HP Inc. (HPQ) Earnings Call Transcript & Summary

Good afternoon, everyone, and welcome. I'm Tony Sacconaghi, Bernstein's IT hardware analyst, and I'm really pleased today to be joined by Enrique Lores, the CEO of HP Inc. Thank you for joining us Enrique, and welcome.

Thank you for having me here, Toni.

Before we get started, I just wanted to say that today's discussion includes forward-looking statements that involve risks, uncertainties and assumptions, which are further described in HP's SEC filings, including HP's Form 10-K and 10-Q. HP assumes no obligation and does not intend to update any such forward-looking statements. For more information, please visit HP's Investor Relations web page at investor.hp.com. So with that behind us, again, welcome, Enrique. It's amazing to think that you've actually been CEO for less than 2 years, given everything that has happened during your tenure. To remind folks, Enrique joined at the end of 2019 and basically coincident with your becoming CEO, HP announced a value creation plan, which included a large restructuring, reducing about 15% of the workforce, a change in the printing business model, the HP+, then you had to deal with Xerox offer. And then you've had COVID for the last 1.5 years. So it's amazing you look this well given what your first 2 years have been like. So I guess, maybe to start, you could just reflect at a high level, what has been most surprising to you over the last 2 years in terms of a positive and maybe the most difficult unintended challenge over the last couple of years?

Sure. I think the -- probably the biggest positive is that kind of the changes that the pandemic is bringing is putting HP at the heart of how people are going to work and live in the future. And this is really opening significant opportunities for us long-term for new PCs, new experiences, new ways of delivering print. More opportunities on the industrial side. So clearly, the pandemic is having a positive short and long-term impact on HP business. And I would say on the negative side, I think, has been the tensions and the pressure that the teams have gone through during the last 24 months. I think if we think of what happened when COVID started, when we asked everybody to work from home, where many countries were in very difficult situations, and still, many countries are in difficult situations, I think the human side of the pandemic is probably what has been the hardest thing to manage, and to really use the company to support employees in any ways we could.

Well, you guys just reported last week, a very strong quarter. Print revenues and PC revenues were both up 20%. I think the one thing that was maybe a little bit of a surprise for investors was that PC margins fell a little bit more. I think you were calling for margins to be relatively flat. They fell a little bit, still very strong. And your guidance for EPS was below normal seasonality. So maybe you can just start by talking about what happened to margin sequentially relative to your expectations? And what do you see with margins happening for the rest of the year?

Sure. So let me start with a few comments on the demand side and the strength of the results because I think what they really show is what I was mentioning before. HP is at the heart of hybrid work, clearly enabling people to work from home, enabling students to learn from home. And this is, again, positive for our portfolio short-term and also long term. If I think about the quarter and the quarter-on-quarter evolution, I think also it's important to see that the overall EPS and profit that we delivered in the quarter was above our guidance and above expectations. And the trends that you saw quarter-on-quarter were in a big part driven by investments that we did during the quarter to continue to enable long-term growth, and we invested in R&D, we invested in marketing. We also increased compensation for employees given the strength of the results. But really, the key thing of the quarter was how strong the results were and really the sustainability of those going forward.

Right. And with respect to guidance for the second half, there was some explicit commentary that margins could be lower in the second half. What -- how should we -- what are the forces at work on margins looking forward? And why the guidance for EPS that is substantially below sort of normal sequential patterns for the fiscal Q3 and Q4?

Yes. Let me first talk about the guidance itself, and then I will talk about some of the trends that we see. When we look at guidance, we actually increased it by $0.25 from where we were a quarter before. So we clearly signaled that we saw the overall year to be stronger than what we were seeing it only 3 months before. Additionally, if we look at the year-on-year growth, EPS in the second half is going to be growing by 46% compared to EPS on the second half last year. And it's true that seasonality is different. But we are in a period of time where really seasonality is not driven by demand, which is what usually happens. In this case, it's really driven by supply. So comparisons quarter-on-quarter are difficult this time just because kind of the overall market dynamics are very different. In terms of what do we see from a margin perspective happening in the second half. We expect to be able to maintain high prices as we have done in the first half, really a good situation on the price side, but we also expect that costs are going to be increasing in the second half. We are -- the industry overall is in a component shortage situation. We are seeing cost of components increasing. We are also seeing logistics cost increasing, and we were reflecting some of this in the guide. Of course, we will be repricing, and we will -- as we have done in the past. What is very hard to predict is exactly what will be the timing of cost increases and price increases. But we have done during the last quarter, our approach has been to be prudent when we give guide. We are giving guide for the full year, and we decided that it was better to be on the prudent side. So investors know really what is the number that we will do. But if we can do better, we will do better.

