Thursday, May 22, 2014

HP's FY14 Q2 Call: Financial Engineering and Confusing Messages

We're more than two years into HP's long journey, which I recall CEO Meg Whitman characterizing as a five year turnaround.  Listening to the analyst questions on the webcast, I can confidently say that I wasn't alone in being confused and a bit concerned about the messaging, particularly from CEO Whitman.

Let's fly over some of the numbers, without going into the minutiae. Consolidated net revenue in the quarter was $27.3 billion, down 1% year-over-year and 3% sequentially.  On a constant currency basis, revenues were flat year-over-year. In the Personal Systems business, revenue of $8.2 billion, increased by 7% as HP regained the leading industry share in corporate desktops and laptops, benefiting from a corporate spend rebound driven by the XP support expiration.  Operating margins continue to be tough in this business, and the OM increased by 30 basis points to a paltry 3.5%.  Printing revenue declined by 4% to $5.8 billion, but the operating margin increased by 360 basis points to 19.5% of revenue.

The discussion of this business was all over the place.  Reference was made to the historical lack of innovation to a tired line of multifunction laser printers, which has opened the door to Japanese competition. With a large installed base, toner business was down, but it was unclear why.  An analyst question on this point drew a confusing response. The consumer ink business was said to be "good," whatever that meant.
A 360 basis point increase in margin deserved a simple, clear explanation, but it wasn't forthcoming.

The printing business' segment operating income in the quarter was $1,430 million.  The operating profits of the Enterprise Group and of the Enterprise Services combined were $1,105 million.  This is not a healthy balance for the future.  Unlike Microsoft's consistent demonstration of the power of its Enterprise businesses, HP seems to be treading water by issuing lots of press releases and launching web pages. The Enterprise Services business continues to go nowhere, with operating margins below that of the Personal Systems business.

For example, it wasn't long ago that a conference call heralded the launch of the Moonshot server line, which presumably was going to rescue the company from the commoditization of ISS.  On this call, Moonshot was again mentioned, but with a very cautionary tone. My takeaway? It is a New Thing, but not the Next Big Thing.

On the current call, the CEO lauded the creation of HP Helion, a sort of "Joy of Cooking" for the IT customer looking to create any kind of cloud: the recipe is in Helion.  Have a look at the HP Chief Marketing and Communications Officer explaining what HP Helion means.

Total non-GAAP operating income of $2,341 million was flattish with a year ago, and the operating margin declined by ten basis points to 8.6%.  Net earnings of $1,691 million were flat to a year-ago, and diluted, non-GAAP EPS of $0.88 per share was at the high end of the guidance and of analyst expectations. The EPS compared to $0.87 per share in the prior-year period, on the same basis.

For the six months fiscal year 2014 to-date, the company spent $1,396 million on share repurchases, about 42% of FCF over the same period, and the average price per share received was $29.70. $596 million was paid to shareholders in the form of dividends over the six months.

The CFO made reference to buying shares only with a "return based" focus: the stock was a bargain, her comments implied. With the current revenue outlook, more significant cost cutting, and a P/E which seems to fairly reflect the uncertainty, what kind of internal model would suggest that shares are a bargain at $30?

Confusing Messages

After looking at the company and its businesses for two years, "more opportunity" was found to improve the cost structure and speed up internal customer response and innovation by having an additional 16,000 staff leave the corporate work force!  This raised a pretty high degree of angst among the cadre of analysts who are the leading voices on the stock, no matter what their opinions.  What were their concerns?
  • Much of the success in righting the ship and stopping the hemorrhaging has been accomplished through the 2012 planned reduction in force. If anything, the benefits expressed in future, lower run rates of expenses have been above-plan.
  • The expected turnaround in revenue from an improving IT cycle and the cloud hype has not materialized.  It seems to be pushed out into the indefinite future.
  • $11 billion was spent on Autonomy, and most of that was written off.  Litigation was promised through the British SFO.  Nothing has happened.  Now, in fact, positive references are made about an Autonomy's win for its IDOL system in the current quarter, and its product revenue grew in the quarter. Will this acquisition be the building block to drive the Software segment forward, or will other acquisitions be necessary?
  • George Kadifa, the former operating Partner from Silver Lake, is giving up his position as head of the Software business, after he was brought on with much ballyhoo reporting directly to Meg Whitman. Robert Youngjohns is taking over this portfolio.  What does this mean?  Is it a real move forward, and if so, "Why?"  
  • References were made to being halfway into the turnaround, and in other places, the company was in the "early innings" of improving execution.  Where are we, and exactly when will the right players be in the right place with the right attitude?  
  • Put it all together, and the analysts, each in their different way, expressed their angst.  Does the announcement of another staff reduction of 16,000 mean that this is the only way in which the management can meet its stated guidance?  Is there diminished confidence in the revenue-producing capability of the businesses?  
  • Does this mean that analysts should be raising their estimates for the impact of this new staff reduction? Should they raise for this AND a revenue turnaround?  Their customers will ask them tonight after the conference call, or by the latest tomorrow morning on their morning calls. They were told to wait until October's Analysts Day for additional guidance.  Wrong Answer!!
  • The CFO made a point that she sees the benefits from cost cutting as allowing higher reinvestment in the business, all of which is done on a "returns basis."  When and where would be reinvestment be done?  Research and development takes time and is expensive. This spend has been flat anyway. What does the CFO mean by this, and how would it compare, return-wise, to share buybacks above $30 per share?
  • A legitimate question was asked about the effects on an organization's morale from continued, substantial downsizing.  It is a very real issue,and the answers were, frankly, inept and insensitive. For the survivors, there will be a period of mourning and diminished productivity.  
  • There was a lot of sharp-penciled financial engineering in the quarter, as in getting the DSOs down to very low levels, apparently helped by increasing reliance on factoring of the corporate receivables, if I heard this right.  This is all good, but it won't get this company where it says it wants to go.  
  • All in all, the tone of this call rang hollow. It is very hard for the Buy/Outperform analysts to make a case going forward for multiple expansion when there is nothing to hang their hats on for a revenue turnaround and predictable business outperformance. 

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