Hewlett-Packard’s (HPQ) CEO Meg Whitman on Q3 2014 Results – Earnings Call Transcript

HP assumes no obligation and does not intend to update any such forward-looking statements. The financial information discussed in connection with this call, including any tax-related items, reflect estimates based on information available at this time and could differ materially from the amounts ultimately reported in HP’s third 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 amongst other things, amortization of purchased intangible assets, restructuring charges and acquisition-related charges. The comparable GAAP financial information and a reconciliation of non-GAAP amounts to GAAP are included in the tables and in the slide presentation accompanying today’s earnings release, both of which are available on HP Investor Relations webpage at www.hp.com.

I will now turn the call over to Meg.

Meg Whitman

Thank you, Rob, and thanks to all of you for joining us today. The third quarter of 2014 marks an important milestone in HP’s turnaround. For the first time in three years, the Company delivered top-line revenue growth on a year-over-year basis. Revenue for the Company was $27.6 billion, up 1%. As I said many times before, turnarounds are not linear and we face some tough comparisons in the fourth quarter, but overall I continue to be very encouraged by the progress we’re making. In the third quarter, we once again achieved our financial outlook. We delivered $0.89 in diluted non-GAAP net earnings per share at the high end of our previously provided outlook and up $0.03 from the prior year period.

In addition, we achieved very strong cash flow performance, delivering $2.7 billion in free cash flow for the quarter, a good sign of improved operations and financial discipline. Our year-to-date free cash flow now stands at $7.4 billion. As a result our operating company net cash position is $4.9 billion. We also returned $881 million to shareholders in the form of share repurchases and dividends. We’re seeing the benefits of the work we have done to get our personal systems and industry standard server business back on track. Our printing supplies business and parts of our software portfolio still face some challenges but HP today is nimbler and better prepared than ever to respond to rapidly changing business conditions. So the leadership teams in both these areas are quickly addressing those challenges.

On the Enterprise Services side of the company, we’re making progress. The nature of ES with longer business cycles and lengthy contract periods, make it tough to realize improvements quickly but I believe the changes Mike Nefkens and his team are making are beginning to take hold. I’m confident that Enterprise Services is on the right path to improved performance and profitability.

The third quarter saw the introduction of some significant innovation across HP. At our Discover customer event in June, we launched the world’s first completely liquid cooled supercomputer, HP Apollo. Apollo offers high performance computing while using half the energy of competitive products.

We also introduced an all flash HP 3PAR Storage array. 3PAR is making all flash arrays viable for a range of mainstream enterprises and service providers, driving down cost while also boosting performance and scale. Initial customer reaction has been very positive.

Our software group announced new HP Atalla encryption and data protection solutions that continuously secure an organization’s most sensitive information whether it resides in a data center, an on-promise server or in the cloud. And we rolled out our vision for what we call The Machine, a new computing platform for the Big Data era. The Machine has become a rallying cry across HP and frankly around the industry for the reinvention of how we compute.

Martin Fink has focused the HP lab researchers on memristors, photonics and a new operating system at the heart of this once in a generation project. I believe we’re clearly demonstrating what I said many times before, that innovation is alive and well at HP. Over the next several months, you can expect to see the introduction of game changing products in personal systems, servers, cloud and printing, that are going to bring some real excitement to these markets.

Before I turn to business group performance, I want to take a moment to once again acknowledge the contributions of Ralph Whitworth. As all of you know Ralph stepped down last month as Chairman of HP’s Board of Directors. I would like to personally thank Ralph for his tireless efforts to help drive HP’s turnaround and for being a wonderful friend and advisor to me during the past three years. Everyone at HP is thinking about Ralph and we all wish him the very best.

HP’s Board of Directors decided to combine the roles of Chairman and CEO, and I’m honored that they’ve asked me to assume this responsibility. I believe this will help us lead more effectively through the turnaround. Let me reassure everyone that the Board and I remain fervently committed to the strong practices and financial discipline we’ve put in place during the past three years. The best interests of our investors are always top of mind, with me, and the HP Board.

Now let me turn to our business group performance in the quarter. Overall, results in Q3 were driven by good performance in personal systems, growth in industry standard servers and networking as well as disciplined cost management across all of our businesses.

