HP: Earnings, Product Revenue, R&D All Drop Year to Year

(MoneyWatch)  Hewlett-Packard's finally released its latest 10-Q after providing press, analysts, and investors with an earnings release last month for the quarter that ended on January 31. Perusing the document again shows why the full information can make for far more interesting, and informative, reading. HP continued to march away from product sales and toward services. Net revenue was flat for the period, with the quarter in 2008 showing $28.5 billion and, in 2009, $28.8 billion. The big difference is in the revenue split between products and services ?€" and a continued significant drop in spending on R&D.

Fiscal Year	Q1 Product Revenue	Q1 Service Revenue	Q1 Financing
2008	$23.1 billion	$5.3 billion	$90 million
2009	$18.6 billion	$10.1 billion	$89 million

On the surface alone the shift is big enough to warrant attention: a 19.5 percent drop in product revenue and, at a 90.6 percent increase, nearly a doubling in service revenue. Think a moment about HP's activities last year and the change is staggering. The acquisition of EDSshould have added big revenue on the service side. But according to HP's numbers from last fiscal year, HP services (including the finally concluded EDS acquisition) represented 11.1 percent of net revenue for all of FY 2008, and about 18.5 percent of net revenue in that year's first quarter. In the first quarter of FY 2009, the percentage that services represented of net revenue shot up to over 35 percent, and yet the revenue was flat.

To put it differently, it was only the acquisition of EDS and the full impact of service revenue that kept first quarter net revenue even flat. Product sales took an enormous hit. Earnings from operations were also down by about 4.5 percent. Net earnings took an even bigger hit of 13.1 percent.

Even there the contribution was mixed. The 10-Q had pro forma results for the EDS acquisition, combining the service offerings in Q1 of FY2008 as though the two had been combined.

Notice that income as a percentage of revenue was clearly up, which is a good sign. But revenue was down by 14.7 percent, suggesting that in an apples to apples comparison, there was actually a significant revenue decline.

Something else intriguing is the cost of products and cost of services. The general assumption is that services offer high margin income, but look at the numbers for the quarter. Cost of products as a percentage of product net revenue was about 76.1 percent. Cost of services as a percentage of service net revenue was 77.5 percent. So the margin advantage that HP (and its investors) might have expected haven't appeared.

As one industry insider suggested, though, some companies account for sales support under services, lowering SG&A costs and increasing cost of services. SG&A did decline a bit quarter to quarter, from 11.6 percent of net revenue in Q1 FY08 to about 10 percent this year.

Not that long ago, I reported on the apparent decline in R&D spending by HP, which was for years known as an "engineering company." In the first quarter of FY08, R&D was about 3.2 percent of total net revenue. This year it was down to 2.5 percent, a total drop of $166 million, or an 18.5 percent drop in actual dollars spent. Perhaps it is part of a strategy to switch more to services, but you have to wonder whether this could result in a negative feedback loop, with less R&D meaning less competitive products and, as a result, even lower future product sales.