Business Context and Reporting Period
This Form 10-Q covers Hewlett-Packard Company (HP) for the quarterly period ended July 31, 2005 (Fiscal Q3 2005) and the nine months ended July 31, 2005. HP is a global provider of IT infrastructure, personal computing, imaging, and printing products and services. The company operates through seven segments: Personal Systems Group (PSG), Imaging and Printing Group (IPG), Enterprise Storage and Servers (ESS), HP Services (HPS), HP Financial Services (HPFS), Software, and Corporate Investments.
Key Financial Metrics
| Metric | Q3 2005 | Q3 2004 | 9 Months 2005 | 9 Months 2004 |
|---|---|---|---|---|
| Total Net Revenue | $20,759 million | $18,889 million | $63,783 million | $58,516 million |
| Earnings from Operations | $913 million | $657 million | $3,241 million | $2,938 million |
| Net Earnings | $73 million | $586 million | $1,982 million | $2,406 million |
| Diluted EPS | $0.03 | $0.19 | $0.68 | $0.78 |
| Operating Cash Flow (9mo) | $6,142 million (vs. $3,101 million prior year) | |||
| Cash and Equivalents | $14,445 million (as of July 31, 2005) | |||
| Total Debt | $5.8 billion (as of July 31, 2005) |
Material Changes vs. Prior Period
- Revenue Growth: Consolidated net revenue increased 10% in Q3 and 9% for the nine-month period, driven by volume growth in servers, notebooks, and supplies, as well as favorable currency impacts (weaker dollar).
- Profitability Decline: Despite revenue growth, Net Earnings dropped 87% in Q3 ($73M vs. $586M) and 18% for the nine months ($1.98B vs. $2.41B). This was primarily due to a $788 million tax charge related to the repatriation of foreign earnings under the American Jobs Creation Act of 2004.
- Effective Tax Rate: The effective tax rate for Q3 2005 was 92.9% (vs. 13.6% in Q3 2004) due to the one-time repatriation tax. Excluding this charge, the rate would have been 16.7%.
- Restructuring: Restructuring charges increased to $112 million in Q3 (vs. $9 million prior year) and $119 million for the nine months (vs. $101 million prior year), associated with severance for approximately 1,450 employees.
- Segment Performance:
- ESS: Revenue up 20% in Q3; operating earnings turned positive ($150M) from a loss of $211M in the prior year.
- PSG: Revenue up 8% in Q3; operating earnings surged to $163M from $23M.
- IPG: Revenue up 5% in Q3; operating earnings declined to $771M from $836M due to margin pressure from pricing and product mix shifts.
Guidance, Outlook, and Risks
- Major Restructuring Announcement: On July 19, 2005, HP announced a plan to reduce its workforce by approximately 14,500 employees (10% of staff) over the next six fiscal quarters.
- Estimated pre-tax charges: $1.1 billion.
- Expected annual savings starting Fiscal 2007: $1.9 billion.
- An enhanced early retirement program in the U.S. resulted in ~3,200 participants at an estimated cost of $400 million, to be recognized in Q4 2005.
- Share Repurchases: HP repurchased 96 million shares for $2.1 billion in the first nine months. On August 25, 2005, the Board authorized an additional $4.0 billion for future repurchases.
- Accounting Changes: HP expects to adopt SFAS 123R (Share-Based Payment) in Q1 Fiscal 2006, which will require expensing stock options and is expected to materially impact earnings.
- Legal and Contingencies:
- Copyright Levies: Ongoing litigation in Germany and Greece regarding levies on printers and MFDs; HP has accrued amounts but outcomes remain uncertain.
- Patent Litigation: Settled disputes with EMC ($325M settlement via product purchases) and Intergraph ($141M settlement).
- Consumer Class Actions: Multiple lawsuits regarding "smart chip" inkjet cartridges and floppy disk controller errors.
Investor Verification Checklist
- Tax Impact: Verify the sustainability of earnings excluding the one-time $788M tax charge related to foreign earnings repatriation.
- Restructuring Execution: Monitor the timing and actual cost of the announced 14,500 employee reduction and the associated $1.1B charge.
- Margin Pressure: Assess the impact of declining Average Selling Prices (ASPs) in the Personal Systems Group and pricing pressures in the Imaging and Printing Group on future gross margins.
- Legal Exposure: Review the status of European copyright levy proceedings and consumer class actions regarding ink cartridges and floppy drives.
- Accounting Transition: Evaluate the projected impact of SFAS 123R adoption on Q1 Fiscal 2006 earnings per share.