In personal systems we had an excellent performance, with revenue up 12% from the prior year period. This represents the third successive quarter of revenue growth for personal systems in a market that has stabilized, but nevertheless, continues to contract. We gained market share both year-over-year and sequentially, and we’re seeing growth across all major categories. The Windows XP expiration has contributed to our growth. Although we believe we’re now through much of that benefit. However, our product line up, driven by products like our EliteBook Series and our x360 convertible notebook, is the strongest we’ve had in years and we continue to see customers looking to refresh their aging installed base.

We believe we can continue to gain share in PCs despite the challenges in this market as it consolidates. The personal systems’ team continues to do a great job managing profitability, with third quarter operating profit margins of 4%, up 0.9 points from the prior year period.

In our Printing business, we continue to build on sustained strong margin performance with an operating profit margin of 18.4%, up 2.6 points from the prior year period. Revenue was down 4% year-over-year driven by supplies where declined in toner continue and ink was weaker than expected. We’re honing our approach here and refocusing on go-to-market which gives me confidence that we will improve our performance over the next several quarters.

Total hardware unit shipments declined 5% in the quarter. However, we gained share in both ink and multifunction printers, important categories where we now lead the market. As planned, our disciplined unit placement strategy resulted in declines in single function Mono and low value home printers. But we’re seeing continued momentum in focus areas like managed print services, where we had another strong quarter of signings. This is an important business for us as it supports a strong aftermarket sales opportunity for supplies.

In the Enterprise Group, revenue grew 2% on strength in industry standard servers and networking, offset by declines in business critical systems, Technology Services and storage. In industry standard servers, we saw 9% growth from the prior year period, which represents our fourth consecutive quarter of revenue growth and we expect to take almost a point of share in the second calendar quarter. We’re seeing good early traction with service providers as a result of our partnership with Foxconn to produce a line of cloud optimized servers and we moved aggressively to take advantage of the uncertainty customers feel about the IBM Lenovo transaction. In head to head fights with IBM for deal, we’re seeing clear improvement in win rates; all this, while delivering stable growth margins.

In Business Critical Systems, revenues declined 18%, broadly in line with the market and our expectations. Storage revenue declined 4% year-over-year. However, converged storage was up 9% while traditional storage declined 14%. 3PAR returned to double digit growth, and we continue to gain share in the mid-range. As the market shift increasingly from high end to mid-range, it is pressuring overall market growth but I believe this plays into a sweet spot for HP, which bodes well for us in the long term.

Networking performed well under the new leadership of Antonio Neri, although there remains opportunity for further improvement. Revenue grew 4% from the prior year period and we saw good growth in switching, where we once again outperformed Cisco. We also have made significant progress on our open NFE program. We currently have 15 proof of concept projects with carriers around the world five R&D labs to provide validation of our integrated solutions and strong partnerships with Alcatel Lucent, NEC and Nokia.

In Technology Services, revenue was down 3% from the prior year period. Despite the revenue headwinds in this business from weak hardware volumes in prior periods, we’ve maintained consistent, stable operating profit margin throughout the year and we’re seeing continued adoption of our new services like Proactive Care and Datacenter Care.

We saw positive order growth in Q3, the best performance in nine quarters. In our cloud product offerings, we are making progress with HP Helion. Since launching in May, we’re seeing strong engagement from customers, and we’re extending our share leadership in private cloud. In Q3, HP CloudSystem had another strong quarter with double digit revenue growth. And I’m particularly excited about the significant milestones in cloud we have on the horizon. By the end of October, we expect to deliver commercial versions of HP Helion OpenStack and the HP Helion Development platform, which will help enterprise customers build and deploy OpenStack based clouds.

We will also introduce expanded professional services that leverage HP’s unmatched OpenStack experience to accelerate customers’ cloud implementations. In fact HP is the leading code contributor to the next release of OpenStack, also scheduled for October.

In June, we announced the HP Helion Network with the support of AT&T, British Telecom, Intel, Synapsis and Hong Kong Telecom. Together we are focused on delivering a global public cloud platform that is 100% enterprise focused and open standard based. In the coming months, we expect to launch an HP Helion Network program with an even broader set of partners, committed to building the world’s largest cloud network.

To that end, HP has reached an agreement with China’s leading content distribution network service provider to build and operate community clouds for enterprise customers in China, using HP Helion OpenStack. This will enable HP to meet customers’ fast growing demand for cloud services in one of the world’s fastest growing cloud markets.

In Enterprise Services, revenue was down 6% from the prior year period. As expected, key account revenue run off negatively impacted year-over-year revenue comparisons. Gross margins expanded as a result of continued labor savings and improvement in underperforming accounts, helping ES achieve an operating profit margin of 4.1%, up 0.9 points from the prior year period and up 1.6 points sequentially.

