Hewlett-Packard Company (HPQ) F3Q 2013 Earnings Call August 21, 2013 5:00 PM ET
Rob Binns - Vice President of Investor Relations
Meg Whitman - President, Chief Executive Officer, Director
Cathy Lesjak - Chief Financial Officer, Executive Vice President
Mark Moskowitz - JPMorgan
Toni Sacconaghi - Sanford C. Bernstein
Katie Huberty - Morgan Stanley
Jim Suva - Citi Research
Ben Reitzes - Barclays
Brian Alexander - Raymond James
Maynard Um - Wells Fargo
Shannon Cross - Cross Research
Keith Bachman - Bank of Montreal
Ananda Baruah - Brean Capital
Good day, ladies and gentlemen, and welcome to the third quarter 2013 Hewlett-Packard earnings conference call. My name is Adrianne and I will be your conference moderator for today's call. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference. (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. Rob Binns, Vice President of Investor Relations. Please proceed.
Good afternoon. Welcome to our third quarter 2013 earnings conference call with Meg Whitman, HP's Chief Executive Officer and Cathy Lesjak, HP's 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 made available shortly after the call for approximately one year.
Some information provided during this call may include forward-looking statements that involve risks, uncertainties and assumptions. If the risks or uncertainties ever materialize or the assumptions prove incorrect, the results of HP may differ materially from those expressed or implied by such forward-looking statements.
All statements other than statements of historical facts are statements that could be deemed forward-looking statements, including but not limited to any projections of revenue, margin, expenses, earnings, earnings per share, tax provisions, cash flows, share repurchases, currency exchange rates or other financial items, any statements of the plans, strategies and objectives of management for future operations and any statements concerning the expected development, performance, market share or competitive performance relating to products or services.
A discussion of some of these risks, uncertainties and assumptions is set forth in more detail in HP's SEC report including its most recent Form 10-Q. 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 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 the HP Investor Relations webpage at www.hp.com.
I will now turn the call over to Meg.
Thank you, Rob, and thanks to all of you for joining us today. as we continue our fix and rebuild year, parts of the business like printing, enterprise services, converge storage and software are making progress, while others like industry standard servers and personal systems have not completely turned the corner.
So overall, I would say, our turnaround continues. We are moving forward against our plans and I remain comfortable with where we are heading. Most importantly, we once again achieved the financial performance we said we would, delivering $0.86 in non-GAAP diluted earnings per share, within our previously provided outlook of $0.84 to $0.87.
During the third quarter, we held our annual HP Discover event in Las Vegas. We brought together more than 11,000 people including more than 120 of the world's top CIOs. These are record numbers for HP. I was encouraged by the interest I heard from our customers about technologies like HP Moonshot, StoreOnce, 3PAR, software-defined networking, Vertica and Autonomy.
At HP Discover, we introduced some very significant new innovations. We announced HAVEn, a big data analytics platforms that leverages our analytics software, hardware and services to allow customers to make decisions in real-time. We also expanded our Converged Cloud portfolio with a common OpenStack based architecture for HP's private, managed and public cloud offerings. And we announced the new partnership with Google to introduce a one-stop shop technology solution for small and medium-sized business customers.
As I said before, HP's turnaround will happen on the back of great products and services. As the benefits of our focus and investment begin to pay dividends in 2014, I expect that you will see increased innovation across HP. From a macro economic standpoint, we see a continued weak enterprise spending environment. Sentiment in the U.S. is improving, although it's not translating to our results yet due to inconsistent execution. I would characterize Europe as challenging and China continues to be soft. We are also seeing acceleration in trends driving customers to the cloud and shifting to mobility.
For the third quarter, our results were driven by solid execution in software, printing, converged storage and enterprise services coupled with the savings from our restructuring program and improvements in our operations. As a result of our focus on operations, we were able to bring our cash conversion cycle down to 18 days, a remarkable achievement compared to 27 days in the prior year. In the quarter, operating cash flow was $2.7 billion, once again another strong performance. As a result, we lowered operating company net debt by $1.7 billion to $1.2 billion.
This represents our sixth consecutive quarter of reducing our operating company net debt by more than $1 billion. Our operating company net debt is now below pre-Autonomy levels and is approaching our goal of approximately zero. We also returned approximately $283 million to shareholders, primarily in the form of dividends in the quarter.
