Digging Into HP’s Q3 Results

HP’s Q3 financial report for the three months ending July 31 once again showed impressive revenue growth along with robust bottom-line earnings, and as we head into year-end, we wanted to dig back into that financial report and look at a few of the specific pieces. 

Some of the financial highlights for the period included:

• 2018 third-quarter net revenue of $14.6 billion, up 12 percent (up 9 percent in constant currency – CC) from the prior-year period;

• Third quarter GAAP diluted net EPS of $0.54, above the previously provided outlook, and third quarter non-GAAP diluted net EPS of $0.52, within the previously provided outlook.

• Q3 net earnings were $880 million, a huge boost over Q317’s $696 million, and the firm reported a GAAP operating margin of 7.4 percent.

“Q3 was another strong quarter, with consistent and balanced performance across segments and regions,” said Dion Weisler, president and CEO, HP Inc., in the earnings release. “We delivered differentiated innovation in our core, advanced our growth initiatives and are investing in our future while delivering profitable growth.” In the conference call reporting the results, Weisler commented, “As I have been clear about, our goal is to consistently deliver on our financial commitments, while executing our strategic framework. We do this by playing our own game and winning in the right way, and by delivering products and services that are consistently engineered to amaze our partners and customers.”

In the analysts’ conference call, Steve Fieler, HP’s new CFO, noted that regionally (revenue in constant currency) Americas grew 6 percent, EMEA was up 10 percent and Asia-Pacific-Japan grew 13 percent. Fieler also acknowledged a squeeze in operating margins – which declined to 18.4 percent, down 20 basis points YOY, “primarily resulting from the addition of S-Print,”- which, in HP-speak, means the inclusion of results from the acquired Samsung printer operation. In a further indication of business confidence, the company also raised GAAP diluted net EPS estimates for fiscal 2018.

Earlier in the year, HP forecast that the inclusion of financial results from the integration of the Samsung printer operation would depress margins for much of 2018 — this indicates the company will continue to spend money integrating and converting the Samsung business into its printer/A3 operations. Fieler explained the margin hit: “Non-GAAP operating expenses of $1.6 billion were up 15 percent; this increase (we estimate it is about $200 million) … was driven by the addition of S-Print along with incremental R&D and go-to-market investments to support growth.” [more about the italicized phrase later. Our Q1 analysis of HP’s results looked at the contribution of the Samsung unit in detail; HP is no longer reporting that activity separately.

Breaking down results by segment, Personal Systems (PC) performance was reported up 12 percent YOY (up 9 percent in CC) with a 3.9 percent operating margin. Commercial net revenue increased 13 percent and Consumer net revenue increased 10 percent. Total units were up 6 percent with Notebooks units up 6 percent and Desktops units up 7 percent. In a simple analysis, if revenues grew by 9 percent in CC, while total units were up 6 percent, the firm’s Average Selling Price (ASP) for PCs must have increased (note that concept for later when we look at printers). We don’t have any publicly available research house numbers for Q318 yet as a reference, but IDC reported Q2 YOY 2018 PC growth in shipments of traditional PCs (desktop, notebook and workstation) of 2.7 percent. IDC noted that the results exceeded IDC’s forecast of 0.3 percent growth and is the strongest YOY growth rate since Q1 of 2012; obviously HP easily bested these overall industry growth rates by a significant margin. Fieler broke out the individual product segment performance, “By product category, revenue was up 13 percent for notebooks, up 12 percent for desktops and up 11 percent for workstations.”

HP’s CFO also touted the PC unit’s competitive achievements, “We outgrew the market by 5.4 [share] points and earned market share of 24 percent, doing so while managing cost headwinds and investing in innovation.” In the brutally cutthroat PC sector, Fieler highlighted HP’s execution discipline, adding “Personal Systems continued to grow operating profit, up $52 million versus last year. We also improved operating margin to 3.9 percent, up 20 basis points year over year and 10 basis points sequentially,” driven primarily by higher ASPs. 

Printers: Positive numbers, but performance comparisons are lacking

• Printing net revenue was up 11 percent YOY, $5.188B (up 9 percent in CC) sporting a 16 percent operating margin. Total hardware units were up 12 percent with Commercial hardware units up 91 percent, bringing in $1.170B in revenue, and Consumer hardware units up 2 percent, delivering $613M in sales. Supplies net revenue was up 8 percent (up 6 percent in CC) to $3.405B. For comparison, the table below compares Q1 and Q3 growth (+/-) figures to HP’s reported Q1 ’18 numbers:

All comparisons – prior year/the same period FY, constant currency    
*Calendar quarter, per HP

Except for commercial hardware unit shipments, all of the firm’s major growth indexes declined from its heady Q1 report. The 8 percent (6 percent CC) revenue growth figure in supplies could ordinarily be considered hopeful, but that growth metric now includes S-Print supplies sales; therefore just how the “organic” HP-branded supplies business performed is unknown.

