2023-05-29 04:44:56 ET
Summary
- HP Inc. has consistently grown its dividend payments over the last 12 years.
- The firm's growing shareholder's deficit may impact its future solvency.
- Target price: $51.
Investors should buy shares of HP Inc. ( HPQ ). Despite beating the S&P 500, HPQ has underperformed its technology sector benchmark over the past three years. Moreover, the firm has grown its dividend payouts over the past 12 years. HPQ's consistent dividend growth , coupled with its relative underperformance makes it an intriguing value pick.
Business Description
HPQ is organized into three segments : personal systems, printing, and corporate investments. Based on recent trends, the personal systems segment tends to make up the majority of the firm's revenues. This is not surprising given the fact that HPQ is a popular seller of desktop and notebook PCs, retail POS systems, and software. In addition, the firm's printing segment contributes to total revenue through sales of printers, ink, and laser technologies. Finally, HPQ's corporate investments segment comprises the firm's venture capital efforts.
HP Inc. Q1 2023 Earnings Announcement
Competitive Landscape
HPQ operates in a highly competitive market. In its annual report, the firm identifies Dell Inc. ( DELL ), IBM Corp. ( IBM ), Lenovo Group Ltd. ( OTCPK:LNVGY ), Canon Inc. ( OTCPK:CAJPY ), Toshiba Corp. ( OTCPK:TOSYY ), Ricoh Company Ltd. ( OTCPK:RICOY ), and FUJIFILM ( OTCPK:FUJIY ) as its main competitors. These firms all compete on factors including technology, innovation, performance, and price.
I created a table to analyze HPQ's competitors. I used data from Yahoo Finance, SEC EDGAR, and Seeking Alpha to inform my market cap, enterprise value, and EBITDA computations.
Valuation Model - Three Statement Projections
Financial modeling involves walking a line between fantasy and reality. Different people often interpret the same financial information in a variety of ways, and my opinion is just one of many. Therefore, I feel obligated to preface my model with the fact that it is forward-looking, and grounded in numerous assumptions about the state of HPQ's future operations. My model is intended to illustrate a base-case where HPQ's current strategic plan is continued into the future.
The first step in building the model was to construct a pro forma income statement. Historical data was taken from the SEC EDGAR website. Net revenue growth is the main driver of the projected income statement. I found the CAGR between 2012 and 2022, and applied it to the 2023 through 2027 time horizon. HPQ's status as a mature company indicates that its revenue growth can be expected to be comparatively low to younger industry competitors. Moreover, other key drivers were calculated as a percentage of revenue, goodwill, and PPE. I assumed that averages from 2020 to 2022 would be sufficient to inform values from 2023 to 2027. In addition, I used HPQ's own disclosure of its future debt maturities to inform my interest rate estimate. Finally, I applied all these assumptions to determine HPQ's projected net earnings between 2023 and 2027.
Following the construction of the income statement, I created a debt waterfall to model HPQ's future interest expense. The firm has a decent amount of debt outstanding, and it is important to model the debt's future implications. First, I analyzed HPQ's short-term revolving credit facility. The firm's 2022 10K reported that it maintains a "5 billion sustainability-linked senior unsecured committed revolving credit facility." HPQ will draw on its revolver if it needs extra cash to service its debt. Based on past data, I assumed that no emergencies would arise where HPQ would use it. Then, I modeled the current portion of the company's long term debt coming due. This yielded a progressively higher interest expense each year between 2023 and 2027. Finally, I modeled HPQ's long term debt based on its future maturities. The result of the debt schedule was substantial interest payments in line with historical data.
I created a pro forma balance following the debt waterfall. The main drivers are days in accounts receivable, days in inventory, and days in payables. These values provide key data regarding the efficiency of HPQ's operations. However, I did not assume any improvements in these areas and kept them in line with their historical values. Debt estimates were informed by the debt schedule and cash levels came from the cash flow statement. Moreover, in order to focus mainly on HPQ's operations, I chose to hold goodwill and other non-current assets constant. It is also worth noting that HPQ has accumulated a substantial shareholder's deficit and I anticipate this to continue growing.