Along with the operational improvements and the workforce restructuring, we are focused on getting the right leadership in place to lead the company to the next phase of the turnaround. To that end, we announced several changes to our executive leadership team during the quarter. In June, Dion Weisler took up our printing and personal system. Dion is more aggressively shifting to a multi-operating system, multi-architecture and multiform factor strategy.
Earlier today, we announced additional changes to our executive leadership team. Bill Veghte, currently HP's Chief Operating Officer will become EVP and General Manager of the Enterprise Group replacing Dave Donatelli who will remain with HP and take on a special assignment. Bill brings a critical set of skills to the management of HP's Enterprise Group. He is a proven technology executive with a wide range of experiences leading sales, services, marketing and engineering at scale.
During his tenure at HP, he has run HP Software, held the responsibility of Chief Strategy Officer and for over 15 months has served as HP's Chief Operating Officer. As COO, Bill helped to create HP's blueprint for the future and deeply understands the strategic challenges and opportunities facing both the company and its customers. As hardware becomes more standardized, leadership solutions are increasingly differentiated by the software layer that drives the hardware.
This is true for both traditional IT and cloud environments. Bill will retain his current responsibility for the pan-HP cloud initiative, and Bill's experiences in software and in the enterprise combined with HP's infrastructure leadership will help HP accelerate innovation in converged infrastructure, cloud and the emerging area of software-defined data centers.
In a separate organizational move, Henry Gomez, EVP and Chief Communications Officer will assume the additional responsibilities of Chief Marketing Officer. By combining marketing and communications, we will accelerate programs that will drive sales, build brand royalty and help customers embrace the new style of IT. HP's current CMO, Marty Homlish will become Chief Customer Experience Officer, a new role that will focus on driving more consistent and high value interactions with customers across all business units.
Now let me turn to our business group performance in the quarter. As you would expect in a turnaround, there are areas where we are doing well and areas where we have to improve. Let me start with the parts of the business that performed well in the quarter.
In printing, we once again delivered a solid quarter. Business initiatives like Ink Advantage and new products like Officejet Pro X continue to take hold with strong customer adoption. As a result, we are seeing strength in our Ink in the Office program. Overall, we grew hardware unit sales for the first time since 2011, gaining one point of share in both Ink and Laser over the prior year and five points of share in Laser over the prior quarter. The printing team has done a very good job executing the strategy we laid out last October.
Although revenue is down, profitability is inline with our expectations and the topline is stabilizing. Printing revenue was down 3.6% over the prior year and 1.4% in constant currency while margins were 15.6% essentially flat over the prior year. In Enterprise Services, the business is stabilizing as we continue to execute well against our recovery plan. Revenue was down 8.7% over the prior year, better than the FY13 outlook range we previously provided.
We saw add-on business offset the anticipated revenue run-off from the four exceptional accounts we identified at our Security Analyst meeting last October. Margin in the quarter was 3.3% bringing enterprise services year-to-date margins to 2.4% at the high end of our FY13 outlook range.
We continue to see improvements in signings but they are mostly renewals. Going forward we are focused on strengthening our go to market capabilities dedicated to strategic enterprise service solutions in areas like cloud, big-data and apps modernization and new account wins. As we outlined in October, this will be a multi-year journey.
Enterprise services was able to secure some major wins in the third quarter. We announced that enterprise services and its partners were awarded the United States Department of the Navy's Next Generation Enterprise Network contract value at up to $3.4 billion over five years. The contract is being protested but we have every confidence in the Navy's evaluation and the ultimate selection of HP.
In the Enterprise Group, we are making progress in executing our vision of converged infrastructure based on HP intellectual property and the software defined data center. We see near-term revenue pressures in ISS and some parts of storage where we face aggressive pricing and competition.
Customer interest in our revolutionary HP Moonshot product has been strong. We are working hard to ramp this product in the market. We are currently in testing and development with many key customers and expect to rollout a number of new innovation on this platform over the next few quarters.
In storage, we are seeing the planned portfolio shift continued with strong performance in our converged storage business which was up 37% over the prior year, being offset by weakness in traditional storage. We continue to see solid growth in our mid range 3PAR products that were launched in the first quarter.
While we were pleased with our networking performance in China, revenue was essentially flat and we must grow this business faster. Going forward, we are focusing on new channel plays and improved go-to-market actions to accelerate growth.
Enterprise group had a number of significant customer wins in the quarter. HP was selected as the official technology partner to Oriental DreamWorks, the joint venture between the China Consortium led by China Media Capital and DreamWorks Animation.
