MONEY A Pick From A Pro

The Case for Hewlett-Packard in the Post-PC World

USAA Investment's Bob Landry thinks so. But to achieve a turnaround, Meg Whitman & Co. will have to develop new businesses.

The Pro: Robert Landry, portfolio manager, USAA Investment Management Co.

The Pick: Hewlett-Packard HEWLETT-PACKARD CO. HPQ 0.1316%

The Case: Last month Hewlett-Packard’s chief executive Meg Whitman announced that she’d be firing up to 16,000 employees. That’s on top of an additional 34,000 workers.

Revenues for HP, the elder statesman of Silicon Valley, have fallen for 11 consecutive quarters. In fact, the company’s trailing 12-month revenues are about the same as they were six years ago.

The company still earns a large portion of its revenue from older fare – think personal computers, and printers – at a time when cloud computing and mobile tablets are becoming the focal points of innovation. And Whitman is in the middle of a 5-year turnaround effort.

Nevertheless, investors have driven Hewlett-Packard stock up 37% over the past year.

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Why? Revenues may be down, but profits have been above $1 billion for the last six quarters. (Total expenses are also down over the last two quarters.)

Plus, USAA Investment’s Bob Landry thinks some investors don’t properly appreciate HP’s aptitude for change. “The biggest misconception is that people believe the company is an old dog that can’t be taught new tricks. That they can’t pivot from being a legacy hardware company to focusing more on enterprise services and software.”

It’s not as if Hewlett-Packard doesn’t have a hand in state-of-the-art technology, like “the Machine.” Cooked up in HP Labs, the Machine is sort of a post-cloud computing system that will be able to deal with huge amounts of data.

Whether Hewlett-Packard can actually evolve into the company Whitman, and her shareholders, want it to become remains to be seen.

Reinvestment

While reducing headcount by 50,000 cannot be good for morale (or perhaps for attracting top talent), the job losses from older parts of the company that have been struggling, says Landry.

“A lot of these people were tied to more legacy products that weren’t growing,” he says. “They’re trying to right size the company.”

This is part of the company’s larger to invest in growth areas, including tables, cloud computing, IT management software and big data.

And restructuring has helped operating margins, which have been positive for the last three quarters, after going negative for over a year.

Value

“Hewlett-Packard is a significant cash flow generator,” says Landry. In other words, after they meet all their obligations and make their capital investments, they still have cash left over that gives them financial flexibility. With a free cash flow yield of 12%, “management has pledged to return at least 50% to shareholders through buybacks and dividend increases,” Landry says.

For instance, last quarter Hewlett-Packard earned $3.0 billion in free cash flow, while returning $1.1 billion to shareholders.

Meanwhile, the stock is trading at a pretty reasonable valuation. With a price/earnings ratio of 8.8, based on estimated profits (per Bloomberg), Hewlett-Packard is a cheaper option than IBM INTERNATIONAL BUSINESS MACHINES CORP. IBM -0.3848% and Xerox XEROX CORP. XRX 0.2172% .

One reason why Landry likes Hewlett-Packard’s turn toward the software and networking aspects of its business is that those sectors are high margin business. Last quarter, operating margins on its software business was 19.2%, second only to printing. Enterprise (which includes networking) was third at 14.4%.

What if the plan doesn’t work?

While Landry is patient with Hewlett-Packard, and believes in its story, he says he eventually needs to see some revenue growth.

“If revenue growth doesn’t come throw, if it falls short of expectations, that would be a problem,” says Landry.

And last quarter proved problematic for some of Hewlett-Packard’s businesses, even its non-legacy ones. Software revenue was unchanged year-over-year, while the enterprise group fell by 2%.

One sector that did see gains (7%) was its personal systems section (which includes notebooks, desktops and workstations). Of course personal systems is a pretty low-margin business.

