Hewlett-Packard: Well-Priced and Gearing Up

By: SumZero Staff | Published: August 10, 2012 | Be the First to Comment

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(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Quick Thesis:
Hewlett-Packard is a a world class company with a 73 year old brand that is globally recognized. It controls the #1 market position in almost every business segment in which it operates.

Here's how I justify investing in this company today:

*Favorable Industry Dynamics
1. Low PC penetration rates in emerging markets support long-term secular demand
2. Shift from analog to digital printing will result in significant growth in printable content
3. Cloud computing presents tremendous growth opportunity

*Shareholder Friendly Capital Allocation
1. Since 2005, $60 billion returned to shareholders through stock buybacks and dividends(1)
2. $9.7 billion remaining

*Attractive Valuation
1. Trades at 4.3x 2013 estimated EPS(2)(3)
2. After deducting the value of ESSN and Services, investors receive the PC, printer, and software businesses for free
3. Free optionality on webOS
4. Paid to wait with a dividend yield of 2.81%.

HP: More Than Just a PC Company
HP has leading market positions in all of its segments. The breadth and product diversity offered by HP is unrivaled by any of its competitors. The market has been overly concerned with HP’s PC business, which represents only 16.9% of
pre-corp EBIT. Despite its low margins, the PC business provides HP with considerable economies
of scale across its businesses.

Wall Street is significantly pessimistic on HP and has set very low expectations. But “No matter how bad the outlook is for an asset, when little or no optimism is incorporated in its price, it can easily be a bargain capable of providing outsized returns with limited risk” - Howard Marks

HP has the largest revenue base and has successfully leveraged its scale to produce industry leading margins. Many competitors are undercutting on price to drive market share and volume gains (i.e. Lenovo). Usually an unsustainable model especially when larger rivals have greater financial resources (i.e. HP and Dell). By taking advantage of its size, producing innovative products, and reducing SKU’s, HP can increase margins by at least 40 bps.

The breadth and product diversity offered by HP is unrivaled by any of its competitors. While continuous innovation is required to stay competitive, HP's financial resources and dominant market share make the Company well positioned relative to competitors. Most competitors have:

1. Lower sales and margins
2. Weak market share
3. íLimited product diversity

So Lets Check Who’s Best Posed to Benefit
1. For 10 consecutive years, 40 straight quarters, HP is the #1 vendor in worldwide server shipments with a 34.6% total unit shipment share
2. HP shipped more than 684,000 servers in 1Q12 which was 180,000 more servers than Dell, 2.6 times as many servers as IBM, 7.9 times as Fujitsu, 16.8 times as many as Cisco and 24.0 times as many as Oracle
HP shipped a server every 11 seconds and shipped more than 1 in every 3 servers customers purchased worldwide
3. HP is the #1 vendor in worldwide server revenue with a 29.3% total revenue share
4. In terms of total revenue share, HP is 2.0 percentage points ahead of #2 IBM and 13.7 percentage points ahead of #3, Dell.
5. HP has a commanding lead in the total blade server market, with a 46.1% revenue share. HP has led the blade server market for 22 consecutive quarters, 5 1/2 years.
6. HP shipped 2.3 times as many blades as IBM, 4.2 times as many as Dell and 4.4 times as many as Cisco 3
For 16 consecutive years, 64 quarters, HP ProLiant is the x86 server market share leader in both factory revenue and units.
7. HP's x86 revenue share, 35.3%, was 13.5 percentage points higher than its nearest competitor, Dell, 20.1 percentage points higher than IBM and 31.3 percentage points higher than Cisco
8. HP is the number one supplier of Itanium (EPIC) based systems based on worldwide unit volume and worldwide factory revenue
9. HP Integrity blades maintained the #1 position in revenue for the RISC+EPIC blade segment with 59.0% worldwide share 5
10. HP is #1 in Windows revenue and units worldwide
11. HP has a commanding 38.3% revenue share of the Windows market and leads over the nearest competitor, Dell, by 14.7 percentage points 6
12. HP is #1 in Linux® revenue, 28.4%, and units, 30.7%
13. In terms of Linux revenue share, HP leads over IBM by 10.8 percentage points and Dell by 10.3 points 7
For the three major operating environments UNIX, Windows and Linux combined (representing 99.9% of all servers shipped worldwide), HP is number one worldwide in server unit shipments
14. HP holds a 34.6% unit market share worldwide, which is 9.1 percentage points higher than #2 Dell

Valuation
Despite being among the leaders in its respective industry, HP’s trading multiple is at a steep discount to most technology companies. HP is trading at historical lows despite being significantly larger as measured by revenues
coupled with improved operating performance.

The mid case valuation is $52.99/share, which is up 282% from the recent share price of $18.81. If revenues grow at 1.0% CAGR for the next several years, year end 2015 value per share is $36, driven largely by cost savings and share repurchases.

Conclusion
HP is in good businesses with attractive characteristics. However, sentiment is poor because PC and printer industries are misunderstood.

HP's defensible market position in nearly every business segment is tough to question. The current stock price is not factoring in cost savings from the announced restructuring plan and potential earnings accretion from future share repurchases.

Share price underperformance has been a result of poor corporate governance which is being addressed. Even if no margin expansion occurs beyond cost savings from announced restructuring, downside is limited.

Upside potential is enormous through multiple expansion largely due to improvement in:
1. Margins
2. Corporate Governance
3. Perception

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