Arik Hesseldahl

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Can HP Still Deliver for Investors?

With so many changes rocking the top managerial ranks at Hewlett-Packard during the last year, investors have punished the stock. About 18 months ago, HP shares were trading for more than $53. Today they’re trading at roughly half that.

Now that new HP CEO Meg Whitman has decided to keep the PC business rather than spin it out as her predecessor Léo Apotheker had proposed, HP appears to be heading back, however slowly, toward the kind of stability for which it had long been known.

But can it still perform? Bernstein Research analyst Toni Sacconaghi took the opportunity to examine the company’s business units and finds that, yes, the prospects for growth aren’t unreasonable. The current portfolio of HP’s business, he estimates, is likely to grow its sales organically by a combined 2.5 percent on an annual basis going forward. Add to that additional growth from the planned shifts toward higher-margin IT service, networking and software businesses, and the picture gets brighter, Sacconaghi writes in a note to clients issued yesterday. HP, he argues, should be able to grow its per-share earnings by 9 to 10 percent annually over the next three to five years.

Part of his assumption is that HP uses about $4 billion of its $8-$10 billion in annual free cash flow for share buybacks, which will help goose earnings on a per-share basis by reducing the number of outstanding shares; plus another $3 billion annually for acquisitions, buying companies at reasonable multiples of about five times revenue.

So how does each sector of HP’s business look?

PCs: Sacconaghi reckons that the global market for PCs will grow about 6 percent a year on a unit basis, down from historical averages of about 10 percent, and that it will grow on a revenue basis by about 2 percent a year through 2015. As the biggest supplier of PCs in the world, HP will, at the very least, hold its market share. While PCs are HP’s largest business, accounting for $40 billion in its last fiscal year and about one-third of its overall sales, the unit generates only 13 percent of operating profits. And, yes, while tablets are a threat, Sacconaghi sees no reason that PCs and tablets can’t grow together. The increasing need for an Internet connection everywhere and the increasing amount that consumers are willing to spend on technology, coupled with price declines over time, mean that consumers will be willing to spend more on notebooks and tablets.

Printers: As with PCs, HP is the market leader in printers, and as that market grows its revenue by about 3 percent a year, HP will probably hold on to its share of the market. Tablets may have a long-term impact on printing behavior, but Sacconaghi argues that consumer behavior tends to change slowly. A decade ago, he says, investors worried that email and the paperless office would kill printing. “Despite these ostensible headwinds, HP and Lexmark collectively grew their supplies revenues by 7 percent per year between 2000 and 2010, driving low to mid single digit growth for the printer industry.” HP’s printer division accounted for $25.8 billion in revenues in the last fiscal year, or about 20 percent overall, and because of its 17 percent operating margin, delivered 29 percent of the company’s profits. It’s a classic razor blade business, as HP loses between 20 and 25 percent on the printing hardware, only to make it up on supplies that command a 60 percent margin. The presence of tablets could actually boost printing, and thus increase the sale of those supplies down the road. Overall, the printer business should continue to grow at about 3 percent a year, Sacconaghi says.

Enterprise, servers, storage and networking: Sacconaghi expects HP to grow revenues in the ESSN unit by about 2 percent a year, slightly below the industry growth rate of 3 percent. He bases this on the expectation that HP can grow its networking business, hold its market share in the Intel-based servers, and lose share in its enterprise storage business to players like EMC and NetApp, and also lose share in the Unix storage business because of Oracle’s decision not to support the Itanium chip.

Services: This unit should grow by about 2 percent annually, slower than the market, which is growing at 4 percent. “We believe that outsourcing is a maturing business, and that EDS, which HP purchased in 2008, is and was an underperforming asset,” Sacconaghi writes. “As a result, we forecast HP’s outsourcing revenues to remain flat.” Expect it to grow in line with the enterprise hardware business, and along with the consulting business.

Software: The market research firm IDC expects the end markets for HP’s software to grow by 7 percent a year. If you assume that HP makes more software acquisitions, which Sacconaghi does, then you can reasonably predict its software revenue will grow by 10 percent a year.

So what’s the risk to all this? Leadership. “Ultimately, our projections for HP are predicated on the company choosing a disciplined financial approach to running the company that includes modest revenue growth, small and leverageable acquisitions, a strong operations focus, and high returns of capital to shareholders,” Sacconaghi writes. The last two CEOs who tried to “transform” HP — Carly Fiorina and Léo Apotheker — failed.

HP’s isn’t “broken,” but in fact offers a favorable risk for patient investors, Sacconaghi says. He rates HP shares as an “outperform,” with a price target of $37.


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