On the sale side, the Enterprise Services team is making progress on aligning their sales engines and we once again saw bookings growth in new logos. Enterprise Services continues to be a work in progress. While the results do not yet reflect all our efforts to strengthen this business, the work of the team as well as the feedback I’m hearing from customers tells me we’re on track.

In Software, Robert Youngjohns has hit the ground running in his new role. Robert and his team are making progress on evolving the Software strategy and addressing the go-to-market model. They have a lot of work to do to simplify our portfolio of offerings, streamline our go-to-market and accelerate our web selling capability.

In the quarter, revenue was down 5% from the prior year period, driven by certain go-to-market challenges. These issues impacted revenue in our core focus areas of security and Big Data. Autonomy and Vertica revenue declined over the prior year period and security revenue grew only slightly.

On profitability, software executed well, improving its operating profit by more than 1 percentage point on declining revenue as gross margins improved, coupled with disciplined expense management. SaaS bookings in the IT management business continue to be strong with double-digit growth over the prior year and exciting new products introduced to the market. We are shifting more of our focus on both the portfolio and the operating model to SaaS and subscription based offerings, which may create near term revenue headwinds while setting up the business for the long-term success.

During the quarter, the software team announced a strategic partnership with Hortonworks. The joint commitment will help accelerate the adoption of enterprise Apache Hadoop by deeply integrating the Hortonworks data platform with Haven.

Overall, I am very pleased with the progress we’ve made. When I look at the way the business is performing, the pipeline of innovation and the daily feedback that I receive from our customers and partners, my confidence in the turnaround grow stronger. HP is quicker to recognize opportunities in our markets and respond to challenges faster and with greater discipline than at any time in recent memory. When challenges appear in any of our businesses, we have a much better sense of what’s happening and surprises are fewer and fighter between.

The adversity of the turnaround is forging a much stronger company, a company focused on results and determined to drive strategy and decisions aligned with a rapidly changing industry. This sense of purpose is motivating our employees to new levels of excellence and a profound commitment to our customers and partners. Against that backdrop, our outlook for non-GAAP diluted net earnings per share for the full year will be $3.70 to $3.74.

Now let me turn it over to Cathie for a closer look at our performance in the quarter. Cathie?

Cathie Lesjak

Thanks, Meg. Overall, we’re pleased with third quarter results. Performance was driven by very strong revenue growth in personal systems as well as growth in industry standard servers and networking. Performance in Printing, Enterprise Services and Software was mixed with good profitability but weaker than expected top-line results. Total revenue for the quarter was $27.6 billion, up 1% year-over-year as reported and in constant currency.

By region, Americas revenue was $12.3 billion, down 1% year-over-year or flat in constant currency. The U.S. was approximately flat on the back of double-digit growth in personal systems. Brazil was up moderately while other countries in the region declined.

EMEA revenue was $10 billion, up 5% year-over-year or up 1% in constant currency, driven by some recovery in mature western economies, partially offset primarily by significant weakness in Russia. APJ revenue was $5.3 billion, up 1% year-over-year or up 4% in constant currency. We experienced solid growth in China, led by a double-digit increase in the Enterprise group, partially offset by weakness in Japan and India.

Gross margin for the quarter was 24%, up 0.6 points year-over-year and down 0.2 points sequentially. The year-over-year increase was driven by rate improvement across most of the portfolio, partially offset by the strong revenue performance in industry standard servers and personal systems.

Total non-GAAP operating expenses for the quarter were $4.3 billion, up 5% year-over-year. The increase in OpEx was primarily driven by increased investments in R&D, as well as real estate gains in the year ago period. Sequentially, OpEx was approximately flat and in line with normal seasonality.

Non-GAAP operating profit was $2.3 billion or 8.5% of revenue, up 2% year-over-year and flat sequentially. We recorded a $145 million of expense on the other income and expense line. With a 22.5% tax rate and a weighted average diluted share count of 1.9 billion shares, we delivered third quarter non-GAAP diluted net earnings per share of $0.89, at the high end of our outlook range.

Third quarter GAAP diluted net earnings per share of $0.52 was below our forecasted range due to a higher than originally estimated restructuring charge of $649 million. However, we expect the total FY14 charge for the incremental restructuring activities to be in line with our prior expectations. GAAP earnings also included $227 million of expense for the amortization of intangible assets.

