The Hewlett-Packard Dilemma


By Margaret Popper Ever since IBM (IBM) remade itself from a lumbering hardware leviathan into a sleek computer-services competitor, tech-stock investors have been on the hunt for other elephants capable of turning themselves into cheetahs. Unfortunately, examples like Big Blue are few and far between. The path to tech adaptability is littered with the carcasses of companies that embarked on makeovers and lost their way -- like the defunct Digital Equipment, to name one.

Hewlett-Packard (HWP) is at a crossroads very similar to the one at which IBM stood in the early '90s. With a 60-year history of focusing on hardware and equipment, the company is trying to figure out how to turn itself into a service organization. Judging by the stock price, which has struggled back to around $25 after taking a modest dip on the company's revised earnings announcement July 26, the investing world seems ready to believe in HP's makeover.

While the cost-cutting initiatives HP recently laid out may help improve profits over the next several quarters, however, the company is a long way from becoming a cheetah. If you're thinking the low stock price presents an opportunity to buy into the retooling for cheap, just remember this: HP isn't the only hardware manufacturer in the middle of a metamorphosis. It has got tough competition and plenty of it. Compaq (CPQ), which faced the same set of challenges in its core PC business that HP is grappling with, is much closer to rebalancing its product mix -- and it has already implemented most of its key cost-cutting measures (See BW Online, 8/2/01, "Waiting for a Compaq Comeback").

KEY ACQUISITIONS? Both stocks are cheap at current levels, but when it comes to reorganization, HP is the tortoise to Compaq's hare. Investors hoping to buy into the next IBM-style miracle need to ask themselves whether HP potentially faces the problems Xerox (X) is confronting. That former technology giant, which has seen its once high-flying stock dive below $10 a share, is struggling mightily to find its way in an Internet-driven world.

In an effort to move into higher-margin, faster-growth businesses, HP during the current quarter has made what it hopes will be some key acquisitions -- Comdisco's business-continuity services business and StorageApps, a provider of one component of storage-management software solutions. These acquisitions may prove to be too little, too late. "In the mid-'90s, HP underinvested in technology," points out Andrew Neff, analyst at Bear Stearns. "If you've underinvested for five years, it takes a comparable amount of time to get up to speed." The company declined to comment.

As HP tries to catch up, it also runs the risk of losing focus. "They're going in a number of different directions," says Neff. "They're pursuing storage, servers, PCs, software, printers, hardware, and services." The danger is that such a scramble could leave the company confused about its mission and no more competitive after its remodeling is finished.

MIXING UP THE MIX. The trick is in picking all the right business-line options, creating efficiencies, and being sure not to get scattered in too many directions. HP itself acknowledges the critical challenge is to change its hardware-heavy product mix. Only about 16% of the company's $11 billion of revenues in its fiscal second quarter were generated by IT services, the kind of consulting and outsourcing business that has become so lucrative for competitors IBM and Compaq.

In HP's latest quarter, which ended April 30, about 81% of revenues came from its printer and computing systems businesses -- mostly equipment, hardware, and the software needed to support it. While HP is dominant in the printer business -- still quite a profitable business -- it's getting significant competition on low-end printers, which has eroded its consumer business.

Competition is also fierce in the server business, another of HP's traditional strengths. HP ranks third behind Sun Microsystems and IBM in total revenues from server sales, and fourth behind Sun, IBM, and Compaq in unit shipments. In her recent third-quarter guidance, HP Chief Executive Carly Fiorina was quick to point out that consulting and outsourcing would grow at a rate of 20% and 9% for the quarter. But given that they're only 16% of total revenues, the growth is not going to create a significant change in the revenue mix. Net, HP expects 14% to 16% year-over-year revenue declines for the fiscal quarter ended July 31.

TAKING OUT THE COSTS. On the cost side, Fiorina announced about 6,000 layoffs -- nearly 6.5% of the labor force -- most of which will happen in the fourth quarter. That should cut annual costs by $500 million. With operating margins in the fiscal second quarter at 2.8% and fiscal third-quarter margins continuing to deteriorate, according to Fiorina's announcement, the company can't take the costs out any too soon.

With the economic storm wreaking havoc with margins across the industry, HP in some ways may have received a blessing in disguise, according to Jay Stevens at New York-based research and brokerage firm Buckingham Research Group. Fiorina is able to perform her reorganization under cover of the bad economy. The downturn also could lower the prices of planned acquisitions.

Stevens has a lot of confidence in Fiorina's ability to pull off the makeover. "The first issue," he says, "is to recognize what's not working, and Carly Fiorina has figured out what's wrong." He says the problem is not enough of the company's revenue comes from services. "The industry changed and the company had to bring someone in from outside just like IBM did in 1993 with Lou Gerstner. Carly's been at it [solving the identified problems] for a couple of years now, and she'll be successful in the end."

THINK TWICE. Looking at the range of target prices -- $15 to $37.50 a share, with an average 12-month target price of $28.20 -- most analysts are not as sanguine as Stevens. Consensus estimates put fiscal third-quarter revenues at $10 billion, with earnings per share of 4 cents, according to First Call Data. Analysts predict total revenues for fiscal 2001 of $45.8 billion, with EPS of 74 cents. That's a decrease of 6% and 57%, respectively.

It's certainly a good idea to be looking for tech bargains during this time of tribulation. And companies in transition certainly make good targets for value investing. But with all the other options out there, investors may want to think long and hard before betting on HP to emerge as a lean cat on the tech savanna once this storm subsides. Popper covers the markets for BW Online in our daily Street Wise column


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