HP: A Look Under the 2008 Financial Covers [UPDATED]

(MoneyWatch)  HP released its 10K for fiscal year 2008 last night. Here are some highlights from a first digging into the document, including more efficient operations over the last two years, at least by some measures, and potential financial weaknesses going forward. They should be of interest to shareholders, competitors, customers, and vendors alike.

About 69 percent of all its roughly $118.4 billion net revenue now comes from outside the U.S., mostly from customers other than foreign governments. As the U.S. seems to have been on the advanced front in this economic downturn, it could mean that HP's relative strength to competitors could take a big hit as things continue to slow overseas.

R&D as a percentage of revenue is down. Absolutely numbers were $3.5 billion, down from $3.6 billion in 2006 and 2007. But revenue in 2006 and 2007 was $91.7 billion and $104.3 billion, respectively. That means R&D as a percentage of revenue was 3.9 percent in 2006, 3.5 percent in 2007, and is now about 3 percent. That seems like a significant trend. If it continues, that could leave HP less effective in developing new products and technologies for future sales. HP holds over 32,000 patents, slightly more than in 2006 and 2007, but there is no easy way of telling their general age or how rapidly they may be running out.

There are seven business segments: enterprise storage and servers (ESS), HP services (HPS), HP Software, Personal Systems Group (PSG), Imaging and Printing Group (IPG), HP Financial Services (HPFS), and corporate investments. EDS was treated as a business unit for financial reporting, as it was brought in during the fourth quarter of 2008. Some segments, particularly ESS, have a higher fixed cost and greater variation in gross margin. Overall net revenue increase over 2007 was 13.5 percent, for a total of about $118.4 billon; gross earnings were 8.8 percent. The table below shows a breakout of net revenue and earnings:

Division Name	Net Revenue (billions)	Earnings	Earnings as % of Net Revenue
ESS	$19.4	$2.6	13.3
HPS (including EDS acquisition)	$22.4	$2.5	11.1
HP Software	$3.0	$0.5	15.2
PSG	$42.3	$2.4	5.6
IPG	$29.4	$4.6	15.6
HPFS	$2.6	$0.2	7.1

Notice that out of the $118.4 billion total sales, $42.3 billion, or 35.7 percent, comes from the personal systems group. That's a heavy reliance on consumer spending [UPDATE: not all of PSG sales are consumer, as they also include commercial PCs and workstations as well as handhelds], and you have to figure that some large portion of the imaging products group is also dependent on consumer sales. HP is vulnerable to any consumer slowdown.

There is a trend, at least over the last few years, of increasing net earnings

No matter how you slice and dice the results, net revenue was up almost 13.5 percent over 2007. Here are some reasons the company gave for growth in specific segments:

• PSG -- 22 percent increase in unit volume, with large growth in notebooks and in emerging markets
• IPG -- hardware units were down, but supplies, particularly color-related, were strong
• ESS -- increase was largely from storage products and increased units of servers and blade revenues
• HPS -- due to growth in business technology optimization, in part due to the September 2007 acquisition of Opsware Inc.

At $10.2 billion, cash on hand is lower than a number of other high tech giants and is down from $11.3 billion at October 31, 2007. That was largely due to large cash outlays ?€" over $13.7 billion in investment activity and more than $2 billion in financing. Investment was $6.3 billion over 2007, "due primarily to higher cash payments made in connection with acquisitions."

Some key performance metrics are interesting. Days of sales outstanding is a measure of how quickly a company collects its receivables. That has gone from 40 days in 2006 to 43 in 2007 and 45 this year, which, given longer-term economic problems, is probably a good management of AR. Days of supply in inventory has dropped from 38 in 2006 to 27 in 2008, which means the company is operating more efficiently. And days of purchases outstanding shows how quickly a company pays its bills; HP has gone from 59 in 2006 to 49 this last year. Faster payment might mean that HP is also getting larger discounts for quicker payment, which would help lower cost and increase margins.

HPFS is the funded more by debt than any other part of the company. At the end of 2007, HP had $22.1 billion in short-term and long-term financing available. By the end of FY 2008, the company had used $10.5 billion, leaving about $11.6 billion still available. Right now, HP has about $6.3 billion in debt due in less than a year.

Although no single customer represents more than 10 percent of accounts receivable, the ten largest distributors and retailers in North America and Europe represented 18 percent of gross accounts receivable on Oct. 31, 2008, down from 23 percent in 2007. The question is how much of this might be tied up with changes that are now having significant financial troubles, like Circuit City, and whether a significant portion of AR is at risk. Out of a total AR of $17.5 billion at the end of October, there was an allowance of $553 million for "doubtful accounts," or about three percent.

Goodwill is riding high, as HP added nearly $11 billion in goodwill to its balance sheet, almost all of which was through the EDS acquisition. That represents almost a 50 percent increase, for a total of $32.2 billion. HP says that it found no impairment of goodwill as of Aug. 1, 2008. Granted that EDS, being a services firm, had its real assets in the people working there and customer relationships, but given that the preliminary purchase price was just over $13 billion, that is a whole lot of goodwill that could turn out to have been inflated during the coming year.