HP Inc. (NYSE:HPQ) Morgan Stanley Technology, Media and Telecom Conference March 3, 2021 11:45 AM ET
Company Participants
Enrique Lores - Chief Executive Officer
Conference Call Participants
Katy Huberty - Morgan Stanley
Katy Huberty
Welcome everyone. I am Katy Huberty Morgan Stanley's IT Hardware Analyst and I'm really pleased to be joined by Enrique Lores, HP's CEO. Enrique is a 30-year veteran of HP who held senior leadership positions across both Personal Systems and Print and became CEO in November of 2019.
Since leading the company, Enrique has committed to a strategic value creation plan that includes long-term profit and free cash flow growth and significant capital return to shareholders.
Before we begin the discussion, let me just inform you that today's discussion includes forward-looking statements that involve risks, uncertainties, and assumptions which are further described in HP's SEC filings including HP's fiscal 2020 Form 10-K.
HP assumes no obligation and does not intend to update any such forward-looking statements. For more information please visit HP's Investor Relations page at investor.hp.com. Please also see Morgan Stanley research disclosure website at www.morganstanley.com/research disclosures.
If you have any questions, please reach out to Morgan Stanley sales rep. Enrique thank you so much for joining us today.
Enrique Lores
Thank you for having me here. Good morning.
Question-and-Answer Session
Q - Katy Huberty
Let's start out with a bit of a download on the quarter that you just reported because there is some very clear trends in the business. Overall, the quarter was incredibly strong led by PCs and the consumer print business which more than offset continued headwinds in Commercial Print. Give us some color as to how you expect those trends the end market and customer segment trends to evolve over the next 12 months?
Enrique Lores
Thank you. So, yes, we had a very strong quarter and we expect many of the trends that we see this quarter to continue in the near future. We've seen that PCs have become essential. This has driven a significant increase of the demand for PCs both for home but also from consumers, but also Notebooks on the commercial side and we think this will continue for the foreseeable future. And on Print, we think that in the short-term, we expect the demand on the home side to continue to be strong.
As the pandemic will be over, we expect the activity in the office to recover. And then the demand on the home side to be impacted a little, but one trend will compensate the other. So, we are really confident about what is going to be the future of the company during the next quarters.
Katy Huberty
And how are you thinking about the permanency of these behavioral shifts? You mentioned a few of them the mix shift to Notebooks away from Desktops does that continue over multiple years as people return to the office? And how do you think the pandemic will impact consumer relative to office print longer term?
Enrique Lores
So, let's say on the PC side, we think that first overall demand is going to continue to be significantly bigger than what we were expecting before the pandemic. I shared last week that if we look now at 2021 and we compare with expectations we had before the pandemic, the market is going to be around 45% bigger. And we think that delta is going to continue for in the future.
And the trend towards Notebooks, we think is going to be reinforced because as we will go back to the office or the offices will reopen, we think that the way of working is going to be hybrid. People will work from the office, will work from home. And therefore the need for mobility devices will continue to be there and will continue to drive this change.
In the case of Print, we think that over time office printing will regain momentum and will grow again, but it will be always lower than what we were expecting it to be before the pandemic because again people will not be spending so much time in the office as they were before and therefore, the total number of pages printed in the office will be smaller.
At the same time when we look at the Home business and pages printed at home, we think that there will be more than we were expecting before the pandemic and one effect will compensate the other.
So, these are the trends that we think will happen. Exactly when the changes happen it's going to depend on how fast the people gets the vaccine and we are able to reopen the office, which at this point, is hard to really say exactly when it'll happen.
Katy Huberty
And HP is really advantaged because of the diversification of your product in end segments. So if vaccine rollout takes longer, your consumer businesses and PCs benefit, and if the vaccine rollout accelerates and we get reopening, you have those commercial markets coming back?
Enrique Lores
Well I think that's a great point. From the very first investor meeting, we highlighted that, we had multiple levels of profit creation, and I think we have demonstrated that during the pandemic. The fact that we have both a PC and a Print business with very strong consumer and commercial segments really has helped us to manage the business during the last quarter. And as you are saying, it will help us to continue to manage it during the next quarters, because we really can balance depending on where we see demand coming from.
Katy Huberty
Right. So I want to drill into each of your segments a little bit more starting with PCs. As you know there's a lot of questions around sustainability. Even with a PC market that's grown for four years and industry analysts that are forecasting another double-digit growth year in 2021, investors are worried about the material slowing in PC growth. And that's not your view this year and it's not your view longer term. And so dig into some of the structural changes. You talked about Notebooks, they have shorter replacement cycles. The shift of more PCs per home. What's driving your confidence in a structurally larger PC market longer term?