Right. And Enrique, when you talk about component input costs rising, what -- specifically, which areas of components are most tightly constrained? And where are you seeing most pressure? And I guess, why would there be a lag in the sense that you do -- you have a very strong backlog. So there's no real risk of pricing too much and then losing a lot of business because you still have a lot to fulfill and catch up on. So 2 questions. What are the areas where you are seeing the most pronounced input cost pressure? And then secondly, why is it more -- why is it not seamless to be able to pass along price increases, given you're in a very strong supply versus demand position.

Yes. So in terms of -- 3 things. In terms of component shortages, we have seen an evolution during the last months on where are the shortages. When 2 quarters ago, we were talking mostly about processors and panels, today, the situation on processors has significantly improved and now we see the biggest shortages in panels, not driven by the glass, but driven by the components that panels used and then in what we call low-cost components that can be WiFi controllers, codecs, bus controllers, almost any other component that is necessary to build a PC. And this is where we expect to see the highest pressures on cost. In terms of -- what was the second part of your question?

Just why not be able to pass them along if you have transparency that cost is going up?

I think is, in the medium term, we will be passing it along. It's just about what contracts do we have in the short term. Some contracts we can reprice, some other contracts we cannot. And this is really what drives our ability to reprice in the short-term but if we look at it with some medium-term perspective, we don't have any limitations as you are saying, and we will be reflecting in our prices the cost increases that we see. As again we have done in the past, if we look at the last 2 years when we have seen cost increases or in the case of the U.S. tariffs increases, that also required a price change. We managed that, and we went through it. So it's more about the transition and depending on how fast cost changes versus how fast we can change prices.

Right. And Enrique, speaking of prices, it sounds like you have ability to pass along, but your ASP strength has been particularly strong. Consumer PCs, ASP was up 8%. Consumer printers, it was up 22%. Is this largely a function of price increases because of components? Or is this a better mix? Or is this, I think, as you said on the call, principally lower discounts that you have because the demand environment is there so you don't have to take your traditional discounts because pretty well every product is being snapped up. And so this notion of, I have to get rid of it to bring a new product just doesn't exist. So what are really the key drivers of that ASP strength?

I think it's a combination of all. I would probably start with -- from discounts and the lack of -- the no need to do aggressive promotions or promotions at all, given how strong demand is. Also the fact that overall demand is stronger than supply gives opportunities to raise prices in some categories. And then in some cases, where we saw price -- cost increases and we also reflected that in the price. So it's always a combination of these 3 things, but they clearly helped during the quarter, as we said last week in the call.

Right. And that has a downstream impact to margins as well, clearly. So if you are able to do less discounting, discounting comes right off the top, your costs remain the same that's highly accretive to margin. So has that been the principal driver of margin improvement in both the printing business and in the PC business is really just this elimination of -- or reduction in discount levels?

Again, this is helping, but also price increases are helping. And this, again, is a combination of -- always of these things that drives improvement. I don't think -- pricing also is not only about demand. It's also about what is the competitive situation. And I think at the end it is difficult to exactly pinpoint what is the key variable because all of them play at once.

Right. Now you've talked a bit about your PC backlog saying that it's elevated and it could -- that elevated backlog could last through the end of the fiscal year. Can you give us any more color on just sort of qualitatively on the magnitude of this backlog relative to normal? So if normal backlog might be 4 weeks or something, is this 3x that level or 5x that level? And do you worry at all about double ordering and whether backlog could be inflated because some customers is in a desperate attempt have placed orders in multiple places and once they get fulfilled may cancel. So a couple of questions. Can you help put in context how significant the backlog is? And then is there any risk that, that may be bigger than you think because of double ordering?

