HP Inc. (HPQ)

Share Price: $18.23
Market Cap: $27.7B
Enterprise Value: $28B
Business Overview:
Revenue Breakdown
7% - Personal Systems: Workstations & other personal systems
41% - Personal Systems: Notebooks
20% - Personal Systems: Desktops
21% - Printing: Supplies
7% - Printing: Commercial hardware
4% - Printing: Consumer hardware

Segment Information
Personal Systems
This segment consists of commercial and consumer desktop and notebook personal computers, workstations, commercial mobility devices, and retail point-of-sale (POS) systems. Notebook PC’s, printing supplies, desktop PC’s account for more than 10% of consolidated revenue. Commercial PC’s are used by enterprise and public sector customers. Consumer PC’s include notebooks, desktops, and workstations. PC hardware uses Microsoft Windows, Google Chrome, and Android operating systems using processors from Intel and AMD. The segment has experienced continued revenue growth driven by commercial products, and a focus on innovation across the portfolio. There have been consistent operational execution and profitable share gains. Innovating includes the launching of new products which include the new HP Elite Dragonfly2, the HP Chromebook 11, and the new HP Envy.

The segment serves the commercial business by meeting the needs of an increasingly mobile workforce by launching latest EliteBookx360 lineup. Security leadership is derived by HP Sure Sense, EliteBook, and by leveraging artificial intelligence to enable real time malware protection. The segment serves consumers through the HP Envy series (distinguished by kill switch and privacy screen), and gaming systems through OMEN ecosystem.

Printing
This segment consists of printer hardware, supplies, and scanning devices. It also offers different services such as Office printing solutions, Home printing solutions, Graphic solutions, 3D printing and digital manufacturing. There has been continued revenue growth in contractual business, including Instant Ink and MPS. There has been continued good market acceptance of JetFusion 5200 series for the 3D market. Innovation includes beginning shipment of new LaserJet 100/200 series and the new Color Laser Jet Enterprise MFP 776 and M856 series for the A3 market. The graphics segment had key wins with HP Indigo Packaging presses. For reference, there are growth opportunities in packaging. The CAGR is higher than 25%, and 9% in textiles, and 7% in labels. The printing segment introduced the HP Never Stop Laser, the first of its kind in the industry. It’s designed for small business owners in emerging markets. The HP Smart Tank for home printing is 38% faster than the previous generation, and also received well by customers.

Logistics
For most products, HP Inc. has existing alternative sources of supply or alternate sources are readily available. There are only sole sources for some laser printed engines, LaserJet supplies, and customized parts for products with short life cycles. Some major portion of laser printer engines and toner cartridges come from Canon. HP is dependent on Canon for that reason, and that relationship would be jeopardized should HP decide to acquire or be acquired by Xerox. HP Inc. is also dependent upon Intel, AMD, and Microsoft for software products.

Competitive Strategy
HP Inc. is disrupting industries by leveraging technology and IP, particularly in graphics and 3D printing. It has a $100-million-dollar deal with ePac. In 3D printing, it has brought end-to-end solutions for customers such as New Balance and SuperFeet by offering them customized 3D printing cards for insource to customers. These companies are also using HP FitStation and Multi Jet Fusion printing technologies.

Additionally, HP Inc. is creating new categories. In the last quarter of 2019, they rolled out big ink and big toner into emerging markets. The reception was positive for big ink and has helped grow their share. Big toner was a category they created, and its launch was also successful. Instant Ink has 6M+ subscribers, and their 3D &Digital Manufacturing segment’s printers are the most used 3D printers. Instant Ink has 20% higher usage per customer, and 20% longer printer life, as well as over 90% consumer retention, all enabled by scaled cloud infrastructure. HP’s new gaming segment went from $0 to $1B in 18 months.

In terms of market leadership, HP Digital is #1 large format design, #1 large format production, and #1 digital press label and packaging. The segment has 50% market share in industrial plastic. They also partner with big name companies like Smile Direct Club, Volkswagen, Siemens, and New Balance.

HP Inc. is also creating value through consolidation. In 2017, it acquired Samsung’s printing business.