Turning to the business units, Personal Systems had an excellent quarter across all businesses with revenue up 12% year-over-year to $8.6 billion, gaining share across the board. Commercial sales grew 14% year-over-year with consumer sales up 8% and strength broadly across all of the regions outside of pockets of weakness in Russia and China. Total unit shipments grew approximately 13% year-over-year with growth in both consumer and commercial, and channel inventory remains within acceptable ranges. Even in a competitive pricing environment, Personal Systems achieved solid operating profits of $346 million or 4% of revenue, up 0.9 points year-over-year.

The improvement was driven by volume and some improved pricing as well as operational cost reductions as the team continues to segment and target the right market opportunities as well as streamline and refine supply chain management across the business.

Printing revenue performance was weak, but profitability remains strong, and as Meg said, the team is in the process of making key adjustments to the go-to-market approach. Revenue was $5.6 billion, down 4% year-over-year as declines in both hardware and supplies were partially offset by continued traction in graphics and managed print services.

Commercial hardware revenue was $1.4 billion, flat year-over-year, and consumer hardware revenue was $529 million, down 6%. Total hardware unit shipments declined 5% year-over-year as we continue to focus on selectively placing high value units.

We continue to see success with our new Print business models. In Q2, we ran a series of promotions to move older Ink in the office products through the channel ahead of our upcoming product transition. As a result, older product sales declined in Q3 and drove overall Ink in the office sales lower year-over-year. However, we saw double digit year-over-year growth in our Officejet Pro X and Officejet Pro X Enterprise products and we expect the program overall to grow in fiscal ’14. Our Ink Advantage program also saw continued traction, and we once again grew unit shipments and revenue by double digits year-over-year.

Supplies revenue was $3.7 billion, down 5% over the prior year and made up 65.5% of printing revenue. Both ink and toner were down. Part of the decline was driven by stronger channel buy in during Q3 last year ahead of pricing actions we took on ink, making for a tough year-over-year compare. We also experienced a larger than expected inventory correction from the consolidation of U.S. retailers, which may suggest some softness in demand, but it’s too early to confirm this is a trend. Supplies channel inventory levels declined on a year-over-year basis, but have increased sequentially and are above our target range. We expect to bring inventory levels back within the range in the fourth quarter and anticipate this will pressure our fourth quarter supplies revenue.

Total Printing operating profit was a strong $1 billion, or 18.4% of revenue, up 2.6 points year-over-year due primarily to favorable currency. The Enterprise group had a solid quarter. Total revenue was $6.9 billion, up 2% year-over-year with growth in industry standard servers, networking and converged storage, partially offset by declines in traditional storage, Technology Services and business critical systems.

Operating profit was $966 million, or 14% of revenue, down 1.1 point year-over-year. Good discount discipline in the quarter was more than offset by higher cost of sales and the mix impact of strong industry standard server revenue growth as well as strategic R&D and sales investments.

By business, industry standard server revenue was $3.1 billion, up 9% year-over-year with improvement in all regions. We also experienced higher average unit prices in ISS as a result of strong option attach. Technology Services revenue was $2.1 billion, down 3% year-over-year. The team continues to execute well in this business and we saw a return to positive order growth and our penetration rate is up over the prior year in BCS, storage and networking.

Total storage performance was a bit disappointing, with revenue of $796 million, down 4% year-over-year, driven by a 14% decline in traditional storage. However, converged storage sales grew 9% this quarter, led by double digit growth in 3PAR as customers continue to adopt alternatives to traditional high end enterprise storage arrays. While 3PAR plus XP plus EVA revenue declined 7% year-over-year, we expect another quarter of share gain in the external disk market overall in calendar Q2 ’14. Networking performed well in the quarter. Revenue was $672 million, up 4% year-over-year driven primarily by strength in switching across all regions. Top line growth is expected to result in share gain in calendar Q2 ’14.

Business Critical Systems revenue declined 18% over the prior year period broadly in line with the market to $233 million. High performance computing is core to who we are at HP and while we continue to manage the decline in units, we are also committed to delivering new solutions to meet our customers’ mission critical needs and are excited about the products roadmap.

Enterprise Services revenue was $5.6 billion, down 6% year-over-year, driven by continued key account run off as well as incremental weakness in EMEA. By business IT outsourcing revenue was $3.5 billion, down 8% year-over-year and applications and business services revenue was $2.1 billion, down 4%. Operating profit for ES was $228 million or 4.1% of revenue, up 0.9 points year-over-year. The increase was driven by continued cost actions and improvements in underperforming accounts.

