HP Is a Legacy Technology Titan Which Lacks a Moat, but Offers Good Shareholder Returns

Analyst

William Kerwin

Revenue segments as reported by the company.

Personal Systems

Printing

Corporate Investments

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HP is a legacy technology Titan with poor competitive positioning in our view, but we like its shareholder returns. HP's core markets of PCs and printing offer low growth, slim profitability, and, in our view, don’t have much potential to aid HP in warranting an economic moat. We don’t anticipate HP improving its midcycle growth potential or margin profile, but we do expect it to continue generating heady cash flow and sending nearly all of it back to shareholders between its dividend and repurchase program. Investors able to look past HP’s low growth may find the company’s distributions enticing.

Despite HP’s market leadership in PCs and printing, we don’t see it having an economic moat. These products are commoditylike and their markets are price-sensitive. Even as these markets consolidate around top players like HP, we foresee little ability to generate stickiness, differentiation, or to exert a cost advantage. Furthermore, we see the printing market as already being in a secular long-term decline, and we expect declines to worsen HP’s overall profitability. As a result, we see HP’s competitive position weakening over the medium term.

We expect HP to focus on the higher-value sections of each of its markets in future, like gaming, premium, and commercial PCs and A3 printing. This should enable slow growth in a mature PC market and stave off steeper sales declines in an eroding printing market. We like HP’s move to a more subscription-based printing model, but don’t anticipate it generating sufficient stickiness to offset a broader industry decline. We think HP’s strategy will center on free cash flow optimization and maintaining its levels of shareholder returns, even using leverage to do so. Nevertheless, we forecast slow declines in profitability and cash flow over the long term. We expect HP to continue bolting on acquisitions to expand its market opportunity and pursue growth, but we don’t foresee any transformative deals. Generally, we believe the firm’s best use for cash is sending it back to shareholders.

Business Strategy & Outlook

We do not believe that HP holds an economic moat. HP holds top market shares in the PC and printing markets, both of which we view as commoditylike and not conducive to moats. We see both markets as being price-competitive, eroding accounting and economic profits for participants. HP’s recent returns on invested capital have exceeded its cost of capital in recent years, but we have little confidence that HP will outearn its cost of capital over the next 10 years.

In its personal systems segment, HP primarily sells notebooks and desktop computers, along with peripheral devices like gaming equipment and displays. In PCs, Dell, Lenovo, and HP control nearly 60% of all sales, with market shares shifting around quarter to quarter. The market is consolidating around these top vendors, but it exhibits highly competitive pricing and slim profit margins for vendors. Vendors like HP are focusing on the highest-growth sections of the market—commercial, premium, and gaming notebooks—but we see the same competitive pricing with other vendors whittling away excess profits in the marketplace. We also see negligible switching costs and intangible assets in PCs. Original equipment manufacturers like HP source critical components like processor and memory chips externally, and Windows is a common operating system between the top-three vendors. We see similar dynamics in peripheral devices like display monitors and gaming accessories.

In printing, HP sells printers, copiers, and multifunction printers that are a combination of printing, scanning, and other office functions. HP is the largest printing supplier in the world, with a particular specialization in serial inkjets and A4 machines that serve the consumer market and lower end of the commercial market. The top-four overall vendors HP, Canon, Xerox, and Ricoh control close to 60% of the market. HP is a newer entrant in the larger and more premium A3 market, where Canon, Xerox, and Ricoh specialize. We view dynamics in the printing market similarly to PCs, with heavy price competition and little profits despite consolidation. HP will source printer engines and toner cartridges from a vertically integrated supplier like Canon, and outsource manufacturing, creating little distinction in the process. In fact, HP has moved to a model of selling printers at a loss and choosing to make money on a recurring stream of supply sales and managed services. We don’t see this recurring revenue stream providing stickiness, due to short contract lengths and a fungible product upon which it is based. In our view, there is no reason why a customer wouldn’t choose a competing printer after the contract ends, with the choice being based almost entirely on price.

None

Economic Moat

HP, Inc. engages in the provision of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. It operates through the following business segments: Personal Systems, Printing, and Corporate Investments. The Personal Systems segment offers commercial and consumer desktop and notebook personal computers, workstations, thin clients, commercial tablets and mobility devices, retail point-of-sale systems, displays and other related accessories, software, support, and services for the commercial and consumer markets. The Printing segment provides consumer and commercial printer hardware, supplies, solutions and services, and scanning devices. The Corporate Investments segment includes HP Labs and certain business incubation projects. The company was founded by William R. Hewlett and David Packard in 1939 and is headquartered in Palo Alto, CA.

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