Hewlett-Packard (NYSE:HPQ) managed to grow revenue by 1% year-over-year during its fiscal third quarter, driven primarily by 12% growth in PC sales. While this is a welcome reversal from the past few years, HP's PC business is low-margin and contributes little toward the company's bottom line. It doesn't matter whether HP can continue to pick up PC market share because the parts of its business that generate most of its profits aren't exactly setting the world on fire.
Here's a summary of how each of HP's segments performed during the third quarter:
Even as the PC business managed 12% revenue growth and 0.9 percentage points of non-GAAP operating margin growth, it still accounted for a little less than 15% of HP's non-GAAP operating profit. This is up from around 10% during the same quarter last year.
HP can continue to win PC market share in a flat PC market, but it matters little in the grand scheme of things. The printing group accounted for 44% of non-GAAP operating profit during the quarter, followed by the enterprise group with 41%. Combined, these two segments account for 85% of HP's non-GAAP operating profit, and neither one is particularly promising when it comes to growth prospects.
The printing segment carries high margins, but revenue has been declining for quite some time. Revenue fell by 4% year-over-year during the third quarter, with both hardware unit sales and supplies revenue contracting. While I don't doubt that double-digit operating margins are sustainable, operating profit will follow revenue lower over the long-run, despite the nice boost in profit the segment enjoyed during the third quarter.
The enterprise group managed to grow revenue by 2% year-over-year, but operating margin has been declining continually over the past two years. Servers, which make up 45% of the segment, grew by 9% year-over-year, likely due to market share gains from IBM (NYSE:IBM) as it prepares to close its deal to sell its x86 server operations to Lenovo (OTCPK:LNVGY), but total operating profit from the division declined year-over-year.
HP is the leader in the global server market, but declining margins should be a big concern to investors. With the U.S. government recently approving the deal for IBM to sell its x86 server business to Lenovo, HP will be facing the company that stole the crown of the world's largest PC manufacturer from it last year. If Lenovo can do the same in the server market as it has done in the PC market, HP may see its market share begin to shrink.
Where will growth come from?
It seems unlikely that either the printing or enterprise groups will be sources of growth going forward, and with PCs not contributing much to the bottom line, how exactly does HP plan to grow its earnings?
HP's shares are cheap enough that it doesn't really even need to grow, and if I had any confidence that the company could maintain its current level of earnings in the long-run I would consider buying the stock. HP trades at about 8 times last year's free cash flow and 10 times its guidance for non-GAAP EPS for 2014, a low enough valuation that no growth coupled with share buybacks would likely lead to decent results for investors in the long-run.
But HP's earnings depend mostly on printing and enterprise hardware, and it's hard to imagine operating profit growing significantly in either one of these segments. If HP's earnings continue to degrade, then the "cheap" price that HP is selling for today won't be so cheap after all.
The fact that HP has managed to return to revenue growth is wonderful, and strength in the PC business is a plus, but the vast majority of HP's profits come from printing and enterprise hardware, and neither of those segments look primed for growth. HP appears cheap, but I'm not confident that the company can maintain its current level of earnings in the long-run.
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