Will HP's Stock Recapture the "Hurd Premium"?

With  Hewlett-Packard (HPQ) shares trading at a substantial discount to our fair value estimate, and less than 6 times enterprise value to cash earnings, we believe the market's short-term anxiety over these shares has created an excellent buying opportunity for investors armed with a long-term perspective.

Hewlett-Packard is trading at a discount to large-cap peers such as  IBM (IBM),  Cisco Systems (CSCO), and  EMC Corporation , and at multiples similar to  Dell's , which is struggling to transition away from its PC-centric model. We believe the discount is unwarranted. HP's diverse model has much more in common with the high-quality tech names than it does with Dell, especially when you consider HP's diverse offerings in services, enterprise hardware, and printing, to drive value. In contrast, only 12% of HP's operating profit is derived from the commodity PC business. The firm lacks the unique assets such as  Oracle's (ORCL) database and IBM's mainframe businesses. However, the printing division is a dominant market player with a vast installed base, its services business is a steady contributor, and its hardware business rivals anyone in x86-based offerings. In other words, although HP may be trading at similar multiples to Dell, it has a much stronger business foundation. Below, we address some of the concerns that have sent investors fleeing the stock, and highlight reasons to be optimistic about the firm's prospects given the stock's current valuation.

"Won't HP flounder without Mark Hurd?"
Hurd was an important force in shaping HP's current business model and its relentless cost cutting. However, we believe the transition to a new leader represents a short-term setback that won't upset the long-term prospects of HP's core business units. We think the foundation of operational excellence established under Hurd's reign will survive his departure. Additionally, despite Hurd's solid performance of turning around a fledgling company, the challenges now facing the firm may be better addressed by a different leadership style. A "numbers-first" focus on cost-cutting was appropriate after the Compaq and EDS deals, and investors clearly benefited from Hurd's approach during very challenging economic times. However, now that HP is down to fighting weight, we believe the firm can benefit from some fresh blood that reinvigorates it by rounding out its portfolio of data center technologies.

"Hasn't HP underinvested in research and development?"
The short answer is yes, but it's not a lost cause. The headlines are fixated on the decline in R&D spend as a percentage of total revenue. However, the product mix has shifted significantly in recent years, with the PC and services business units that require minimal R&D, such as PCs and services, now accounting for over 60% of revenue (up from 50% three years ago). Nonetheless, HP still appears to have taken a more constrained approach to R&D than rivals IBM or Cisco, but we believe the firm is successfully supplementing the internal R&D pipeline through acquisitions.

In a sense, acquisitions can be thought of as outsourcing the R&D process. The upside is that you only have to pay for R&D that has proven to be effective. The downside is you pay a steep premium for technologies once they become proven. Investors should focus on HP's financial discipline to not overpay (which became questionable in the 3PAR deal), and how this impacts earnings quality. Acquiring R&D can shift an operating expense into goodwill in the short-term and worst-case, to a below-the-line impairment charge in the long term, so we recommend adjusting earnings numbers to reflect the outsourced R&D. Ultimately, the true test of a firm's R&D is the resulting product line. HP continues to deliver leading data center technologies and innovative printing solutions. We remain comfortable that the firm can continue to do so through a combination of internal and external R&D.

"Isn't HP Irrationally overpaying for acquisitions during the CEO transition?"
The recent acquisitions of 3PAR and ARST were clearly in line with HP's strategic direction, but they came at a steep price. Allocating capital is one of the most important responsibilities management has to its shareholders, so we do not casually write off billion dollar acquisitions, even if the size is small relative to HP's ability to generate $10 billion in annual free cash flow. Nonetheless, we are not losing any sleep debating if ArcSight should have been valued at $1.3 billion versus $1.5 billion, because the strategic reasoning is sound.

The recent acquisitions of 3COM, 3Par, and ArcSight all improve HP's ability to deliver integrated data center solutions, as the industry turns from trusted partnerships with respective strengths to a battle for supremacy with all-in-one solutions. Additionally, while synergies can be difficult to justify in large acquisitions, we firmly believe value is created when the proven technology of a small firm is paired with the vast distribution and marketing resources of a technology giant.

There are clear precedents for success with this acquisition approach, notably Dell's purchase of EqualLogic (also for a hefty premium) in 2008. Dell has taken a business that had an annual revenue run rate of $125 million, and increased it to over $800 million in less than three years' time. That being said, we do not give carte blanche for wild acquisitions, and the final valuation of 3Par was pushing the limits of our tolerance. Furthermore, we think the board's top priority should be securing the right CEO, and will view any additional acquisition activity as distractions unfavorable to shareholders.

Reasons to be Optimistic About Hewlett-Packard
While these issues have generated some uncertainty for this tech titan, we believe HP's shares have reached a valuation where upside greatly outweighs downside. The short-term looks stable, and we remain optimistic about HP's long-term prospects for several reasons:

1. HP retains an impressive base of recurring revenue and sticky customer relationships. No firm is immune to economic uncertainty, but the recurring nature of HP's revenue, and a low relative valuation, provide significant downside protection. Multiyear contracts for services, a vast installed base of printers that continues to consume highly profitable inks and supplies, and strong customer ties related to data center technologies, will help sustain HP's momentum through the short-term turmoil. The company's PC segment is less protected from stumbles, but the challenging economics of that business simply remain as difficult as they were before the news broke. Fortunately, HP's nonPC divisions account for nearly 90% of the firm's operating profit.

2. As Hurd exits, he leaves behind a deep and talented group of managers who are more than capable of leading HP through the current challenges. Interim CEO Cathie Lesjak, a 24-year veteran of the firm, brings stability to the transition by stepping into the CEO role while the board selects a replacement, and the firm has already raised its 2010 guidance to reflect positive short-term momentum. The biggest risk facing the firm is the potential to lose focus during the transition, but so far HP has acted cohesively, and we expect new leadership to be named shortly. We will be looking for the next leader to bring a strong strategic vision for how HP will compete, as the technology industry enters a new phase of competition while leveraging the benefits of the lean operational structure Hurd put into place. Despite the material loss of a strong leader, we expect any headwinds to be short-term in nature, and that the board will successfully leverage the company's brand, storied history, and current prospects, to recruit a talented leader.

3. HP is positioned for success in the battle for data center. We like HP's prospects as the industry giants encroach upon each others' traditional markets, aiming to provide all-in-one systems (that include servers, storage, and networking). Investments in storage technologies, the Procurve networking line, and the acquisition of 3Com are leading HP into higher-margin territory. In contrast, rival Cisco's quest for growth is leading the networking firm away from its bastion of high-margin networking into more competitive situations. IBM and Oracle present real threats as well, but we believe HP will have success leveraging its market-leading position in servers to extend its footprint within its substantial client base.