More Work, But Plenty of Opportunity Ahead for HP
Management is executing well, but investors should wait for a larger margin of safety before diving into HP, says Morningstar’s Pete Wahlstrom.
Management is executing well, but investors should wait for a larger margin of safety before diving into HP, says Morningstar’s Pete Wahlstrom.
Hewlett-Packard's (HPQ) fiscal third-quarter revenue was slightly ahead of our expectations and adjusted EPS was generally in line as the firm placed another notch in its operational turnaround story. There were several puts and takes in the quarterly results and we still have questions about normalized revenue and underlying cash flow generation potential, yet we think management has done well to manage expenses while routing capital toward strategic growth areas. While we plan to update our financial model for the quarterly results and management's tweaked full-year outlook, we are maintaining our $29 fair value estimate for now, and we would wait for a margin of safety before committing capital to this narrow-moat firm. We do, however, expect to take a hard look at our DCF model leading up to, and likely following, the upcoming analyst day in early October.
Fiscal third-quarter revenue ticked up 1% year over year (showing growth for the first time in more than two years) to $27.6 billion. While the catalyst behind the outperformance (Personal Systems, up 12%) is likely to normalize in the next few quarters as the PC refresh cycle tails off, it's good to see HP take share in what has otherwise been a challenging and very competitive global personal computer market. HP's industry standard server unit and networking unit each posted year-over-year revenue growth, at 9% and 4%, respectively, and head-to-head wins against IBM and Cisco were highlights this quarter, with the firm's x86 server growth standing out as surprisingly strong. The restructuring program is going well (36,000 people have exited the company) and the cash conversion cycle benefited from a temporary mix shift, but there's still more work to be done--non-GAAP operating profit margin came in at 8.5% this quarter, up just 10 basis points year over year. Non-GAAP diluted EPS rose only slightly (by 3%) to $0.86.
One thing that we're keeping an eye on is the firm's steady transition to a SaaS model in its software and professional services businesses. This will undoubtedly result in revenue headwinds, but it's the right strategic move, in our view. We still don't bake in much in the way of improving profitability over the next few years either. HP is quite strong in x86 servers, which offer lower-margin potential than storage, networking, or proprietary servers, and it will be difficult to move the needle quickly. However, there appears to be a greater emphasis on go-to-market positioning, renegotiating unfavorable deals, and extending partnerships, which are all long-term positives in our view.
In the meantime, management remains disciplined with expense control and capital allocation. During the quarter, HP generated $2.7 billion in free cash flow, used $881 million for dividends and share buybacks, and invested more in specific R&D projects. With the balance sheet in much better shape today, management reiterated its commitment to do more in the way of buybacks (these were limited in the third quarter due to the presence of material nonpublic information), and return 50% of free cash flow to shareholders this year.
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