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HP Earnings: Product Sales Up, R&D Down, Strategy Dubious

I've been writing for a while about HP's (HPQ) evolving business model, with more emphasis on services, less on products, and a reduction in R&D spending. The company's earnings announcement yesterday showed a marked shift in one trend and an increase in the other.

In its latest quarter, which ended January 31, HP saw a strong growth in year-over-year revenue of 8 percent. But of particular interest is how the revenue broke out for the quarter:

Revenue was down year-over-year in services and up everywhere else. This is the mirror image of what happened last quarter, when services was the only division to see an increase over the same period in 2008. The personal systems group saw 26 percent -- a big lift to the company's numbers, but not entirely surprising given that all PC unit shipments were up last quarter.

There are two peculiar things about this. One is that it seems odd for services to drop by 3 percent since the previous quarter, given that hardware sales were up. It sounds as if HP pushed extraordinarily hard on the services front when hardware sales were doing poorly. Have they now let up, or has the company changed its business emphasis? Whatever the reason, it doesn't seem like a good sign, as HP seemed so focused on expanding its service business, much as IBM successfully did.

The other -- and odder -- thing to me is how a company that's enjoying a product sales resurgance is going to do in the long run when its spending on R&D has been dropping steadily over at least the last 13 quarters, not just as a percentage of revenue, but in absolute dollars. Take a look at the following graphs:

For a technology company, R&D is as basic a requirement as brand-building. Even more so. CEO Mark Hurd says it's all about being efficient in R&D spending. I buy that, but only to a point.

HP tried peddling the same point to me when I first pointed out the R&D drop. But, come on -- this isn't a one-time adjustment. Virtually every quarter, percentage and absolute numbers continue to drop, even as revenues climb. I don't believe there was that much inefficiency to pull out of research and development, although I do believe HP thinks this is the case. The problem with such strategies is that you discover their unpleasant consequences only years later -- when you're lagging behind your competitors. By then it's too late.