Hewlett-Packard (NYSE:HPQ) has a history of destroying a tremendous amount of shareholder value through poorly timed share buybacks. From fiscal 2009-2011, HP spent a total of $26.3 billion repurchasing its own shares, taking on debt in order to finance the transactions. The stock is now well below the peak levels of those years, and CEO Meg Whitman, who ascended to that position toward the end of 2011, has since drastically reduced the buyback activity of the company.
HP has spent about $2.5 billion on share buybacks over the past 12 months, and the company has $5.7 billion remaining in its previous stock repurchase authorization. While HP will likely continue buying back its own shares, the company should instead consider raising the dividend significantly, scrapping the remaining $5.7 billion buyback authorization entirely.
The problem with HP's buyback program
HP has plenty of capital available for share buybacks, but simply having the ability to buy back shares doesn't make it a good idea. A company should only buy back its own shares when the stock is materially undervalued, and while HP may appear inexpensive based on current earnings, I'm not confident that the company can grow, or even maintain, those earnings in the long term.
The two largest components of HP's profits are the printing group, which is composed of printers and printing supplies, and the enterprise group, which consists of enterprise hardware like servers, as well as technology services. Combined, these two segments accounted for $8.2 billion of non-GAAP operating income in fiscal 2013, compared to $2.9 billion generated by the rest of the company.
HP's printing business is a cash cow, albeit one in decline. Revenue has been falling for quite some time, but HP has managed to keep operating margins in the high teens. The enterprise group has also been in decline, although HP did manage to boost revenue by 2% year over year in the most recent quarter. The real problem, though, is that the enterprise group's operating margin has been continually declining for the past two years. And with the Lenovo-IBM deal finally set to close, HP could be facing a very aggressive competitor in the enterprise hardware market.
HP generated $8.4 billion in free cash flow in fiscal 2014, putting the current market capitalization at a little more than eight times this number. Share buybacks may seem like a no-brainer at this valuation, but if the free cash flow contracts over time, a reasonable assumption given where the bulk of it is generated, then the stock isn't nearly as cheap as it appears.
The dividend should be raised
The best thing that HP can do for investors is raise its dividend. The stock currently yields about 1.8%, and HP will pay out just $0.64 per share in dividends over the next year. That's only $1.2 billion, or 14.3% of the free cash flow.
HP can afford to significantly raise the dividend, bringing it up to the levels of other large tech companies. Historically, HP has heavily favored buybacks, keeping the dividend flat from 1998 all the way through the beginning of 2011, all the while reducing the share count with buybacks. This policy hasn't done much for investors.
Even if HP's earnings decline, the dividend currently accounts for such a small portion of profits that it shouldn't cause any problems. A 50% dividend increase would lead to $1.8 billion in payouts each year, so even a massive 50% collapse in HP's free cash flow would still give the dividend plenty of breathing room.
Before any more money is spent on share buybacks, HP should raise its dividend to make it comparable to other big tech companies like Microsoft and Intel, which are currently both yielding 2.6%. HP's share buyback record is abysmal, buying when the stock is high and cutting back when the stock falls, and the company should instead give that money directly to shareholders in the form of dividends. The average investor could almost certainly do a better job than HP has done allocating that capital.