In software, we saw good performance and improved execution. We grew revenue nearly 1% over the prior year and 4.3% sequentially. We saw continued improvement in operating leverage as margin expanded 2.5 points over the prior year and 1.4 points over the prior quarter and achieved an operating margin of 20.5%.
Performance in software was driven by strength in security which saw double-digit revenue growth, strong momentum in Vertica which saw triple-digit growth and sequential license revenue growth in Autonomy. In addition, we saw pockets of improvement in IT management, although we saw continued pressure from the shift to SaaS coupled with a portfolio that is weighted towards services and support.
Now let me turn to where our performance needs to improve. Overall, the enterprise group's performance was very disappointing. Enterprise group profitability was pressured by lower revenue, particularly in ISS, resulting in an operating margin of 15.2%, down 1.9 points over the prior year and 0.7 points sequentially. ISS continues to experience near-term business model challenges impacting our competitiveness in the hyper-scale market.
In addition, mainstream server weakness was driven by execution challenges, competitive pricing and a misaligned go-to-market model. This impacted our revenue and profitability. The net impact of these execution challenges is an expected loss of five points of market share on a revenue basis. Fixing execution across enterprise group will be Bill Veghte's top priority in his new role.
In our personal systems business, we are seeing continued PC market contraction as HP revenue declined 11% over the prior year. On a positive note, in the third quarter we saw relative strength in market share gains in growth markets like Asia-Pacific and in commercial PCs. According to IDC's second calendar quarter results, HP has achieved its highest ever PC share in India with 34.1%, leading in every category of the PC market. Overall margin for the quarter was 3%, down 0.2 point sequentially and down 1.7 points over the prior year.
Looking forward, we are focused on driving profitable growth in personal systems. It's going to take time to get margins to our desired levels against the back drop of a changing marketplace but we are confident that our differentiated approach from competitors including our focus on beyond the box innovation will pay off over the long term.
Now let me turn to our future outlook. As you know, I stated in May that I believe that company level revenue growth was still possible in fiscal 2014, particularly given the challenges I just highlighted in enterprise group and personal systems as well as the fact that 2013 revenue from key accounts in enterprise services is running off more slowly than anticipated. We now expect that total company year-over-year revenue growth in fiscal 2014 is unlikely.
That said, I remain confident that we are making progress in our turnaround. We are already seeing significant improvement in our operations. We are successfully rebuilding our balance sheet. Our cost structure is more closely aligned with our revenue. We have reignited innovation at HP with a focus on the customer. So I do expect that we will see pockets of year-over-year revenue growth across certain parts of the business in 2014.
As is our normal practice, we will give a more comprehensive outlook on 2014 including EPS at our Security Analyst Meeting on October 9 and I look forward to seeing you all there.
Now let me turn it over to Cathy for a closer look at our performance in the quarter. Cathy?
Thanks, Meg. Good afternoon, everyone. Total revenue for the quarter was $27.2 billion, down 8% year-over-year and down 7% in constant currency. Overall, our results came in largely as expected with some variance in performance among the business units.
Enterprise services came in slightly ahead of expectations and printing and software were broadly in line. However a weak PC market and increasingly competitive pricing pressured personal system and execution challenges and aggressive pricing impacted industry standard server performance. I will go into more detail on each segment shortly.
By region, EMEA remains weak, particularly in consumer, with revenue of $9.6 billion, down 10% year-over-year and 8% in constant currency. Revenue in the Americas of $12.4 billion declined 7% year-over-year as reported and in local currency, partly driven by weakness in U.S. public sector spending as well as soft demand in Brazil and Canada.
APJ was mixed with strong growth in India due in part to our recent educational PC win in the State of Uttar Pradesh, partially offsetting weaker China performance. APJ revenue was $5.2 billion, down 8% year-over-year and down 5% in constant currency.
Turning to gross margins. Improved enterprise services and technology services margins combined with a favorable mix from software, printing and personal systems offset a highly competitive pricing environment across most of our hardware businesses. Gross margins were flat on a year-over-year basis and down 30 basis points sequentially.
Non-GAAP operating expenses were $4.1 billion down 4% year-over-year and 2% sequentially driven by expense benefits from restructuring actions and lower R&D investments in business critical systems. Non-GAAP operating profit of $2.3 billion was 8.4% of revenue, down 80 basis points year-over-year.
We recorded a $146 million of expense on the other income and expense line. With a 22% tax rate and roughly flat share count of 1.9 billion shares outstanding, we delivered non-GAAP diluted earnings per share of $0.86. Our non-GAAP EPS excludes pre-tax charges of $356 million in amortization of purchased intangibles, $81 million of restructuring charges and $4 million in acquisition-related charges.
