HP Delivers Another Disappointing Forecast

Looking to stem the damage from a leaked internal memo,  Hewlett-Packard (HPQ) made a last-minute change and moved its earnings release to Tuesday morning. The memo implied that HP was in for a difficult third quarter, and the official release confirmed the market's fears. Current-quarter results were actually in line with expectations, but for the second quarter in a row, HP lowered its full-year expectations. The disappointing outlook has three contributing factors. First, lost end-market demand and supply-chain issues in the printing segment should create a $700 million headwind for the back half of the year. Second, the consumer remains extremely weak, as represented by the 23% year-over-year decline in consumer PC revenue. Third, HP lowered its operating margin forecast to 13.5%-14.0% for the services segment.

The lower forecast for services is the most concerning change for investors. Revenue appears to be back on track for flat to low-single-digit revenue growth in this segment, but execution issues are hindering the operating margin. Management's claims of underinvestment in this segment ring true to us (despite the opportunistic timing to blame the previous regime), and we believe it will take several quarters for HP to get back on track. Key changes to services include bringing in a new executive reporting to the CEO (with direct responsibility solely for enterprise services), and realigning the technology-services subsegment with the enterprise servers, storage, and networking segment for greater transparency. Additional short-term pain will be felt as HP ramps up its investment in the salesforce and software, but we believe these investments will pay off in the long run. We would be more concerned if HP were mortgaging the future to squeeze excess basis points out of the current quarter, but this is clearly not the case.

Management's credibility is taking a hit with this second adjustment, but we have not lost faith in the value of HP's core assets. The printing segment (with supplies revenue up 7% year over year) and the ESSN division (with revenue up 15% year over year) continue to perform well. Meanwhile, weakness from consumer-facing products is in line with our long-term expectations as we believe HP lacks a sustainable competitive advantage in most consumer-facing areas. We are lowering our 2011 forecast for operating margins in the services segment by about 100 basis points, but our fair value estimate is unchanged.

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