Hewlett-Packard Company (HPQ) Q2 2014 Results Earnings Conference Call May 22, 2014 5:00 PM ET
Rob Binns - VP of Investor Relations
Meg Whitman - Chief Executive Officer
Cathie Lesjak - Chief Financial Officer
Keith Bachman - Bank of Montreal
Toni Sacconaghi - Sanford Bernstein
Katy Huberty - Morgan Stanley
Ben Reitzes - Barclays
Amit Daryanani - RBC Capital Markets
Sherri Scribner - Deutsche Bank
Brian Alexander - Raymond James
Kulbinder Garcha - Credit Suisse
Bill Shope - Goldman Sachs
Rod Hall - JP Morgan
Jim Suva - Citigroup
Good day, ladies and gentlemen and welcome to the Second Quarter 2014 Hewlett-Packard Earnings Conference Call. My name is Ellen, I'll now 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 second quarter 2014 earnings conference call, with Meg Whitman, HP's Chief Executive Officer and Cathie 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 and 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, margins, expenses, earnings, earnings per share, HP's effective tax rate, 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 reports, including its most recent Form 10-Q. HP assumes no obligation and does not intent 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 second quarter Form 10-Q.
Revenue, earnings, operating margin 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 earning release, both of which are available on 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. With the first half of fiscal 2014 close, I'm pleased to report that HP's turnaround remains on track. As you would expect in the turnaround at this scale, there are some businesses performing better than we expected and others with more work to do. We've made significant progress in putting the systems and structures in place to more effectively manage the business. And we are focused on putting the right talent in place to lead the next leg of the turnaround.
Most of all, we stabilized the topline and we are starting to see the benefits of our focus and investments in key technologies. We have more work to do to improve the consistency of our execution and lower our cost structure to drive overall profitability. But I believe we're well positioned as we enter the second half of 2014. Rest assured, sustained profitable revenue growth remains our top priority.
Innovation is at the heart of our strategy to turn HP around. And in the second quarter you saw the launch of several critical elements of our innovation agenda. In cloud, we launched HP Helium, a portfolio of products and services that enables the next phase of our enterprise customers cloud journey. Helium is changing the game in cloud by allowing the integration of public, private, managed cloud and traditional IT environments on an open and secure platform. We are addressing a major pain point for the enterprise customers with Helium and the early interest has been very positive. We also announced further significant business model innovation in our server business with the creation of a joint venture with Foxconn. Together we’re creating a new line of cloud optimized servers specifically targeting service providers.
This partnership brings together the high volume design and manufacturing expertise of Foxconn with the compute services brand and go-to-market leadership of HP. Together, we will redefine the infrastructure economics of the world’s largest service providers. In big data, we unveiled the HP Shark system for SAP HANA. This new converged system is designed to deliver higher levels of performance and availability for in memory computing at upto twice the speed of other solutions.
We saw strong sequential growth in our HANA offerings in the second quarter and we introduced OpenNFV, a comprehensive network function virtualization program. This new program is designed to help telecom customers launch new services faster with less expense and lower risk. NFV is one of the most significant shift that telecommunications industry has experienced in the last 20 years and represents an important opportunity for HP.
As I’ve said before, we continue to see an acceleration of the massive shifts that are transforming the way customers buy, pay for and consume technology. This reality is creating both opportunities and challenges for HP and every one of our competitors. To win, we have to continue to focus and make HP a more nimble, lower cost, and more customer and partner centric company. We have made a lot of progress to that end over the past two years but we still have more work to do in our structure, our systems and our go to market.
In the second half of 2014, we will be accelerating these activities to ensure that we have the right structure in place as we enter 2015. As a result, we now expect up to an additional 16,000 employees will leave the company under the previously announced 2012 restructuring program. This will bring the total number of employees leaving under the program to as many as 50,000. No company likes to reduce their workforce but the reality is that HP must be maniacally focused on continuous improvement in our cost structure.
We believe this further alignment along with the expected [industry] investments in innovation and infrastructure set us up as a force to be reckoned with in the rapidly shifting markets where we compete.
Turning to the second quarter, HP delivered $0.88 in diluted non-GAAP net earnings per share at the high end of our previously stated financial outlook of $0.85 to $0.89 per share. For the second consecutive quarter, total revenue for the company was approximately flat in constant currency. And we once again delivered very strong cash flow, generating $3 billion in cash flow from operations.
