Could that be the case with his recent $4.2 investment in HP? Berkshire became the technology group's largest shareholder, with over 11% of equity capital. Not much to write home about though since this investment remains negligible related to Berkshire's total assets and stock portfolio.
HP Inc is the surviving hardware business of former parent Hewlett-Packard following the spin-off of its enterprise business (HPE). The separation concluded a long and painful sequence of losses and endless restructurings, following the disastrous acquisition of Autonomy in 2011, which made the company "un-investable". But this troubled past is now history.
What Buffet is seeing in HP
HP now solely focuses on personal computing, printers and other devices. On the surface, this might not be very alluring, because the competition in this sector is extreme, but also because there is a lack of pricing power. However, HP still enjoys a highly respected franchise and customer mindshare, in particular in the US. This, on top of an excellent management that has proved shrewd at controlling costs and enhance returns of capital to shareholders.
Beyond a textbook value investment, it is possible that Buffett saw something the market missed. HP does benefit from recurring and stable earnings thanks to its consumables business, mostly printer cartridges. The model, to some extent, resembles Gillette's, one of Buffett's most famous investments in the late eighties. However, consumables only represent 20% of HP's consolidated turnover. Two-thirds of sales are still linked to the sale of computers, mainly notebooks.
Xerox, backed by Carl Icahn, attempted an aggressive takeover of HP about two years ago, with a bid that valued the company at $31bn, while the current enterprise value is $45bn. The deal made sense as it would have put together the leader in corporate printers (Xerox) and the leader in consumer printers (HP). Even though the deal was aborted, it has set a floor on HP's valuation. Between Xerox's bid and Berkshire's investment, HP stands out as an ideal acquisition target in a valuation range between $30bn and $40bn, slightly below today's valuation.
A positive development for HP is that it is refocusing on its core hardware business. Experience shows that technology groups rarely succeed when they branch out too far from what made them successful in the first place. Some examples that come to mind is Google's foray into social networks or Apple's difficulties with its streaming platform.
At the financial level, despite a lack of pricing power, HP’s business is everything that Warren Buffett likes: revenue of $65bn, slow growth but recurring sales, and strong consumer franchise. It also has excellent cost control that helps keeping operating margins at 10%, as well as a resilient business entirely funded by debt and no need for equity – which means very high returns for shareholders.
Cash earnings (free cash-flows) are hard to assess with accuracy. This is because of the significant boost, possibly temporary, during the pandemic, as people worked from home. But roughly speaking, the company’s free cash flow stands at about $4bn to $6bn per year, for a market cap of $40bn. This equals to a current valuation of x6 to x10 the group’s earnings, which is way below market averages, for a resilient business with very high returns on shareholders' equity! This is a very interesting business indeed…
A big safety margin
As usual, with the kind of business that Buffett enjoys investing in nowadays, the entire free cash flow is returned to shareholders via massive share buybacks ($6.2bn last year) and dividends ($1bn last year). All else being equal, HP will return its entire market cap to shareholders in five to six years, which is very attractive as it means cash returns of 15% to 20%.
However, despite these qualities, insiders are still selling. We can only wish that we saw the opposite, as it would be a strong signal. All In all, there are two ways to consider the stock. It might be that Buffett sees a high-quality business, with high returns on capital and a compelling valuation caused by the market misappraising the company due to its troubled past. If this is the case, then this is a no-brainer: HP is a super compelling opportunity. However, another way that Buffet might see the stock is that it's only a quantitative value play, which means a passable business trading at a bargain price. In other words, a typical value investment.
The main risk is a decrease in revenue, following a temporary boost from the work-from-home trend during the pandemic. The company just posted its results for its fiscal second quarter ended April 30, which show that consumer sales declined 6% and notebook units tumbled 23% in the period. Printing revenue dropped 7% to $5 billion, with total hardware units down 23%. However, the Personal Systems division revenue increased 9.2% to $11.5 billion, led by commercial sales. The strong demand from companies upgrading their computer systems led sales to climb 3.9% overall to $16.5 billion, vs $16.1 billion expected by analysts. Earnings, excluding some items, were $1.08 a share, also topping estimates.
In any case, there's a big margin of safety at this price. If growth continues, this investment will be a homerun for Berkshire.