By Andrew Park Three years ago, when Hewlett-Packard (HPQ) CEO Carleton Fiorina announced her blockbuster plan to merge with Compaq Computer, critics derided the idea of combining the unprofitable PC businesses of both companies, predicting that HP's $29 billion exposure to the cutthroat PC market would sink the deal. Michael Dell, founder of rival Dell (DELL), told colleagues: "Minus-1 plus -1 equals -2."
As it turns out, HP has an altogether different albatross weighing it down: Its $15.4 billion-a-year enterprise-server and storage business. On Aug. 12, while praising its PC division for squeezing out a $25 million profit, HP blamed the server and storage group for the company's disappointing quarterly earnings, which fell 38% short of Wall Street's expectations. For its third fiscal quarter, ended July 31, HP posted quarterly profits of $586 million on revenues that rose 9% to $18.9 billion. By contrast, sales of enterprise servers and storage fell 5% from a year ago and swung to a $208 million loss.
Fiorina placed much of the blame on execution -- and took action fast. She cited unforeseen operational problems, falling prices in the storage business, and internal sales expectations late in the quarter that failed to materialize. She promptly axed three top executives, including Enterprise Sales Chief Peter Blackmore, and pledged to redouble efforts at improving profit margins (see BW Online, 8/13/04, "HP's Executive Brain Drain"). "With these changes, we expect our server and storage business to return to profitability in [the next] quarter," Fiorina said in a conference call with analysts.
THRIVING RIVAL. But Wall Street wasn't in a forgiving mood. After the announcement early on the morning of Aug. 12, HP's shares tumbled 13%, to close at $16.95, their lowest point since May of last year. "The stock looks cheap for a reason," quipped First Albany Capital analyst Joel Wagonfeld.
Meanwhile, major rivals are executing solidly, deftly navigating a market that turned choppy this summer. Some software and semiconductor makers reported a pause in tech spending in June, but at archrival Dell, there has been no sign of slowing. On Aug. 12, the company said sales had risen 20% in the quarter ended July 30, including a 22% surge in server and storage sales, and projected similarly strong growth in the current quarter. "We feel very good about the steady improvement in the corporate market," said Dell CEO Kevin Rollins.
Nowhere are HP's missteps more obvious than in its storage business. When the merger was announced, Compaq was the storage king. It had smartly developed less expensive storage systems, besting rival EMC (EMC). But under HP, the group has stumbled, losing focus and key talent. In the most recent quarter, sales of HP's storage systems fell 15%, while EMC's storage sales climbed 19%. "They're losing the street battles," says Steve Duplessie, founder of the Enterprise Strategy Group, a Milford (Mass.)-based research firm.
MAJOR DRAG. HP also is taking a beating in servers, another bread-and-butter business that was supposed to take off after the merger. During the quarter, sales of servers running on chips from Intel (INTC) and Advanced Micro Devices (AMD), rose just 2%. That's way off the estimated 15% growth for the entire market, says IDC analyst Crawford Del Prete. "Dell is being aggressive, and Dell is working very hard to gain share," Del Prete says.
HP's high-end server lines did even worse, declining 8%, to $828 million. Del Prete says the problem may be that HP's overlapping product lines are confusing customers. And, he says, that's benefiting IBM, which enjoyed a rise in server sales in its most recent quarter and a 10% jump in overall enterprise-computing revenue.
HP's news wasn't all bad, however. Its printer sales grew 8% in the quarter, software was up 17%, and PCs rose 19%. But none was high enough, or profitable enough, to offset the drag from servers and storage. And unlike IBM, HP hasn't yet translated growth in its services division -- 12% during the quarter -- into higher sales of corporate computers, another key rationale for the merger with Compaq.
MERGER IN THE SPOTLIGHT. During the conference call, Fiorina acknowledged that HP had lost business to rivals due to the quarter's "execution issues," including delays in a computer upgrade that wreaked havoc on customer orders. HP may woo back some of those buyers, but investors will be harder to win over. At its current price, investors are valuing HP at just 13 times its expected full-year earnings, compared to 30 times the day before the deal with Compaq was announced.
"We would not be rushing to buy the stock," wrote Goldman Sachs analyst Laura Conigliaro in a note to clients. That may once again put the spotlight on the value of the HP-Compaq merger. Park covers the computer industry for BusinessWeek