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H-P Investors Turn to EDS Integration

The company's quarter had a few bruises, but the mega-merger is getting traders' attention.



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strong quarter covered up a couple of unflattering bruises.

Sales of the company's servers, as well as sales in the U.S. in general, both came in weaker than expected -- a rare sign of weakness for the Palo Alto, Calif., tech giant.

But the negatives weren't enough to put a dent in the Street's confidence in H-P.

"Hewlett is a company with a variety of product lines. You put them all together and they still exceeded expectations," says Mike Binger, a fund manager at Thrivent Financial, which owns H-P shares.

H-P's stock was off 2.2%, or $1, to $45.45 in midday trading Wednesday. But the decline seemed more indicative of the continued

misgivings about the recently announced $13.9 billion



acquisition than on H-P's latest earnings report.

"What investors are going to focus on now is the EDS acquisition," says Thrivent's Binger, particularly how it H-P integrates the technology consulting firm and how it affects H-P's profitability.

H-P CEO Mark Hurd reiterated his vision for the EDS deal during Tuesday's earnings conference call, citing the improved reach it will give H-P into important corporate accounts. He said H-P saw opportunities to "materially" improve the profit margin for its technology outsourcing group once the two businesses were combined.

While investors waits to see how the acquisition proceeds,

H-P's 16% increase in net income during its fiscal second quarter

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kept Wall Street analysts happy and offset the weak spots in the report.

Citigroup analyst Richard Gardner lifted his price target for H-P from $64 to $71. Citigroup has provided investment banking and non-investment banking services to H-P within the past 12 months, and a Citigroup director also serves as a director at H-P.

Goldman Sachs bumped up its EPS estimates by three cents for both 2008 and 2009, but kept its $59 price target.

While H-P's results provided another piece of evidence that demand is deteriorating, the company also demonstrated that it has more options than its peers to offset the macroeconomic softness, wrote Goldman Sachs analyst David Bailey in a note to investors Wednesday.

"H-P's reach and breadth should allow it to continue to target higher growth areas, while its cost cutting initiatives continue to drive operating margins higher (although at a slower rate), despite sluggish demand in some key markets and incremental competition," Bailey said.

Goldman Sachs makes a market in H-P shares and has provided H-P with investment banking and non-investment banking services in the past 12 months.

Hurd told investors that the U.S. market was "spotty" during the quarter, but stressed that business was not all bad in the U.S. with strength in storage and printers.

The fact that tech spending in the U.S. has weakened is not exactly a shock to investors.

Sun Microsystems







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have all told similar stories during the past few quarters (although


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actually cited strength in the U.S. during its most recent earnings report).

As for the poor sales of industry-standard servers, Hurd acknowledged that H-P had lost out on a few deals in its fiscal second quarter.

Citigroup's Gardner suggested that H-P may be suffering from increasing competition with


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"We do expect Dell to grow x86 server units at roughly twice the rate of H-P in the April quarter," Gardner wrote in a note to investors.

Another potential worry are the prices of components that are used in H-P servers and PCs. The company noted that it expects component pricing in the current quarter to be less favorable than it has been in the past few quarters.

Doug Reid of Thomas Weisel Partners reckons that increasing costs for DRAM memory and LCD panel components, along with stable microprocessor prices, could shave at least 30 basis points from H-P's gross margin in the current quarter.

Thomas Weisel has provided H-P with non-investment banking services in the last 12 months.

"We see few catalysts for H-P in F3Q08 that will produce upside to management's EPS guidance," wrote Reid, who is among the minority of analysts with a hold rating on H-P shares.

H-P projected that it will earn between 82 cents and 83 cents, on an adjusted basis, in the current quarter, with revenue between $27.3 billion and $27.4 billion, which would represent a respectable 7.5% increase from last year's sales level.

H-P has already convinced investors it can grow in the face of weak economic and business conditions. Whether it can digest a company as large as EDS is the question now on investors' minds.