HP's Transformation Continues Amid Quarterly Pre-AnnouncementsHP's Transformation Continues Amid Quarterly Pre-Announcements

While the recent performance of tech stocks might leave the uninformed to believe the IT downturn is at an end, I'm afraid that's not the case. As most investors know, the warnings of poor earnings start two weeks before the end of the quarter. Hewlett-Packard (HWP--NYSE) started early by pre-announcing its results, the third pre-announcement in as many quarters. HP chairman and CEO Carly Fiorina said the company may again miss financial expectations, and placed the blame on the IT spending slowdown, which used to be a domestic phenomenon but is spreading worldwide.

Fiorina arrived at HP about 18 months ago amid much fanfare and went to work trying to turn the company around. Under Fiorina, HP's strategy centers on moving away from delivering standalone products to providing solutions and services to its customers, both businesses and consumers.

A change in strategy was imperative to stop HP's decade-long decline. The top line grew, but gross margins declined from more than 50% to less than 30%. Operating margins have fallen from 11.3% five years ago to 2.8% in the last quarter.

HP has reorganized into three divisions: Imaging And Printing Systems, Computing Systems, and IT Services. Imaging and printing systems includes laser and ink-jet printers, scanners, digital photography, fax machines, and consumables such as printer cartridges. It accounted for 41.1% of revenue in fiscal 2000. Computer Systems encompasses home, commercial, and mobile PCs, PC servers, Unix servers, storage, and a relatively new member of the HP product line: software solutions for E-services, network management, and operating systems. This segment contributed 41.5% of revenue. The last segment is IT Services, which includes support, outsourcing, and consulting. This division generated 14.4% of revenue.

Most of HP's businesses face intense competition, marked by price wars and declining margins, and that's forcing it to move beyond being a box maker.

The Imaging and Printing division faces competition from low-cost Asian producers, while the Computing Systems division competes against Compaq, Gateway, IBM, and Sun Microsystems, to name a few. Finally, the IT Services division has to contend with systems integrators such as Accenture, Cap Gemini Ernst & Young, EDS, IBM, and PricewaterhouseCoopers.

HP has expanded its consulting and outsourcing operation and become more involved in software. The need for a beefed-up software offering led it to acquire Bluestone, a Web application server software company that it renamed HP Bluestone. The company's Total-e-Server competes against BEA Systems' WebLogic and IBM's WebSphere servers. BEA Systems is pushing its Commerce Servers hard, but these compete with products from its own customers. IBM prefers to sell end-to-end solutions. HP wants Bluestone to conquer the middle ground. This is characteristic of much of HP's objective: to become a trusted, independent adviser.

While HP's new strategy isn't a bad one, it reminds me of another large company doing similar things. Hmmm, does the color blue come to mind? But remember, IBM started eight years ago. Lou Gerstner bet the future of his company on offering services and bundled solutions, but realized that the real margins were in software, not hardware--hardware is a necessary evil. HP has gotten part of the picture, namely IT as a service offering, but it still puts hardware at the center. In particular, the Imaging and Printer division could easily be spun off, as Lexmark was from IBM, except that HP needs the cash flow. Carly has some difficult strategic decisions to make.

Until the company shows a turnaround in profit margins and resolves some of the competitive business problems it faces, it's hard to get excited about HP's stock. HP recently said it expects revenue to grow 10% to 12% during the next couple of years, down from 15% to 17% historically. Despite the weak stock performance, HP's stock still trades at almost 20 times second-quarter earnings per share. I prefer to stand on the sideline.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the information 100 Stock Index. Reach him at [email protected].

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