Despite Layoffs, Signs of Stability Emerge from H-P

  HP (HPQ) reported second-quarter results that suggest signs of stability for the wounded technology giant. Our confidence in the firm's multiyear turnaround effort continues to build as the new management team implements a systematic and methodical approach to the issues HP has struggled with recently. HP also took this opportunity to announce the next step in the turnaround: a new restructuring effort that will trim its work force by 27,000 jobs. Finally, management also reaffirmed the full-year target for non-GAAP EPS of more than $4 per share, a critical step in rebuilding investor confidence. Our $40 fair value estimate is unchanged.

A substantial reduction in HP's work force is the most newsworthy item from the quarter, but we view this as a necessary, and not unexpected, step in the turnaround story. HP will trim its work force by approximately 27,000 employees, or 8% of its work force. The total cost of this restructuring is expected to approach $3.5 billion, including a $1.7 billion charge that will have an impact on HP's fiscal year 2012 results. Cash outflows in fiscal 2012 related to this effort are expected to total approximately $400 million. HP expects approximately one third of the employees to exit the firm in fiscal 2012, with the remaining 18,000 to exit by the end of fiscal 2014. HP expects to generate annualized savings of $3.0 billion-$3.5 billion by the end of fiscal 2014. The majority of the savings will be reinvested back into the business.

The current quarter's results were above management's guidance, but the comparison with last year's second-quarter results remains sobering. HP delivered non-GAAP EPS of $0.98 versus management's guidance of $0.88-$0.91 per share. Total revenue declined 3% year over year, to $30.7 billion. The PC segment fared better than rival  Dell , with flat year-over-year growth. The enterprise hardware division (ESSN) continued to struggle as the supply of industry standard servers (x86) was hindered by hard disk drive shortages. Furthermore, the business critical systems segment continues to fade because of Oracle's decision to withdraw support for the Itanium platform. Revenue from the printing segment dropped dramatically, falling more than 10% year over year as the firm continues to deal with channel inventory issues. Revenue from the services segment was down 1% year over year, in line with our expectations as it tackles a multiyear retooling effort. In contrast to the uninspiring revenue growth, HP delivered reason to be optimistic about its operating profits. After falling to 8.6% two quarters ago, HP's operating margin expanded to 10.2% this quarter. The path forward will not always deliver linear improvement, but investors should be gaining confidence that HP's operating results are no longer in free fall.

In our opinion, outside of the European macroeconomic issues that threaten all technology firms, the biggest risk to our fiscal year 2012 forecast for HP as we enter the back half of the year is the health of the printing division. For several quarters, there have only been excuses about channel inventory issues. Now, however, management has signaled that the inventory correction is over, so the results going forward should be more representative of the printing segment's true potential. That being said, HP has underperformed its peers, and better execution is necessary to stabilize this segment. Management discussed some of the secular issues plaguing this business unit, namely the decline in consumer printing. Nonetheless, there are company-specific issues that need attention, including emerging market distribution and product pricing (hardware and ink). HP has moved past the head-in-the-sand approach to the issues, but this unit still represents a big risk point in HP's turnaround.

The key takeaway from the quarter is that the headwinds facing most of HP's core business units are built into the current results. There is no second shoe that we are expecting to drop. Instead, we think there has been a permanent impairment of HP's operating margins for printers, services, PCs, and enterprise hardware. Looking ahead, we believe that the first half of fiscal year 2012 represents the new normal level of operating profitability, with upside potential during the next several years as CEO Meg Whitman puts her stamp on the firm by controlling expenses and shifting the savings into the investments that lay a foundation for success in future years.

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