Hewlett-Packard Goes Back to Basics

New CEO Meg Whitman used  Hewlett-Packard's (HPQ) fourth-quarter conference call to send a clear message to investors: Management is focused on operating the businesses that HP already owns, not lusting after acquisitions. HP faces diverse headwinds, creating an uphill climb to re-establish operational improvements, but investors finally have reason to be optimistic as Whitman looks to restore order from the chaos that has consumed HP during the past 12 months.

Fourth-quarter results were slightly better than we anticipated on revenue and earnings, but with the new regime in place only eight weeks, it is the 2012 outlook that matters most for investors. Management guided to lower revenue and earnings in fiscal 2012, with non-GAAP earnings expected to be greater than $4.00 per diluted share, a sharp decline from the $4.88 delivered in fiscal 2011. We believe the $4.00 EPS level represents a solid target with little risk of a miss, but also allows for the investments necessary to position HP for subsequent years of EPS growth. No specific revenue guidance was given, as management looks to emphasize profitability over growth.

Despite our enthusiasm for the new strategy, HP faces stiff headwinds in its core operating units, including printing, servers, and services. The printing segment's operating margin fell to just 12.8%, as sales of high-margin supplies stagnated because of excess inventory that accumulated earlier in the year. HP expects two more quarters of challenging results to work through the issue. Sales of HP's business-critical servers are now in secular decline (down 23% year over year) after Oracle pulled support for the platform. The decline will have a long tail, but the damage appears to be irreparable. Finally, after a long period of underinvestment, the services segment continues to underperform the industry and is facing a turnaround that will be measured in years. On top of these issues, economic uncertainty in Europe threatens to damp IT investment across the globe.

Facing these issues in its core units, HP is wise to abandon the acquisition-focused transformation the former regime was pursuing. The software-focused acquisition strategy was based on promises of margin expansion and increased customer stickiness, but was fraught with overpayment and integration risk. HP's new focus on its current businesses provides less revenue and earnings growth potential but delivers greater stability. We plan to lower our fair value estimate to account for the investment required for HP's turnaround and capture the revenue trade-offs we expect HP to make as it shifts to emphasize profitability over growth. However, we also plan to lower our fair value uncertainty rating to medium, reflecting our greater confidence in HP's ability to achieve its goals and its commitment to avoid large acquisitions and prioritize strengthening its balance sheet and returning cash to shareholders as the best uses of free cash flow.

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