2023-05-19 09:11:38 ET
Summary
- The PC market saw a very tough last year and '23 started just the same.
- The uncertainty of the economy and negative sentiment towards the PC market is weighing on the company’s performance.
- The buying of devices will come back soon as people tend to replace devices every 3-5 years. The pandemic cycle is coming soon.
- Financials show a mixed bag of numbers, which forces me to discount much more.
- The company is a hold at this time until demand comes back and margins start to improve.
Investment Thesis
With the earnings just around the corner, I wanted to take a look at HP Inc.'s (HPQ) financials, what the PC industry looks like in the near future and how it may affect the company's stock price performance, and what the company with reasonable and conservative assumptions is worth to a long-term investor. While the decline in the PC space is quite evident, this will reverse in the coming years and HPQ will benefit from the pick-up in demand. The company gets a hold for now until the demand comes back, and margins start to improve.
Briefly on the Company's Revenue Segments
The company operates in 3 segments: Personal systems (70% of FY22 total revenue), Printing (around 30%), and Corporate Investments which make up an insignificant amount so far. HPQ is one of the top players in the PC industry and has been for a while now. The majority of the PS segment comes from the sale of notebooks, followed by desktop PCs, and workstations.
HPQ is still quite big in the printing industry, and although the COVID pandemic hit the company's printing revenues, it is still benefiting quite a bit from a hybrid workplace.
I won't even get into the last revenue segment yet because it doesn't offer much as it is still losing money.
The company saw quite big declines in revenues in the two main segments in the latest quarter, around -18% y-o-y, while margins saw mixed results, some increased, and some declined.
PC Sector Demand is Still in a Bad Shape
As I mentioned around 70% of the company's revenues come from the PC sector. The build-up of inventories recently caused average selling prices ((ASP)) to come down due to discounting.
HPQ has been consistently second in terms of sales of their products, trailing only Lenovo by market share.
Quarterly Market Share (Statista)
I've covered a few semiconductor companies in the past and many of them that produce chips for the PC sector have mentioned that the PC sector is the one that is bringing down their revenues in recent quarters. The smartphone sector is also not doing too well, but that's beside the point.
In the first quarter of '23, PC sales declined by 30% according to Gartner , citing,
"An unfavorable combination of oversupply and continued low PC demand due to economic uncertainties and a lack of purchase motivation led to the second consecutive quarter of historic year-over-year decline."
In the same report, it is interesting to point out that HPQ experienced the least decline out of the other players this quarter, which suggests that it may start to take some market share from Lenovo (LNVGY) in the future.
Market share in Q1 '23 (Gartner)
People have upgraded massively since the beginning of the pandemic which drove huge demand for new laptops, PCs, and other equipment to help them with working from home. These people are not looking to upgrade just yet, especially with high inflation, rising interest rates, and the economic uncertainty that is looming over the globe.
We saw '22 was bad for the PC market, and it already seems like there will be plenty of short-term pain in '23 also. However, as with many semiconductor companies reporting a pickup in demand in the latter half of the year, a lot of analysts suggest the same for the PC market also.
According to this article , it is suggested to upgrade your hardware every 3-5 years, so the cycle of the pandemic buyers is coming very soon and HPQ, like many other top players in the market, will benefit from the surge of demand. According to a survey done by Home Depot people tend to upgrade their laptops and other similar devices every 4.8 years , which falls between the suggested timeline. I am one of the outliers that has been using my laptop for around 7 or 8 years now, it still works fine.
In terms of the office and printing segment, I am a big proponent of going paperless, however, with the return to the office and hybrid working, the demand for these will remain for a while as people still print a lot of paper and use a lot of ink, even if a lot of it is a waste of time and the printed documents may never be looked at. I would assume this segment will keep steady for a while and start to come down slowly over the next decade. This segment may never experience pre-pandemic levels of growth, but it certainly saw much better revenues after the pandemic panic eased all around the world and people came back to the offices.
