2023-08-31 05:15:12 ET
Summary
- HP Inc. is considered a resilient business model with potential for growth in the context of interest hikes and a potential recession scenario.
- HPQ's transition to a subscription model, starting with its printing business, is attracting investors like Warren Buffett.
- The company's combination of metrics, including strong return on equity and lower stock-based compensation, makes it an attractive investment compared to its competitors in the PC industry.
- The last Q3 2023 results seem to confirm management expectations; the TAM for fiscal year 2024 has been reduced slightly, pushing down the stock price in the short term.
- We rate the stock as a buy, as our view is for the long term.
We rate HP Inc. (HPQ) as a buy since the company is making a transformation to a subscription model that would enable it to build up a more resilient free cash flow generation. HPQ has interesting characteristics that make it a resilient business model, particularly in this context of interest hikes and a potential recession scenario.
The Q3 2023 report recently launched reveals that the company is performing as expected with revenue growth of -9.9% YoY in Q3, non-GAAP diluted net earnings per share of $0.86, which is within the previously provided outlook of $0.81 to $0.91 per share, and GAAP diluted net earnings per share of $0.76, which is above the expectation of $0.61 to $0.71 per share; it was expected a recovery in the second half, particularly in the last quarter of 2023. In addition, the TAM for fiscal year 2024 has been reduced slightly, driven by the decline of the TAM in China, as that market has not grown as expected. Probably, this is affecting the stock right now, but long-term holders might see this drop as an opportunity to start a position. In this article, our focus will be more on the long term.
The brand "HPQ" might not be as powerful as other brands in Berkshire's stock portfolio, such as Apple (AAPL) or American Express (AXP), but still, the stock represents around 1% of the stock's portfolio, which is part of its top ten most important positions. It's possible that Buffett is attracted to HPQ's printing business as the company started a transition toward a subscription model some years ago, which means more recurrent cash for a company that is strongly oriented to reward its shareholders using that cash. However, the company is working to make this transition not only in its printing business but also in the majority of HPQ's portfolio. As such, we could expect that in the long term, HPQ might turn its business model into an entire subscription business model, including PCs.
Context
COVID-19 in 2020 and 2021 triggered the need to have a hybrid work, which boosted HPQ's sales in 2021 given its wide offering of PCs, printers, web cameras, video conference systems, audio, etc. Nevertheless, as the pandemic was receding combined with a policy of interest rate hikes by the FED to control inflation rates, demand started to slow down globally. In 2022 , HPQ's revenue growth was -0.8% YoY, and in the first half of 2023, revenues experienced a decline of 20.2% YoY as a result of the toughest macro environment that affected the entire industry:
Indeed, companies like Dell (DELL) and Acer (TPE: 2353) experienced a drop of 20% and 26.67% , respectively, as of the first half of 2023 YoY. Nevertheless, the management expects a better performance, particularly on the consumer side, in the second half of 2023, as end-user demand is stronger than in the first half of the year. The recently launched results for Q3 2023 seem to confirm this. Indeed, there are some important drivers, such as the back-to-school and holiday seasons, that might boost the demand for HPQ's hardware and services again in the last quarter of 2023.
At this point, you might ask yourself what Buffett has seen in this company that makes it different from its main counterparts, and that's the question that we will try to solve in this article to see if you should have it on your radar and what stock price would be attractive.
HPQ's capital allocation and negative equity
Some investors might consider HPQ's balance sheet risky as it shows negative equity since 2016, when the company was split from Hewlett Packard Enterprise (HPE). The reason is that liabilities are bigger than assets, which was a result of the 2016 split.
HP's Consolidated Statements of Equity 2016
As such, HPQ's negative equity is a result of two factors: i) a significant portion of the pre-split equity was taken by Hewlett Packard Enterprise, which left HPQ with negative equity; and ii) the annual allocation for share buybacks, which permanently reduces the equity, as we know that repurchases are included as negative as part of the stockholder's equity.
If the negative equity had come from a permanent HPQ's negative earnings consuming its assets while using more debt, the negative equity would have been seriously risky. However, HPQ is delivering stable and predictable free cash flows YoY since its split from Hewlett Packard Enterprise in 2016; thus, we do not consider that the negative equity is risky at all in this particular case, and, most likely, Buffett would agree with us.
