The investment thesis
Berkshire Hathaway’s recent 13F disclosure shows that Warren Buffett created a large position in HP Inc. (NYSE: HPQ). The position is worth around $4.3 billion at the time of this writing and is the 12and largest position in BRK’s massive equity portfolio. You might be wondering why Buffett, who repeatedly said he wouldn’t invest in tech stocks because he didn’t understand tech stocks, suddenly created a large position in a computer company now.
This article will show that beneath its technological surface, HPQ is actually an exemplary Buffett-type company. It has all the characteristics of a perpetual compounder that Buffett is looking for: superb profitability and return on capital, financial flexibility, strong cash flow but low maintenance CAPEX requirements, generous shareholder returns, et al. Finally, his current valuation also fits what I call Buffett’s 10x pre-tax rule, as shown immediately below.
PQ and Buffett’s 10x pre-tax rule
According to Buffett’s 10x pre-tax rule, HPQ is now a wonderful business to sell at a bargain price, as shown in the chart below. The figure compares the historical price of HPQ and its 10 times earnings before taxes (also known as EBT, Earnings Before Taxes). As seen, if the price rose near or above 10x EBT, it was a good time to sell like in 2016 and 2017. And vice versa, when the price fell below 10x EBT, it was a good time to sell. was a good time to buy. And now, with a valuation of 7.2x FW EBT, it’s such a good time to buy. As detailed below, at 7.2x EBT, even if HPQ’s earnings stagnate indefinitely, the investment would already yield a pre-tax return of nearly 14%, comparable to a 14% capital bond.
If you’re new to Buffett’s 10xEBT rule, I have a free blog post to provide all the details along with all the questions and answers I’ve received. A quick summary for ease of reference:
- Buffett paid about 10 times his pretax profits for many of his biggest and best deals. The list goes on, ranging from Coca-Cola, American Express, Walmart, Burlington Northern, and also the more recent purchase of AAPL. This is no coincidence, as buying a company that stagnates indefinitely at 10xEBT would already provide a 10% pre-tax earnings return, directly comparable to a 10% yield bond. Any growth is a bonus.
- The 10xEBT rule does not DO NOT mean that you should go out and buy all stocks priced below 10xEBT. Investors face two main risks: A) quality risk or value trap, and B) valuation risk, ie paying too much. The 10x pre-tax rule is primarily used to avoid Type B risk AFTER Type A risk has already been eliminated.
- So how do you eliminate type A risks? I’m mainly looking for three things. First and second, the company should have no short-term and long-term existential problems. And third, the business should have a decent chance of growing (at the so-called perpetual growth rate). It will be a plus.
So, with this framework, let’s take a closer look at HPQ.
HPQ: Does he have any short-term existential issues?
As detailed in our blog post, a shortcut to examine the existential short-term question is the dividend, the most reliable indicator of a company’s profit.
As shown below, HPQ has been paying dividends for years. Despite the upheavals between 2015 and 2016, dividends showed a general upward trend. The growth rate over the past decade has been a healthy CAGR of 5.2%, and over the past 5 years it has been nearly 10%.
Another reliable measure is interest coverage and financial strength. The company currently carries long-term debt of approximately $6.4 billion. Its total interest expense is approximately $252 million and its effective tax rate is approximately 13.5%. Thus, the company’s debt coverage (defined as EBIT divided by interest expense) is approximately 17x, essentially debt-free.
HPQ: Does he have any long-term existential issues?
In the long term, the existential question is ultimately a largely subjective judgement. For me, HPQ’s core business is serving the needs of a society that stretches endlessly into the future: our basic computing, work, and play needs. Even within its mature businesses, it prospects for turnover exist, albeit slowly. But again, at its current valuation of 7.2x EBT, the return on investment would already be in double digits if there was no growth. Product cycles for PCs and printers are not as big as they once were, but we can still expect slow secular growth in the long-term low-single digit range.
At the same time, there are signs of higher growth and higher margin areas. In particular, it has just posted a 20% growth in its income in Personal Systems Gaming. Gamers spend lavishly and sometimes even uncontrollably on equipment – and unfortunately I have to experience this as a parent of a teenager – such as cameras, speakers and headsets. Its new breakthrough such as Omen can fuel further growth as it incorporates social networking aspects and keeps gamers connected.
HPQ: what are its prospects for infinite growth?
As detailed in my free blog post, over the long term, the growth rate is simply given by the product or the ROCE (return on capital employed) and the reinvestment rate.
HPQ has been able to maintain an extremely high ROCE over the past decade, as you can see from the following chart. It has averaged 103.5% over the past decade. And note that this average has already been skewed by the drop in profitability it experienced between 2012 and 2014, when the ROCE fluctuated between 37% and 65%. Since 2015, its ROCE has been constantly and significantly above 100%, with the exception of 2020 when it fell slightly to 88%.
For reinvestment rate, HPQ enjoys strong cash generation and capital allocation flexibility, as you can see in the following highlights from its latest earnings report:
- HP’s net cash provided by operating activities in the first quarter of fiscal 2022 was $1.7 billion.
- HP generated $1.4 billion in free cash flow in the first quarter. Free cash flow includes free cash flow from operating activities of $1.7 billion adjusted for net investments in leases of $20 million and net investments in property, plant and equipment of $273 millions of dollars.
- HP’s dividend payment of $0.25 per share in the first quarter resulted in a cash use of $0.3 billion. HP also used $1.5 billion in cash during the quarter to repurchase approximately 42.6 million common shares on the open market. As a result, HP returned 127% of its first quarter free cash flow to shareholders. HP ended the quarter with $3.4 billion in gross cash, which includes cash and cash equivalents, and short-term investments of $5 million.
In total, HPQ has spent on average only about 13% of its operating cash flow on maintenance CAPEX in recent years, about 20% on dividends, and has maintained a reinvestment rate between 5% and 7, 5% in recent years.
We can now estimate the long-term growth rate using both the ROCE and the reinvestment rate obtained above, as shown in the following table. Note that I have adjusted the growth rate by 2.5% to account for inflation. As you can see, for me, the most likely long-term growth scenario would be a higher single-digit annual growth rate, between 7.0% and 9.5%.
Now, to put the pieces together and conclude:
- HPQ is currently valued at 7.2x EBT, which is equivalent to a 14% yielding equity bond.
- At the same time, there is a good prospect of a long-term organic growth rate of 7% to 9.5%.
- Thus, an investment here is similar to a stock bond with a return of almost 14% and at the same time with an increase in the coupon payment of 7-9.5% per year, which leads to a very favorable probability of return. long-term double digits.
Final thoughts and risks
This article analyzes HPQ, the newest major addition to BRK’s equity portfolio. Beneath its tech surface, it’s a classic Buffett investment with a high return on capital (over 100% on average in recent years), strong cash generation but low cash requirement (on average, it requires only 13% of operating cash flow as maintenance CAPEX), and generous returns for shareholders (redemptions of $1.5 billion in the last quarter plus $0.3 billion in dividends ). And this industry-leading personal computing space is now on sale at just 7.2x EBT.
Finally, the risks. HPQ faces both macro risks and risks of its own. The effects of the COVID-19 pandemic represent a major risk. The actions taken by governments, companies and individuals in response to the situation are totally unpredictable. For HPQ itself, it relies on third-party suppliers and a global distribution network. Such dependency creates risks, including component and supply chain shortages. The war and pandemic between Ukraine and Russia may create further complications.
Thanks for reading ! I look forward to your comments and thoughts!