HP Inc.: The Fever Dream May Be Reaching An End

Summary

• HP Inc. looks healthier than it has in years, with revenue and earnings growing at double digits y/y.
• Comps will start to look a lot tougher for HP, however, as we lap the work-from-home lifts stemming from the pandemic last year.
• A big question is whether the demand strength over the past year is a pull-in of demand, or represents truly sustainable growth.
• In the meantime, supply chain challenges continue to impair a swath of HP's portfolio. The company has built up inventory as well, likely to guard against future shortages.
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HP Inc. (NYSE:HPQ), one of the world's largest makers of PCs, continues to float on clouds. The pandemic-induced tailwinds for computers and other devices seems to be much longer-lasting than analysts had expected, and HP continues to drive double-digit growth in units and revenue for both its PC and printing divisions.

Shares of HP have risen more than 70% over the past year, the sharpest rally the stock has seen since it split of from its enterprise software-oriented cousin, Hewlett Packard Enterprise (HPE), in 2015. Year to date as well, HP has risen >20%, beating the S&P 500 (a very rare circumstance for HP to be in) and dramatically outperforming most other tech stocks, many of which are still in negative year-to-date territory.

Data by YCharts

HP has fallen ~20% from peaks, however, and I still think that the company is fairly valued at best. I lowered my outlook on HP to neutral last quarter amid rising share prices and the risk that current demand strength can fade.

Now, truth be told, I like the stock much better at $29. At these levels, the stock yields 2.6% and trades at a 8.4x P/E ratio based on Wall Street's current-year pro forma EPS expectations of $3.49 (data from Yahoo Finance). However, I find it difficult to see HP rallying substantially from here, as the recent May/June correction factors in a number of very real risks:

• Tougher comps ahead. HP's most recent quarter captures only the comp from the early months of the pandemic, before work-from-home demand settled in. Looking ahead to Q3, there may be some favorable tailwinds on the printing side as offices reopen, but y/y growth rates will almost certainly see a sharp decline.
• Pulled in demand? People don't buy new computer and printer hardware every single year. The strong sales growth that HP has seen over the past year may have come at the expense of late 2021 or 2022 demand. If this is the case, rather than viewing HP as "cheap" versus current FY21 earnings estimates, we have to consider the fact that HP may currently be at the peak of its cycle. For FY22, Wall Street analysts are currently expecting flat revenue growth to FY21 and 2.6% EPS growth - which may be very difficult to achieve after lapping a very strong FY21.
• Supply chain challenges. HP isn't alone in this boat, but a shortage of chips has the company citing supply chain concerns throughout at least the tail end of 2021. Rising component prices has HP and other PC makers raising their prices to pass on the cost to consumers, which may have the compounded effect of slowing demand as WFH tailwind fade.

In short, I remain neutral on HP, but continue to keep a close eye on the stock. I think the risk-reward profile for HP becomes much more compelling if and when the stock hits $24, which represents a 7x multiple against this year's earnings (even a ~20% compression to these levels would only take HP back to where it was trading last December), and would be a buyer at that threshold. Until then, however, I remain on the sidelines.

Q2 download

Let's now discuss some of the highlights from HP's most recent quarter (Q2, ending in April) in greater detail. See below for a recap of how the company's PC division has performed:

Figure 1. HP PC performanceSource: HP Q2 earnings deck

There's no doubt that HP continued to exhibit tremendous strength through Q2. The company generated $10.6 billion in revenue in the PC division, up 27% y/y (25% y/y on a constant currency basis). We do want to re-emphasize the point that Q2 still comps versus the "easier" part of the pandemic when demand was temporarily depressed - beginning in Q3, when work-from-home began to settle in as the norm, HP's overall revenue made an uncharacteristic 15% sequential jump from Q2 to Q3, versus just 4% in the prior year.

Even so, however, the fact that HP generated flat sequential PC revenue versus Q1 (also at $10.6 billion), despite the fact that Q1 contains the usual sales lifts for both Black Friday and Christmas, is impressive. We note that consumer preference toward notebooks (laptops) continues to be more pronounced, with notebook revenue up 47% y/y amid a -8% y/y decline in desktops.

Figure 2. HP printing performance Source: HP Q2 earnings deck

Printing, showcased in the slide above, exhibited similar strength. Q2 printing revenue of $5.3 billion lifted 28% y/y and 6% sequentially. There is one caution to add, however. The underlying mix of this growth is tilted toward hardware devices, with hardware units up 42% y/y and supplies revenue only up 17% y/y. Supplies are the bread-and-butter of HP's steady printing business, and the source of its margin - but printer hardware is an infrequent purchase, and whether Q2 strength is a pull-in of demand driven by the return-to-work situation across the U.S. is still unknown.

Overall revenue of $15.88 billion between the two divisions (+28% y/y) vastly exceeded Wall Street's expectations of $14.96 billion (+21% y/y), while the company also recorded a record-high gross margin of 21.7%, up 120bps y/y driven by favorable pricing.

CFO Marie Myers, however, issued a cautious forward-looking statement during her prepared remarks on the Q2 earnings call. The company expects to continue being gated by constrained components (presumably chips) and to take some hits on commodity pricing:

We expect supply constraints to continue to negatively impact our ability to meet demand in PCs and Printers, at least through the end of calendar 2021. We expect gross margin pressure in the second half of the year in both Personal Systems and Print due to increased costs and commodities and logistics as compared to Q2 levels and as we expect to see some more normalization in the market and pricing environment. We expect operating expenses in the second half of the year to be more similar to Q1 run rate. Finally, we continue to closely monitor the current COVID resurgence and its potential impact to our supply chain, particularly in Southeast Asia."

We note as well that in Q2, HP saw a strong buildup in inventory to $7.5 billion, representing both a sequential and a y/y increase, as well as representing a high 12.5% of revenue. Myers noted that the company has executed "strategic buys" of certain components, particularly CPUs, to get around potential supply chain shortages down the line. We do worry about a buildup in inventory, however, as it tends to have a very short shelf-life in technology, especially if HP has planned its inventory based on current elevated levels of demand that may taper off as we enter Q3 and Q4.

"Figure 3. HP inventory buildupSource: HP Q2 earnings deck

Key takeaways

In my view, sentiment for HP should cool off as we enter the back half of 2021, which may come from a combination of tougher comps as well as a bona fide slowdown as work-from-home tailwinds subside. Continued supply chain woes, a buildup of inventory that may age quickly, and uncertainties around office reopenings are also on the horizon. Remain cautious here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.