Berkshire Hathaway recently announced they now are the proud owner of an 11% stake in PC Maker HP. However, only a small number of people actually understands why the Oracle of Omaha has bought shares in HP. Several articles even state 4 reasons why Warren Buffett’s 11% HP Buy is a bad bet:
- HP’s products lack universal appeal
- Customers do not have an addictive need to buy HP’s products
- HP has no moat
- Buffett lacks superior computer industry insight
Given his track record, Warren Buffet doesn’t buy into a company unless there is deep value to be found. Clearly, Buffet found value in HP Inc. and it would seem the general investment public does not agree. In the article below, I will showcase the bullish scenario for HP and why I am buying shares.
HP Inc. provides personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services in the United States and internationally. The company operates through three segments: Personal Systems, Printing, and Corporate Investments. The Personal Systems segment offers commercial and consumer desktop and notebook personal computers, workstations, thin clients, commercial mobility devices, retail point-of-sale systems, displays and peripherals, software, support, and services. The Printing segment provides consumer and commercial printer hardware, supplies, solutions, and services. The Corporate Investments segment is involved in the HP Labs and business incubation, and investment projects. It serves individual consumers, small- and medium-sized businesses, and large enterprises, including customers in the government, health, and education sectors. The company has been around since their foundation in 1939.
The value in HP Inc. lies in their share buyback program and the mathematics involved in dividing growing earnings on a decreasing number of outstanding shares. At first, we notice several key points that highlight the potential value investing in HP Inc. (HPQ) as per Yahoo Finance:
- With a stock price of $36.78, and given the fact that HPQ has 1.092.205 shares outstanding, this leads towards a marketcap of $38.74B.
- The stock trades at $36.78 (at the time of writing), with a 52-week range of (26.11 – 41.47). HPQ trades at a TTM (forward) PE ratio of 6.61 (8.17) which is significantly below the industry average of 13-15 and below their own historical PE ratio of 9.6. This indicates that HPQ is undervalued relatively to their own price history, the current industry and market averages and the historical industry and market averages.
- HPQ has an annual dividend of $1, which is a dividend yield of 2.72%.
- HPQ is currently implementing a hefty share buyback program and has decreased the shares outstanding from 1,560,000,000 in 2018 towards 1,060,987,000 in Q1 2022, a decrease of nearly 32%.
- HPQ has average free cash flow of $4.382B for the 2018-2021 period, even after buying back on average $1.5B worth of their own shares in the past quarters.
- HPQ has increased their revenues, earnings and margins in the past year and has been profitable. Overall, the fundamentals are rock solid and are worth a buy on their own.
2. SHARE BUYBACKS AND THEIR EFFECT ON EPS
Below is my conservative investment thesis for HP Inc., I have assumed no growth in revenue, earnings and margins in the years towards 2025 as a conservatism and margin of safety are both important investment values. In the past 4 years (2018-2022) HPQ has bought back 500M of their shares for a total value of $14B, or an average of $3.5B and 125M shares per year. In Q1 2022 alone, the company purchase $1.5B of their stock, decreasing the number of shares outstanding by 31M shares. HPQ has a 4 year average earnings of $4.456B, an 2021 earnings even topped at $6.5B. We build our investment theses therefore with 2 possible scenario’s: the conservative $4B in earnings and the recent $6B earnings for the 2022-2025 period. Eventhough analysts expect the Computer Hardware industry to grow with an annual growth rate (CAGR) of 7.6%, we consider no growth in earnings in order to be conservative in our investments. The results are shown below in Table 1. We expect the company to buying back shares at the same rate as shown in history, which amounts to 125M shares annually. We ignore price appreciation of the stock that is bought back because we are conservative in our estimate for the number of shares bought back.
|Year||Shares outstanding||EPS $4B ($6B)||Share price (PE = 8)||Return|
|2022 Q1||1,060M||$3.77 ($5.66)||$30.16 ($45.28)||–|
|2023 Q1||967M||$4.13 ($6.20)||$33.04 ($49.06)||–|
|2024 Q1||842M||$4.75 ($7.12)||$38 ($56.96)||–|
|2025 Q1||717M||$5.57 ($8.36)||$44.56 ($66.88)||21.28% (82%)|
From the table above, we notice that the minimum expected return for HPQ is 21.28% for the 2022-2025 period, an can potentially rise to 82% when the company keeps their earnings at $6B annually. This is considering no earnings growth in an industry that grows nearly 8% per year and from share buybacks alone.
