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Carly Fiorina's Next Big Challenge

By Amy Tsao For a while, it appeared that skeptics of the Hewlett-Packard marriage with Compaq would be proven wrong. CEO Carleton S. Fiorina wowed analysts with cost cuts faster and deeper than they had ever imagined when shareholders approved the controversial merger last year. More recently, Fiorina unveiled a new line of head-turning HP consumer products. Investors were willing to chalk up anemic revenue growth to the difficult technology-spending environment.

HP stock (HPQ) flirted with a 52-week high of $24 a share for most of the summer. Until Aug. 20, that is, the day after HP announced it had missed its third-quarter earnings expectations. The reason: slack European markets, which account for up to 40% of company sales, plus price-cutting in personal computers and weakness in HP's enterprise businesses. The stock slid 11%, to $19 on the news, with shares trading at quadruple typical daily volumes.

Joe Beaulieu of Morningstar, a self-described HP skeptic, concedes that he was "eating some crow" until the announcement. Now, he's pulled the feathers from his mouth. "Even with all the cost-cutting, it doesn't appear that Compaq has added much value," he says, estimating a $17 fair value on the stock. It closed at $19.84 on Aug. 21.

DUMMY PROOF. A temporary setback for Fiorina, perhaps. But smart investors may want to keep an eye on HP through the rest of the year. It looks like it could meet Wall Street expectations over the next two quarters, with a seasonal pick up in server and storage sales. And HP's plans to excite consumers, who have been steadier customers than its corporate clients, could boost sales.

The company is pinning substantial hope on the notion that consumers want to add more digital gadgetry to their homes and home offices. The consumer segment "is certainly a very large piece and one of the key growth areas of the company," says Chris Morgan, HP's vice-president of worldwide sales and marketing, imaging and printing. That's why Fiorina launched 150 new products on Aug. 11, in time for the back-to-school and Christmas seasons. Consumer-related sales make up 30% of total HP sales.

The strategy has its merits. The idea is to expand consumers' use of personal computers beyond the home office by offering a suite of easy-to-use digital products -- notebook computers, printers, scanners, digital cameras, and devices that all interconnect so fluidly that even technophobes would feel comfortable downloading data and sending digital photos directly to their printers.

EMBEDDED RETAIL. HP is also testing a "store-in-store" concept at consumer electronics retailers, including Circuit City (CC) and J&R Music & Computer World. The HP area within these larger retailers will emphasize how all the HP products work together. "There's a lot more opportunity in the home than just PCs and printers, and by addressing ease of use, HP can garner a bigger piece of the market," figures John Jones, an analyst at SoundView Technology. (Jones does not own shares and his firm does not perform investment banking.)

The strategy has its risks. Apple Computer (AAPL), Gateway (GTW), and even Sony (SNE) have had limited degrees of success with their retail concepts. However, HP may have an edge if, as many analysts who follow the industry believe, digital photos really catch on with consumers in the next few years. If its printers are both affordable and easy to use with digital-camera hook-ups, HP's dominance in the field could give it a profit boost.

Morgan says HP's lowest-priced photo printer is now $99 and photo-ready paper costs as low as 10 cents per 4-by-6-inch sheet. "If they can be big in digital photo and printing photos, that could provide some nice synergies for them," says Morningstar's Beaulieu.

INKY MARGINS. Other products too, like media-center PCs that link home entertainment and computers together, could spark sales, says Bob Sutherland, senior analyst at industry researcher Technology Business Research, based in Hampton, N.H. "I expect them to have a good year in the consumer space," he says, as long as the market for consumer electronics is robust this holiday season. He thinks bells will be ringing: "The pie for consumer digital [sales] this holiday is going to be large. Regardless of consumer spending being up or down, HP will get good share."

There are plenty of doubts about betting so heavily on rising sales of consumer-electronic products. "This is a very aggressive business. It's not high margin for very many people," Jones says. But he offers a novel theory: "HP is very fortunate to have its consumer business driven off [costly cartridge] ink. That gives them a really nice margin."

Even if the strategy works, HP will need to execute better in its other businesses if the stock is to strengthen. Its ability to compete in the desktop market against powerhouse Dell (DELL) remains in question. Adding to HP's worries, Dell recently announced that it would cut prices on personal computers and network servers -- a direct hit to HP, which is trying to reverse a period of overly aggressive discounting. Sales for HP's personal-systems division, which includes notebooks and desktops, rose 4.5% in its third quarter, but the division remains unprofitable.

SYNERGY WATCH. Printers have long carried HP, and the latest quarter was no different, with sales rising 10% year-over-year. Yet, the enterprise-systems group, which consists mainly of servers and storage units, continues to struggle. HP lost $70 million in the most recent quarter in its enterprise group, up from a loss of $7 million in the prior quarter.

"The real challenge is to get appropriate margins in the server-and-storage business. They're dealing with negative growth when they should have double-digit operating margins," Jones says. Sutherland adds that high-end server offerings from IBM (IBM) and Sun Microsystems (SUNW) could put further pressure on HP.

What would lift HP's valuation? Beaulieu says revenue growth above the industry average "for a sustained time" will do the trick. He also wants to see if its new products really have the synergies that HP promised with the merger. Until that happens, valuation will look relatively cheap. It's trading at less than one times revenue, while IBM trades at 1.7 times revenue. Its forward-looking p-e ratio is 13.5, while the S&P 500 index trades just below 18.

In the meantime, Fiorina & Co. will likely resort to more cost-cutting to meet Wall Street's earnings targets (HP announced on Aug. 20 it would lay off another 1,300 workers) and keep their fingers crossed that consumers like what they see. Tsao covers the markets for BusinessWeek Online in New York

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