Annex Bulletin 2007-07                              February 20, 2007

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INDUSTRY TRENDS

Updated 2/21/07, 10:15AM EST, adds Market Update

Analysis of Hewlett-Packard's First Quarter FY07 Business Results

Toward New Highs?

Revenue Grows in Double Digits; Profit Surges 31%

NEW YORK, Feb 20 - Hewlett-Packard's Mark Hurd did it again.  Once again, his company has exceeded Wall Street expectations.  And once again, HP did it the hard way - by growing both revenues and profits at the same time. 

First quarter revenues rose 11% to $25.2 billion, while net earnings jumped 31% to $1.8 billion.  And upward trends were evident in all of HP's lines of business.  That's more than just music to Wall Street ears; that's pure symphony.  

No wonder the HP stock rose to $43.13 in regular trading in anticipation of another solid quarter, closing just shy of the multi-year high set last month.  

"This was a solid start to (the) year, (as) revenue grew, margins expanded and we continued to take market share," Hurd told the media after the results were release, but prior to the analyst teleconference.  

Ironically, the HP shares gave up most of the earlier gain in after-hours trading despite its stellar latest business results.  Go figure... Wall Street has never been known to overdose on logic.

Business Segment Analysis

PCs. Take the PC unit, for example.  Yes, HP competitors, like Dell and Lenovo, have had their share of problems lately.  But HP has had little to do with that.  Hurd is evidently not the kind of CEO who "buys the business," as they say (drops prices and sacrifices profits to gain market share).   HP's PC revenues grew 17% to $8.7 billion, while its corresponding operating profit rose 41% to $414 million since a year ago period.

Some of the HP growth in the PC business has clearly come at Dell's expense.  But most of it seems to be coming from consumer markets.  The holiday season has certainly given HP a big boost.  They surged by 28% in the quarter (vs. 8% rise of commercial PC revenues and a 1% drop in desktop business).  Notebook sales now account for nearly half of the total (see the chart).  Maybe that's why Michael Dell beefed up his executive team yesterday by adding former Motorola executive to head up its consumer business?

Imaging & Printing (I&P). The most profitable HP business continues to be, well, the best.  The I&P revenue grew 7% to $7.0 billion, while operating profit rose 13% to $1.1 billion.  At a 15.3% operating margin, up from 14.9% a year ago, this is by far the most profitable HP unit.

Within the above totals, the supplies revenue, at 58% the largest I&P sub-segment, grew 11%, while the commercial hardware revenue grew 2% and consumer hardware was flat.   Unit shipment volumes increased in all of the I&P product lines, some in high double digits. 

Enterprise Servers & Storage (ESS). The ESS revenues rose 5% to $4.5 billion, while its operating profit jumped 28% to $416 million.  While the corresponding operating margin of 9.3%, up from 7.7% a year ago, is the second best on record, not everything has turned up roses in this unit.

A 6% decline in "business critical servers," for example, was one of the few blemishes in an otherwise excellent quarter.  The drop confirms that Sun Microsystems has been gaining share from HP in the Unix market, as was also evident from Sun's last month's excellent business results.

Asked to explain this blemish during the conference call, Hurd felt the drop was mostly due to relatively poor execution in this quarter, and should not be taken as a sign of any long-term malaise.

Meanwhile, HP's industry-standard (Intel-based) server revenue, the largest ESS sub-segment (60% of total), increased 10%, with blade revenue up 45%.  Storage revenue rose 3%.

Services (HPS).  HP Services was the company's most-improved operation this quarter in terms of profitability.  Its operating profit soared by 41% to $414 million, equaling the PC unit's total on less than half the revenues ($3.9 billion, up 5%).  The HPS operating margin of 10.5% represents nearly a three-point jump from a year ago (7.8% of revenue).

The Technology Services (maintenance), HPS' biggest segment at 54% of total revenue, grew 1% over the prior year period.  Consulting & Integration and Outsourcing sub-segments were up 10% and 11% respectively.  

Software.  HP Software, on the other hand, received the biggest revenue boost of any HP unit.  Benefiting from the Mercury acquisition, software surged 81% to $550 million.   Operating profit was $47 million, or 8.5% of revenue, up from a profit of $9 million, or 3.0% of revenue, in the prior year period.  And that's despite a write-down of certain costs and expenses related to the Mercury purchase.  So it would seem fair to say that at HP, Mercury is rising. J

Excluding the effects of the Mercury acquisition, which closed in November, revenue increased 7% over the prior year period.   HP OpenView grew 14% while HP OpenCall dropped 6%. 

