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Why HP's rally doesn't compute
It's doubled the S&P 500's recent performance, but mistakes, questionable accounting and an underfunded pension plan all point to trouble. Plus: four things to watch in the recession-vs.-recovery debate.
By Jon D. Markman
Few stocks symbolize the invidious danger of the equity markets war rally as much as computer manufacturer Hewlett-Packard (HPQ, news, msgs).
From March 13 through March 21, shares of the embattled California tech concern rose 17% -- double the increase in the benchmark S&P 500 Index ($INX) -- amid optimism that, following a fast victory in Iraq, businesses around the world would quickly refocus on purchase orders rather than marching orders.
Yet you have to wonder whether Hewlett-Packard, in particular, deserved such good treatment, considering its cash flow is waning, its internal controls are demonstrably suspect, its overpayment for Compaq is bound to result in write-offs before long and its core business is weakening.
Bad start to a (probably doomed) rally
To be sure, the stock appears on the surface to be cheap, considering its trailing price-to-sales multiple is a paltry 0.8, its price-to-book multiple is just 1.47 and its forward price-to-earnings ratio is around 14.8, if you believe current estimates -- all near 10-year lows. And bears had certainly already punished the stock, pushing the stock recently to an eight-year low. Thats far more than such peers as International Business Machines (IBM, news, msgs) or Dell Computer (DELL, news, msgs). Management sold the Hewlett-Packard-Compaq deal to investors as a cost-cutting story, a theme that takes time; so far, in the early chapters, that angle is progressing nicely.
But the boost in Hewlett-Packards price this month had an inauspicious start and is likely to come to an unfortunate end.
The rally began a day after the company, which has no significant competitive advantages in any of its business lines except -- barely -- printing, announced that it had erroneously reported that its operating cash flow for the first quarter of 2003 was $791 million. Instead, it said in an amended quarterly filing on March 12, cash flow had actually been $647 million -- an 18% difference.
Bulls were quick to accept the companys explanation for the mistake, and it was somehow forgotten in the overall markets subsequent boom. However, buyers at the current level should be concerned that the companys poor internal controls increase the probability that irregularities will surface in the future. A mistake of that size could not occur without either epic dishonesty or incompetence, neither of which is an attractive trait. When spirits are high, all is forgiven. When the news cycle inevitably shifts to pessimism again, views will be harsher.
Of course, more than psychology is at stake. At the same time that Hewlett-Packard reported a 22% increase in pro-forma earnings for its fiscal first quarter, operating cash flow plunged. Using the companys revised figures, cash flow sank 62% from $1.7 billion in the first quarter of 2002, to just $647 million in the first quarter of 2003. Accountants at Camelback Research Alliance, which serves as a strategic adviser to my fund, said in a report that fiscal 2002 cash flow was itself an artifact of the companys acquisition of Compaq that year. According to Camelbacks analysis, combined company operating cash flow for the four quarters ending Jan. 31, 2003, was $4.3 billion, a 29% decline from combined company operating cash flow for the four quarters ending Jan. 31, 2002. These are not the results of a company that shows any early signs of a material rebound.
The problem with pro-forma earnings
Of course, Hewlett-Packard is a habitual abuser of a non-standard form of bookkeeping known as pro forma. Many companies use pro-forma results, rather than results that stem from Generally Accepted Accounting Practices, or GAAP, to show what results would have looked like if not for certain extenuating circumstances, such as a merger or a natural disaster. However, some companies become addicted to the practice and use pro-forma results to disguise their problems.
Camelback researchers point out that that Hewlett-Packards hodgepodge of pro-forma earnings has materially exceeded GAAP earnings in every quarter but one of the past five years. The latest quarter was a perfect example: Management emphasized its pro-forma earnings per share of 29 cents, which beat estimates of 2 cents a share and exceeded GAAP earnings of 24 cents by 21%. The difference between the two is important, according to Camelback researchers, because recent academic evidence has shown that special charges -- the ones removed from pro-forma earnings figures -- are useful in predicting stock-price underperformance. That is, companies that flush a lot of disagreeable expenses out of their reported performance tend to be companies whose shares suffer, possibly out of investor skepticism over the quality of those earnings.
Additionally, Hewlett-Packard persists in claiming an unusually low tax rate -- a practice which is probably unsustainable and will likely affect future earnings reports. In the first quarter of 2003, managers used a combined-company tax rate of 22%, which is 13% lower than the federal statutory tax rate. The company attributes the difference to earnings from operations outside the United States. But the government has cracked down on similar practices at other firms. According to Camelback researchers, had the company reported taxes at Compaqs average effective tax rate of 32.7%, first-quarter pro-forma earnings would have been 25 cents rather than 29 cents.
Three more issues that should raise red flags:- First, the company carries an extremely large restructuring reserve of $1.1 billion as a result of major restructuring charges at both Hewlett-Packard and Compaq before the merger. Some of this reserve could well be reversed in the future, giving an undeserved boost to reported earnings.
- Second, because of the Compaq acquisition and other previous acquisitions, the company carries a goodwill balance of $15.1 billion. This inflates the companys book value and, in the event of sustained stock underperformance in the future, is likely to be written off as impaired -- an action that the market tends to treat with disdain.
- Third, the company has a seriously underfunded pension plan. Hewlett-Packard was forced to take a charge of $379 million to account for its pension deficit in 2002, and management has indicated that it expects to have to take another charge to contribute as much as $800 million in fiscal 2003.
