Hewlett Packard is Undervalued

Let us now delve into the actual value investing process and start analyzing stocks. I apologize for the delay in doing so. I had gotten busier than I had expected. Today I will be showing you why I believe
Hewlett-Packard Company (HPQ) is undervalued.

First we must assess the quality of the businesses. They make their money from selling laptops, printers and a few services to businesses. There are other things they do but this makes the bulk of their money or will in the future make the bulk of their money. Regarding services to businesses it is very profitable but HPQ does not make as much money off of this as IBM and others do. This line of business is very profitable but this line more or less may make HPQ more valuable in the future. The laptops and printers are the present.

So let us start with laptops. There are desktops too, but we know that far more laptops are sold so let us not expect much from their desktop business. Let us just analyze the laptops. Here in my opinion the business economics are poor. You have a lot of businesses trying to sell laptops (ACER, ASUS, Dell etc.). So naturally there are price wars and also this competition leads to a lot of problems because now customers can find someone who do what you do and get it cheaper. So it sounds like a bad business to be in, and it is, but HPQ has done an outstanding job in it. What they realized is that they can be the low cost producer. Even the laptop I own is from HPQ because it's cheap. People tell me it's a bad idea because HP laptops stop working after around 4 years. I point out 2 things to them, mine has lasted longer, and every 4 years or so Microsoft comes out with a new Windows so I can use that as an excuse to get a new laptop anyways. HP's strategy is not to be the high quality laptop, just wanted to mass produce and sell them. However, in recent years you will have noticed that people would pay more for a laptop because you can download the new Windows from the Internet for free (yes I know it's illegal, but people still do them). So hopefully HPQ has learned to make higher quality laptops cheaper but right now it's anyone's guess. As a result HPQ has found a niche in the laptop market and as such will be able to make good profits from them.

Now on to the printers. There really isn't much to say except that HPQ dominates the printer market. They own 40% of the printer market. Furthermore, other printer companies use gimmicks like the printer will not print unless it has working ink of both colour and black & white even if you have black & white ink working and you only need that. HPQ doesn't use such gimmicks. Brother printers are the first serious threat they've ever had, but with the low cost of HPQ printers and the brand name itself they are expected to continue to dominate the industry. In case you were curious, Brother owns 6.5% of the market last time I checked. Not bad, but not there yet.

So we've established that the businesses are stable and that the future of the business may depend on the business services division. So, how do I analyze the fundamentals of this business? First I look at the balance sheet. Typically I want twice as much current assets as current liabilities and twice as much total assets as total liabilities. And here you notice that HPQ fails that test. But remember, failure of one test does not mean it's a bad investment. So why is the balance sheet so bad? Here we have to understand that the current CEO has been in for a short amount of time. Here predecessor made a very bad move in spending $11 billion to acquire Autonomy which is almost completely a write-off. However, over the last few quarters we see that the debt has been going down though mostly it's the short term debt like A/P going down. That is bad because you want to pay your vendors as late as possible to maximize use of your cash. Assets have also gone down, especially current assets like A/R, but that is good because you want to collect from your customers as quickly as possible. Also cash has gone up by about 20% in the last 3 quarters. Not bad. However, the balance sheet needs to improve. Here I find that mostly the huge acquisition of Autonomy along with an aggressive dividend and buyback strategy has hurt the balance sheet in the past. The new CEO, Meg Whitman has stated she will not be that aggressive so we can expect the balance sheet to improve in the future. Of course nothing is certain, but while I grade the earlier businesses an A, I grade the balance sheet a C-.

Now on to the income statement. Here we must tread carefully. We must remember one time write-offs cannot be considered as normal income. On the other hand you cannot dismiss them, especially if they occur repeatedly, because then they are not really non-recurring charges. Now HPQ has non-recurring charges in all of their last several quarters including the last one, but again this is mostly the Autonomy case, and some other small points. If we ignore the Autonomy profits are actually quite nice. You'll notice that the profit margins are around 5%. Some bad businesses, but the laptop business must have brought it down a lot as well as their margins are typically low. While I prefer high margin businesses, this business has dominated one industry and done very well in another, so this is not bad. Think of it like Walmart's low margins even though they rule the retail industry. The income statement gets a B from me. Would like better margins but better.

Cash flow statement is the final area. And here is where you measure how much money the business truly made. Income statements may have some shenanigans but cash flow statements show how much more cash you have. So without outright fraud, it is hard to manipulate. Here you will notice that the free cash flow from the business for the last 3 years has been $7-$10 billion per year. If that keeps up the current market value of $28 billion will mean you are getting between 25% and 35% returns which is outstanding. We have to keep in mind that the Autonomy gone wrong acquisition was a problem but it was a one time thing. If we look at the free cash flow from the last 4 quarters we get $6.3 billion. Not bad considering this temporary problem. As such we can project it to be a worst case scenario to earn $6.3 billion per year and that averages 22.5% per year as a return. That is an outstanding scenario. I would recommend buying shares in this company.