What makes a CEO covet a P/E ratio of 14.1 for their stock? Having a P/E ratio of only 10.8. All else being equal, moving a P/E from 10.8 to 14.1 equates to a 31% boost in share price ... no easy feat.

IBM envy
That's the challenge for the new CEO of Hewlett-Packard (NYSE: HPQ), which is trading at a 10.8 P/E. Competitor IBM (NYSE: IBM) commands a comparatively high 14.1. What does IBM have that HP doesn't? For one thing, IBM's net margin -- net income as a percentage of revenue -- is 14.9%. HP's 7.2% is less than half of that.

What's behind IBM's superior margins? A look at some HP competitors and other major tech companies shows Lexmark (NYSE: LXK) and the software players all have higher margins than HP.


EBIT Margin

Microsoft (Nasdaq: MSFT) 40.4%
Oracle (Nasdaq: ORCL) 34.0%
SAP (NYSE: SAP) 31.1%
IBM 20.0%
Lexmark 11.7%
HP 10.5%
Dell (Nasdaq: DELL) 5.7%

Source: Capital IQ, a division of Standard & Poor's.

You've gotta love those software margins.

The softer side of HP
Although software accounts for only 3% of HP's revenue, last fall the board hired a relatively inexperienced CEO from software provider SAP. What might seem an odd choice may be a case of IBM envy. Over the past several decades, IBM has evolved from a declining hardware company into an enterprise IT leader. The differing revenue and profit contributions from software and hardware at IBM and HP explain a lot.

Last 4Quarters



Hardware % of Revenue 19% 47%
Hardware % of Profit 8% 30%
Software % of Revenue 25% 3%
Software % of Profit 46% 4%

Source: Capital IQ, a division of Standard & Poor's.
Profit percentages are author's calculation.

Easier said than done
With software contributing almost half of IBM's profit, it's no surprise HP CEO Leo Apotheker is upfront about wanting to beef up HP's software capabilities. Fortunately, he plans to stay away from applications, an area in which IBM floundered early on (remember the Lotus acquisition?). But what looks good on a PowerPoint is fraught with risks.

First, acquisitions rarely deliver the hoped-for benefits. Furthermore, as a tiny part of HP, even stunning software growth would barely move the needle. Finally, software companies trade at premium multiples that make acquisitions expensive. At some point, a growth-through-acquisitions strategy could drain cash. It's also worth noting that IBM's mainframe operating system -- which HP can't match -- likely drives a significant portion of IBM's software profits.

Foolish takeaway
Beefing up HP's software capabilities makes sense strategically, but is easier said than done. It also isn't enough to right the company. HP needs to correct years of under-investing in R&D, recent missteps in China, and deteriorating quality that has both increased warranty and service costs and tarnished the HP brand. It's going to be a long haul.

More HP Foolishness