Hewlett-Packard's CEO Discusses Q1 2012 Results - Earnings Call Transcript - Seeking Alpha

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Executives

Steven Fieler -

Margaret C. Whitman - Chief Executive Officer, President and Director

Catherine A. Lesjak - Chief Financial Officer and Executive Vice President

Analysts

Benjamin A. Reitzes - Barclays Capital, Research Division

Bill C. Shope - Goldman Sachs Group Inc., Research Division

Brian G. Alexander - Raymond James & Associates, Inc., Research Division

Shannon S. Cross - Cross Research LLC

Keith F. Bachman - BMO Capital Markets U.S.

Richard Gardner - Citigroup Inc, Research Division

Maynard J. Um - UBS Investment Bank, Research Division

Kulbinder Garcha - Crédit Suisse AG, Research Division

Hewlett-Packard (HPQ) Q1 2012 Earnings Call February 22, 2012 5:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2012 Hewlett-Packard Earnings Conference Call. My name is Jeff, and I'll be your conference moderator for today's call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Steve Fieler, Vice President of Investor Relations. Please proceed.

Steven Fieler

Good afternoon. Welcome to our first quarter 2012 earnings conference call with Meg Whitman, HP's Chief Executive Officer; and Cathie Lesjak, Chief Financial Officer. Before handing the call over to Meg, let me remind you that this call is being webcast. A replay of the webcast will be available shortly after the call for approximately one year. Some information provided during this call may include forward-looking statements that are based on certain assumptions and are subject to a number of risks and uncertainties, and actual future results may vary materially. Please refer to the risks described in HP's SEC reports, including our most recent Form 10-K.

The financial information discussed in connection with this call, including tax-related items, reflects estimates based on information available at this time and could differ materially from the amounts ultimately reported in HP's first quarter Form 10-Q. Revenue, earnings, operating margins and similar items at the company level are sometimes expressed on a non-GAAP basis and have been adjusted to exclude certain items, including, among other things, amortization of purchased intangibles, restructuring charges and acquisition-related charges. Comparable GAAP financial information and a reconciliation of non-GAAP amounts to GAAP are included in tables in the slide presentation accompanying today's earnings release, both of which are available on the HP Investor Relations web page at www.hp.com.

Before I turn it over to Meg, I just wanted to briefly touch upon a financial reporting item. Each year, as part of our first quarter annual financial review, we review all reported segments and make any necessary changes to reflect any organizational shifts among our businesses. This year, these re-alignments resulted in the transfer of revenue and operating profit the Services, Imaging and Printing Group, Enterprise Servers, Storage and Networking, Software and Corporate Investments segment and a transfer of revenue among the business units within the Services segments. In addition, we have reclassified certain costs previously reported as cost of sales as selling, general and administrative expenses to better align these costs with the functional areas that benefit from those expenditures. This reclassification of costs did not impact segment reporting and relates only to the line item within the P&L in which the costs are booked. A detailed reconciliation of the changes, including historical data, is available on our Investor Relations website as well as furnished on our Form 8-K filed with the SEC. I want to be clear that the changes do not impact HP's previously reported consolidated net revenue, earnings from operations, net earnings or EPS. I'll now turn the call over to Meg.

Margaret C. Whitman

Thank you, Steve, and thanks to all of you for joining the call. Since I spoke to you last, I spent a great deal of time with our employees, our customers, partners and investors. Given some of the challenges of the last year, we've been working hard to set the right tone, calm the waters and reassure our stakeholders that HP is the same reliable company that they've known and admired for decades. I visited HP offices, hosting roundtables and employee meetings in Palo Alto, Cupertino, London, Vienna, Chicago, Houston, London and Alpharetta, Georgia. I spent some time with the sales force, communicated regularly with our senior leadership and worked very closely across the executive team. And I've been out with our customers. At HP DISCOVER in Vienna, we brought together more than 7,000 of our top enterprise customers in the biggest event in HP's history. And I participated in more than 80 customer visits, meetings and conversations. I've engaged with the channel through partner meetings, roundtables, interviews and, just last week, at the first-ever HP Global Partner Conference.

