Investment summary

My previous investment thought on HP Inc. (NYSE:HPQ) (published in March) was a hold rating because the valuation and demand outlook were not attractive. I remain on the sidelines for HPQ as the earnings outlook remains uncertain, despite the strength seen in the commercial PC segment, given the uncertain macro backdrop, non-existence of a growth catalyst and competitive pressure on margins in the print segment, and an elevated inventory level.

3Q24 results update

Released on 28^th August, HPQ 3Q24 revenue was $13.5 billion, with Personal Systems [PS] revenue of $9.4 billion and Print revenue of $4.1 billion. While revenue came in slightly above consensus estimates, EBIT margin was 8.1%, which underperformed expectations by 50 bps as weak performance in the Print segment dragged down performance. As a result, EPS also missed consensus estimates by coming in at $0.83 vs. $0.86.

Recovery in Personal System is positive, but not all is good

The acceleration in growth seen in the PS segment was in line with my previous view that HPQ will benefit from the PC replacement cycle. However, the strength behind the recovery was quite disappointing. The 5% y/y growth was mainly driven by the Commercial PC segment, which saw unit shipment growth of 6% and revenue growth of 8%, a big difference from the Consumer PC segment, which saw unit shipment decline of 6% and revenue decline of 1%. My view is that the replacement cycle in the commercial space will continue as growth was seen across the board, with government growing 6% to 7%, enterprise growing ~5%, SMB growing 3%, and education growing 1%, indicating a broad-based recovery trend. Moreover, in the commercial space, the tailwind from the ending of support for Windows 10 is more prominent given that it impacts cybersecurity.

The problem lies in the consumer segment, which I am very negative about. Firstly, unlike the commercial segment that pays more attention to Windows support and the “age” of the PC, consumers are likely to be more willing to continue using the PC for a longer time. Secondly, the discretionary spending environment is not in favor of HPQ as consumers remain wary about the macro climate. I wrote about my macro views in this Kohl’s Corp. (KSS) post. Thirdly, I am not sure if the demand for AI PC is going to be as strong as I thought it would be, given the poor adoption of Window’s Copilot.

Based on how the macro environment is today, I am not confident that this will be the case. It is apparent that consumers are still cautious in their spending, preferring value buys, which has benefited many value retailers (e.g.., Target, Walmart, and others). The consumer confidence index also provides little grounds to believe discretionary spending will pick up. Per management’s own words, they are also seeing their customers showing more discretion during the quarter. Lastly, with interest rates still at elevated levels vs. recent history, consumers continue to feel the pain from it (per KPMG report). Therefore, my take is that consumers will continue to: (1) trade down to more value purchases, and (2) pull back on discretionary spending

All these negative points led me to believe that consumer PC shipments will remain weak for the foreseeable future, and this may drag down the growth strength of the PS segment.

Print segment remains under pressure

As for the print segment, it remains under pressure—revenue is now down for the 11^th consecutive quarter. In the quarter, HPQ continues to see weakness in demand and a negative geographic mix as it shifts away from China. Given no change to the structural headwind of less print demand (i.e., there is no strong case to support businesses using more paper/print) and also a continuous declining supply revenue trend that indicates lower utilization, I expect this segment to continue reporting revenue decline.

The bigger problem that surfaced in 3Q24 is that margin has fallen sharply to 17.3%, marking the lowest point over the past 11 quarters, mainly driven by the continued competitive pricing pressure due to ongoing weakness in the Japanese Yen. Assuming that the Japanese Yen continues to stay weak vs. the USD and that revenue growth continues to decline given the demand headwinds, I am inclined to think that EBIT margin will continue to face pressure in the near term.

What could help HPQ elevate this margin pressure is the strong execution in driving down its cost structure. To recap, the target is to achieve $1.6 billion in total cost savings by FY25 through portfolio simplification, digital transformation, and automation. So far, HPQ is on track to realize a cumulative 80% of its total cost savings goal by FY24, faster than the previous guide of 70%, indicating solid execution.

I will give management the compliment in this aspect, and this may help it to achieve the high end of its long-term margin target range for the Print segment (16 to 19%), but I don’t see this as a sustainable way to protect margins because there is only so much cost that HPQ can cut. So long as demand doesn’t recover (i.e., headwind persists), the pressure on the print segment earnings will always be there, and with fixed costs associated with the business (i.e., manufacturing facilities and related labor, the back office team, the customer service team, etc.), margins will start to decline at some point.

Balance sheet pointing to potential margin pressure

An emerging concern I have with HPQ is the growing inventory level on the balance sheet, reaching ~$7.8 billion in 3Q24, the highest ever over the past 2 years, and inventory days remaining at an all-time high. Management’s reason is that they are conducting strategic component pre-purchases and are preparing for higher product volumes in 4Q24. With my overall negative demand outlook for the business (except the commercial PC segment), my fear is that this may cause margin pressure as HPQ is forced to reduce selling price to sell these inventories.

Valuation

I choose to remain on the sidelines for HPQ, as I don’t think the growth tailwinds in the commercial PC segment are able to overcome all the other negative headwinds that I am seeing. More importantly, the market has rerated HPQ’s forward PE multiple up to 9.5x (from the ~8.5x in March), now above its past 5 years trading range (7.5x to 9.4x). I am not a fan of this optimism that the market has incorporated into the valuation, given my demand outlook. If things play as I expected, where revenue declines and margin continues to fall, I think a plausible outcome is valuation multiples trade down from the current 9.5x to 8.5x easily.

Conclusion

My view for HPQ is a hold rating. The ongoing weakness in the print segment, coupled with the potential for margin pressures (driven by the elevated inventory position) and a challenging macroeconomic backdrop, makes me believe that near-term earnings outlook will remain pressured. While HPQ has seen strength in the commercial PC segment, I don’t think this will be enough.