H-P Builds Great Expectations

While cost cuts prove a boon, some wonder if the company can hold the line on margins.
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Hewlett-Packard's

(HPQ) - Get Report

impressive beat after the bell Wednesday cheered investors, who sent the company's shares up more than 8% Thursday.

There was little to find fault with in the results, but H-P's quick progress on itsturnaround plan raised one question: Now what?

The Palo Alto, Calif., company is only two quarters into a restructuring plan that began in earnest in July 2005, and has only completed 40% of its planned workforce reduction. Yet H-P has already reached many of the milestones it set for fiscal 2007, particularly on the margins side.

The PC, server and printer businesses all turned in operating margins in the first quarter at the high end of the ranges H-P set for 2007.

Along with its first-quarter results, H-P bumped up the low end of its 2006 non-GAAP EPS range by two cents, setting a new range of $1.90 to $1.95.

"We continue to see potential upside for revisions to estimates," wrote Prudential analyst Steven Fortuna in an investor note raising his own estimates for H-P.

In its first quarter, H-P boosted profit more than 30% year over year, delivering an operating profit of $1.5 billion, or 42 cents a share. Sales were up 6% from last year's first quarter, at $22.7 billion.

The focus on cost-cutting, controlling expenses and improving internal operations all contributed to the impressive results, which came in above theStreet's expectations.

"I just like the fact that they're bringing profits to the bottom line, which is what you want to see with companies," said Thrivent Financial fund manager MikeBinger, whose firm owns H-P shares.

H-P's stock was up $2.63, or 8.3%, to $34.30 in midday trading Thursday.

The company's strong performance and its early progress in its turnaround plan led some analysts to wonder if H-P's 2007 margin targets were too conservative.

During the post-earnings conference call Wednesday, H-P CEO Mark Hurd stuck to the targets, noting that the second and third quarters are seasonally tough ones, and that the company would be re-investing some of its profit in areas where H-Psees opportunities for growth.

The company has intimated that much of its futureM&A strategy will focus on software and services, such as its recent acquisitions of OuterBay, Peregrine Systems and AppIQ.

H-P is also investing internally, strengthening its sales force. And with competition getting fiercer in some of its key businesses, H-P will need extrafirepower as it fights for market share.

In printers, for instance, H-P grew revenue to $6.5 billion in the first quarter, up 8% year over year, despite facing increasing pressure from competitors like

Lexmark

(LXK)

and

Dell

(DELL) - Get Report

. In fact, Lexmark reported in January that its fourth-quarter revenue declined 12% from the year-before period.

Hurd attributed the printer group success to new product innovations, like H-P's scalable print technology, acquisitions, cost-cutting and "targeted pricing actions to drive market share gains in areas of high supplies consumption."

According to some analysts, H-P aggressively slashed prices on inkjet printers over the past year, thereby increasing the installed base of customers whobuy printer supplies, which experienced an 11% increase in sales during the first quarter.

The results suggest that H-P is taking share from Lexmark, and they quell any concerns about printer demand industrywide, said some analysts.

The printer group also assuaged fears that its days of high margins were nearing an end. After turning in disappointing operating margins of 13.2% in the fourth quarter, the printer group bounced back to 14.9% in the first quarter. The results were at the top of the 13% to 15% 2007 target set by the company. Still, Hurd said the company remained comfortable with the 13% to 15% margin range.

"The implication of this, we believe, is that H-P expects some drop in supplies growth in the long run," wrote AG Edwards analyst David Wong in an investornote raising his estimates but maintaining his hold rating on the company (AG Edwards has received non-investment banking compensation from H-P in thepast 12 months). "And also that the company may constrain margin growth by pressuring hardware prices in order to continue gaining share and build itsinstalled base," wrote Wong.

In other words, H-P needs to find new ways to grow in the coming quarters in order to hold on to its recently achieved margin gains. For many investors,that's good news enough.