HP Pulls Off a Respectable Second Fiscal Quarter

by Timothy Prickett Morgan

Hewlett-Packard's new president and CEO, Mark Hurd, got his first try in the HP hot seat this week as the company reported its financial results for the second fiscal quarter ended April 30. And while Hurd cannot take much credit for the numbers that HP turned in, he can at least breathe a little more easily than if HP had turned in much worse numbers. All in all, considering IBM's recent Wall Street miss, HP did okay in its most similar quarter.

Sales in the second quarter were up 7 percent to $21.6 billion, and net earnings climbed 13 percent to $966 million. Earnings per share in the quarter came to 33 cents per share, up 14 percent. And Hurd was muted in discussing the numbers, as you might expect him to be, since every CEO's job is about as secure as the numbers in any given 13-week quarter. "HP had a solid quarter," Hurd said in a statement accompanying the financial results. "We grew revenue 7%, non-GAAP earnings per share rose 9% and we generated $2.4 billion in cash flow from operations. Nevertheless, our overall performance leaves room for improvement in many of our businesses. We expect to provide details as soon as our plans are finalized that will move us toward that objective."

If you were expecting any revelations on what Hurd will and will not do with HP, it seems that he and his team are still mulling the options. But the consensus on the rumor mill is that HP is not inclined to break itself up--any more than IBM was when it was on the rocks and firing tens of thousands of people in great swaths in the early 1990s--and that Hurd is probably going to do exactly what IBM's venerable ex-chairman and CEO, Louis Gerstner, did: keep his mouth shut and focus on execution. When Hurd has something to say--like maybe several years from now--he'll say it. Just like Gerstner eventually came out of the shadows of IBM Armonk and Somers and started talking as IBM as much as for IBM. There is also a lot of talk about whether or not HP will write down all or some of the Compaq acquisition on its books, thereby admitting that the Compaq deal was not worth what HP paid for. Such a move would be folly, since HP has no intention of undoing the Compaq merger, and it would only invite HP shareholders to launch into a massive class action lawsuit along with the Hewlett and Packard families and their foundations. And what would they get out of this? They would hurt HP further and bash down its stock price even further. Then, when you consider that it is possible (but not inevitable) that HP can generate roughly the same sales as Big Blue and, in theory, can deliver almost the same profits if it gets its businesses in order, such an admission of a mistake as that write down would embody seems unlikely. Don't hold your breath on that write down.

On a product category basis, the crown jewel of HP, its Imaging and Printing Group had sales of $6.4 billion in the quarter, up 5 percent, but operating profits took a hit, with coming in at $814 million, down 14 percent (including $71 million in layoff costs in the quarter). HP has cut prices on its printers and other imaging products to jack up unit volumes, which has also impacted profitability. Unit shipments of color laser printers were up 96 percent and multifunction printer shipments were up 61 percent.

The problematic Enterprise Storage and Servers group had sales of $4.2 billion, up 6 percent. Sales of so-called Industry Standard Servers--by which HP means X86 and X64 tower, rack, and blade servers--were up 12 percent in the quarter. Blade servers grew 56 percent, according to Hurd. Somewhat surprisingly, the Business Critical Server unit, which sells Itanium and other enterprise-class servers, had sales up 2 percent. Inside the BCS unit, sales of Itanium-based Integrity servers (which support HP-UX, Windows, Linux, and OpenVMS) were up 37 percent (and accounted for 21 percent of total BCS sales). Sales of HP-UX servers based on the PA-RISC processors were up 9 percent, which was a bit of a surprise and which further suggests that HP may be enjoying an upgrade cycle for its HP 9000 base, which peaked during the dot-com bubble just like rival Sun Microsystems' own base did at the same time. Storage sales were down 6 percent in the quarter, and continue to be a sore spot. "We have a lot of work to do to get this business back on track," Hurd admitted, saying that HP is building out its storage sales force and has just revamped its storage product line this week to try to get some traction in the market. "We are aware of what needs to be done," he added. The ESS Group had an operating profit of $184 million after a $24 million charge for workforce reductions, considerably better than the $119 million operating profit that HP booked in the ESS unit this time last year.

HP's CFO, Bob Wayman, said in a conference call with Wall Street analysts that all of the server units were profitable in the quarter--perhaps not as much as HP would like, but profitable nonetheless. Hurd, who was also on the call, did not elaborate much on how where HO was getting traction in the enterprise business. "While there have been nuances by region, demand has been pretty steady," he said. He added that for the Unix business in particular, sales in the Americas region was higher than expected.

HP's Personal Systems Group raked in $6.4 billion, and saw unit shipment increases of 12 percent in the quarter, with desktop sales only up 1 percent, but notebook sales up 10 percent and commercial client sales (including workstations) up 3 percent. PSG had an operating profit of $147 million, also much better than the $44 million HP had a year ago and the highest profit that this unit has posted since the merger with Compaq. HP Services boosted sales by 14 percent to $4 billion, with managed services up 27 percent, technology services (mostly maintenance) up 11 percent, and consulting and integration services up 10 percent. Operating profits decreased by 12 percent to $292 million, including a $74 million hit for layoffs in this unit. HP's software business grew 23 percent to $277 million, but it still had an operating loss of $6 million. That said, it posted a $52 million loss this time last year in software and Hurd said that HP's software business would be profitable in the fourth fiscal quarter. Finally, HP's Financial Services unit had sales of $544 million, up 16 percent, and an operating profit of $58 million, up 66 percent.

On a geographic basis, HP's sales grew 4 percent in the Americas region to $8.8 billion, which is not exactly great growth, but remember IBM's growth in the Americas region was only up 2 percent in its first quarter, which ended March 31. Sales for HP in the Europe, Middle East, and Africa region were up 10 percent to $9.1 billion, but taking out currency effects, growth in local currencies was only 4 percent, according to Wayman. Sales in the Asia/Pacific region were up 9 percent to $3.6 billion as booked back in Palo Alto in U.S. greenbacks, but in local currencies sales were up 6 percent, said Wayman.

Looking forward, HP says that the third quarter will be tough as it always will be. With HP being a dominant supplier of consumer technology as well as a big player in Europe, the summer months are always tough for HP. And that is why HP is figuring that fiscal third quarter sales will be on the order of $20.3 billion to $20.7 billion, and non-GAAP earnings per share will be in the range of 29 cents to 31 cents a share. HP said that its shares will be impacted in the quarter by the first pay raises HP has given to employees in two years, which went into effect on May 1 and which will shave about 3 cents a share off earnings going forward. HP will also have some charges for continuing layoffs, but the company has taken most of these charges in the second fiscal quarter, with 1,900 employees taking voluntary layoffs and HP taking a $177 million hit.

As for what Hurd plans to do with HP, he said that he had spent the past month visiting thousands of HP customers and managers to get his head wrapped around the company, and that he would put forth an operational plan within the next couple of months. He said that there was no quick fix to get the company back on track, but that HP was one of the few remaining hardware innovators in the IT market, that it had a strong brand, large customer base, and the ability to become more profitable. "I believe that much of our success lies within our own hands," he said.