Some days, the saying goes, you’re the windshield, and some days you’re the fly. Over the last several quarters, the personal computer business has found itself in the unenviable position of being the fly, helpless to the force of the windshield that has been embodied by difficult macro trends.
Research firm Gartner recently published a note on the PC industry, highlighting that shipments in Q4 2022 declined 28.5% year over year, largely due to consumers feeling pinch of inflation and putting off large purchases, combined with the fact that the industry pulled forward a large amount of sales at the height of the pandemic. Further, the all-important enterprise buyer is extending lifecycles in a bid to save cash on new purchases.
It is against this backdrop that we consider HP Inc. (NYSE:HPQ), the PC maker which has captured roughly 20% of this troubled market.
Let’s dive in.
A Tough Quarter
HP reported its Q1 results at the end of February, and like the rest of the industry, the results weren’t pretty. The results, however, were not an anomaly. The trend has been outright negative since Q3 of 2022, and it can be argued that the slowing in growth began a year prior, in Q3 of 2021.
Three quarters of consecutive revenue contraction makes a trend, and in HP’s case, the trend seems to be worsening. Q3 2022 recorded -4.1% growth, which only accelerated in the fourth quarter of 2022 with a -11.2% growth. Q1’s number was an even worse -18.8%.
Analysts don’t seem to believe that the pain for HPQ stock will let up anytime soon, either.
Estimates for future revenues (the above chart is looking currently into FY 2024) have steadily declined since mid-2022 from a high of roughly $64 billion to a now-estimated $54 billion.
As would be expected, HP’s cash flows have suffered as a result. In the last five years, HP has only printed one other quarter with negative cash from operations.
This is troubling, no doubt, and something to watch closely in the future.
These declining cash flow levels are problems compounded by the fact that HP’s inventory is growing at a rapid clip. We also point out that while aging inventory is never a good thing, it’s especially bad in the PC industry where rapid advances in technology quickly can render even relatively new machines obsolete.
To assess the inventory backlog, we’ll look at the days outstanding inventory metric, which compares inventory to sales and can help us see if a trend is forming.
Looking back five years on a quarterly basis, we can clearly see that HP’s days outstanding inventory has been climbing on average. This is, in our view, indicative of an issue with management’s ability to accurately forecast and adjust to market demand for its product. One or two quarters would be understandable, but to see multiple consecutive quarters of rising inventory versus sales points to, in our opinion, a failure to adapt to market conditions.
Perhaps most troubling overall is the fact that the situation at HP has necessitated that the company slow (and now temporarily halt) its stock buyback program.
Management has for a long time committed to a robust stock buyback plan, believing that the shares are fundamentally undervalued and that buying stock is a good use of capital. (Shareholders also like this because it means a large buyer is generally always available, which helps support the share price.) In fact, CEO Enrique Lores recently stated at the UBS Global TMT Conference that the company’s plan long-term is to “return 100% of free cash flow to investors,” while acknowledging that the company would have to slow down its buyback activity in the near term.
Of course, the near-term is only an estimate, and it’s entirely possible that a near-term projection could turn into a medium-term and even a long-term projection if business conditions to not improve. With that in mind, we caution investors against assuming that buybacks are guaranteed to resume in the back half of 2023 or even 2024, especially given the forecasted macro headwinds faced not only by HP, but other PC makers in general.
With all of these headwinds, it would be reasonable to assume that perhaps HP represents a good value or turnaround play. But a review of the numbers shows that this may not actually be the case. In fact, in the face of falling expectations, it seems surprising that the stock chart has been so resilient.
Looking back five years, both forward PE and EV/EBITDA valuations are not far from historical norms. The stock’s current forward price to earnings of 8.5x is only slightly lower than the five year average of 9x, and the current forward EV/EBITDA multiple of 7x is only a bit above the historical metric average of 6.8x.
This suggests to us that the market has not priced in current concerns. This could be for a number of reasons, but the most likely ones are that investors either believe that the downturn in demand will be short-lived, or that the downturn will not be as severe as feared. After all, people and companies can’t put off buying computers forever–they’ll be back, the thinking goes.
We feel, however, that the current valuation represents a risk, especially when considered against industry peers. Consider, for example, Dell’s (DELL) forward EV/EBITDA compared to HP’s.
Dell’s valuation responded rapidly to deteriorating conditions, falling from more than 9x forward EV/EBITDA to 5.5x. Compare this to HP’s relatively muted valuation response to similar market conditions, and we are left to wonder if there isn’t a similar downside risk for HP.
The Bottom Line
The macro picture for the personal computing market has been negative for several quarters and is likely to be negative for the near future. While HP’s stock has largely been resilient to these headwinds, we think that resilience has set up a situation where the stock is priced to perfection with little upside potential in the near term and more downside risk than we are comfortable with. We plan to re-evaluate as macro conditions change, but today we must pass on HP.