Description

We believe HPQ is a stealth COVID beneficiary whose secular decline is masked by temporary benefits associated with COVID. Unlike most COVID beneficiaries who trade at mid single-digit P/E or EV/EBIT multiples with high short interest and in many cases have round-tripped to pre-COVID levels, HPQ remains near multi-year highs with short interest still less than 4%. We think the company and investors are too optimistic in projecting recent strength going forward.  Furthermore, we believe secular issues, which were already bad pre-COIVD, are in the process of accelerating.  We see ~30-50% downside as investors once again price in a secular decline similar to what they were pricing in on a pre-COVID basis.  We believe HPQ is a classic value trap; while it may not have the downside of unprofitable recent IPOs, it presents an attractive risk adjusted return while hedging a value tilted long book. 

HPQ has two business units - personal systems, which sells notebooks, laptops, and monitors to consumers and businesses, and printer supplies, which sells printers and ink to consumers and businesses. Our thesis is simple:

1. Pre-COVID, HPQ was perceived as facing fierce competition in both business segments, which themselves were in varying degrees of secular decline (especially their printer business). 
2. Since COVID, margins have expanded dramatically in both segments as well as revenues in certain pockets (namely in consumer-oriented sales)
3. Management and sellside project these gains on a go-forward basis
4. We believe both revenues and margins will normalize as COVID-induced demand subsides. We identify a few specific areas of over-earning: a) unsustainably high printer prices due to component shortages, b) unsustainably high demand in consumer notebooks alongside similar supply chain issues, and c) margin-accretive mix shifts in both segments during COVID that will unwind.
5. Reasons to think pre-COVID challenges, namely in print, are just as pertinent if not magnified in a post-COVID world.
6. We see ~30-50% downside as earnings normalize and investors again recognize competitive and secular issues

1. Pre-COVID, HPQ was perceived as facing fierce competition in both business segments, which themselves were in varying degrees of secular decline (especially their printer business). 

HPQ is composed of two segments, print and personal systems. In 2019 (pre-COVID), personal systems represented 37% of EBIT and print represented 63% of EBIT. Both businesses struggled to grow:

The personal systems business has roughly been flat pre-COVID, but has been facing increasing pressure from lower cost Asian competitors who have taken share over time, especially in HP's core lower-end consumer PC segment.

HP's competitive position in print is stronger, but secular trends there are more negative and obvious. Based on global point of sale data from GfK and NPD, we estimate that global printer hardware sales have declined at a -5% CAGR from 2015 to 2019.  Ink cartridge sales have declined at a -3% CAGR, including a modest pricing benefit on the consumer side which can to a degree take price and increase cartridge size to offset page print declines.

Furthermore, print was historically a razor / razor blade business, where printer manufactures sold the printer at breakeven or a loss to get high margin consumables sales. Relevant structural challenges in print include:

• Declining page count: the world is consistently printing less each year as the world slowly digitizes, pages declining LSD each year. This decline is faster in consumer and in developed markets, both higher margin than their counterparts leading to negative mix shift as well.
• Heavy competition from print OEMs: print consumers are exceptionally price sensitive and brand agnostic - up to 80% of people who buy a printer from one brand do not buy the same brand the next time. Although there are only several players, even one undisciplined competitor trying to steal share has been enough to hurt margins for the whole industry.
• Increasing threat from illegal third-party supplies: the market (especially Chinese players, such as Ninestar) have gotten remarkably better at making rip-off HP cartridges over the past 3-7 years and undercutting HP's "razor blades," hence undermining the HP print business model. This came to a head in FY19 with 2 material print-segment guide-downs, 2 departed executives, HPQ stock down 30%, and HP giving up on their previous "4-box" razor / razor blade model. 

As such, it is unsurprising that pre-COVID, HPQ traded at very low forward EV/EBIT multiples to reflect its structurally challenged market positions:

*Represents NTM EV/EBIT multiple of HPQ. HPE spin off occured in 2017; however, both entities have traded at similar multiples since spin.