How Buffett picked HPQ and not other in the PC industry, excluding Apple
When Buffett picks stocks, he likes to study the competitors since he has discovered that, several times, those competitors might show better metrics and competitive advantages than the company he is actually studying. We sum up some of the metrics used by Buffett:
The table above can help us see what could have been Buffett's motivation behind his purchase of HPQ shares. Maybe you are asking yourself how we got a ROE of 78.8% on average over the last 5 years for HPQ in the fourth column if its equity is negative, and that's fair. Nevertheless, the book "Warren Buffett and the Interpretation of the Financial Statements" by Mary Buffett and David Clark helped us solve the problem.
Indeed, both authors suggest that we need to subtract the share buyback effect from the equity by adding two times the amount of those share buybacks to the negative equity. Our particular view is that makes more sense, as a share buyback policy means fewer outstanding shares, but the amount of equity should not be affected.
Now, looking at the ROE and repurchases/FCF in the table, HPQ and Dell are the best out of the group. The problem with Dell is that it holds lots of long-term debt and a way higher SBC/FCF. The SBC is the stock-based compensation, and we would expect that this metric is relatively lower than the comparables, as the SBC implies the issue of more new shares that cause dilution among the current investors. HPQ's metric is among the lowest compared to the other players.
Regarding Lenovo (HKG: 0992), it allocates less money for repurchases, with a higher SBC/FCF, a lower ROE, and less efficiency in terms of R&D/gross margins than HPQ. The same simple comparison can be made between Acer and IBM (IBM) with HPQ. With respect to R&D expenses, Buffett loves to see a company that uses relatively lower R&D expenses over gross margins while keeping or improving its market position. HPQ improved its market share in Q1 2023 YoY by 1.3 points, driven by the improvement in the commercial segment by 2.5 points, while keeping relatively low R&D expenses over gross margins.
Only Acer shows a lower proportion of R&D over gross margins than HPQ, but at the same time, the former shows poor performance in other important metrics.
We can determine that HPQ has the best combination of metrics, which might justify why Buffett has finally chosen it over its main competitors.
The subscription model: the HPQ's future
In a recent interview , CEO Enrique Lores said that HPQ is moving to a subscription model. This is how he pictures the company's future:
As of today, we have ink, toner and paper. Very soon you will be able to buy your printer as part of the subscription. Soon after that, you will be able to buy your PC. And over time, our goal is to offer the full portfolio. I think it's the desire to be more relevant to our customers. We can offer a much stronger value proposition to customers with, rather than a product, a full service. It's all about engaging with customers in a more permanent way.
Indeed, HPQ is gradually developing its subscription model, having already started with ink; this is the current offer for its ink service:
In the last call for the Q2 2023 results, Lores said that HPQ is extending the service to toner and paper. Basically, by paying a monthly fee, clients will not have to think about reloading the ink or buying more toner or paper, as the service includes the supply of these products. The more recent service is instant paper, which has been growing very fast in 2023.
Now, HPQ is planning to introduce the first printers within the subscription model to those customers who are already in the program. Right now, the services associated with ink, paper, and toner are already implemented in North America , and HPQ is planning to extend those services globally.
Under these important advances, HPQ wants to capture more value per customer, pushing up the net promoter score (NPS), which is an important metric that measures customers' willingness to not only return for another purchase or service but also make a recommendation to their family, friends, or colleagues.
NPS is higher in subscription models, so that represents an interesting opportunity to generate higher stickiness toward HPQ's products, producing higher margins and more free cash flows, smoothing its volatility, particularly in recession scenarios. HPQ's printing business, which is already part of the subscription model, was showing operating margins between 18 and 19%, while the PC business has only delivered operating margins between 5 and 7%. As HPQ keeps developing its subscription model to sell its PCs, the PC business segment might increase its operating margins.
Between commercial and consumer business segments in HPQ, the commercial segment will benefit the most under the subscription model, as companies would allocate their resources more efficiently by paying a monthly fee for services related to PCs, printers, ink, toner, etc. As HPQ grows its subscription business, it is increasing its pricing power with the possibility of offering more and more services to raise fees while creating more value for its customers.
Buffett loves these kinds of businesses that earn recurrent cash flows without increasing the sales force to gain each new sale.
Generative AI could benefit the subscription model
HPQ is working on its products to develop their capabilities for AI, which require a new architecture of PCs-in other words, new programs, processors with AI processors, or GPUs. Among other projects, HPQ is working on the advantage for its clients to run AI applications at the edge container, which enables users, for example, small companies that want to protect their confidential data, to not run those applications on the cloud but run them locally.
