H-P's Profit Margins Key

Gains in PCs and servers should help Hewlett-Packard beat first-quarter estimates.
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Since Mark Hurd took the reins at

Hewlett-Packard

(HPQ) - Get Report

last spring, investors have applauded practically his every move, bidding the company's stock up 44% in his 10-month tenure.

When the company reports its fiscal first-quarter financial results on Wednesday after the close, investors will be looking for more evidence that the Hurd turnaround remains on track.

Though the tech giant's modest 4%-5% revenue growth projections aren't too inspiring, investors have their sights set on H-P's profit margins to gauge its progress.

Analysts polled by Thomson First Call are expecting H-P to earn 44 cents a share, on revenue of $22.5 billion. That's at the high end of the company's EPS guidance of 42 cents to 44 cents and $22.3 billion to $22.6 billion in sales.

Contributing to this bullish sentiment are the strides H-P has already made throughout its various business units as it focuses on improving operations.

In the enterprise storage and servers group, operating margins in the fourth quarter of 2005 jumped to 9.1% from the 2.5% level in the year-ago period. The personal systems group, which includes notebooks, desktops and handheld PCs, more than doubled its operating margins year over year, coming in at 2.8% in the fourth quarter.

The Palo Alto, Calif.-based company

has set a goal of achieving 3% to 4% margins in the PSG group in 2007.

"A year ago those businesses were the nonperformers. Now they're adding incrementally to the bottom line," says Pat Becker Jr., of Becker Capital Management, whose firm owns H-P shares.

Becker expects H-P's earnings to come in a little above expectations for the first quarter, thanks to continued improvements in the PC and server businesses.

Even the software group achieved its first-ever profitability in the fourth quarter, earning $27 million on $311 million in sales.

Meanwhile, H-P has taken steps to improve its internal organization. On Monday, the company announced that

it was separating its handheld computer business into its own unit in order to capitalize on growth in the market.

To see what Street Insight is saying about tonight's call, please click here

.

Though H-P has aggressively moved to cut costs, announcing 15,000 job cuts in July 2005, some analysts believe that those benefits have not yet begun to affect the bottom line.

"We continue to believe savings from the Jul-05 restructuring plan have had a nominal impact on earnings to date," Moors & Cabot computer-hardware analyst Cindy Shaw wrote in a recent note to investors.

According to Shaw, the 4,700 workers laid off as part of the plan in the fourth quarter were dismissed so late in the period that it contributed roughly six-tenths of a cent to EPS.

H-P has said that the layoffs, which resulted in a $1.6 billion charge, will save the company roughly $1 billion in 2006 and $2 billion in 2007.

The brunt of the margin gains to date, say some analysts, is the result of H-P's renewed focus on business fundamentals, such as the company's concerted efforts to sell servers with storage accessories and richer memory configurations.

The server group also has implemented internal programs to lure customers from competitors such as

Sun Microsystems

(SUNW) - Get Report

.

Of course, H-P's server business is also getting a boost from the fact that rival

Dell

(DELL) - Get Report

does not use

Advanced Micro Devices

(AMD) - Get Report

chips -- an increasingly popular option.

American Technology Research analyst Shaw Wu believes Dell is likely to adopt AMD processors this year, eliminating H-P's advantage in the server business. What's more, Wu sees trouble ahead at H-P's most profitable business: printers and imaging.

The industry shift to laser printers from inkjet printers means less revenue from lucrative consumables such as inkjet cartridge refills. And because most of H-P's intellectual property for printers is on the inkjet side, Wu says, the margins in laser printers are much less attractive.

Still, Wu, who rates H-P a hold, expects the company to beat expectations in the near term, post a sizable EPS upside for the first quarter and guide a few pennies above the Street's 45-cent forecast for its fiscal second quarter.

"Beyond these next two quarters, I think these other issues come more into play," says Wu.

Shares of H-P closed Tuesday's regular session at $32.49, up 75 cents, or 2.36%.