So what have I found? Certainly, I found some skepticism. But I have also found that we have incredible support. People who believe in HP, people who want us to win, people who want to work with us and build for the future. And every day, I learn something new about our technology and innovation, our solutions, often just a story about the role HP has played in someone's life or a customer's success. It's inspiring. The more time I spend listening and learning, the more committed and passionate I've become. I've also gotten to know many of you, our investors. And just as I have with our other stakeholders, I'm working hard to strengthen our clarity and transparency. I want you to understand where we're taking HP and why. Most of all, I want to set HP on a path to continue to meet and exceed our expectations for the longer term. I believe we've started on that journey during the past few months, but we have a long road ahead of us.

Back in November, we set the outlook. We said we had a lot of work to do, and we detailed the headwinds that were likely to pressure our business in 2012, including a hard drive shortage and an uncertain macroeconomic environment. In Q1, I think our performance, by and large, tracks pretty close to those expectations. The headwinds we discussed did impact performance, contributing to a decline in revenues, operating margins, cash flows and earnings year-over-year. That said, we met our guidance and delivered non-GAAP diluted earnings per share of $0.92 and revenue of $30 billion. Frankly, it was a tough quarter, and every business had its challenges. In PSG, the hard drive shortage and continuing difficulties in China contributed to a revenue decline of 15% year-over-year. With the supply challenges, we focused on profitability rather than market share and did a good job of delivering an operating margin of 5.2%.

PSG is important to HP. It gives us great return on invested capital and a lot of synergies. During the quarter, we also saw PSG returning to its roots as an innovation leader. With the introduction of the Spectre ultrabook, HP won the prestigious Best of Show at the Consumer Electronics Show in Las Vegas a few weeks ago. We need more of that. We need to keep driving innovation that generates desire and demand with our customers. The fact is that for all that's right with PSG, we underinvested in innovation for the last several years, and we've been late to market too often. We have to lead again.

In Imaging and Printing, year-over-year revenues decreased 7% with declines in supplies and hardware in consumer and commercial. And operating margin declined to 12.2%. All of you know IPG has been the lifeblood of our company for a long time with great margins and very resilient revenues. And IPG is still a great HP business, the undisputed leader in the printing and imaging industry and well positioned to capture the shift from analog to digital. But we also have to recognize that the business is being pressured on multiple fronts, and revenues from our adjacent businesses, like commercial digital prints, are doing quite well, but not developing fast enough to replace the revenues we've been losing. We have work to do here and are aggressively exploring ways to build on IPG's leadership given the realities of today's marketplace.

In ESSN, revenues declined 10%, and operating margins fell to 11.2% year-over-year. Industry Standard Servers revenue was down in a highly competitive environment that was compounded by the hard disk shortage. Business Critical System revenues also declined as we continued to address the Oracle Itanium situation. 3PAR delivered another terrific quarter; but in our broader storage business, we're still working through a product transition. And our networking business remains well positioned in a high-margin category.

Although the overall market was challenging, we're really excited about some of the innovations we're bringing to our customers. We've launched some great new products like the ProLiant Gen8, the industry's most self-sufficient line of servers. We believe that this is just the type of game-changing innovation that can help us regain our momentum in the category.

In Services, year-over-year revenues were up 1% while operating margins declined to 10.5%. This continuing margin pressure in Services really goes straight to a couple of our major challenges, like resource utilization and business mix. We're focused on transitioning to more profitable services while enhancing our systems, processes and sales force. Last quarter, we characterized Services as a long-term effort. That journey continues.

In Software, with the addition of Autonomy, revenue grew 30% year-over-year with a 17.1% operating margin. The Autonomy acquisition is going well. And we're continuing to grow our set of assets from information management to our IT Performance Suite, including security, management of hybrid clouds and application life cycle management.

Software is a critical part of our portfolio and of our forward-looking strategy. It amplifies, differentiates, optimizes and secures our core infrastructure, builds on our solution capabilities and expands customer relationships. For example, with an asset like Autonomy, we see potential synergies across the entire portfolio in IPG, ESSN, Services and in other Software assets like security.

Now from a macroeconomic standpoint, we're seeing an uncertain environment. In the U.S., there are some signs of economic improvement, but we're still experiencing a weak consumer market and commercial customers who are investing cautiously. In Europe, the Middle East, Africa and APJ, conditions are mixed. We remain guarded about Europe, but some of the larger economies do seem to be stabilizing.

