A nagging question has dogged Mark Hurd's revival of Hewlett-Packard ( HPQ).

While Hurd's knack for cutting costs and boosting profit margins has won him goodwill on Wall Street, H-P's chief executive has yet to articulate how he intends to grow the company's top line beyond the mid-single-digit level.

Investors perusing the company's latest annual report found more cause for concern: For the fifth year in a row, H-P's spending on research and development declined as a percentage of total revenue.

H-P spent $3.6 billion on R&D in its fiscal year ended Oct. 31, 2006, or 3.9% of revenue. That's hardly chump change, but it's down from the 6% that H-P spent on R&D in 2002.

In Silicon Valley, where innovation and success are synonymous, easing up on R&D is regarded as suspect, if not downright derelict. And while H-P's newfound focus on efficiency and cost savings has served it well, its approach to R&D raises questions about whether the company is shortchanging its own growth prospects.

Shane Robison, H-P's chief strategy and technology officer, says the company has not backed off its commitment to R&D and argues that looking at R&D spending as a percentage of revenue does not tell the whole story.

H-P's profile has changed over the past few years, as the company relies more on industry standard hardware and differentiates itself with software, meaning that the bulk of R&D efforts now go to software. Five years ago, H-P's R&D investment was 70% hardware-related, and 30% went to software; the numbers are now reversed. Funding software R&D is inherently less expensive than funding hardware.

"Just to do a single microprocessor is several hundred million dollars a year of R&D," says Robison. "Software engineers don't require big fabs, and lots of hardware and all the prototypes."

In other words, says Robison, H-P is booking revenue from both hardware and software, yet investing primarily on the software side. That makes it appear as if the company is underfunding R&D as a percentage of total revenue, while H-P is in fact getting tremendous leverage from its investment, he says.

Related initiatives such as the three-year-old intellectual property licensing group enable H-P to milk even more benefits from its R&D investment, through royalties and patent swaps with other companies.

The approach doesn't seem to be hurting H-P's standing so far.

Whither the Growth?

Last week, industry research firms Gartner and IDC announced that H-P had widened its recently captured lead over Dell ( DELL) as the world's No.1 PC maker in the fourth quarter of 2006.

But markets eventually get saturated, says Monetta Fund portfolio manager Bob Bacarella, who wonders where the company's next growth opportunities will come from without the kind of innovation pipeline that typically comes from scaling R&D investment with revenue.

"It gives me pause from wanting to be more aggressive with the stock," says Bacarella, who doesn't own shares of H-P.

This doubt is reflected in H-P's relatively modest multiple of 16.5 times 2007 earnings, compared with other large-cap tech players such as Apple ( AAPL) and Cisco Systems ( CSCO), which recently commanded multiples of 28 and 20 times earnings, respectively.

H-P's stock is trading at multiyear highs, but without a clear sign of future growth opportunities, investors' enthusiasm for the stock has limits.

Some new opportunities may come from outside of Palo Alto, Calif. On Monday the company announced plans to open a new research facility in St. Petersburg, Russia -- H-P Labs' third international outpost to be established in the past five years.

And though total R&D spending has lagged revenue growth in recent years, H-P has found other ways to tap into innovation, relying on its $16 billion war chest and $115 billion market cap.

In the past year, H-P has made a string of acquisitions including Mercury Interactive, VoodooPC and Bitfone, among others.

"We have smart people, and given enough time they can get it done. But the market passes you by if you take too much time," Robison says.

The tack plays well to H-P's increasingly diversified business, much of whose future growth, say analysts, will come from software and services. In those markets, M&A is as expedient a tool for growth as internally developed R&D.

"When it comes to the global services market, if they H-P are going to become a major player, they're not going to do that organically," says Annex Research President Bob Djurdjevic, who owns H-P shares.

And for all the reverence that R&D receives in the tech world, the real-world payoff does not always match the investment.

A recently released study of the world's 1,000 largest corporate R&D spenders by the consulting firm Booz Allen Hamilton found that there is no significant statistical link between R&D spending and growth in sales and earnings.

That's not to say that companies can get away with no R&D spending, says Barry Jaruzelski, vice president of Booz Allen's strategy and innovation practice. But it's clear that companies can do more with less.

"The quality of the process, your understating of the market and customers, far outweigh trying to have some sort of arms race with your competitors in absolute R&D spending," Jaruzelski says.

Booz Allen identified 94 companies that spent less on R&D than the median in their industries over a five-year period yet were ahead of the pack in such key performance metrics as sales growth, gross profit growth and total shareholder return.

Among these so-called high-leverage innovators were Apple, Toyota ( TM) and Caterpillar ( CAT). Missing from the list was H-P.

If H-P's new-look R&D pays off, that may soon change.

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