2023-06-02 17:04:18 ET
Summary
- HP Inc. has benefited from a boom induced by the pandemic.
- Excess earnings were more than spent on the Poly deal and share buybacks, leaving the business quite indebted.
- Stagnation is expected here, and while shares look cheap, they likely deserve a lower multiple than the market.
In April, I concluded that stagnation was seen for shares of HP Inc. ( HPQ ) as post-pandemic trends continued to come down. This was concerning, as it resulted in inevitable earnings pressure. While that in a sense does not come unexpected, the timing of such earnings reversal was poor following an aggressive pace of share buybacks and the acquisition of Poly in 2022.
While valuations looked dirt cheap, I failed to have conviction given these conditions, as stagnation seems to continue here, with few imminent green shoots other than that margins have held up quite well.
A Base Case
Pre-pandemic, HP was a rather stagnant business, which saw shares trade around the $20 mark. That all changed as work-from-home trends, induced by the pandemic, triggered massive demand for printers and PCs, pushing shares up to the $40 mark on the back of underlying demand and involvement by Berkshire Hathaway in the form of an investment.
Pre-pandemic (or actually in the year ending October 2020) the company posted sales of $56.6 billion and earnings of $2.8 billion, equal to roughly $2 per share. Revenues rose 12% to $63.5 billion in 2021, as this was accompanied by more than two points in margin gains, pushing up earnings to nearly $4 per share, driven by the Personal Systems business with sales of notebooks, workstations and other products being on the increase.
The company originally guided for 2022 earnings per share to rise from $3.79 per share to $4.17 per share, but the reality was that elevated buybacks would be responsible for most of the earnings per share growth, with actual earnings growth (in dollar terms) hard to see. Following a solid first quarter, the company kept on buying back shares and announced a $3.3 billion deal for Poly, all resulting in a rather rapid built up in net debt. After hiking the full year earnings guidance to as much as $4.31 per share alongside the second quarter earnings report, HP posted soft third quarter results, a quarter which broke the upwards trend.
This caused shares to fall to the $30 mark in September last year, as net debt would rise to $9 billion, while earnings power apparently came in closer to $3.50 per share instead of a >$4 earnings number communicated beforehand. As it turned out, HP posted a 1% fall in 2022 sales to $63.0 billion, as adjusted earnings did still come in at $4.06 per share. While this marks growth, it is entirely due to buybacks, as the actual dollar amount of adjusted earnings were down from $4.6 billion to $4.3 billion.
The company announced a $1.4 billion cost-saving program through 2025 and guided for 2023 earnings between $3.20 and $3.60 per share. First quarter sales for 2023 ended up falling 18%, despite the contribution of Poly, although the company maintained the full year guidance. Net debt of $9 billion was a bit rich, as I peg the EBITDA performance around $5 billion, for a nearly 2 times leverage ratio. This is still manageable but requires some attention.
Amidst continued inflation, largely a commodity product, and a reversal of pre-pandemic trends on the way, I saw downside risks to the guidance. Moreover, poor cash flow conversion made that net debt was not really coming down in a rapidly rising interest rate environment. Amidst all this, I was still happy to hold onto my position which I initiated in the high-twenties in 2022 but see no reason to add to that position.
Stagnating
Right now, shares trade at $30 as the market digested the second quarter earnings report rather well. By the end of May, HP announced a 22% fall in second quarter sales to $12.9 billion although that non-GAAP operating margins held up well, only down 10 basis points to 8.7% of sales. Amidst some buybacks, the company saw a mere 26% fall in adjusted earnings per share to $0.80 per share.
Weakness was driven by a 29% fall in Personal Systems sales to $8.2 billion as printing revenues were down just 5% to $4.7 billion, being a real stable foothold for the business. While the company has narrowed - but essentially maintained - the full year adjusted earnings guidance, now seen between $3.30 and $3.50 per share. Net debt ticked down to $8.7 billion amidst better cash flow conversion, due to lower share buybacks.
And Now?
The reality is that HP Inc. is performing pretty much according to expectations with second quarter sales down more than 20%, but fortunately, the company maintained the full year guidance, which is comforting. The margin performance is better than expected, although the topline sales number is softer than anticipated, with the net impact being pretty stable and in line with expectations.
This means that the grind continues, although I am pleased to see discipline with regard to the allocation of capital, badly needed as HP overspent on Poly and share buybacks last year.
Right now, the HP Inc. situation is stabilizing, and other than better operating margins, there is not much to be excited about. I do not see much room for valuation multiple expansion here, as HP Inc. is positioned as a GDP business, or perhaps a bit less. Hence, I continue to see HP Inc. as a fairly valued, to a bit of a cheap, stock here but still do not see a reason to alter my modest long position.
For further details see:
HP Inc.: Stagnating As Expected (Rating Downgrade)