According to this article, the amount of paper used for printing is expected to increase by 50%, while the cost of printing will increase by 30%, so HPQ will still have considerable revenue there if this is true.
Financials
I will present a few graphs that have full-year results instead of the latest quarters as it gives a fuller picture of the overall trend the company is seeing. I will include relevant pieces of results from the latest quarter to give more color also.
At the end of FY22, the company had $3.1B in cash and almost $11B in long-term debt. That is a big amount for sure. Is it a problem? Not at all. Annual interest expense was around $350m, which is easily covered by the company's annual EBIT. At the end of FY22, the company's interest coverage ratio was almost 15x, which means that the company can cover the interest expenses 15 times over. Many investors may see debt and not invest in a company, but if the debt is manageable, there is nothing wrong with using leverage.
Coverage Ratio (Own Calculations)
Cash at the end of Q1 '23 decreased to $1.8B, while long-term debt went down slightly to $10.3B, which is a good sign.
I'm not the biggest fan of a current ratio being below one, but it seems to be normal for companies like HPQ because Lenovo and Dell ( DELL ) are both below 1.0 also.
Current Ratio (Own Calculations)
In terms of profitability and efficiency, I do not like the fact that the return on equity has been very negative for at least 6 years now. It got a little better, however, it is still slightly worrying. If the company manages to reduce long-term debt over time and stop accumulating, it can be fixed for sure, but right now this metric will discount my valuation a little more. Return on assets has been trending downwards also, which can be explained by the tough year in the sector. I wouldn't be surprised if it comes down a little bit more.
ROE and ROA (Own Calculations)
On the other hand, the return on invested capital is outstanding but has been on the decline. At the end of FY22, it stood at around 33% which is extremely good. This suggests the company has a competitive advantage and a decent moat. However, it may also mean that the company has underinvested in its business and missed out on some growth opportunities.
Overall, it seems like a mixed bag of a balance sheet. Some worries regarding ROE and subpar current ratio which seems to be declining still, while a very good ROA and ROIC balance it out.
In terms of margins, these have declined in the last year, and in the most recent quarter, we saw further declines, which means that the pain is not over just yet.
Once the market improves, the company will be able to achieve higher profitability and efficiency, but this may take a little while longer.
Valuation
For the base case, I decided to reduce the company's revenues by around 10% for '23 to reflect a tough market and negative sentiment surrounding the whole global economy. In '24, if we can believe the analysts and other speculators, we will see a rebound in PC sales of all kinds, I decided to increase revenues by around 5%. After that, the revenue will linearly grow down to 3% by '32, giving me an average annual growth of 2.6%, which I think is very achievable.
For the optimistic case, I went with 4.6% average growth, while for the conservative, I went with 60bps.
These estimates are quite conservative, I believe, but I like to be safe than sorry when it comes to a company that barely grew its revenues in the last 8 years.
In terms of margins, I decided to implement further margin contractions in '23 that improve over the next decade by 200bps. There's not a lot of room to play around with gross margins, but I believe 200bps over the next decade is achievable.
On top of these estimates, I will add a 30% margin of safety to the intrinsic value calculation. I usually add 25% to companies that have a really good balance sheet, but since I saw some red flags on HPQ's books, I decided to play it slightly safer.
With that said, the intrinsic value of HPQ is $32.67 a share, implying around a 7% upside from the current valuation, which to me seems like it is fairly valued.
Intrinsic Value (Own Calculations)
Closing Comments
HPQ seems like a good company in the long run, with decent profitability and still holding onto that market share, however, the only reason I'm giving it a hold for now is because the market is still very weak and might keep declining a little while longer which may present a better entry point and better risk/reward profile in the upcoming quarters. The company is due to report in less than 2 weeks, and I will be interested to hear what the management is seeing in terms of demand. There will be much more volatility in the upcoming months due to overall sentiment in the economy.
I do believe that in the long run, the company is a good investment, and the short-term obstacles are just noise that shouldn't matter too much to the long-term investor.
For further details see:
HP Inc.: A Good Buy Once The Sentiment Improves