H-P Needs to Talk Growth, Not Cost-Cutting

If the stock market is a financial popularity contest, H-P ( HPQ) has lately looked like a wallflower.

The company's shares have been abandoned on the sidelines amid a run-up that has propelled most tech stocks upward since April -- and that says as much about investors' expectations as anything.

Year to date, H-P's stock price has actually lost ground, down 2.8% compared to a 10.1% rise for the S&P computer hardware index. In the same period, Dell ( DELL) tacked on 13.4%, while IBM ( IBM) grew 11.5%.

No big surprise, then, that while H-P is expected to deliver second-quarter earnings on target, the Street still can't summon up much enthusiasm for the shares.

"H-P has been a cost-cutting story for the better part of the year, basically since the merger with Compaq. But a lot of that story is done, and now H-P is really being forced to address the revenue side of the story," says one buy-side analyst.

The revenue picture isn't reassuring: Analysts believe the company's April-quarter sales will slip 2.6% from a year ago. Compare that with rivals Dell and IBM, which recently posted sales growth of 18% and 11% for the same period.

"IBM and Dell have been very aggressive in market share in servers and the PC business, and now Dell's doing printers. So there's pressure from all sides," points out the analyst. "People are looking at the eventual recovery and who's going to have better revenue growth. You're probably better off with the other two."

On the sell side, some analysts have expressed concerns about a possible revenue shortfall in H-P's April quarter, though others think the company can meet the numbers.

Among the more hopeful is Merrill Lynch, which has argued that a favorable currency exchange should help H-P to match or even exceed revenues and EPS expectations. (H-P will benefit from the weak dollar, since it pulls in 59% of sales from overseas.) Wall Street analysts are gearing for 27 cents on $17.7 billion in sales.

Merrill also thinks H-P will back consensus estimates for the third quarter -- an outlook that implies sequential sales will dip slightly, by about 2%.

But though analyst Steve Milunovich is relatively optimistic on the numbers, he doesn't think H-P qualifies as a decent investment, having downgraded the shares to a neutral rating last month. Merrill has done banking for H-P. "We believe forward-looking investors should ask themselves whether the cost-cutting story still has legs, and assess the risk of adding to positions at a time when focus may be shifting toward competitive performance vs. Dell and IBM," he says in a note.

Other analysts are even less sanguine. Lehman's Dan Niles says it's possible H-P's revenue could come up a little short in the April quarter, though it's likely to meet EPS targets through cost-cutting. Lehman has done recent banking for the company.

Going forward, H-P may have trouble meeting consensus estimates for the July quarter, Niles writes. Though cost savings will help, he says, "it will be very challenging to offset a 5% revenue decline in the July quarter with enough cost controls to keep EPS flat quarter on quarter, which is the current consensus expectation." The bottom line: Future EPS growth depends on revenue growth, which for the moment is sorely lacking.

To be sure, if H-P could manage to boost the revenue picture, it might find some willing buyers. "If they showed a little improvement on the top line, I'd look at buying some," says Patrick Adams, manager of the ( CHLAX) Choice Long-Short fund (CHLAX). "But it can't all be currency benefits. There has to be some unit growth; they've got to stem the market-share loss."

On the basis of enterprise value to revenue (enterprise value is debt plus equity divided by revenue), H-P shares actually look fairly cheap with a ratio of 0.7, Adams argues. "The lower it is, the more interesting. At 0.7 times, you're getting close to a bankruptcy type of valuation. Sun ( SUNW), which is considered a broken company, is at 1 times, and IBM is at 2.2 times."

Business Breakdown

A big soft spot for H-P is likely to be its PC business, which accounts for around a quarter of revenue and just returned to profitability last quarter. Though competitor Dell pulled off its usual spectacular growth in the most recent quarter, other results show that demand remains weak. On the hardware side, sales at tech giant IBM were down 6% from the same quarter last year (when adjusted for currency differences). Ingram ( IM), the world's biggest tech wholesaler and a favored litmus test for demand, startled analysts with a second-quarter forecast that puts sales 7% below last year's levels.

At Fulcrum Global Partners, analyst Robert Cihra predicts that H-P's PC line will stay "modestly profitable," but he thinks the PC and enterprise divisions will both come up short of his expectations. Enterprise servers and storage, which kicks in another 20% of sales, is widely expected to remain in the red.

H-P's printing business is likely to do a bang-up job, as usual -- but that's already been factored into expectations, notes Milunovich. "The printer business isn't likely to get better," he summed up in a note accompanying a downgrade of the stock in April. Though he gives the division credit for gaining substantial share and posting double-digit second-half growth, he thinks Dell's entry into the printer business will probably cap the P/E accorded to the division in the longer term.

Any ceiling on H-P's printer business poses a particularly nasty challenge for the company, since printers contribute the bulk of profits. In the quarter ending in January, the printer and imaging line delivered a whopping 78% of operating profit, but only 31% of sales.

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