Wanna make a gutsy call like Seth Klarman? Let's look at HP

Think that Hewlett-Packard (NYSE:HPQ) is a dog? Well one of the best value investors might disagree with you...

For many investors, Seth Klarman is not a household name, but he is one of the most astute value investor around.  He is known for holding a large portion of his clients' assets in cash, around 20-50 percent, while having annual returns of about 19 percent since 1983 through his Beaupost Group.

So how does a such a conservative investor earn 19% per year for so long, while holding on to so much cash? Klarman simply follows a basic sum-of-its-parts analysis to any investment idea, and if the parts are trading a large discount to the company's market price, he will take a position in said stock. He will buy when the price decreases and sells when the price increases, and completely sell out once the market price reaches the value of the sum of its parts. Sounds simple, but it is. It’s just investing. It does require a contrarian attitude and nerves of steel. 

The reason that I am talking about Seth Klarman is that Seth has been building a reasonable sized position in HP stock. In fact it is 14% of his portfolio. Now that everyone (well almost) is calling for the end of the PC era and the fact that the large PC makers such as Dell and HP have been getting crushed recently makes for an interesting and contrarian analysis. 

Klarman's Beaupost Group has been buying HP all the way down, at first initiating his position in the low 20s and additionally adding to the position in the past quarter. If you like Klarman, the stock keeps going down so you could buy it at a lower price than he did. Klarman bought the stock in its low 20s and will continue to buy as it dives.  Since he often looks for very large margins of safety of 50 percent or more, it probably means that the stock is worth at least USD 30.

So as a whole and excluding its low valuation of FY1 PE of 4.5, what makes this stock so attractive? Well the most attractive part of the company is the fact that it caters mostly to enterprise consumers. It’s a relatively simple business that works on a strong supply chain and business relationships, like most enterprise technology businesses. But this isn't RIM, as HP is not dependent on consumerism for its revenues. In fact this has kept HP's topline fairly steady, see Chart 1.

Without going through a detailed analysis of the company we can look at the company's cash generation capabilities... The company is capable of generating about USD 10bn in cashflows less USD 4bn in capital expenditures which is actually quite high. So the comapny produces 6bn in cold hard cash per year at a minimum, but let's assume that this decreases by 5 percent per year. If we discount this by 10 percent, which is aggressive, we get a very basic value for the company of around 41bn, a 25 percent upside to the company's current value.

But right now HP is a mess. In fact a huge driver for the poor earnings is the company's list of expensive acquisitions, which are heavily impacting HP's working capital and the income statements through 'unusual expenses'. Yet throughout all the restructuring charges and questionable acquisitions, there is a company with a strong relationship to the enterprise sector that is capable of earning USD 8-10bn of cashflow per year, and this is where the value lies. 

In the chart below we can see that the acquisitions the growing discrepancy between operating income and net income for HP past 2009. These are problematic but they are also temporary as it often takes a few years to iron out the kinks of a takeover.

So if you have trust in Seth and HP CEO Meg Whitman, HP might be a good deal if you are willing to trade through the gyrations. Don't expect others like David Eihorn of Greenlight Capital  - who was recently burned by a Dell buy-and-sell at a steep loss - and Bill Ackman of Pershing Square to follow. Bill mentioned last year that HP was not on his list of buys although it did appear cheap. Maybe the fall from 28% drop from October 2011 might have changed his mind...So if you like Seth, use his free publically- available advice and dive in to HP.

Happy investing/trading!