HP Inc.

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

HP Inc. is a global technology company that provides personal computing devices, print-related products, and services.

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The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

HP’s moat is rated a 2 out of 5. The primary sources of competitive advantage, namely brand recognition and customer lock-in through its printer ecosystem, are under sustained pressure due to technological shifts and commodification of hardware.

Moat Justification:

  • Brand Recognition (Limited Moat): HP has a strong brand, built on decades of history. However, this brand recognition does not translate into significant pricing power in the PC market, which is highly competitive and price sensitive. While there’s some level of brand loyalty, customers are increasingly influenced by price and specific features. In printing, HP benefits from brand recognition, particularly in the consumer market, but it cannot command significant premiums as competitors such as Canon, Epson and Brother have created considerable competition.

  • Customer Lock-in in Printing (Narrow Moat): HP’s primary moat comes from its printing ecosystem: once customers invest in an HP printer, they tend to continue purchasing HP ink cartridges or refills, and software. However, customers are increasingly shifting towards wireless printing, and cheaper compatible alternatives from third parties, thus impacting the recurring income stream for supplies. This also reduces the brand-related switching costs.

  • Lack of Network Effects and Cost Advantages: The company doesn’t benefit significantly from network effects. Furthermore, cost advantages, while present to some extent, are being constantly challenged due to intense global competition. HP’s production is often outsourced, and thus, it does not have the same control over costs.

Legitimate Risks to the Moat and Business Resilience:

  • Technological Disruption: The rapid changes in technology, like the shift to cloud printing, the growth of mobile devices, and the increasing popularity of digital documents, pose a significant threat to HP’s traditional business model. If the company can’t adapt quickly to new technology trends, its market share and profitability can be severely impacted.
  • Intense Competition: The PC market is fiercely competitive with razor-thin margins and is dominated by competitors like Lenovo and Dell that can often undercut HP’s prices. In the printing market, while HP is a leader, the competition from Canon, Epson, Brother and third parties is continuously threatening HP’s recurring revenue model based on proprietary supplies.
  • Supply Chain Disruptions: The semiconductor chip shortages have affected the whole industry’s ability to produce products and deliver them on time, thus affecting overall revenues and profitability. Supply chain management issues are likely to persist for a while and thus pose a threat.
  • Economic Downturn: As discretionary spending is often impacted negatively during times of financial crisis/downturn, HP’s sales volume and revenue is likely to suffer.
  • Shift to Subscription-Based Services: While HP has been trying to push towards this model, the acceptance by customers is still far from ideal, and the lack of stickiness might hurt the potential of this shift.
  • Geopolitical Risk: The ongoing Russia-Ukraine war, rising trade tensions, and other political developments may affect the business negatively.
  • Cybersecurity threats: Growing cyber security threats might lead to data breaches and customer dissatisfaction.

Business Explanation:

HP operates through two main segments: personal systems (PCs and workstations) and print (printers and supplies). These product segments are supported with service lines, which include device repair, hardware configuration and financing. These products and services are sold to individual customers, small and medium businesses (SMB) and enterprise/government bodies globally. Revenue Distribution:

  • Personal Systems: This segment generates the most revenue, mainly coming from sales of laptops, desktops, and workstations. The revenue mix can vary from quarter to quarter depending upon seasonality and demand. Recent trends show that laptops/notebooks are gaining more revenue share than desktops.
  • Print: This segment derives most of its revenue from printer sales as well as printing supplies (ink and toner cartridges). The demand for printing supplies has often been stronger than the sale of printing machines.
  • Geographic Mix: HP has operations globally across all geographies, including North America, Europe, Asia, Africa and South America. The revenues are very well distributed with North America and Europe usually accounting for most of the revenue share.

Trends in the Industry:

  • PC Market: This market is going through a significant period of change, as customers prefer to shift towards mobile computing and thus less emphasis is given to desktops. There is intense competition, and pricing is very aggressive. There is also concern about chip shortages, which are leading to high prices and non-availability of inventory. The revenue of this segment is dependent on refresh cycles as a majority of the sales is dependent on replacement needs, rather than on newer markets.
  • Print Market: This market is also very volatile. HP’s legacy printing business is under pressure due to the rise of alternatives and the commodification of ink supplies.
  • Hybrid Work: The trend for work-from-home models has created a new area for growth in PC’s as well as in home printing, but the growth is limited, and as companies and businesses adopt a hybrid approach, the demand may wane.

