2023-03-13 08:30:00 ET
Summary
- Dell Technologies Inc. and HP Inc. recently reported their earnings results, which were quite fine given the challenging economic environment and deteriorating consumer sentiment.
- However, since investors likely own DELL and HPQ stock for the dividend and buybacks, it is important to understand the reasons for the cash flow vacuum apparent at both companies.
- In addition to discussing the results, I will also reassess dividend safety and share whether the recent results have changed my opinion of the companies.
Introduction
I first covered the two computer giants, HP Inc. ( HPQ ) and Dell Technologies Inc. ( DELL ) in late December 2022. In that article, I outlined the reasons why I believe Warren Buffett chose HP over Dell. My regular readers know that I am an income-focused investor, and as such the two stocks are naturally interesting due to their comparatively high dividend yields. Nevertheless, I dismissed both HPQ stock and DELL stock back in December for a number of reasons.
Three months have passed and the companies have reported their quarterly results in what was arguably a rather difficult environment. HP Inc. reported its first-quarter fiscal 2023 results on February 28, and rival Dell Technologies Inc. reported its full-year fiscal 2023 results on March 2. Although the two stocks have not moved much in the meantime - HPQ is up 2% since my last report and DELL is down 5% - I think it is a good time to assess whether the recent news have changed my view of the companies.
HPQ Stock – First Quarter Earnings Review And Dividend Quality Assessment
Given the rather difficult environment, I think the company had a solid quarter. Demand for personal computers and printers has been rather weak, underscored by a high double-digit decline in sales to $13.8 billion. In addition to a deterioration in consumer sentiment, the ongoing normalization of demand after the surge during the pandemic also contributed. As expected, consumer demand was significantly weaker than commercial demand. This is also apparent in other sectors. For example, Leggett & Platt ( LEG ), a supplier of bedding, furniture and industrial components that I report on regularly , reported a very similar trend. In addition, HPQ is still under pressure from supply chain disruptions and resulting inventory issues, but the situation has definitely improved. Sales will continue to be quite weak, but management expects an improvement in the second half of the year and especially in the fourth fiscal quarter, mainly due to seasonal effects (p. 40, FQ1 2023 10-Q )
HPQ management reported first quarter results that were in line with analyst estimates. GAAP diluted earnings per share ((EPS)) were $0.49, down 51% year-over-year ((YoY)). Excluding one-time items and other adjustments, earnings declined 32% YoY, or 38% YoY excluding the positive impact of share repurchases. Weighted average diluted shares outstanding declined by approximately 9% compared to the first quarter of fiscal 2022.
The largest adjustments to GAAP earnings ($487 million) were restructuring charges ($141 million), acquisition and divestiture charges ($84 million), and intangible asset amortization ($85 million). I'm generally not a big fan of adjusted earnings, especially in the context of restructuring charges, which are the rule rather than the exception at HPQ. I believe that the cash flow statement generally provides a more accurate picture of a company's earnings, especially when assessing the situation through the lens of an income-oriented investor. Over the past three years, HPQ has generated on average a fairly solid free cash flow ((FCF)) of about $3.7 billion annually, after normalizing for working capital movements and adjusting for stock-based compensation expense ((SBC)). Cash flow plummeted in the first quarter of fiscal 2023 - HPQ reported negative operating cash flow (OCF) of $16 million, compared to positive quarterly OCF of $1.7 billion a year ago. While this is startling at first glance, it is important to understand that HPQ significantly reduced its somewhat bloated ($15.3 billion a quarter ago) accounts payable by $1.7 billion. In FQ1 2022, the company had to "borrow" cash by increasing its payables by approximately $2.0 billion, in part to fund additions to inventories ($1.3 billion) in the wake of still-ongoing supply chain issues and the onset of inflationary pressures. Fortunately, industry-wide inventory and supply chain issues have improved recently, so from a cash flow perspective, HPQ saw a $218 million decrease in inventory in the first quarter of fiscal 2023. It is also important to note that management expects FCF of $3.0 billion to $3.5 billion for the full fiscal year 2023, which is definitely a significant move in the right direction. Given the still noticeable inventory headwinds, I think it's a strong sign that the company expects to beat analysts' mid-point free cash flow estimates by about $150 million.