Now let me turn to our business group performance in the quarter. Overall, results in Q2 were driven by solid performance in printing, networking and personal systems, as well as disciplined cost management across all of our businesses. In personal systems we had a very strong performance with revenue up 7% over the prior year. Overall, we’re seeing a slowing market contraction and signs of stabilization, particularly in commercial PCs. This is coupled with support from a refresh of an aging installed base and the expiration of Windows XP.
HP executed well in the quarter particularly in our commercial PC segment. Overall PSG operating margins improved and we gained share with good growth in Europe and Japan. We reclaim the number one position in both commercial PCs and in desktops, all against the backdrop of a declining market.
Looking forward, I'm excited about the strength of our product line-up and we will remain focused on profitable growth and continuing to drive further actions on our end-to-end cost structure. For the fourth consecutive quarter, our printing business once again outperformed the market and saw unit placement growth and we held or gained share in every major printing category and region on a year-over-year basis. All while delivering another quarter of excellent profitability.
In enterprise services as expected revenue was down 7% over the prior year as delayed key account revenue one-off from FY13 continued, the operating profit margin in ES was flat over the prior year and up sequentially. We expect to see a continued ramp and margins in the second half and Cathie will elaborate further on this in a moment. We remain focused on our proactive sales efforts in ES and are in the early stages of this transition, but I can feel the increased confidence from our customers.
While total signings were down over the prior year strategic enterprise services bookings growth is encouraging and we saw good new wins in the quarter. For example, the U.S. Department of Homeland Security awarded HP a Cyber Security contract worth up to $32 million and Belgium's Flemish Government awarded a seven year of €500 million contract to HP and Belgacom to offer ICT services to all local and prudential government entities. The program will give citizens, access to information and services through a virtual private cloud solution.
We've made progress, the opportunities remain for improvement in services bookings and we need to move faster and ramping up our cost savings and productivity initiative. However, I'm confident that the leadership team is taking the right steps to get enterprise services back on track. In the enterprise group revenue declined 2% over the prior year, driven by lower technology services and storage revenue as well as the expected decline in business critical systems. This was partially offset by growth in networking and industry standard servers.
We continue to see a very competitive market in enterprise infrastructure, I'm confident that the changes we've made in the leadership and go-to-market execution coupled with cost saving opportunities and our investment and innovation have put this business back on the right path However we expect it will take a few quarters for these changes to consistently take hold.
In addition to the new products that I discussed earlier, I'm very excited about some of the innovations that we'll be rolling out in the second half of the year from our server, could storage, technology services and converge systems team. We're doubling down on innovation in EG, because we believe that it's how we're going to differentiate in this market.
In the industry standard servers revenue grew for the third consecutive quarter. The team continues to make progress on stabilizing this business and improving our cost structure and go-to-market. We continue to see good customer interest in Moonshot with over 100 beta customers and engagements through our discovery labs and over 40 partners in the program. While we are seeing a ramp in Moonshot revenue, we don't anticipate this will become material in the near term. However we believe Moonshot is on its way to becoming a disruptive product in a new category of servers.
The decline in business critical systems moderated in the quarter, revenue was down 14% over the prior year and up 1% sequentially. Storage revenue was down 6% over the prior years, as customers appear depart to assess new products and market innovations. Despite the market, we still expect to gain a point of share overall. We have work to do to improve our go-to-market in this business, particularly our execution in the Americas.
We've invested in additional storage sale specialists, but these take time to ramp to full productivity. Overall we remain very confident in our storage business. We believe our converged storage portfolio is well positioned to address shifting market forces with products like 3PAR, Store Virtual and Store Once.
Networking performed well with an acceleration of growth. Revenue grew 6% over the prior year with strength in switching and raving and we saw growth across all our regions.
As I have said many times in the turnaround having the right people in the right place at the right time is critical. To that end we’ve recently announced that Antonio Neri has assumed management responsibilities for the networking business in addition to his current role leading the server team. Antonio is a proven leader who has done an excellent job guiding our server business over the past several quarters and our technology services business before that. Integrated systems are becoming increasingly prominent in the data center and Antonio’s new role will help us better align our compute and networking product strategies.
In technology services revenue declined 5% over the prior year. The nature of this business means performance typically lagged hardware sales overall, so we expect revenue to stabilize in line with the progress we’ve made in our hardware sales. The leadership team and TS has done an excellent job managing this business and we continue to see very good customer adoption of our new services and margins remain strong.
In software, revenue was flat over the prior year. Performance in the quarter was driven by growth in Autonomy licensing and strong double-digit growth in Security and Vertica offset by softness in our traditional IP management business.
