HP's servers and storage hit a wall in Q2

Global economy, legal entanglements to blame

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Hewlett-Packard reported its second quarter financial results for fiscal 2009 ended in April. Like other IT players, HP's server and storage sales were slammed by the economic downturn and intense price competition that is the result of the poor economy.

The company's Enterprise Storage and Server group, which is trying to poach EMC executive David Donatelli to take over as its general manager, posted $3.46bn in sales in the second fiscal quarter, down 27.7 per cent from the same period a year ago.

The drop in sales and the cut-throat competition in the server and storage racket has eaten mightily into profits. Earnings from operations for the ESS group fell 61.8 per cent to $250m. IBM's Systems and Technology Group, which sells storage and servers as well as OEM chips and other tech, reported an 80.7 per cent drop in pre-tax income in its first quarter ended in March to a mere $28m - and that is with mainframes and big Unix boxes helping out on the profit side.

HP does not report pre-tax income for its various groups, but if you allocate the overhead of HQ, amortization, restructuring, and other costs above and beyond operations costs proportionately to revenue, then the ESS operating income would be hit with around $177m in additional costs, yielding around $133m in pre-tax earnings.

For all we know, ESS took a much larger hit than this, but the point is that big servers are not shoring up profits at either company when volume server sales are collapsing.

Drilling down into revenues within the ESS group, the Industry Standard Server division, which makes ProLiant and BladeSystem x64-based servers and which is the volume engine of the HP server operation, saw sales plummet by 29.5 per cent to $1.99bn in the quarter. The company's Business Critical Systems division, which peddles Itanium-based Integrity and NonStop servers, with a smattering of HP 9000 and AlphaServer gear, had a 29 per cent revenue decline in the quarter, to $650m. The Integrity line declined only 18 per cent, however.

This was comparatively good compared to the sales of ProLiant rack and tower servers. HP said that blade sales also held up relatively well, only dropping 12 per cent in fiscal Q2. (HP sells Itanium and x64 blades, and that number cuts across both the ISS and BCS divisions.)

Cathie Lesjak, HP's chief financial officer, also said that margins in the server business were pressured by lower volumes and tough market conditions, and then added in the effect of some litigation relating to RISC servers.

Specifically, Lesjak said that HP's operating profits in the ESS group were impacted by litigation charges relating to an intellectual property lawsuit between the company and Cornell University. On March 30, HP filed an appeal in the U.S. Court of Appeals to try to get a decision in the U.S. District Court for the Northern District in Syracuse (New York) reversed. It ruled that HP's PA-8000 series of processors had infringed on patents relating to parallel processing which are controlled by the university.

If you don't remember the case in question, it is because Cornell filed its patent infringement lawsuit against HP at the end of 2001, concerning a patent that expired in February 2006.

A jury in a Syracuse court, presided over by Judge Randall Rader, found that HP had infringed on Cornell's patents, and the judge calculated and awarded $184m in damages in May 2008. But in March this year, Rader said he had calculated the damages incorrectly and reduced the award to $53m. Cornell is now appealing that ruling.

HP said on April 10 that it is appealing the original decision and would book a charge against Q2 earnings to cover its legal costs and reserves in the event it loses the case. That was roughly 2 cents per share, and if you work the maths out backwards, that is a $47.9m additional reserve. Half of that amount hit ESS operating profits, according to HP.

On the storage front, HP said that its StorageWorks division posted a 22 per cent drop in the quarter, to $829m, with midrange EVA disk array sales falling 21 per cent. Lesjak blamed the decline in storage on "unfavorable currency exchange rates" and "market conditions."

HP's Software group, which is closely aligned to its systems business, posted a revenue decline of 15.3 per cent in Q2, to $880m. But earnings from operations rocketed up 51 per cent to $157m, a relative bright spot on the systems side at HP.

The company's Financial Services group, which is seeing a spike in activity as companies lease equipment instead of spending their own cash to upgrade IT gear, nonetheless had a 6.4 per cent revenue decline to $641m. Operating profits for Financial Services held up pretty well, through, only dropping 2.1 per cent to $46m. Lesjak said that the decline in revenues at Financial Services was mainly due to currency effects.

Mark Hurd, speaking on a conference call with Wall Street analysts after the market closed and after HP announced it would be cutting another 2 per cent of its workforce, said HP was staying focused on gaining market share. "We like our chances - when the rebound does occur - to be a major participant in the market when that occurs because of what we're doing right now," Hurd said. "And I say again that the winners, when the rebound occurs, are determined in the downturn."

That said, the ESS business is under pressure, perhaps as much pressure as was brought to bear when HP acquired Compaq right smack dab in the middle of the dot com bust and a number of server product transitions at both companies.

"We have customers that tell me, we're just delaying as long as we can until we have to buy," explained Hurd. "And we've got a pretty good model that looks at what those time frames are that people can put things off to." And rather than expecting some sort of upswing in enterprise spending that will magically appear before the end of the year, Hurd explained that he was more interested in what the discussions for IT budgets for the 2010 calendar year would look like as HP's customers start their planning cycles for next year around August and September.

"I think CIOs have been given marching orders that say 'take that infrastructure and keep that infrastructure running. If you have to replace things to keep things running, replace it. But for new projects, be very particular about new projects you start. And if you can avoid starting that project, avoid starting it.'" ®

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