Long-suffering Hewlett-Packard (NYSE:HPQ) investors needed some good news, and they got it in the fiscal second quarter. While HP's revenue and margin performance was better than expected, as was management's updated guidance, there are still some substantial challenges ahead. Years of underinvestment in R&D have taken their toll and showy moves like mass-firings don't change some of the most pressing problems.

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While even very modest growth assumptions suggest HP shares are undervalued, investors shouldn't underestimate the company's challenges. Becoming a leader again in the teeth of competition from companies like IBM (NYSE:IBM), EMC (NYSE:EMC) and Apple (Nasdaq:AAPL) isn't going to be easy, and the Street is seldom enthusiastic about tech stocks that can't post strong revenue growth.

SEE: A Primer On Investing In The Tech Industry

Small Beats in Q2 Are Steps in the Right Direction
Bears may argue that the HP didn't blow anybody away this quarter, but the reality is that it was a good quarter.

Revenue fell 3% from last year, but rose 3% sequentially and beat most estimates by around $1 billion. A lot of this outperformance came from the PC business, where revenue was basically flat with last year. Printing was quite weak (down 10%), while services was a bit soft (down 1%) and ESSN (enterprise, storage, networking) was down 6%.

Margins weren't bad for a company in the midst of a major restructuring. Gross margin improved nearly a point from the first quarter, while falling about a point and a half from last year. Reported GAAP operating income and adjusted operating income performance were directionally similar - both declined from last year by more than 20%, while showing a single digit sequential increase.

SEE: Make Money Trading Earnings Announcements

Is PC Outperformance Sustainable?
Compared to Dell (Nasdaq:DELL), HP had a significantly better quarter in PCs. In fact, HP stacked up pretty well against Lenovo as well. The big questions, though, revolve around sustainability and relevance.

With Dell and Lenovo showing weaker shipment numbers and retailers like Best Buy (NYSE:BBY) showing pretty poor sales, did HP put too much into the channel? And even if that's not the case, are PCs really a growth business in the face of smart devices from Apple and Samsung? I would argue that the demise of the PC has been exaggerated, but time will tell.

It's also worth noting that success in the PC business is a mixed blessing in terms of margins. The PC business is far and away the lowest-margin business at HP. While combining the PC and printing business could produce some cost savings, this isn't a market that's going to lead HP's long-term turnaround.

SEE: Will The Personal Computer Industry Ever Rebound?

Mixed Messages Here and There
HP's service business performance was so-so - not as good as IBM's first quarter, but better than Dell's performance. Some of this seems to be due to deliberate trade-offs, opting to turn away less lucrative business.

Likewise, the performance of the storage business is mixed. Relative to IBM and Dell, HP is doing quite well. Relative to EMC or NetApp (Nasdaq:NTAP), the company is lagging. While HP's high-end business seems to be competitive (thanks to 3Par), I do wonder if HP is going to have to spend a fair bit more capital to broaden and deepen its offerings so as to better compete with EMC's high-end business.

Last and not least is the software business. Growth looked good (up 22% annually and 3% sequentially), but the underlying trends don't seem as positive. Management noted weakness in the Autonomy business; while disruptions in the aftermath of acquisitions are commonplace, this business needs to start performing a lot better to validate the premium HP paid for it.

SEE: Biggest Merger And Acquisition Disasters

The Bottom Line
Investors seemed to like the news that HP will be cutting its workforce by 27,000 people and re-investing a lot of the savings into the business. I can appreciate the need to free up capital for catch-up spending in R&D, but I don't believe mass-firings really work in the long run for most companies.

Nevertheless, HP shares don't look at all expensive today. Even just 1% compound growth in free cash flow over the next decade would suggest that the shares are substantially undervalued. The question, though, is whether they can do that. The PC and printing businesses no longer seem capable of supporting much growth at all, and the company still has a lot of work to do in improving businesses like services, storage and networking - improvements that have more to do with features and capabilities rather than firing tens of thousands of workers.

I'm going to wait at least a little longer before taking a flyer on these shares. I do see the capital gains and turnaround potential, but I need to hear more from management about how they mean to compete on the top line before getting more confident about the turnaround prospects.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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