HP Inc (HPQ): Safe Dividend Growth or a Value Trap?

Back in 1939, long before Steve Jobs, there were two guys in Palo Alto, Bill Hewlett and David Packard.  Armed with less than $600, they started a small electronics testing company.

 

Over the next 70+ years, Hewlett-Packard grew into one of the world’s largest technology firms with over $100 billion in annual sales.

 

Last November, the current HP Inc. was created as one of two successors of Hewlett-Packard (the other half is HP Enterprises).

 

The idea was to take the mature HP Inc. operations and create a cash-generating, dividend-paying machine with leaner operations.

 

For income investors, HP has been a reliable dividend-paying stock for over 25 years and increased its payout for 6 consecutive years.

 

Furthermore, the stock offers an above-average 3.2% dividend yield and has seen its dividend compound by 9.4% per year over the last decade.

 

Higher-yielding dividend stocks usually do not record this strong of dividend growth, but HPQ could be an exception if things go right. Many of the most important financial ratios I analyze (see them all here) also look encouraging.

 

Furthermore, HPQ’s stock trades at a rather modest 9x estimated earnings. Let’s take a closer look at the company and whether or not it offers safe, growing dividend income or could be a value trap as the world of technology evolves.

 

Business Description

Hewlett-Packard was founded 77 years ago. In November of last year, the mother ship was split in two based on end user markets: HP Enterprise and HP Inc.

 

Hewlett-Packard’s $103 billion in revenue was split almost equally between the two businesses.

 

HP Enterprise trades under the ticker symbol HPE and provides a mix of IT infrastructure such as servers, storage, and other data center systems to corporations. Its offerings also include software, consulting, security, and financial services.

 

HP Inc., which trades under the ticker symbol HPQ and is analyzed in this article, consists of the company’s personal computer (PC) and printer businesses.

 

PCs and other personal systems account for roughly 63% of sales and close to 30% of operating profit. The segment generates 3-4% operating margins.

 

The printer business accounts for the remaining 37% of revenue and roughly 70% of operating profit. The segment generates 18-20% operating margins.

 

HP’s total revenue breaks down as follows: notebooks 36%, print supplies 24%, desktops 21%, printer hardware 13%, workstations and other personal systems 6%.

 

By geography, roughly 49% of revenue is from the Americas with another 32% from EMEA and 19% from Asia.

 

HP products get to market in two ways. A vast network of channel partners provides service to most commercial customers.  In addition, sales are made directly to big box store accounts like Best Buy, Staples, and Office Depot.

 

Business Analysis

Over the course of many decades, HP has built up number one or two market share positions in all of its core markets, which total over $400 billion in size.

 

Replicating the company’s broad lineup of products, intellectual property, and distribution network for more than 250,000 channel partners would be extremely costly.

 

However, HP products still live in an intensively competitive world. Technology rapidly changes, product lifecycles are short, and commodity-type profitability is the norm as differentiation is difficult.

 

The company’s massive distribution network serves as an advantage, but the global PC market is in a mature, declining phase.

 

Desktops transitioned to laptops and are not morphing into ever-smaller, more mobile devices.

 

International Data Corp (IDC) reports global shipments continue to slip, including a 4.5% drop during the second quarter of 2016.

 

HP’s leading share in the U.S. market is constantly being challenged by archrival Dell and a number of low-cost foreign competitors as well.

 

HP’s strategy is to redesign and reposition PC products at higher price levels to compete with hip and slick laptops like the MacBook.

 

However, profits are still difficult to come by even despite HP’s status as a market leader. As previously mentioned, HP’s PC segment earns 3-4% profit margins.

 

Mature market conditions are present in other HPQ product groups as well. Just take a look at the steady decline in the Printing segment’s revenue below.

 

The segment is still a cash cow thanks to its high-margin ink cartridges, but the sales trend is concerning. Management is trying to move into the $55 billion copier market, but the economics of this industry are also challenging.

 

Source: HP Investor Presentation

 

Decaying revenue trends has pushed management to cut costs aggressively.

 

In connection with the separation of Hewlett-Packard into two companies in late 2015, HP’s board announced a major restructuring plan calling for the elimination of more than 30,000 jobs.

 

For now, HP’s leading market positions and mature operations will continue generating excellent free cash flow.

 

However, the company will eventually need to figure out how to restore profitable growth across the enterprise.

 

Key Risks

There are risks that face management of every company, and HPQ is no exception.

 

Any given quarter can be impacted by volatile spending trends from consumers and businesses alike. While this doesn’t impact HP’s long-term earnings power, the company’s stock can swing around over short periods of time depending on the trend.

 

Looking longer term, notebooks (36% of sales) and desktops (21%) account for over half of HPQ’s total revenue.

 

While these are very large markets, they are coming under pressure from the continued rise in mobile devices and the digitalization of information.

 

PC’s and printers are technology dinosaurs, and HPQ could struggle to unlock profitable growth over the next five years.

 

An unexpected shift in market share could also result in negative profitability in the PC segment. Technology is constantly evolving, and no single company has the field cornered. It’s a tough industry to be in.

 

High profit margins on printers, especially disposables like ink cartilages, attract competition as well.