2. Since COVID, margins have expanded dramatically in both segments as well as revenues in certain pockets (namely in consumer-oriented sales)

As you would expect, HP has seen a meaningful bump in its consumer segments since COVID - while office may have been impacted to some degree, we believe this is more than made up for by the surge in consumer related volumes and higher mix/pricing. As such, each segment is significantly more profitable than it has been in years:

Notably, we've seen the biggest benefit in consumer sales -- home printer sales up 30% in FY21 vs FY19 and notebook sales up 33% in FY21 vs FY19.

We can also see this jump in point of sale data in key end markets.  Based on global point of sale data, we estimate that printer hardware units increased +5% in 2020 and cartridge units increased about +3%.  More importantly, we estimate that hardware revenues in particular increased in excess of +20% as many printers saw massive ASP price increases on like-for-like models as discounts disappeared.  This is important as we believe nearly all the margin improvement HP has seen in their print segment is due to higher printer ASPs which we do not view as sustainable.

The temporary COVID tailwinds can be explained by a number of factors, including:

• PC has seen a material volume benefit, due to a rush to buy / upgrade PCs for home use during COVID. Consumer print also saw a big lift, though volumes were offset by weakness in office print.
• Both segments have benefitted materially from pricing. With component shortages temporarily forcing otherwise brutal competitors to become price disciplined, HP has been able to eliminate their normally massive levels of discounting in printers and computers to drive revenue and margin.
• Further, both segments have benefited from mix improvements. In print, the mix has shifted drastically from office to consumer as much of the world was forced to work from home -- consumer has gained nearly 10pts of hardware mix in FY21 vs FY19. This has been a boon to margins, where consumer carries at least double the contribution margin of office due to consumers' lower purchasing power, consumers' price insensitivity, and HP's stronger IP footprint in consumer printer technology. In PC, HP has disproportionately allocated chip supply to their higher end PCs to improve mix, where HP has historically been a weaker competitor.

3. Management and sellside project these gains on a go forward basis. 

Management makes dubious claims that the business can retain the recent strength since COVID on a go-forward basis. Management is guiding LSD revenue and EBIT growth off 2021 levels:

Source: HPQ 2021 Investor Day

Sellside has eaten up this commentary, raising FY23 operating profit estimates by 34% since the start of COVID:

Source: Visible Alpha

Management justifies these targets with logic in both print and PC that do not particularly add up in our view.

In print, HP claims it can grow revenue ~1% / annum from 2021 levels and keep margins materially elevated vs pre-COVID due to three factors, all of which we disagree with:

• Volume growth, through Office/Industrial: they claim that volume should grow substantially in office as it reopens, and that graphics / industrial printing has now accelerated
  • We think the volume growth via office is a misnomer -- it should cannibalize consumer print volumes, which actually doesn't improve overall volumes and would actually decrease margins. Graphics / industrial printing should grow but likely won't be material at ~10% or less of the print segment. 3D printing is a non-sequitur due to its tiny size.
• Improve Consumer profitability by reducing unprofitable customers: in the razor + razor blade model, HP discloses that 25% of them pre-COVID never bought enough supplies to break even on an LTV basis. To counteract this, they have introduced HP+ (same printer as pre-COVID but requires HP original cartridges for life) and profit-upfront models (Smart Tank where you sell all ink upfront in a tank that rarely runs out, or HP Standard which is essentially the same pre-COVID printer but 1.5-2x the ASP) with the goal to reduce unprofitable customers to 0% over time.
  • We note the model shift is essentially a closet price increase on hardware. Profit-upfront are obviously price increases on hardware, and HP+ locks customers into a higher ASP supply stream in a way it did not before (while modestly increasing upfront ASP as well). HP claims early victory on the model shift as it has not reduced market share, but we note these higher ASPs are untested in a normal competitive environment where all players are not significantly supply constrained
    
