What does Buffett see in HP?

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Most UK schoolchildren will have some understanding of the Great Depression from reading Of mice and Men, in which George and Lennie’s struggle to escape the drudgery of their lives as ranch hands acts as a metaphor for each other’s daily struggle for existence. Although Warren Buffett (b. 1930) may not remember the full extent of the Depression, it is certainly evident that some of his lucrative early ventures bear the imprint of those troubled economic times. According to his biography, “Warren was so desperate to make money that in 1938, in the sweltering Nebraska summer heat, he rode miles to the racetrack where he spent hours on the hands and knees scouring sawdust-covered floors for discarded running heels, hoping to find a winning ticket.

While it’s an endearing and pitiful anecdote, it also says a lot about Berkshire Hathaway’s later approach to investing in the US stock market, which encompassed both finding unloved gems and unbeatable brands at reasonable prices. While Alex Newman recently cleverly dissected Berkshire’s annual jamboree, from an investor’s perspective, it’s worth analyzing individual Berkshire purchases and determining if there are other opportunities available that could reflect their fundamentals, especially now that the US market is beginning to correct sharply.

In the current climate, it is worth remembering that companies are facing a combination of unprecedented inflation in input costs, combined with uncertainties in their supply chains. Buffett has therefore opted for investments that he understands and that can provide a safe margin of income against the cost of inflation that all investors are currently looking for. Berkshire took a six-year break before plunging into the market earlier this year and buying Alleghany (US:Y) outright, alongside a significant stake in the printer maker and software company Hewlett Packard (US: HPE). Setting aside our own portfolio of US stocks this time around, the detailed analysis of these two buys can provide some insight into Buffett’s thinking and the state of the US market as a whole.

Industrial boring: the case of Hewlett Packard

It’s fair to say that Berkshire Hathaway’s surprise 11% stake in computer, printer and cartridge maker Hewlett Packard has raised quite a few eyebrows. It’s worth noting that the stake is relatively small in the context of Berkshire’s overall holdings – Apple alone accounts for around 45% by value of the publicly traded portion of the portfolio – but the boring but vital nature of the company, as well as its brand and position in the US market, must all have played a role in the investment decision-making. It is also helpful if recent counts show a marked level of improvement.

In the end, it all comes down to money, and HP is raking in that right now. In the latest round of annual results, the company reported free cash flow of $3.5bn (£2.9bn), a five-year high. This is no doubt due to a return in demand after the worst effects of the pandemic have subsided, but also to ongoing problems with supply chains. In this case, a need for restocking to meet potential demand, which is clearly seen in increased inventory levels to meet higher expected orders. These expectations were largely met in the first quarter results and the increase in inventories helped to support the increased order levels. Notably, HP is still producing high levels of free cash – over $500 million in the first quarter, with hopes that this will be between $1.8 billion and $2 billion for 2022. together, this pushes HP’s return on assets well above the long-term average. Last year, it was over 17%, compared to a five-year average of 11.9%.

HP’s cash flow is improving rapidly
Year 2016 2017 2018 2019 2020 2021
End of period October 31 October 31 October 31 October 31 October 31 October 31
($M) ($M) ($M) ($M) ($M) ($M)
CASH FLOW
FREE MOVEMENT OF CAPITAL
Operating cash flow 5,056 1,335 2,964 3,997 2,240 5,871
Tax paid
Capital expenditure -3,280 -3,137 -2,956 -2,856 -2,383 -2,502
Free cash flow (FCF) 1,776 -1,704 172 1,297 22 3,553
VALUES PER SHARE
Operating cash flow per share (ȼ) 290.7 79.7 190.9 292.6 173.1 441.4
FCF ps (ȼ) 102.1 -101.8 11.1 94.9 1.7 267.1
Capex ps (ȼ) 188.6 187.4 190.3 209.1 184.2 188.1
*Source: FactSet

So overall an improving trend that attracted Berkshire Hathaway – that and a price-earnings (PE) ratio of just nine, just under half the S&P’s PE rating before the recent falls. The only fly in the ointment is whether the penchant for strategic errors that has plagued HP over the past decade is now firmly behind it. Still the ghost of the party is the disastrous $11 billion takeover of software maker Autonomy, which resulted in an acrimonious and, in part, ongoing court case. Besides being deeply embarrassing, the case exposed infighting and disagreements among key HP insiders that contributed to the company’s poor strategic decision-making.