Turning to the business groups. I will start with printing. We continue to execute on our strategy and the group delivered solid results in the third quarter. Revenue of $5.8 billion was down 4% year-over-year. Total unit shipments grew 5% year-over-year as we took advantage of a depreciating Yen to place more units and partially offset other currency headwinds. Operating profit of $908 million or 15.6% of revenue was down 0.2 points from last year.
Commercial hardware revenue declined 3% year-over-year, while units increased 12%. We experienced strength in low-end laser sales, while high-end revenue declined due to a mix shift in the value segment. We saw good growth in managed services and Indigo sales. Consumer hardware revenue was flat while units increased 2% against the prior year, driven by strong Ink in the Office and Ink Advantage sales.
Supplies revenue declined 4% against prior year and made up 66% of printing revenue. Our overall channel inventory has moved slightly above of our target range. This was partly driven by supplies demand from our channel partners seeking to maintain service and reliability levels to their customers. We need to bring down channel inventory in the fourth quarter.
Personal systems continues to face a challenging environment. Revenue was $7.7 billion, down 11% over the prior year led by weakness in consumer. Total unit shipments declined 8% year-over-year. We saw a broad-based regional softness lead by EMEA.
Consumer sales declined 22% year-over-year, while commercial performed much better down just 3%. Commercial unit shipments outpaced the market by 8% year-over-year and we maintained our number one market share position in this category. Continued pricing pressure and currency headwinds drove an operating profit of $228 million or 3% of revenue, down 1.7 points over prior year.
Personal systems contributed just 9% of HP's segment operating profit. We remain focused on improving profitability in this business over the long-term.
Turning to enterprise group. Results were weaker than expected with revenue down 9% year-over-year to $6.8 billion. We continue to see positive momentum with our converged storage solutions but we faced extreme competitive pricing in industry standard server and storage and continued weakness in traditional storage demand. We were also working to address execution challenges across ISS and as Meg noted, we need to improve the go-to-market fundamentals across Enterprise Group.
Operating profit was $1 billion or 15.2% of revenue, down 1.9 points from last year. Higher margins in technology services helped offset weakness in the other businesses, primarily ISS and storage.
By business unit, Industry Standard Servers revenue declined 11% year-over-year to $2.9 billion. We saw double-digit declines in mainstream and Hyperscale. Hyperscale results partially reflected a tough compare over the prior year. Storage revenue declined 10% year-over-year to $833 million. We remained excited about our converged storage offerings which grew 37% year-over-year.
3PAR was up double-digits again and StoreOnce continue to do well. Together, 3PAR plus XP, plus EVA, a metric that adjust for the planned product transition outgrew the market.
Business Critical Systems revenue declined 26% year-over-year consistent with expectations at $284 million. We continue to face Itanium pressures and the overall units market secular declines persisted. This more than offset solid growth in mission-critical x86 sales.
Networking sales were flat year-over-year at $644 million. We continue to make strides in wireless LAN and [attack] the strong customer interest in our new software-defined networking solutions that we introduced earlier this year. That was offset by weakness in U.S. public sector spending.
Finally, in Technology Services, revenue declined 7% year-over-year to $2.2 billion, driven by hardware decline, particularly in DCF in traditional storage. We are focused on improving our attach rate on our newer products.
Turning to Enterprise Services, revenue of $5.8 billion declined 9% year-over-year as public sector austerity measures continued to pressure discretionary IT spending particularly in the U.S. and U.K., but performance was still ahead of where we expected due to incremental business offsetting expected runoff.
Operating profit of $192 million, or 3.3% of revenue was down five points year-over-year due to the higher operating expenses on a tough year-over-year compare, offsetting improvements in resource management and cost controls and our handling our underperforming contracts.
By business units, IT outsourcing revenue was $3.7 billion down 7% year-over-year and Applications and Business Services revenue was $2.2 billion, down 11% year-over-year. Both business units were significantly impacted by contractual run-offs.
Strategic Enterprise Services revenue continues to grow double digits driven by cloud, security, application modernization and big data solutions. We are pleased with the execution progress across ES. Our signings were up double digits both, year-over-year and sequentially, driven by renewals. However, our ability to grow sales beyond traditional offerings needs to improve. Growing our bookings at SES by better embedding in our large deals and winning smaller deals remains a top area of focus.
