Industry insiders said merging Hewlett-Packard and Compaq would create a supersized hippopotamus: slow, clumsy, and easy prey. They said Carly Fiorina would never reduce enough costs to compete with Dell and IBM. They said Sun Microsystems and IBM would own the high-end enterprise, Dell would dominate the market for consumers and small businesses, and, eventually, HP would get squeezed out as each side moved to the middle.

Well, guess what? It looks like they may be all wrong.

Although you may think of HP primarily in terms of printers, enterprise hardware, laptops, and desktops, that's not an accurate representation of its business. Instead, think ink and services. The hardware just gets HP in the door, and if money can be made, great. If not, well, that isn't the point.

The imaging and printing division--that is, the ink--accounted for 75% of HP's profits in the fiscal year ended in October, while the services division comprised the rest. Despite having been mired in losses for a long time, the other areas were about breaking even for the entire year and are now achieving modest profitability for the third quarter in a row. HP has saved $3.5 billion in costs since the merger, which is $1 billion more than it expected and a year ahead of schedule. Furthermore, the company released 660 new products last year.

One big knock against HP is the fact that Dell is teaming up with Lexmark in the consumer printer market, which some see as disaster for HP's cash cow. Yes, HP's market share for all-in-one products has been reduced from 55% a year ago to 50%, but this is a nicely growing market, especially with digital photography and color printing becoming more popular.

Managed services continue to see strong growth, but HP's higher-margin consulting and integration is awakening from a long winter's nap and could drive revenue and profits higher. HP signed a $3 billion outsourcing deal with Procter & Gamble last year, and a large deal with British Telecom was inked in the second quarter of fiscal 2004, which ended in April. Despite falling margins at competitors, HP's services division held its operating margin steady this quarter.

Interestingly, the enterprise division sold 32% more servers than last year; this compares with 24% unit growth for Dell. HP bought some market share as its prices were down 13% versus only 2% at Dell. HP's reduced costs are allowing for competitive pricing, and this division's operating margin doubled, to 3%. Personal systems grew 19% for notebooks and 13% for desktops, but lost market share to Dell. HP believes it can significantly improve its operating margin from 0.7% to 3% to 4%, which may be difficult to achieve.

From a valuation standpoint, HP is trading at 14 times this year's earnings-per-share estimates and 12 times next year's EPS. This gives little credit to the $8 billion in cash sitting idle on HP's books, 13% of the company's market capitalization. On top of all this, the stock trades at only 10 times 2003's operating cash flow. In my opinion, investors have HP all wrong: The stock may be undervalued at current levels.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected]. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.

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