Margins Still Mastering H-P

A solid earnings report doesn't offset concerns about the company's chances of improving profitability.
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Hewlett-Packard

(HPQ) - Get Report

shares followed the market lower Thursday as investors began to look past the company's short-term earnings triumph and focus on the longer-term struggles -- both internal and external -- that it faces.

Specifically, Wall Street analysts seemed convinced that there was limited upside as long as margin pressures continued and the company remained without a permanent leader following the technology hardware giant's ouster of CEO Carly Fiorina last week.

The stock slipped 21 cents to $20.85 early Thursday after initially moving higher.

In a

first-quarter earnings report that otherwise beat analysts' earnings and revenue estimates, H-P said its gross margin slipped to 22.9% vs. 23.3% in the fourth quarter and 24.7% in the same quarter last year. H-P cited margin pressure from pricing and product mix for its enterprise storage and servers, software and services.

"While we continue to make progress in growing our top line, there is work to be done to improve our profitability. As the board conducts a CEO search, our management team is focused on driving improved execution to serve our customers, strengthen our competitiveness and improve shareholder value," said Bob Wayman, the company's chief financial officer who has taken over interim chief executive duties.

But analysts didn't see an immediate end to margin pressure. Chris Whitmore, an analyst at Deutsche Bank, trimmed his fiscal 2006 earnings estimates on the company.

"As H-P becomes more heavily reliant on commoditizing markets like PCs and servers, we believe the company will continue to face margin pressure," he wrote in a Thursday morning research note. "In addition, with

Dell

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becoming more competitive in the printer space, we believe a price war is brewing in H-P's 'crown jewel' business."

The company also admitted having near-term pressure on printer margins. In order to spark sales for its important printers and imagers, especially in the consumer segment, H-P expects increased promotions in the near term. Consumer hardware sales dropped 13% from the same quarter last year as digital imaging and scanners fell off.

"We are taking aggressive actions to insure improvements in the next three to six months," said Vyomesh Joshi, executive vice president of H-P's Imaging and Personal Systems Group. He said to expect increased investments in pricing, retail aisle presence and promotions. But Joshi said operating margins will decline as profitability takes a back seat to growth. "We are going to drive faster hardware growth and recapture some share losses."

In PCs, too, H-P is caught between Dell's mass-produced boxes on the low end and

IBM's

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ability to offer a comprehensive set of hardware and services at the high end.

Still, H-P executives were adamant that they can compete. In the near term, the company plans to try to regain lost market share, reduce its costs and improve its supply chain.

"We do believe that we can do -- and are doing -- some things that will ultimately help us resist the downward gross margin trend that we have been experiencing," said Wayman during a conference call. "We don't believe the year-over-year change we saw here is the kind of change we'll see going forward."

But margins weren't the only problem that analysts foresaw for H-P.

Analyst Robert Cihra at Fulcrum Global Partners said the company's shares will likely remain stagnant for several months, lacking any catalyst to inspire buyers. "We'd worry H-P now not only needs to find new leadership, and possibly strategic direction, but does so facing the headwind of its two seasonally weakest quarters," he said in a morning research note.

Wednesday's report marked the beginning of a new era for H-P, which removed Fiorina from the corner office last week. She

was ousted as H-P's chief executive on Feb. 9 following growing criticism of her management style and her lack of momentum in business areas outside of printing.

The change comes at a crucial time. Only a month ago, H-P placed its personal computer systems group under the management and oversight of its imaging and printing unit.