Magic Formula Stock of the Week: Hewlett Packard (HPQ)

We’ve already seen several of the “old guard” tech giants on the magic formula list. Companies like Dell (DELL), Microsoft (MSFT), and Cisco (CSCO). But perhaps none of the “old guard” is more hated than current magic formula stock Hewlett-Packard (HPQ). In just the past eighteen months, the company has been hit by a scandal which lead to its CEO resignation, two very pricey acquisitions in Palm and 3Par, and the laptop / PC killer that is the iPad.

And the bad news keeps coming- just today ,the company sold off over 6% (though it’s hard to read much into that, given today’s market down ~5%) after 4th quarter guidance came in below expectations. Add it all up, and you have the recipe for a company that’s lost almost 50% of its value over the past year.

Given all that, HP must be a dying business soon to join the likes of the buggy whips and abacus, right? After all, this is a business that only makes PCs and laptops, and everyone knows that their two core products are rapidly being replaced by smart phones and tablets.

Not even close. While HP’s business might be in decline, the numbers don’t really back that up. Though aided a bit by acquisitions, revenue has increased nine of the past ten years (the one modest decline was during the depths of the financial recession) and EBITDA has increased in each of the past ten years. Return on tangible assets (defined as ebit / tangible assets) has actually increased massively, going from around 5% at the start of the decade to over 17% in the past twelve months.

But more than any of that, the perception of HP as solely a consumer and laptop business is wrong. The personal PC business accounts for about a quarter of HP’s revenues and, given it is a lower margin business than the rest of HP, even less of their operating profit. HP’s new CEO has a software background and is focused on shrinking the legacy PC business and growing out the higher margin, higher growth software business.

But enough of the qualitative talk. Let’s start talking numbers and see how good of returns HP is actually generating and exactly how cheap the company is.

Returns

So just how good are the company’s returns?

The company currently employs just over $82B in tangible assets. After excluding non-cash restructuring charges, the company has earned just over $15b in operating income over the past 12 months for a return on tangible assets over 18%... and remember, HP expenses almost $3b in R&D every year. If you adjusted for that, returns on assets would be even higher!

Valuation

So, at today’s prices, what are you paying for HP? Remember, this is a business with literally decades of history of solid growth and innovation that is currently generating returns on tangible assets better than 65% of the S&P 500.

Honestly, almost nothing. At today’s price of ~$30 per share, you’re buying HP for under 4x EV / EBITDA and just over 5x EV / EBIT. Those multiples are more in line with a business in complete terminal decline than a market leader with a history of growth. As a matter of fact, businesses in complete terminal decline trade for higher multiples- Earthlink (ELNK), an almost pure play on dial up internet, trades for almost 5x EV / EBITDA!

Catalysts

There are even some catalysts on the horizon for value realization. The company today announced that they are exploring the possible spin off of their PC business, which, once completed, could help highlight the high returns and faster growth in their other divisions.

On the other hand, they also announced they’re in talks to buy a U.K. technology firm for $10 billion. While this furthers their goals of expanding the software business, HP is paying a pretty lofty multiple of almost 10x sales. Given accusations they may have over paid for 3Par, value investors probably aren’t too happy about the new acquisition. They’d probably rather HP increase its dividend or repurchase shares at a faster clip.

Still, at today’s prices, investors are buying a world class franchise for a rock bottom valuation. HP would make a great addition to any magic formula portfolio.