Planned Spinoff Completes Management’s Five Year Turnaround, Unlocks Long-Term Shareholder Value

Hewlett-Packard Company (NYSE: HPQ) is a global provider of technology solutions and services to small, medium and large enterprises as well as individual consumers. The company operates under six segments: Personal Systems, Printing, Enterprise Group, Enterprise Services, Software and HP Financial Services. The company is a leader in the diversified computer systems industry and remains ahead of the curve by consistently introducing new innovative technology.

Geographically, Hewlett-Packard derives 45% of its net revenue from North America and 55% from the rest of the world (Europe, Middle East, Africa, Asia Pacific and Japan). While sales have been flat to declining in North America, they’ve risen 5% in EMEA and 1% in APJ as emerging countries seek more computing resources.


Hewlett-Packard Plans Even Split into Two Industry-Leading Companies

On
October 6, 2014,
Hewlett-Packard announced plans to split into two publicly-traded Fortune 50 companies: Hewlett-Packard Enterprise which will focus on enterprise customers and HP Inc. which will focus on personal computing and printing. Shareholders will receive one share of each new company her HP share held. After the split, the company plans to build on the gains it’s made as part of its 5-year turnaround plan, and drive industry leadership for both of the new companies.

Hewlett-Packard Enterprise will include the Enterprise Group, Enterprise Services, Software and HP Financial Services, and focus on servers, storage, networking, converged systems, services and software and invest in the OpenStack Helion cloud platform, and will be headed by current CEO Margaret Whitman and current CFO Cathie Lesjak. The Enterprise business has annual revenue of about $58.4 billion with operating profit of about $6 billion with a 10.2% operating margin.

HP Inc. will include Personal Systems and Printing, and focus on printing, 3D printing, scanning, personal computers, tablets, POS point-of-sale systems and calculators, and will be headed by Dion Weisler, current Executive VP – Printing and Personal Systems. This segment has annual revenue of about $53 billion with operating profit of about $5.4 billion and a 9.4% operating margin.


The separation is expected to close by the end of FY2015 and will likely be a tax-free transaction for shareholders. The spinoff comes as part of management’s five-year turnaround plan to accelerate performance, drive sustained growth, become an industry leader and maximize shareholder value. Splitting Hewlett-Packard will give each company the independence, focus, financial resources and flexibility to quickly address market and consumer demands and trends in a way that drives revenue, profits and long-term value for shareholders. Both companies will have investment grade ratings and the ability to tap into capital markets as needed. Broadly speaking, HP Inc. is expected to deliver higher dividends while HP Enterprise plans to focus on growth and investing to stay competitive.

Revenue, Operating Profit Breakdown by Segment

Hewlett-Packard Enterprise businesses contributed 50% of net revenue, while HP Inc. businesses made up the other half.

The Enterprise Group had net revenue of $6.9 billion (24% of total net revenue), mostly from enterprise server and technology services. Enterprise Services net revenue of $5.6 billion (20% of total net revenue) was from infrastructure technology outsourcing. HP Financial Services net revenue of $855 million (3% of total net revenue) was from financing HP sales in the Americas and EMEA regions. Software net revenue of $959 million (also 3% of total net revenue) was from licensing and maintenance agreements.

Personal Systems net revenue of $8.6 billion (30% of total net revenue) was largely from notebook and desktop sales. Printing net revenue of $5.6 billion (20% of total net revenue) was mostly from commercial sales of HP printers, scanners and supplies.


 

As the chart above shows, the company’s split is a clean 50-50 break-up by net revenue and puts both surviving companies in a strong financial position to continue sector leadership.

The split also holds clean by non-GAAP operating profit with $1,361 million for Hewlett-Packard Enterprise and $1,372 million for HP Inc.


The split isn’t expected to significantly add to administrative cost duplication because the businesses have been operating independently for several years. Post-spinoff, HP Enterprise will focus on growth through organic projects and M&A while HP Inc. is expected to lever up and increase cash flow distributions to shareholders, supported by strong free cash flow.

