Another Desultory HP Second Quarter Call

The first confusing signal on the second quarter conference call came from the CEO's remarks.  She described spending time at Tech Con, an internal HP innovation show which used to have a blog populated by HP Fellows talking about big ideas in the mode of IBM's Watson Research Center. This wasn't a forum about new products, but about big ideas, which seemed to be the point of HP's acquiring Automomy. CEO Whitman was "blown away" by ideas discussed at Tech Con.  Upon announcing the expensive acquisition of Autonomy in past quarters, the CEO could then scarcely contain her enthusiasm about the synergy in customer and prospect lists and near-term opportunities.  Autonomy was almost not to be found in this quarter, so it would seem as if its offerings were no longer mind blowing.  More on this later.

Overall, the quarter looked pretty lackluster, with the reported diluted EPS of $0.81 being below a consensus $0.91, but non-GAAP, diluted EPS of $0.98 coming in above the $0.91, a number whose basis was unknown.  It was a positive surprise, and the lifeless analysts on the call were congratulatory about the "execution" in the quarter.  I can't find what these analysts were pleased about reading through the financials.

The Enterprise Server, Storage and Networking (ESSN) segment saw revenue decline 5.5% to $5.2 billion, while the segment's pre-tax margin declined 260 basis points to 11.2%.  The problem for HP and for the entire industry is that servers and storage have become commodity boxes and services.  These items may have to be bundled or serve as loss leaders in a larger, solutions package.  CEO Whitman made a strange comment about HP not being penalized as much as larger companies because HP has a $5 billion business in ESSN and not a $30 billion business.  This went over my head.  Recent newspaper reports have the CEO describing HP's unequaled opportunities in cloud computing. This segment's results are troubling no matter what the spin and don't seem to back up that assertion.

The Services segment reported revenue of $8.8 billion, a decline of 1% year-over-year.  Pre-tax margins in this segment declined by 410 basis points to 11.3%. If HP were going to morph into IBM, these kinds of margins won't carry the day for shareholders.

The Imaging Printing Group (IPG) reported a 10.4% decline in revenue to $6.1 billion, with the pre-tax margin dropping by 340 basis points to 13.2%.  In a sidebar conversation with an analyst about printer pricing in emerging markets, the CEO said the company was finding that higher printer prices at retail, along with lower supply prices led to better market share and consumer satisfaction.  This is just the opposite of the U.S. market strategy, and the pricing of U.S. cartridges and ink has probably peaked out. 

The Software segment increased revenue by 21.7% to $970 million, due to the inclusion of Autonomy's revenues for the full quarter.  Margins in this segment too fell, by 210 basis points to 17.7%.  Autonomy founder and CEO Mike Lynch is leaving the company, which to me doesn't seem to be a good thing and is inconsistent with some of the CEO's remarks about the "big data" opportunity. 

Lynch is a Cambridge Ph.D. mathematician who founded Autonomy and got it into FTSE 100 index in London as a global leader in turning mountains of files and data into usable information for decision making and risk management. While he is sometimes equated to Bill Gates, I think that the more appropriate pairing to someone like Steve Wozniak.  Selling Autonomy and helping to define the field of big data is something to which Mike Lynch is uniquely suited.

Perhaps HP could have helped him run the business by hiring him a Chief Operating Officer or a smart CFO who would remove all the headaches of running the back office interface to HP and keep the metrics on track.  There was a comment about developing a better interface between Autonomy systems and those of HP.  Now I know that they really overpaid for Autonomy, but letting Lynch leave seems to make no sense, since the British press suggests he wanted to stay and grow the company he founded in 1996.

The last item for me was the 33% decline in cash from operations to $2.5 billion.  This doesn't speak to execution of any kind.  Management can produce all the non-GAAP numbers they want, but this is a metric where the rubber meets the road.

Bernstein analyst Toni Sacconaghi suggests that the forward growth rate for HP might be 1%.  The company is going to be in a turnaround mode for quite some time, even after having lowered expectations below the level of the roadway.  The CEO seems to be trying to convince herself that she can turn this ship around when she makes repeated reference to having been through "a number of these (?) turnarounds."  Based on what knowledgeable investors can see forward, it's hard to make a case for the stock, except for appealing to some historical average margins and multiples which are no longer relevant.

The company suggested that there could be a sharp sequential growth in diluted EPS from Q3 to Q4, due to seasonality and to restructuring efforts.  Since this is a one-time item, hopefully it is priced in and ignored.  I wish I could take a trip to Suffolk and find Dr. Lynch in his favorite pub to talk about "big data."