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Hewlett-Packard (HPQ): There Is Hope, But too Early To Buy Stock

 November 30, 2012 12:59 PM

(By Mani) Hewlett-Packard Co. (NYSE: HPQ) has been under intense pressure, with earnings being reset downward, the stock price falling, and now the Autonomy controversy keeping the company in the headlines.

However, the company is of the view that investors are underestimating its products and ability to innovate by pointing to key new products in inkjet printing, tablets, networking, and cloud services. It also argues that HP Labs remains a prize. Finally, the company believes that customers really want HP to succeed.

"We've heard this over the years and believe it is true that HP's success is important as a balance to Oracle and IBM. Competitors claim that HP's brand has frayed and that it is easier to beat today; we do worry that customers' patience is wearing thin," UBS analyst Steven Milunovich wrote in a note to clients.

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HP's financial outlook is murky but not entirely negative. Although revenue pressures are likely to continue through next year, cost savings and a focus on cash flow should prevent the bottom from falling out.

CEO Meg Whitman maintained fiscal 2013 non-GAAP profit guidance of $3.40-$3.60 despite the expectation of a seasonally weak first quarter.

"However, we are concerned about potential weakness in printer supplies revenue given recent declines in printer hardware," the analyst noted.

The company could meet the annual guidance aided by cost savings, which would be used to protect profit. In addition, there will be savings from supply chain improvements, process re-engineering, and stock keeping units (SKU) reductions.

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In the second half, non-labor savings could be half as much as the labor savings or about 25 cents per share in additional bottom-line protection. Consequently, HP has about a 25 cents buffer to make its $3.40- $3.60 guidance..

In addition, investors now care primarily about free cash flow, which is guided at $5 billion for fiscal 2013. 

"Still, we see FCF improving to over $6bn in F14," Milunovich said.

The primary use of cash flow is to reduce debt. Net debt is $5 billion and could decline by $3 billion in the next year. HP intends to take net debt to near zero by the end of fiscal 2014 and win a single-A rating back. In the meantime, stock buybacks only will offset dilution and acquisitions will be smaller tuck-ins.

However, the company couldn't predict with confidence that the worst of revenue declines is past. In the fourth quarter, PC sales were down 14 percent, printing was down 5 percent, and the enterprise business revenue dropped 9 percent.

Although HP does not expect long-term declines in PC or printer revenue, neither is it confident that the rate of decrease will immediately drop.

"We do expect most product segments to experience similar declines in F1Q as F4Q/12 followed by improvement, but still falling revenue year over year," Milunovich noted.

Meanwhile, printer supplies growth may tumble. Since laser hardware margins are low and inkjet hardware margins are negative, supplies drives IPG margins.

"Our concern is the recent disparity between hardware unit declines (commercial and consumer combined) and supplies growth. In theory, supplies lags hardware growth by three quarters," Milunovich said.

However, the two have tracked pretty closely even on a coincident basis until the last two quarters, when unit growth has slid to 20 percent while supplies growth has improved. HP points to a couple explanations, including channel inventory fluctuations given that sales are reported on a sell-in basis and HP's de-emphasizing low-end hardware that doesn't drive much supplies revenue.

"Nevertheless, we think this gap must narrow and that high-margin supplies revenue is at near-term risk," the analyst added.

HP has said it expects about flat PC sales long term as emerging market growth offsets moderate declines in the developed world. Printing and Personal Systems head Todd Bradley thinks HP's printer sales can grow if the company executes.

"Our view is that HP is too optimistic on PCs, but we are less willing to say printers will decline substantially," Milunovich noted.

Still, HP has printer opportunities as there is a big focus on increasing ink sales. While HP makes money on laser hardware and supplies, inkjet supplies are the big profit generator. Ink is small in large business, which HP is aiming to change with its Ink in the Office push with 16 new Officejet Pro models.

Inkjets haven't offered the speed and print quality for most office work, but the new line changes that and could cannibalize low-end lasers. Nevertheless, how printers perform is critical since it is HP's biggest cash generator.

"If these color MFPs gained half the share of HP's mono lasers, it would result in an incremental $2bn of revenue," said Milunovich who doubts that printing, if it declines, it should be a single-digit, controlled decrease, unlike PCs.

"The stock appears inexpensive with a F13E P/E of 3.5x and yield of 4.4 percent, but we see it underperforming given expected weak 1H results," Milunovich added.



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