Margins:

  • The gross profit margins in printing are significantly higher than those in personal systems as the sale of supplies is much more profitable than printing hardware itself. However, the margin is still being impacted due to the competition and increased sales of third-party alternatives.

  • Operating margins are relatively low, due to intense competition in PCs, a highly competitive printing market, and high operating costs.
  • The overall gross and operating profit margins have improved a bit in recent quarters, mainly due to improved cost management.

Competitive Landscape:

  • PC Market: Dominated by Lenovo, Dell, and Apple. Competition is mainly on price, features and design.
  • Printing Market: HP is a leader, but strong competitors like Canon, Epson, and Brother have put considerable pressure. Also third-party suppliers of printing supplies is a growing threat.
  • Service Market: This market is dominated by specialized service providers.

What Makes the Company Different:

  • Scale: HP’s extensive global reach and broad product portfolio give it some advantages of economies of scale.
  • Integrated Ecosystem (printing): HP’s end-to-end printing ecosystem has its advantages as customers are unlikely to jump to new ecosystem, especially if their existing system is working well. However, this may not create significant long-term advantage due to the commodification and new alternatives available.
  • Focus on Sustainability: The company is making efforts to create sustainable products and operations to help it be in compliance with the changing ESG norms.

Financials (In-Depth Analysis):

The financials of the company should be looked at holistically, and a deep dive into a particular year might give misleading results.

  • Revenue: The total revenues are a blend of sales from personal systems, printing, and related services, with the majority of the revenue coming from the personal systems segment. The revenue growth has been largely flat in the recent quarters. The revenues are highly dependent on macro economic cycles and product refresh cycles and tend to fluctuate according to those factors.
  • Profitability: The company has high gross profit margins in the printing segment but the operating profit margins are low because of intense competition, high operating costs, and a relatively high percentage of total revenues coming from the relatively low-margin personal systems.
  • Cash Flow: HP generates decent levels of free cash flow that are mostly used to fund share repurchases and dividend payments.
  • Capital Structure: HP has been following a policy of aggressively repurchasing stock, which in turn is improving the EPS figures and dividend payout ratio. This strategy works well as long as the firm can continue to generate excess cash and the stock price is not overvalued, otherwise this could hurt the firm. The debt levels are higher than what is seen in the past as the company has used debt for acquisitions and to repurchase more stock. The company also has very low levels of cash equivalents.
  • Capital Allocation: The company spends the majority of its cash on share buybacks and dividends. In previous years the company also spent on acquisitions to expand its business.

Understandability: The business is not very simple to understand. There are two sides of this business: the personal systems segment and the printing segment. Both these have their own quirks. The printing segment is dependent on consumables, and thus, the revenue models are more complicated, and the PC market faces headwinds from the mobile computing market. It also involves a wide range of products and services. We rate the understandability a 2 out of 5 because there is a mix of both simple and complex factors, and also the interplay between different segments of this business is slightly difficult to grasp.

Balance Sheet Health:

HP has a 3 out of 5 for its balance sheet health. The main points of concern are high debt levels, low cash equivalents, and its aggressive share repurchase policy that uses borrowed funds, thereby increasing leverage. The good thing is that the debt service and interest rates are easily manageable. Therefore, we rate the balance sheet moderately healthy. However, there is considerable risk if HP is forced to take more debt, due to some unforeseen reasons, or if the company goes through a period of significant reduction in profits.

Recent Concerns/Controversies & Management View:

  • Lower Demand for PCs: Management has consistently mentioned a decline in PC demand from customers and how that has impacted their revenue. They are relying more on their higher-margin segments to generate revenue during this period.
  • Uncertain Economic Times: The uncertain macroeconomic environment has been a cause for concern for both management and investors, and they are keeping close watch on how this may affect the company’s business.
  • Cost Cutting: The company is aggressively pursuing cost cuts in order to maintain profitability. Management believes that this measure will help the company to weather through the upcoming headwinds.
  • Acquisition of Poly: The company recently acquired Poly, a global provider of workplace collaboration solutions. Management expects this to boost its printing business in the long-term.
  • Focus on Long-Term Value: While short term market fluctuations continue to cause volatility for their business, the management team is focusing on long-term growth prospects of the company and ensuring that all decisions are aligned with this goal.