<%@ LANGUAGE=VBScript %> <% Set asplObj=Server.CreateObject("ASPL.Login") asplObj.Protect Set asplObj=Nothing %> Analysis of HP's 2Q09 Results (May 21, 2009)

Annex Bulletin 2009-10                            May 21, 2009

A partially OPEN edition

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Updated 5/22/09, 6:30PM PDT

Analysis of Hewlett-Packard's 2QFY09 Business Results

Suddenly, All Lines Point South

Shades of IBM's Gerstner in Palo Alto?  HP Now Also Seems to Be Resorting to "Financial Engineering" to Try to Cover Up Shortfalls in Operational Success in Services

HAIKU, Maui, May 21 – The first quarter of HP's fiscal year 2009 marked Mark Hurd's first misstep (see Hurd's First Stumble, Feb 2009).  The quarter that followed seems like an unmitigated fall from grace on Wall Street.   Both revenues and earnings were down (3% and 17% respectively).  The company that not long ago was firing on all cylinders, is now sputtering on most of them.

Server and storage revenues plunged 28% since a year ago.  Printer and supplies business declined 23%.  PC sales dropped 19%.  Software revenues shrank 15%.  Financial services was down 6%... You'd think the wheels are coming off the computer industry's largest company.

But Wall Street took the bad news in stride, a credit to Mark Hurd's and his investor relations team's PR skills.  The HP shares took only a five point dive the day after the company released the disappointing results.  But the stock that not long ago topped all Dow Jones 30 industrials, now seems headed south if you look at long-term trends (see above chart), even if an occasional market rally lifts it like a high tide raising all boats.

So Hurd, the CEO who once looked as if he could walk on water, now has two strikes against him.  And the outlook isn't pretty, either.  HP is now forecasting a 4% to 5% revenue decline this year.  And the company has just announced 6,400 new job cuts, in addition to the 25,000 people it said it would lay off when it acquired EDS last summer.

Spinning the Bad News

You'd never know how bad things are at HP if you heard or read what Hurd said at the May 19 analyst teleconference that followed the earnings release.  HP's chief spinmaster made it sound as if everything is hunky-dory, that the universe is unfolding as it should and that things are going the HP way.

"In the second quarter, Hewlett-Packard executed well in a tough market environment," the HP CEO told the analysts.  "Across HP, we're making good progress on our cost structure, with transformations across virtually every function and business group."

Hurd cited three reasons why he thought HP would emerge from the current market environment as a stronger force in the industry.  First is HP's "broad market-leading portfolio."  Second, its "increasingly efficient cost structure."  Third, is "a track record of successful execution."

"As this quarter demonstrates, we are executing in the marketplace, executing on the EDS integration, and executing on our cost initiatives," Hurd boasted.

Execution, Execution... Hurd Starting to Sound Like Gerstner

Execution, execution... while revenues and profits shrink.  Hm... and here we thought that companies' performances are judged by results, not efforts, elegance or execution.

So boastful statements like that try to deflect attention from what seems broken at HP reminded us of IBM's former boss, Lou Gerstner, in the mid-1990s.  Gerstner was also blessed with a gift of gab.  And was an excellent manager.  But the legacy of his tenure at IBM is the worst track record in company's 97-year history (see the charts below).

The above IBM historical charts suggest that what it takes to be a great leader is vision and creativity, not just execution, execution... or the gift of gab.

At the teleconference with analysts, Hurd sidestepped thorny subjects in his introductory remarks, leaving it to Cathie Lesjak, the CFO, to explain why sales were down nearly across the board, or why the latest gross margins for the company were 23.5%, down 150 basis points from 25% one year ago.

"This decrease was driven by the addition of EDS, which has lower gross margins, as well as rate declines in our hardware businesses," Lesjak said.

Services, Services... "Financial Engineering" or Misleading Data?

Yet, services, services... seemed to have been the main theme of HP's teleconference with analysts.  HP executives chose to highlight their Services business segments results this quarter as the bright light, stressing the 99% revenue jump to $8.5 billion.  It was the first time ever that this perennial hardware company has led its quarterly review with services.  Hurd also boasted about the alleged success of that integration.

"I can tell you I am as happy as I was when we announced the EDS deal, as optimistic as I think Cathie and I were in August of last year," Hurd said.  "I would say that we are even more positive on it today than we were at that point."

The strength of EDS is absolutely superior service delivery to its customers," he added. "We believe it is the best service delivery organization on the planet -- that's our belief. And that our data supports that with the measurements that we did.”

Okay, let's look at some of the data...

True enough, HP Services revenues did double since a year ago, as you can see from the table (right).  But that's an apples and oranges comparison.  For, the apparent growth is solely due to the EDS acquisition.  If one were add EDS last year's Feb-Apr revenues to the 2008 total, HP Services revenues would be down nearly 13%, as you can also see.

So even if you take away 6% on account of currency translations, the business segment that HP focused on as model of its quarterly success appears to be down about 6% even in local currency.  So we asked Mark Hurd to comment about our analysis.

"From what I can see, if you actually add in EDS numbers for 1Q08 and normalize the HP results based on that, your services numbers would be off 12% as shown below," this writer said in an email to the HP CEO.

"Oh my. You’re a mile off," Hurd replied. "Currency is far bigger below of the impact of the pound.  In addition, the convergence of policy with HP accounting and EDS on deferred revenue is material. EDS revenue minus currency and policy convergence is flat year over year."

