There's a big difference between “cheap” and “cheap for a good reason”, and it's not always easy to tell the two apart. While Hewlett-Packard (NYSE:HPQ) shares still appear to be undervalued on the expectation of any growth at all, the ongoing execution issues do mean that a return to growth shouldn't be taken for granted. At a minimum, there's still quite a lot of work for management to do make this turnaround a success, and I do have my concerns about the the effect of competition on those plans. On the other hand, today's valuation doesn't exactly presume that those efforts will end in major success.
Fiscal Q3 Comes In On Target
For a company that delivered a couple of beat-and-raise quarters despite some tough end markets, Hewlett-Packard's in-line fiscal third quarter will likely go down as a disappointment, as will management's guidance that growth is not likely in the near term.

SEE: Navigating Volatility During Earnings Season
Revenue fell 8% from the year-ago level and 1% from the prior quarter, which was basically on par with Street expectations. HP's segment results were also broadly as expected, with PC revenue down 11% (a little better than expected), printing down 4%, enterprise down 9% (a little worse), services down 9%, and software up 1%. 
On a less positive note, HP's adjusted margins didn't show quite the expected level of progress, though the discrepancies were small (on the order of less than a quarter-point). Gross margin was basically flat with last year and down slightly on a sequential basis, while operating income fell 16% and operating margin fell 80bp (though the sequential drop was just 3% and 20bp, respectively). Enterprise hardware margins were particularly disappointing, while software margins improved nicely.
PCs Lacking Momentum, Printing More Stable
While plenty has been written about how bad the PC market is these days, HP isn't exactly making the best of a bad situation. Not only did Dell (Nasdaq: DELL) outperform HP this quarter (with a 5% decline in “end user computing), but Lenovo (Nasdaq:LNVGY) actually showed year-on-year growth of 2% in its PC business. HP has been unwilling to sacrifice margins in PCs and compete on price, leading to sizable share gains for Lenovo.
Printing is incrementally better. Although the 4% decline in supplies was troubling (as this is a lucrative source of cash flow), HP rivals like Lexmark (Nasdaq:LXK) and Canon (NYSE:CAJ) see the market stabilizing and Canon has made it clear that it has no intentions of trying to compete on price.
Enterprise May Be The Bigger Worry
HP continues to report disappointing enterprise hardware results, a situation which has led to a change in management for the division. Server sales were down 11% this quarter, suggesting that Dell's decision to compete on price paid dividends, though IBM's (NYSE:IBM) x86 server sales were down a similar amount. Storage was also quite weak, with a 10% decline for the quarter.
Here, too, I don't have a lot of confidence in HP's positioning or strategy. I think HP is falling behind in storage and, at the risk of talking my own book, I think Lenovo's plans to grow its server business (management recently laid out the goal of becoming the #3 player in three years) directly threaten Hewlett-Packard's business.
The Bottom Line
Hewlett-Packard really has a lot of work left to do. The margins in the service business need to be substantially better than what they are now, the enterprise business lacks competitiveness, and I don't think HP is following the right strategy in the PC business. So while it's all well and good that the company's cash flow is improving, it can't happen at the cost of long-term competitiveness.
Still, the valuation on HP shares assumes very little in the way of improvement. Zero free cash flow growth can generate a $25.50 fair value, though skeptics may well argue that simply holding firm at zero growth would be an accomplishment in its own right. Given the progress that Lenovo is making and Dell's apparent willingness to sacrifice margin for share, I think the competitive environment is getting more challenging. That said, investors who still believe that HP can grow again could still find something to like in these shares.
Disclosure – At the time of writing, the author owned shares of Lenovo.

Related Articles
  1. Stock Analysis

    How Toyota Succeeds at Home and Abroad (TM)

    Japan's biggest car manufacturer is also one of North America's biggest, delighting shareholders with its high profit margins.
  2. Stock Analysis

    Starbucks: Profiting One Cup at a Time (SBUX)

    Starbucks is everywhere. But is it a worthwhile business? Ask the shareholders who've made it one of the world's most successful companies.
  3. Stock Analysis

    How Medtronic Makes Money (MDT)

    Here's the story of an American medical device firm that covers almost every segment in medicine and recently moved to Ireland to pay less in taxes.
  4. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  5. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  6. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
  7. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  8. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  9. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  10. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center