- Hewlett Packard met earnings/revenue expectations but reduced free cash flow outlook, which negatively affected HP Inc. stock.
- However, I anticipate PC market demand to stabilize as segmentation does not imply PC obsolescence.
- HP Inc. stock is still undervalued, and I anticipate value mean reversion plus the dividend yield to outperform the broader market.
For the most part, Hewlett Packard Inc. (NYSE:HPQ) had a fairly solid quarter, probably as good as one could really wish for. However, the guidance was somewhat underwhelming, anticipating further weakness to FCF as they enter into a transitional stage where they reduce their cost structure by accelerating layoffs, which will increase severance (restructuring) costs by $300 million on a one-time basis, but on a normalized basis, the FCF margin will remain in-line. The free cash flow figure was the real disappointment coming out of the quarter despite meeting headline consensus estimates for EPS and revenue.
HP Inc. reported revenue of $12.246 billion and EPS of $0.36, which compares to analyst consensus of $12.195 billion and EPS of $0.36. Despite revenue upside, the bottom line figure was in-line due to worsening expense leverage resulting from mix-shift in printer products to lower-end SKUs in conjunction with currency/heightened operating expenses.
I come away from the quarter with the impression that HP Inc. is better positioned to drive reasonable revenue/earnings growth following FY’16. However, it’s worth noting that there aren’t too many near term drivers to top line/earnings with the exception of F/X stabilization and a better PC environment once we exit out of 1H’16.
Catherine A. Lesjak (CFO) mentioned on the earnings conference call:
Given the acceleration of our restructuring activities, our fiscal 2016 free cash flow outlook will be in the range of $2.3 billion to $2.6 billion, a reduction of $100 million from our prior outlook. The updated outlook now assumes approximately $300 million for separation and $300 million for restructuring activity payments. We expect to retain our normalized annual free cash flow in the range of $2.9 billion to $3.2 billion.
Of course, the narrative of accelerating further cost reductions has been played out for quite a while now. Whether they can sustain cost reductions without damaging top line growth is the real question coming out of this quarter. After all, Hewlett-Packard’s financial position has deteriorated over the past couple of years, and while they’ve made noteworthy improvements to their product line, the product mix has shifted continuously to the lower-end. Hence, ASPs have declined in both the laptop and desktop category.
According to UBS analysis, the desktop ASPs have declined from $524 to $505 in Q1’16 whereas laptop ASPs have declined from $549 to $469. These efforts to reduce pricing across the product line didn’t mitigate a rather steep drop-off in unit demand, which declined 8% and 13%, respectively, for notebooks and desktops. However, relative to other competitors, HPQ managed to increase its market share to 20.1% of global PC shipments, according to UBS. So, relative to other competitors with the exception of Apple, HPQ is going pretty good despite broad secular weakness in PCs. Whether these trends are transitional or part of a larger shift to other alternative computing devices is the big debate among investors.
However, I find long-term risks to PCs slightly over-played. Yes, the device mix has shifted to mobile, tablets, and wearables. However, these devices remain content consumptive, so there’s still room for content creation devices, as viable alternatives to a full-functioning keyboard with higher-end CPU/GPU performance tied to a commercial app ecosystem do not exist. In other words, PCs are still the most useful device to the enterprise, and various efforts to transform tablets into more multi-functional work capable devices is more niche oriented as tablets provide some form factor advantages for certain cellular capabilities that allow them to alternate as POS terminals, or drawing capabilities that make them uniquely compatible to Adobe Creative Cloud. However, the vast majority of localized work instances are done on PCs with certain data computations done in larger hyper-scale data centers. But, generally speaking, the use case for PCs has remained constant over the years, which implies that the market vertical for both laptops/desktops remains somewhat intact.
The difficult PC environment is due to an aging installed base of PCs. People simply do not replace their PC unless it breaks down. Generally speaking, a well-maintained PC with occasional replacements to hardware components can have a useful life from five to seven years. Of course, there will be hard drive failures along the way, but from what I’ve seen, people would rather take their PC to the local repair shop before buying a brand new PC.
