<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> Analysis of HP's 1Q09 business results (Feb 20, 2009)

Annex Bulletin 2009-05                            February 20, 2009

A partially OPEN edition

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Updated 2/27/09, 9:50AM MST, adds Market Update...

Analysis of HP's First Quarter FY 2009 Business Results

Hurd First Stumble

Revenues, Earnings Disappoint Wall Street; Stock Down Sharply

SCOTTSDALE, Feb 20 – For a while, it looked as if HP's CEO might be able to keep working his Wall Street magic forever.  After all, he has been meeting or exceeding analyst expectations for nearly four years now.  Well, the streak is now over.  HP disappointed investors this week with its first quarter results.  And the stock tumbled, making 1Q09 Mark Hurd 's first stumble.

Nor was the HP stock decline limited just to the "day-after" knee-jerk reaction.  Dip... dip... dip... went the HP shares throughout the week - before, during and after the first quarter earnings release (after the markets closed on Wed, Feb 18).  The decline erased about 12% of the HP shareholder's market value. 

To be fair, the Dow Industrials were also down for the week, but by about half as much as the HP stock.  And since HP is a part of the 30 stocks that comprise the Dow, it means the largest computer company's weakness dragged down the overall index, too. Even IBM was pulled down by the week's pessimism even though Big Blue reported solid fourth quarter numbers a month ago (Two Thumbs Up for Big Blue, Jan 20).

HP said it earned $1.85 billion, or 75 cents a share, for the three months ended Jan 31, compared with a profit of $2.11 billion, or 80 cents a share, during the year-earlier first quarter. Revenue rose 1% to $28.8 billion from $28.5 billion in the prior year's first quarter.

Despite the disappointing results, Hurd tried to put on a brave face.

“HP is a market leader executing well in a tough market,” he said. “Our market strength, disciplined cost management and diverse portfolio allowed us to differentiate HP in the global marketplace and gain share in key markets.”

Business Segment Analysis

Services Up, Sort of...

In a subsequent teleconference with analysts, the HP CEO and its CFO, Cathy Lesjak, both stressed that the company had gained market share. 

"We gained share in almost all of our key segments," Hurd told the analysts, "while integrating EDS in an environment of volatile currency and worsening and toughening demand.  And in many ways I will tell you Q1 from an execution perspective was among the strongest (quarters) we have delivered."

"We saw pressure on our hardware businesses due to the slowing global economy," Lesjak echoes her CEO's comments. "We reacted well in this tough market, outpacing the competition and gaining share in most segments."

We found that hard to reconcile with sharp revenue declines in nearly all of its businesses (see the left chart).  Printing and imaging and PC revenues were down 19%; servers and storage dropped 18%; software was down 7% and even the services business (EDS) was down 15% on an apples-to-apples basis, even though it appeared to be up 116% as reported (EDS was not a part of HP a year ago).

In fact, we have found it a bit, shall we say, "aggressive," not misleading, of the company not to have provided the "organic" services growth numbers.  It was only during the Q&A that the HP CFO admitted this business was actually down.

"If you actually look at EDS on a combined company basis, getting them in the base for last year and also this year for the quarter, revenue declined roughly 15%," she said, answering an analyst question. 

A 15% drop is a far cry from the 116% increase.  Which is why we think the company should have been more forthcoming about its true, organic services growth.  Such numbers are a little harder to hide when it comes to margins.  HP's overall first quarter margins were 23.4%, down 130 basis points from 24.7% one year ago.

"This decrease was driven primarily by the addition of EDS, which has lower gross margins," Lesjak explained.

But to the credit of the HP Services  unit (HPS), thanks to other cost and expense cuts (9,000 jobs have been eliminated since the EDS acquisition), they were able to actually increase their operating margins to 12.8%.  This has made now HPS the company's biggest profit contributor, surpassing for the first time its erstwhile "cash printing" machine, the printing business ($1,123 million vs. $1,105 million in operating profit).

