Hewlett-Packard Limps Through the Fourth Quarter

 Hewlett-Packard (HPQ) delivered weak operating results that were roughly in line with our expectations, but the firm's first-quarter guidance was disappointing. HP continues to suffer from secular and cyclical pressures on its PC, printing, and enterprise hardware businesses while working through a protracted turnaround in services. We expect to lower our fair value estimate by 10% to 15% as we trim our revenue and operating margin forecasts. While we continue to believe that HP's shares are fundamentally undervalued, we note that there is a high degree of uncertainty surrounding our forecasts and we would prefer a wider margin of safety before recommending the stock. 

HP experienced year-over-year revenue declines across nearly all of its businesses, with only networking and software posting meaningful growth. We underestimated the rate of decline in HP's PC business this quarter, and we are lowering our long-term revenue forecast for the segment. Still, the variable cost nature of HP's PC business should allow it to remain profitable even as revenue declines, and we note that the PC segment has been profitable in each of the past 16 quarters. Printers, on the other hand, performed better than our expectations, with revenue falling 5% from the year-ago quarter and adjusted operating income expanding significantly on both a year-over-year and sequential basis. The significant increase in profitability was primarily result of mix-shift into higher-margin ink supplies, and management cautioned investors that printer profitability would contract next quarter as inventories normalize. In total, adjusted operating income attributable to PCs and printers came in at $1.4 billion, or 41% of HP's total adjusted operating income. Printers and PCs face secular headwinds, and we expect operating profits from these businesses to decline over time, on an absolute basis and as a percentage of HP's overall revenue. 

HP's enterprise hardware business came in below our expectations with revenue falling to $5.1 billion, down 8.6% from the year-ago quarter. Adjusted operating income fell sharply to $423 million, due primarily to increasing price competition in x86 servers, a sharp decline in HP's higher-margin business critical systems business, and fixed-cost deleveraging. Software performed reasonably well this quarter as HP's increasing focus on this business may be bearing fruit. Software revenue and adjusted operating income grew 15% and 12%, respectively, from the year-ago quarter, with software accounting for 9% of HP's adjusted operating income in the quarter. We expect HP to look for ways to more tightly integrate its enterprise software and hardware businesses over time, and we expect software revenue to continue to grow faster than the overall enterprise IT market during the next several years, both internally and through acquisitions. 

HP's services revenue fell 5.6% from the year-ago quarter with infrastructure outsourcing, application, and business services falling faster than technology services, which is primarily comprised of product support. While services profitability improved significantly this quarter, management still expects that adjusted operating income will fall significantly next year as a number of large services engagements roll off. We maintain our view that HP should rid itself of its labor-intensive services businesses in order to increase its focus on enterprise hardware and software.

On a consolidated basis, fourth-quarter revenue fell 6.7% year over year to $30.0 billion, while non-GAAP earnings per share fell to $1.16, compared with $1.17 in the year-ago quarter. Management expects non-GAAP earnings per share of $0.68 to $0.71 in the upcoming quarter, while reiterating its full-year guidance of $3.40 to $3.60 per share. Moreover, management has not backed off its earlier forecast of approximately $5 billion in free cash generation in fiscal 2013, set during its October analyst conference. HP generated $3.5 billion in free cash flow in the fourth quarter, up significantly from the $1.2 billion generated in the year-ago quarter and above our expectations. The firm continues to prioritize strengthening its balance sheet over accelerating share repurchases, and the firm's net debt position improved sequentially from $20.2 billion last quarter to $17.1 billion this quarter. We expect HP's management to continue to aggressively pay down debt through 2014. 

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