Hewlett-Packard Slips on Downgrade

J.P. Morgan becomes bearish on virtually all of H-P's product lines.
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J.P. Morgan downgraded shares of

Hewlett-Packard

(HPQ) - Get Report

from an overweight to a neutral rating Tuesday morning, saying the beaten-up shares are cheap for a reason.

In a research note, the influential investment bank singled out the potential for near-term weakness in the tech giant's printing and enterprise lines, among other concerns.

Meanwhile in a related move bound to raise hackles in H-P's Palo Alto, Calif., headquarters, J.P. Morgan hoisted its rating on chief rival

IBM

(IBM) - Get Report

from a neutral to a buy, saying Big Blue is an ideal counter-cyclical play at a time other tech companies are showing signs of decelerating growth.

In recent trading H-P shares were off 31 cents, or 1.6%, to $18.75, while IBM was gaining 58 cents, or 0.7%, to $87.74.

J.P. Morgan said it has become bearish on the outlook for virtually all of H-P's business lines, from computers to printing to servers and storage.

H-P's broad exposure to consumer PCs and printing are of particular concern, given signs of continuing softness in the broader economy. "We believe these markets will exhibit muted seasonal demand over the holiday season," said analyst Bill Shope. Consumer PCs account for nearly a third of H-P's PC sales, while consumer printing represents most of H-P's printing profits.

Shope said he has also backed off his earlier view that improvements in H-P's enterprise segment could help spike earnings, adding that H-P's relatively high cost structure could prove a disadvantage amid a rapid industry shift to lower-margin industry standard servers. "Without another dose of massive restructuring in its enterprise division, we believe the prospects of additional shortfalls in fiscal 2005 remain high" for H-P, said Shope.

He lowered his revenue estimate for H-P's fiscal year 2005 by nearly $2 billion, to $83.6 billion from $85.5 billion, while reducing his earnings per share outlook to $1.45 from $1.56.

In the same research note, Shope said H-P shares deserve to be valued below peers. The stock currently trades at a mere 13 times J.P. Morgan's 2005 earnings estimate, compared with an average price to earnings multiple of 21 times for rival computer system companies.

He said the market may have been too quick to forgive H-P's

massive two-quarter earnings warning on Aug. 12, noting the stock has now recovered from its steep loss to $16.08 after the surprise announcement. On Monday, shares closed at $19.06.

That shares have regained lost ground suggests "the market believes H-P has made a rapid fix," noted Shope. "But we believe this assumption may prove incorrect."

Separately, Shope said he believes IBM stands to gain share in enterprise and said its troubled semiconductor division should start contributing to overall profit in 2005. He also expects to see profit margins improve in IBM's flagship services arm next year.

He raised his calendar 2005 earnings-per-share estimate to $5.58 from $5.45, while tipping up revenue to $102.2 billion from $101.1 billion.

On a price-to-earnings basis, IBM clocks in with a 15.6 times multiple, at the low end of its 10-year average, but Shope said he thinks the stock could trade higher, given the likelihood of improvements in its business.

"This year, with most growth in tech showing some signs of deceleration, we view IBM as the ideal counter-cyclical play," he wrote. "We estimate that 35%-40% of the company's revenues are recurring in nature and the company's new product cycle should allow it take share in the high end server market." Those factors should help insulate IBM from some of the bearish sentiment weighing down its peers, he said.

J.P. Morgan has done investment banking for both H-P and IBM in the past 12 months.