On the one-year anniversary of its merger with Compaq, Hewlett-Packard ( HPQ) took a moment to crow about its recent string of services wins. The deals, including a just-finalized $3 billion, 10-year contract to manage Procter & Gamble's ( PG) technology, fit with H-P's strategy to boost its services and software lines relative to slower-growing hardware. To be sure, H-P's services arm needs to do some hustling, given rival IBM's ( IBM) decade-long head start and revenue base of more than three times H-P's size. But the P&G contract at least shows H-P can play in the big leagues, with the company having largely quashed initial worries that its integration with Compaq would turn messy. A year after the merger, investors and analysts give H-P credit for making some progress in services -- an area that's strategically vital, with the hardware business now mired in permanent slow-growth mode. To put the growth potential in perspective, consider technology outsourcing, a service market that's forecast to grow at a relatively impressive 10% to 15% a year. That's as much as double the rate of H-P overall, which CEO Carly Fiorina has forecast to grow at a long-term rate of around 7% to 9%. Not only is services expected to grow faster than computers, but the area also offers a welcome measure of sales stability, generating steady revenues over the life of a typical three-to-five-year contract. "H-P is pretty new at services, but we think it's pretty important, given the size of the company, that they move in this direction. It's absolutely the right long-term move," says John Rutledge, manager of the ( ETCAX) Evergreen Technology fund, which has 6.7% of its assets in the stock. Granted, reaction to the high-profile P&G deal itself was mixed. "P&G has a history of demanding irrational terms, so H-P might have taken big risks -- some of which H-P might not recognize given its lack of experience -- in order to establish a beachhead in outsourcing," wrote Merrill Lynch analyst Steve Milunovich in a recent note. "I hope the P&G contract is executed profitably," says Rutledge.
Still, H-P is clearly tickled about P&G and a string of other wins following last fall's announcement of its first multibillion-dollar services deal with CIBC. In the past 12 months, the company says it's signed more than 200 similar managed services contracts, including recent deals to manage IT services for Telecom Italia, Ericsson and the Bank of Ireland (the latter two haven't yet been finalized). "More than the revenue itself, it's that those deals put them on the map for mega outsourcing deals," says Humberto Andrade, director of professional services business quarterly at Technology Business Research, a market research and consulting firm. "They couldn't be happier. You talk to them and they don't stop laughing." Explains H-P's chief marketing officer Michael Winkler, "You don't see this show up in the current quarter or the next in dramatic revenue gains, but there's a backlog of customer wins that have cemented very good annuity revenue streams for the future." But there's no question H-P is entering a tough playing field, with Winkler calling IBM "the only other legitimate competitor."
Size MattersBig Blue has a tremendous head start on H-P. "Clearly, IBM has been at this business for 12 or 15 years, and they've been really aggressive at it for the last 10, building it up under Lou Gerstner," says fund manager Rutledge, who has a stake in IBM, as well as in H-P. IBM's first-quarter services sales of $10.2 billion far surpass H-P's $3 billion. On staff too IBM's global service arm dwarfs H-P, with a payroll of 194,000 compared with 65,000. "In a lot of ways IBM is in a completely different sphere in terms of outsourcing," says Christine Ferrusi Ross, a senior analyst at Forrester Research. "Like J.P. Morgan ( JPM)" -- a $5 billion, seven-year outsourcing deal IBM scored with the giant bank last December -- "H-P just won't get called into those deals," she says.
On the plus side, H-P stands to benefit from the recent turmoil at computer services giant Electronic Data Systems ( EDS), whose stock plunged last year after business took an unexpectedly sharp dive and the company was forced to take a big charge based on a wrong-headed stock bet. Last fall, EDS got egg on its face after
intimating it was on the short list of contenders for the P&G contract, only to ultimately lose out to H-P. While EDS is solely a services vendor, H-P is steeped in the intricacies of hardware, which still constitutes the vast majority of its business. Meanwhile, though H-P can't hope to compete with IBM on scale, it argues that it can carve out a niche in the services market. "We take the approach that says we'd like to deal with more of the overall agility of the enterprise, lowering the cost of IT in general," while at the same time offering customers enough tech flexibility so they can adapt to changes down the road, explains Winkler. He contends H-P is more brand-agnostic than IBM. For example, after shuttering its own application server business last year, H-P sells application servers from BEA Systems ( BEAS) while it counts Oracle ( ORCL) as a partner on databases. The company also partners with consultants from Accenture, Cap Gemini Ernst & Young and Deloitte. But analysts cite H-P's lack of an in-house consulting base as its greatest weakness. "They don't have enough consultants and industry knowledge," says Technology Business Research's Andrade. He predicts H-P will end up buying a consulting outfit, maybe Deloitte (which is possibly also being eyeballed by EDS). Rutledge agrees H-P is likely to go into acquisition mode for a consulting outfit. "I think it will be a target of theirs as Compaq becomes more digested," he says, calling IBM's acquisition of PricewaterhouseCoopers "a coup."
PwC has clearly given a boost to IBM's services revenues, which jumped 15% in constant currency in the first quarter. Two years ago, H-P had offered a hefty $18 billion for the firm, but later backed down from the offer amid shareholder pressure. Last summer, of course, IBM scooped up PwC for a mere $3.5 billion. But from an investment standpoint, Rutledge points out, H-P's share of the total services market isn't so important; what matters is that it's making services a bigger part of its own revenues. Again, compared to IBM it has a long way to go: Big Blue drew half its sales from services in the first quarter, while services at H-P accounted for a mere 17% of total sales. The latest services wins are "not going to change the income statement that much over the next year or two," acknowledges Rutledge. But he and others say they at least show H-P is headed in the right direction.