Hewlett-Packard (NYSE:HPQ) is set to report its first-quarter earnings on Feb. 20, and investors will be looking for any indication that the company's turnaround efforts are working. While some improvements were seen last quarter, with HP stealing away some server market share from rivals like IBM (NYSE:IBM), the company is still far from returning to consistent growth. Here's what to look for when HP reports earnings.
What analysts are expecting
Revenue for HP's first fiscal quarter is expected to decline by 4.1% year over year, larger than the 3% decline recorded in the previous quarter. Analysts expect EPS to rise slightly compared to the same quarter last year, with an average estimate of $0.84, representing about 2.4% EPS growth. EPS fell by 13% in the previous quarter, although it beat analyst estimates slightly.
HP's server business, a major source of profits for the company, managed to win market share last quarter at the expense of rival IBM. The server sales rise was the first in many quarters, as both sales and margins have been declining for quite some time, and it's unlikely that HP will be able to reproduce that result this quarter. This may already be factored into analysts' estimates, given the larger expected revenue decline compared to last quarter.
A shake-up in the server market
HP currently has the largest share of the server market, according to IDC, controlling 28.1% as of the end of the third quarter of 2013. IBM was in second place at the time, with a 23.4% share, and newly private Dell was in third place with a 16.2% share. HP is also the leader in the x86 server market, composed of servers powered by x86 chips from Intel and AMD, with a 32.3% share.
But IBM's recent sale of its x86 server operations to Lenovo (NASDAQOTH:LNVGY) promises to shake up the server market, possibly threatening HP's position as market leader. Lenovo bought IBM's PC business back in 2005, and since then, the company has become the largest PC seller in the world. Margins in the PC business are extremely low, with HP's PC segment recording a 3% operating margin in fiscal 2013, and Lenovo's rise to prominence certainly hasn't helped.
HP's enterprise group, which includes servers, has seen its margins decline nearly every quarter for the past few years. Much like PCs, servers are becoming increasingly commoditized, with many big web companies choosing to design their own servers instead of relying on companies like HP and Dell. This has led to the server market contracting, squeezing profits for the big server companies like HP.
The problem for HP is that a large portion of the company's profits come from the enterprise group. In fiscal 2013, the enterprise group accounted for about 45% of the company's non-GAAP operating profit, with printing accounting for most of the rest. Lenovo is looking to do with its server operations what it did with its PC operations. This could mean lower margins for the industry as a whole. Lenovo's companywide operating margin was just 2.4% in fiscal 2013, so it's clear that the company is willing to accept low margins in order to win market share.
HP's enterprise group operating margin is a number to watch, both in the upcoming earnings report and in future reports. The biggest fear for HP investors should be profits from servers drying up, caused by both the contraction of the server market and new competition from Lenovo. If HP can't stabilize its margins in this area, then it's hard to see a way for earnings to grow in the long term.
The bottom line
HP is in the tough position of deriving a large portion of its profits from the server industry, and while the revenue increase last quarter was a welcome surprise, the falling margins are likely to continue. Lenovo's acquisition of IBM's x86 server operations makes the company a far more formidable competitor in the server business, and HP will have a difficult time maintaining its margins in the face of increased competition. Investors should keep a keen eye on HP's enterprise group margins when the company reports its earnings, as any chance of a return to earnings growth depends on HP halting the current trend of declines.
Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. 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.