2023-09-10 00:38:32 ET
Summary
- HP Inc. is no longer as attractive of an investment as its yield is poorer than risk-free rates.
- The company is facing challenges in its printer and PC businesses, driven both by current macro headwinds as well as secular obsolescence challenges in printing.
- Though cheap, HP is a value trap that will continue to see profit deterioration eat into its cash flow and ability to finance shareholder returns.
One corner of the stock market has performed terribly this year, and for unsurprising reasons: dividend stocks. With risk-free yields returning ~5%, income seekers have difficulty fathoming why they'd put money into a risky equity play for a less-juicy yield.
HP Inc. ( HPQ ), the maker of PCs and printers, has felt that burn with share prices falling sharply since July, though the stock is up ~10% on the year (underperforming the S&P 500). The question for investors now: is there still a reason to stay in invested in HP:
Since my last neutral article on HP in March of this year, several things have happened:
- Interest rates have continued to mount higher
- HP has continued to see deterioration in its printer business
- To HP's credit, however, it has continued to exercise cost discipline and is laser-focused on delivering margin gains
In spite of the last factor there, I find HP unappealing in the current environment and am cutting my rating on the stock to bearish.
Aside from the sheer fact that HP's yield is now facing sharp competition from risk-free rates, there are a number of red flags in the bear case that we have to watch out for:
- HP's cash cow, the printing business, is headed for obsolescence. The pandemic accelerated a trend that is unlikely to reverse: we are printing fewer and fewer things. As meetings move to virtual formats and we become accustomed to sharing screens instead of reading printouts, HP's most stable source of profits faces long-term secular risk.
- The PC market is in a bind. Not only does HP face so many competitors in the personal computing space, but both consumers and enterprises are holding onto devices for longer. People are buying up, but with the intention of drawing out replacement cycles as well.
- Can HP keep up its shareholder returns program? HP has for long been generous with returning its cash flow to shareholder in the form of dividends and buybacks, but with revenue shrinkage and margin contraction, dampening this program may be necessary - and invite further pessimism on the stock.
Is HP cheap? Certainly. At current share prices just under $30, HP trades at just a 8.5x FY24 P/E multiple based on Wall Street's pro forma EPS expectations of $3.45 for next year (data from Yahoo Finance ). I, however, am more inclined to think HP is a value trap worth avoiding.
The bottom line here: HP Inc. faces a double whammy of both undergoing fundamental challenges in each of its core lines of business, while also facing market competition from yields that are richer than its dividend - which may also be at risk. With this in mind, I see more downside than upside for HP, and am content to sell here.
Q3 download
HP released fiscal Q3 (calendar Q2) results in late August, but even without going through the details, this chart below showcases the core issue that HP has been dealing with:
Since Q3'22, for five straight quarters, HP has seen y/y revenue declines. Q3 revenue of $13.2 billion declined -10% y/y and missed Street expectations of $13.4 billion (-8% y/y) by a two-point margin, with two points of FX unfavorability. And for the past four quarters, the company has also faced double-digit declines in pro forma EPS (even with the aid of aggressive share buybacks in 2022). These are all emblematic of a tough macro environment and a business that is struggling to stabilize.
In the PC business, as shown in the chart above, revenue declined -11% y/y, while operating profits remained roughly flat from a margin basis at 6.6%. PC units increased, but both consumer and commercial segments declined, reflecting the back-to-school season (cheaper devices) and more aggressive pricing amongst competitors.
Management blames the slowdown on macro, while noting that HP gained market share in both commercial and consumer, while retaining the #1 lead spot in the commercial PC space. CEO Enrique Lores noted as follows on the Q3 earnings call:
The macro situation is not improving as quickly as anticipated. And while we expect to deliver another quarter of sequential growth, we are moderating our expectations for Q4 and the full year, consistent with the revised market outlook. This outlook is largely driven by the continued aggressive pricing environment in PCs, sluggish demand in China and enterprise demand."
Results were equally disappointing in the printing segment - which, as a reminder, generates far less revenue than the PC business, but a much greater share of overall profits.
Revenue in printing declined -7% y/y, while operating margins shed -120bps to 18.6% (operating profit dollars fell -12% y/y on a nominal basis to $794 million).
Here, the main drag was on printer hardware, down -19% y/y on a units basis. The same principle of PCs holds: both people and businesses are holding onto their devices for longer. Fortunately, supplies, which is the main cash cow, saw a more muted quarter with revenue flat after accounting for FX movements. Geographically, management called out weakness in China as one of the core sore spots:
We continue to see soft demand, particularly in China as well as aggressive pricing in the consumer print market and delayed enterprise spending in the industrial space. Supplies revenue was roughly flat year-over-year in constant currency, in line with our expectations."
Again in the printing business, we have to be critical on whether we expect there to be a long-term future for paper and ink. With the prevalence of tablets and digital meeting formats, as well as other trends such as businesses cutting direct mail in favor of email - it's difficult to believe that HP's golden goose has much of a future ahead of it.
And with profits declining, we have to ask if HP can sustain its shareholder returns. Already in FY22, as shown in the chart below, the company's $5.3 billion of capital returns (more than 80% of which went to buybacks) was greater than the $3.9 billion of free cash flow that the company generated.
Year to date HP has been more prudent, spending only $0.9 billion of the $1.2 billion in FCF that it has generated. It has slashed buybacks to near-nothing, while slightly boosting its quarterly dividend to $0.2625 (from $0.25 before). So far, with dividends coming in at a 64% payout ratio of FCF, it appears that HP's dividend is safe. But I still find it difficult to believe that even in a macro rebound scenario, HP can return to meaningful revenue growth. It is more focused on cost now: by the end of the year, it expects to achieve ~40% of an opex savings plan that is targeting to remove $1.4 billion in annualized expenses. But even these savings can be easily wiped out if revenue continues to decline, and if printing margins (driven lower this quarter by a more competitive pricing strategy) continue to dwindle.
Key takeaways
Declining top-line trends and secular headwinds in printing, deteriorating margins from a more competitive pricing environment, and a dividend yield that no longer stands out and consumes most of HP's cash flow: to me, there's more risk than reward here. Steer clear.
For further details see:
HP Inc: A Value Trap To Avoid In This High Interest Environment (Ratings Downgrade)