Looking forward we will continue our transition to SaaS while rejuvenating our core portfolio and investing in operational improvements across this business. In addition, I’ve asked George Kadifa to take on a new role as Executive Vice President of Strategic Relationship. In this role George will responsible for leading growth initiatives and alliance programs with key partners, service providers and our largest customers. After leading HP software George has gained a unique perspective on our strategic priorities of cloud, big data, security and mobility. He understands both the customer requirements and the partner ecosystems that must be built to realize the potential of these technologies.
Robert Youngjohns will take over for George as the Executive Vice President and General Manager of HP Software. Robert is a very seasoned technology executive with more than three decades of experience. He joined the company last year to lead the turnaround of HP Autonomy after serving as President of Microsoft North America.
Overall, I am very pleased with the progress we have made but we still have a lot more work to do. Our focus continues to be driving innovation, simplifying our organizational structure to speed decision making and reducing cost. These initiatives are particularly important as we continue to navigate a rapidly shifting marketplace. Against that backdrop, our Q3 outlook for non-GAAP diluted net earnings per share will be $0.86 to $0.90 and for the full year the outlook will be $3.63 to $3.75.
So now let me turn it over to Cathie for a closer look at our performance in the quarter. Cathie?
Thanks Meg. As Meg said, we feel good about where we are overall as we reach the midpoint of the turnaround. In Q2, total company revenue was in line with expectations with pockets of strength in PCs and networking. Enterprise group revenue was somewhat lower than expected as storage revenue fell although converged storage solutions continued to outperform the market.
Total revenue for the quarter was $27.3 billion, down 1% year-over-year and approximately flat in constant currency. By region, Americas revenue was $11.7 billion down 6% year-over-year or down 4% in constant currency. In the U.S., revenue was impacted by key account run offs in enterprise services plus softness related to jet printing and in most EG business units. This was partially offset by strength in commercial PCs and networking. In Brazil, we experienced weakness across all of our businesses. EMEA revenue was $10.3 billion, up 4% year-over-year or up 2% in constant currency, driven growth in mature western European economies.
We experienced double digit growth in personal systems in EMEA partially offset by declines in printing. APJ revenue was $5.3 billion, up 1% year-over-year or up 6% in constant currency. We experienced revenue growth in China primarily on the strength in enterprise group and printing. In Japan, personal systems revenue was very strong due to the XP migration.
Gross margin for the quarter was 24.2%, up 0.5 points year-over-year and up 1.4 points sequentially. Year-over-year strength in printing and improvements in enterprise services were partially offset by pressure from the strong revenue performance in personal systems and weaker enterprise group margins due to a competitive pricing environment.
Sequentially, most of our businesses improved their gross margins due to good cost management and pricing discipline. Total non-GAAP operating expenses for the quarter were $4.3 billion, up 3% year-over-year, primarily associated with incremental R&D investments. Sequentially, OpEx was up 6% on higher R&D investments as well as a tough compare due the real-estate gains as reported in fiscal Q1.
As a result, non-GAAP operating profit was $2.3 billion or 8.6% of revenue, flat year-over-year and up 0.1 point sequentially. We recorded a $174 million of expense on the other income and expense line. With the 22% tax rate and a weighted average diluted share count of 1.916 billion shares, we delivered second quarter non-GAAP diluted net earnings per share of $0.88. Second quarter non-GAAP earnings primarily excludes pre-tax charges of $264 million for amortization of intangible assets and $252 million for restructuring charges.
Now turning to the business units. In printing, we saw very strong profitability and further traction in key initiatives like Ink in the Office and Ink Advantage as well as in graphics. However, weak toner sales continued to be headwind as the hardware installed based remains under pressure. We are focused on placing value-added units to support the installed based throughout the rest of fiscal '14.
Total printing revenue was $5.8 billion, down 4% year-over-year, driven by a decline in supplies revenues, primarily related to lower toner sales. Commercial Hardware revenue was $1.4 billion, down 1% year-over-year while Consumer Hardware revenue was $566 million, up1% year-over-year. Total hardware unit shipments grew 1% year-over-year.
Ink in the Office and Ink Advantage units and revenue each grow double-digits and we grew share in both ink and laser hardware units. Supplies revenue was $3.9 billion, down 6% over the prior year period and made up 66.3% of printing revenue. Although the mix is down a point year-over-year, ink is a greater part of supplies mix which helps offset the negative impact of lower supplies on overall printing profitability.
