HP’s Worth $38 as Impending Recovery Supports Outlook

by Trefis Team
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HP (NYSE:HPQ) announced its Q1 12 earnings results last Wednesday after the close only to see its stock tumble by six and a half percent the following day. With revenues down 7% to $30 billion and declines of 210 basis points and 380 basis points in gross margin and operating margin, respectively, HP’s earnings fell well short of expectations for the quarter. However, the quarterly results provided some positive indications as to HP’s future, and we remain cautiously optimistic on the company in the long term believing it could follow the path of tech giants and rivals like IBM (NYSE:IBM) and Cisco (NASDAQ:CSCO).

Given HP’s huge revenue base, we believe (and you can see for yourself in our model below), a marginal improvement in profit margins will help improve the grim outlook for HP and thankfully that is all the company is focused on according to remarks from CEO Meg Whitman. We now have an updated $38.70 Trefis price estimate for HP, about 40% above the market price, and below we take a look at some of the factors we believe drive the value for HP.

See our full analysis on HP

PC Business to Bounce Back (or Sustain At least)

Last year was nothing short of a nightmare for HP’s Personal Systems Group (PSG) business. Despite being the global leader in the PC market, the company announced the spin-off of its PSG business under the leadership of the then HP CEO Leo Apotheker. As it turned out, the decision was among the worsts that HP made in its entire history, resulting in a nosedive in the company’s stock followed by the firing of its second CEO within a span of one year; shattering both investor confidence and client relations.

While HP rolled back the PSG spin-off decision in October 2011, under new CEO Meg Whitman, there was no respite for the PSG business as the global PC market was hit by hard disk drive shortage (HDDs – a major component in PCs used for storing data) during Q4 11. As a result of severe flooding in Thailand, which accounted for nearly 40% to 45% of global supply in first half of 2011, [1] the supply of hard disk drive was about 30% below the expected demand leading to higher component pricing and lower PC sales. This led to a 15% decline in PSG revenue in Q1 12 and contributed more than half of HP’s revenue declined during the quarter.

However, with a renewed focus and commitment to innovation in the segment, we believe HP will be able to bounce back in the PC market and prevent its market share from eroding further in the future. This coupled with the expected growth in the PC market in second half of 2012 and 2013, driven by the improvement in HDD supply and launch of Windows 8, [2] makes PSG a vital business that could bring about the turnaround which HP needs.

We forecast HP’s PC EBITDA margin will decline in 2012 as the full impact of the HDD shortage and higher costs takes effect and as the wait for Windows 8 (due later in 2012) affects PC sales. However, the margins can improve starting 2013 driven by refresh cycle for Windows 8 PCs and the increase in popularity of ultra-thin, light weight and premium priced Ultrabooks.

Software is a Potential Business Segment

HP identifies the software business as a critical part of its forward looking strategy and the addition of Autonomy underlines this. In Q1 12, HP’s software revenue increased 30% and given HP’s commitment to investment in the segment similar growth can be expected going forward. As we transition into the age of Cloud and Big Data, the importance of software will only grow and HP’s focus on next gen software capabilities will pay off.

On the other hand, HP’s software EBITDA margin declined significantly in the year 2011 (see chart above) driven primarily by acquisition related charges. As the company continues to acquire more assets in software business, the margins will remain at these low levels in 2012, but we expect margins to start recovering in 2013.

Fewer Loses on Corporate Investments

With HP finally finding its focus, we believe the company will be able to cut down its losses on corporate investments, which by the way were at an all-time high of $1.5 billion in 2011 – thanks largely to Palm/webOS fiasco. By any means these losses are unlikely to continue in the future and simultaneously any reduction in these losses will boost HP’s bottom-line significantly sending the company’s EPS flying.

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Notes:
  1. Thailand floods spur rush to SSDs, computerworld.com []
  2. PC Market Stumbles on HDD Shortage While U.S. Market Sees Worst Annual Growth Since 2001, IDC []
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