The earnings shortfall that Hewlett-Packard announced on Monday morning packed a double whammy.
Not only did the company miss the Street’s earnings forecasts by a dime per share, which is longer than a country mile by Wall Street standards, but it also blamed its failure to spot the problem sooner on a new financial management system.
The software wasn’t actually implemented until Nov. 1, the day after the company’s fiscal fourth quarter closed, but HP said that during a transition phase leading up to the implementation, the new system failed to accurately disclose that the company’s revenue mix was shifting toward lower margin products such as personal computers.
Over the weekend, HP’s board also decided to scrap its ambitious plan to buy the consulting business of PricewaterhouseCoopers for $18 billion.
How serious was the software problem, and will it do lasting damage to HP’s dealings with Wall Street? It’s hard to say.
“It’s worrisome,” says Shebly Seyrafi, an analyst with A.G. Edwards. “The last thing an investor wants to hear from management is that controls weren’t up to snuff.”
“It is a little troubling that they don’t have visibility into their businesses,” says Art Russell, an analyst with Edwards Jones. “But I’m not sure I’d blame it on the new system.”
Russell says the company may have been so focused on its attempt to acquire PwC that it lost sight of its revenue picture at a time when its sales force was aggressively pushing low-margin items like PCs and printers.
Exactly what went wrong with the financial management system isn’t clear. The company didn’t provide many details, and a spokesman for HP said neither Robert Wayman, its CFO, nor the company’s recently hired chief technology officer, Richard DelMillo, would be available for interviews.
“We’re not in a position where we can talk about it,” said the spokesman.
Wayman has been in the CFO’s spot for 14 years and with the company for 21. He’s also well regarded on Wall Street, as is his boss, chief executive Carly Fiorina, who in her first four quarters on the job, beat estimates each time.
The failure to (once again surpass estimates) is costing her some hard won credibility, and she isn’t going to win it back easily.
Should HP have recognized the problems sooner? The verdict from Wall Street is, “Absolutely.” Now that the company has tripped over its own software, it will have to work overtime to regain its credibility with Wall Street.
In fairness to HP, it did take the unusual but helpful move of speeding up its earnings announcement once it learned of the extent of its earnings disappointment over the weekend. The company released its fourth-quarter results Monday morning before the market opened. It had been scheduled to release its results Wednesday after the market closed.
Given that HP is being so tight lipped about its software problems, it’s difficult to assess what financial software the company has, either in the new system or the one that was replaced. That also makes it virtually impossible to understand exactly what failed in the systems in recent weeks. Several analysts contacted for this story said they were not aware that there was any problem lurking in the company’s management reporting systems until Monday’s conference call.
Granted, it’s not unheard of for companies the size of Hewlett-Packard to switch accounting systems, and it’s hardly a unique situation when a new system is loaded with bugs. But it is unusual that a new system would foul up management’s ability to track the firm’s performance and undermine its ability to give the Street adequate guidance.
“I’ve seen that happen in a few other cases where a company has installed a new financial reporting or ERP system, and the bugs aren’t out of it yet,” says Joseph Beaulieu , a senior analyst at Morningstar. “Even a small mistake in a query can give you the wrong result.”
While Beaulieu is reluctant to blow the incident out of proportion, he says, “I definitely think the burden of proof is on them.” It may take HP a quarter or more before it returns to Wall Street’s good graces.
It doesn’t help that the market has been plagued by a bearish mood for the past seven months. Beaulieu says, “The market is not giving anybody the benefit of the doubt these days. They’re going to have to have show some very good cost control efforts.”
In the scheme of things, HP is hardly in financial trouble. The company’s net income for the fiscal fourth quarter ended Oct. 31 grew 21 percent to $922 million on17 percent revenue growth to $13.3 billion. For the full year, the company’s net income rose 6 percent to $3.7 billion on sales of $48.8 billion. IBM is the only U.S. technology company that’s larger in terms of sales.
But perception is everything on Wall Street, and when the Street is expecting net income of 51 cents per share, as it did with HP, and only sees earnings of 41 cents per share, that company is going to pay dearly for the disappointment.
On Monday, HP’s stock fell $5, shaving 20% from the company’s market capitalization.
Still, some additional perspective may be in order here.
“We have real strong feelings that both the media and analysts are putting too much emphasis on estimates and guidance,” says John Waterman, chief investment officer for Rittenhouse Financial. “People are looking at the world with one standard and expecting perfection.”
“To try to forecast quarter by quarter down to the penny is unreasonable,” he adds. “The 51 cents was an estimate and people are acting like it was etched in stone.”
It may be reasonable to expect precision when forecasting the performance of a consumer goods company like Procter & Gamble, but it’s not so practical to precisely forecast earnings each quarter for large technology firms that sell into multiple markets, Waterman says. “We don’t do it for Hewlett, and we don’t for any tech company,” he adds.
Still, for HP, which by virtue of its size and product mix is one of the handful of tech sector bellwethers and a component in the Dow Jones Industrial Average, the foul-up is worrisome.
If a company of HP’s stature can mess up like that, then who isn’t vulnerable? Moreover, HP sells technology. If it can’t manage its own products properly, what does that suggest about the company’s products?
Finally, the earnings disappointment occurred barely four weeks into the brave new world of Regulation FD, the Securities and Exchange Commission’s attempt to level the playing field between large institutional shareholders and retail investors. HP was one of the few companies to spell out in writing its policies on Reg. FD in a mid-October letter the company’s investor relations staff sent to analysts. The company told analysts that it would provide less frequent guidance to the Street in order not to run afoul of regulators.
But HP is also a company with something of a soiled past. It was only a few years ago it ran off a string of earnings disappointments, souring its relations with the Street. When Fiorina was hired in the spring of 1999, one of her first priorities was to get a better grasp on the company’s performance and improve its guidance for investors.
If the new software was part of that initiative from Fiorina, then there’s obviously some work that needs to be done.
In addition, one of Fiorina’s first moves was to switch HP’s compensation package for its salespeople. The company scaled back base pay in favor of higher commissions. But the commission incentives may have fueled some of the surge in revenue from low-margin PCs that helped the company meet its sales forecasts for the quarter, but squeezed margins.
At any rate, HP now has to demonstrate not only that its control of operations is sound, but it has to improve its performance as the business environment is getting tougher. The economic expansion of the 1990s may be running out of fuel; growth in the PC sector is slowing and with so many failures in the dot- com sector, the demand for Internet servers is weaker than it was a year ago.
Russell says HP’s management is going to have to work overtime to convince Wall Street that it has fixed its problems. “You need better visibility into the business,” he says. “That they don’t have it is troubling. I’m not sure what took so long to understand the full picture.”