Looking forward, we expect meaningful, incremental benefit in the fourth quarter from the workforce restructuring implemented during the third quarter, as well as continued improvements in underperforming accounts. Turning to sales metrics, small and medium sized deals grew and we continue to see strong double digit bookings growth in strategic Enterprise Services or the services for the new style of IT, although lower renewals drove overall signings down.

Turning to Software, while Software revenue declined the team continue to drive solid profitability through gross margin expansion as well as disciplined expense management. As Meg talked about, the software team is focused on evolving the business strategy and go-to-market approach to better leverage the great products we have in the portfolio. Weakness in license revenue of that continued growth in our Software as a Service offering driving total software revenue of $959 million, down 5% year-over-year.

Operating profit remains solid at $203 million or 21.2% of revenue, up 1.1 points year-over-year. License revenue declined 16% year-over-year with weakness across the portfolio. Support revenue was flat over the prior year with growth in security offset by weakness in the rest of the portfolio from past license revenue declines. Professional services revenue declined 3% year-over-year with softer IT management revenue partially offset by growth in security. Our continued focus on profitability in this business impacted our top line performance in the quarter.

SaaS revenue grew 8% year-over-year and we continue to see strong bookings growth in IT management. We launched exciting new products in the quarter including the June release of service anywhere, which we believe positions us very well against the competition and it’s getting good early customer traction.

HP Financial Services revenue was $855 million, down 3% year-over-year. Operating profit was $79 million or 9.2% of revenue. HPFS revenue and operating profit were impacted both on a year-over-year and on the sequential basis by customer billing adjustments but were otherwise in line with expectations. New financing volume grew 14% and return on equity was 14.7%, down 2.6 points year-over-year, entirely due to the billing adjustments.

Turning to cash flow and capital allocations, we had another strong quarter with $3.6 billion in operating cash flow and $2.7 billion in free cash flow. Our cash conversion cycle was eight days in the quarter with year-over-year improvement of one day in both days of inventory and day sales outstanding and an eight day improvement in days payable outstanding.

Favorable payment terms with suppliers, strength in personal systems and the factoring program mentioned last quarter supported the cash conversion cycle improvement. Although we do not typically update our outlook every quarter, I did want to lay out how we think cash flow will end the fiscal year. Our free cash flow is already $7.4 billion year-to-date and I expect that we will exit this year at approximately $9 billion for the full year.

Cash flow remains a priority for us and we continue to execute well. We repurchased 17.5 million shares in the quarter and paid $299 million in dividend. In total we returned approximately $881 million shareholders in Q3. During the quarter we were limited in our ability to purchase shares due to material non-public information. We intend to resume the share repurchase program during Q4 and remain committed to returning 50% of free cash flow to shareholders in fiscal 2014.

Our restructuring program is on track and approximately 36,000 people have exited the company under the program through the end of the third quarter. We expect approximately 41,000 to exit by the end of the fiscal year and a total reduction of 45,000 to 50,000 under this program with the remainder exiting in fiscal 2015. Looking forward to Q4, in personal systems, while the Uttar Pradesh [ph] deal last year will make for a tough compare, we still expect to gain share in the market on the back of a strong product line up and go-to-market approach.

In printing we expect supplies to remain under pressure in the fourth quarter as we bring channel inventory levels back within our target range but we expect to see continued momentum in our innovative new programs across the portfolio. In the Enterprise group, overall we expect the hardware market to remain highly competitive. However, in Storage, we anticipate that the market will continue to shift from the high to the mid-range where we are well positioned.

And in ISS, while the Bing deal from last year will create a tough compare, the team is executing well. In Enterprise Services, given the incremental weakness we saw in Q3 from EMEA, we are updating our full year revenue outlook. We now expect full year revenue to decline 6% to 7% over the prior year. However, given our good progress on cost management and execution, we continue to believe that we can achieve a full year operating margin within the previously provided range of 3.5% to 4.5%.

From a macroeconomic perspective, we expect geopolitical uncertainty to continue, impacting specific territories such as Russia, as well as increased competitive pressures likely in China. With that context, we expect full year fiscal 2014 non-GAAP diluted net earnings per share to be in the range of $3.70 to $3.74. From a GAAP perspective, we expect full year GAAP diluted net earnings per share to be in the range of $2.75 to $2.79.

With that, let’s open it up for questions.

Question-and-Answer Session

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