When we last spoke at the end of Q4, I've been CEO of HP for about 8 weeks. Now coming out of Q1, it's closer to 6 months, and my perceptions of the business have evolved in that time. Some of that has to do with the external environment. But I also have a clearer picture of the work we need to do in our business.

In my mind, I put the issues into 3 buckets. First is fixing our execution, ensuring we have the right systems, processes and people. This includes things like optimizing our supply chain, including SKU reduction, to remove unnecessary complexity from the way we design, manufacture and deliver products; upgrading our sales tools and systems to respond more quickly to customers; and increasing the productivity of our sales force by rationalizing our go-to-market.

The second bucket is about addressing ongoing issues in each of our businesses, from IPG to PSG to ESSN to Services. We didn't make the investments we should have during the past few years to stay ahead of customer expectations and market trends. As a result, we see eroding revenue and profits today. We need to invest now as a market leader from a position of strength. And that's especially true because these businesses are not only under intense competitive pressure, but are also under pressure from tectonic shifts that are taking place at the very foundation of the industry.

And that's the third bucket, how we deal with these industry shifts. We are at an inflection point where the delivery, consumption and business model for technology are all being redefined. Long-established profit tools are under pressure, and other profit tools are forming fast. We need to move quickly to capture emerging opportunities in areas like cloud, security and information management. We've already assembled some formidable assets. Now we need to align our portfolio to deliver a new generation of capabilities.

We see a once-in-a-generation chance to define the future of technology and position HP as a leader for decades to come. But to seize this moment, we have to stabilize financial performance. That's really at the heart of any discussion of business fundamentals, generating enough profit to invest for the future and deliver solid returns for your investors, all underpinned by a disciplined capital allocation strategy. And it's clear, from both our revenue and margin profile, that our current cost base just isn't affordable. On the current trajectory, we just won't have the capacity that we need to invest. For years, we've been basically running our business in silos. And under that model, we built some of the leading franchises in technology, but it's also made us too complex and too slow. Yes, some of the obvious costs were dealt with in recent years, but there are still much more that we can do to streamline operations. Even more promising is what we can accomplish by tackling our business processes. We need to standardize, optimize and automate many of our processes, which will allow us scale the business without increasing costs at the same rate. We can also take a ton of complexity out of the system, improve our effectiveness and significantly reduce costs.

It's not easy work and it's not a quick fix, but it holds the potential to improve the way we operate and execute, and it simply has to be done. We have got to save to invest. We have got to save to grow.

In the near term, our focus remains on stabilizing the business, driving execution and getting back to basics, like aligning our cost structure with our revenue profile. Longer term, we'll invest to capture opportunities in cloud, security and information management that will position HP as a leader for decades.

We have a lot of work to do. I've gained visibility into the business over the last few months, and I feel very good that we know the challenges, we know what we're going to do about them and we're headed in the right direction. After the time I've spent with our stakeholders, I am increasingly confident and optimistic about what we're doing. We have incredible strength and an incredible community of people who care deeply about HP. With their support, we've embarked on rebuilding HP in a thoughtful way that is true to the spirit of innovation, financial discipline and financial success that has defined this company.

I have no doubt that we'll turn HP around. I look forward continuing our dialogue about HP's progress in the coming quarters, and I appreciate your continued support for our company. And with that, I'll turn it over to Cathie for some additional color on our Q1 performance.

Catherine A. Lesjak

Thank you, Meg. Let me review the details of the quarter, and then I'll provide some color on our outlook for Q2.

Revenue of $30 billion was down 7% as reported or 8% in constant currency year-over-year. We estimated that more than 1/2 of the revenue decline was due to the hard disk drive shortage that impacted both PSG and ESSN. As you know, due to the flooding in Thailand that began last fall, the industry's supply of hard disk drives was about 30% below the expected demand in calendar Q4. Faced with this shortage, we made the decision to prioritize profitability, product performance and quality over shipment volume and market share. We expect the supply of hard disk drives will remain constrained for HP in Q2.