Total printing operating profit was $1.1 billion or 19.5% of revenue, up 3.6 points year-over-year. We saw a positive currency benefit of approximately 1.5 points in second quarter margins plus we realized some of the benefit from our focus on reducing non-labor costs and disciplined OpEx management. We expect to reinvest back some of these profits in value added hardware units.
Supplies channel inventory levels remained very slightly above our target range. This was primarily due to softer toner sales in Europe, but we did make progress reducing overall toner channel inventory in the quarter.
The personal systems group had a strong quarter. Despite a contracting PC market, revenue in personal systems was up 7% year-over-year at $8.2 billion, driven by strong growth in commercial desktops and notebooks.
Commercial sales grew 12% year-over-year with consumer sales down 2% although consumer notebook revenue grew slightly for the first time since the fiscal 2010 third quarter.
Total unit shipments grew 10% year-over-year with growth in both commercial and consumer; each segment outperformed the market. Total channel inventory remains well within acceptable ranges. Personal systems operating profit was $290 million or 3.5% of revenue up 0.3 points year-over-year driven primarily by favorable mix partially offset by competitive pricing.
Enterprise group revenue was $6.7 billion down 2% year-over-year or down 1% in constant currency driven primarily by declines in technology services, storage and business critical systems. Operating profit in the quarter was $961 million or 14.4% of revenue flat sequentially and down 1.4 points year-over-year as a result of the continued competitive pricing environment and increased investments primarily in R&D.
By business, ISS revenue was $2.8 billion, up 1% year-over-year with strength in EMEA and APJ. Sequentially revenue declined on lower hyperscale mix after we completed shipping a large deal in the first quarter. Lower hyperscale mix and good pricing discipline drove gross margins up sequentially again this quarter. While the server market remains very competitive we believe we’re taking the right actions to improve our go-to-market strengthen our channel and align our cost structure.
Technology services revenue was $2.1 billion down 5% year-over-year. TS revenue continues to be impacted by past declines in hardware sales but the strategy we have in place remains unchanged and the team is making progress. Penetration rates were up year-over-year driven by storage and networking attach and we’re seeing strong growth in our newer offerings like proactive care and data center care. Profitability in this business continues to be strong.
Networking performed well in the quarter, revenue was $658 million up 6% year-over-year with strength in switching across all regions and we once again outgrew the networking market leader. Storage results however were disappointing. Revenue was down 6% versus the prior year period at $808 million. Converge storage declined 3% year-over-year and 3PAR plus EVA, plus XP also declined but continued to outperform the market.
While it’s clear we aren’t alone in experiencing weakness in the storage market we also have an opportunity to improve execution particularly in the U.S. We still expect converge storage to become greater than half of all storage revenue later this year but we expect Q2 results to pressure overall storage revenue for the full year.
Business critical systems revenue declined 14% year-over-year to $230 million as strength in mission critical x86 help to offset the continued impact from the units declined. Enterprise services was $5.7 billion down 7% year-over-year primarily driven continued key account run off. By business IT outsourcing revenue was $3.6 billion down 7% year-over-year and applications and business service revenue was $2.1 billion down 8% year-over-year.
Operating profit for ES was $144 million or 2.5% of revenues flat year-over-year. Sequentially operating margins were up 1.5 points driven by ongoing cost management and continued improvement in our under performing account.
We expect to see continued progress in both of these areas in the half of the year as well as better top line trends as key accounts run off tapers driving the full year operating profit margin within our outlook range of 3.5% to 4.5%. Although total signings were down year-over-year strategic enterprise services signings were double digits once again and we saw encouraging improvement in win rate.
Our trailing 12 month book-to-bill was slightly lower sequentially as we exited Q2. Signings can be lumpy but we anticipate improvement in this metric during the second half of the year. Overall, we're making progress on our sales transformation and are seeing a better mix of new logo, but we still have more work to do to successfully pivot to a more proactive sales approach.
In software, revenue was roughly flat over the prior year period at $971 million with better license revenue due to continued strength in our key focus areas of security and big data offset by lower support revenue. License revenue grew 8% year-over-year with strength in ArcSight, Fortify, Vertica and Autonomy.
Support revenue declined 4% year-over-year as pass license revenue declines continue to create a headwind. Professional services sales grew 1% year-over-year driven by strength in security and big data. SaaS revenue grew 6% over the prior year period and we had strong bookings growth in IT Management and Autonomy.
Operating profit was $186 million or 19.2% of revenue up 0.6 points year-over-year, primarily driven by continued gross margin expansion in professional services partially offset by increased investments in R&D. We completed a small software acquisition in the quarter (inaudible) provide network virtualization technology and had no material impact on our financial results in Q2 and is not expected to materially impact the full year.
