HP's Sales Up 10 Percent as Repatriation Taxes Whack Profits

by Timothy Prickett Morgan

IT industry juggernaut Hewlett-Packard, which is arguably as much of a bellwether as rival IBM, reported its financial results for its third quarter of fiscal 2005 this week, and the company did a little bit better than many analysts on Wall Street expected. Sales were up 10 percent to $20.8 billion, cash flow was $2.2 billion, and non-GAAP operating profits were $1.2 billion. But, HP decided to repatriate $14.5 billion of the profits it has parked in foreign subsidiaries, which raised its taxes big time in the quarter and pushed down profits.

The U.S. Congress last year enacted a law called the American Jobs Creation Act that allows companies with foreign profits they have been hoarding to repatriate them back to the States at 5.25 percent tax rate in 2005 instead of the normal 35 percent rate (next year, that tax rate goes back up). The Bush Administration is cleverly trying to get some cash back into the local economy, and estimates of the total amount of cash that can be repatriated could be as high as $400 billion to $750 billion (the lack of specificity is a measure of how well companies can hide profits). HP was a big lobbier for the tax break, and seems to be bringing home all of its foreign profits as it restructures itself. IBM plans to repatriate about $9 billion in profits, or about half of its hoard. HP will move the $14.5 billion during the third and fourth quarters, and is paying a $988 million tax adjustment after taxes to cover the cost of this repatriation. Excluding these tax charges, HP brought $1.06 billion or 36 cents a share to the bottom line, considerably better than the $728 million, or 24 cents a share, in the year before and quite dismal third quarter.

When also is said and done, HP will add $14.5 billion to the $14.4 billion in cash and equivalents it already has in the bank, and it will have one of the largest piles of cash in the IT industry from which to fund its next moves as well as to tide it over as it restructures its businesses.

With its Enterprise Storage and Systems group getting slammed this time last year and HP's prospects looking brighter in this key group in the prior quarter, HP was probably pretty sure it would see big improvement in this quarter, and it did. ESS accounted for 19 percent of HP's sales in the third fiscal quarter, with $4 billion in sales, up 20 percent from $3.3 billion, and $150 million in operating profits, a big improvement over the $211 million operating loss this time last year. In the fiscal second quarter, ESS sales were $4.2 billion and operating profits were $184 million, a better ratio than in the third quarter. If HP can grow sales sequentially by about 8 percent in its fiscal fourth quarter (as it did in 2003), then sales should hit $4.35 billion. Where operating profits might be for ESS is anyone's guess--and you can bet that Wall Street will be guessing and betting. (A good bet might be north of $200 million in operating profits, maybe as high as $220 million.)

Mark Hurd, HP's president and CEO, said that sales in the Business Critical Servers unit were up 7 percent across HP's Integrity, HP 9000, AlphaServer, and NonStop product lines, and that sales of HP-UX servers (including both PA-RISC and Integrity variants) grew by 8 percent. BCS sales accounted for 22 percent of ESS sales, or about $880 million. He also said Integrity servers, which are based on the Itanium processor that Intel co-designed with HP, were up 113 percent. That would put Integrity sales at around $211 million in the quarter. The Industry Standard Server product line, which is comprised of Xeon and Opteron servers in tower, rack, and blade form factors, accounted for 58 percent of sales or about $2.3 billion. The remaining 20 percent in ESS sales (about $800 million) came from various HP disk and storage product lines. Storage sales increased by 15 percent, with increased across all major lines according to Hurd, but he singled out the new midrange EVA products, which were recently announced, as a key driver of growth, with sales up 44 percent.

The company's profit engine, the Imaging and Printing Group, had sales of $5.9 billion, up 5 percent, and booked an operating profit of $771 million, down from the $836 million HP booked this time last year. IPG hardware aimed at consumers saw increased sales of 1 percent, with unit shipments up 8 percent, and commercial IPG gear (color laser printers and multi-function printers being the stars) saw sales rise by 5 percent with unit shipments up 12 percent. Color laser printer shipments were up 31 percent and multi-function printer shipments were up 67 percent. HP is responding to competitive pressures from Dell, Lexmark, and others by rolling out new products, pricing them aggressively, and counting on an upswing in extremely profitable ink sales down the road.

HP's Personal Systems Group, which was de-merged from IPG after he took over a few months ago, is still HP's biggest revenue generator, with $6.4 billion in sales in the quarter. PSG posted 8 percent revenue growth against unit shipment growth of 14 percent. Bob Wayman, HP's chief financial officer, said in a conference call with Wall Street analysts that this is normally HP's weakest quarter, particularly in PCs, but this time around, because it had the right products in the market at the right time, sales were up and profits were up. He said that HP's new X64-based workstation lines, which use Intel and AMD processors, did well and that consumer notebooks did "particularly well," which is CFO speak for "I ain't gonna tell you more, but if I did, you would be surprised." He said further that consumer notebook sales were larger than consumer desktop sales for the first time in either HP's or Compaq's history. PSG posted an operating profit of $163 million, more than double from a year ago, when HP booked $77 million in operating profits for this group. Desktop PC sales were about $3.33 billion (down 3 percent), notebook sales were about $2.43 billion (up 21 percent), and workstation sales were about $320 million.

On the services front, the HP Services unit had sales of $3.8 billion in the third quarter, up a healthy 10 percent, with managed services growing 21 percent, technology services up 7 percent, and consulting and integration up 12 percent. HP Services had an operating profit of $256 million, and Wayman said that profits were adversely affected by employee performance bonuses (which impacted HP's overall results by less than a penny a share). Wayman said that HP had not issued performance bonuses in the first two fiscal quarters. HP Financial Services had sales of $489 million, flat from a year ago, with an operating profit of $58 million. HP's Software Group, which is dominated by the OpenView systems management tools and its OpenCall call center software, had sales of $249 million in the quarter and an operating loss of $40 million, but Hurd said he expected it to be profitable in the fourth quarter.

Looking ahead, Wayman said HP expected sales in the fourth quarter to be between $22.4 billion and $22.8 billion, with non-GAAP earnings in the range of 44 to 47 cents a share. Taking into account amortization charges of 3 cents a share, workforce reduction charges of 22 cents a share, and a gain of 5 cents a share related to benefits package changes announced a month ago, that works out to a baseline of 24 to 27 cents a share of profits.

When asked if there was some reason why HP beat expectations, Hurd did not chalk it up to improving market conditions or strategy shifts. "I am not sure that anything changed, except that the people at HP focused," he explained. "We are off to a good start, and we are more or less aligned with expectations, but we still have a lot of work to do." As for how the HP restructuring and the 14,500 layoffs are going, Hurd said that the voluntary retirement program was just finishing up in the United States, and that once this was finished, HP would begin the process of making layoffs around the world.