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IT SERVICES

Analysis of Hewlett Packard’s Fourth Quarter Business Results

HP Hits Home Run

Solid Growth Across All Business Segments; Printers Most Profitable

PHOENIX, Nov 16 – After disappointing investors with its third quarter results (see HP Savaged by Wall Street, Aug 2004), Hewlett Packard hit a home run in its fourth and final quarter of fiscal 2004 (ended Oct 31).  Net earnings surged by 27% on record quarterly revenues ($21.4 billion, up 8% from a year ago). 

It was a complete turnaround, akin to Red Sox’s comeback last month against the Yankees.  Night became light as Red (Sox) shone bright. 

For the full year, HP’s net profit surged by 38% to $3.5 billion on revenues of $80 billion.  Nipping at IBM’s heels ever since its Compaq acquisition, HP has now become an $80 billion-company just as IBM is about to breach the $95 billion-revenue mark.

“We achieved solid revenue growth… and achieved record revenues in every business and every region,” said Carly Fiorina, HP’s CEO.

Business Segments

ESS.  The greatest improvement during the last three months occurred in HP’s Enterprise Storage and Servers (ESS) unit, the problem child of the third quarter.  Revenues surged (sequentially) from $3.4 billion to $4.1 billion, while operating profit swung by a whopping $315 million – from a $208 million loss, to a $107 million surplus.  Year-over-year, ESS fourth quarter revenues increased by 7%, while its operating profit declined 8%.

HPS. As predicted, HP Services’ revenues grew in double digits (up 13% to $13.8 billion), while its operating profit dropped by about 10%, ending the year with a 9.2% operating margin ($367 million).  Such is the life of a “megadeal” winner. 

In fact, HPS’s fastest growing segment – “managed services” (outsourcing) – whose revenues were up 35% in the quarter, actually produced red ink at the bottom line during these early phases of the big outsourcing contract wins.

“Managed services was not in the black in the quarter, although its bottom line performance improved,” said Fiorina, answering an analyst’s question.  “We’re looking for that business to be profitable in FY05, hopefully in the first half,” she added.

As Bob Wayman, HP’s CFO, put it during a teleconference with analysts, “the rate of return to profitability depends inversely on how much revenue we go after.  If we go after more, bigger, (upfront) aggressively priced contracts, the return to profitability will take longer.”

The way we see it, given the dynamics of “megadeals” the company has won so far, look for HPS to start adding some significant profit numbers to the corporate bottom line after the second quarter of its 2005 fiscal year.

Printers (IPG).  Meanwhile, while HPS will be a big profit contributor in the future, HP’s printing and imaging division (IPG) is doing it today.  Its operating profit margin of about 16% is by far the highest of any HP division.  In the fourth quarter, it actually improved to 16.6%, or $1.09 billion, on record revenues of $6.5 billion – the highest of any HP unit.

This IPG unit also shipped a record 14 million printers in the fourth quarter, for a total of 47 million printers in all of FY04.

Printers and imaging are to HP what mainframes and servers used to be (and are becoming again) at IBM – a source of stability and profitability.  Printers, as mainframes, represent a platform from which to launch promising, but more risky ventures of the future. 

While the very term “printer” evokes an old mundane hardware connotation, one must not forget that under “imaging” this division includes some of the most ‘state of the art’ projects, such as its collaboration with DreamWorks Studios, for example, that produced such movie box office winners as “Shrek” and “Shrek2.”

PC.  Personal systems revenues also grew at a healthy 9% rate in the fourth quarter, while its physical shipments jumped by 11% during the same period.  Although the PC revenues were just a shade lower than those of the printing and imaging (IPG) unit, they were far less profitable.  The PC unit produced a $78 million operating profit in the fourth quarter as compared to a $1.1 billion contribution by the IPG division.  But it at least it did not bleed any red ink which its brethren in the Big Blue camp seems to do in most quarters.

Software. Speaking of red ink brethren, while IBM software is its most profitable unit, HP software is losing money.  In FY2004, it had revenues of $922 million and an operating loss of $145 million, lower than the $190 million HP software lost a year ago. 

Since HP software is where the company is making strategic investments in support of its “Adaptive Enterprise” push (see IT Industry: Whither Goeth It?, Jan 2004), it can be equated with IBM’s “Enterprise Investments” unit - a perennial (and intentional) money-loser on IBM financial statements.  Its purpose is less to make money than it is to lead the corporation into new areas that P&L-driven units could not justify on their own.

Stock Buybacks

The same cannot be said of stock buybacks, a practice that both HP and IBM have embraced in the last several years.  To us, that’s a lose-lose proposition, in the long run.  Yet, HP has just ratcheted up its stock buyback program.  The company spent $2.2 billion on its own share repurchases in the fourth quarter alone.  For the full year, HP bought back $3.3 billion-worth of its stock.

And what does the company have to show for all this money?  Not much.  Take a look at the stock charts.

A week or so after the new buyback program was announced (Sep 20), the HP stock was roughly where it began – between $18 and $19 per share.  And despite having wasted $3.3 billion on stock buybacks, prior to today’s earnings release, HP shares were down 12% from a year ago.  No surprise there...

To us, share repurchases are a form of Wall Street-devised bribery system (see Where Armonk Meets Wall Street, Greed Breeds Incest, Nov 1998, Stock Buybacks Questioned: Is IBM Mortgaging Its Future Again?, 4/29/97).  Companies use their hard earned money to line the pockets of Wall Street institutions, the most likely sellers.  They do it in the hope that the latter would, in turn, endorse their stock, and thus cause its price to rise.  That’s at least the theory upon which huge amounts of corporate capital end up being wasted on Wall Street, instead of invested into their own businesses.

In practice, however, as you saw from HP’s example, it’s a different story.  Wall Street pocketed HP’s $3.3 billion in FY2004, and didn’t even say “thank you.”  It’s a small consolation to HP that IBM has squandered over $57 billion of its money since 1995 in exactly the same way.

Summary

Overall, the fourth quarter marked a terrific finish for HP.  The company ended the 2004 season with a big home run.  Based on the company’s projections for FY2005, it looks like next year will be even more exciting and more profitable, too.

Happy bargain hunting

Bob Djurdjevic

For additional Annex Research reports, check out... 

2004 HP:  HP Hits Home Run (Nov 2004);; HP Savaged by Wall Street (Aug 2004); "HPS Wins by a Nose!" (Octathlon 2004); "A Passage FROM India" (Feb 2004);  "Still No Cigar" (Feb 2004); "Nokia Dials HP!" (Feb 2004)