Summary
- Shares of HP Inc. rallied more than 3% after the company reported fiscal Q1 earnings and released updated FY23 guidance.
- Investors cheered the company's commitment to maintaining its free cash flow guidance of $3.0-$3.5 billion for the year.
- Though HP looks cheap across a number of valuation metrics, its soft multiple is a reflection of a business in a secular decline.
- Both printing and PCs saw large decreases in revenue year over year, and the former in particular has few levers to reignite growth.
In today's market, we're all searching for the perfect value play. Even despite the sharp rally in stocks since the start of the year, the rapid rise in interest rates has us looking to dividend-rich value stocks that can compete against the attractiveness of simply sitting in rich-free cash.
HP Inc. ( HPQ ) is often a stock touted for both value and dividend. The legacy computer giant just reported fiscal Q1 (January quarter) results, and the stock rallied roughly ~3% in after-hours trading in response.
Investors primarily cheered the company's ability to retain its free cash flow guidance, which is an important draw for Inc. because so much of the company's appeal is in sustaining its rich buyback and dividend programs (which have, by the way, pulled the company into a deeper net debt position - see the chart below):
But here's the rub: HP Inc.'s core businesses are in a secular decline, and that's why its free cash flow year-over-year is projected to decline. And in my view, this will continue declining as the company's margin-rich printing segment continues to suffer deep revenue drops.
I am neutral on HP Inc. While I certainly think HP Inc. remains a cheap stock with a rich 3%+ dividend yield, I find it difficult to ignore the declines in HP's revenue trends which will bleed into multi-year EPS and free cash flow declines. I'd prefer to remain on the sidelines here.
Valuation checkup against latest outlook
For the current fiscal year, HP is guiding to $3.20-$3.60 in pro forma EPS, and $3.0-$3.5 billion in free cash flow. The implied decline in free cash flow relative to FY22 at $3.85 billion is -22% to -9% y/y.
At current share prices near $30, HP trades at a market cap of $29.0 billion, and after adding in the $9.1 billion of net debt on its books, the company's resulting enterprise value is $38.1 billion.
Against the midpoints of the company's EPS and FCF guidance ranges for this year, this puts HP's valuation multiples at:
- 9.0x FY23 P/E
- 10.6x FY23 FCF
No doubt about it - these bargain-basement multiples are difficult to find in a stock market that remains fully valued even after last year's sharp pullbacks. But in my view, HP Inc. is cheap for a reason - and that's because investors are rightly concerned about HP's ability to sustain its bottom line when its core businesses are quickly fading.
Q1 highlights: both PCs and printing are seeing sharp declines
For investors who are newer to HP, the company operates two primary segments: Personal Systems and Printing. The former consists of both desktop and laptop products geared toward both consumers and enterprise customers; and the latter consists of both printer hardware as well as printing supplies. The Personal Systems segment accounts for roughly two-thirds of overall company revenue, but the margin-rich Printing segment is responsible for roughly two-thirds of company operating profits.
Both, unfortunately, are in decline. The Personal Systems segment raked in $9.2 billion in revenue in Q1, down -24% y/y.
As can be seen in the slide above, both consumer and commercial segments are seeing deep declines in revenue. This puts credence to the long-held thesis that COVID had the effect of pulling demand forward - similar to what we saw in real estate, home goods, vehicles, and other one-time purchases. Moving forward, we may even see customers elongate their PC replacement cycles in a recessionary macro environment. This may be especially true for enterprise buyers, as companies have sought to trim expenses in FY23 to preserve the bottom line at all costs.
Note as well that the sharp decline in revenue in the PC segment, as well as the "aggressive pricing environment" in which HP has had to compete, has caused a -280bps reduction in operating margins in this business to just 5.4% of revenue - a very, very slim margin that leaves little room on the pricing side to try to sweeten demand trends.
As concerning as PC trends are, printing may be in even more trouble longer term (as some of the softness we are seeing in the PC business may simply be cyclical as buyers tighten belts in the current down market). Printing, on the other hand, is in a secular decline for a number of reasons: remote work has reduced the need for printing paper documents; the prevalence of Zoom ( ZM ) and virtual meetings has gotten us used to sharing screens instead of printing presentation materials; and environmental concerns are also encouraging a reduction of paper use.
HP Inc. printing segment performance (HP Inc. Q1 earnings deck)
These trends are all evident in the Printing segment's continuous declines, with revenue down -5% y/y to $4.6 billion. I'll emphasize again here that Printing is the lion's share of HP's operating profit - so continued declines here will be a consistent drain on HP's bottom line.
Can HP keep up its shareholder returns?
And this leads me to my next concern: having established that the profit-rich Printing segment is declining, can HP continue to keep up its rich profits and dividends that are the main appeal to value-conscious investors?
HP Inc. cash flow/shareholder return trends (HP Inc. Q1 earnings deck)
You can see in the chart above that in FY22, HP generated $3.85 billion in FCF but disbursed $5.33 billion in shareholder returns. This year, when HP is looking to generate $3.0-$3.5 billion in FCF, total shareholder returns are almost certain to decline (though the company so far has maintained its $0.2625 quarterly dividend). The good news is that HP is still generating enough FCF to finance its ~$1.0 billion annual dividend program which is certainly more visible to the market.
Key takeaways
I'd sum up HP this way: cheap, but cheap for a reason. Buying the stock at a ~10x P/E and FCF multiple is certainly appealing, but when I fail to see any significant drivers to revive growth in the company's main profit center (Printing), I'm more cautious on the company's prospects.
For further details see:
HP: Cheap Play, But Does This Company Have A Future?