HP’s print operating profit grew $25 million YOY, but operating margin was 16 percent, down 1.3 points year over year (it was 17.3 percent in 2017). Printers delivered $832M in profits in Q3, up 3 percent from $807M in the prior year quarter, but slightly down from the $839M earned by the group in Q2.

Why did printer operating margins decline in Q3? In part, Fieler conceded that, “… our supplies mix is down year over year,” – an acknowledgment that the sales ratio of profitable OEM supplies sold to installed base units weakened. That effect happens when the installed base prints fewer pages (and consumes fewer supplies), or switches to aftermarket supplies, or a mix of both (it can also be driven by a decline in installed base units – for example, if field units are retired or replaced by new non-HP units).

Questioned on the margin decline by analysts during the earnings call, Fieler was more specific. “When I look at our [margin] rate now, it is more driven by the addition of S-Print than any … other factors.” So specifically, the printer operating margin decline was the result of the inclusion of S-Print financials and “strong unit placements and investments in growth and future initiatives, including A3 and 3D printing.” The S-Print effect had been explained by HP previously — including that it expected the adverse financial effect of integrated S-Print activities to wane over the course of 2018. That could mean that S-Print sales operations are losing money (again, see our Q1 analysis of this situation). HP also noted that margins were impacted by an increase in raw material costs in the period, which is expected to continue into in Q4 results.

Here are the major printer operating indexes and what they reveal about the underlying HP printer business activities:

• By quarters, FY 2018 total printer hardware units increased 12 percent in Q3, 13 percent in Q2, and 14 percent in Q1; an average increase across the three quarters of 13 percent
• By quarters, FY 2018 commercial printer hardware shipments increased 91 percent in Q3, 88 percent in Q2, and 73 percent in Q1; an average increase across the three quarters of 84 percent
• By quarters, FY 2018 consumer printer hardware shipments increased 2 percent in Q3, 4 percent in Q2, and 7 percent in Q1; an average increase across the three quarters of 4.3 percent
• By quarters, FY 2018 supplies net revenues increased 6 percent in Q3, 6 percent in Q2, and 10 percent in Q1 (in constant currency); an average increase across the three quarters of 7.3 percent

Of note here is that typically for HP, supplies revenues are double what hardware revenues are – outlining the basic business model ratio that 33 percent of revenues are from hardware and 66 percent from supplies – but with vastly different gross margin ratios, of course.

As a reminder, HP printer “commercial” unit shipments include such pricey hardware as 3D systems ($100K and up), large-format DesignJets, Indigo Digital Presses, commercial Latex and PageWide production/industrial presses, and the new A3 hardware. Beyond A3 models, every one of these machine types have dramatically higher ASP than any office-class inkjet or laser printer. So, all things considered, if anything, the typical ASP of HP’s commercial print hardware should be increasing.

But, if commercial and consumer hardware unit shipments increased an average of 84 percent and 4.3 percent respectively across the three FY18 quarters, with a combined average unit increase across the three quarters of 13 percent, why did printer hardware revenues only increase an average of 26.3 percent when the biggest shipment increases came from non-consumer, higher ASP models? We believe it is because of average sales price.

All dollar figures are as reported in CC – YOY

Connecting the dots, commercial print unit shipments were up 91 percent in Q3 YOY. That is almost a doubling of shipments, but the bump in revenue for the same quarter, Q3, for commercial hardware was only $230M ($1.170B vs. $940M YOY) – an increase of only 24 percent YOY. Since the margin decline was caused by “investments in growth and future initiatives, including A3 and 3D printing,” we believe the decline is a combination of lowered hardware unit prices and spending of marketing dollars to move or place units, perhaps including seed or demo machines like the A3-class, and possibly other hardware growth categories such as 3D.

No crystal ball

HP’s printing unit performance is almost impossible to assess at the moment because, to start, the group has a lot of moving parts in various stages of market growth and maturity (printers, A3, 3D, wide-format, Indigo, new models, closeouts, etc.) and the FY18 numbers now include the acquired Samsung printer unit activities – which cloud the picture: reported revenue, profit, supplies and unit shipments. At this stage, the best we can do is guess, and hope that the fog that appears to be obscuring HP’s printer unit financials will clear up in the next several quarters because at the moment, they are virtually inscrutable.