Hewlett-Packard Financial Ratio Analysis: Profitability & Risk

Profitability Ratio Analysis

The industry in which Hewlett-Packard competes, according to MSN Moneycentral, is "diversified computer systems," and contains most of the major computer system manufacturers listed on the Nasdaq and the NYSE. This website also provides industry averages for a range of financial ratios. There are a number of different profitability ratios that can be analyzed. The first major set consists of the margin ratios, while the second major set consists of the return ratios.

HP's gross margin is 23.5%, compared with an industry average of 39.2%. This lag has been consistent over the past five years, with HP recording a five-year average gross margin of 23.8% and the industry recording a five-year average gross margin of 37.8%. While the industry has become slightly more profitable in recent years, HP has not. There has been only a slight decrease in the gross margin at HP over the course of the past five years. Four years ago it was 24.1%, so the decline is noticeable but not catastrophic.

The net margin for HP is 7.0%, compared with an industry average of 12.2%. The five-year average net margin for HP is 6.9%, compared with 10.6% for the industry. In this case, HP's average has improved only marginally while the industry has seen its net margins improve to a larger degree. Despite the slight decline in pricing power evidenced by the shift in gross margin, HP has improved its operating and net margins over the same time period. Operating margin has increased steadily from 7.1% five years ago to 9.1% at the end of the last fiscal year. The net margin has increased from 6.7% to 6.95% over that same period. This indicates that HP has been able to adjust its cost structure to meet the demands of its current operating environment. The company's selling, general, and administrative expense has fluctuated, but HP has steadily reduced its research and development expenditures over the past five years. More recent figures, despite being better for operating and net margin, were actually harmed by a writedown of $1.437 billion in fiscal 2010.

The return on assets for HP is 7.3%, compared with an industry average of 11.3%. This lag is also historic, although not as pronounced. The five-year average return on assets for HP is 7.6%, and for the industry it is 10.0%. The return on equity for HP is 21.6%, compared with an industry average of 48.9%. The five-year return on equity for HP is 19.6%, compared with 39% for the industry. Similarly, the company lags the industry on return on capital, recording 12% last year compared with 17.5% for the industry. Over the past five years, HP's return on capital is 13.3%, compared with an industry average of 16.1%.

In general, HP earns lower margins than other firms in the industry. That some of these margins and returns differ dramatically is in part expected, because HP is a legacy firm in the industry and has a higher cost structure and larger asset base than many of its newer competitors. It has differentiated itself over the years from other firms in the industry, so it cannot be expected to share the same metrics. That said, these statistics do indicate that there may be more attractive investment opportunities elsewhere in the industry.

Return Ratios and Equity Structure

Disaggregating HP's return on assets, the decline can be attributed to both falling profit margin and lower asset turnover over the past year. Only the improvement in inventory turnover has helped HP's ROA figure. The company has managed its SG&A expense, but has steadily lost pricing power over the past couple of years. If this trend is not related to the recession, it is a cause for concern — though there is no clear evidence that the lower margins HP is receiving are particularly persistent.

Understanding the investment return ratios requires an examination of the figures that underlie these numbers. While the company has been growing assets and liabilities, its equity was at a five-year low in fiscal 2010. This lack of growth in equity would be expected to prop up the ROE figure, and indeed the most recent ROE is higher than the five-year average. However, many other firms in the industry are in a much stronger financial position — the balance sheets of companies like Apple and Microsoft are impeccable, for example. HP's capital structure is weighted 67.5% debt and 32.5% equity, while the stronger firms in the industry carry little or no debt. Yet those firms still have a higher ROE. This indicates that the more significant problem may lie with HP's earnings. The company's much lower net margin relative to its industry peers supports the idea that, while HP's performance is not poor, it does not generate nearly as much profit as its peers — and this explains the persistent lag in HP's profitability ratios compared with industry averages.

An analysis must also be conducted of HP's risk ratios. The first category is short-term liquidity risk. HP's current ratio is 1.1, compared with an industry average of 1.2. The quick ratio is 1.0, compared with the industry average of 1.1. No industry average is available for the cash ratio, but HP's stands at 0.22. None of these numbers are poor, and they lag the industry by only a small margin. However, these figures do represent a long-run decline in HP's liquidity. The company's current ratio was 1.35 in fiscal 2006 and has generally slid lower since that point. The cash ratio shows the same pattern, falling from 0.46 in 2006 to its current level. The quick ratio has also declined, from 1.13 in 2006 and 0.83 in 2008 to its present level.

Short-Term Liquidity and Working Capital Ratios

While the natural assumption might be that HP's current ratio is too low — since it is only slightly above 1.0 — there are two mitigating factors. The first is that the industry average is almost as low. The second is that the quick ratio is typically close to the current ratio for HP. This is important because it means that the firm's solvency is not dependent on its ability to liquidate inventories.

Cash flow from inventories divided by average inventories is another ratio that can be used to assess short-term solvency. No industry averages are available for this figure. HP's 2010 ratio was 0.25, down from 0.28 in 2009, 0.31 in 2008, and 0.26 in 2007. These figures are relatively steady, but they also indicate that HP is at the low end of its historical range for this ratio. While the firm generates cash flows from operations despite its high level of current liabilities, it is also less able to meet its obligations than it typically has been. Either the company needs to generate more free cash flow or it needs to reduce its level of current liabilities.

The next set of ratios covers the working capital activity ratios. The receivables turnover was 6.2 times, compared with 4.5 times for the industry. The inventory turnover was 15.3 times, compared with 19.2 times for the industry. The asset turnover was 1.1 times, compared with 1.0 times for the industry. Over the past few years, HP has reduced its inventory by 19.5% from its high in 2007, while the cost of goods sold increased 21.8% in that time. Four years ago the inventory turnover rate was 10 times, so the past four years have seen a dramatic improvement in that metric. The receivables turnover, however, has dropped steadily over the past four years — it was 5.2 in 2007 and has declined to its current level. Return on assets has also declined steadily over the same period, falling from 1.25 in 2007. These ratios indicate that the company has struggled to utilize its working capital and total assets efficiently over the past four years. While HP has made strides in lowering its inventory levels — and therefore improving its inventory turnover rate — the trend in the other two working capital activity ratios indicates a decline in effectiveness.

That HP is having difficulty with its receivables turnover is not surprising given the economic downturn. Ideally, HP would stretch its accounts payable turnover to offset the increase in its receivables turnover. This has not occurred: HP's payables turnover has remained around its current rate of 6.6 times, with only a brief exception in 2009 when it was 5.8 times. Thus, while HP is effectively extending credit to its customers — presumably to help them through the recession — it is not extending its own credit obligations in the same way. With $10 billion in cash on the books, extending credit is not a necessity for Hewlett-Packard.

Conclusion and Stability Assessment

The lack of material changes is indicative of the firm's stability. While the economic downturn has taken its toll on many of the firm's key performance measures, HP is so large that it is unlikely to experience major changes in any significant line items unless it undertakes a sizeable restructuring. The company earns much of its revenue from servicing contracts and long-term relationships, which has contributed to its stability. The major point of concern is that most of the negative trends in the company's numbers began before the recession was underway. This calls into question whether the decline in performance is truly related to the financial health of HP's customers or whether the company is suffering as a result of increased competitive intensity or permanent changes to its operating environment.