HP Inc (NYSE: HPQ) on the surface looks cheap – the stock trades on a trailing P/E of 8.4x and has a relatively clean balance sheet. However, we would caution those that rush to make a case for HPQ as a value investment. A deeper analysis reveals that even with a seemingly low price-to-earnings ratio, HPQ is not cheap. Rather, for a business facing a number of structural headwinds and increasing competition, the cash flows of the business are unlikely to be sufficient to support the current market valuation.
HPQ has two reported segments, Personal Systems, and Printing. Personal Systems comprises the sale of primarily notebook and desktop computers, and it is a segment that has been experiencing structural pressures. Global PC unit shipments have been materially declining for some years now, with a stabilization not forecasted by PC market analysts until 2018.
The headwinds faced by the PC market include: (i) competition from mobile phones and tablets; (ii) a free Windows 10 upgrade program which is thought to have prolonged the PC replacement cycle; and (iii) economic weakness in some regions, particularly Latin America. HPQ has not been immune to the general PC market decline, with Personal Systems revenue declining by over 8% in FY15.
However, an estimated 80-100% of HPQ’s consolidated earnings are derived from printing supplies, given the thin margin earned on computer sales, as well as the estimated loss taken on printing hardware. Printing hardware follows a “razor-razor blade” model – that is, sell the consumer a cheap razor and then charge high prices for the replacement razor blades. In the case of printers, the “razor blade” is ink and the prices charged for ink cartridges are simply astronomical.
Take for example a 10mL HP 27 black ink cartridge, which sells for approximately $30. The cost of that 10mL of ink is the equivalent of paying $3,000/L (don’t even ask how much color ink costs!). As a comparison, a 100mL bottle of Chanel No. 5 perfume sells for $234, equating to $2,340/L. Printers are typically sold at prices so low that the manufacturers will make a loss on the sale. The premise of this is that the manufacturer will successfully recuperate that loss through the high margin printer ink supplies the consumer must purchase. As the installed base of that manufacturer’s printers grows, the ink supplies revenue should grow commensurately.
Printer manufacturers must estimate the value of aftermarket ink supplies they expect consumers to purchase from them, given that this will determine how much of a loss the manufacturer can take on the hardware sale whilst ensuring that the overall sale is still value-accretive. Interestingly, this stream of aftermarket supplies is not guaranteed. In fact, the ability for manufacturers to reliably predict the value of that aftermarket supplies stream is being challenged by:
- structural changes in end-markets that result in less pages printed – particularly the electronic substitution of photographs in the consumer market due to the increasing take-up of smartphones and tablets to consume content; and
- third parties “remanufacturing” used ink cartridges (i.e., refilling the cartridges with ink and selling them back to the consumer for prices far lower than the prices charged by HP). There is an omnipresent risk of remanufactured supplies cutting short this valuable aftermarket tail of supplies.
Despite a recent improvement in the trajectory of printing hardware unit sales growth in 3Q16, total printing unit sales growth has still been significantly negative for the past 9 quarters, and this attrition of the installed base is beginning to have a deleterious effect on printing supplies revenue streams.
In HPQ’s recently reported 3Q16 earnings result, there was a marked acceleration in the printing supplies revenue decline, falling by -17.8% YoY compared to a -15.9% YoY decline in 2Q16.
We see further risks to printing supplies revenues in light of a recently announced overhaul of HPQ’s supplies pricing architecture, whereby the Company will shift from a promotional approach to an Everyday Low Prices (EDLP) strategy. HPQ’s management team noted customers having more choice as to where they shop, with increased transparency of inconsistent pricing, as a reason why promotional strategies for printing supplies were having less of an impact.
In conjunction with the announcement of the major changes to HPQ’s pricing of printing supplies, HP management also announced that they had sold a marketing optimization business and had earmarked a roughly $290m gain on sale to be recognized over subsequent quarters. Remarkably, management framed this gain on sale as being “reinvested” into the Printing business to reduce supplies channel inventory and to increase marketing spend (how one reinvests a non-cash gain on sale back into a business has left the Montaka team scratching their heads). “Reinvested” in our view was being used as a euphemism for lowering printing supplies pricing to clear excess inventory, a surprising move given that management had reiterated their comfort around supplies channel inventory levels a mere month prior on their second quarter earnings call.
This gain on sale is being used opportunistically by management. Unlike most companies that exclude one-off asset sale gains from their adjusted earnings, HP has oddly included this gain on sale in their non-GAAP earnings. This is crucial, as the gain on sale is being used to help offset the $450m decline in supplies revenue that is estimated to result from the shift to the new pricing model; this takes pressure off management to downwardly revise their adjusted earnings.
We view this change in pricing as a move that reeks of desperation, with management throwing a Hail Mary pass in an attempt to stem the continued decline of HPQ’s earnings growth driver – the supplies business. A failure of this strategy to gain traction, whether it be through a greater-than-anticipated competitive response elicited from competitors or otherwise, could have an outsized impact on HPQ’s consolidated earnings and cash flows, given the significant contribution from the printing supplies business.
Montaka is short the shares of HP Inc.
N.b.: For those wondering whether printer ink is the most expensive liquid in the world, it is in fact not. The most expensive liquid is thought to be scorpion venom, for which you would have to pay a whopping $10 million per litre.
George Hadjia is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.