HP Stock: A Free Cash Flow Machine (NYSE: HPQ)

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Investment thesis

HP Inc. (HPQ) is trading at a steep discount to the projected share price of $40.13. This represents an upside potential of around 15% from current levels. My bullish outlook on HP shares stems from the strong growth we’ve seen in the company’s personal systems segment and the potential for its printing business to continue its post-pandemic rebound. Management plans to buy back $4 billion of shares in 2022, or 10.80% of the company’s current market cap, which will provide valuation support. The shares are currently cheap, trading at 8.68x forward earnings and 6.4x TTM earnings. I expect its multiple to rise as investors appreciate the ~$4 billion in free cash flow in 2021 and the outlook for $4.5 billion in free cash flow in 2022. The company returns 2.84% , providing technology investors with cash flow in our current uncertain macro environment. Overall, I think investors should view HP as a growing, profitable, and cash flow-generating tech stock that has about 15% headroom.

Company overview

HP operates in two segments: personal systems and printing. In the personal systems segment, HP sells personal computers, desktops, workstations, software and other tangible workspace applications. This segment represents the majority of HP’s business, contributing 68% of total revenue in 2021. HP offers printers, related supplies, services and other solutions for commercial businesses and consumers in its other segment , the impression. The company’s printing segment contributed the remaining 32% of revenue in 2021.

Financial performance

HP delivered strong operating results in 2021, with revenue up 12% from $56.6 billion in 2020 to $63.5 billion. On a quarterly basis, revenue rose 9% to $16.68 billion, beating consensus estimates of $1.25 billion. In terms of EPS, the company reported $0.94, beating the consensus of $0.06. This is not a new phenomenon for HP, as the company has exceeded consensus earnings expectations by 8/8 quarters over the past two years.

Surprise EPS (% base)

Surprise EPS (Base %) (Seeking Alpha) ()

I think analysts are under-expecting HP’s results as the company continues to over-deliver consensus EPS estimates.

HP continued to show resilience in its profit margins as the company improved its gross profit margin, net profit margin and kept its free cash flow performance relatively stable.

Graphic
Data by YCharts

Of these operating metrics, I am most impressed with the company’s ability to maintain a strong free cash flow yield of 13.52%. Shareholders should be optimistic about management’s plans with all that cash, as the company plans to buy back an additional $4 billion in stock in 2022. That would leave an additional $2.4 billion in the company’s buyback program. company, supporting buyouts in 2023 and beyond.

Graphic
Data by YCharts

As you can see, management is not afraid to buy back its shares at current levels and I expect this trend to continue in the years to come.

Management should also continue to pay shareholders in the form of dividends. HP has a forward yield of 2.84%, a 5-year dividend growth rate of 10.50% and has increased its dividend over the past 11 years.

HP dividend level

HP Dividend Grade (looking for Alpha)

Seeking Alpha rates both dividend consistency and HP’s yield at an A, which is impressive for a growing tech company.

Improving income composition

As the pandemic shifted consumer trends away from printing in physical form, HP was quick to change strategy. The company began to focus on its personal systems segment and improved its revenue mix.

HP Income Mix

Produced by the author using the 10-K SEC report

HP was able to grow its personal systems revenue, comprised primarily of laptops, desktops, and workstations, by 11% in 2021. Revenue in this segment grew 34%, which shows that the company has translated this growth opportunity to its lowest point. line. Total printing revenue increased 14% year-on-year, with profits jumping 46%. Although revenues have increased from a weak 2020 mix for the enterprise print segment, I am still encouraged by the return of demand as we enter the new hybrid work environment. I expect this transition to continue as businesses continue to return to the office.

Evaluation

My assessment based on the DCF depends on my optimistic revenue assumptions for HP in the future. They can be found below.