  • We also note that by shifting the balance of customer LTV from ratable supplies profit over time to upfront profit at printer sale, HP will effectively be pulling forward revenue over the "model transition." To the degree HP can continue to sell these units at elevated prices vs pre-COVID, these will pad revenues and profits over the install base transition period -- HP would earn an outsized share of the customer LTV upfront on new-model sales as well as still earning the bulk of customer LTV on previous old-model sales, where LTV is backweighted (due to old-model LTV being in the tail of supply / "razor blade" sales). However, this dynamic would also cause a cliff in headline performance on the back end, as the transition completes and the tail of old-model supplies revenue dissipates.
• Shift to subscription supplies model, i.e. instant ink at home and managed print services (MPS) in office: this is supposed to prevent customers from going to illegal third party supplies, claiming this increases customer LTV long term.
  • Much of this transition is in the office, where industry experts note (and HPQ conveniently avoids commenting on) that converting business from one-off transactional to a single MPS contract is almost always decreases profit dollars to HP. This is intuitive - an MPS contract increases customer / reseller's price sensitivity and bulk purchasing power...and generally the transition is at the behest of the customer, rather than proactively pushed by the print OEM. At home, Instant Ink may be profit accretive but only represents ~5% of supplies revenue after being in market for almost 10 years. 

We note that all HP print formers we spoke to say the print business was challenged but "saved" by COVID.

In Personal Systems, HP claims it can grow revenue LSD and maintain significantly elevated margins vs pre-COVID due to a) allegedly 1.5x larger market than 2yrs ago, b) mix shift to higher ASP PCs and c) growth in higher margin peripherals. We note that volume and pricing benefits that the PC business has seen recently have benefited greatly from temporary COVID and supply chain situations, and that the peripheral business is very small at <5% of the business and has benefited from the same tailwinds seen in other segments.

4. We believe both revenues and margins will normalize as COVID-induced demand subsides. We identify a few specific areas of over-earning:  a) unsustainably high printer prices due to component shortages, b) unsustainably high demand in consumer notebooks alongside similar supply chain issues, and c) margin-accretive mix shifts in both segments during COVID that will unwind.

(a) As discussed earlier, we believe nearly all the improvement in print margins have been driven by lower discounting that has turned formerly unprofitable hardware sales into the main driver of segment margins. We expect the same industry behavior that existed pre-COVID to return. As pricing in all likelihood unwinds, we expect that HP will either a) lose market share from the high ASPs of HP's new revenue models or b) have to materially lower those upfront ASPs to keep in step the fierce pre-COVID competition that will almost inevitably resume post-COVID.  HP has introduced many "new" models over the past couple years that make comparisons to prior pricing trends more difficult.  Based on an exhaustive review of historical printer prices on Amazon and point of sale data, we isolate a few popular HP printers across price brands pre-COVID models and how pricing on these models has changed to illustrate the magnitude of the margin improvement:

HP Officejet 6978: This was historically a low selling model on Amazon pre-COVID and retailed for $89.99.  Beginning in March 2021, HP began selling many more of these units and raised price from 89.99 to 179.99, or nearly 100%.  Pricing has bounced around between $119 and $179 since then, and today is currently about $165.

HP Laserjet Pro M479FDW: This is a higher-end SMB printer that saw sales jump 300% in 2020 and was the best-selling printer on Amazon in 2020.  In 2019, pricing averaged $458.  When COVID began, pricing increased to $598, or 30%. Today pricing is now a $688, or up +50%.

HP Officejet 3830: This was a popular low end HP printer that sold at an $80 MSRP but almost never sold at that level, with most sales occurring when the product was discounted to $50 and discounted closer to $40 in Black Friday period.  As supply chain issues hit discounts when away and all sales occurred at $80.  Eventually in late 2020 MSRP increased to $100, again a 100% price increase from pre-Covid realized pricing.

