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   Confidential Annex Research Client Edition

IT SERVICES

Analysis of Hewlett Packard Services (HPS) Fourth Quarter Results

Strong Finish Not Enough

HP Stock Gives Up Its Earnings Announcement Gains

PHOENIX, November 20 – Hewlett Packard (HP) ended its fiscal year 2003 with a bang.  Revenues grew in double digits (up 10% to $20 billion), while earnings more than doubled in its fourth quarter ($862 million vs. $390 million in FY02).  Both figures exceeded Wall Street’s expectations.

No wonder the HP shares rose 2.4% in after-hours trading that followed the earnings announcement.  They had also jumped nearly three points earlier the same day (November 19).

But that’s all she wrote.  For, the following day (November 20), the HP stock dropped to $21.59 - below the level it had traded before the earnings release. 

The ostensible reason was Wall Street’s concern with HP profit margins, and its alleged fears that HP may not be able to sustain its stellar performance relative to competition. 

Both “concerns” are bogus.  Wall Street dumped HP because it saw better opportunities elsewhere (not necessarily in the IT sector).  Investment cash flows will win out any day on Wall Street over profit margins.  Just consider the facts…

The HP gross margins only dropped half a point (from 25.9% to 25.4%).  Other companies’ margins, meanwhile, have been known to drop several points only to be greeted with a shrug from Wall Street (e.g., “Small Is Now Big at Big Blue,” Oct 2003).

Furthermore, HP’s operating profit in the fourth quarter has been by far the best so far this year ($1.07 billion; 5.4% margin).  More importantly, for the first time this year, all HP lines of business operated in the black.  No wonder the HP CEO, Carly Fiorina, gloated over her company’s latest results. 

“We delivered on our commitments,” she said in a teleconference with analysts that followed the earnings release.  “The results validated the success of the (HP-Compaq) merger.”  She added that the latest quarter has been “by far the strongest since the merger.”

Well, a strong finish was evidently not enough on Wall Street.  Nor was HP’s balanced performance.

Balanced Performance

Services.  Hewlett Packard Services (HPS), for example, grew its revenues by 5%, both sequentially and over the last 12 months.  The $3.23 billion fourth quarter revenue was also its best during the current fiscal year.

For the full year, HPS revenues were $12.3 billion, virtually flat with the pro-forma combined HP-Compaq revenues from the prior fiscal year.  But the “managed services” segment (read “outsourcing” - $2.1 billion or 17% of total) surged by 36% in the fourth quarter, while the “customer support” (i.e., “maintenance” - $7.7 billion or 63% of total) rose by 5%.  Revenues from the “consulting and systems integration” area ($2.5 billion, or 20% of total) declined by 10%.

The fourth quarter was also HPS’s most profitable period by far.  Its $393 million operating profit yielded a 12.2% margin – the year’s best.  For the full year, HPS’s operating profit was $1.37 billion – an operating margin of 11.1%, up from 8.3% in FY02.

The improvement in HPS profit margins, after adjusting for merger-related charges, is even more apparent.  The operating profit in the latest fiscal year has more than doubled – from $605 million (4.9% margin), to $1.24 billion (10.1% margin).

Hardware.  Among the HP hardware units, as usual, the Imaging and Printing group was the best performer.  Its fiscal year 2003 revenues grew by 11% to $22.6 billion, while its operating profit jumped to $3.6 billion, for a 15.8% operating margin.

Business hardware was up 6%, home hardware up 5%, while supplies rose 14%.  The imaging revenues were up 18%.

The Enterprise Systems group, the home of HP servers, has been racking up losses quarter-after-quarter.  But it also turned in a $106 million profit in the fourth quarter, on revenues of $4.07 billion.  For the year, revenues were up 2% to $15.4 billion, led by increases in online storage (up 9%).

The Personal Systems group also had its strongest quarter of the year, with revenues of $6 billion, up a full billion dollars from the previous quarter.  For the full year, this HP unit had revenues of $21.2 billion, up 19% over the fiscal year 2002.

The PC unit also eked out a small profit in the fourth quarter ($21 million), following a $56 million loss in the previous three-month period.  This means that for the full year, the HP PC unit has earned $19 million – for a 0.09% operating margin. 

Even such minuscule margin, of course, beats the losses that the Big Blue PC unit keeps piling on nearly every quarter on revenues half the HP PC’s size. 

Makes you wonder why some of these companies stay in the PC business, doesn’t it?  Probably because somebody has to… (besides Dell, of course).  Or does it?

Happy bargain hunting!

Volume XIX, No. 2003-20
November 20, 2003

Editor: Bob Djurdjevic
Published by Annex Research
e-mail: annex@djurdjevic.com

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