Focusing on “turnaround” stocks was a favorite angle for investors in the 1990s. Many companies had been run poorly, but new management could easily unlock value by focusing on a deep restructuring. The key was to find businesses that still possessed sizable market share, brought in new leadership and most importantly, were already cheap based on current cash flow, let alone what future cash flow growth might entail.

This is the recipe in place for Hewlett-Packard (NYSE: HPQ) today, which only a few decades ago was considered to be one of the premier technology firms in Silicon Valley. New CEO Meg Whitman has her work cut out for her, but she inherits a business that is already a cash-producing machine (free cash flow has averaged $8.5 billion during the past three years). And trading at just six times projected 2012 profits, it’s clear investors aren’t holding her to a very high set of expectations. Look for Whitman to lay out plans to revitalize the company in coming months. Far-sighted investors need to pay attention.

Fixable, not broken
From Wang to Digital Equipment to Novell, the high-tech sector is filled with examples of companies that lost their luster and faded into oblivion. These were broken business models that were ultimately sold off for a fraction of their peak value. Yet HP isn’t broken and there is a clear fix in place for its myriad businesses. Trouble is, previous management moves have failed to really tackle any core challenges the company faced. Former CEO Mark Hurd was more concerned with cost-cutting and acquisitions, while virtually ignoring internal development. Cost-cutting helped boost earnings per share (EPS) steadily in the last half of the past decade (from $0.82 per share in 2005 to $3.25 in 2008), but underinvestment in the business started to create an opening for rivals to take market share.

#-ad_banner-#Let’s look at IBM (NYSE: IBM) as an example. While both firms focus on large enterprise contracts that entail management of all aspects of a client’s technology base, IBM was investing heavily in software, noting that this value-added segment can bring more robust profit margins than simple hardware configurations. As a result, IBM generates 20% operating margins, while HP’s enterprise unit generates 15% operating margins. A recent move to acquire Autonomy Corp. for $10 billion will boost HP’s software efforts — though HP vastly overpaid for it — yet Whitman will acknowledge that HP needs to invest even more in software in 2012.

In the computer segment, HP was lauded for overtaking Dell (Nasdaq: DELL) as the world’s top seller in 2006, but a lack of investments led the company to virtually miss the ongoing tablet-computer revolution. Still, HP’s commanding size in the PC business gives it significant buying power in terms of components, which helps HP generate $2 billion in free cash flow from this business. A just-announced decision to retain this division (and likely step up investments in 2012) is a wise one, as computer sales are so closely intertwined with HP’s other divisions such as printers and services.

The printer division, by the way, is a crown jewel, with 40% global market share (as much as Canon and Epson’s combined share). The division’s 16% operating margins (and $4 billion in annual operating cash flow) are the simple results of ongoing investments in printing technology. This is a lesson likely not lost on Whitman as she draws up plans to revive other parts of the business.

Analysts at Aurgia Securities have analyzed each of HP’s divisions, assessing a comparable value for each against a set of peers. On a sum-of-the parts basis, they say shares could trade up to $47 from a current $27. Yet few will buy HP stock on this rationale. Instead, they want to see how Whitman can tinker with the business to restore HP’s competitive positioning.

So how will this play out? A bit of counter-intuitive logic is necessary. Myopic investors often look to dump the stock of a company when it announces plans to step-up spending (reducing EPS guidance in the process). Yet HP is an exception. Let’s assume the current 2012 EPS forecast of $4.70 a share needs to be slashed to $4 as spending rises. Well, the stock is still cheap, and would trade for just seven times that lowered figure. More important, the spending signals HP won’t just sit on its hands anymore. It plans to remain relevant — and thrive — well into the future. Doubts about the future are what this cheap stock price is really telling you.

This lowered guidance is likely to come this winter as the new CEO “resets expectations.” This is what all CEOs do, and it is widely expected from HP. To be sure, most investors will take a wait-and-see attitude to see how Whitman’s strategy will play out. So shares of HP are unlikely to move back to the $40 mark very quickly. But over the course of 2012, there’s no reason this stock can’t move back to the mid-$40s (simply based on that sum-of-the-parts analysis that Auriga’s analysts suggest).

Risks to Consider: Tech spending by corporations has held up fairly well in 2011 and is expected to remain robust. Any pullback in tech spending would keep HP from reaching new profit margin goals that are laid as out as any part of a business transformation.

Action to Take –> This is an absurdly cheap stock that is subject to very low expectations. Yet a considerable amount of strengths remain, and Whitman’s turnaround task is not as steep as the lagging share price implies. Even if the plan takes longer to realize, shares are so cheap that they likely possess considerable downside protection. That 74% gain to reach Aurgia’s price target should look tempting, yet keep in mind that this is only a play for the patient investor, because it’s likely to be “three steps forward and two steps back” as HP slowly pivots back into investor favor.