HP Deskjet 4511: This was a new model released in May 2021 that replaced the Officejet 3830 listed above, with an original MSRP of $99.  Once again, the product hasn't been discounted and now has an MSRP of $120, a 140% price increase over the $50 average realized MSRP of the model it replaced.  

(b) Similar dynamics that occurred in the printer market have also occurred in the PC market - higher demand driven by COVID drove increases in volume (especially in consumer), a narrowing of discounting, and a mix shift towards higher ASP / higher margin products as typical competitive pressures dissipated due to supply chain. Due to the constantly changing nature of PC SKUs, the kind of analysis we show for printers is harder to do here, but we believe this reality is reflected in industry commentary, HP's own comments and in their results more recently that show improving mix. It's also worth noting that HP is over-indexed to Chromebooks, which surged in 2020 and early 2021 on the back of school demand, which we believe masked the margin expansion and mix improvement in personal systems for much of 2020.  As consumer demand slows (already happening) and supply chain tightness eases, we anticipate margins and revenues to revert closer to pre-COVID revenues, margins, and trends vs company guidance for growth on an elevated base.

(c) HPQ has benefitted from the multitude of factors mentioned above that drove short-term margin-accretive mix shift. We expect on the print side that mix will revert from high margin consumer supplies to lower margin office supplies (which earn at most 1/2 the margin of consumer) as workers come back to the office, taking a hatchet to margins. On the personal systems side, we expect that as the market loosens, HP will need to shift its mix back towards its lower-margin core economy PC offering to maintain share. Both of these effects should move margins back towards historical averages.

5. Reasons to think pre-COVID challenges, namely in print, are just as pertinent if not magnified in a post-COVID world.

While difficult to prove today empirically, we think the rate of secular decline should be just as strong if not stronger post-COVID. The decline in print volumes has been driven by broad digitization; with consumer more able and willing to change habits than long-ingrained business workflows, consumer volume declines have historically outpaced the office. However, multiple industry experts have called out that COVID has forced a step-function change in business digitization to catch up to consumer -- many mandated biz workflows have changed due to COVID protocols and remote work. There has been broad adoption of e-signature platforms. Physical archiving requirements had to be rethought as work transitioned to home. Paperwork for regulatory purposes (such as at auto dealerships, e.g. financing docs etc) are increasingly going digital. While this effect is masked by short-term noise of pricing and volume impacts from shifting WFH and hybrid work protocols, we believe results over the medium-term will demonstrate a hastened rate of secular decline in office print (and to a degree in consumer as well).

We also call out that HP's attempts to squash illegal third-party ink will take many years to take full effect. In Dec 2020, HP estimated that third-party immune systems (HP+ and Smart Tank products) would be 80% of sales by the end of 2022. Only a year later, they were only at 40% and pushed that target back two years to end of 2024. By those numbers, we estimate only 5-8% of HP's install-base are "third-party immune," leaving >90% of the HP print install base -- that relies on supply sales for profitability -- still susceptible to being undercut by cheaper and improving third-party cartridge technology.

6. Downside view 

In reasonable cases of COVID benefit reversion and modest margin compression, we find the set of possible outcomes for HPQ as asymmetric and negative. What we think is a quite fair base case, by simply reverting to pre-COVID print trends (not accounting for the likely scenario that COVID accelerated the decline of print) and pre-COVID PC trends (at materially above historical margins, we might add), yields 25-30% downside. A less rosy picture can easily yield close to 50% downside. Meanwhile, a bull case where HPQ somehow maintains vastly elevated margins from COVID does not imply particularly scary upside and highlights the attractive risk/reward.

DISCLAIMER

As of the publication date of this report, the author has a short position in HPQ and stands to realize gains in the event the stock price decreases. Following publication of the report, the author may transact in securities of HPQ. All content in this report represents the opinions of the author who has obtained all information within this report from sources they believe to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind – whether express or implied.  

Catalyst

Earnings misses, disappointing guidance