HP Inc Revenue Forecast

HP Inc revenue forecasts (made by the author using his own forecasts)

I expect revenue to grow at a CAGR of 3.19% over the next five years based on continued demand for HP’s personal laptops (as we move into a hybrid work environment) and the continued resumption of corporate printing activity (as return-to-office plans materialize).

In my model, I assume historical margins remain constant, a WACC of 6.61% and an exit multiple on Year 5 EBITDA of 4.7x (in which I arrive at my TV after a discount of $35.95 billion). The rest of my EBITDA and free cash flow assumptions can be found in the model below.

DCF model from HP Inc.

HP Inc DCF model (made by author using own assumptions)

After adding the projected cash flows and the terminal value, I arrive at a fair enterprise value of $46.55 billion. After subtracting net debt, my projected HP net fair value is $42.04 billion. Assuming management continues with its aggressive share buyback plan in 2022, I believe shares outstanding will decrease to 1.047B from the ~1.2B shares currently outstanding. My assumption that approximately 150 million shares will be repurchased over the next five years is conservative, given that 224 million shares were repurchased in 2021 alone and the company has committed $4 billion to buybacks shares in 2022.

My end result is a stock fair value of $40.16, 15% above where the stock is currently trading.

Balance sheet analysis

In terms of HP’s track record, there are both positives and negatives to point out.

Important figures of the HPQ balance sheet

Important figures from the HPQ balance sheet (graph created by the author using Seeking Alpha Financials)

The biggest highlight on the balance sheet is the 33% year-over-year increase in inventory. This inventory is expected to convert into revenue and help drive top-line growth as demand continues to accelerate in 2022. It also shows that the company is managing supply chain issues well, having the ability to stock such high stocks in a context of persistent constraints. Cash has decreased by 12% and the company still has more current liabilities than assets (with a current ratio of 0.76). I’m not worried about HP’s liquidity though, given the free cash flow the company generates each quarter. Total debt has increased by 19%, but the vast majority ($6.40 billion) is long-term and non-current. HP should have no problem paying this back in the future, as the company’s free cash flow metrics can be used to support the amount of leverage the company has taken. For example, if the company used all of its $4.5 billion in free cash flow it expects to generate in 2022 to pay down its debt, it could reduce it by more than 50%. Instead, the company opts to support shareholders in the form of dividend payouts and share buybacks.

Valuation risks

The main risk to my valuation is worsening supply constraints in the second half of this year and in the first half of 2023. While HP has managed to manage constraints well, any major developments on persistent constraints could adversely affect the company’s ability to maintain inventory levels which translates into slower revenue. Another risk is a complete abandonment of physical printing, which would hurt HP’s revenue. Although I do not foresee these events occurring, I believe it is important for investors to be aware.

Competitors

Below is a chart of HP’s peers along with their ratings from Seeking Alpha.

HP Inc Peers / Ratings

HP Inc Peers / Ratings (Seeking Alpha)

HP is one of two companies with a “Strong Buy” thanks to Seeking Alpha’s quantitative score, which beats the market. I’m also impressed with HP’s strong revenue growth relative to its alternatives over the past three years, which should support its valuation going forward.

Graphic
Data by YCharts

As you can see, HP was able to increase its revenue by 8.05% since pre-pandemic, which is higher than all of its competitors.

HP is also trading at the cheapest valuation compared to its peers, as shown below.

Graphic
Data by YCharts

HP is currently trading at 6.4x TTM earnings, cheap for its industry and compared and compared to its peers.

Final Thoughts

I can cite many reasons why HP stocks are worth looking into. Whether it’s aggressive stock buybacks, returning cash to shareholders in the form of dividends, strong Y/Y revenue growth, $4.5 billion in expected cash flow generation in 2022 or a cheap multiple, there are plenty of reasons to be interested in current levels. I think the stock is undervalued by about 15% based on my DCF model and has a fair price of $40.16 on the stock. I assign “Strong Buy” to stocks at current levels and recommend investors take a look at this tech stock given that it is in high value territory.

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