CLIENT VERSION - Analysis of Hewlett Packard Services FY02 results (May 13, 2003)

Confidential Annex Research Client Edition

IT SERVICES

Analysis of Hewlett-Packard Services’ FY02 Business Results

From Obscurity to Stardom

In Battle for No. 3 Spot in Industry, HPS Competes with CSC, Accenture

PHOENIX, May 13 - Whether or not a relative newcomer to the major league of IT services - Hewlett-Packard Services (HPS) - has already become the No. 3 in the industry, as some of its executives claim[1], or is on its way to a “bronze” medal, there is no doubt that HPS has become a major global player. And not just because of its megadeal wins this year (see “HP's Hat Trick”, Apr 15).

HPS’ last year’s “pro forma” revenues ($12.4 billion, for the full year FY02 ended Oct 31, 2002, after the Compaq merger) would have indeed put it in the No. 3 spot, ahead of Accenture and CSC (at $11.4 billion and $11.3 billion respectively in 2002). But HPS’ actual FY02 revenues of $9.1 billion, as reported in the HP Annual Report, place it as the No. 5 in the world. For the purposes of Annex Research rankings, and apples-to-apples comparisons with other vendors, we estimated HPS’ calendar 2002 revenues to be about $10.4 billion.

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That still leaves HPS as the No. 5, of course. But if one were to include the full year Compaq services revenues, as Livermore apparently did, the relative newcomer would be indeed the third largest IT services vendor in the world. Which makes HPS’ journey to the revenue “bronze” one of the fastest trips from obscurity to stardom in the IT industry.

Perhaps the most redeeming feature of HPS’ success, however, has been its profitability. This relative newcomer commands the IT services industry’s best profit margin (11.2% net margin in FY02). And in the latest quarter (ended Feb 28, 2003), the HPS net margin improved slightly (to 11.5%).

Catching Up to IBM

Yet only three years ago, HP was still struggling to figure out a way of catching up to IBM, a company that already had over a 10-year head start on HP in the IT services business. So in September of 2000, HP attempted to buy the PriceWaterhouseCoopers Consulting (PwCC) unit for $17 billion to $18 billion. And it hired Steve Huhn, a seasoned IBM Global Services (IGS) executive, to run the business (see “HP to Buy PwC Unit,” Sep 2000).

Back then, HP had a homegrown services workforce of only 6,000 people, mostly delivering hardware maintenance. IGS, on the other hand, had a 160,000⁺ staff, encompassing “soup-to-nuts” IT services around the globe.

Luckily for HP shareholders, the PwCC deal fell through. Two years later, IBM poached PwCC for a “mere” $3.5 billion after the latter struggled with an attempted IPO (Initial Public Offering).

By that stage, however, HP had also already acquired Compaq, a company with solid services business that Compaq itself had bought in 1998 with its purchase of Digital Equipment Corp. (DEC). HPS had also formed a strong partnership with at least one major “mainframe-class” customer (CIBC - one of Canada’s largest banks) leading to its first real megadeal (see HP Breaks into IT Services Major League, Sep 17, 2002).

In other words, HPS was on its way… The company has been quickly catching up to IGS. And this process accelerated in 2003, as you have seen from some of our recent reports (see HP's Hat Trick, Apr 15). We estimate that as of the year-end FY02, HPS had over 60,000 employees (vs. IGS’ 180,000 as of year-end 2002). By the time the current fiscal year-end rolls around, we figure HPS will have over 80,000 people. And its revenues will be in the $13 billion range, on their way to $15 billion⁺ in FY04.

Text Box: So one way or another, whether through PwCC or through Compaq, HPS’ quick rise to the No. 3 spot has been due to its acquisition strategy, coupled with its deft executive hiring. Which is basically the recipe for growth that we have also just given to the IBM leaders (see “Save, Spend and Split,” May 8).

Business Segment Analysis

HPS does not break out its three business segments’ results, but we figure that hardware maintenance, or “Customer Support,” as HP calls it, is still the largest segment of its services unit’s revenue stream. We estimate that in the current fiscal year maintenance will account for about $5.2 billion, or 40% of HPS’ revenues. That makes it actually bigger than the equivalent IBM revenues that have been hovering around $5 billion in the last three years.

As you know, we have been showing the IBM maintenance revenues and profits as separate lines, both in the IGS charts and tables and in those for its parent company. It is from those figures that we were able to deduce IBM’s possible motive for including a hardware-related activity in IGS business. Which is… that maintenance is still an IBM “cash cow.”

Text Box: But until now, we have not been including maintenance for our Global IT Services Heptathlon - our annual comparison of business results of top services vendors. That’s because none of the other top competitors, except for IBM, had it.

Well, now that HPS is among the “Top 6,” we also have put IBM maintenance back into the IGS figures. Besides, with the advent of outsourcing, a field engineer nowadays is often called upon to handle problems of with multiple vendors’ equipment. So maintenance, like pure IT services, is becoming more “color blind” when it comes to technology.

Anyway, the upshot is that this change is that it makes IGS look better in terms of profitability while it diminishes its revenue growth rates (especially the long-term ones, as maintenance has been a shrinking business segment at IBM). But that’s the way IBM is organized today and is reporting its IGS results, and so it is a Big Blue fact, as it is in HPS’ case.

The second largest HPS business segment is “Consulting and Integration.” We estimate its FY03 revenues to be about $4.3 billion, or about one-third of the total HPS business.

Outsourcing, or “Managed Services” as HPS calls it, is the fastest-growing part of the company. We expect its revenues to nearly double this year (from $1.8 billion to $3.5 billion).

Summary and Outlook

Looking at 2003 and beyond, HPS’ hold on the third spot in the industry will be undoubtedly challenged. CSC, for example, is forecasting revenues of $14.3 billion to $14.7 billion for its current fiscal year (that ends Mar 31, 2004). Of course, HPS revenues will also grow more rapidly as a result of its recent megadeal wins, none of which have been included sp far in its revenue stream.

So chances are, we will have another nip and tuck contest in 2003 for the IT services “bronze.” Except that it will be between CSC and HPS, and not between CSC and Accenture, whose race to “show” we had been witnessing for years.

Happy bargain hunting!

Bob Djurdjevic

[1] Ann Livermore, HP’s executive VP in charge of HPS, told Reuters on Apr 11, 2003 that, “we’re number three and gaining (market) share.”

For additional Annex Research reports, check out...

2003: HP's Hat Trick (Apr 15)

2002: HP Breaks into IT Services Major League (Sep 17, 2002)

A selection from prior years: Industry Stratification Trend (Mar. 30, 1990).

... on IBM Global Services

2003: “Investing in Growth” (Apr 30), “Turnaround Continues...” (Apr 15), “Start of a Real Turnaround?” (Jan 17)