HP 'Miracle Margins' Update

(By Anthony Miller – Wednesday 19th August 2009 5:30pm). I just don’t understand why nobody on the analyst concall asked the question I asked in my post last night (see HP Services miracle margins) i.e. how much further does HP management think it can push services margins? Or even, how long do they think they can keep services margins at 15%+? The only clue we got was when CFO, Cathie Lesjak, implied that most of the 1.4 pts of services sequential margin gain came from EDS, but the 2.3 pts yoy gain was pretty much shared between Technology Services (i.e. break/fix) and EDS.

Now this is telling. Today TS comprises 28% of HP’s services business and ought to be the most profitable part. They are doing a lot of work to automate fault detection and repair, and this seems to be having the desired effect on profitability. But judging from Lesjak’s comment, it sounds like most of that work has been done, i.e. there’s not much more margin benefit to be gained.

Which leaves the ‘real’ IT services bit. This breaks up as follows: 65% is IT outsourcing, 23% is application services, and 12% is BPO. In other words, most of the rest would also be contracted revenues. They’ve already sacked 16,000 people and it seems there are another 9,000 to go. The way HP reports operating margins (as do many others, to be fair) excludes so called ‘one off’ restructuring costs (and don’t get me on that soap box again, purleez!). Therefore, HP can show immediate margin benefit the moment the sacked employees are off the books. But the contracted revenues are still, for the most part, rolling in. Hence ‘miracle margins’.

But of course to sustain these margins, the staff that are left have to continue to deliver the same service volumes at the same service levels. And then let’s not forget, customers are still demanding ‘more for less’. Even assuming that there was real ‘dead wood’ being chopped, it sounds like there are some generous assumptions being made on productivity improvements for those services employees still with jobs. Whether they can deliver will only become apparent over the next few quarters.

Pre-EDS, HP’s services margins were typically in the 10-12% bracket, when break-fix was 50% of the business. EDS’ margins were 5%. By the way, IBM’s services business hit 14.4% pre-tax margins last quarter (i.e. including any ‘nasty bits’), and they have richer mix of higher value (i.e. higher margin) services than HP.

Undoubtedly there was scope for margin improvement in the combined HP/EDS services business. But once all the restructuring is complete, and HP is no longer able to hide behind these costs to flatter its services profitability, I just cannot see how a 15%+ operating margin is sustainable. I ask again, why isn’t anyone else challenging management on this? HP Services is, after all, the biggest profit generator in absolute terms in HP’s business.

One last point. There was media speculation just prior to the Q3 results announcement that HP is thinking of selling parts of its outsourcing business, notably BPO. Frankly, it probably should. It’s one thing to host a customer’s HR or payroll application - and there’s no reason why HP shouldn’t be able to do that as well as the next IT outsourcer. Indeed, this is one way that IT outsourcers look at playing in the 'cloud'. It’s quite a different matter to optimise, perhaps re-engineer, and then take over the running of all or part of a customer’s HR function. That's real BPO. That’s not HP’s ‘knitting’. I doubt it ever will be.