"I still think, we'll be doing work five to six quarters from now to get the entire model where we would like to," Hurd said. "I do think it probably operate a little faster than we planned when we look at it against the total, meaning it's a percent of the total, but we'll have work to do as we go out over the next several quarters. But we are ahead of schedule."

Enterprise Hardware Down...

As for the enterprise hardware businesses, whose revenues dropped 18% and operating margin sank to 10.3% of revenues, HP CFO said that the margins were down "mostly because of competitive pricing environments."

"This year, we're passing way more of that through to the customer... (and) more customers are moving to lower-end, less configured, less business-critical systems, mix, that type of thing that drives margins down as well."

Meanwhile, storage revenue declined 7%, business critical systems revenue declined 17%, and industry standard server revenue declined 22% from the prior year, "even as HP  gained almost 3 points of share in the x86 market in calendar, Lesjak said.

How's that possible? Well, look at IBM, HP's chief hardware competitor.  It its fourth quarter, hardware revenues were 20%, led by declines in the System i and System x businesses, down 92% and 32% respectively, as well as the company's chip business, which declined by 34%.

On the other hand, the System p revenues were up 8% (up 14% when adjusted for currency).  The System z (mainframe) business was also up 1% in constant currency, though it was down 6% as reported.

So IBM beat HP in the Unix market and cleaned up in the mainframe business, from which HP is virtually absent.  So where HP gained share, as its executives hailed, it was in the loser business segments for both companies.  HP gained share by losing less than IBM.  That's some feat...

Meanwhile, even as IBM gross margins also dropped from 45.7% a year ago, to 39.9% in the latest quarter, Big Blue's hardware is still more profitable than HP's (12.7% pretax margin vs. 10.3% operating margin for HP).

BRIC by BRIC...

"Brick by brick, my fellow citizens, brick by brick" (Roman Emperor Hadrian (76-138 AD)

Also by contrast to IBM, HP's revenue in the BRIC countries (Brazil, Russia, India and China) declined 22% in the quarter over the prior-year period while accounting for 7% of total HP revenue.  In IBM's case, while 4Q08 revenues in major (developed) countries shrank 5%, the business in the BRIC markets (Brazil, Russia, India and China) grew by 2% (up 13% in constant currency).

IBM's Russia business in that country contracted 22%, mirroring HP's woes there, too.  But IBM revenues in India, Brazil, Egypt and Chile, among some developing countries, soared.  And China also bounced back with a 14% revenue surge (up 9% in constant currency).  HP's Asia/Pacific revenues, on the other hand, declined 11% since a year ago.

Cash Flow Squeeze

HP's sharply lower cash flow was another reason for some raised eyebrows among the analysts and investors.  Cash flow from operations was $1.1 billion for the quarter and free cash flow was $450 million.

"Q1 cash flow was unfavorably impacted by the softening economy," HP CFO said. "ESS and PSG responded quickly to the change in demand, while IPG inventory levels remained above plan."

"What really was the negative impact on cash flow was that inventory didn't come down the way it needed to come down," she added.  "And this gets back to the execution issue that -- and challenges that we're having with -- in the IPG business. Again, we need to get that inventory down."

Share repurchases in the first quarter totaled $1.2 billion or approximately 34 million shares. Finally, HP paid its normal quarterly dividend, totaling $193 million.

Asked by an analyst why the company's stock buybacks were substantially above the free cash flow in the quarter, Lesjak said that, "we haven't really tied it directly to -- I'm only going to spend whatever the free cash flow is in a particular quarter. Even when we do look at free cash flow, we look at it over a longer timeframe."

HP's CEO Hurd tried to put a positive spin on the cash flow issue.  "We think overall we'll have a good cash flow (in 2009)," he told the analysts.

Summary & Outlook

Hurd also tried to put a coat of pink paint over the company's lower outlook for the rest of the year.

"We see the opportunity here for us to put the company in a better position, to level the strength of our model, expand our penetration in the market, and accelerate our cost actions," he said. "I want you to be confident in our ability to execute and deliver the EPS guidance within the revenue ranges that we have spelled out."

