Recent market volatility has brought down several stocks that had been enjoying a long, nearly uninterrupted bull market. Interestingly, some value stocks fell nearly as much as their high-flying growth counterparts. HP Inc (NYSE: HPQ), a value stock that I hold in my personal portfolio, has seen its share price drop more than 14% since the beginning of October. The drop in price occurred despite the company reporting a solid fourth quarter to conclude its fiscal year and a much lower P/E ratio than the average company in the S&P 500.
In Q4, HP's revenue rose to $15.4 billion, a 10% increase year over year, and non-GAAP earnings per share (EPS) grew to $0.54, a 23% increase over 2017's fourth-quarter total. This was the company's fifth straight quarter of greater than 20% earnings growth, an impressive feat for a "stodgy" hardware company! The company's adjusted operating margin did fall a bit to 7.1%, but that was primarily the result of the acquisition of Samsung's printing division, S-Print, and other investments for future growth. Given these solid results, it's only natural to ask, "What gives?" Let's take a closer look at the company to see if we can determine if the drop in stock price is justified, or if this represents a buying opportunity.
HP's business model
HP operates two business divisions: personal systems and printing. Personal systems is responsible for manufacturing and selling HP's line of personal computers, laptops, tablets, and other pieces of computing hardware. The printing division provides printers, supplies, and services for commercial and consumer customers.
In Q4, revenue in personal systems increased 11% to $11 billion. While this division contributes much more to the company's top line, its lower operating margin, only 3.8%, means it actually contributes less income than the printing segment. One thing HP is doing to increase margins for this business is to market subscription-based device and services bundles to commercial clients. HP's device-as-a-service (DaaS) is advertised as "a complete solution that combines hardware, insightful analytics, proactive management, and device lifecycle services." In the company's fourth-quarter conference call, CEO Dion Weisler stated:
The printing business also continues to show profitable growth, increasing revenue to $5.3 billion, a 9% increase over last year's fourth quarter. While this is only half of the revenue the personal systems division puts up, printing actually contributes more than twice as much earnings to HP's bottom line because of its much higher operating margin of 16.1%. In the conference call, Weisler said the overall printer market was flat in an industry with about a dozen major players, making growth difficult. One way HP is pursuing growth in this tough market is through strategic acquisitions. Last year, it acquired S-Print, Samsung's printing segment. This year, it followed up the S-Print acquisition by buying Apogee for about $500 million, a U.K.-based office equipment dealer that significantly increases HP's sales presence in Europe.
HP also remains committed to returning significant capital to shareholders. In Q4, HP spent $200 million on its quarterly dividend payout and another $600 million on repurchasing shares. For the total fiscal year, the company spent approximately $3.5 billion on share repurchases and dividend payments, good for 83% of the company's free cash flow. The money allocated toward buybacks was enough to reduce its share count by about 112 million shares. In November, HP increased its dividend by 15%, something the company has faithfully done since 2011, raising its yield to 2.9%. Based on the new quarterly dividend, HP's payout ratio is only 32%, meaning the company has plenty of room for future hikes, too.
Management seems to be committed to continue both of these actions in the new fiscal year. While forecasting for the upcoming year during the conference call, CFO Steve Fieler stated, "We expect to return approximately 75% of free cash flow to shareholders through a combination of dividends and share repurchases over the course of the full year."
A compelling valuation
One would think that, given the company's healthy dividend yield and five consecutive quarters of 20%-plus earnings growth, HP's valuation would be at least as high as the overall market's, yet that proves not to be the case at all. Based on the company's adjusted EPS of $2.02, HP sells at a P/E ratio of just 10.9. It's not as if the company is guiding for reduced earnings in the year ahead, either. Management projects 2019's adjusted EPS to come in between $2.12 and $2.22, giving HP a forward P/E of just 10.1 at the midpoint of its earnings outlook.
Why I own shares of HP
HP does not operate in sexy software markets, where those SaaS companies are always strutting their stuff. Nevertheless, the company has found a way to drive profitable earnings growth, taking market share in slow-growing and flat addressable markets through innovative products, new services, and acquisitions. If the company was selling at a premium valuation, whether HP's low-margin hardware business deserved a spot in investors' portfolios would be a worthy discussion. At their present discount, though, the shares seem to be a much more viable option. It might take a while for the market to recognize HP's true value, but investors can comfort themselves with sizable dividend payments while they wait. With the company's consistent growth and compelling valuation, HP has already found its way into my own portfolio.
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