 

With no signs of growth in its core markets, HP’s management team is looking into adjacent markets for opportunities to expand the companies reach.

 

The company has its eyes on 3D printers, large copiers, gaming systems, and high-end laptops in hopes of discovering profitable growth, but the answer is likely years away.

 

Essentially, HP’s slowly shrinking and highly competitive core markets are pressuring the company to preserve cash flow and find its next growth driver.

 

There is a lot of uncertainty facing HP’s long-term outlook, and management’s capital allocation decisions over the next five years will define the business for better or worse.

 

I imagine HP will make for an interesting case study in 10-20 years, and I generally do not like to invest in companies that must significantly evolve their operations to remain relevant.

 

Dividend Safety Analysis: HP Inc.

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Hewlett Packard’s dividend and fundamental data charts can all be seen by clicking here.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Hewlett Packard’s Dividend Safety Score is 65, which indicates that its current dividend payment is somewhat safer than average and unlikely to be cut anytime soon.

 

One reason is the company’s low payout ratio of just 27% of earnings per share and 22% of free cash flow over the last 12 months.

 

The company plans to return 50-75% of free cash flow to shareholders and has plenty of room to continue paying and moderately growing its dividend.

 

 

The company’s performance during the last recession also provides clues about its dividend safety.

 

During the financial crisis, HPQ revenues fell by 3% while the company maintained its dividend. HPQ’s common stock also returned -28% in 2008, outperforming the S&P 500 by 9%.

 

However, this may not be a good indicator of HPQ’s sensitivity to economic twists and turns since these results were recorded prior to the breakup of the company in 2015.

 

 

In addition to recession performance, free cash flow generation is a major factor impacting a company’s ability to pay sustainable dividends.

 

Fortunately, HP has been a cash cow. The company has already generated over $2 billion in free cash flow through the first nine months of 2016. Its business does not require substantial capital to operate, and HP’s economies of scale crank out cash.

 

 

Another pleasant discovery is found in HPQ’s balance sheet. The company holds $5.6 billion in cash compared to total debt of $6.8 billion.

 

HP’s cash balance alone could cover the current dividend payment for nearly seven years and provides management with plenty of flexibility.

 

 

Overall, HP’s dividend is very safe today. The company’s low payout ratios, excellent free cash flow generation, and sturdy balance sheet all provide nice support.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios.  Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

HP’s Dividend Growth Score of 63 suggests that the company has decent dividend growth potential.

 

The company has increased its dividend for 6 consecutive years and paid uninterrupted dividends for over 25 years.

 

As seen below, HPQ has delivered excellent dividend growth over the years. The company has raised its dividend by 9.4% per year over the last decade and 15.0% annually over the last three years.

 

 

Management is challenged with the tasks of maintaining HP’s brand leadership, supporting the company’s distribution network, and maximizing cash flow in mature markets.

 

Revenues in each of the five major business segments have experienced negative growth over the past three years.  Adverse currency translations have further crimped reported growth. The focus going forward is all about controlling costs and managing assets.

 

Rightsizing the company is a major HP project over the next few years and could impact future dividend growth.

 

However, with reasonably healthy payout ratios and solid free cash flow generation, I believe HPQ is positioned to continue rewarding shareholders with moderate dividend growth.

 

Management last raised the dividend by 8% in February 2016, and low-to mid-single digit annual growth will likely continue.

 

Valuation

Shares of HP Inc. trade at a forward-looking price-to-earnings (P/E) multiple of 9.3 and offer an above average dividend yield of 3.2%.

 

A low P/E multiple is often a sign that investors expect a company’s profits to contract or at least fail to grow. In HP’s case, this seems to be valid concern.

 

I am uncomfortable forecasting a long-term earnings growth rate for the business because of the many uncertainties it faces.

 

In my view, an investment in HP really comes down to whether or not an investor believes HPQ can stabilize its current business and find a way to return to growth in the next couple of years.

 

HPQ could turn out to be an excellent investment if management unlocks the next profitable growth driver for the company, but I think the odds are stacked against them.

 

The market seems to agree considering HPQ’s P/E multiple.

 

Conclusion

For investors seeking safe current income with moderate growth, HPQ looks like a reasonable bet at first glance.

 

The company’s current double-digit dividend growth days are not likely to last forever, but payout raises have plenty of support to continue at a pace well in excess of the rate of inflation. This is supported by HP’s low payout ratios, excellent free cash flow generation, and solid balance sheet.

 

However, an investment in HPQ is not without risks. The stock’s low P/E multiple could very well be cheap for a reason.

 

The company is driven by trends in several mature and highly competitive markets. Should market conditions begin to deteriorate more quickly as technology trends evolve, HPQ’s profitability could contract.

 

HP Inc. is presumably now better positioned to compete as a freestanding corporation, but technology hardware is a risky industry to participate in.

 

Investors considering a stake in HPQ will need to keep an eye out for developments impacting the PC and printer markets, which are cash cows today but might not be around forever.

 

Until HP has found its next growth driver, my preference is to avoid the company. The road to profitable growth could prove to be long and very costly for HP and its shareholders.

 

For now, I prefer to stick with some of my favorite blue-chip dividend stocks here.