by Charles Brewer, Actionable Intelligence
After reporting lackluster third-quarter results in August, Hewlett-Packard indicated it was restructuring to pursue “higher value, higher margin growth categories.” Details of the planned reorg provoked already-angry HP investors when they learned that the firm planned to end production of webOS devices like the recently released HP TouchPad and signaled it may — or may not — sell or spin off its PC unit.
Investors took little comfort in the fact that HP was sinking $10.2 billion in the U.K.-based software developer Autonomy, which markets enterprise search technology. A subsequent stock sell-off cost HP dearly; share prices plunged to a six-year low.
News that HP planned to exit certain hardware markets while expanding its software business has fueled speculation that the company is accelerating its transition from hardware manufacturer to services provider. HP, so it would seem, wants to be more like IBM than its longtime computer rival Dell. IBM, of course, has been wildly successful since it transformed itself into a services organization, while Dell has sputtered along as a hardware vendor. HP has been working to grow its business around services for a while. Many of the investments the company has made over the past few years, including the $13.9 billion EDS acquisition in 2008, were made expressly to help HP be a larger services provider.
HP is establishing a decent track record as it grows its services business. In the third quarter of 2006, HP Services generated $3.9 billion in revenue, and by the end of the last quarter, that number was $9.1 billion. Profitability has also improved. Five years ago, third-quarter operating profits were 9.4 percent of revenue, or $364 million. During the last quarter of 2011, operating profits had increased over 300 basis points since Q3 2006 to 13.5 percent of revenue, which represented a profit of about $1.2 billion.
No direction known?
Despite its success in its attempts to be a services provider, investors are worried that HP’s business plan is less than clear. And that point is well-taken.
The decision to pull the plug on the webOS hardware, for example, seems rash. HP spent some $1.2 billion to acquire Palm last year and gain access to its operating systems and hardware. The firm said the Palm acquisition would allow it to introduce hip, new products better able to withstand the withering margin compression that has commoditized personal computers. But just weeks after the July 1 introduction of HP’s first webOS tablet, the HP TouchPad, HP CEO Léo Apotheker said the firm would discontinue manufacturing webOS hardware. He added little clarity when he said the webOS technology was popular with developers and would live on despite the move away from hardware but provided no subsequent details.
Of course, IPG is bound to suffer in the long run if HP telegraphs to the market that it doesn’t really care about hardware anymore. … HP’s printer business has benefited from the company’s ability to provide corporate clients with a range of products.
To make things even more confusing, as we went to press, we learned that the TouchPad may have had a stay of execution. On August 31, Reuters reported that “HP announced a temporary about-face on the gadget” after the demand for the TouchPad spiked at the end of August. HP slashed the price from $399 and $499 to $99, and sales went through the roof. The ultimate fate is still anything from certain. The firm said it will continue to make the tablets to fulfill its orders, but it appears HP loses a lot of money with each sale. Reuters said, “According to IHS iSuppli’s preliminary estimates, the 32 GB version carries a bill of materials of $318.” How long will HP market a device on which it loses more than $2 for each $1 it brings in?
In addition to the confusion over the webOS tablet and smart phone business, HP appears to be wavering in its commitment to the PC space in general. This revelation was nothing less than shocking because the firm is the world’s largest producer of PCs. When Apotheker spoke to analysts during the third-quarter earnings call, he said the company was exploring a “range of options” related to its Personal Systems Group (PSG), which is responsible for marketing HP PCs as well as webOS-based hardware. The options include selling PSG, spinning it off or leaving it in place. A final decision is not expected until next summer or maybe as late as 2013. In the meantime, the industry is left to speculate what will become of PSG.
Shannon Cross of Cross Research asked Apotheker the obvious question: “Why not just spin (PSG) off right now? Why leave the overhang of some other potential strategic move?” The reply really answered nothing, as Apotheker said, “The announcement of today will allow us to look at this much more closely, including all of the synergies, the dissynergies, and other aspects of this operation and over time, a decision will or will not crystallize on what the most appropriate way is to deal with PSG going forward.”
PSG: Not a strong performer
HP really needs to clarify its message because the steps it is taking are not necessarily the wrong ones. Margins for PCs have been squeezed, and that’s not going to change regardless of how big HP’s PC business is. In fact, a big reason HP wanted to move into the tablet market, as noted earlier, was because sexy gadgets like iPads and high-end smart phones are not experiencing margin pressures associated with PCs.
A post at the Guardian’s tech blog (www.guardian.co.uk/technology/blog/) summarized the problem with PSG in three concise graphs. The first plotted each of HP’s business units’ revenue since 2005 and showed PSG revenue has been growing. At 31 percent, PSG was HP’s No. 1 revenue generator during the period just ending. The second graph detailed the amount of profit in dollars for each unit, and the blog pointed out that “while PSG generates lots of revenue, it doesn’t do the same when it comes to profits.” The third graph showed PSG operating profits as a percentage of the unit’s revenue. According to the blog, “now, PSG is not the biggest (HP business group), but the smallest; an average, over the period, of just 4.6 percent, compared to 12 percent for Services and over 15 percent for Imaging & Printing.”
Unlike the PSG unit, HP’s Imaging and Printing Group (IPG) appears to be a steady performer. IPG is consistently the No. 2 or 3 revenue generator, and its margins typically range between 15 and 17 percent. Although some may feel that HP’s move away from hardware foreshadows the inevitable exit from the office equipment space, I think the business is on a solid foundation — at least at present.
Right now, only uncertainty is certain
Of course, IPG is bound to suffer in the long run if HP telegraphs to the market that it doesn’t really care about hardware anymore. I think that HP’s channel partners will find themselves in a weaker position trying to win bids without PCs — and without tablets. HP’s printer business has benefited from the company’s ability to provide corporate clients with a range of products. IT groups have come to see HP as a one-stop shop for servers, routers, computers and printers, and HP has invested heavily in having a deep product portfolio. It appears now that HP’s product catalog won’t be so rich.
I wonder what will happen to HP’s printers in the retail space if PCs go away. The planograms in certain retail outlets have featured what amounts to an HP store within a store. In Staples, for example, I’ve seen centrally located areas that are crammed with HP PCs, laptops, printers, MFPs, ink and toner cartridges, and paper. Could HP command such prime real estate if it didn’t have a full range of products in the computer category? It’s very unlikely.
In the long term, IPG will need all the help it can get as print volumes continue to decline. One reason why HP’s overall performance was off in the third quarter was because IPG’s revenue and operating profit were under pressure. HP Chief Financial Officer Catherine Lesjak reported that net IPG revenue was $6.09 billion in Q3 FY 11, which represented a 1 percent decline compared to $6.17 billion one year ago. Supplies net revenue was flat, and commercial revenue declined about 7 percent. Net revenue from consumer hardware was the only gainer, and it was up an anemic 1 percent. Worse yet, operating profits were down significantly, dropping 220 basis points from 17 percent of IPG revenue in the third quarter of last year to 14.7 percent this year.
HP is the market leader in the desktop printer space, and that’s not going to change anytime soon. That said, however, the competition is fierce, and IPG is not invincible. Its rivals can and will take market share. HP must make some critical strategic decisions that will allow it to grow. Once a road map has been established, HP’s senior managers must articulate it to investors and execute. Lacking that, who knows? Currently, I have many more questions than answers.