MORE detail on G-S Alert this am:
Hewlett-Packard reported its first quarter as a merged company. Going into the earnings report, investment opinion had almost uniformly begun to expect that HP would need to take down its targets. Although most of the results of the quarter were consistent with expectations - with printers responsible for nearly 200% of segment profitability and HP's enterprise and personal systems groups extremely weak - restructuring is sufficiently on track to enable HP to cut some of its segment losses even in the face of weak revenues, resulting in minimal estimate changes.
*PRINTERS CONTINUE TO DRIVE REVENUES AND PROFITABILITY, PROVIDING COVER FOR STRUGGLING SERVER, STORAGE AND PC UNITS AND INITIAL COST CUTTING MEASURES APPEAR ON TRACK. Despite moribund IT demand and substantial restructuring actions, HP's July quarter was roughly in-line with our revenue and EPS expectations. In its first quarter as a combined company, HP reported revenues of $16.5 billion, $104 million lower than our estimate and $201 million behind consensus, and pro forma EPS of $0.14, a penny better than our $0.13, but in line with consensus. --Imaging and Printing continues to gain in importance, contributing 28.3% of revenue and almost 200% of segment operating income, up from 26.7% and 106% in the April quarter, respectively. Imaging and Printing revenues increased 9.7% YoY while declining only 3.4% sequentially, versus the 10.7% decline in overall HP revenue, driven by higher supply sales which were up 19% YoY as all-in-one printers and the use of printers for color hardcopy and photos continue to gain in popularity. --Total revenues were weighed down by the 19% sequential decline in HP's personal systems business, 28.5% of revenue, as both consumers and corporate customers continue to lengthen their PC upgrade cycles. --In addition, revenue from HP's enterprise systems group dropped 8% sequentially to 22.4% of revenue, due to weak corporate demand and stiff competition. --Operating losses in HP's personal and enterprise systems units continue to grow, accounting for operating losses of $620 million ($422 million for ESG and $198 million for PSG). The following table presents overall reported results versus our estimates.
Estimate Actual Variance
Net Revenue $16,640 $16,536 -104
Cost of Sales 12,413 12,282 -131
Gross Profit 4,227 4,254 27
Gross Margin 25.4% 25.7% 0.3%
R&D 959 983 24
SG&A 2,782 2,738 -44
Total Opex 3,741 3,721 -20
Operating Income 486 533 47
Operating Margin 2.9% 3.2% 0.3%
Int Income&Other 25 20 -5
Pretax Income 511 553 42
Income Taxes 125 133 8
Tax Rate 24.5% 24.1% -0.4%
Net Income 385 420 35
Net Margin 2.3% 2.5% 0
Operating EPS $0.13 $0.14 $0.01
Shares(Diluted) 3,065 3,047 -18
It appears that HP's cost reduction efforts are in line or slightly ahead of the targets laid out at the company's analyst meeting in June. In addition to lay-offs (4,740 in F3Q'02 and 1,760 thus far in the October
quarter) as the company works toward its goal of 10,000 by fiscal year end, HP appears to have made solid initial progress in reducing its facilities, direct and indirect procurement and IT expenses. However, it is important to keep in mind that many of the cuts in the quarter were back-end loaded and there is a long way to go before HP realizes its savings targets of $500 million in FY'02, $2.5 billion in FY'03 and $3.0 billion in FY'04.
*WE ARE MAKING A MINOR DOWNWARD CHANGE TO OUR OCTOBER QUARTER ESTIMATE, BUT ARE KEEPING THE REST OF OUR MODEL UNCHANGED. We are tweaking down our October quarter estimates slightly, to reflect the lower F3Q'02 base and are now looking for EPS of $0.22 on revenues of $17.4 billion, up 5% sequentially. The remainder of our model is unchanged as we think we sufficiently lowered our revenue assumptions when we revised down our numbers on the group a few weeks ago given our outlook on sluggish IT spending growth in 2003. We have also kept our EPS estimates unchanged as we continue to believe that HP has room on the cost side, particularly in FY'03 when the benefits from the numerous restructuring actions begin to kick in. It is also worth noting, that we would not be surprised if HP were to take some additional headcount reductions above the 15K related to the merger if the IT spending environment remains anemic, providing potential additional cushion to the bottom line. The table below provides a quick summary of our new estimates.
Revenue EPS
Old New Old New
4Q'02 $17.6B $17.4B $0.23 $0.22
FY'03 73.0 73.0 1.20 1.20
CY'03 74.3 74.3 1.30 1.30
*VALUATION IS ATTRACTIVE AND EVEN MARGINAL IMPROVEMENTS IN ONE OF HP'S 'PROBLEM' BUSINESSES COULD HAVE A MAGNIFIED IMPACT ON THE STOCK ALTHOUGH WE SEE FEW NEAR-TERM CATALYSTS. Although the shares should post a mild rebound minus the July quarter overhang, HP still faces significant hurdles in over 50% of its revenue base. However, should either HP's personal or enterprise systems businesses begin to improve and given even a mild rebound in HP's multiple, the stock could find itself back around the $20 level before long. Unfortunately, for now there remain too many moving parts and too few catalysts to get it there. Thus near-term, the stock's prospects likely remain valuation driven, with the good news being that at only 11x our CY 2003 EPS estimate of $1.30, below its pre-bubble range of 12-22x and at a discount to its peers IBM (17x), SUNW (17x), and LXK (16x consensus estimates), HPQ could continue to gradually inch higher before investors are forced to refocus on fundamental weakness and competitive threats.
