International Business Machines Corp. (NYSE:IBM) derives most of its revenue from software and services, though, so the threat is not nearly as large as it is for HP. IBM’s transition into a software and services company is the model for the HP transition, but so far progress has been slow.
The enterprise-services group, which includes IT outsourcing, has both shrinking revenue and PC-like margins. HP is betting on new cloud services within this group, which are growing quickly, but the segment as a whole will continue to weaken until these new services gain traction.
Software is the only group which grew in the quarter, although barely. Operating margin is high at 20.5%, but because the group is so small it contributes about as much to total operating profit as PCs contribute. Services and software are supposed to be the future of HP, but so far they offer little hope.
Competitor Xerox Corporation (NYSE:XRX) has actually done a better job of transitioning into a services company than HP has done. Best known for its photocopiers and printers, Xerox now derives more than half of its revenue from services. In the most recent quarter, Xerox grew services revenue by 5% year-over-year with an operating margin of 10.2%. These are numbers that HP can only dream of.
One area of Xerox Corporation (NYSE:XRX)’s business which is particularly strong is health care solutions. Xerox works directly with 31 states and Washington, DC, providing services such as fraud and abuse prevention and to analytics and reporting. Xerox’s services are used by over 1,500 hospitals, and a full two-thirds of insured patients in the United States are served by Xerox.
As the Affordable Care Act becomes fully implemented, with its penalty for being uninsured, the number of U.S. citizens with health insurance should rise considerably over the next few years. With Xerox Corporation (NYSE:XRX)’s significant presence in the health care industry it stands to reason that the company will benefit from this development.
Deceptively cheap
One encouraging trend for HP is its decreasing debt. Net debt has dropped from $19.5 billion a year ago to $11 billion today, a significant improvement.
Including this net debt, HP’s enterprise value after the post-earnings decline is roughly $54.5 billion. The company expects free cash flow of about $8 billion this year, putting the EV/FCF ratio at about 6.8.
If HP could maintain its current level of profitability going forward, it would be a great value. But, unfortunately, that does not appear to be the case. The units that make up the bulk of HP’s profits are declining, and it will likely take years before there’s any chance of the company turning the corner.
The HP turnaround is a multiyear process that, if successful, will not be complete any time soon. Revenue will continue to decline, taking profits with it, and this makes buying the stock unappealing.
The bottom line
HP would need to look outrageously cheap for me to have any interest in the stock, and right now it’s not cheap enough. Trying to predict how far the profits will fall is not a game that one shouldn’t play, especially when one cannot ascertain where growth is going to come from.
The article Why You Should Avoid This Deceptively Cheap Tech Dinosaur originally appeared on Fool.com and is written by Timothy Green.
Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
