Hardware & PCs

Return to Article

H-P's Turnaround Rings True

Kevin Kelleher

It took nearly five years for Hewlett-Packard to go from aging but respected tech giant to over-the-hill and irrelevant dinosaur. The silver lining to such a fate is that the company's turnaround might turn out to be just as long-lasting.

H-P's stock has emerged as one of the most unlikely stars of the tech sector for 2005, rising 34% in the past six months. Not every company with $87 billion in revenue sees that kind of a gain. And that performance isn't far behind Google , everyone's favorite runaway stock, which is up 39%; and it's even better than the 31% rally seen in Motorola , which is being hailed as the turnaround of the year.

Compared with its peers, H-P's rally since June is even more striking. IBM is up 19% and Dell is down 22%. And that adds up to an impressive first act from H-P CEO Mark Hurd. At the beginning of 2005, if you had polled investors on which of the above stocks would be up more than 40% at almost year-end, H-P almost certainly would have lost the vote.

But that was when Carly Fiorina was at the helm. H-P's stock was trading around $50 when Fiorina showed up with promises to bring the aging tech giant into the 21st century. After three years, the stock was trading below $11, and for the following couple of years, Fiorina was never able to nurture it above the $20 mark for long -- resulting in a market cap that was two-fifths as large as when she showed up.

But is it too late for investors to get in on the recovery? Some analysts don't think so. Cindy Shaw at Moors & Cabot Capital Markets (which has no underwriting relationship with the company) believes H-P's strong performance in the quarter ended Oct. 31 is just the prelude to further gains that are tied to restructuring savings and IT improvements, both of which will play out for the next few years.

"There is potential for upside to consensus estimates as H-P fleshes out the details of its restructuring," Shaw says. What's more, "the Street doesn't appreciate the savings H-P could reap through fiscal year 2009 from streamlining processes and improving IT."

But some analysts advise a cautious approach. Needham & Co. analyst Charles Wolf, who rates H-P hold and values the stock at $22 (it closed Monday at $29.97), is waiting to see improvement in revenue growth. Robert Jakobsen at Jyske Bank agrees, saying Dell and IBM are more attractive as their revenue is poised for faster growth. Neither company has an investment banking relationship with H-P.

But it may be risky to underestimate the ability of Hurd, who has already surprised many with his ability to undo many of the missteps of the Fiorina era. Supporters and detractors of Fiorina will always disagree on whether she was better at photo ops than she was running a tech conglomerate.

But the numbers since her departure present a compelling case. In the fourth quarter of 2004, the operating margin for H-P's enterprise storage and servers, which make up about one-fifth of the company's revenue, was 2.6%. In the fourth quarter of 2005, under Hurd's steady hand, the operating margin grew to 9.1%.

This is significant because the storage market is one of the key areas for H-P's future growth. Revenue from disk storage systems grew 12.5% to $3.9 billion in the third quarter, according to research firm IDC, which noted that the growth rate was the fastest since it started tracking the sector in 2001.

What's more, the market leader EMC saw its market share slip one percentage point to 20.3% from the year-ago quarter, while H-P's share grew 40 basis points to 19.1%, IDC said. So, H-P is poised to take the lead spot in the growing storage market if those trends continue.

Overall operating profit in the fourth quarter was 7.6%, up from 7% in the year-ago quarter. While the operating profit dipped in the printer business -- to 13.2% from an unusually high 16.6% a year ago -- margins grew in other areas such as personal systems. And H-P's troubled software business went from a loss to a profit that was 8.7% of revenue.

But nobody invests in what a stock has done in the past. It's about what a stock is going to do in the next few months, at least. So, can H-P deliver a strong second act? As is the case with turnarounds, the bulk of the gains that H-P has seen have come from righting itself. With a historical P/E ratio of 36, the expectations are that the tech giant will have reason to grow profits once the restructuring has run its course.

One encouraging sign is that H-P is finally moving beyond its dependence on its core printing business for generating profit. In four years, H-P estimates that the digital press market will grow 26% a year to $4.4 billion, while the large format printer market will expand 9% a year to $8.2 billion. That's fine, but faster growth rates are likely to come from other areas, such as storage and services.

In the past, it seemed like H-P was shoring up printer profit to keep the entire ship running. In the fourth quarter of 2004, 73% of the company's operating profit came from the printer business. Last quarter, it was only 52%, still a large portion but reflective of the effort that Hurd has made to make the other lines of business more profitable. Printers make up only 30% of H-P's revenue.

All of this is a tall order. In addition to returning operational efficiency to the company, Hurd must reignite revenue growth -- most likely by strengthening its lead in the storage market. But thanks to the legacy of the Fiorina years, he has lots of room for improvement.

In other words, after paying Fiorina $14 million in severance to go away quietly, H-P has reaped roughly $28 billion in increased market value. Not a bad return on what appeared at the time to be an overpriced payment.

Get Jim Cramer's picks for 2006.