In terms of our revenue performance by geography, revenue as reported was down 9% in Americas, 4% in EMEA and 10% in Asia Pacific year-over-year. All regions were impacted by the hard disk drive shortage. In addition, EMEA revenue was impacted by the macro challenges, and APJ's revenue decline was driven by the weakness in China. On a constant-currency basis, Americas, EMEA and APJ revenues were down 8%, 5% and 12%, respectively, year-over-year.

Non-GAAP gross margin of 22.4% was down 210 basis points year-over-year and down 90 basis points sequentially. Non-GAAP gross margins continue to be impacted by the strong yen, a lower mix of ink supplies, competitive pricing in our hardware businesses and continued margin pressure in Services. Non-GAAP operating expenses were $4.2 billion, up 6% year-over-year. If we exclude the impact of the real estate gains that drove our operating expenses down in Q1 last year, operating expenses were essentially flat year-over-year. Non-GAAP operating margin of 8.6% was down 380 basis points year-over-year, and the company delivered $2.6 billion in operating profit.

The bridge from operating profits to our earnings per share includes the following: other income and expense yielded a net expense of $221 million; our tax rate was 22%; and we used $780 million to repurchase 29 million shares, bringing our weighted average share count to 1,998,000,000 shares, which is down 10% year-over-year. As a result, we exceeded our guidance in the quarter, delivering non-GAAP diluted earnings per share of $0.92 and GAAP diluted earnings per share of $0.73. The majority of the difference between GAAP and non-GAAP earnings in Q1 was amortization of purchased intangible assets.

Now turning to our business units. The Personal Systems Group delivered revenue of $8.9 billion in the quarter, down 15% year-over-year, with a 5.2% operating margin. Total units shipped were down 18% year-over-year. Our Q1 shipment volumes in PSG were impacted by the hard disk drive shortage, and our performance reflects the choices we made to drive profitability and tightly manage inventory distribution. By segment, commercial client revenue declined 7% and consumer client revenue declined 25% year-over-year. Workstation revenue was flat year-over-year, desktop revenue was down 18% and notebook revenue declined 15% year-over-year.

Moving on to Services. Services delivered revenue of $8.6 billion, up 1% from the prior year quarter. Operating profit of $905 million was 10.5% of revenue, down 5.7 points from the prior year, primarily due to the cost of additional headcount in sales and service delivery. In the first quarter, IT Outsourcing revenue of $3.7 billion was up 2% year-over-year. Application and Business Services revenue was flat year-over-year at $2.4 billion and Technology Services revenue grew 2%.

Turning to Imaging and Printing. Net revenue for IPG of $6.3 billion was down 7% year-over-year with supplies revenue declining 6%, partially due to our focus on reducing channel inventory. Operating profit was $761 million, or 12.2% of revenue, which was down 440 basis points year-over-year. These margins remain unfavorably impacted by the strong yen and an unfavorable ink supplies mix. Within the segments, we saw double-digit revenue growth in graphics and managed print services, and we shipped more than 5 million web-connected printers this quarter. We now have nearly 27 million web-connected printers in use around the world. By category, commercial printer revenue was down 5% year-over-year with commercial hardware units down 10%. Consumer printer revenue and units were both down 15% year-over-year, and total printer units shipped were down 13% year-over-year.

Turning to the Enterprise Servers, Storage and Networking business. Revenue declined 10% year-over-year to $5 billion due to the impact from the hard disk drive shortage and the continued weakness in BCS. Operating profit was $562 million, and the operating margin of 11.2% was 360 basis points lower than the prior year period due to reduced volumes and competitive pricing.

Now let's dive into the ESSN performance by business. Storage revenue was down 6% year-over-year despite double-digit growth in StoreOnce and nearly 100% growth in 3PAR. Year-over-year declines in our base [ph] and EVA product lines offset this growth.

Overall, Business Critical Systems revenue declined 27% year-over-year. Within BCS, our mission-critical x86 and NonStop products grew double digits, but not by enough to counteract the impact of continuing Itanium challenges.

With respect to our Itanium portfolio, we are working diligently to enforce the commitments that Oracle has made to our customers and to HP. And our customers are excited about the capabilities of our new Odyssey platform, which allows enterprises to transition workloads off UNIX-based systems to mission-critical, Xeon-based x86 chips.