Yes. So probably, it's worth that I explained what we mean by backlog because in different industries, backlog has a different meaning. At least in the case of HP, when we talk about backlog, we refer to -- in for both PCs and printers. We refer to orders that customers would like to get now and that we are not able to fulfill. And when I say now, I mean, within the next weeks, and this is -- when we say that we finished with elevated backlog is we are really referring to these orders where customers would like us really to deliver the goods, and we are not able to do that because we don't have enough supply. We have not quantified how big the backlog is. But I would tell you it's very significant when we compare it to the normal sales that we will be doing in a quarter. So it's -- when we say it's the highest we have had, we mean that it's really a very significant number. And you were saying it will last through the end of the year. I think it's going to depend on what is the overall situation on components. But if it doesn't improve, which is what we expect, it could continue through the first half of 2022.

Right. I mean, if you're saying, look, this is a meaningful number relative to quarterly revenue. That suggests that you have significant revenue. You could have revenues -- demand go down a lot and drain your backlog for a while and still really not see it in terms of the results. So that's significant. But if we were to quantify it relative to -- is it like 3 to 5x bigger than it normally is? Or is it 30% bigger than it normally is? I'm just -- I'm trying to -- because I have no context for what backlog is as a percentage of your quarterly revenue usually. I suspect it's only a few weeks to be a small percentage of quarterly revenue, and I'm suspecting it's multiples of that bigger, but I don't know if it's 30% bigger or 3 to 5x bigger?

I'm not going to quantify because we are not disclosing publicly this. I would say, significantly bigger. So it's...

I mean, I hear in the channel it's 3 to 5x bigger, which is why I keep saying that number. Okay. And when we -- when you look at that backlog, is it principally consumer and Chromebooks? Or are you seeing elevated backlog on the corporate PC side as well?

We are seeing it across the board. It is consumer, but it's also commercial. What we have started to see, as we said during the call, is an increase of the demand on the commercial side, as companies are planning their reentry to the offices. They are also investing to provide a more flexible environment to their employees. And this has been really driving a significant increase of the business on the commercial side through the last quarter, and we expect it to continue through the rest of the year. You were also asking about potential double ordering and how do we feel about the -- how solid we think the backlog is. This is something we monitor very carefully. For those of us that have been in this business for a while, we have been in situations where double ordering has happened in previous situations, and we don't see this happening this time. The key thing we look at is cancellations because in the past, when there was double ordering, we saw also an increase of cancellations. And cancellations are in -- are very, very low levels. So this is why we think backlog is real. It continues to grow, and cancellations are at very low levels compared to where they have been for many, many years.

Right. And you talked about this pickup in commercial. Now commercial is the vast majority of Chromebook sales that -- because they go to education. So if I take out Chromebooks entirely, are you seeing unit growth on the commercial side?

We are seeing unit growth on the commercial side, and what is more important, we are seeing demand growth from the commercial side from large enterprises, small businesses investing again in the business.

Right. So ex-Chromebooks, commercial units grew in the quarter and commercial backlog ex-Chromebooks also grew sequentially in the quarter?

We have -- if you think about -- we have a lot of large customers which are now investing in their employees. They are starting to hire employees that are really in need for us to supply the demand that they have for notebooks, which is really where we are seeing the majority of the demand. Desktops continue to decline as we shared in the call, and we think that, that trend is going to continue.

Right. Now if we kind of step back and put this PC strength in perspective, the obvious question is, what happens going forward, right? And I think many of you in the PC industry have said, look, people are going to have more -- there's going to be higher PC penetration. There may be shorter replacement cycles. But we've had a really uniquely huge surge in PCs, right? So just conceptually 2011 PCs peaked at $360 million. I think they dropped to about $260 million. This is including Chromebooks in 2018. And this year, we think they're going to be $360 million. So just extraordinary growth in a very short period of time. And we think Chromebooks are going from $15 million to over $60 million in 2 years. So what happens on the other side of that, right? We've run installed base models, it looks like a lot of new users, especially in Chromebooks, because replacements just weren't big enough to drive this growth. So a lot of new users, probably in consumer, a lot of new users. Is it realistic to think you're going to have as many new users next year and the following year? And for the industry, not HP, is there a risk that PCs are down and potentially down meaningfully at some point in 2022 or 2023? And how do you guys think about that?