Intel (NASDAQ:INTC) plans to tackle this challenge by introducing new connectivity standards, and will maintain an accelerated product release cadence to render older generation components obsolete. Of course, Moore’s Law hasn’t produced massive gains in instructions per cycle in the latest iteration, but the reduced die size from node shrinkage does create additional space for more CPU cores, which implies that performance scaling will continue at an accelerated pace as we move into Windows 10 where multi-threaded applications are becoming increasingly common. Nonetheless, the vast majority of consumers are happy with content consumption devices, and today’s PCs are overkill for watching video and reading news articles.
However, the market for PCs will eventually stabilize as more PCs means a broader shift to business-like workloads. However, the convergence to large scale productivity has yet to materialize. The number of people who need higher powered PCs have become the minority, which is why the PC market is significantly smaller in terms of unit shipments when compared to both smartphone and tablet. However, I anticipate that this large secular shift to content consumption devices will eventually hit an equilibrium point with wallet share stabilizing for different computing devices.
In other words, organic growth will eventually materialize as a stable base of high-end PC users will materialize. This will normalize PC growth trends as smartphones and tablets aren’t overlapping replacements, but rather compliments to PCs. It just so happens that the devices compete for wallet share among each other, but with the tablet category in a full-blown decline, it’s likely that we’re finally witnessing a pattern of elongation across all consumer electronics/computing categories as opposed to the hyped-up commotion over device cannibalization. In other words, PCs aren’t going away any time soon, just as DSLR cameras seem to co-exist alongside smartphone cameras. While PC market segmentation implies near term headwinds to HP Inc. sales, I don’t anticipate large scale decline due to product obsolescence, but rather a pathway to PC segment stabilization as we move into 2017.
Here was some additional noteworthy commentary released by investment bank analysts following the earnings report:
At 80% of profits, printing will continue to be a main driver. Printing revenue came in lower than expected, down 17% vs our expectations of a 13% decline. Printing margins of 17% were below our expectation of 17.5%. The company expects supplies revenue, down 14% in F1Q, to have a stable trajectory by the end of F17. Our price target of $11 is based on multiples of 7x normalized EV/FCF and 7x F16E non-GAAP EPS of $1.59. With an almost 5% yield, the stock has limited downside but also limited upside given negative printer and PC trends. – UBS, Steven Milunovich
While the company has challenging quarters ahead, we believe HPQ has a solid franchise and a multi-faceted strategy to offset secular pressures in its end-markets. Specifically, with better visibility on printing supplies, the company could attain modest low single digit operating income growth. With an inexpensive valuation and significant cash return, we maintain our Outperform rating and PT of $19. We revise our FY16/17 EPS estimates to $1.59/$1.63. – Credit Suisse, Kulbinder Gharcha
Trimming PT to $13 from $16 on lower market multiples; maintain Buy. We believe HP Inc. should be valued at an 8x forward P/E multiple, in line with peers. Our $13 PT is based on 8x our FY-17E EPS estimate of $1.60. With shares trading at a discount to these levels, we rate HPQ a Buy. Downside risks: higher declines in PCs and printers, lack of supplies growth, and operational challenges post the split of the company. – Deutsche Bank, Sherri Scribner
With HP Inc. stock declining 4.4% following its earnings announcement, it’s hard to label the quarter a wild success. I still think HP Inc. stock is undervalued, but broader sentiment will take a while to recover. I believe the best argument for owning HP Inc. stock is due to the depressed valuation it currently trades at, and a stable dividend yield for the foreseeable five-year period. I don’t think PCs will remain a declining category for much longer. While near-term trends imply further weakness, the long-term dynamics are still compelling for PCs assuming organic growth continues and new use cases for high-end PC components begins to materialize. Nonetheless, I’m revising my EPS to $1.59, which is in-line with other analysts and reflects management guidance. Generally speaking, HP Inc. is pretty consistent with its guidance, so there’s an extremely low probability that there will be significant variance from expected results.
I’m lowering my HP Inc. price target to $11.73 (7.38x GAAP EPS) from $11.80. I still believe HP Inc. stock has a 13.4% upside from current price levels and when combining with the 4.5% dividend yield, I anticipate a total return of 18%. HP Inc. stock will ride a broader recovery in equity prices, but will likely outperform due to mean reversion and the attractive dividend yield.