Geographies.  Asia/Pacific was HP's fastest growing region in the quarter, rising 15% to $4.0 billion (up 12% in constant currency).  Europe, the company's largest geographic unit, was also up in double digits as reported (up 14$ to $10.7 billion), but it rose only 6% in constant currency.  The Americas region, the second biggest, grew 6% to $10.4 billion.

Financial Services.  Financial Services' revenues grew by 10% to $547 million.  They generated $32 million of operating profit for a margin of 5.9%.  Including the Corporate Investments, this business segment grew 12.4% to $704 million.

About 55% of the total came from the Americas region, with Europe accounting for just a little over one third.

Outlook and Market Valuation

Commenting about the outlook for the second quarter, the new HP CFO Cathie Lesjak raised the revenue guidance, both for the quarter and the full year.  

"We now expect second-quarter revenue to be approximately $24.5 billion, versus the current consensus estimate of $24.1 billion," she said.  "Historically, revenue was roughly flat in constant currency from Q1 to Q2."

Thanks in part to a stronger than expected first quarter, HP boosted its full year revenue estimate to between $98.0 billion to $99 million, up from its prior guidance of $97 billion.

Lesjak also lifted the earnings estimates, both for the next quarter (to approximately $0.63 to $0.64 per share), and for the full year and full-year fiscal 2007 (to $2.60 to $2.65 per share), up from the prior guidance of $2.48 to $2.53, and versus current consensus estimates of $2.57.

"So all-in-all, we have a lot of work to do but lots of opportunities as well," Hurd said in his closing remarks.  "I think it's a solid start to the year, and I am confident that we can continue to execute with discipline and deliver a year of strong financial returns."

In short, it looks like HP leaders think that the good news they've just reported for the first quarter will get better as the year goes on.  Yet investors traded down the HP shares by 1.3% in after-hours session.  Go figure, as we've said earlier.  

Meanwhile, we find that the aggregate component value is now slightly higher than the actual HP market cap (click on the chart right to enlarge).  So the stock appears to be pretty much priced in line where it should be relative to the P/E ratio of its various competitors.  Anything much higher than that, could be considered a premium.  And rationalizing that would require some logic and sanity.  Maybe tomorrow morning?

Happy bargain hunting!

Bob Djurdjevic

Click here for PDF (print) version

MARKET UPDATE

HP Stock Slides Nearly Three Points Despite Upgrades

"Barely Exceeding" Expectations Is No Longer Enough

NEW YORK, Feb 21 - Normally, a stock is supposed to rise when the company has a great quarter.  HP had a great first quarter of its fiscal year 2007.  Normally, share prices are boosted by analyst upgrades at prominent Wall Street firms.  This morning, Goldman Sachs and Credit Swiss raised their estimates for HP.  To no avail...

HP shares gave up $1.18, or 2.7%, to slide to $41.99 in early morning trading after the computer giant "gave a second-quarter forecast that barely exceeded Wall Street analysts' forecasts," reported the Dow Jones' MarketWatch after the markets opened.

So now, it's not enough to exceed the fickle investor expectations.  Now, some companies get punished on the street called Wall when they "barely" surpass them.  How perverted can the market get?

Such is the fate of Wall Street highfliers.  No surprise there.  We thought it would be instructive to revisit something we said back in November BEFORE HP's fourth quarter release (see "New King of the Hill," Nov 2006):

"Guess if there is a lesson other CEOs can learn from this Hurd example, it is the importance of building trust on Wall Street.  His cache of personal credibility acted as a stabilizer in the storm.  In my books, keeping up the stock's upward momentum amid the boardroom crisis is as big a feather in Hurd's cap as anything else he has done in his short time at HP.

But here comes the catch now.  Is there such a thing as "too much credibility?"  No one can walk on water, yet Wall Street just about seems to expect him to do that every quarter.

After you exceed the Wall Street expectations as many times as he has already done, guess what... they expect you to exceed them again.  And if you "just" meet them, or exceed them only slightly, the market may react as if you missed the target and sell off the stock.

Perverse?  Perhaps.  But that's Wall Street for you.

In short, what I am saying is - I would not be surprised to see a sell-off in the HP stock unless after the results come out unless the 4Q is really another whopper of a strong quarter.

(An excerpt from comments to a reporter prior to HP release, 11/16/06)

Well, now you can see for yourself how perverse and insatiable Wall Street can be.  Even "excellent" is not good enough if you "just" keep excelling.  That's the banality of success.  Can you imagine what would happen if HP ever stumbled?"

(An excerpt from "New King of the Hill," Nov 2006)

And that's all she wrote... for this quarter.

For additional Annex Research reports, check out... Annex Bulletin Index 2007 (including all prior years' indexes)

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