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Hewlett-Packard Company: Can The Free Cash Flow Improvements Sustainable?

 May 24, 2013 09:57 AM

(By Mani) Despite generally poor revenue performance, Hewlett-Packard Company's (NYSE: HPQ) profit and cash flow picture is improving on the heels of over $1.00 per share in cost savings. The free cash flow estimate has jumped from $5 billion to $6 billion to $7.5 billion, which gives the company options.

Free cash flow is well ahead of plan. Free cash flow (FCF) in the first half was $5 billion, equal to HP's full-year plan not long ago. The new target is $7.5 billion, which could take net debt to zero by year end, almost a year ahead of plan.

Reduction in the cash conversion cycle to 21 days, despite the fall off in PC sales, has been a contributor and could still go down a couple days. In addition, restructuring cash payments are coming in below expectations.

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In light of declining sales, cash generation remained solid with FCF of $2.9 billion, significantly up year-over-year on higher improving working capital metrics and prudent capex spending.

"The company said not to view the full year cash flow as unusual, which we question given the cost savings. Still, HP will soon have the option of reinvesting, increasing capital return, or doing deals," UBS analyst Steven Milunovich wrote in a note to clients.

Cost savings are expected to protect fiscal 2013 earnings. The almost $2.2 billion of labor savings is augmented by about $1.1 billion for savings flowing to the bottom line of about $1.10 per share.

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Ironically, it could be said that HP is falling the Mark Hurd plan of boosting profit through cost-cutting through no doubt current management believes it is investing more in the future.

Meg Whitman, who was appointed as CEO in September 2011, has been making sweeping organizational changes for the past several months in a bid to make HP a leaner and meaner company. In May 2012, HP said it would cut about 27,000 employees by the end of fiscal year 2014 as part of a restructuring that is expected to generate annualized savings of $3.0 billion to $3.5 billion.

However, revenue growth appears to be a stretch but more savings seen in fiscal 2014. Chief Executive Meg Whitman previously said she expected revenue growth in fiscal 2014; although, that is a stretch now with the services run-down partially shifting into fiscal 2014.

HP needs some macro uplift because it is losing share except in printing and networking. Additional cost savings could total 75 cents next year to improve the operating margin to 9.7 percent.

In addition, the free cash flow growth in fiscal 2014 should be limited given future demand headwinds in the form of PC softness and delayed services contract run-offs that may impact the first half of fiscal 2014.

"We question the sustainability of improvement, but management deserves credit for its discipline," Milunovich said.

Meanwhile, quarterly margin surprised to the upside aided by mix and cost savings. More than offsetting the revenue softness was operating margin improvement from 7.9 percent in the first quarter to 8.6 percent in the company's second quarter.

The gross margin of 23.7 percent was quite high with the mix shift away from PCs helping. However, it was more than that as the Services operating margin of 2.6 percent was at the high end of the expected range, printers had a healthy 15.8 percent margin, and even PCs improved sequentially to 3.2 percent.

"Management appears very focused on making earnings, but at the same time we give it credit for executing well and improving the culture," Milunovich said.

For the second quarter ended April 30, 2013, the Palo, Alto, California-based HP reported net income of $1.1 billion or 55 cents a share, compared to $1.6 billion or 60 cents a share for the year-ago quarter. Excluding items, it earned 87 cents a share, which came in above Street view of 81 cents a share.

Revenue for the second quarter dropped 10 percent to $27.58 billion, missing consensus view of $28.08 billion. HP's Personal Systems revenue fell 20 percent to $7.6 billion. Printing revenue declined 1 percent to $6.1 billion, and Enterprise Group sales dropped 10 percent to $6.8 billion.

Looking forward to the third quarter, HP sees earnings of 56 to 59 cents a share and adjusted earnings of 84 to 87 cents a share.

For the full year fiscal 2013, the company now expects earnings of $2.50 to $2.60 a share and adjusted earnings of $3.50 to $3.60 a share. Previously, the company had expected earnings of $2.30 to $2.50 per share and adjusted earnings of $3.40 to $3.60 a share.

Analysts currently expect the company to earn 84 cents a share for the third quarter and $3.49 a share for the fiscal year 2013.



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