Shares Up 43% over Past Year, Still Undervalued

Hewlett-Packard traded at $34.93 per share (as of 10/24/2014), near the top of its 52-week range of $23.64 – $38.25 and up 48.7% over the past year, with a market capitalization of $65.5 billion.


 

Shares are valued at 13.2x earnings (well below the industry average of 29.8x), 2.3x book value and 8x cash flow.


Shortly after announcing the plan to split, shares fell about 6.5% but subsequently recovered most of their losses and are below Wall Street’s 12-month average price target of $40 though many analysts see shares rising to $45 based on operational stability, scope for more predictable cash distributions, conservative guidance and steep undervaluation.


For example, investment bank Credit Suisse believes shares could be worth at least $45 based on $26.80 per share for HP Enterprise and $20.63 per share for HP Inc., and adjusting for expenses and net cash.


 

Enhancing Shareholder Value through Dividends, Buybacks

Hewlett-Packard has distributed quarterly cash dividends since April 15, 1992, and has increased the dividend amount 10 times over the past 22 years, with dividends up 10.2% over the past year. While dividend increases are not stellar, dividend payouts are steady and reliable, with a broad and stable revenue base that virtually guarantees stable dividend income for investors.

On October 1, 2014, the paid a quarterly dividend of $0.16 per share ($0.64 annualized) for a dividend yield of 1.84%. Over the nine months ended July 31, 2014, the company has paid out $875 million in dividends.


Over the past seven years, Hewlett-Packard spent $50 billion on share repurchases, with $1.98 billion in buybacks for the nine months ended July 31, 2014. In Q3 alone, Hewlett-Packard spent $582 million of cash on hand to buyback approximately 17.5 million shares, with $5.7 billion available for further buybacks at the end of Q3 2014.

However, as the chart below shows, the company stepped up buybacks in FY10 and FY11 when HPQ shares were significantly below current levels and has reduced buybacks with shares near a 52-week high.


Further, management is committed to returning
50% or more of free cash flow to shareholders through dividends and share repurchases.

Growth through Strategic Partnerships

Hewlett-Packard has long favored lucrative long-term client and partner relationships over point sales. This strategy improves revenue visibility and encourages the company to dedicate resources to the accounts it manages, so HP staff can gain sub-sector expertise and add greater value to the accounts they serve.

For example, Hewlett-Packard recently signed a 5-year, $50 million extension with the Massachusetts Executive Office of Health and Human Services that will expire in 2019, where Hewlett-Packard will provide support and system upgrades for Medicaid Management Information Systems. HP has worked with the state of Massachusetts since 2005. Hewlett-Packard is the nation’s largest provider of process management solutions for Medicaid and Medicare, with healthcare customers in 19 states.

The company recently expanded its 14-year partnership with cloud and virtualization software provider VMware (VMW) with the launch of the HP ConvergedSystem 200-HC EVO: RAIL that lets small and midsize companies simplify their purchasing, deployment and support of IT infrastructure.

Hewlett-Packard’s big data platform, HAVEn, was selected by New Zealand’s Auckland Transport for video analytics from based on transportation data. In the first phase, Auckland law enforcement will use HP Intelligent Scene Analysis to recognize license plants and identify dangerous road activity through video image analysis. Hewlett-Packard is helping Auckland transform itself into a ‘Smart City’, an emerging industry sub-sector that with expected revenues of $12 billion in 2025.

Management Has Proven Track Record

Margaret Whitman has served as Hewlett-Packard’s President and CEO since September 2011. Whitman earlier served as the CEO of online auction site, Ebay (EBAY), from 1998 to 2008 and oversaw revenue expansion from $4 million to over $8 billion over her ten-year stay. Whitman has also held senior corporate and serves on several Boards. While many doubt her technical capabilities, she has firmly proven her leadership at Hewlett-Packard.

