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Shares of Hewlett-Packard (NYSE:HPQ) have really come to life in a post-pandemic move. Shares were stagnant at around the $20 mark for quite a while; shares were initially hit hard by the pandemic, but as shares rallied in a convincing way in 2021, they hit the $40 mark, before now settling at $35.
HP was doing quite alright in the aftermath of the pandemic as a $2 per share earnings run rate has accelerated to roughly $4 per share, in part because excess earnings were used for an aggressive buyback program. This is to be applauded, yet I have real concerns about the longevity of the current earnings momentum, as there are real risks to the 2022 guidance amidst multiple concerns on various fronts, leaving me a bit cautious here, despite a very non-demanding multiple at which shares currently change hands.
Where Do We Come From?
HP has a fiscal year which ends in October, which makes that the 2020 results include roughly half a calendar year of pandemic impact. Revenues fell by some $2 billion that year to $56.6 billion, as net earnings fell to $2.8 billion with earnings reported around the $2 per share mark, amidst aggressive buybacks. This came amidst a strong balance sheet as HP has taken on just a very modest net debt position at the time.
The delayed impact of the pandemic was seen in the fiscal 2021 results as both segments of the business, printers and personal computers, benefited from the pandemic with workers working more from home, and more discretionary consumer dollars being earmarked for such goods.
The company grew revenues by 12% to $63.5 billion as operating margins grew aggressively, up 230 basis points to 8.4% of sales. This resulted in an earnings explosion with adjusted earnings improving from $2.28 per share to $3.79 per share, as that number looks relatively clean (albeit that some recurring restructuring costs are incurred). GAAP earnings actually came in higher than that following litigation proceeds from Oracle (ORCL).
Aggressive buybacks, to the tune of $6.2 billion in the past fiscal year, resulted in an aggressively shrinking share base, but made that the very strong balance sheet shows $3.2 billion in net debt by the end of 2021, after a very strong year. There is no need to worry as operational EBITDA comfortably surpasses this number, so leverage concerns are far from an issue.
Zooming Into The Business
The largest business of HP Is what it calls Personal Systems, responsible for two thirds of total revenues of $43 billion per annum. Notebooks are the largest segment within this business, posting 18% growth in 2021 to more than $30 billion. This is complemented by a $9 billion desktop business and smaller workstation and other business. With $3.1 billion in EBIT, before corporate cost allocation, operating margins are quite low at around 7%.
Printing revenues rose 14% to more than $20 billion. Revenues are organized under a more than $12 billion supplies business, complemented by a larger consumer and commercial business. With $3.6 billion in actual segment earnings, the business is more profitable in actual dollar terms than the personal system business, despite being twice as small in terms of revenues. This clearly reveals very strong margins by these activities.
Comforting is that the company sees momentum continuing in 2022 with non-GAAP earnings seen at a midpoint of $4.17 per share, plus or minus ten cents.
Trends Solidify
After the company posted solid first quarter results in February, the company updated the full year guidance, now seeing adjusted earnings at a midpoint of $4.28 per share, but continued buybacks made that net debt inched up to $3.6 billion. With 1.1 billion shares trading at $35, equity is valued at $38.5 billion, for a $42 billion enterprise valuation. This results in non-demanding sales multiples (at far less than 1 times) and with EBITDA rapidly approaching the $6 billion mark, overall valuations remains non-demanding.
Confidence is clearly rising, amidst aggressive buybacks but other forms of capital deployment as well. Towards the end of March, HP announced the purchase of workforce collaboration provider Poly (POLY) in an all-cash deal valued at $40 per share, or $3.3 billion in actual dollar terms. Being equal to 8% of HPs enterprise value, the deal is significant, more than a bolt-on deal, but at the same time not a game changer either.
The deal is set to back up a bet on the continued rise of hybrid work, even after the pandemic. After all, many millions of workers are active from their home, where they do not have full meeting room solutions, including video calls. Poly's strength in video conferencing solutions, cameras, headsets, voice and software will be combined with HP's line up as management has high hopes, believing it can deliver on $500 million in revenue synergies through the mid 20s.
This should accelerate Poly's growth in the near term as operating margins are targeted to rise by six points in 2025. Pro forma net debt will jump to $7 billion, yet with EBITDA of the core business trending at $6 billion already, all this still seems very manageable.
Poly will add $1.7 billion in sales, so the 2 times revenue multiple applied to the business in terms of sales marks a big premium from HP's own valuation. With Poly's non-GAAP operating margins currently trending around 10%, such margin gains are needed to grow the margins to acceptable levels to justify the purchase price. Investors think that HP has some to prove as well as a $1 move lower in the share price boils down to roughly a billion in value going up into smoke on the back of roughly half a billion dollar premium being paid for Poly, as much of its enterprise value comes in the form of net debt.
Concluding Remark
Truth be told is that valuations are dirt cheap at 8 times forward earnings, albeit that it must be said that earnings have moved higher in recent times. Leverage is inching up rapidly, after the company has operated with a nearly flattish net cash position in recent times, but the increase in net debt is still very manageable.
The concern of course relates to the outlook after 2021 and 2022 are set to be very strong years, with inflationary concerns, slower economic growth, inflationary pressure and supply chain issues causing real concerns to the outlook for the business.
While it is realistic that the earnings guidance could come under pressure, valuations remains very reasonable as the market has been skeptical about HP for a whole of course. Nonetheless, the current earnings yield remains very compelling as HP has proven the skeptics wrong for quite a while as well.
That said, I think that concerns to the 2022 outlook are on the rise as the Poly deal comes with a few question marks, and hence I am not willing to commit just yet here at $35. I am looking for a retest of the $30 mark or high-twenties before potentially getting involved (again).
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