Thursday, February 20, 2014

H-P Upside Surprise for 1Q FY14: Execution Issues Still Remain.

H-P surprised analysts expectations in terms of revenue and EPS, and the businesses about which analysts were concerned also did better. Revenue of $28.2 billion was down 0.7% y/y and up 0.3% on a constant currency basis; this compared with expectations of a revenue decline of around 4%.

Revenue, Earnings and Cash Flow

Consolidated GAAP operating margin of 7.1% was up 90 basis points over the prior year period; on a non-GAAP adjusted basis operating margin of 8.5% increased 60 basis points year-over-year.

GAAP diluted EPS of $0.74 per share increased 17% over the prior year period level of $0.63.  The company had bracketed its expectation between $0.60-$0.64, a flat to down quarter year-over-year.

Non-GAAP diluted EPS came in at $0.90, representing a 10% increase over the prior year quarter's level of $0.82 per share. The company's guidance had been in the range of $0.82-$0.86.

CFO was $2,990 million, compared to $2, 562 million in 1Q FY13, an increase of 17%, well ahead of all expectations. Free cash flow cited by the CFO was $2.4 billion. The company did a large, well received institutional debt offering of $2 billion in the quarter.  Return on equity was 18%.

$843 million in cash was returned to shareholders in 1Q FY14, comprising $278 million in dividends and $565 million in share repurchases at an average price of  about $28.25.  The percent of free cash flow returned in the quarter was about 35% compared to the target of 50%, which I still believe should not be a focus for management's energy or shareholder capital at these levels.

Surprises in Business Segments

The Personal Systems Group revenue grew 4% to $8.5 billion, which CEO Whitman said was its best performance in the past four quarters, possibly signaling an inflection point in the PC cycle. Analysts had forecast doom and gloom for this business, as the world would be working on tablets, according to them.

Total unit sales were up 6%, with commercial units sold increasing 8% while consumer units declined by 3%. Desktop units in total decreased 3%, while notebook units sold increased 5%.  The Windows XP changeover to Windows 8.1 was not a major factor in the segment's unit sales, according to the CEO. 

Operating margin in the Personal Systems Group was 3.3%, almost 50 basis points ahead of the prior year period. 

PSG revenue accounted for 30% of 1Q FY14 consolidated revenue and about 10% of non-GAAP operating profit. 

The Printing business of $5.8 billion declined 2% year-over-year, and about 1% in constant currency. Printing's operating margin of 16.8% was 50 basis points ahead of last year. Total hardware units sold were up 5%, with laser units sold increasing by 2%, leading to a 2% increase in market share, according to the CEO. Supplies sold decreased by 3%, while ink sales increased.  This business, which for a time was milking consumers for ink sales to maintain its profits, seems to have returned its business model to some normalcy, focusing on units in its key commercial segment.  The CEO gave a "shout out" to her new leadership group in this business. 

Printing accounted for 20% of consolidated quarterly revenue and a hardy 37% of non-GAAP consolidated operating profit.

The Enterprise Group revenue of $7.0 billion increased 1% over the prior year period.  Operating profit of $1 billion represented an operating margin rate of 14.4%, down about 100 basis points compared to the prior year period.  Now that the revenue base has stabilized, the CEO noted that the profit margins really have to increase in this business.  A lot of the margin has to do with mix of sales, she noted. If H-P can mix in more storage and networking products and services into sales, this would be accretive  to margins, whereas higher sales of Industry Standard Servers ("ISS") are dilutive to margins  ISS sales are still 46% of EG sales, and ISS sales grew 6% while storage sales were flat and networking sales were up 4%.  

Highlighting the issue of product line transitions, storage sales were flat overall, but sales of the Converge line of storage solutions increased 43% and the former 3PAR products form the backbone of the new solutions. Traditional, stand-alone storage solutions will have to be transitioned out of the portfolio.  

Two Challenging Areas

Since 2010, we have expressed our view that the Enterprise Services business doesn't really fit as a value contributor.  Representing 19% of quarterly revenue, it contributed only 2% of non-GAAP consolidated operating income. 

This business can't compete with the high end IT consulting groups, and so it cannot aspire to that industry-leading profitability. 63% of its revenue still comes from Information Technology Outsourcing ("ITO") a commodity business in its sunset years, especially for profitability. The ITO business was down 9% year-over-year.  Enterprise Services revenue of $5.6 billion declined 7% year-over-year, while producing a meager $57 million in operating profit, or a paltry 1% of revenue.

Here's what we wrote about this business after reviewing the 2013 Analyst Day presentations:
"The CEO reviewed the major businesses. Enterprise Services, a $17.5 billion business (based on nine months, YTD), accounts for 21% of the YTD revenues but only 5% of the non-GAAP operating income. Whitman cited the inconsistent leadership, strategy, lack of EDS integration, and inadequate internal systems as the biggest reasons for its historically poor performance.  This business needs some portfolio pruning, in my opinion, but the CEO said that there would be no major restructurings in fiscal 2014.  The segment's non-GAAP operating margin was said to be at the high end of the outlook given at last year's meeting, but that doesn't change the fact that this is an albatross that needs to take flight.  It clearly has the CEO's attention.
Whitman cited a pretty extensive list of new leadership within Enterprise Services, including executive promoted from within and new hires from Bain, Accenture, Microsoft, and Elastic Intelligence/BMC.  The leadership group has pretty easy comps to have a strong 2014, let's hope that they get there."
Listening to the CEO on this quarter's conference call, it sounds like the group has its sales tools, new leadership and new processes, but the kind of change from putting a bucket out and waiting for renewals to going out and proactively marketing new ideas takes time and nine months of fiscal 2014 seems like a short time.  Let's see.

 Software was the second challenging area, in our opinion, in an otherwise strong quarter that caught analysts off guard on the upside. Something appears wrong in this segment, and the measured evaluation of prospects by George Khadifa at Analysts Day may have been too optimistic. If I recall, Mr. Khadifa was to report directly to the CEO.  Software is only 3% of the first quarter's revenue and 5% of its non-GAAP operating profit. 

Quarterly revenue of $916 million was down 4% year-over-year, while operating profit of $145 million was a sub-standard 15.8% of revenue, a 50 basis point decline over the prior year period. Support revenue which is 53% of the business and an add-on to a project sale was down 2%.  Professional Services, the equivalent of a higher-end offering, declined by 12%.  This business needs more critical mass.

Closing Comments

The CEO, in response to a question, said that acquisitions were back on the radar, and certainly looking at the software business, it's not hard to see why.  Areas that would be considered are in security, big data, mobility and cloud.  Of course, some of these areas are precisely what Autonomy was supposed to provide. The target size was described as "small to medium" sized companies.  The $2 billion in debt, along with continued strong cash flows from operations, and some portfolio pruning could set the stage. 

CEO Whitman talked about increased innovation from inside H-P, and she drew attention to the wide range of new product introductions at the European client meeting in Barcelona.  This is all to the good.

The company guided to 2014 EPS in the range of $3.50-$3.79, on a non-GAAP basis.  This seems like this would support a price from $30-35 a share, absent any collapse in corporate technology implementations for which there seems to be a growing appetite. 

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