The strong free cash flow guidance is good news for investors, as I believe those who own the stock are doing so because of the expected near-term cash flows that management has promised to use for large share repurchases and dividend payments. While HPQ's current dividend yield of 3.8% is certainly quite high, it only costs the company about $1.05 billion to service - the dividend is very well covered from an FCF perspective.
Share repurchases declined significantly year-over-year, from $1.5 billion to only about $100 million in FQ1 2023, an amount that could only offset the dilution from SBC. During the earnings call , CFO Marie Myers said the company remains committed to its capital allocation but does not expect to buy back shares in the second quarter. However, she expects the company will have room for repurchases in the second half of the year due to the cyclicality of free cash flow. She went on to say that HPQ remains keen on keeping its gross leverage below two. I think management is acting reasonably prudent here. Gross debt of $10.8 billion is certainly no mean feat, but it is important to remember that there are no significant maturities until 2025, so HPQ will not suffer immediately from the rising interest rate environment. Also, HP Inc.'s weighted average interest rate is only 3.7%, while Dell Technologies' is 4.6%. If interest rates are maintained or even further increased over a longer period of time, I can well imagine that HPQ's weighted average interest rate will increase significantly, also in light of its Baa2 senior unsecured rating (BBB S&P equivalent).
The dividend payout ratio remains very comfortable at about 30% of free cash flow, on the basis of the expected free cash flow for fiscal 2023. HPQ's dividend growth rate is very solid at 14% (3-year CAGR) and 12% (6-year CAGR). However, given the extremely generous 26% increase in 2021, I would not over-interpret these growth rates. In my opinion, the latest increase by 5% is a more reasonable expectation going forward.
However, it should be remembered that while HPQ is one of the top companies in its field alongside Dell and Lenovo Group ([[LNVGY]], [[LNVGF]]), it operates in a largely commoditized and cyclical industry. As can currently be seen, and as is to be expected for a cyclical company, cash flow can be very volatile. HPQ usually has a solid cash buffer, but the developments in the first quarter of fiscal 2023 clearly show how quickly the company's cash position can decline (Figure 1). Future revenue growth will likely remain elusive, but taken together, I doubt that HP Inc. will have to cut its dividend in a recession - as long as it is not overly severe and long-lasting. However, I can imagine the company prioritizing deleveraging over share repurchases, as it is quite unreasonable to expect the Fed to cut interest rates back to near zero in the event of a mild recession.
Figure 1: Cash, cash equivalents and restricted cash of HP Inc. [HPQ] (own work, based on the company's quarterly and annual financial statements)
DELL Stock – Fourth Quarter Earnings Review And Dividend Quality Assessment
Similar to HPQ, Dell also reported a significant decline in revenue, albeit at a rate of only about 11% year-over-year ($25 billion vs. $28 billion). On an annualized basis, total net revenue actually increased - from $101 billion in fiscal 2022 to $102 billion in fiscal 2023.
The significant difference with HPQ in terms of revenue decline is primarily due to strong revenue growth in Dell's Services portfolio, which grew 9% and 8% on a quarterly and annual basis, respectively. Also, don't forget that Dell's Infrastructure Solutions Group (servers, networking and storage) contributed 40% of total revenue in fiscal 2023, and the segment performed really well due to its focus on commercial clients - especially the Storage sub-unit ($5 billion, +10% YoY). Of course, a severe economic downturn would hit Dell as hard as HPQ, but so far commercial revenues are still strong (but also expected to weaken going forward). The company has issued a rather cautious revenue guidance of -15% YoY for fiscal 2024. Like HPQ, Dell expects things to improve in the second half of the year. Soon-to-be ex-CFO Tom Sweet hinted at margin compression, partly due to a normalization of currently strong revenue growth in the high-margin storage business, pricing discipline and continued investments.