Enrique Lores
I think I said it with some humor during the call last week. But the key thing is that the PC has become personal again, and that every person each of us need a PC to communicate, to work, to play, our kids to do their homework and this will continue to drive significant growth in the category. Additionally, as we were just discussing, there is going to be discontinuous shift from Desktops into Notebooks that also helps on the market size because of the shorter renewal cycles. And these two factors give us great confidence on what is going to be the evolution of the PC market going forward. On top of that, we are seeing an even bigger opportunity than we were expecting in what we used to call accessories that now we call peripherals. And I think each of us have learned during the last six months that it's not only about the PC it's also about having the largest display. It's also about having a good micro, a good camera, and this is really opening another additional opportunity in this space that we have started to target both organically and inorganically, as we announced last week with the acquisition of HyperX. So it's not only the PC market, but the overall personal computing business, we saw the peripherals around, a category that we think is going to continue growing for the foreseeable future.
Katy Huberty
Since you brought that up, let's talk about HyperX for a minute. It's a company that specializes in gaming peripherals. What attracted you to that brand? And could we see additional M&A in the peripheral space as you expand the portfolio?
Enrique Lores
So what attracted us to invest in gaming is, first, it's a market that for us is growing significantly. We said that we were growing more than 20% this quarter on gaming PCs. And when we think about -- when we look at consumer behavior, we think that we are all spending money on peripherals. A gamer spends at an average 16 times more money on peripherals than let's say a normal person. Normal is the wrong word to use. So it's really an attractive opportunity for us to invest. When we look at that category, HyperX is the leading vendor today for headsets, which is one of the categories that is growing the fastest. And we thought we had an opportunity of taking that company and helping them to accelerate their progress.
We have a broader geographical presence than they have, so we can bring them to more countries. We have more retail reach than they have, so we can help them to accelerate their sales through retail. And we can take that technology and those products and expand them into the commercial space for professionals that will be working from home both on headsets and microphone. So we really saw a clear growth opportunity of -- by taking that company, integrating that company in HP, leveraging their brand, leveraging their technologies and really help them and help us to accelerate the growth.
Katy Huberty
Now your PC business has been constrained by supply, not by demand, over the last year. And you noted last week that you expect these supply constraints to last through your fiscal third quarter. What are you doing to mitigate that dynamic? And what's your view on commodity pricing given the tight supply chain, is there a risk that commodity prices come up? And what would be the impact on your margins?
Enrique Lores
Yes. So, the supplies challenges that we are seeing are driven by how strong the demand is. When you think about many of the components and the lead times that they have, especially a new factory needs to be built for semiconductors or for panels, there is no way they can respond to a 45% increase of demand, as we are seeing this at the market level.
And this is really what is behind the shortages that we are seeing. And as we said, we expect them to continue, at least through Q3. But, of course, this is always going to be depending on how strong the demand continues to be. What we -- and we are working very actively across the full value chain to mitigate as much as we can the impact of that.
We have significantly raised our projections for market growth, to make sure they continue to invest in increasing capacity. We have also seen that some of the shortages are coming from low level components that until now were managed by our audience.
So we are managing now those vendors directly. So we can have a better forecasting process for them. So they also continue to invest more regularly. We are improving our processes to match processor and components during the quarter.
We announced last week that we have increased the inventory levels that we are going to be operating with, to make sure that if during the quarter some components are made available, we can mix and match and create more products. So, really across the full value chain, we are driving every change that we can think of to be able to respond to demand faster and to increase our capacity.
Katy Huberty
And do you expect commodity prices to be impacted? And how should investors think about whether or not it impacts your margins?
Enrique Lores
Yes. We expect that some of component costs – again, these as the normal demand and supply, low cost will be increased -- will be increasing but all of that is part of the guide that we provided last week that was a fairly strong guide for the full year. But, we are building all our assumptions in terms of cost increases as part of this guide.
Katy Huberty
Yes. Speaking of which, your PC operating margins have been above 5% for I think, seven consecutive quarters, and it was an impressive 7% plus operating margin in the first quarter that you just reported. And this is all despite Chromebook mix, that is higher CPU constraints you've had shipping and logistics costs around COVID.
So, should we think about PC operating margins as structurally higher than the 3.5% to 5.5% operating margin range that you've talked about in the past, or do you fully expect margins to normalize at some point?
Enrique Lores
As Marie said during the call, the key -- the biggest driver of this favorable margin is favorable pricing, given that there is a difference between supply and demand. This really helps us and our partners to maintain higher prices not having to discount, not having to run, so many promotions.
And we think that this over time as supply will be more available will be reducing. We have not and we are not updating our long-term guide at this point, but we think that we are going to be operating on the higher end of it during the next quarters given the strength of the demand and the strength of the momentum of the business.
