STOCK WATCH


HP: A Deal That Could Pay Off

Anne Kates Smith

Shares took a hit on news of the company's acquisition of EDS, but, over time, Hewlett-Packard and its stock should benefit from the merger.



On any given day, you can walk into a Best Buy or Circuit City and get a great deal on a Hewlett-Packard computer. Some folks think that investors are getting the same opportunity right now in HP stock.

The reason for the spring sale? Investors took a mark-down pen to HP shares (symbol HPQ) after news surfaced on May 12 that HP is pursuing an acquisition of information technology giant Electronic Data Services for $25 a share, or $14 billion. Both companies' boards have approved the deal, but HP shareholders gave it an immediate thumbs down.

HP's stock sank nearly 9% in the week and a half following news of the merger. Even a report on May 21 of a strong second quarter (the company's fiscal year ends October 31) hasn't helped much. The stock closed at $45.70 on May 27, up 1.65% for the day, but down 7% from a recent peak of more than $49 a share on May 9.

Shareholders have a right to be nervous about the merger, expected to close in the second half of this year. "I had a 'sell' on EDS before HP agreed to acquire it," says analyst Steve Biggs at Zacks Investment Research. Revenues at EDS are growing in the low single-digit range, compared with high single-digits at HP, he explains, and profit margins at EDS are slimmer. Last year, the number of big IT management contracts won by EDS was down from '06 levels. For that matter, the market for the kind of large-scale, soup-to-nuts IT management that EDS specializes in is on the decline in the corporate sector, although still strong in the government.

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And yet, Biggs is among the bulls recommending purchase of HP shares. That's because, in the long-run, the EDS business is a good fit. The merger would double HP's IT services revenue, which came in at $16.6 billion, or 16% of total revenues of $104 billion, in fiscal 2007. Together, the companies logged more than $38 billion in services revenue, and with a combined 5.3% share of the service market, pose meaningful competition to IBM, the global IT service leader, with 7% of the market.

HP's largest business segment is its personal computer division, accounting for 34% of sales, followed by printers and imaging, 27%. Servers, software and financing round out the offerings for the largest technology infrastructure company in the world, revenue-wise.

EDS may not be much help right away in the revenue department. But analyst Shaw Wu, who covers HP for American Technology Research in San Francisco, says the acquisition can add a nickel to six cents a share to HP's earnings in fiscal '09 and as much as 27 to 32 cents a share in fiscal 2010 and beyond, as HP cuts costs and achieves some operating synergies.

HP chief executive Mark Hurd is just the man to wring the inefficiencies out of EDS. Since Hurd's arrival at HP in 2005, notes Morningstar analyst Rick Hanna, the company's sales have grown faster than the industry average while the company has gained market share in virtually every product and geographic region. Operating profitability has improved dramatically, with profit margins up from 9% of sales in 2005 to 12% in 2007, and contributions from HP's business segments have become more balanced.

Results for the quarter ended in April handily beat what analysts had been expecting. The company earned 87 cents a share, versus the 85 cents expected. Earnings per share were up 24% from the same period a year ago. HP also reported $28.3 billion in sales, up 11% from a year earlier. The bulk of the company's revenue -- 70% -- comes from overseas, making up for sluggish sales here.

Meanwhile, based on estimated earnings of $3.67 per share for the 12-month period that ends next January, the stock has a price-earnings ratio of 12 and is trading at a discount to both IBM (IBM), which closed May 27 at $127.32 with a P/E of 15, and Dell (DELL), which closed at $21.49 with a P/E of 14.

In the short-term, investors will likely realize they've overreacted to the risks of integrating EDS. Standard & Poor's analyst Thomas Smith estimates HP's next four quarters of earnings (to April '09) at $3.78 a share. So he figures the stock deserves to trade at about 15 times that estimate -- a P/E that's in the bottom half of a four-year historical range for HP and below the average for companies in the S&P 500 Information Tech sector.

Smith says $57 a share within 12 months is a reasonable target price for the stock. Even Morningstar's notoriously conservative "fair value" estimate for HP is $54 a share, hinting at a potential return from the current stock price approaching 20%.

Even the best of bargains can engender some buyer's remorse early on, however, and investors who buy HP stock now should be prepared for volatility over the next year or two. Says Zacks analyst Biggs: "EDS is an acquisition that will benefit the company. But it'll take a couple of years to realize it."




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