When the Dow Jones Industrial Average was reformulated in September, former technology leader Hewlett-Packard (NYSE: HPQ) was quietly replaced. It was yet another tough blow for a firm that is on track for its third straight year of sales declines. CEO Meg Whitman, who was just celebrating her second full year at the company’s helm, could not have been pleased.

But Whitman is surely getting the last laugh. Because against the odds, Hewlett-Packard has turned out to be one of the top-performing tech stocks of 2013. Shares have doubled in value, putting the S&P 500 Index’s 25% gain to shame. More than $25 billion in market value has been added, and Whitman has less need to worry about job security.

#-ad_banner-#Yet a deeper look reveals a company that remains mired in a deep slump, and a stock price that is now sharply overvalued. As UBS’ Steve Milunovich noted in a recent report, “The stock has rebounded as fundamentals improved from very poor to mediocre,” adding that “HP appears secularly challenged with too much hardware and a paucity of software revenue.”

Indeed, the only good news for Hewlett-Packard is that it isn’t performing as poorly as many had expected. For example, sales in HP’s fiscal fourth quarter (which ended October) slipped just 3%, compared with expectations of a 7% decline. The upside came from a large one-time sale of computers in India, which analysts believe came with very low profit margins.

Indeed, if Whitman was being assessed by profit metrics, investors would be much less impressed. Hewlett-Packard’s earnings before interest and taxes margins fell from 10.8% in fiscal (October) to 8.5% in fiscal 2013. The only reason that margins haven’t fallen even further is that Hewlett-Packard has laid off 25,000 employees over the past few years.

To her credit, Whitman has consistently said that her strategy revolves around belt-tightening. Hewlett-Packard has throttled back capital spending, which set the stage for a solid rebound in free cash flow to rebound from $6.9 billion in fiscal 2012 to $8.4 billion in fiscal 2013.

	Flickr/megwhitman2010
	Whitman has led Hewlett-Packard to become one of the 2013’s top-performing tech stocks. Shares have doubled in value, while adding more than $25 billion in market value.

Yet there’s no masking the fact that sales continue to fall. Analysts expect fiscal first-quarter sales to fall 4% (to $27 billion), and sales for the full year are expected to drop around 3%. Equally important, Hewlett-Packard can’t continue to starve capital spending, which is expected to rebound by at least $500 million (to around $3 billion). A slump in the company’s cash conversion cycle will also hurt free cash flow. That’s why management recently predicted that this metric will drop to around $6 billion to $6.5 billion in the current fiscal year.

To be sure, Hewlett-Packard would likely have been faring a lot worse were it not for some of the tough steps taken by Whitman. And they haven’t been just about cost cutting. For example, savvy marketing in the printer division has led quarterly revenues to stabilize at around $6 billion — at a time when printing rivals are stills seeing sales declines. Not only is Hewlett-Packard taking market share in printing, but profit margins haven’t been sacrificed in the process.

Also, Hewlett-Packard has again becoming a relevant player in data storage, growing divisional sales in line with the broader industry.

Yet Hewlett-Packard remains poorly positioned in many other divisions. For example, the company’s once-proud IT services division is now facing contract run-offs. “This is one of HP’s largest profit pools that may be in the midst of an increasingly severe secular decline,” note analysts at Goldman Sachs. And Hewlett-Packard’s huge exposure to personal computers is a millstone at a time when Apple (Nasdaq: AAPL) and Samsung (OTC: SSNLF) spearhead a consumer push toward tablets and smartphones.

Hewlett-Packard generates skimpy margins in the PC division, which explains why the whole company continues to post gross margins of just 23% (where they’ve been for nearly a decade, despite a huge amount of layoffs). As a point of reference, Apple’s gross margins are 37%, IBM’s (NYSE: IBM) gross margins stand at 48%, and Microsoft (Nasdaq: MSFT) still enjoys gross margins above 70%.

In the context of ongoing top-line pressures and a lousy margin profile, what should this stock be worth? Consider that the enterprise value is now roughly 9 times forward free cash flow, up from a multiple of 5.5 a year ago. Goldman Sachs, which prefers to use a price-to-earnings (P/E) ratio, estimates shares are worth just $17, or five times their projected calendar 2014 earnings per share estimate of $3.36. That represents 40% downside from current levels.

Risks to Consider: As an upside risk, consumers may migrate back toward PCs and away from tablet computers. This segment currently carries very low expectations from investors.

Action to Take –> Give Whitman credit for stabilizing a sinking ship and showing the fortitude to oversee a massive shrinkage in Hewlett-Packard’s overhead. But she has given investors few insights as to how Hewlett-Packard can once again become an industry powerhouse. The secular pressures faced by Hewlett-Packard have not gone away, despite the impressive share price rebound. And that is likely to come back into focus in 2014, after Hewlett-Packard became one of the top-performing tech stocks of 2013.

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