Katy Huberty
Okay. So let's shift to the Print business. At your Analyst Day in 2019, you laid out a strategy to evolve HP's Print business model with a goal of improving the value proposition for your loyal customers and reducing the mix of unprofitable customers. Talk about where HP is on this journey, and how these actions will impact printing revenue growth and profitability going forward?
Enrique Lores
Yes. I think we are making very good progress implementing this change. What we said at that point was that we had three strategies to drive it. One was the evolution into a subscription model and we reported this quarter that now we have 9 million subscribers in our Instant Ink program, which I think versus where we were at that point means, it's almost 2x the number of subscribers. And we – in Q1, we added 1 million subscribers, which is the most we have ever added. So it's really gaining momentum and really is having – because of the strong value proposition it provides.
Second element of the change was the creation for emerging markets of what we call Big Ink and big toner products. Products that bearing supplies, when you buy them they have the supplies built into the product. And those – both categories grew double-digit in Q1, really, especially in emerging countries which is where we really think they will be playing a strategic role.
And then the third element of the change was the creation of a new model. At that point we didn't have a name, we call it HP Plus, that really helps us to shift and to rebalance profitability from supplies into hardware. We launched HP Plus at the end of the previous quarter in the US with Staples. We have – the response we have got from customers has been very positive. We are at or above all the key metrics that we had for the program. And we – during 2021 and early 2022, we will be rolling it the rest of the portfolio first ink and then laser.
So it's working. We are very happy with the progress we have made. And again, it will help us in the long-term, the combination of these three things because offer a better value proposition to customers, help us to rebalance profitability from hardware to supplies and with a goal of reducing the number of unprofitable customers.
What we shared at that point is that in that quarter we had 25% of unprofitable customers. With all these actions our goal is to significantly reduce that number. So we – the long-term profit of Print will grow just because we will not be losing as much money with some customers as we are doing today.
Katy Huberty
When you talk about moving away from unprofitable customers, investors, worry about market share loss, with that evolution but the reality is you're moving away from customers that were never going to be profitable. And as you said, that helps you grow profits. But I think more importantly, there are still some areas of the Print market, where you think you can gain share and where you see significant growth. Talk about where those are?
Enrique Lores
Yes. So let me talk on both. So you're right. In some areas on the consumer side, we will – our plan at that point was to lose some share because these are customers we are not making money with. And these are customers that of course, we don't want to maintain in our portfolio.
On the other side, especially when we think about the office side and contractual, we see an opportunity to grow profitably and growing in that space. This is why we launched the A3 initiative some time ago. Now really our focus is not only on A3 but the overall contractual category both A3 and A4.
Our share continues to be significantly lower than the share that we have in other parts of the Print business. And this is long-term, a key strategic area for us to grow. What is important to note, as well is that the pandemic has opened new opportunities for us to differentiate in that space because what we are seeing is many companies as they would be reopening their offices they only – they want not only us to manage their printer fleet in the office but also to enable their employees to print in a secure way from home and we are now expanding our offering in the contractual space to enable printing from home securely, which is a key differentiator we have versus any other company in the industry.
Katy Huberty
Now earlier in the discussion you talked about compared to your pre-COVID forecast, you expect the consumer print business to be larger and the office print business to be smaller than pre-COVID expectations. How does that impact – how does that mix shift impact your HP Print margins?
Enrique Lores
What we have said is we think one factor will help us to compensate the other. So we haven't changed our long-term guidance for the Print business to be between 16% and 18%. Of course, we are still playing with a lot of scenarios because it's really hard to predict exactly how many people will come back to the office, how many people – how – what will be the additional pages printed at home. But given that more pages at home – we make more money with pages printed at home, we think that we can more than compensate the negative impact of a potential smaller office business going forward.
Katy Huberty
Right. Because the margins -- with your vertical integration the margins in consumer are higher than…
Enrique Lores
It is two factors. One is, our margins are better in the home versus office and also our share of pages is significantly higher at home than in the office. At home, our share of printers is 50%, which means that share of pages is in that range.
In the office, our share -- printer share is lower, but also we have lower share in higher volume printers, so our page share is lower. So when a page is not printed in the office and is printed at home the probabilities it will be printed in an HP printer are significantly higher.
Katy Huberty
Right. Now, there's -- over the last couple of months there's been a resurgence in investor interest in the 3D printing space. And you've seen most 3D printing stocks significantly outperformed year-to-date. I realized that 3D printing is a long-term investment opportunity for you.
But are there any data points or milestones that you could share that would help investors understand how HP's position competitively in that market and how you may benefit from improving adoption?
Enrique Lores
Yes. So, I think, the pandemic has been both positive and negative for 3D. Has been positive, because it has helped potential customers to understand the value of the technology. How important it can be to be able to design and manufacture products locally and with a much shorter design cycle.
