HPQ

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

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.