HPQ FY 4Q 2011 Earnings – An improvement but far from fixed

HPQ’s first report in the Meg Whitman era shows improvement in communication, but not better business fundamentals.  The overriding issues for HP remain: declining PCs; weak consumer; required investments; integration; and competition.  In addition, the macro weakness and supply chain issues resulting from the floods in Thailand are now added to the mix.  All that considered HP is doing okay, but not great.  Much work and investment is needed.  Whitman’s performance on the call was average – she sounded honest in her attempts to understand HPs issues and customer concerns – the question of what to do about it remains uncertain.  From a strategy perspective it appears that HP is taking a page out of Dell’s playbook, of focusing on profits instead of revenue leading to a newfound discipline that focuses on mix and operating improvements and de-emphasizes low-margin businesses, future M&A, and even share repurchases until the balance sheet improves.

HPQ is no longer providing revenue guidance but suggested that F2012 would face pressure from a weaker macro-environment led by Europe (EMEA is 36% of sales), an inventory correction in imaging supplies, HDD supply issues, and underinvestment in key business areas that has led to market share pressures and profitability reductions.  Guidance of “at least $4.00” is achievable for this year but not without cost cuts or improved macro (likely cuts) and puts the company at a more realistic 6.6x EPS and projected FCF Yld ~8-9%. As a reference, Dell trades at 7.3x fwd EPS and the recent range during its turnaround has been as high as 8-9x.  If HP is able to execute, this is the range to focus on, not an IBM like multiple.

It is clear from the results and comments that HP is working towards a more sustainable strategy, but that this turnaround will take more than a few quarters.  We agree with the assessment that printing may see more pressure than expected and that the PC business suffered brand damage, particularly in Asia and the enterprise.  On the positive side, the R&D may actually yield product advancements for the first time in years – such as their new Moonshot servers.  Time will tell, but expect the headwinds to remain strong for Q1 and Q2 and would stay away from the potential value trap.

Results:

*EPS $1.17 vs St $1.13; revs $32.1b vs St $32.1B;

*guidance lowered to more reasonable levels – will only guide EPS from now on: Q1 83-86c vs St $1.13 (whisper $1) and FY12 >$4.00 vs St $4.69 (whisper closer to $4.10);

*commercial revs -2%, consumer -9%; strong performance in services but margins weaker; personal systems weak but margins better, units +2%

*Americas -4%; EMEA -6%; APac +3% (ex Fx – Americas -5%, EMEA -10%, APac -4%)

*ESSN -4%, Imaging -10%; Person Systems -2%; Services +2%; Software +28%; Financing +18%

*Margins: ESSN 13% (-); Imaging 12.8% (-); Personal Systems 5.7% (+); Services 12.8% (=); Software 27.7% (+); Financing 10.3% (+)

*on imaging – channel inventory reductions, broad-based weakness in EMEA and softening consumer demand, particularly for supplies. Margins were unfavorably affected by the strong yen and lower-than-normal supplies mix of 54% as we continue to work down the high supplies channel inventory. Commercial printer revenue was up 4% year-over-year with commercial hardware units up 5%. Consumer printer revenue was down 8% year-over-year with an 8% decline in units. In total, printer unit shipments were down 5% year-over-year

*on ESSN – Across ESSN, we are seeing the effects of a slower economic environment. operating margin of 13% was 210 basis points below the prior year. Operating margins were impacted by a lower mix of BCS revenue, competitive pricing pressure and incremental investments in sales and R&D

* Business Critical Systems declined 23% yoy primarily due to a decline in our Itanium-based servers – impacted by Oracle’s Itanium decision to stop support

* HP networking grew 5% year-over-year, and enterprise switching and routing grew 7% from the prior year period

* HP Software revenue of $976 million, up 28% compared with the prior year, including 33% license growth, 36% services revenue growth and 20% support revenue growth – closed Autonomy in Oct

*non-GAAP gross margin of 23.2% down 170 bps yoy and down 10 bps qoq; impacted by the strong yen and a lower mix of printing supplies, as well as continued margin pressure in Services

* increased our R&D spend in FY ’11 by nearly 10%. And in 2012, we plan to do more of the same and to increase our R&D investment once again

*$2.4b in cash flow from operations; free cash flow of $1.2 billion; inventory days +4 to 27; gross cash $8.1b vs LT debt $22.5b; repurchased 17 million shares in the quarter for $500 million; roughly $10.8 billion remaining in our share repurchase authorization

Comments from Conf Call:

“Our near-term focus is on driving execution and investing for the future. But frankly, many of the FY ’11 headwinds are still with us. We’re expecting to climb in both revenue and profits in FY ’12”

“You should assume in 2012 that HP will be rebuilding its balance sheet and will not be doing any large M&A. Additionally, you should expect that share repurchases and dividends will continue to be a core part of our long-term capital allocation strategy. Over the long term, we expect HP to be a GDP-type growth company that can grow revenue in line or better than our markets, grow earnings faster than revenue and produce consistent cash flow.”.

“Macro environment remains uncertain globally and particularly in Europe. Consumer spending remains soft, and we have begun to see a slowdown in commercial spending. We expect these dynamics will lead to below-normal sequential revenue performance in Q1 and year-over-year revenue declines through 2012.”

“From a business perspective, we expect the decline in our Business Critical Systems business will remain a headwind throughout the year. Additionally, during the first half of the year, we expect to experience headwinds associated with the flooding in Thailand affecting hard disk drive supply, primarily within PSG but also across ESSN. We also expect a slow correction in our IPG channel inventory level.”

“We want to manage this company for a profitable growth. We really want to put the focus on earnings per share and cash flow so that we, particularly in some of our businesses like Services, we drive towards more profitable business”

“Appropriate to think about the Services as more as a turnaround. So turnaround is measured, success is measured in years as opposed to quarters.”

“I’m in favor of acquisitions, but I will tell you we cannot continue to rely on acquisitions alone at Hewlett-Packard. It’s just the wrong thing to do.”