Neither the storage nor BCS results were dramatically impacted by the hard disk drive shortage. However, we did see a significant impact on Industry Standard Server revenue, which declined 11% year-over-year. The hard disk drive shortage caused a mismatch between supply and demand, so we had demand that we could not meet in the quarter.

Networking revenue was flat year-over-year at $586 million. We are confident that we have the right product portfolio and a total cost of ownership advantage to compete and win. Software delivered revenue growth of 30% year-over-year to $946 million supported by the acquisition of Autonomy. In the quarter, we saw a 12% license growth, 108% growth in services and 22% support revenue growth.

Overall, first quarter operating profit for Software was $162 million, or 17.1% of revenue, unfavorably impacted by acquisition-related integration costs and accounting adjustments, as well as a lower mix of license revenue in the quarter.

We are pleased with the Autonomy acquisition. The pipeline is strong, and the level of lead generation we are seeing across HP for Autonomy software and services is compelling.

HP Financial Services continues to deliver strong, consistent results. In the first quarter, financing revenue grew 15% to $950 million. Financing volume was flat year-over-year, and net portfolio assets increased 8%. Operating profit of $91 million was up 15% year-over-year to 9.6% of revenue.

Now on to capital allocation and the balance sheet. Our focus is on rebuilding our balance sheet this year. But HP's long-term strategy is to allocate our capital in a balanced manner between investing in the business and returning capital to shareholders. During the quarter, we returned $780 million in cash to shareholders via share repurchases, leaving roughly $10 billion remaining in the share repurchase authorization. We also paid $244 million to shareholders in the form of dividend. HP generated $1.2 billion in operating cash flow in the quarter and free cash flow of $406 million. Our total gross cash at the end of the quarter was $8.2 billion.

In terms of working capital, our first quarter cash conversion cycle was 28 days, up 7 days from the prior year. The increase was due to higher DSO and days of inventory by 2 days and 3 days, respectively, as well as a decrease of 2 days in days payable outstanding. Exiting the quarter, channel inventory was higher than our acceptable ranges due to impacts of the hard disk drive shortage on ESSN and soft sellouts in laser and ink supplies.

Now on to our outlook. As we discussed last quarter, HP is managing the business to deliver earnings performance rather than specific revenue growth objectives. And we will continue to provide our earnings per share outlook consistent with this management approach.

I'll wrap up with an update on the assumptions relating to revenue and earnings. We remain cautious about the macro environment globally for both consumer and commercial spending. In Q2, there will be an impact to revenue due to the hard disk drive shortage, although we expect the impact will be smaller in Q2 than Q1 based on the drives [ph] to which we have line of sight. We still have work to do in aligning our supply channel inventory levels with the current demand environment, and we will continue to see a headwind in Business Critical Systems due to the Itanium challenges.

Moving on to margins. First, the expected year-over-year decline in revenue, including the impact from the hard disk drive shortages, will impact margins; second, we expect the pricing environment will continue to be very competitive; third, we expect to continue to have an impact due to a lower mix of Business Critical Systems revenue; fourth, the services turnaround continues, and we expect margins to continue to decline year-over-year. Fifth, we expect OI&E to be at the low end of our previous guidance, an expense of $1 billion to $1.3 billion for the full year. And we will continue to invest in innovation and the systems and processes needed to improve performance across all of our businesses. With that context, we expect second quarter non-GAAP earnings per share to be between $0.88 and $0.91. We expect second quarter GAAP earnings per share to be between $0.68 and $0.71. We have not changed our full year FY '12 guidance. We continue to expect at least $4 in non-GAAP EPS and at least $3.20 in GAAP EPS. Now I'll turn it over to Meg for a few comments on the upcoming year.

Margaret C. Whitman

So to wrap up before going to Q&A, I'd really like all of you to take away these 3 messages. One, we're committed to clarity and transparency. We want you to understand the challenges and opportunities we have in front of us. Two, we are getting back to basics, driving execution, focusing on profitability through mix and costs and investing in our business with a disciplined capital allocation strategy. Three, we are building HP to last. We are not managing for short-term objectives. We are taking advantage of this opportunity to position HP for success, not for the next quarter, but for decades to come. And with that, I'll open it up for Q&A.

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