Software had a solid quarter with revenue up 1% year-over-year to $982 million. We are especially pleased with the continued performance in our strategic areas of cloud, security and big data. Sales of our security solutions grew double digits while Vertica revenue was up triple digits. At the same time, we continue to prune our professional services portfolio which tampers revenue growth, but improves profitability.
Operating profit for the quarter was $201 million or 20.5% of revenues. This was up 2.5 points year-over-year and 1.4 points, sequentially, showing real signs of improved operating leverage.
License revenue was flat year-over-year, while support revenue grew 4% over the prior year. By design, professional services revenue declined 11% from last year and SaaS revenue was up 4% on prior year which is below our expectations, but bookings growth was solid in the quarter. Across software, we saw better sales execution this quarter with improved license conversion, but we still have work to do and building our pipeline and continuing to improve our sales execution.
HP Financial Services revenue declined 6% year-over-year to $879 million due to Enterprise Services volume decline offsetting solid direct business growth. Financing volumes were down 9% year-over-year with net portfolio of assets of $12 billion, down 4%. Operating profit was $99 million or 11.3% of revenue. The return on equity in HP Financial Services continues to be strong.
Moving on to our balance sheet and capital allocation for the quarter. We continued to execute our strategy of driving free cash flow and strengthening our balance sheet. Operating cash flow was $2.7 billion in the quarter, down 6% year-over-year and free cash flow was $2 billion, down 2%. We continued to see improvement in working capital with the cash conversion cycle down nine days year-over-year to 18 days. The year-over-year reduction was driven primarily by improvements in days payable.
Sequentially, the reduction of three days was in line with typical seasonality for days payable and days inventory where we were able to offset the increases from the large deals I noted last quarter with other inventory improvements. Day sales outstanding was better than normal seasonality as a result of strong collections as well as better usage of cash discount.
I want to take a minute to comment on our share repurchase program. In Q3, we spent just $3 million on repurchasing 168,000 shares in the quarter, well below our historical levels. During the quarter, we had material non-public information that prevented us from putting in place a share buyback plan as we typically do.
However, we have developed the plan for Q4 that will ramp up our spending to offset dilution from Q3 and Q4 but will remain inline with our broader FY13 goal of rebuilding our balance sheet. We will provide an update on our capital allocation priorities for fiscal '14 at our Security Analyst meeting in October. We remain committed to overall capital distribution to shareholders and we have paid out $280 million in dividends in Q3.
Gross cash at the end of the quarter was $13.7 billion. Operating company net debt was $1.2 billion, down another $1.7 billion from the last quarter and down $10.6 billion from the peak in the first quarter of fiscal 2012. I am pleased with our progress in reducing operating company net debt and on August 1, we have further reduced gross debt by paying off a $1.l billion maturity.
Looking ahead to the fourth quarter, we see mix trends. At a macro level, we expect consumer demand weakness in the PC industry will likely continue to impact personal systems and we expect continued pricing pressure in printing, personal systems and industry standard servers. At the same time, we expect to see a more favorable trends and demand for commercial PCs relative to consumer. We expect printing to continue to perform well as we utilize Yen tailwinds to place more unit, but as we mentioned, we do have a little bit more work to do to bring down supplies channel inventory.
For enterprise services, contractual run-offs continue but we expect the overall full year revenue decline to be in the 8% to 9% range less than the 11% to 13% range we indicated in the Q2 earnings call. For the year, we continue to expect margins to be at the high end of our zero to 3% range that we provided last October.
Software will have a tough Q4 compare due to the large General Motors deal we noted last year. We still expect to see improved execution and strong customer demand across our big data, security and cloud offerings. Finally, we anticipate one point of currency headwind to revenue in Q4.
With that context, we expect full year fiscal 2013 non-GAAP earnings per share to be in the range of $3.53 to $3.57. We expect full year fiscal 2013 GAAP earnings per share to be in the range of $2.67 to $2.71.
Finally, although we don't typically update our cash flow outlook quarterly, we think it makes sense to update our expectations given our Q3 cash flow performance. We now expect free cash flow to approach $8 billion for the full fiscal year 2013. We did better than expected in Q3, but we believe that Q3 cash conversion cycle was below what we consider to be at sustainable long-term rate. So we expect some pull back in Q4.
I know everyone wants to hear our view on n fiscal '14, but we will provide our detailed outlook at our upcoming Security Analyst Meeting on October 9. We look forward to seeing you all then.
With that, let's open it up for questions.
Earnings Call Part 2: