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Thursday, October 19, 2006

In-dept Analysis of HP's Business & Competitive Landscapes (HPQ)(DELL)(SUNW)(IBM)(AMD)(INTC)

By Yaser Anwar, CSC of Equity Investment Ideas

I think changes in the competitive landscape across all of HP's major segments set the stage for slowing profit growth over the next several quarters.

When evaluating HP as a potential investment, I think it is important for investors to understand exactly where the company’s dramatic rise in profitability came from.

Analyzing the business segment shows that nearly 80% of HP’s profit increases over the last two years can be attributed to its Enterprise Servers & Storage and Personal Systems Group divisions, due to revamped product lines, cut costs, and set prices to maximize profitability rather than revenue.

S&P expects gross margins to widen to 25% in FY 07, from FY 06's expected 24.4%, on higher volumes and manufacturing efficiencies. They see a further reduction in SG&A expenses, on a percentage of revenue basis, and believe that FY 07 operating margins are likely to approach 9%, versus FY 06's forecast of 7.9%. S&P also think results will be aided by additional share buybacks, as the company has instituted a new $6 billion share repurchase program.

Investors should expect cost measures in its PC segment as largely exhausted, and expect pricing pressure to intensify as demand slows and Dell reclaims its cost lead.

In servers and storage, The Street notices profit growth as being more difficult in coming quarters due to stronger product offerings from competitors Dell, IBM, and EMC.

I don’t expect printing to compensate for the slower growth in these segments. While recent printer share gains should provide near-term visibility for supplies growth, I expect competition to intensify as Lexmark and Epson re-establish their positions in the inkjet market following their decisions earlier this year to abandon free printer bundles.

Taking a look at the competitive landscape- According to IDC, the top four PC vendors; Dell, HPQ, Lenovo and Acer maintained double-digit unit growth rates in the second quarter of 2006. Technology and innovation, cost efficiency, distribution, research and development, and prices are key variables of competition in this industry.

As S&P expects information technology spending will increase in 2006 at a moderate pace, I believe HPQ can leverage its broad product and customer base to increase market share through lower prices made possible due to various cost cutting initiatives.

Going forward, I believe that changes in the competitive landscape set the stage for slowing profit growth in each of these two segments.

Just as in PCs, HP’s industry standard servers have benefited with regard to units costs from the company’s adoption of AMD processors. However, even more important for servers was the impact on product differentiation, as AMD’s Opteron chip had a clear performance per watt advantage over Intel’s Xeon MPU.

HP aggressively embraced Opteron, while IBM was slower to move and Dell maintained a product portfolio entirely based on the stale Intel Xeon chip line. I believe this differentiation enabled HP to maintain server share while pricing for margin optimization.

Server competitors IBM and Sun are now aggressively ramping AMD Opteron systems, and Dell has announced AMD-based systems for late 2006.

Intel has revamped its Xeon product line with the Woodcrest chip, marking a considerable improvement in performance per watt vs. its prior line. As a result, I expect HP’s server advantage stemming from the use of AMD chips to fade.

On the other hand, a positive for HP’s server business is the introduction of Montecito, Intel’s new dual core Itanium chip. HP has been eagerly awaiting this product as the company transitions customers from HP’s proprietary PA-RISC chip.

I expect the performance bump with Montecito to increase the competitiveness of HP’s Integrity line in the mid-range and high-end segments vs competitors Sun and IBM.

Over the past two years, HP has grown its PC operating margin from below 1% to its current level of 4%.

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