Profit-Takers Pounce on H-P - TheStreet

Profit-Takers Pounce on H-P

Concerns about rising inventories and margins spark a selloff.
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Double-digit growth and

Hewlett-Packard

(HPQ) - Get Report

don't normally go together.

But the top line on H-P's latest income statement showed

revenue up 11% year over year to $25.1 billion.

Take away favorable foreign-currency effects, and H-P's sales were up 7% -- still an impressive feat for a company with $91 billion in annual sales. A blockbuster holiday season with strong sales of notebook PCs and printers were the main ingredients of the growth.

Investors reacted by sending shares down 4%, or $1.71 to $41.42 in recent trading Wednesday. But with H-P's shares up 37% since mid-June, some degree of profit-taking was inevitable.

A couple of disconcerting trends within H-P's quarterly results appeared to accelerate the selloff, as investors took fright at rising inventory levels, declining gross margins and a negative cash flow.

"Together, these have sort of worked in concert to help support bearish arguments on the stock," says one investor who is long H-P.

If gross margins continue to get compressed over the next couple of quarters and inventories build, then H-P could be in a tough spot, acknowledges the investor, speaking anonymously because of his firm's policy. At this time, though, he believes it's premature to react to these initial signs.

H-P's internal inventory swelled to $8.4 billion in the first quarter. That's up 8% sequentially and 24%, or by $1.8 billion, year over year.

Meanwhile, H-P's gross margins for the fiscal first quarter were 23.7%, vs. 24.3% in the fourth quarter.

Together, these two trends paint a picture of a company cutting prices in an effort to move goods piling up in its warehouses.

If that's the case though, you'd never know it from H-P's sales performance in the first quarter, note some H-P bulls.

Notebook PC unit shipments were up 57% year over year, and printer unit shipments up 18%.

"The quarter has proven that things are selling well," says Thrivent Financial fund manager Mike Binger, whose firm owns shares of H-P.

"I think every analyst on the Street that has a neutral or underperform rating on the stock is trying to make a big deal out of inventory, but I don't think it's a big deal," Binger says.

With

Microsoft's

(MSFT) - Get Report

new Vista operating system hitting store shelves, some investors say it's natural that H-P would be beefing up its inventory to meet demand. And there is some level of an inventory hiccup to be expected during the transition from older-generation Windows XP-based machines to new Vista-computers, as PC makers need to meet demand for both types of system.

H-P's management ticked off a catalogue of reasons for the inventory build, including stocking up on components from Chinese suppliers ahead of the Chinese New Year, when business comes to a standstill.

"It sounds like they intended to build inventories, but they probably built them too much," says Bill Gorman, vice president of equity research at PNC Advisors, which owns H-P shares. While the company will have to work hard to trim down this inventory over the coming months, Gorman says he isn't concerned about the potential of any write-downs.

H-P's declining gross margins also look ominous. But given the phenomenal performance in H-P's PC group -- the company's least profitable business -- many analysts and investors were willing to chalk up the falling gross margins to a mix issue.

H-P's overall sales comprised a greater portion of less-profitable PCs during the fiscal first quarter, but that dynamic paid off: In the October-December period, H-P beat out

Dell

(DELL) - Get Report

for the title of the world's No.1 PC maker for the

second quarter in a row, according to industry research firms.

Of course, now that Michael Dell has retaken the CEO post at Dell, the days of H-P's easy share gains may be coming to an end. And

Eastman Kodak's

(EK)

recent decision to enter the inkjet printer market will mean more competition and pressure on margins in H-P's lucrative inkjet supplies business.

Kodak is slated to begin selling inkjet printer cartridges for half the price of what's currently on store shelves during the current quarter. That's the time when H-P's printer supplies business typically kicks in, as consumers refill the ink cartridges for the printers they received as holiday gifts.

The new band of competitors lining up against H-P, not the first quarter's inventory situation, could prove to have the biggest impact on the company's future prospects.