None of these issues is insurmountable, and the company clearly has the opportunity to hit on all cylinders if the overall worldwide economy improves. But at recent levels as high as $17.50 a share, an awful lot of good future news is factored into the stock price.
Recession vs. recovery: four things to watch
The leading hope for companies like Hewlett-Packard in coming weeks is that successful execution of the war in Iraq will lower oil prices and cheer stock investors, and that good vibes from Wall Street will fan out to Main Street and into executive suites, leading, reflexively, to increased consumption of stuff all around.
The good-news scenario is absolutely possible (though by no means assured), because positive economic stirrings are currently being completely trumped by geopolitical concerns. Lakshman Acuthan, managing director of the Economic Cycle Research Institute (ECRI), recommends that investors focus on the following factors:- The money supply is booming. Even though the Federal Reserve did not lower interest rates at its last meeting, it is still attempting to boost the U.S. economy by increasing the amount of money in the system. This is a big, hidden positive, in the short to intermediate term, at least. Excess money usually finds its way into the capital markets.
- Industrial prices are rising. Acuthan uses the ECRI-Journal of Commerce index to measure industrial wholesale prices because it does not have a heavy weight in oil. It is designed to reveal broad-based price movements in economically sensitive commodities such as tin, copper, steel, textiles, tallow, lumber and rubber. The index has been moving steadily forward, with minor setbacks, in a pervasive manner. This indicates that there is real, positive demand in industry.
- Real estate loans continue to rise. Loans for new purchases -- not just home-mortgage refinancings -- are up. The number of people willing to make such a major commitment at a time of rising unemployment is also a big positive.
- Unemployment claims are rising. At the margins, in recent weeks it appears that businesses have begun a new round of job-shedding. Even once-stable companies such as Solectron (SLR, news, msgs) and Applied Materials (AMAT, news, msgs) have, in recent weeks, announced cuts of 12,000 and 2,000 jobs, respectively. If unemployment continues to rise, the odds of a relapse into recession becomes much more likely -- jobless people generally dont buy much, setting off a chain reaction in the economy.
Acuthan says well know which way the economy will tip in the next month. The real problem for companies like Hewlett-Packard is that if the United States tips into the abyss, its highly likely that the rest of the world will follow into a gruesome, global synchronized decline, where there will be no place to hide. If so, it would be worse than the mild global recession of 2001, which was relieved by a powerful campaign of U.S. interest-rate stimulus plus emergency fiscal stimulus in the form of tax cuts and military spending. There is little room for either of those moves today.
If youre optimistic at this point (and why not, after all, you can marshal data to support it), you can gamble on the huge upside ahead for U.S. equity values by laying in wait for Hewlett-Packard to return to the $12-14 area. But if youre prudent, you should wait a month to determine whether renewed recession is the more likely scenario, in which case $8-$10 may be the price level at which you will be compensated for the risk of owning a company with so much heavy financial baggage.
Fine Print
Goldman Sachs said on Tuesday that while No. 1 personal computer and printer company Hewlett-Packard may meet its targets for the current quarter, it will be close because of the tough economic environment. HP is still in a position to make the April quarter, although outside forces will undoubtedly bring it right down to the wire,'' Goldman analyst Laura Conigliaro said in a report. ... Competition is increasing competition: Dell Computer said Tuesday it will to begin taking orders this week for its new inkjet and laser printers, as well as ink and toner cartridges that were made for it by Lexmark International (LXK, news, msgs). Dell had previously sold printers from Hewlett-Packard, Lexmark and others, but its relationship with Hewlett-Packard ended after the Austin, Texas company said it would start branding its own. While it's uncertain if printer sales will add meaningful margin to Dell, it's certainly true that the last thing Hewlett-Packard or any manufacturer needs at this time is for an important distribution channel to disappear. ... Time for a rundown of my prior calls on stocks with poor earnings quality. The most recent came on Nov. 20 when I proposed in the column An insecure homeland security stock that PEC Solutions (PECS, news, msgs) earnings reports were overly rosy: The main problem is that free cash flow at PEC Solutions has trailed net income by a wide margin since the company went public three years ago -- and recently there has been an unusual increase in both normal and unbilled receivables along with a strangely low reserve for bad debt. The stock was then trading around $32. After two earnings warnings, its now trading around $10. Before that, on Sept. 25, I complained about low-quality earnings at Cablevision Systems (CVC, news, msgs) when the stock was around $10. The stock went on to lose 30% before almost doubling to $18 after the companys board took unexpectedly strong action to shore up its balance sheet with asset sales. On Aug. 7, I raised questions about General Mills (GIS, news, msgs) slow integration of Pillsbury and noted that its high debt load reduced breathing room at a time when shares fetched $41. Theyre going for about $46 now as earnings have been boosted by the introduction of many new products, such as an adult-oriented version of yogurt in a tube and bigger packages of refrigerated cookie dough. Back in ancient history, columns on earnings quality over the summer at Emulex (ELX, news, msgs) here, and Toys R Us (TOY, news, msgs) here both augured much lower prices, as did a column on Electronic Data Systems (EDS, news, msgs) in April. Indeed, Toys R Us fell another 7% on Monday after Fitch Ratings lowered its view of the toy retailers debt to BB-plus, or junk status, citing soft operating results, a weak retail environment and growing competition from major discount chains.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund was short IBM but held no positions in any other companies mentioned in this column. Positions can change at any time.
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