Yes. The way we think about that is that we -- our belief is that this has been a structural change and that the increase of penetration of PCs is something that is here to stay. And that basically has been a reset in what is the total market size and that the market is now going to operate at these higher levels going forward. And this is really driven by the fact that we have changed how we work. We have changed how our kids learn. We are continuing to see strong demand from entertainment, from gaming, and this has really driven the demand now, and we think we'll continue to drive demand going forward. And this structural change is what makes us be optimistic about what will be the performance of this business, not only this year, but also in year 2022. And we actually agree with your estimate that the market size for this year will be in the $360 million range. But I would also add that this is a supply-constrained number. If it was not driven by supply, we could even see a higher number in 2021.

Right. So I get the possibility of a structural change in PCs kind of longer term. But if I think of that $260 million to $360 million over the last 2 or 3 years or $260 million to maybe even higher if it wasn't supply constrained, probably more than half of those are new users, right? And so I get that the base is higher, and 2 or 3 years from now, those people will all replace. But next year, your replacements may be elevated and they may be the same as this year. But are you going to get 30 million, 40 million, 50 million new users again next year and the following year? Because if you don't, and the replacements aren't different, units are going to go down. And so how do you think about that? How do you gain confidence that, that can mathematically occur?

Most of this is driven by increases in penetration. I'm going to use education that is one example. When we look at the education space, less than 10% of the students have access to a PC today. So even with all the growth that we have seen, when we look at the number of students in the world, the penetration is still relatively low. And when you compare that with penetration of other type of technology, this gives us kind of confidence that this number is going to continue to grow going forward. And when you look at penetration of PCs per household and you compare to the number of people per household, we are still in the very low side, where we think that eventually, we will get to 1 PC per person. So all these drivers tell us that the market could continue to grow or at a minimum to stay at the same level where we are going to be finishing this year.

Right. So you don't think there's likely to be any kind of hiccup or downturn on the other side before you get back to sort of normalized growth?

Again, when we look at the trends and the key variables we are tracking, that we're optimistic about what this business is going to be.

Right. Because -- I mean I'll just push in, I don't want to go down this rabbit hole too long. But -- so I've looked a lot at the education market. There are 50 million education aid students in the U.S. and maybe 40 million of them can get a PC, some are a little too young. This is age 5 through 18, so exclude college. So there are maybe 40 million in the U.S. And the U.S is 1/4 of everything. 1/4 of global GDP, 1/4 of IT spend, 1/4 of everything. So I sort of go, okay, well, maybe there could be 160 million to 200 million PCs for students at penetration. Maybe I'm wrong on that. And my Chromebook model is like 150 million units in the installed base next year, right? So to me, I know there are 1 million students, but there are many, many of those in Africa that probably won't have a PC, and you could do the same cell phone math. So am I -- like am I wrong in that analysis? Or like I get it's 10% penetrated. It's $100 million out of $1.2 billion. But realistically, like why isn't that addressable market only $200 million, given that kind of the U.S. is about 1/4 of everything?

Yes. I think because when we look at the opportunity in education, we continue to see opportunities, not only in the U.S., but also in many other parts of the world that are investing significantly in this category. And I think this is why we continue to see growth in the education side, and we expect to continue to see it in 2022.

So could -- do you have a sense, if I take out U.S., Japan and Western Europe, what was the growth rate in Chromebooks and education in those 3 countries versus the rest of the world? I would bet that it was fivefold of what it was in the rest of the world. And that's why I'm asking you. And maybe I'm wrong, but...

I don't know that specific data, Toni, but I'll be happy to go and check and discuss it with you.

Okay. Fair enough. Sorry, I didn't mean to put you on the spot, and I just thought of it.

Okay.

So maybe we could just talk a little bit about printing. So supplies revenue are basically flat with 2019 in the just reported quarter. And prior to the pandemic, supplies were generally going down low single digits per year. We've had a pandemic. Office printing has been decimated. And yet supplies arguably on a 2-year basis have had their best 2 year performance in 2 years. Why is that? Like just intuitively, it doesn't seem like that would be the case given the trend it was on before and this might hurt printing. So how do we reconcile that?

I think there are 2 key things. First is what has happened with -- on the home space, from printing at home side, where we have seen much better performance than we were projecting before the pandemic. And this has been a clear driver of growth. And second is also what we were discussing before about pricing and promotions. Similar trend what we have seen on the hardware side has happened on the supply side. Given the component, the shortages that we have seen, we have not promoted, we have not discounted, and we have been able to hold share. And therefore, this has also had a positive impact on the supply side.