This possibility to run AI applications at the edge appears to be highly appreciated by customers, since they would not want their new models exposed to the cloud with less privacy and security. HPQ is moving in that direction in order to benefit from the first-mover advantage.
These new changes will bring a big driver of refreshment in both the commercial and consumer spaces, and some of them are expected to be launched in 2024. These changes in printing and PCs might generate a much better perception of value under a subscription model, which would help HPQ consolidate its project.
Valuation
According to SA, the HPQ stock is attractive when comparing its different multiples with its comparables:
To supplement the last information, we will use a discounted cash flow ((DCF)) method to see the intrinsic value and the margin of safety.
Assumptions
- Outstanding shares as of 2022: 1,220,075,046
- FCF margin projections: 6% (average of the last 7 years after the split from HPQ Enterprises)
- Revenue growth: -18% for 2023 (conservative) and 1% for years beyond 2023 (less than the consensus )
- FCF 2023: $3 billion ($3 billion-$3.5 billion according to the management in the last call Q2 2023)
- Cash as of April 2023: $1,940 million; total debt as of April 2023: $10,360 million.
- Discounted rate: 9%
- FCF growth perpetuity: 3.5% (HPQ delivered a FCF growth of 5.8% annual in the last 6 years).
To find the perpetuity, we needed to use the formula:
Perpetuity = FCF 2027/(discounted rate- g)
where g = annual FCF growth =3.5% annual
With perpetuity, we calculate the present value of all the FCFs beyond 2026. Then, we calculate the enterprise value using the following:
Enterprise Value = Present value of FCF (from 2023 to 2026) + Perpetuity + cash - total debt
Finally, the intrinsic value is calculated by taking the enterprise value and dividing it by the outstanding number of shares. The intrinsic value is $34.83 per share, so we would buy shares at around $28 or less to increase our margin of safety.
Even when there is only an upside of 24%, our model is not incorporating the future scenario when HPQ completes its transformation to a subscription model, making it a more resilient business model in difficult scenarios and bringing it more growth opportunities while the market would be willing to pay higher multiples for the stock. In addition, this model does not incorporate the effect of lower debt, as was announced by the management in the last Q3 2023 results.
Risks
A risk might be that HPQ's competitors are taking similar steps to develop their respective subscription models in order to take advantage of the benefits of that model. However, HPQ has the best combination of those metrics usually evaluated by Warren Buffett, as we've seen in this article, so that would enable HPQ, with its strongest shareholder orientation, lower SBC, and more efficiency in its R&D expenses, to reward more its shareholders.
As HPQ is advancing and pleasing its customers, particularly in the commercial space, which represents more than 70% of its revenues, it would be way more difficult for them to leave HPQ's subscription services to go to another competitor. We think that each player in this industry might benefit from the growth opportunities related to generative AI and subscription models; though only time will tell, HPQ is better prepared to harness these opportunities.
Another risk could be that some people may think that the digitalization could slow down the growth prospects of HPQ's printing business, as it would be expected to have a lower usage of paper. However, digitalization does not mean that papers will not exist anymore since there will always be documents that are needed physically.
In general, companies can only implement a paper digitalization process for a few processes, leaving several manual processes in place. We could imagine that in the next 10 years, printers will be as necessary as they are today, which brings growth opportunities for HPQ to keep developing its subscription model in the next few years.
Final Thoughts
In this article, we wanted to emphasize the importance of the gradual transformation of HPQ's current business model into a subscription model that will enable it to create more value for its clients with new products and services, generate more stickiness toward its services, and take advantage of the increasing needs for generative AI by offering more advanced hardware and software to support the AI capabilities.
On the other hand, the Future Ready Transformation Program, already implemented by the company in November 2022, which is a strategy of cost-cutting with a focus on the faster company's growing segments, is advancing well, according to the management . HPQ's goal is to reduce the structural costs by $1.4 billion and achieve 40% of those in 2023.
This cost-cutting program and the subscription model would allow HPQ to raise fees and cash flows, which will make HPQ's business model more resilient in recession scenarios under a more long-term view. On the other hand, it was important to determine why Buffett selected HPQ over its main competitors; we gave some interesting insights, showing a table of the main metrics usually evaluated by him and how he might have chosen HPQ according to his own circle of competence.
For further details see:
HP Inc.: The Subscription Model Is The Future