This Stock Rose 67% in the First Quarter

BA is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Hewlett-Packard (NYSE: HPQ) stock rose 67% in the first quarter 2013, making it the best-performing stock among the 86 large cap technology stocks trading on major U.S. exchanges. 

Why the big jump? HP posted better than expected earnings in its fiscal Q1 2013, ending Jan. 31. Better here means "less bad," given the behemoth's turnaround status. The quarterly jump places the stock's share price 3% above where it stood a year ago before it bottomed out last fall. 

Current biz snapshot  

Here's the current business mix and operating margins (non-GAAP) by segment. 

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Chart by BA McKenna based on company's F. Q1 2013 data. *Overall GAAP operating margin is 6.2% & non-GAAP is 7.9%. 

The two problem children are the personal systems (notebooks, PCs, workstations) and enterprise services (IT consulting) segments. They're both large and barely eking out an operating margin -- and we're taking non-GAAP. These segments -- which together account for 40% of total revenue -- are a big drag on the company's performance.

As to the services business, IBM (NYSE: IBM) and Accenture (NYSE: ACN) are two main competitors. IBM's competing segments had 19.2% (tech services) and 17.2% (business services) margins in 2012.  Accenture's (NYSE: ACN) operating margin was 14.1%; notably, Accenture's 61% ROE (with no debt leveraging that number up) indicates it's been incredibly efficient at generating earnings.

The printing and enterprise group (hardware for businesses) segments are keeping the company afloat. Software has a nice margin, but since it only accounts for 3% of revenue, it's not adding much to the bottom-line. Whitman is wise to focus on growing this segment. Software is a cash cow for IBM, which successfully transitioned from a largely hardware business to one heavily focused on software and services in the mid-90s. In 2012, IBM's software segment, which accounted for more than 23% of its revenue, sported a 37.6% operating margin.  

Where forth from here?

CEO Meg Whitman is undeniably extremely talented and also known as a tough competitor. However, I just don't think that's going to be enough to turn this huge ship around. That said, I know what I don't know -- and I (and most others) don't know the business connections and politics that take place behind the scene. The X factor could be a plus or minus. 

I wrote in March 2012, "I'm not sure if anyone could reverse the damage done under previous CEOs." That's still my opinion, especially if HP stays in the PC and other low-margin businesses.

A few of HP's major business issues:

1. Low margin PC business an anchor on performance

The PC market is contracting both in size and margins. So, it seems the best HP can hope for is to stem further deterioration in margins, rather than improve them. Given the size of the segment (29% of revenue), the other segments are going to have to churn out some out-sized margins to make up for this anchor.  

A wise move seems like it would be to either spin off its consumer business (or portions of it, including PCs) or divest it, as IBM did when it sold its PC division to Lenova in 2004.

However, there's a complicating factor and one IBM did not face in its decision -- the printer segment. HP's printer business, while no longer the powerhouse it once was, is still a nice money maker. Surely, printer sales are often paired with PC sales. So HP's printer business would likely be hurt (the question is to what degree) if HP exited the PC business. 

2. Late entrance into mobile makes for uphill battle 

Whitman has said that HP plans to offer a smartphone. Google's Android and Apple's iOS have a combined 90% market share in the U.S. BlackBerry, the former Research in Motion, and Microsoft control almost the entire remaining 10%. (I’ve not ruled BlackBerry down for the count. Its execution has been poor, but there's at least a small market for its phones due to the security element. We'll see how the Z10 does in the U.S.) There’s also buzz that Amazon might enter the space. We all know Amazon’s MO – its phones would likely be sold at about cost. 

The smartphone market in the U.S. is quite saturated -- more than 50% of all activated mobile phones are smartphones. Those eager for one already have one, if they can afford one. Those remaining don't believe they need one or can't afford one. These are not desirable groups to target. The former will need the mix of a good price combined with yet-to-exist features to be sold. Some in the latter category will only be sold on price. So, HP needs to offer a compelling reason why people should switch from their current smartphones. That's a tall order given how entrenched many are in their favored ecosystem.

Globally, markets such as China and other emerging markets are far from saturated. However, HP still faces the formidable Google-Apple competition. 

3. Enterprise services segment stuck in Catch-22

HP's IT business is essentially the former EDS, which it acquired in 2008 for $13.9 billion and for which it took an $8 billion impairment charge last August. This business accounted for 21% of HP's revenue in its most recent quarter. Its non-GAAP operating margin was 1.3%. Again, IBM's competing segments had 19.2% (tech services) and 17.2% (business services) margins in 2012, and Accenture's operating margin was 14.1%. 

There are likely a few reason why HP is getting hammered on margins, but surely one is some businesses are hesitant to contract with a company that's future is uncertain. The safer bets are to go with others, such as IBM or Accenture, which I highlighted recently in "Are There Irish Stocks That Could Keep the St. Patrick's Day Celebration Going?" We all know IBM always ranks at the top of various "best brands" and "best places to work" lists. Accenture's star has been rising in this respect; for instance, Accenture has been named to Fortune Magazine's 2013 “100 Best Companies to Work For” list for the fifth consecutive year.

So, HP likely has to "buy" some business. This hurts the bottom line. Thus, the circular Catch-22. Whitman is no doubt working on this issue, but, like most Catch-22s, it's going to be very difficult to fix. Investors and potential investors should keep their eyes on progress here.  

The Foolish bottom line

HP is not a stock for most long-term individual investors; it's better suited to speculators with higher-risk tolerances who are willing to follow the twists and turns of a turnaround. HP has a solid brand name in some corners, top R&D talent, and the extremely capable Meg Whitman at the helm. However, it seems the long-term odds are against HP given the amount of damage done under previous CEOs and the length of time it slumbered (and went on foolish buying binges) while competitors raced ahead with commercially-successful innovations. 

BA McKenna has no position in any stocks mentioned. The Motley Fool recommends Accenture. The Motley Fool owns shares of International Business Machines.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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