Friends hi-fi system not very good, what do you do or say?

If you feel compelled to make any comments at all, I would ask them questions like,

• "how do you like the sound of your system, and what do you like most about it?"
• "how often are you able to listen?"
• "how do you like the source you are using (i.e., turntable, CD player, digital streaming, etc.)"
• "what new music have you heard lately?"

Rather than judge right out of the gate, try to understand first. 

You might realize it is a pretty good system for the money they are able to spend, or for the types of music they enjoy or, you might realize they simply don't know how to put together a good sounding system.  Even if you don't like it, simply enjoy your visit with your friend. 

OTOH, if they have heard your system and recognize you as an authority on audio systems, and if they really want your opinion then, baby steps.  With any feedback, it works much better if you try to find and start with something positive.  Find something, anything, you like about their system and compliment them, i.e., "I used to use those footers and really liked them" or "I always wanted to try those, what do you think?"  Develop some level of trust and rapport first and then provide your honest critical feedback in measured doses.  Even if pretty much everything about their system sucks, you could start with, "if I were trying to improve this system, I would consider new speakers" then "let's talk about what type of sound you like best and the options in your price range."

You said the person is a "friend" so treat them like one.

In the first visit never say any negative things about my friends system. It will hinder their aspirations to learn this hobby. You will loose the opportunity to share what you have if they took it personal.They will not incite you again.

I've been there. Say it's nice, then let them listen to yours. Let them draw their own conclusions. 

A friend has asked me for advice and I am perfectly willing to give it. However, I soon learned that he had made some decisions that aren't open for discussion.  His system is based on an Onkyo int. amp. and CD player, entry level phono player w/built-in phono preamp,  He has small three way floor standers, name not visible to me and forgotten by buyer.  He has basic computer streaming, but no external DAC.  No power conditioning.  All is connected with cheap cables and lamp wire.  The set up is in large room with a high slanted ceiling, hardwood floors, no rugs.  The speakers are placed against the front wall with maybe six inches clearance.  It sounds, well, like you'd expect.  Instruments and voices are indistinct with no identifiable sound stage.  There is perceptible itermodulation distorition.  Wall placement seems to be non-negotiable.  He is awaare that something isn't right and would like to fix it.  Rather than suggest new gear I am urging him to experiment with different speaker placements before he does anything else.  Once he discovers that his system can be improved with some simple set up changes -- Move the speakers away from the walls, maybe tilt them inward, and lay down a throw rug or two.  If he hears improvements than perhaps he will be OK with new speaker placement.  Or, at least he will know that he needs speakers that will accommodate his decorating preferences.  My expectation is that his basic Onkyo setup would sound OK if set up properly in a smaller room and might even be OK in his large room, even though, YES! I yearn to recommend some great bang-for-the-buck components we all know about, modestly priced power conditioning, better wire.  But that might be a bridge too far for my friend.  What is good enough to him might never satisfy me.  But if he's happy, why shouldn't I be?  I'd rather keep him as a friend than nag at him to improve his system along lines that I would like.  And besides, it's fun to go home, listen to my own gear, and smile.

In his 1880 essay, "On the Decay of the Art of Lying," Mark Twain suggests that people should lie thoughtfully and judiciously, with a good object, and for the benefit of others. He also suggests that people should lie gracefully, firmly, and frankly, with their head erect.