HP (HPQ) released its 10-K late yesterday. And when you read between the lines of numbers, you see that the EDS acquisition last year effectively masked some significant business issues and trends for the company.
The first trend is one that we've been looking at for some time: the switch from a product-based business to one driven by services -- and services, specifically, in the U.S. You can see the shift in the business through the weighted net revenue change that each division had in 2008 compared to 2007, and in 2009 over the previous year, in this chart from the 10-K:
The services business is a bit tricky to analyze because the EDS acquisition only closed in August, in time for the fourth quarter. As HP effectively notes, that acquisition was the big factor in keeping overall results from being even worse than they were. The EDS addition helped drive U.S. net revenue upward by 12 percent year-over-year in 2009, versus net revenue outside the U.S. falling by 10 percent. Think of that for a moment and look at the following information on geographic contribution to revenue from the 10-K:
If most of the U.S. growth was EDS, what would have happened had HP not acquired the company? Let's guess for a moment that U.S. sales would have been largely flat. That would have translated into a 6.9 percent decrease. So EDS was worth a 3.7 percent positive bump in net revenue. Not only did was the acquisition smart strategically, as hardware will increasingly become a quasi-commodity business, but it also pulled the company's chestnuts out of the fire. It suggests that service revenue outside the U.S. is too weak, so HP will be shopping for more international presence and, my guess, another potential acquisition within the next few years.
Now, the chart of overall financial results:
As I've been noting over the long haul, now, R&D spending keeps going down, down, and down. In relative spending, it's down a half percent of total net annual revenue. This is a honking big deal, because of HP's tradition of being an engineering-driven company. Clearly that is on the wane, even though at one point an HP PR person actually tried to convince me that up was down and that R&D spending increased, even as it dropped in percentage and absolute dollar terms.
Selling, general and administrative (SG&A) has also been trimmed over the last few years, from 11.9 percent in 2007 to 11.3 percent in 2008 and down to 10.1 percent in 2009. Just in one year, management axed 1.2 percent of spending out of the budget. But there's another reason for aggressively trimming expenses and R&D: cost of sales as a percentage have been going up steadily, from 75.4 percent in 2007 to 75.8 percent in 2008 and, this year, 76.4 percent. That's a marching drumbeat that no CFO, and no investor, is going to like. Unless HP can start getting that under control, expect that money will continue coming out of other budgets, making you wonder at what point the company passes fat and starts excising muscle, sinew, and bone. I'd argue that that may already be the case in R&D.
There's also economic pressure in terms of paying bills and getting paid, otherwise known as looking at the capital metrics:
Customers have been slower in paying, moving from 43 days sales outstanding in accounts receivables in 2007 to 48 days in 2009, or a 9.3 percent increase. Days of purchases outstanding has also gone up, from 53 days in 2007 to 57 days in 2009, or a 7 percent increase. So, for the most part, HP simply slipped its payments to offset the slip in receipts. Inventory supplies have gone down significantly, though whether that is a result of tighter business processes or a response to lower demand for products, it's hard to say.
So, HP is a company in transition, moving its business center-of-gravity from one area to another and, in the process, is wrestling with trying to make the transition and deal with some significant economic pressures, both in terms of the economy and its own cost of building and delivering products.