For the fourth quarter of fiscal 2023, Dell reported adjusted EPS of $1.80, beating analysts' estimates by about 10%. On a full-year adjusted basis, Dell earned $7.61, up 22% YoY. 5% of the earnings growth was due to share repurchases. For fiscal 2024, the company expects mid-point adjusted EPS of $5.30, down 30%, due to the reasons mentioned above. 2024 EPS will also not see a boost due to repurchases, but the company expects to be able to offset SBC-related dilution.
The earnings adjustments were fairly significant - on an attributable basis, GAAP earnings for fiscal 2023 were only $2.44 billion, compared to non-GAAP earnings of $5.73 billion. The main adjustments were amortization of intangible assets ($970 million), SBC ($931 million) and other corporate expenses ($1.8 billion), largely representing impairment charges, severance payments, and costs related to Dell's exit from its business in Russia. As I discussed in my previous article, SBC at Dell is quite high at about 10% to 17% of normalized operating cash flow. SBC at HPQ has been in the mid to high single digits for the last six years. I think Dell's outsized SBC is a good example of why it's misguided to focus on adjusted EPS or reported operating cash flow. When performance-based awards vest, they result in dilution that must be offset by share repurchases - at which point the seemingly non-cash charges represent an actual cash outflow.
On the cash flow front, things looked rather bleak in fiscal 2023 - Dell generated just $3.6 billion in operating cash flow, down 65% year-over-year, not even including adjustment for stock-based compensation expenses. The company invested about $3 billion back into the business, resulting in de facto free cash flow of zero for the year. For comparison, over the last three fiscal years (2020 to 2022), Dell generated an average of $6.2 billion in normalized free cash flow. The company did not break out its working capital adjustments in its fourth-quarter fiscal 2023 earnings release, but a comparison of its fiscal 2022 and 2023 balance sheets shows that Dell, like HP, has significantly reduced its accounts payable ($18.5 billion versus $27.1 billion a year earlier). To cover the shortfall in cash from operations (Dell repurchased $3.3 billion of stock and paid dividends of $1 billion in fiscal 2023), net debt increased from $17.4 billion at the end of fiscal 2022 to nearly $21 billion at the end of fiscal 2023.
While the significant decline in free cash flow is worrisome at first glance, it is reasonable to expect it to mean-revert over the next years as the company continues to improve working capital management. In his remarks, Dell's CFO acknowledged that the company had a significant amount of working capital tied up on the balance sheet at the end of the year, but he also pointed out that inventory management had already improved in the fourth quarter (inventories were down $1.4 billion from the previous quarter). I think the fundamentally solid profitability from a cash flow perspective is also underscored by management's stance on shareholder returns. As mentioned earlier, Dell paid out about $4.3 billion to shareholders in fiscal 2023 (not adjusted for SBC) and also announced a 12% dividend increase to $1.48 per share on an annualized basis.
Like the temporarily weak cash flows, I would not overstate the increase in net debt. With its current fairly strong cash position of $8.6 billion (down 9% YoY), the company is well positioned to pay off $1 billion of 5.45% notes due in June (p. 116, fiscal 2022 10-K ). Next up are the 4.00% notes in July 2024 ($1 billion). From this perspective, Dell is fairly well insulated from the rising interest rate environment, but the recent debt raised naturally led to an increase in interest expense. Also, the company expects to incur approximately $200 million in higher interest expense in fiscal 2024 as it funds Dell Financial Services ((DFS)) originations. Over the longer term, and assuming interest rates remain elevated for several years, I believe Dell's debt profile is more vulnerable to costly refinancings than HPQ's, as most of its debt matures in the next seven years. HPQ has no near-term maturities, and about 90% of its long-term debt matures starting in 2025, and fairly evenly distributed through 2032.