Hm... if that's the case, wouldn't you think HP should have disclosed the information that its CEO thinks is "material?"  We do.  In fact, we expressed our reservations about the fuzziness of HP's services numbers even after the first quarter three months ago:

"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."

(see Hurd's First Stumble, Feb 2009)

So we wrote back to Hurd on May 20: "Okay, if I am 'a mile off,' and the convergence of HP and EDS accounting policies is 'material,' as you said, why did you not disclose that in the release?  That way, we could all see what the results were like on an apples-to-apples basis, or 'organically,' as EDS used to call it."

"We did and gave the number in the public domain on the call," Hurd wrote back this morning.  "EDS local currency revenue after policy convergence (was) flat year over year."

Well, we poured over the teleconference transcript as well as the earning release and other HP documents related to the 2Q numbers but could not find anything about it.

So we wrote back to Hurd and told him so. 

"Maybe you can point me to where exactly during the telecom you or Cathie talked about it? Assuming it was there and I missed it, are you really saying that the convergence accounting and currency amounted to $1.2B?  For, that’s the difference between the two 2Q sets of numbers – in 2009 vs. 2008 – that would take to make the (HP) services revenue flat."

At that point, the HP CEO referred us to his VP of Investor Relations.  Jim Burns agreed in a subsequent phone call this afternoon that the teleconference did not include any discussion about the EDS revenues being flat.  He added that the weakness in the British pound had a lot greater effect on EDS' business than on HP overall (6%).

Okay, so let's now accept HP CEO's statement at face value.  If EDS revenues were flat in local currency, that would make them about $4.8 billion in 2Q09 dollars.  Which would mean that the rest of the HP services revenues were about $3.7 billion, down more than 13% from a year ago (see the left chart).  And that's hardly something to write home about.

So we agreed with Hurd.  The part of the financial disclosure that HP omitted was material.  And also misleading, as evident in this excerpt from a TheStreet.com report on HP's results, which cited an alleged "strength" of its services business:

"Seen as one of the tech firms best equipped to withstand the recession, H-P enjoyed a strong performance in services...," wrote James Rogers on May 20.  Some other articles also suggested that media or analysts swallowed HP's claims hook, line and sinker.  Which is why we wrote back to the HP CEO saying:

"We, as analysts, or the investing public, aren’t privy to such inside ‘financial engineering’ details as convergence of accounting practices, so as to be able to make heads or tails of the numbers.  If the figures you and EDS disclosed to the public a year ago and now are 'a mile off,' that’s precisely why I (and presumably others) needed an explanation.  So my suggestion is that you release that kind of data in the future to the public so that fair comparisons would be crystal clear to all, rather than just some HP/EDS insiders or those whom insiders choose to take into confidence."

We repeated that suggestion to Burns, HP's IR head, during our Thursday phone conversation.  He agreed that providing greater transparency to the EDS-HP merger would be a good idea.  But said that was difficult to do, as some parts of EDS had been allocated to other HP lines of business (such as software, for example). 

When asked what percentage of the total such (presumably minor?) numbers represent, Burns said he did not know it offhand.  He said the company provided that with the first quarter's numbers. But we could not easily find it.  Maybe you can?

Meanwhile, we do find it more than a little ironic that HP is struggling, with all its business lines pointing southward, shortly after it had claimed the epithet of becoming the largest IT company in the world.  So much for the "virtues" of size! 

Business Segment & Profitability Analysis

Okay, now for some good news.  HP did have a strong quarter when it comes to cash flow ($4.1 billion).  And its operating profit margins improved in several of its lines of business even if their revenues declined.

In services, for example, the operating margin was 13.8%, up from 11.9% a year ago.  In software, it surged from 10% to 17.8%.  The Imaging and Printing Group's profitability also improved, from 16% to 18%.

But the profitability of HP's enterprise servers and storage plummeted to 7.2% from 13.7% a year ago.  And the PC unit's margins also shrank from 5.4% to 4.6%.

In terms of geographies, the Americas region turned in the best performance, rising 9% since a year ago.  Europe was down 11%, while Asia/Pacific revenues declined by 10%.

Summary & Outlook

Looking ahead, HP executives said they expect the third quarter FY09 revenue to be approximately flat to down 2% sequentially, with the EPS in the third quarter FY09 diluted EPS is expected to be approximately $0.64 to $0.68.

HP estimates full-year FY09 diluted EPS is expected to be approximately $3.02 to $3.16.

So just like one swallow does not make a spring, two bad quarters don't mean necessarily an HP downfall.  But they do show that even the largest of the birds can be vulnerable to strong headwinds. And they also indicate that the best of CEOs, even those who looked as if they could walk on water, can stub their toes once in a while.

For that reason, we'll let Mark Hurd have the last word.  When talking about EDS, he said, "this is an organization that created most of its demand by picking up the telephone and hearing from a contract negotiator that a company was about to outsource. So… we are trying hard to align the demand to get the leverage of the greater HP sales organization that's out in the field. And you're beginning to see that occur in the funnel ('pipeline')… because we are seeing more deals than EDS saw before, because of our position in the marketplace through our sales force.”

Sales synergy between HP and EDS about which Hurd is talking here was and is the greatest benefit that we could see from this merger.  So if the HP sales force indeed does help EDS sell more in the future, this benefit may partially offset the negative effect that EDS' lower margins have had on HP business.

 Happy bargain hunting!

Bob Djurdjevic

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Volume XXIII, Annex Bulletin 2009-10
May 21, 2009

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

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