It's Payback Time at Hewlett-Packard

A previous version of this article provided an incorrect figure for revenue growth in HP's software unit. The correct software revenue growth was 17%. The Fool regrets the error.

Last year IBM (NYSE: IBM  ) CEO Sam Palmisano said Hewlett-Packard (NYSE: HPQ  ) underinvested in R&D. HP's latest earnings call proved him right. Now it's payback time.

The news came as part of HP's earnings release. Though non-GAAP EPS of $1.24 beat the consensus estimate of $1.21, management guided fiscal 2011 to "at least $5.00." Previously, HP had expected $5.20 to $5.28. According to a leaked email, the company is cutting back spending, suggesting that its revised outlook would be even worse without belt-tightening.

One out of three is bad
Management cited three reasons for the reduced outlook, but provided little quantification. 

First, the tragedy in Japan occurred after prior guidance. HP expects weaker Japanese demand, supply chain disruptions, and higher costs. That's fair. 

Japan's Canon (NYSE: CAJ  ) is a key LaserJet supplier. HP's printer business accounts for 28% of operating profit. By some estimates, LaserJets account for about half of that. HP estimates the revenue impact at $700 million, about 2% of quarterly revenue. The cost impact could be far greater, as HP scrambles to keep high-margin toner flowing and prevent customer defections to third-party suppliers. Still, many HP competitors have been far less affected by the tragedy in Japan.

Second, weakness in consumer PC demand is worse than expected. Whatever happened to lowballing forecasts, just to be on the safe side? HP is far more exposed to this segment than Dell (Nasdaq: DELL  ) , which just announced better-than-expected earnings and raised guidance. And Apple's (Nasdaq: AAPL  ) premium-priced Macs -- popular with consumers -- are making impressive share gains.

Third, HP is stepping up investments in its services business. Hmmm ... that's what EDS management said a few years before it was acquired by HP in 2008. It seems HP did a good job of taking costs out -- then-CEO Mark Hurd was known for that -- and a bad job of investing to adapt to an ever-changing technology landscape. IBM's Palmisano was right.

But wait, there's more
HP's cash position is deteriorating. Net cash excluding debt in its financing business dropped from $6.6 billion entering 2010 to -$0.4 billion as of January, as HP's debt-to-equity ratio jumped from 38% to 55%. Operating and free cash flow declined year over year in both fiscal 2009 and fiscal 2010. While operating cash flow improved over its previous year total in the last two quarters, HP's net cash continued declining as it stepped up share buybacks and spent on acquisitions.

Acquisitions and buybacks are part of HP's EPS growth strategy. But the company dipped into its cash stash to fund both -- an unsustainable strategy. Last quarter's buybacks reduced share count more than 8% year over year, and accounted for more than half of non-GAAP EPS growth of 14%. How much can HP keep boosting EPS growth with negative net cash?

During the call, one analyst asked about 7% year-over-year growth in printer supply revenue. TManagement said it expects long-term growth in the low- to mid-single-digits. That's disappointing, since printer supplies account for a huge percentage of HP's profits.

Now what?
The disruptions related to Japan are unfortunate, but they should be temporary, giving HP easier comparables next year. The PC business may or may not recover from current challenges in the consumer segment, and HP is showing improvement in China after 2010's missteps. HP is optimistic about its new TouchPad tablet, due this summer; investors should get early indications later this year.

While some services business investments could pay off this year -- e.g., hiring to meet current demand -- for the most part the payoff will take place over the intermediate to long term. What's more, the planned investments include hiring an Executive VP for the business. More negative surprises may await investors -- and HP -- once the new EVP gets his or her arms around the business.

Foolish takeaway
HP reiterated its fiscal 2014 non-GAAP EPS target of "at least $7.00" (compounded annual growth of about 11%) on its earnings call. But management doesn't seem to have a good handle on its business, casting doubts on its ability to hit that target. In contrast, IBM expects similar EPS growth through 2015 with potential for upside. IBM also has superior management, a richer dividend and better quality of earnings.

With a P/E ratio of only 9 times, and management expectations that it can increase non-GAAP EPS at least 40% by 2014, HP investors could be well-rewarded. Still, IBM is a safer long-term play on enterprise computing, and in the near term, Dell appears better-positioned to reward investors.

Do you think HP can pull its act together? Or is it a value trap? An easy way to stay on top of the latest developments is the Motley Fool's free new My Watchlist feature. You can get up-to-date news and analysis by adding these stocks to your Watchlist now:

Fool contributor Cindy Johnson does not own shares of any company in this article. The Motley Fool owns shares of Apple and International Business Machines. Motley Fool newsletter services have recommended Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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