Tuesday, August 28, 2012

Hewlett-Packard (HPQ) Qualitative Analysis

Over the past week, Hewlett-Packard Company (ticker: HPQ) has fell over 17% to the current price of $16.83 per share. This drop was largely due to the company's recent 2012 Q3 earnings report released after hours on August 22, where they reported a net earnings loss of 8.9B.
The PC isn't going away any time

On the surface, I think it is quite natural to feel grim about the company's prospects after such a dramatic loss. In my personal portfolio, if I had sold my shares before the earnings report, I would have realized a 12% gain, whereas now I am sitting on a 7% loss. So while emotionally I am obviously not happy with the turn of events, that should not impact the underlying analysis on which I base my trades.

In fact, it is precisely bear-ish sentiments like these that give investors arbitrage opportunities like this.

As such, I stick by original positive prospects for HP and would buy even more shares if I had the cash and sufficient diversification to do so. Here is why:

Company Overview

Most people associate HP with two primary segments: personal computers and printers. However, while these two certainly play a large role in the company, HP also has a hand in several other markets.

  1. Imaging and Printing Group (IPG) - printers, scanners, printing supplies, digital cameras
  2. Personal Systems Group (PSG) - personal computers for businesses and consumers, PC accessories
  3. Enterprise Business (EB)
    1. Enterprise Storage, Servers, and Networking (ESSN) - servers, data storage
    2. Enterprise Services (HPES) - IT outsourcing
    3. Software Division - enterprise software including SaaS, cloud computing
HP also runs the advanced research group HP Labs.

Number of Employees: ~340,000
Market Cap: $34B
Total Equity: $32B

Similar Companies

On the PC side of things, we have a direct competitors Dell (ticker: DELL) and Apple (ticker: AAPL) in both business and consumer markets.

HP currently dominates the consumer printing and imaging market. However for enterprise solutions, Xerox (ticker: XRX) comes into play.

In terms of providing enterprise software, there is IBM (ticker: IBM), SAP (ticker: SAP), and Oracle (ticker: ORCL).


Total Equity

The total equity, or book value, is the net assets minus liabilities. HP is trading at approximately 1.06 times its book value (P/B ratio). Comparing this to other company's in the sector, Dell is trading at 2.2, Apple at 8.2, Xerox at 0.8, IBM at 11.3, SAP at 4.9, and Oracle at 3.6.

Only Xerox is comparable in terms of having a low P/B ratio. While this may be a feature of the print services, the PC and enterprise solutions segments of HP should certainly bring its P/B ratio up to at least 2.

Looking at the balance sheet, we see a healthy amount of cash on hand (9.5B) and both inventory and accounts receivable. One particularly worrisome aspect here is the large amount attributed to goodwill and intangibles. I haven't fully analyzed HP's recent acquisitions, but they certainly look at least a bit overpriced and that attributes to the large amount written off to goodwill. I'll come back to this in the next section.

Because of the large amount of goodwill, we cannot simply say HP is a definite good buy just based on book value. Goodwill tends to obscure the true book value and in many cases it is better to completely remove it from consideration.


So I think what worries most people is HP's ability to generate sufficient earnings. In particular, this past quarter has been absolutely dismal in terms of net income. But let's break down exactly what happened.

Net earnings is is the total revenue, minus cost of revenue, operating expenses, and taxes. From Q2 to Q3, earnings fell from 1.6B to -8.9B.

However, revenue stayed fairly consistent at 29.6B compared to Q2's 30.5B and Q1's 29.9B. The cost of revenue similarly stayed the same, resulting in steady gross profits.

If we look at the standard GAAP reported income statement (e.g. as provided by Google Finance), we see a whopping 11B under the line "Unusual Expense", compared to previous quarter's 70M. So in order to find out what this constitutes, I dug into the actual earnings report released by HP. It turns out that this 11B reported loss comes from goodwill impairment charges in regards to in the services segment and intangible asset impairment charges for the Compaq trade name.

As I mentioned earlier, the goodwill line of the balance sheet causes a bit of worry. However in some sense, the negative effect is double counted in the income statement. If we view goodwill as a bad thing in the balance sheet, we shouldn't readjust for it when reading the income statement. In fact, if we ignore impairment charges, HP actually earned 2B this past quarter.

In terms of P/E, HP is sitting at around 4. By comparison, similar companies are sitting on P/E ratios of around 10-15. Even if earnings dip further in the future, I don't think it justifies such a low P/E ratio.


Despite income related headwinds, HP maintains strong, consistent dividends between 2-3% per year. That is an additional bonus on top of any capital gains. While shareholders aren't guaranteed dividends, historically speaking HP has been very kind to shareholders in the dividends department.

This factor should play a huge role in future valuations of the company.

Restructuring Changes

If you're following HP related news, you will see a lot statements being thrown around about restructuring changes in the company. About 1.8B in the income are attributed to restructuring charges. This is also rather superficial and has very little to do with the core business of HP.

These changes include laying off about 27,000 employees and moving towards emphasizing their services segment as opposed to PC and print segments. This is largely due to the general slowdown in PC sales and printer sales. I find these changes good and will likely play out well for HP in the long run.


I also feel that investors are too pessimistic about the future of the PC market. While smartphones and tablets are all well and good, I highly doubt that they will replace the PC in any sense. Sales may have slowed down recently because of all these new gadgets on the market, I believe that the drop will level off soon enough. The buy cycle for the PC may have increased slightly, but people will always need newer computers.

Obligatory Disclaimer

The author is not a financial adviser, tax accountant, or lawyer and disclaims any and all liability for the contents of this blog. The information reflects the author's personal research and experience, which may contain errata.