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Standard & Poor's


05/25/15 10:00:11 AM



This week's Focus Stock of the Week is Hewlett-Packard (HPQ: $33.60) which carries S&P Capital IQ's highest investment recommendation of 5-STARS, or Strong Buy. HPQ is a leading global provider of personal computers, printers, enterprise server and storage technology, software and a wide range of related products and services to individual and enterprise customers worldwide.

Our Strong Buy recommendation reflects our view the PC demand is nearing a trough following a steep correction in early calendar year 2015, our belief that the pending split of the company will unlock significant shareholder value, and what we view as an attractive valuation. Hewlett-Packard is set to report April quarterly earnings results on May 21st.

HPQ is in the midst of splitting itself up into two companies -- Hewlett-Packard Enterprise (focus on servers, storage, networking, software and services) and HP Inc. (focus on PCs and printers). Meg Whitman will run Hewlett-Packard Enterprise while Dion Weisler will become CEO of HP Inc. Based on FY 14 results, the two companies had virtually identical revenue ($57.6 billion for Hewlett-Packard Enterprise and $57.3 billion for HP Inc.). The spin-off is expected to be completed by FY 15 year-end and be tax-free. We positively view the pending transaction, as we see it unlocking significant shareholder value and opening up strategic opportunities for both companies. However, we note more than $2.5 billion in total costs related to the HPQ separation will temporarily negatively impact free cash flow.

While we see further revenue declines in FY 15 (Oct.), largely reflecting PC and foreign currency headwinds, we see stabilization in FY 16. While about two-thirds of revenue was recently derived outside the U.S. (over half from EMEA), we note that the negative impact of currency is reflected in our EPS estimates. We believe the PC landscape is likely to contract about 5%-7% in calendar year 2015 but think the industry should see notable improvement in the second half. Specifically, we see challenging comparables related to Windows XP support and a period of inventory digestion ahead of the Windows 10 launch this summer as key reasons to the recent softness. On a constant currency basis, we believe that HPQ will be able to see flat to higher revenue along with better operating results across most of its segments. Longer term, we see opportunities within the server, 3D printing and cloud arenas.

Despite challenges related to top-line growth, we expect HPQ to focus on improving profitability. At the end of January, the company had reduced its workforce by 44,000 since announcing its 2012 restructuring plan, with plans to complete the program with an additional 11,000 employee reductions (55,000 total) by FY 15 year-end. We see opportunities to reduce its workforce once the separation of the two companies is complete, providing further upside potential to margins. We see EBITDA margins remaining around 12% in both FY 15 and FY 16.

We believe free cash flow is an important metric for investors to look at when valuing Hewlett-Packard. In fiscal year 15, we expect free cash flow to decline to $3.5-$4 billion to reflect cash-related separation activities and recent currency trends. By FY 16, we see free cash flow bouncing back towards $6.5 billion and potentially exceeding $7 billion by FY 17. At current levels, that implies an attractive price/FCF of less than 10X based on next fiscal year's estimates. With HPQ solidifying its balance sheet in recent years following M&A blunders by regimes prior to Meg Whitman, we see the potential to return more cash to shareholders in future years while also being opportunistic with acquisitions. Over time, we expect the company to return at least 50% of free cash flow to shareholders.

We forecast operating EPS of $3.63 in FY 15 and $3.80 in FY 16. The company sees a significant ($0.30 per share) negative impact on FY 15 results given an unfavorable foreign exchange shift.

Risks to our recommendation and target price include lower than expected demand for PCs and printers given the secular challenges in both these areas, lower than expected margins, unanticipated changes in foreign currency, execution issues related to the pending split of the company, and greater than forecasted competitive pressures.

We apply a peer-average multiple of 11X to our FY 16 operating EPS estimate to arrive at our 12-month target price of $42. We view the shares as attractive valued, as HPQ currently trades below 10X operating EPS while we anticipate stabilization across its end-markets.

S&P Capital IQ's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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