From a dividend payout ratio perspective, and ignoring the temporary decline in FCF, Dell appears to be better positioned than HP, with more room for growth. Both companies currently pay out about $1 billion annually to shareholders, but Dell's free cash flow is typically 60% higher than HP's (expected fiscal 2024 difference of ~25%), as is its revenue. The problem - if you will - is Dell's de facto non-existent dividend history. While HPQ has raised its dividend for 13 consecutive years , Dell didn't start paying a dividend until fiscal 2023. Also, the fact that Dell has been taken private in the past - with shareholders paying the price - should be taken into account before considering the stock as a potential new investment. And it's important to remember that Michael Dell is the company's largest shareholder - he and the Susan Lieberman Dell Separate Property Trust and affiliates collectively controlled over 94% of the total voting power at the end of fiscal 2022 (p. 28, fiscal 2022 10-K ).
Conclusion – Which Of The Two Stocks Is The Better Dividend Pick?
HP and Dell currently offer enticing dividend yields of 3.8% and 4.0%, respectively. Assuming that both companies will be able to increase their dividends annually in the mid-single-digit percentage range in the future, they are much more interesting from a yield perspective than ordinary long-term Treasuries, which currently offer a similar yield.
According to FAST Graphs, HPQ stock currently trades at a blended P/E of 7.2 (Figure 1), while Dell stock trades at a P/E of 5.0 (Figure 2). Of course, earnings and cash flow growth remain elusive, and valuations are also due to the fact that the market has priced in a mild recession, from which companies offering more or less ordinary IT equipment without a significant selling proposition will surely suffer. The high earnings uncertainty is also reflected in the current free cash flow yields of 12% (HP, based on fiscal 2024 guidance) and 15% (Dell, based on the CFO's vague remarks during the earnings call). I think Morningstar has modeled the "true" value of HPQ and DELL quite well. The two stocks are currently rated three stars with estimated fair values of $30 and $46, respectively. No economic moat has been assigned to either company and the fair value estimates are subject to high uncertainty. From all angles, Dell currently has the better upside.
Figure 1: FAST Graphs chart of HP Inc. stock [HPQ] based on adjusted operating earnings; note that the estimated rate of return does not include dividend payments (obtained with permission from www.fastgraphs.com)
Figure 2: FAST Graphs chart of Dell Technologies Inc. stock [DELL] based on adjusted operating earnings; note that the estimated rate of return does not include dividend payments (obtained with permission from www.fastgraphs.com)
Nevertheless, the latest results from HP and Dell have not really changed my position. Dell seems to be the better investment from a dividend perspective in principle, as the payout ratio is lower and the business is better diversified. I also like it better from a valuation perspective. However, the lack of dividend history is a negative, as is the company's ownership structure - I would not rule out the possibility of the company being taken private again, perhaps to the detriment of minority shareholders.
Dell and HP operate in a largely commoditized industry where it is extremely difficult to build an ecosystem with network and lock-in effects. In this context, Dell's server and cloud solutions could be mentioned positively, as well as HP's increasingly subscription-based printing business. In a direct comparison, I consider Dell's enterprise solutions to be stickier with customers.
I don't think these are great investments, but to be fair, they are also priced accordingly. It would be overly negative to call DELL and HPQ stock outright bad investments. Dell's ownership structure is a deal-breaker for me, given what's happened in the past, even though I like the company and its diversification better than HP's. HP Inc.'s efforts to create a moat around its printer business are nice to see, but I doubt that the company can shake off its mantle as a supplier of standard equipment - just like Dell. As a result, I think it's unreasonable to expect either company to significantly improve its profit margins. In my own portfolio, I largely focus on companies with a solid economic moat and strong profitability. Of course, such companies tend to be significantly more expensive, but I believe that quality is worth paying for - especially in a difficult economic environment such as the current one.
Thank you for taking the time to read my article. Regardless of whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments section below. And if there is anything you would like me to improve or expand upon in future articles, drop me a line as well.
For further details see:
Dell Vs. HP Stock: Which Is The Better Dividend Pick?