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Summary

  • Consumer segment receives a temporary boost on PC refresh.
  • Enterprise in full-blown decline, and fundamentals unlikely to improve based on competitive environment.
  • Earnings guidance for the year misses consensus estimates.

For the most part Hewlett-Packard's (NYSE:HPQ) recent quarter was disappointing. If I had to summarize what went wrong, it had everything to do with worsening enterprise trends, paired with lackluster growth from consumer hardware.

We're seeing some growth in Hewlett-Packard's PC segment; it just wasn't enough to offset the declining enterprise business. Many are advising people to get rid of their legacy Windows XP OS, but stubborn as they are, some people don't want to migrate to newer operating systems. Even if they did migrate to a newer operating system, the temporary boost in sales doesn't explain where Hewlett-Packard is going to go over the next five years.

No one has a clear idea on where Hewlett-Packard will be in the next five years, so why should anyone invest into the company?

Quick synopsis of the PC space

Hewlett-Packard's consumer division faces legitimate structural issues. We're seeing Microsoft (NASDAQ:MSFT) directly compete with its partners. Microsoft doesn't have to pay its own licensing fees to itself, and likewise is able to sell each incremental tablet at a better profit margin even if the average selling price remains constant with its OEM partners.

Laptop is the primary growth category among standard PCs, and it's projected to be the case over the next five years. Tablets are displacing laptops, and with a slightly bigger screen, you can create a tablet-laptop hybrid. If Microsoft were to increase the range of screen sizes even further on its Surface tablet line, the traditional laptop will be replaced by tablet PCs entirely. This is highly unfavorable to OEMs, which is why Hewlett Packard is also offering Android-based tablets.

Hewlett-Packard has been marketing Windows PCs for 20 years now. But now it wants to jump on Android? Isn't it too little too late? I don't know about you, but… part of being a PC guy involves using Windows. Hewlett-Packard = Windows, not Android. HP's jump onto Android makes sense to the CEO, but it doesn't make sense to the consumer.

It's also unlikely that Hewlett-Packard has a legitimate strategy in the enterprise space as cannibalization from Amazon Web Services (NASDAQ:AMZN) and other cloud players continues to unfold. I just don't understand how Hewlett-Packard is going to price itself like Amazon, and earn margins like IBM and Oracle (NYSE:ORCL). Furthermore, Microsoft and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) want to offer infrastructure as a service as well.

Maybe, Meg can clarify this issue in more detail, but from what I got from the conference call, I'm not entirely convinced. This idea of "investing" into the enterprise group hasn't yielded in revenue growth. Maybe the enterprise group should be treated like a legacy business, and undergo the private equity model of squeezing whatever remaining profit, rather than investing into a declining segment in hopes of becoming the reigning king of cloud. I just don't think Hewlett-Packard is ready, nor does it have the capabilities to compete with Microsoft Azure, Google Cloud, IBM Cloud, Oracle Cloud, and etc. It doesn't make sense.

The "special value case" just doesn't seem to add up. I'm a momentum guy, I don't believe in businesses that don't offer strategic value over the long haul. I've also read various free cash flow estimates, and DCF models on Seeking Alpha that estimate aggressively positive inputs, thus allowing for a present value assumption that's significantly higher than it should be.

Competitive landscape not looking good

(click to enlarge)

Source: Hewlett-Packard

Overall, Hewlett-Packard reported modest growth across its personal systems, with a sliver of growth from printing supplies/printers. The enterprise group and services reported declines, and there's just no way in heck I see this trend improving at all. Hewlett-Packard is falling behind the pack when it comes to R&D.

Source: YCharts

As you can tell, Hewlett-Packard is far behind, whereas Amazon is blasting well ahead of the pack. Amazon's revenue growth is not being used to finance share buy-backs, the company is trying to squeeze as much investment out of every dollar it generates from sales. This really makes me wonder whether Hewlett-Packard can keep pace with the growing retail conglomerate, but ignoring the retail conglomerate. Look at more traditional IT players, every single one has increased R&D spending over the past five years… all except for Hewlett-Packard.

Amazon can allow revenue to run, and use the sliver of margin on products and services to pay for R&D, or CAPEX. Amazon's revenues for 2013 were mind boggling at $74.45 billion. Operating costs went up by a whopping $13 billion year-over-year. That added revenue flowed into additional R&D, which is why Amazon's R&D spending is bigger than IBM's.

In other words, Amazon has the most flexibility when it comes to allocating costs out of the whole entire group. With so many cost levers that can be pulled, and an entrepreneurial founder at the head of the company, I wonder if anyone in Silicon Valley can get a good night's rest thinking about what Bezos is capable of.

Source: YCharts

Furthermore, Hewlett-Packard's capital expenditure spending has lagged Amazon's in the past five years. Admittedly, Amazon's CAPEX involves fulfillment centers. But in recent years, Amazon primarily allocated CAPEX into datacenters. Amazon had the capacity, plus infrastructure in place well ahead of everyone else in the IT space, which puts Hewlett-Packard behind by 2 or 3 investment years.

How does Meg Whitman plan to kick the reigning king off of his mightily built mountain? I have no freaking idea. If someone were to project declining sales from consumer, data-centers, and enterprise services the outward price assumption would be way lower.

And if no one has the guts to make that kind of projection, I will. And I'll publish the result on Seeking Alpha.

Earnings summary

The consensus earnings estimate was $0.88 per-share non-GAAP. The reported non-GAAP figure for Q2 was $0.88. They met expectations, but didn't actually exceed them. Hewlett-Packard met expectations through cost management. Consolidated revenue declined by 1%, and to top that off, guidance missed expectations.

(click to enlarge)

Source: Hewlett-Packard

Hewlett-Packard's full-year guidance has a midpoint of $3.69. The consensus earnings target for the current fiscal year is $3.71. It's off by 2 cents. Not a big deal, until you realize that 2 cent miss is likely to come from further declines in consolidated revenue that cannot be offset by further cost-cutting.

(click to enlarge)

Source: Yahoo! Finance

As you can tell, Hewlett-Packard has had a track-record of beating on earnings per share. At the present moment, Hewlett-Packard barely met expectations, and full-year guidance is below the mid-point set by analysts. Hewlett-Packard's fundamental trajectory is weakening, and it's unlikely to improve.

Conclusion

Hewlett-Packard faces challenges in both its consumer and enterprise segment. Hewlett-Packard will have to focus on its core strengths, and build upon a unique product category that can grow over the long haul. This growth strategy hasn't materialized yet, and at the present time, Hewlett-Packard is getting a modest jump in demand due to PC-refresh. The boost in revenue from PC refresh will be temporary, and will inflate revenues for a couple fiscal years.

Eventually, investors should anticipate ASP trends to decline, and a lack of unit volume growth as the tablet category is dominated by Samsung, Apple, and Microsoft. The three companies are vastly more competitive in their own respective software ecosystems. Furthermore, the Laptop category will return to an extremely low growth rate, and in the worst-case scenario will exhibit full-blown decline.

Because Hewlett-Packard's main lines of business are weakening, and unlikely to improve as indicated by its guidance, I can't recommend Hewlett-Packard at this time. In fact, recent earnings may be an indication to back-up the dumpster truck, and unload.

Source: Hewlett-Packard A Festering Black Swan... Beware