Well, you saw what the marketplace thought of it.  It turned thumbs down on HP, dropping the value of its shares by 12% this week alone. 

The day after these optimistic remarks, an HP news release told "the rest of the story."

"Hewlett Packard is cutting executive and employee pay across the board in an effort to reduce costs after announcing a 13 percent drop in first quarter profits," news media reported.  "The Palo Alto, Calif. company’s chief executive, Mark Hurd, will take a 20 percent pay cut, other executives will take a 10 percent to 15 percent pay cut, and most employees will take a 5 percent pay cut," the story said.

Well, at least no one can accuse Hurd of not putting his money where his mouth is.

Annex Clients: CLICK HERE for detailed HP P&L tables & charts

 Happy bargain hunting!

Bob Djurdjevic

MARKET UPDATE 2/27/09, 9:50AM MST

IBM Again Exerts Market Leadership

Big Blue Tries to Pull Dow, HP Up

Stock Up Sharply after CFO's Remarks at Investor Conference

SCOTTSDALE, Feb 27 – Just as it did last July, IBM is again trying to take over the market leadership.  Big Blue stock moved up sharply in the last two days, following yesterday's bullish remarks by its CFO at an investor conference in San Francisco.  IBM shares are up by almost 10 points since Wednesday morning (Feb 25), while the laggard HP and the reluctant Dow are still dragging down the market (see the chart).

Obviously, the circumstances are very different now from those last July.  Back then, IBM stock soared to within a dollar of its all-time high ($132).  Now, it's struggling to get out of the $80s - through no fault of its own.  The decline in the IBM stock is a classic example of how low tides can drag down all boats regardless of how spiffy and great they are. 

Unlike some of its other competitors, IBM has been been sailing through turbulent global and U.S. economic waters practically unscathed.  Yet is has been tarred with the same brush as HP, Dell, Microsoft etc., the IT companies whose business results disappointed investors and matched the general gloom and doom of the marketplace.

Guess that is why the IBM CFO Mark Loughridge (right) took an unprecedented step of speaking out publicly about the company's results mid-was through the first quarter.  He reaffirmed its full-year $9.20 per share earnings outlook on Thursday, and forecast growth in its services business in the first quarter, in sharp contrast to many technology companies that have scaled back expectations.

Shares of International Business Machines Corp rose 3.7 percent yesterday, and are up another $3 this morning. 

As the Big Blue did back in July, IBM's 4Q earnings, as well as its 2009 outlook, had exceeded market expectations. The company has credited its relative strength to its expansion from hardware to higher-margin businesses like software and services.

Contract signings for business services have grown so far this year, Loughridge said.

"On a quarter-to-date basis, our long-term signings are up double digits, and we would expect signings to be up for the quarter on a year-to-year basis and double digits on long-term. So I think we have a good hand," he said, according to Reuters.

Loughridge added that IBM has a good pipeline in software in the first quarter.

IBM has also said its expansion overseas has been helping its business. The company earns around two-thirds of its revenue from outside the United States.  Revenue in growth markets in January outpaced growth in major markets by 7 points, Loughridge said.

So why is IBM zigging while the market and its competitors are zagging?  To find an answer to that question, we need to go back to something that its CEO Sam Palmisano said at another investor conference in Bangalore, India in June 2006 about the company's strategy.  Here is our summary of it...

So IBM has been focusing on quality rather than quantity of business.  That is why such high margin units as software and services are thriving, while its competitors' hardware or commodity-based businesses are suffering. 

Such a strategy had paid dividends for IBM shareholders in good times, as the record stock price of last summer showed.  The same strategy is now helping protect the company from the economic storms that are raging around it.  And that is why Big Blue is once again become a market leader, notwithstanding HP's bigger size.

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Volume XXIII, Annex Bulletin 2009-05
February 20, 2009

Bob Djurdjevic, Editor
e-mail: annex@djurdjevic.com

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