Inside HP's Earnings: The Hardware Canary in the Coal Mine

HP (HPQ) employees have been leaking memos with dour financial outlooks like mad. Today's Q2 earnings announcement, which was decent enough at first glance, served as further evidence that HP and its rivals should start seriously worrying. Legacy business models that focus on selling boxes at as high a margin as possible won't last in an era of increasing hardware commoditization and cloud computing.

CEO Léo Apotheker had it right in this morning's earnings call when he said that the future will belong to those who let go of legacy business to move where they need to. That's one scary statement from a major corporation, and it explains the essential problem now facing the computer-hardware industry. How do they make money if not by selling more server, storage, and networking gear? Services and software can no longer be second class citizens used to help close hardware deals.

On the surface, HP's overall revenue was up 3 percent year over year. But the quarterly trend looks bad, both for revenue and earnings per share, as this graph from HP shows (click to enlarge):

When you look at the individual business lines, you can see the weak areas:

Revenue for the services division has limped along since HP acquired EDS a few years ago (click to enlarge):

HP's service initiative was supposed to counter IBM's traditional strength in the area (a shift that company took to avoid this very problem of being too dependent on hardware sales) while adding significant growth to the company. Instead, HP kept its focus on pushing hardware. The service operating profit keeps dropping probably because HP gives away services or slashes rates to help close deals on enterprise hardware. Not a good sign if, as HP as said, you want to be in cloud computing, which is largely a service business. You can see a related problem in the software business (click to enlarge):

Revenue is up, but operating profits have gone off a cliff, suggesting that HP has deeply discounted software even more as a way to continue pushing hardware. Unlike services, the incremental cost of providing the software is essentially sending over a license, so cutting software costs is even more tempting.

This may be another reason Apotheker stressed going beyond a legacy business. Currently, much of HP exists to support the enterprise hardware business (the ESSN division sells enterprise servers, storage, and networking). Unfortunately, that business is trending in exactly the wrong direction (click to enlarge):

Apotheker now says he will fold the services business into ESSN. In fact, during the earnings call, he took a back-handed shot at former CEO Mark Hurd, saying that the massive changes planned for services should have been done "years ago."

He hopes to get hardware and services to work together, but that's not going to be easy. The problem lies in culture. Right now, HP's salespeople are motivated to discount anything if it'll bring in the big enterprise deals. Shifting that may take a number of quarters, at the very least. Fixing the situation will be complicated, as the problem in the PC division will distract top management (click to enlarge):

That's a significant sequential quarterly drop due to consumer PC sales sliding by 23 percent year over year. Even growth in commercial PC sales couldn't help. Furthermore, the PSG group is getting hammered by hardware commoditization. Notice that unit sales were actually up by 1 percent, year over year, which means that prices and margin and down.

HP's problems are symptomatic of the entire computer-hardware industry, which is still having trouble coming to grips with the changes in computing. Corporations are moving to technologies such as virtualization and cloud computing so they can run their IT systems more efficiently, which ultimately translates into needing less hardware from vendors. Many consumers are still hurting financially, and also realize that much of what they use computers for can be satisfied by a tablet or even a smartphone.

This is an industry that has to find its future through all the pressure from Wall Street, and that's going to make the whole process tough. At least Apotheker is addressing it head-on, rather than calling for massive layoffs and cost-cutting in order to save an old way of life.

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