Guild Companies

Hewlett-Packard yesterday reported financial results for the fiscal third quarter ended July 31, and the numbers were not as good as HP's top brass or Wall Street had expected. HP chairman and CEO Carly Fiorina has had her share of sitting in the hot seat since she was given the reins of HP in July 1999--yes, that was four years ago--and has spent plenty of time there since launching the merger with Compaq Computer in September 2001.

While Fiorina was disappointed with Q3 and spent some time explaining what went wrong, she has her eye on Q4 and seems pretty confident she can get all of HP's disparate units, which have their own customers and sales cycles, profitable during that quarter.

"Due to normal seasonality, the third quarter is always tough," she explained. "But we should have done better." Without skipping a beat, she moved right on to Q4. "We expect to report a strong fourth quarter, with all of our businesses profitable." As regards to the Personal Systems Group and Enterprise Systems Groups, she explicitly declared that they would be profitable in Q4, and HP's chief financial officer Bob Wayman said the same thing repeatedly during the conference call with Wall Street analysts.

HP's sales across all units and all geographies amounted to $17.35 billion in Q4, up 5 percent compared to last year's fiscal third quarter. However, too-aggressive price cutting on PCs, a shift away from selected entry and midrange Unix gear and towards Windows and Linux Intel-based servers that is moving a little faster than HP anticipated, more aggressive headcount reductions in its Enterprise Systems unit, and pay raises across the company put the squeeze on profits in the quarter pushed earnings down to $297m or 10 cents a share.

While this was a far cry better than the $2 billion loss (67 cents a share) HP reported in last year's third quarter, it was about $200 million shy of what Wall Street, on average, thought HP would do. And in the fiscal second quarter ended April 30, HP was able to bring in $659 million in profits or 22 cents a share; however, it did that with $635 million more in sales, so to one way of looking at it, HP's cost cutting measures made Q3 a more solid quarter--even with all the problems--than Q2.

Everyone expects the PC business to be problematic, and the real heat is on Peter Blackmore, who heads up the Enterprise Systems unit, which sells servers, storage, and software to corporations. ESG sales were $3.71 billion, flat compared to last year's Q3, and operating losses improved to a loss of $70 million compared to a loss of $252 million this time last year. But in Q2, HP was able to get operating losses down to only $7 million, and Wall Street was clearly hoping to see it cross the profit line this quarter.

Fiorina said that sales of Superdome machines were up 64 percent compared to the same quarter last year and that shipments were strong. She did not say how far Itanium-based servers were pushing sales, but did say the recent benchmark results for Unix, Windows, and Linux on the Integrity servers put to rest any issue about HP's and Compaq's separate decisions to move to Itanium years ago.

Sales at ESG were down for two reasons, apparently. First, HP is seeing companies move away from entry and midrange Unix servers toward Intel-based machines, while other companies are moving away from mainframes and other proprietary high-end equipment, like HP's own Tandem NonStop machines as well as IBM mainframes, toward big Unix iron.

The midrange, it seems, is hollowing out a little. Fiorina said that the market is polarizing and bifurcating in this manner, and that this expectation was one of the drivers behind the HP-Compaq merger. However, she said that it has accelerated more rapidly than expected. To that end, HP is having a harder time selling entry and midrange Unix kit, and to position itself better for future quarters, it laid off 2,000 ESG workers in the quarter, more than the 1,200 it expected to let go. These layoffs, while positioning HP for the future, adversely impacted Unix server sales in the quarter just ended.

Sales of AlphaServer Unix and OpenVMS boxes and NonStop servers were down 8 percent together (NonStop had a slight decline), but sales of Intel-based servers were up 4 percent with shipments up 16 percent. Network storage sales were up 8 percent year-on-year, and raw disk sales were up 7 percent.

Sales in the Personal Systems Group were $4.97 billion, up 5 percent, with unit shipments up 16 percent across all types of machines. Laptop sales were strong, with shipments up 54 percent, and consumer desktop shipments were up 18 percent. But these shipment gains were offset by double-digit declines in commercial desktops. PSG had an operating loss of $56 million, an improvement over the $140 million it lost in PCs this time last year, but worse than the$21 million operating profit it had in Q2.

One of the problems HP had was that it didn't have enough flat panel displays to meet demand, and it had to pay extra freight charges to get gear from suppliers to customers to avoid losing the business. While HP was able to sell 54 percent of its PCs directly to customers in the quarter, and the company is poised for the back-to-school consumer and end-of-year commercial upgrade cycles, there is work to be done here. "We must do a better job of cross selling and upselling to improve our average selling price," she said.

During the Q&A session following Fiorina's and Wayman's comments explaining the financial results, and questions arose about causes for the shortfall in profits, Wayman reminded everyone HP did not give specific profit targets and that the consensus estimates everyone is talking about done by Wall Street.

That said, Wayman said the miss was due because HP had cut prices on consumer and desktop PCs too deeply, while the word on the street is that Dell and others did not follow, and had expected decreased component prices that did not materialize, which hurt PC profits. To fix that problem, HP actually raised prices a few weeks ago. Whether or not these price increases can stick or not is another matter, but HP is clearly betting that they will.

In the Imaging and Printing Group, which is the real profit engine at HP, sales were $5.24 billion, up 10 percent, and operating profit was $739 million. Digital imaging grew 16 percent, and business printing hardware that (included custom printing solutions grew 6 percent.

On the services front, HP Services posted sales of $3.08 billion, up 5 percent compared to fiscal Q4 2002. Operating profits in the quarter for this unit were $337 million. Sales of managed services were up 140 percent. "HP has a seat at the table at nearly all large outsourcing deals," said Fiorina, once again justifying one of the core reasons HP acquired Compaq. She said that while customer support sales, which is the most profitable service HP offers, were under pressure because companies were hesitant to commit money in a speedy fashion and because of competition from third parties, HP nonetheless managed to improve margins on support services and boosted revenues by 8 percent in this area. Financial Services, the financing arm of HP, posted revenues of $442 million, down 13 percent, yet had an operating profit of $18 million in the quarter. HP had more financing money this time last year, and had an operating loss of $21 million. Something has improved here.

As for the Adaptive Enterprise architecture that HP outlined in May, Fiorina summed it up this way. "Customers get it, and they like it. It is opening doors and it is closing deals."

Everyone wants to know about the fiscal fourth quarter, and Wayman said HP expected overall revenues to grow between 8 percent and 10 percent sequentially, hitting between $18.8 billion to $19.1 billion. These numbers assume a normal seasonal lift of about 30 percent comparing Q3 to Q4, explained Fiorina, and do not take into account any upturn in IT spending that some people have been seeing in recent months.

Concerning the faith that she has in HP's ability to make those revenue numbers and her stated goal to have all of HP's business units profitable in the fourth quarter, Fiorina showed the typical bluntness and confidence that is becoming her hallmark. "We're reasonably confident or we would not be providing that guidance," she said.