HP financial services revenue was $867 million, down 2% year-over-year, operating profit was $99 million or 11.4% of revenue. While revenue continues to be impacted by financing volume shortfalls from fiscal '13, new financing volume grew 12% year-over-year. The health of our portfolio of assets remained strong and return on equity was 18.2%.
Turning to cash flow and capital allocation. We had another strong quarter, generating $3 billion in operating cash flow and $2.3 billion in free cash flow. We continued to focus on working capital and brought our cash conversion cycle down to 13 days in the quarter, helped by a favorable mix with strong personal systems revenue and the expansion of our factoring program.
Consistent with our efforts to improve our payment terms with key partners that I talked about in previous quarters, we increased net utilization in our factoring program by approximately $750 million in the quarter. However, we believe many of our customers would have taken advantage of early payment discounts, so we estimate the actual benefit to cash flow to be approximately 1 to 2 days to our cash conversion cycle.
For the year, we continue to expect some upside to our original cash flow forecast, as I talked about last quarter, driven by working capital efficiencies. We further expect the expanded factoring program to provide some additional benefit.
In Q2, we accelerated our return to shareholders by repurchasing 26.7 million shares in the quarter and paid $298 million in dividend. In total, we returned approximately $1.1 billion to shareholders in Q2 and we are still committed to our plan to return at least 50% of free cash flow to shareholders in the form of share repurchases and dividends for the full year.
We improved our operating company net cash position by approximately $1 billion for the 9th quarter in a row and ended Q2 with operating company net cash of $2.7 billion.
Now looking forward to Q3. In printing, we'll continue to focus on placing value added units and expanding our innovative ink, laser and graphics programs. We expect that toner will remain under pressure for the rest of the year.
In personal systems, we expect the market to remain challenging and that the upward pressure from higher component costs may limit our ability to pursue upside deals as we focus on profitable growth. Also don't forget about the (inaudible) deal from last year that will make for a tough revenue compare in Q3.
In EG, we have a strong team in place that is focused on aligning our cost structure, managing our margin profile and improving our go-to-market execution across the businesses, while investing for long-term success. In ES, as I talked about, we expect the ongoing actions we’re taking to improve our cost structure and our underperforming accounts along with the tapering of revenue run-off to result in better profitability in the second half of the year.
In software, we expect to see continued traction in key growth areas like big data and security while we invest in the business and manage our portfolio transition to SaaS. Across all of our businesses, competing and winning in today’s challenging environment requires lean organizations with the focus on strong performance management. We’re optimizing our workforce and reengineering our business processes to both build a strong operational foundation and create capacity for investments to drive further growth.
Through this ongoing focus, we’ve identified incremental opportunity as I have signaled in the past quarters and we now expect approximately 45,000 to 50,000 people to leave the company under our announced 2012 restructuring program. This is up from our previous estimate of 34,000. We expect the total of approximately 41,000 people to leave by the end of fiscal 2014 with the remainder in 2015.
We expect this to create additional run-rate savings in fiscal ‘16 of approximately $1 billion per year on top of what we previously laid out although we expect some of this will be reinvested back into the business. In fiscal ‘14, we expect approximately $0.02 to $0.03 of incremental savings and estimated incremental charge of approximately $500 million and an additional cash flow impact of approximately $200 million in the second half of fiscal ‘14. We will provide further clarity on the specific FY15 impact to P&L and cash flow when we provide our outlook for the next year at a Security Analyst Meeting in October.
As we said, we won’t do additional restructuring at a corporate level after this program is complete. However, each business will continue to drive workforce rebalancing and will account for those changes within the segment P&L.
With that context, we expect full year fiscal 2014 non-GAAP diluted net earnings per share to be in the range $3.63 to $3.75. For fiscal 2014 Q3, we expect non-GAAP diluted net earnings per share in the range of $0.86 to $0.90. From a GAAP perspective, we expect the full year GAAP diluted net earnings per share to be in the range of $2.68 to $2.80 and GAAP diluted net earnings per for fiscal Q3 is expected to be in the range of $0.59 to $0.63.
With that let’s open it up for question.
Thank you, Cathie. Before we go to questions, I am sure you all noticed that earlier today the HP press release with earnings went live before the appropriate time and we are sorry about that and we’ll make sure that that doesn’t happen again. So now we’ll go on to questions.
Earnings Call Part 2: