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For Value Investors, It’s IBM — Not HP

HPQ is down for good reason. Stick with Big Blue for real value


Hewlett-Packard (NYSE:HPQ) announced its fourth-quarter earnings after the close of business Nov. 21, and as everyone knows by now, they were awful. To her credit, CEO Meg Whitman didn’t try to paint a pretty picture, preferring instead to be brutally honest about the difficulties that lie ahead.

With HP trading 53% below its five-year high, value investors are likely taking a close look at the battered tech giant. It’s an intriguing proposition for sure. That said, unless you’re prepared for several years of volatility, the smarter bet is to pass on Hewlett-Packard and buy IBM (NYSE:IBM) instead.

The natural thing for investors to focus on in HP’s fourth-quarter earnings is the $885 million impairment charge to goodwill and purchased intangible assets resulting from the shuttering of its WebOS tablet and smartphone business. That charge cut operating profits for the year by 8.4%.

It’s a big chunk for sure, but so much more is going wrong at HP that it’s pointless to worry about the impairment charge. Add back in the $885 million, and you still have an 8% decline year-over-year in operating profits on a 1% increase in revenues. Operating margin narrowed 80 basis points to 8.3%, its lowest rate since 2006.

Now compare this effort with IBM. In the nine months ended Sept. 30, IBM’s operating margin was 18.1%, 80 basis points better than the same period a year earlier and nearly double HP’s. It’s hard to find anything that paints a clearer picture of the differences between the two companies.

5 Reasons to Shun HP

Larry Dignan, editor-in-chief of ZDNet, wrote today about five specific areas of concern for HP in 2012.

At the top of the list is HP’s enterprise servers, storage and networking unit. Dignan points out that the group saw a 4% decline in revenue in the quarter. What he doesn’t mention is that the unit’s operating income dropped 17.5% year-over-year to $733 million. While that’s still 20% of HP’s overall operating profit in the quarter, the slide is definitely troubling.

HP’s biggest revenue loser in the quarter was its Itanium-based server line, which saw revenues decline 23% due to a lawsuit with Oracle (NASDAQ:ORCL) that contends HP is forcing Intel (NASDAQ:INTC) to continue developing the Itanium servers despite the fact they aren’t selling. It’s not a good partnership when one party is forced to participate.

Services, the segment upon which IBM rebuilt itself a decade ago, seems to be failing HP. In the latest year, this segment’s operating profit declined 160 basis points to 14.3%. Dignan points out that this measure has been on a downward slide since the fourth quarter of 2010. On the other hand, IBM’s operating margin for services in the first nine months of the year increased 90 basis points year-over-year to 14%. Perception is everything I suppose.

Having recently written an article about Lexmark (NYSE:LXK), I’m all too aware that consumers are cutting back on the use of printers and ink. In 2011, HP’s printing and imaging group saw operating margins decline by 400 basis points to 13.1%. Basically, it was giving away the ink.

Last, and the most important of the five points, is research and development. HP has gotten away from R&D spending in recent years, and it shows. No longer, says Whitman, will HP avoid innovation. That can’t happen soon enough. HP currently spends 2.5% of overall revenue on R&D compared to 6% for IBM. Unfortunately, Whitman suggests the increased spending won’t arrive until 2014 at the earliest. If that’s true, why would any investor gamble on something hypothetical when you can get the real thing at IBM.

Warren’s Big Blue Wisdom

Warren Buffett is known to invest in great companies. IBM was a great company for a long time, before stumbling in the early 1990s. Lou Gerstner took over in 1993 and completely changed the culture and in the process reinvigorated Big Blue. He then wisely passed the baton to Sam Palmisano, who himself will hand the top job to longtime IBM veteran Virginia Rometty on Jan. 1. Seamless transitions. Something HP can only dream about.

Buffett recently became the largest IBM shareholder because he saw a company that avoids the drama of business and simply makes money. By 2015, it should earn $20 a share. In 2001, IBM’s EPS was $4.35 with an average market price of $104 for a P/E of 24 times. Its EPS in 2011 will be more than $13 for a P/E of 14 times. I’d say Buffett paid a fair price for a great company.

Forget the value play in HP and invest in the better company.

As of this writing, Will Ashworth did not own position in any of the stocks named here.

Article printed from InvestorPlace Media,

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