*LOSS IN ENTERPRISE SYSTEMS GROUP (ESG) LIKELY TO DECLINE DRAMATICALLY DESPITE MUTED DEMAND AND RABID COMPETITION. Weak demand, particularly outside of the US, coupled with a salesforce reorganization, and uncertainty surrounding product transitions led to continued deterioration in HP's enterprise hardware business with revenues down 22% YoY and 8% sequentially to $3.8 billion and an operating loss of $422 million versus a loss of $233 million in the April quarter. Intense competition from Sun and IBM at the high-end and Dell at the low-end is likely to lead to further market share losses and pricing pressure in servers, limiting near-term revenue growth for HP in this segment. In addition, it appears that EMC's heightened efforts in mid-range storage contributed to a double-digit storage revenue decline in the quarter - both sequentially and YoY - a situation that could become worse with Dell's movement into the segment. Despite sluggish revenue growth, with our forecast showing a 9% YoY decline and 4% sequential improvement in the October quarter due primarily to a slight seasonal pick-up in demand, there is significant room for profitability improvement in HP's enterprise systems group. In the just- reported July quarter, enterprise systems operating losses included a $100 million one-time item related to salesforce training and the creation of new product roadmaps. At the same time, our assumption is that roughly two thirds of HP's 6,500 headcount reductions came from enterprise systems. At an estimated $100K fully burdened expense per employee, this could amount to an additional savings of $100 million per quarter. The combination of these two items could halve HP's $422 million loss to around $200 million in F4Q'02.
*HP'S IMAGING AND PRINTING BUSINESS HITS RECORD LEVELS OF PROFITIBILITY, CONTRIBUTING CLOSE TO 200% OF SEGMENT OPERATING PROFIT. We expected the printing business to continue to be the standout category in the quarter, and it was. Revenue increased 10% YoY, and operating margins reached a record high of 17.2%, increasing 150 bps sequentially, driven by a healthy contribution of supplies, and continued strong demand for inkjet products, particularly, All-in-Ones, PhotoSmart printers and the newly redesigned low cost inkjet printers (albeit to a lesser extent). While some of the factors leading to higher operating margins are short-lived, such as the shortage of All-in-Ones, others such as the growing contribution from supplies, which exceeded 50% of revenues for the second consecutive quarter, are more likely a sustainable trend. We expect printer profitability to move down some in the coming quarter, as supply catches up to demand on the All-in- Ones and hardware increases as a percent of the overall mix. That said, we still think operating margins could be as high as 16%, in the October quarter, meaningfully exceeding the company's stated target of 11-13%, as demand should continue to be relatively healthy.
*PERSONAL SYSTEMS: A COMBINATION OF TEPID DEMAND, PRODUCT TRANSFORMATIONS AND COMPETITION FROM DELL LIKELY TO MAKE CONSISTENT PROFITABILITY ELUSIVE. While HP continues to streamline its PC supply chain and operations, lower sales (down 19% YoY and 18% sequentially) and above-target consumer channel inventory levels contributed to an operating loss of almost $200 million in the quarter. --In its commercial PC line, the company has made significant progress, standardizing on a single product line and exiting the quarter with 2.9 weeks of worldwide channel inventory, which will likely lead to a rebound in sales and profitability in this segment when corporate demand resumes. --We view the company's consumer PC business as more troublesome. HP's strategy of maintaining both the Hewlett-Packard and Compaq brands could limit its marketing and manufacturing savings. In addition, the company's extensive use of resellers increases the risk of excess channel inventory and makes it difficult for the company to quickly respond to pricing actions, promotional activities and marketing campaigns by Dell. HP exited the July quarter with consumer channel inventory at 8.3 weeks. Although the company has been able to work inventory down during the first half of August to 7.2 weeks, we are wary of HP's ability to work inventory down to more normal levels of 4-6 weeks, given uninspiring signs of back to school demand to date. We therefore continue to think that the recent indications of increased motherboard orders reflect consolidation of suppliers rather than any pick-up in demand. --With its product strategy still evolving and a cost structure that trails Dell, we expect HP to suffer losses in its PC business through the end of FY'02 and into FY'03, despite headcount reductions that could cut operating losses by over $50 million per quarter starting in the October quarter.
*ALTHOUGH OPTION AND PENSION EXPENSE REPRESENT TWO ADDITIONAL NEGATIVE VARIABLES, THEY ARE PROBABLY NOT SIGNIFICANT ENOUGH TO PULL FY'03 EARNINGS BELOW $1.00. While HP management indicates that it is not yet prepared to commit to expensing options, noting that over 90% of currently outstanding options are under water, our analysis suggests that, even if expensed, HP's FY'03 options exposure would probably amount to less than $0.10 per share. Pension risk is harder to calculate, depending on both HP's own assumed rate of return on pension assets, currently at 9%, and on the magnitude of actual returns. Looking only at the company's expected rate of return, our understanding is that a 50-100 basis point reduction would not represent a material change, again suggesting less than a $0.10 per share reduction. |
