Tuesday, May 24, 2011

Ira Sohn Investment Idea Contest

On Friday, I completed my entry to the Ira Sohn Investment Idea Contest, a major investment contest with many heavy-hitters among the list of speakers. They include: Bill Ackman, Seth Klarman, Carl Icahn, David Einhorn, Joel Greenblatt, and Steve Eisman. On Monday, I was delighted to find out I was chosen among the semi-finalists, which means I will be able to attend. Included below is a copy of my entry.
Stay tuned, I will be posting my notes from the conference later in the week.
In the interest of full disclusure, I am long HPQ.
Your Investment Idea
Hewlett-Packard Company (HPQ)
$44.00; I believe HP's lowered third quarter guidance has led to a market overreaction and will lead to an earnings surprise. After they beat concensus estimates later in the year, investors will value HP on a comparable basis to the industry. With even a conservative valuation (11x earnings) this would place HP in the mid-$40s.
Companies engaged in the diversified computer systems industry such as IBM, Dell, Cisco, and EMC Corporation.
Catalyst - Please explain what action, event, situation or future realization will cause the market to recognize the value discrepancy that you observe. I expect to wait until the third or fourth quarter results are announced, which I fully expect to top the dampened expectations. In other words, I believe that their continued profitability will prove to investors they have overreacted to a nonfactor like guidance.
Hewlett-Packard issued a second quarter press release before the opening of the market on May 17, 2011. In the release, HP reported beating the consensus second quarter earnings estimates ($1.24 vs $1.21), but went on to lower their guidance for the full year citing a tough PC market and weak consumer demand. Investors punished the stock and it opened 6% lower than the close. It has since shed 10% since before the announcements. HP is now trading near its 52-week low at a P/E of 9.2. The market has vastly overreacted.
I believe that the lowering of expectations is setting up an earnings surprise situation because, fundamentally, the public has a misperception of HP's business model and in turn value the company inappropriately. The investing public believes HP is a commodity company yet 63% of its 2010 operating earnings came from recurring revenue streams such as services, networking, and software. Aside from the PC group, none of the other business lines have seen any decline since CEO Leo Apotheker took the helm after Mark Hurd's exit in November. In fact, servers, storage, and networking revenues were up 15% year-over-year, software revenues were up by 17%, and financial services revenues increased by 17% as well. A decline in consumer demand may lower the top-line revenues, as these are HP's most competitive business lines, but it will tend to increase their margins. It will not have the devastating impact on their business that people expect; rather, it will be a symptom of the continued evolution of their business model into a higher margin company.

Investors are discounting the steadiness of HP's earnings stream, not to mention their continued growth in their more profitable services business line. I think it's paradoxical for second quarter GAAP earnings to grow 15% year-over-year and increase gross margins by 1%, and have the market reaction to be to knock 10% off their market cap.

HP is still massively profitable and throwing off enormous amounts of cash which they are using to reward their shareholders. They generated $4 billion of cash in the second quarter and a 22% return on equity. They only paid out $182 million in dividends, but they returned $2.7 billion to the shareholders by repurchasing approximately 64 million shares of stock. They have authorization to repurchase another $8.6 billion in stock and the cash to do it with ($12 billion, or around $6 a share); at present prices this could pull an addition 237 million shares off the market and have a significant impact on their future earnings results. Not to mention the secondary affect it will have on their market price. All of these factors combine to add to the margin of safety of this trade.

Despite being in the tech industry, which doesn't lend itself to value plays very often, HP passes even Ben Graham's stock screener. Their earnings yield (10.9%) is many multiples over the two times the AAA-bond yield (2.8%) criterion. Their total debt ($23 billion) is well less than the 2/3 tangible book value ($68 billion) needed to pass. They do, however, fall short of having a dividend yield (0.9%) of at least two-thirds of the AAA-bond yield, but this is only a crude measure. If we take into account the large stock buybacks that dwarf the declared dividends, we can be sure they are returning a large amount of earnings to their shareholders.

I believe Ben Graham's requirements for purchase of a "bargain issue" from chapter 7 of The Intelligent Investor exactly fit HP's current situation. For one, HP has reasonable stability in its earnings, not only in consistent profitability but also in topping expectations. Even through the financial crisis, HP did not take the large writedowns that plagued other firms. They had only profitable quarters. In HP's worst quarter, Q2 of 2009, it still earned $0.86 a share. According to Graham, a potential investment should have significant size and financial strength. With a $78 billion market cap and $12 billion in the bank, HP does. The $23 billion in debt may be troubling at first glance, but nearly 40% of this figure are short-term borrowings on which they are paying very little (roughly 2% weighted average interest rate), by historical standards, in interest expense. Beyond the $1.75 billion in debt that becomes due this month, there will be no other due dates until March 2012 so the financial risk in the near term is minimal. As already determined, HP is trading well below both its average price and a reasonable P/E valuation based on either its industry position or its prospects. HP passes every Graham requirement to be considered a suitable investment for a defensive investor.

When Hewlett-Packard beats expectations in the third or fourth quarter, Apotheker will emerge from Mark Hurd's shadow and HP will again be a Wall Street darling. Within the next year, as Apotheker's HP proves itself, investors will value the stock closer to the industry average of 14.8. (For comparison - its closest competitor, IBM, which is three times as large, trades at a multiple of 14.3) I've cited my price expectation at 44, which represents a 22% premium to today's market value and covers my required rate of return (which I borrowed from Warren Buffet) of 15%. I believe this is a conservative estimate which provides the investment with a wide margin of safety. Even if HP were to earn exactly what it did in the third quarter last year (which would actually be a decline in total earnings based on the continuing repurchase of shares) and was only valued at 11 times the trailing twelve months earnings, then it would still rise up to the mid-40s. Were it to trade at the industry multiple previously cited, HP could easily trade into the mid-50s. To the best of my ability, I believe Hewlett-Packard represents an excellent risk-reward tradeoff: downside protection based on their industry position and financial history with significant upside potential based on their investment in higher margin and growth industries. This is a classic Graham-type value trade with an embedded option on cloud computing.


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