According to academic Stephen Kahlert, author of Leadership and Change Management: A Case Study from HP, the company’s main problem over the years was a ‘top-down’ management culture that was primarily cost-driven – for example, the company even reduced the number of bin collections at its headquarters. The net result was anarchy when weak leadership at the top allowed factions and infighting to develop between the software industry and the traditional manufacturing industry. The response was to separate and merge parts of the software business with Microfocus in 2017, while retaining the core Software as a Service business which, judging by its gradually improving base numbers in the meantime, seems to have been the right course of action.

In other words, if Berkshire Hathaway was watching HP closely, it waited for the actions taken by new management to start bearing fruit before acting, which may have also been delayed by the impact of the pandemic. It’s worth bearing in mind that for all its past dysfunctions, Hewlett Packard is a highly recognizable brand that holds its own alongside a highly select group of tech peers. It also has pricing power; the cost of its consumable ink cartridges, for example, can be well above the rate of inflation because many people use its branded cartridges in their printers. All in all, it was clearly too tempting an opportunity for the Sage of Omaha to ignore.

Alleghany as a hedge against inflation?

Berkshire’s other main buy this spring, Alleghany, is in many ways a better deal. For starters, it was an outright purchase rather than a simple equity build-up, and Berkshire Hathaway was willing to shell out more than $11 billion for a conglomerate of disparate companies. While Alleghany’s main business is insurance and reinsurance, a separate holding company owns businesses that manufacture everything from precision machine tools to cemetery furniture and tombstones, and the quirky collection originates because it started life as a simple holding company for accumulated investments.

Alleghany fits nicely into Berkshire’s existing insurance business and is expected to strengthen its presence in personal lines such as motor insurance, as well as its play in the reinsurance market. What the company has in common with Berkshire Hathaway is a clear ability to generate significant amounts of free cash. This varied depending on the underlying claims market, but the trajectory was clearly up and hit an eight-year high of $1.8 billion in the latest results. The cash available is significant as it funds a dividend payout which, prior to the Berkshire acquisition, stood at nearly 9%, with a PE ratio of around 11 slightly below the index average. S&P 500 multiline insurance of 11.5. The impression is created that one of Berkshire Hathaway’s concerns when buying a high-yield insurer is that the company is looking to deploy capital to offset the impact of inflation on its overall cash position – Berkshire still holds at least $130 billion in cash.

What is the next step ?

The instability of the underlying US indices, particularly the much more volatile Nasdaq, should provide more buying opportunities for value-oriented investors in the months ahead. With quick fixes across the board, it won’t be long before Berkshire Hathaway makes its next move.

Some stocks have clearly suffered more than others. There aren’t many tech companies on the Nasdaq that haven’t experienced 50% or more year-over-year declines; as the market re-evaluates their outlook, and some large-cap companies have seen stock prices pull back to levels that are clearly a knee-jerk reaction to the general sell-off. For example, the likes of Pfizer (US: PFE) are currently reporting 9.1% on a PE ratio of just 11, returning 17% over the past 12 months as the impact of the pandemic on vaccine sales has begun to ease. Pfizer is also posting a very strong return on capital employed of 18%, driven in part by sales of its Covid vaccine. It seems that the market’s expectation that the boost will only be temporary has led to a selloff.

Now that begs the question: is pharmaceuticals an area that Berkshire Hathaway would be interested in again? Last year, Berkshire reduced its investments in companies like Merck (US: MRK)Pfizer and Bristol Myers Squibb (US: BMY) and opted instead for smaller biotech companies – like Royalty Pharma (US: RPRX), MorphoSys (DE:MOR) and Biohaven (US: BHVN) were all beneficiaries of Berkshire Hathaway’s investments. This reflects the decline in U.S. biotech valuations over the past 12 months, which would give Berkshire higher average returns if its smaller company investments all break through with tradable products. Whether this strictly represents “value” investing is a moot point and these companies are hardly brand names, so it would not be surprising if the current market rout soon brings Buffett back to large-cap pharmaceutical stocks.

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