Organically, Personal Systems is the largest driver of profitable growth, accounting for 2/3 of consolidated revenue. HP continues to outgrow the market in revenue and profit. The HP Elite Dragonfly is the world’s most secure PC’s with its privacy camera and privacy screen. It’s also the world’s lightest compact business convertible, and world’s first laptop with built-in tile.

PC’s market share was 23.6% in 2019 (grew from 20.9% in 2016, and 16.6% in 2013). The share in higher value categories includes 21.9% in premium in terms of HP unit share, 11.4% in gaming, 13% in retail point of sale, and 25.7% for the rest of PC.

HP Inc. is working to increase its supplies share and evolve the business model over time by growing contractual sales while optimizing system profitability with improved hardware margins. They are doing so by expanding solutions in graphics, 3D printing, and digital manufacturing. Currently however, supplies revenue is declining. HP management expects the decline to decelerate, and eventually improve over time despite declines in the installed base.

HP is also working on reducing the percentage of unprofitable customers of print business. Currently, 25% of customers don’t buy HP supplies of use imitation supplies. By shifting more business to upfront, contractual, and optimized pricing models, HP has an opportunity to evolve the print business profitability. This strategy is enabled by big data built on unique cloud infrastructure developed over past 3 years. The end-to-end system is believed by the majority of customers to be better value. This program rewards loyal customers that use HP Printer and HP Supplies.

Xerox Takeover Offer:
According to their management’s proposal, Xerox wants to acquire HP, so that HP can serve as the sole manufacturer of equipment to be sold by Xerox.
Xerox does not have HP’s shareholders’ best interests in consideration. There is no overlap between Xerox and over 90% of HP Inc’s business. While HP is a global leader in both Personal Systems and Print, Xerox has no presence in Personal Systems. HP is also outperforming Xerox in terms of contractual revenue growth (>60% vs. -16%, respectively).

In February 2020, Xerox proposed a tender offer for HP shareholders. The offer stated the tender of shares for $24/share, broken up into $18 in cash, and the rest in Xerox stock. In response, HP adopted a shareholder rights plan to counteract the tender.

Financial Review:
In analyzing their working capital, HP Inc. has a negative cash conversion cycle, and has had so since 2014. Their use of working capital is highly efficient, and bolstered by the fact that they factor their receivables. HP turns inventory 8x a year, which is highly efficient in on par with some of its successful peers. Receivables are turned 9x, while payables are turned 3x. While they aren’t any noted in the 10-K, it’s possible that there may be arrangements with financial firms to factor payables.

On the balance sheet, HP has a negative equity. The reason for this is not a cause for certain. Why? Because, HP repurchases shares of common stock every year, and pays a hefty sum for cash dividends. Effectively, it’s returning cash to shareholders in two big ways. So, negative equity signals value.

In terms of its debt load, HP has a Net debt/EBITDA is 0.13, with cash slightly less than total debt. Short-term and long-term debt have been decreasing drastically for the past three years. Meanwhile, OCF and FCF surpass total contractual obligations per year. Interest coverage is also healthy. OCF/interest paid is 19x, and FCF/interest paid is 17x.

For return metrics, HP has a ROA of 12%, a starting ROIC of 25%, an average ROIC of 16%, and a cash return on assets of 14%.

In addition, it has significant NOL carryforwards: $7,856 million, which is a sum larger than its cash on the balance sheet.

Valuation:
While Xerox’s offer values HP at 7x PE, Xerox is valued at 9.4x. Despite this, HP has been growing over the years, and Xerox has been declining. HP currently trades at 7x FCF (14% FCF yield), 6x OCF, and 0.47x sales.

I will value HP Inc. based on no growth assumptions. As a result, these are the most conservative forms of the downside.

Normalized FCF, using no growth multiple of 10x, FCF per share normalized past four years of $2.63, gets you intrinsic value of $26.3 per share


Normalized FCF upside: 35%
EPV upside: 42%

Catalysts:
Earnings growth driven by new products and shifting the printing business through innovation and contractual business.
Continued return of cash to shareholders through repurchases and cash dividends.

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