MONEY A Pick From A Pro

For Lions Gate, The Hunger Games is Only the Appetizer

140530_INV_PickPro_HungerGames_1
From left to right: Woody Harrelson ("Haymitch Abernathy," left), Josh Hutcherson ("Peeta Mellark," center) and Jennifer Lawrence ("Katniss Everdeen," right) star in Lionsgate Home Entertainment's THE HUNGER GAMES: CATCHING FIRE. Murray Close—Lionsgate

So says Federated Investors' Lawrence Creatura. The studio's next challenge: parlaying its hits into franchises for years to come.

The Pro: Lawrence Creatura, co-manager of the Federated Clover Small Value fund

The Fund: Federated Clover Small Value invests in shares of undervalued small- and medium-sized U.S. companies. Under Creatura, the fund has beaten more than 70% over the past 15 years.

The Pick: Lions Gate LIONS GATE ENTERTAINMENT CORP. LGF 1.7896%

The Case: Lions Gate has gone from a bit player in Hollywood — a decade ago it was mostly known for small, independent films such as Dogville and Monster’s Ball — to the king of the young-adult heroine blockbuster.

The film and TV production company purchased Summit Entertainment, which included the Twilight franchise and library rights, in 2012. Throw in The Hunger Games and Divergent, its newest franchise, and you have potentially more than 10 films and dozens of branding opportunities going forward.

In television, Lions Gate also has big hits on its hands such as Netflix’s Orange is the New Black and AMC’s Mad Men. Such shows have helped the production company increase revenue by 66% since 2011.

There is a downside, though, to hitting the big time: Investors constantly want to see big results. And when the company announced late last week that revenues had fallen in the recently ended quarter and fiscal year, the stock lost more than 10% of its value in a day.

Nevermind the fact that in its most recent fiscal year, Lions Gate had only 13 wide release films compared to 19 in the prior year — and that the most recent quarter only included about 10 days worth of Divergent’s box-office.

Federated’s Creatura says investors misunderstand the nature of Lions Gate’s business. “They think it’s a hit-driven volatile business,” he says, “when it has a portfolio of evergreen property which will produce dependable cash flows for years and years and years to come.”

These are franchises such as Twilight, The Hunger Games, and Divergent, which just started filming its sequel.

The Hits Go On
Lions Gate’s dive into young adult franchise films gives the company a seemingly endless number of movies to produce. “The first Hunger Games starts with the 74th annual Hunger Games — what happened to the first 73?” asks Creatura.

And if Lions Gate decides to make 73 prequels, there’s reason to think they’ll be profitable. The most recent Hunger Games, for instance, took home more than $860 million in theaters, per BoxOfficeMojo.com, and cost $130 million. Divergent made more than $266 million and cost just $85 million.

Not only are Lions Gate films profitable, they generate a ton of so-called free cash flow, which is the amount of money left after paying all the bills and making all necessary investments in the business. (See the chart below.)

Lions Gate Free Cash Flow Yield
Lions Gate’s free cash flow yield beats that of rival Dreamworks Animation

Relative Value
Lions Gate is a play on fast growth. But that doesn’t mean the stock is necessarily expensive, says Creatura. Lions Gate’s price/earnings ratio based on estimated profits, for instance, is 20.3. That’s not considered cheap, but compare that to the 33.3 P/E for Dreamworks Animation. Plus the company’s earnings are expected to grow 17% annually for the next five years.

“The stock is not expensive if you consider the likelihood and longevity of future cash flow,” says Creatura. “These properties are evergreen – they can be reused and reformed again and again.”

Box office risks
While Lions Gate may have valuable franchises in the canon, there is a limit to what one brand can get you. Is Lions Gate more than The Hunger Games?

Divergent did perform well, but took in about a third of the box office of the first The Hunger Games film. Ender’s Game, another book based on a young adult novel (although this one featuring a male lead), failed to develop an audience and only made $125 million worldwide –limiting it’s potential for a viable franchise.

Ender’s Game wasn’t the blockbuster that some believe it could have been and that hurt the perception of the stock,” says Creatura.

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