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Commentary: HP looks strong despite earnings shortfall

Despite its earnings disappointment this quarter, Hewlett-Packard looks basically sound. However, it faces important challenges, and its 2001 performance depends greatly on the health of the cooling economy in the next year.

Despite its earnings disappointment this quarter, Hewlett-Packard looks basically sound. However, it faces important challenges, and its 2001 performance (like that of every other company) depends greatly on the health of the cooling economy in the next year.

The detailed figures in HP's quarterly report show that much of its earnings drop can be attributed to the drop in European currencies against the dollar. HP's overall growth was strong--13 percent in the United States and 26 percent overseas in local currencies. But it lost 12 percent of that overseas growth to fluctuations in the currency markets. It actually made some extra in the Asian markets, where the local currencies are gaining strength against the dollar as those economies continue to recover from the "Asian contagion" of 1998. HP officials highlighted a 17 percent growth in expenses as another reason for the disappointing performance this quarter. In general, HP needs to get these costs back under control.

See news story:
HP misses earnings expectations, drops PwC bid
Stronger growth in home PCs (62 percent) and notebooks (164 percent) is in contrast to HP's historically lackluster performance in these areas and may indicate that the company is finally succeeding in using its very strong printer distribution channel, one of the strongest channels in the industry, to pull through other products. HP executives have promised this for several years, but until now we have seen little evidence of success.

For the past few years, HP's dominance in the printer business and the higher margins (13.4 percent in the fiscal fourth quarter) of this business have given it a cushion as it has moved to rehabilitate its computer systems business (3.7 percent margin) and grow its services business. The printer business has also provided a strong distribution channel, which HP could leverage to drive its PC and notebook business--particularly to consumers and small businesses. Indeed, the strong growth reported in the PC and notebook businesses indicates that HP is having some success with this strategy.

The good news is that HP's computer systems business is growing 29 percent. The bad news is that growth in the higher-margin imaging and printer business is modest (about 6 percent). Computing systems revenue surpassed imaging and printing revenue in the quarter, making the overall HP earnings cushion from imaging/printers less effective. This shift in the business mix, along with the currency conversion issues, is putting pressure on earnings and will increase the pressure on HP to execute well on its computer systems and services strategies to meet Wall Street expectations for the coming year.

The promise of Superdome
There is some reason for optimism about HP's future, given that it is entering a Unix server replacement cycle with the introduction of its new Superdome server line. The high end of this server line, in particular, should sell into pent-up demand from companies that have been waiting for a larger system from HP for applications that have outgrown their present systems.

However, HP has premium-priced its Superdome systems, and their success will depend in part on the state of the economy in 2001. This calendar year has seen a general economic cooling-off from 1999, and it seems clear that next year will see a further cooling. The question is whether the economy will make a "soft landing" or whether it is headed for a serious recession. If a major recession does develop, many HP customers will not have the budgets to pay those premium prices, which means that either HP will not sell the volumes it expects or it will have to cut its prices. Either way, in a recession it will have a hard time meeting Wall Street's expectations and its own predictions for next year--but that would also be the case for most other companies.

Meta Group believes that HP's decision to break off negotiations with PricewaterhouseCoopers was a good move overall. In general, its consulting business has not been an outstanding performer in the past, and if it purchased PwC, it would have had a hard time convincing other vendors and their users that the PwC consultants would remain neutral. Competing vendors (such as Sun Microsystems, IBM and Compaq Computer) would have strongly suspected that HP would use PwC as a channel to sell its hardware into their clients' shops, and they would have spread that suspicion to their clients. We believe that this would have inevitably resulted in a drop in PwC business. We believe that some other, more neutral party would be a better parent for the valuable PwC consulting business. Nevertheless, HP still needs to buttress its consulting capabilities with a more complete-solution story.

HP needs strong Superdome sales to fuel its growth over the next three fiscal years. However, it also needs to maintain its premium pricing to achieve its income goals, and the slowdown in its printer business puts more pressure on it to sell servers. HP users should prepare for hard-nosed negotiations with HP over Superdome prices and over terms and conditions, where HP may be more willing to negotiate. Whether HP becomes willing to give users a price break will depend in part on the state of the economy as the new year progresses.

Meta Group analysts David Cearley, Peter Burris, Val Sribar and William Zachmann contributed to this article.

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