We furthermore notice that the PE ratio for HPQ is considerably below their own historical average (9.6), the industry average (13-15), the market average (21), the historical industry average (17.3) and the historical market aveage (13-15). The PE ratio for HPQ therefore is in the lower range and signals that HPQ is undervalued relative to their own historical price and the industry average. If the PE ratio for HPQ is to increase (i.e. investors are willing to pay more for $1 of profit), the share price is to increase as well. We demonstrate the effect of PE ratio’s on the share price in Table 2 below.
|Source||PE ratio||Share price $4B earnings||Share price $6B earnings||Return|
|Forward HPQ||8||$44.56||$66.88||21.28% (82%)|
|Historical average HPQ||9.6||$53.47||$80.25||45.53% (118%)|
|Industry average||13-15||$72.41||$108||97% (193%)|
|Median industry||14.8||$82.43||$123.72||124.36% (236.74%)|
|10Y industry average||17.3||$96.36||$144.63||162.27% (293%)|
It is perhaps unlikely for HPQ to achieve a PE ratio of 14.8 or even 17.3, but a PE ratio of 10 seems achievable which puts the share price at $55.7 and $83.60, respectively. This would lead to a 50%+ return, or even 125%+ return, in the 3 year period with the most conservative assumptions possible.
3. FURTHER FUNDAMENTAL ANALYSIS
HPQ is furthermore expanding their business and has announced it is acquiring Poly, a company that specializes in video and audio equipment, for a purchase price of $1.7 billion, with a total transaction value of $3.3 billion, including debt. The deal is expected to close by the end of 2022, signalling that HP goes deeper in hybrid work and is expanding their business to adapt to changing market conditions.
We furthermore notice that insiders have been heavily buying shares into the company. In the past 6 months, insiders have been buying 12M shares while only selling 350K shares. From further inspection of the 2022 Annual Statement, we notice that management incentives are in line with the incentives of the shareholders through various short term and long term performance incentive plans. Management therefore has further incentive to increase the share price and personally benefit from an increasing share price.
HPQ has paid a dividend for nearly 20 years and have increased their dividends in the past couple of years. In the 2018-2022 period, the company has paid dividends of $900M each year. If we divide this $900M by our 2025 outstanding shares of 717M, we notice that the dividend per share increases from $1 in 2022 to $1.25 per share in 2025, or a 25% increase.
4. CONCLUSION AND THE STORY
Ever since I read the book ‘One up on Wallstreet‘ by legendary investor Peter Lynch, I have taken the Lynch approach in investing which basically comes down to the following: for every investment that you make, you should be able to clearly specify the investment analysis in 10-15 sentences (the story) to yourself or another individual. So, here is our story for HP Inc.:
HP Inc. provides personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services in the United States and internationally. HP Inc. is profitable and has high free cash flows that the company uses to pay a 2.73% dividend and buying back their shares from the market. HP has been able to increase their revenues, earnings and margins for the past years, has a solid balance sheet and low valuation. Due to our calculations, we found that the stock price is likely to increase by 21% from buybacks alone, assuming the company has earnings of $4B (which is even below their 5 year average). HP is undervalued compared to their own price history and their industry average. If the current forward PE ratio of 8 is to increase to the companies historical average PE ratio of 9.6, the share price is expected to increase by 45.53% due to buybacks alone.
If on the other hand, the company is able to maintain their earnings of $6B in the coming years and the company is able to buy back 150M of their shares instead of 100M each year, the EPS can even increase to $10.90, which at a PE ratio of 9.6 leads to a $100+ share price, or a 184% return in 3 years. In the current turbulent and volatile market, HP Inc. seems like a great value buy and the perfect assymetric risk/reward investment. At the current share price of $36.74, I can only agree with Buffet and buy some shares myself.
Eurykleia Investments is not a registered investment, legal or tax advisor or a broker/dealer. All investment/ financial opinions expressed by Eurykleia Investments are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that the all information is accurate and up to date, occassionally unintended error and misprints may occur.
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