So this has really helped us to validate the technology and the capabilities. And what we have shared is that, in Q1 the number of printer parts in our equipment grew more than 30%, which is a very good number.
At the same time, it has been negative, because most companies have slowed down or stopped investment in capital equipment, just given the uncertainty we were seeing. So I think there has been a slowdown on the business because of that.
But we think that the value that customers see will help us to reenergize that business as the overall industrial activity and how people will really go back to a more normal way of working. And this is why we continue to be very bullish in our investment in this category, very optimistic about the value it will create.
And also as I shared before, we are really focused on two specific things: digital manufacturing and selling printers, consumables and services for other companies to manufacture their products. And also, we are creating, what we call, end-to-end businesses, where HP plays a more active role in the design of the parts and in potential selling of the parts to the user of the parts.
And last quarter we announced a new opportunity around molded fiber packaging, where we are designing the molds for that business, which helps us, again, not just to sell products, but really to sell the parts and to sell the design of the part, which, from a margin perspective is a better margin business than just to sell printers.
Katy Huberty
Shifting to capital allocation. HP has committed to repurchasing at least $1 billion of stock per quarter. You've outperformed that the last couple of quarters and it's an important contributor of your long-term EPS growth outlook.
Talk about why you believe that significant stock buybacks is the best use of capital versus, say, even higher reinvestment into the business, or even more accretive M&A, like the HyperX deal that you just did, to sustain revenue growth?
Enrique Lores
Yes. I think, first of all, we continue to believe that buying our shares is a good investment, because our shares are undervalued versus what we think their value would be or should be. And therefore, we are going to continue to buy, as you said, at least $1 billion of shares.
M&A is as well part of our strategy. We have also said that we are going to be always doing M&A that will support our strategy. So we are going to surprise investors with a move in an area that we haven't explained before. We need to be sure that we have a strong operational plan to deliver on the value of that transaction.
And third the return on investment of that activity needs to be equal or better than the return that we will be getting by buying shares back. And when we see opportunities that fit those three criteria, we may acquire companies, as we did this quarter with HyperX, but we still have a very healthy balance sheet. We have opportunities to increase our debt, which is part of what we communicated when we shared the value plan. We are generating a lot of cash. We communicated we will be generating at least $4 billion of free cash flow in 2021. So we have an opportunity to continue to buyback aggressively. And if there is an attractive M&A opportunity we may do it as well.
Katy Huberty
And you prudently operated the business at lower leverage during the pandemic. Are we in a macro environment where you would feel comfortable running at higher leverage now if there was an opportunity out there?
Enrique Lores
We -- at least for the next quarters, we think it's still better to continue to be prudent and be at below 1.5 range that we communicated. If -- I think we are more optimistic in general than what we were a few quarters ago, but we still need to acknowledge that the situation keeps being very fluid. We need to see what is the economic recovery, especially after the summer unemployment continues to be very high.
So I think there are still significant uncertainties out there that make us to be prudent even if both from a guide perspective and from the projections that we have with our businesses, we are very optimistic about where we will be in 2021 and the next years.
Katy Huberty
And you just mentioned that you clearly view HP shares as undervalued, which is a key driver of the aggressive share repurchase plan. What do you think is most underappreciated by the market about the HP story?
Enrique Lores
I think, first, we just talked about it our free cash flow generating capability. In every quarter we are buying close to 5% of our shares that talks about how much cash are we able to generate per quarter. At the same time if I think about the growth opportunities that we have whether it's in personal systems, in print, in some of the adjacencies we have been talking in the growth businesses, I think we need to continue to do work with investors so they appreciate the value that we can generate.
And also the fact that we as a team have been able to manage the company in very difficult situations, deliver on the goals that we have in many cases exceed the goals that we have. And I think this needs to be part of the story that we need to continue to reinforce with our investors.
Katy Huberty
That's great. I know we're just about out of time. Would you like to end with any final thoughts?
Enrique Lores
Yes, maybe only three things. First is, as we have said we delivered a very strong Q1 driven by the strong demand that we see in our products, but also by the ability of the team to execute in a difficult environment both to reconfigure our offering, but also to continue to execute on our cost reduction plans.
We have also shown that we have opportunities to leverage the changes that are happening in the world to accelerate our transformation, accelerate our business, whether it's to accelerate the evolution of the pre-model as we have discussed, or increase our presence in adjacencies. It is clearly showing that we have opportunities to do even better than what we were expecting. And this gives us great confidence about the future of the company and the ability we have to continue to create value going forward.
Katy Huberty
That's great. Perfect place to end. Enrique, thank you so much for joining us today.
Enrique Lores
Thank you. It's been great to see you.
Katy Huberty
Have a good day everyone.
Enrique Lores
Thank you.
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