Following the balance sheet, I created a pro forma cash flow statement. The net earnings line was taken from the income statement. I held most of HPQ's investing activities to zero. They have a history of purchasing and selling investment securities, but I think that this is at odds with the operational nature of their business. Moreover, I assumed that HPQ will continue paying cash dividends and will repurchase more of its shares outstanding.
Valuation Model - Cost of Capital
After completing the three statement model, I moved on to compute HPQ's cost of capital to be used in the final discounted cash flow ((DCF)) model. When computing the cost of equity, I assumed a 3.8% risk free rate based on the current ten year treasury yield. In addition, I assumed a 5.5% market risk premium in line with historical data and the current riskiness of the U.S. stock market. I then calculated HPQ's equity beta by regressing the firm's weekly returns against those of the S&P 500 from January 2021 to present. HPQ's cost of debt was calculated by dividing its 2022 interest expense against its 2022 long term debt outstanding. The company's target capital structure was assumed to be 22% debt compared to 78% equity. HPQ's debt to equity ratio is somewhat confusing given the fact that it has a shareholder's deficit. However, I based the company's market value of equity based on its MVE reported on the first page of its 10K. Finally, I put these values together to compute HPQ's weighted average cost of capital ((WACC)).
After computing HPQ's WACC, I computed the company's unlevered free cash flows between 2023 and 2027. The firm's EBITDA was taken from income statement values. Then, I adjusted for depreciation and amortization as well as taxes to find the net operating profit after tax (NOPAT). NOPAT was then adjusted for non-cash items, capital expenditures, and working capital. This yielded HPQ's unlevered free cash flows. These were then discounted by the firm's WACC to arrive at the discounted cash flows.
Valuation Model - DCF
When computing the firm's implied share price, I made assumptions to use an appropriate exit multiple and growth rate in perpetuity (GRIP). I used 2% as the GRIP based on the long-term GDP growth of the U.S. economy. Moreover, I assumed an exit multiple of nine times. Exit multiples are a bit arbitrary and are often best calculated when comparing multiple companies. Because of the flimsiness of this methodology, I sensitized these values. These sensitivity tables are included towards the end. Both the GRIP and exit multiple yielded similar terminal values. Adding the terminal value to the discounted cash flows provided HPQ's enterprise value of roughly $61 billion. Net debt was then subtracted to leave equity value. Finally, HPQ's fully diluted shares outstanding based on the treasury stock method were divided from equity value to yield an intrinsic share price between $50 and $51. This implies an upside of 66% from HPQ's current share price.
Valuation Model - Sensitivities and Summary
I conducted sensitivity analyses on both the exit multiple and GRIP. The purpose of this data was to determine how different WACCs, GRIPs, and exit multiples affect implied share prices. There is a considerable range based on the effects of different assumptions, but the floor of roughly $32 per share in a bear case is quite encouraging.
Finally, I created a valuation summary to display a range of different values to consider regarding HPQ. It therefore seems reasonable to assume a target of $51 per share.
Risk Factors
The biggest risk factor for HPQ is the shareholder's deficit on its balance sheet. The firm's stock buyback programs have played a large role in creating a situation where liabilities exceed assets. This is problematic because the firm could face a situation where it becomes insolvent. Moreover, HPQ receives 65% of its net income from countries outside of the United States. This geographical reach is generally advantageous, but can be problematic during times of international strife. In addition, the firm's reliance on third party suppliers also leaves it open to negative financial results. This was evident during chip shortages during the Covid-19 pandemic . Finally, a pause/cancellation of future dividend payments and share repurchases would damage the value associated with HPQ shares.
Investment Conclusion
HPQ provides a good investment opportunity for anyone looking for value-based exposure in the information technology sector. The firm's growth era is most likely behind it, and it has done a nice job returning cash flows to shareholders instead of plowing funds into meaningless projects. I would prefer for HPQ to be better fortified from a solvency perspective, but the firm's executives have not callously sought out debt in the past. It would be wise to continue paying debt down, and management will hopefully continue to prioritize dividend payments going forward.
For further details see:
HP Inc.: A Model Of Dependability