HP Conference Call Gives No Comfort For Investors

HP's 4th Quarter and fiscal year-end conference call marked new CEO Meg Whitman's debut after eight weeks on the job; it gave no comfort for investors, and analysts from Goldman, Morgan Stanley and Citigroup seemed almost comatose, not challenging the disjointed and contradictory presentation.  The stock sunk immediately after the call, on healthy volume.

One fundamental comment concerns the financial statement presentation: Big 4 auditors in my experience are usually reluctant to permit widespread use of non-GAAP financial measures in presentation of results, and they try to limit their use and keep the corresponding GAAP measures adjacent to the non-GAAP measures.  Although HP provides reconciliations in their slides (what they call a "bridge"), the management leans totally on non-GAAP measures of performance.  One of the problems with the non-GAAP measures is that they are not comparable across companies, since companies differ in what they consider one-time or non-operating items.

For the full fiscal year 2011, HP reported GAAP pre-tax income of $8,982 million, or $3.32 net per diluted share. Adding back charges for impairment of goodwill and purchased intangibles, amortization of purchased intangibles, restructuring, and acquisition related charges, produces $4,350 million of adjustments to pre-tax income.  At a 22% tax rate, non-GAAP adjusted EPS for 2011 becomes $4.88, like magic!  Similar hand-waving for the fourth quarter turned reported EPS of $0.12 into a non-GAAP EPS of $1.17.

By making these adjustments for comparability, the board and the management escape the fundamental problem that these large acquisitions now being written down were the avowed strategy of the company over a long period of time.  The adjustments are economic testimony to the fact that they were poorly conceived and executed.  Aren't these "operating" items for a company whose stated goal has been to make mega-acquisitions?  I realize that I'm mixing accounting with what the statements are trying to represent, but I hope the reader will indulge me.  In fact, CEO Whitman continued to talk about acquisitions in HP's future, saying only wanly that there might not be any more mega-deals. I certainly hope not!

In an amazing show of chutzpah, the management said that they would no longer give any forward guidance, except for EPS.  Consider what they said.  For fiscal 2012, management expects the company to earn at least $3.20 on a GAAP basis, compared to $3.32 on the same basis in the prior year, a decline of 3.6%.  I sincerely doubt that management will be compensated for 2012 on EPS, as suggested by CEO Whitman.

On a non-GAAP basis, management said that the company is expected to earn at least $4.00 per share, compared to $4.88 in the prior year period, on the same basis, a decline of 18%!  Buried in a footnote in one of the presentation slides is an item that says, "Full year fiscal 2012 non-GAAP diluted EPS estimates exclude after-tax costs of approximately $0.80 per share, related primarily the amortization and impairment of purchased intangibles, restructuring charges and acquisition-related charges."  So, the stream of "one time" items continues into 2012, and there will again be a difference between reported EPS and non-GAAP EPS.

The new CEO says that the number one question she faced when going out and talking to customers, partners and investors was "What is HP?"   She characterized the company as being No. 1 or No. 2 in all of its operating business segments.  Based on the performance of the segments and on their outlook, this statement seems inaccurate.  There was talk about how smoothly the Autonomy acquisition was going, with the companies "exchanging hundreds of sales leads," and yet the acquisition seemingly has no impact on EPS in 2012, but without any detailed guidance, this isn't easy to tease out.  Autonomy's website claims the company has 25,000 customers worldwide, many of which must be small and scattered across a variety of product offerings from social media analytics to eDiscovery.

The Personal Systems Group (PSG) which was going to be sold off by Whitman's predecessor will now be retained.  Based on its performance and outlook, it must be an industry No. 2 because there are only two horses in the race.  The company's commentary during the call was guiding strongly to single digit declines in PSG revenue in 2012 compared to 2011.  Disk drive shortages from Thailand flooding, widespread consumer spending declines for both notebooks and tablets, the failure to have an established tablet product in the market, and a decline in ASP's will all militate against revenue growth and margins may touch record lows. Fourth quarter 2011 operating margins in PSG were 5.7%, typical of a commodity business.  In the first half of FY 2012, these margins may drop as low as 2-3% before a macroeconomic industry upturn in the second half starts to raise units, price, and mix.  2012 seems like just putting a finger in the dike for this business.

We've written before about HP's being overly reliant on the printing supplies business, which is included in Imaging and Printing Group (IPG).  The company pushed too much product into their wholesale and retail channels in 2011, and it hopes to work these off in the first half of FY 2012.  Operating profit in this segment had a recent peak at 17% in FY 2010, and it may spend FY 2012-2013 in the 13-14% range.  This is an industry leading business, but to paraphrase the CEO, "Printing is a coincident indicator of economic and business confidence and sensitive to price in a downturn."  Remember how we were all going to print studio-quality photos on our printers at home?  Not!

Services 2011 revenues of $36 billion is just behind PSG's 2011 revenues of roughly $40 billion.  As I think of the industry leaders in this segment, I think of IBM and Accenture, not HP.  CEO Whitman's talk about this business was not at all enthusiastic.  She talked about a multi-year turnaround for this business, the need to hire people who "can actually deliver what the customer wants," the need to invest in better quality sales people, and margin pressure in the basic service offerings. This does not sound like a No. 1 or No. 2 business leader in the industry.

IBM Global Services Revenue, by contrast, is projected by Credit Suisse to be $63 billion in 2012, with 33% gross margins and 15% pre-tax margins.  HP's management has suggested operating margins for Services in the 10-12% range for 2012-2013 on flat to low single digit revenue growth.

The Enterprise Server, Storage and Networking Business (ESSN) The company is one of the market leaders in Industry Standard Serves (ISS), but even this segment of the business would, according to management, be facing macroeconomic deceleration in upgrade and replacement cycles, continuing problems with Oracle's move away from the Itanium chip,  Facebook, Google and others building their own servers, and a deterioration in HP's traditional storage offerings. Now that Dell has acquired Compellent, they would seem to have a more innovative and attractive set of options for large volume storage customers. Operating margins in this business should continue to be under pressure in 2012.

The company will be ramping up its R&D spending, something which does not give us comfort given that previously high levels appear to have yielded nothing, which then required the company to purchase innovation expensively in the capital  markets.

Whatever FCF the company generates in FY 2012, it will be dedicated to paying down debt related to the Autonomy acquisition, and so cash returned to shareholders, which is a healthy percentage of the free cash flow, probably won't grow too much.

The HP value creation machine may be stuck in neutral almost certainly through Q1-2 FY 2012, and time continues to be on the value investor's side to see if this is the board and management team has the ability to restore the company's tarnished luster.