Catherine Lesjak has served as Chief Financial Officer and Executive VP of Hewlett Packard since January 2007. Lesjak has been with the company for 17 years and is responsible for overall financial activities.

Mohamad Ali has served as Chief Strategy Officer of Hewlett-Packard since 2012 and earlier held senior positions with Aspect, Avaya and International Business Machines (IBM). Ali brings several years of strategy and corporate development experience.

Dion Weisler serves as Executive Vice President – Printing and Personal Systems. He has over 23 years of IT industry experience and has held senior executive and marketing positions in the Asia Pacific market.

Management has delivered an 8.5% Return on Invested Capital and a 19% Return on Equity over the past 12 months, with strong EBITDA margin of 11.5%.


Q3 2014 Results – Operating Cash Flow Up 36%

For its third quarter ended July 31, 2014, Hewlett-Packard had net revenues of $27.6 billion (up 1% from the year-ago quarter), earnings from operations of $1.5 billion (down 21%), net earnings of $985 million (down 29%), and net earnings of $0.52 per diluted share (down 27%).

HP’s turnaround efforts appear to be working with sales up 1% in its recent quarter – the first revenue increase over the past three years, with sales growth in personal systems and enterprise groups more than offseting revenue declines in other divisions. In addition, cost cutting efforts and operational optimization increased pretax profit in all groups except servers and networking equipment. The turnaround and HP’s decision to split into two companies should increase the overall competitiveness of each of its business segments in a manner that accommodates longer technology renewal cycles at corporations.

Q3 results were partly powered by a move to purchase new systems (by HP customers) in response to Microsoft’s (MSFT) decision to end support for its windows XP operating system in April 2014 so gains on that count were more of a one-time effect.


Net revenues were led by year-over-year increases of 12% for personal systems (with desktop revenue up 9% and notebook revenue up 18%) and 2% for enterprise groups (with networking revenue up 4%). These increases were offset by decreases of 4% for printing, 6% for enterprise services, 5% for software and 3% for financial services.


As of July 31, 2014, Hewlett-Packard had $14.5 billion in cash and cash equivalents, $17.1 billion in long-term debt (0.7x Equity, 0.19x Total Assets) and $28.9 billion in total stockholders’ equity.


For the third quarter the company had cash flow from operations of $3.6 billion (up 36%).


 

Reassuring Guidance for Q4 and FY15

Management expects net earnings of $0.83 to $0.87 per diluted share for Q4 2014 and $2.75 to $2.79 per diluted share for FY14, with free cash flow of approximately $9 billion.

For FY15, management reaffirmed net earnings guidance of $3.23 to $3.43 per diluted share, operating cash flow of $10 billion to $10.5 billion, and free cash flow of $6.5 billion to $7 billion.

The company expects revenue stability and a moderate increase in operating margin, with a decline in PC and Enterprise Services revenue offset by growth in servers, storage and networking, with much of this downside baked into the stock price. The company plans to reduce headcount by 10,000 and this could expand margins despite $1.8 billion in restructuring expenses.

Management will announce Q4 2014 results on November 25, 2014.

Summary

Hewlett-Packard management has dedicated the past five years to turning the company around, and has positioned both businesses – HP Enterprise and HP Inc. – to capitalize on strengths and compete aggressively in their markets.

As HP transitions its business model to software-as-a-service with subscription fees, it will lose out on larger licensing and maintenance deals. In a slowing market for HP’s core products, its move to cloud computing is a bright spark that promises revenue growth. In addition, the company could realize higher profits through cost savings initiatives such as planned large-scale workforce reductions.

Wall Street believes shares are significantly undervalued at current levels. Moreover, management has a strong shareholder orientation and while HP Enterprise shareholders could see capital gains tied to business growth, HP Inc. shareholders can expect a steady stream of dividends driven by strong free cash flow and buybacks. The current dip in shares offers a compelling buying opportunity for near-term gain and long-term capital and dividend upside.

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