Highlights From HPQ's Q2 Conference Call: Tops Estimates, But Guides Below

Hewlett-Packard Company (NYSE: HPQ) reported Q2 EPS of $1.24, $0.03 better than the analyst estimate of $1.21. Revenue for the quarter came in at $31.6 billion versus the consensus estimate of $31.54 billion. Shares are currently trading down 7.53% to $36.81.

Highlights From HPQ's Q2 Conference Call:

• Sees Q3 adj-EPS of about $1.08, vs. the consensus of $1.24. Sees sales of $31.1-$31.3 billion, vs. the consensus of $31.81 billion.
  
• Sees FY2011 adj-EPS of at least $5.00, versus the consensus of $5.24. Sales move from $130-$131.5 billion to $129-$130 billion, which compares to the Street estimate of $130.3 billion.
  
• (Lo Apotheker) At HP we intend to lead by making the right customer-focused decisions to take advantage of the changing technology and Web [ph] and by executing aggressively on our long-term strategies. As always, these decisions need to be balanced with a focus on operational efficiency and prudent financial disciplines.
  
• In the second quarter we demonstrated our ability to execute aggressively, make the right decisions for our future and drive operational efficiency. We achieved solid results, growing revenue 3% and gaining market share in key segments.
  
• From a profitability perspective, we expanded both gross and operating margins as we continue to drive a better portfolio mix. We grew non-GAAP EPS 14% versus last year; and we generated a healthy $4 billion cash flow from operations in the quarter.
  
• We continue to make investments in the business with new innovations and incremental R&D spend. We announced many new offerings including the successful launch of cloud systems, flex network and networking, end of year Smartwork.
  
• Cloud systems is a great example where we were leveraging conversion infrastructure, software, security and services to help customers build, manage and consume cloud services across private clouds, public clouds and traditional IT environments. We have already attracted thousands of customers in our pipeline.
  
• In Q2, we continue to demonstrate strength in our Commercial business across the company. Our Commercial business, which represents close to three quarters of HP revenue was up 8% year over year.
  
• And I'm pleased with the improvements being made our Software businesses, which grew total revenue 17% nd license revenue 29% versus last year.
  
• In Q2, consumer PC revenue decline over 20% year over year. Even though our consumer PC expectations have been cautious, the steepness of our Q2 decline is greater than what we had anticipated.
  
• We are remaining cautious in the near term. However, we are excited about the tablet opportunity. We'll be hearing and seeing more from our touchpad in the weeks and months to come. It will be an exciting positive thing for HP. A quick update regarding PSG in China.
  
• We still have significant headroom to get back to the share we lost and we expect our momentum to carry into the second half.
  
• As a result, our short-term margin expectations have been too high. This has impacted our ability to create sustainable growth for the long term. In particular, we have not yet shifted our services mixed to higher value, higher margin and higher growth categories.
  
• First, due to the importance of increasing the value of our enterprise services business we have decided to launch a search for an EVD for this business reporting directly to me and even more [ph] in addition, to the role of EVP for our enterprise business will be the interim leader of here [ph].
  
• We also have decided to combine the technology, services organization with the ESSN organization under Dave Donatelli's leadership. The TS businesses has made great improvement over the last several years. The next phase is to create greater go-to-market leverage with our products and invest more technology into our products to further ultimate services.
  
• Second, we will accelerate portfolio investments and higher value-added services. We will deepen industry content. We will form a business solutions group to create more strategic value for our customers.
  
• Finally, we will continue to have a tight focus on operational excellence. We will move forward with modernizing our data centers and rationalizing processes, leveraging HP software.
  
• (Catherine A. Lesjak) We grew non-GAAP earnings per share by 14% and generated $4 billion in cash flow from operations. Revenue for the second quarter totaled $31.6 billion, up 3% from the prior year. Commercial hardware was strong across the company but we still saw weakness in consumer PCs.
  
• By geography, revenue in Asia Pacific region grew 10% year-over-year, or 4% in constant currency. Revenue in the Americas grew 2%, or 1% in constant currency and revenue in EMEA was down 1% year-over-year, or flat and constant currency.
  
• Gross margin in the second quarter was 24.6%, up 100 basis points from the prior year due to our continued favorable commodity environment as well as favorable mix from networking, PSG and software.
  
• We are investing some of our gross margin improvements back into the business. Total operating expenses were $4.2 billion, up 10% year-over-year with increases in R&D and deal-selling costs, both of which are expected to enable revenue growth in coming quarters.
  
• Non-GAAP other income and expense yielded a net expense of $76 million due to a more favorable currency impact. We delivered non-GAAP operating income growth of 3% year-on-year to $3.6 million or 11.3% of revenue. Second quarter on-GAAP net income improved year-over-year to $2.7 billion and non-GAAP diluted earnings per share increased 14% to $1.24.
  
• In the second quarter we continue to execute on our cloud vision, including all aspects of the Converged infrastructure from Storage, Servers and Networking to Software and Services. The Enterprise Servers, Storage and Networking business grew revenue 15% to $5.6 million. Operating profit grew 1.5 times revenue growth or 23% to $756 million for the quarter.
  
• Our Industry Standard Servers business remained #1 in share across all three regions with revenue growth of 11%. Revenue in Business Critical Systems was up 1.5% year-over-year with strength in non-stop enterprise servers. In addition, customers are responding to the low total cost of ownership and the reliability in our Superdome 2 systems.
  
• Overall, HP Storage revenue increased 3% from the prior year with strong growth in our scale of products and data duplication technology partially offset by lower EVA revenue as some customers wait for the new product refresh this summer. HP remains #1 in the blade server market and grew ESS blade revenue 20% year-over-year.
  
• HP Networking grew 118% including the acquisition of 3Com and 14% year-over-year on an operational basis. While our major competitors are seeing declines in their networking businesses, we delivered double-digit growth in our Switching and Routing business.
  
• HP Services delivered revenue of $9 billion, up 2% from the prior-year quarter. We delivered operating profit of $1.4 billion or 15.2% of revenue, down 60 basis points from the prior year. IT Outsourcing revenue was up 2% year-over-year.
  
• In Q3 of fiscal '11 we expect Services margins to be 13.5% to 14% as a result of lower revenue growth in local currency, unfavorable mix and investments we are making to further enable higher margin business. For Q4 we expect Services margins to be a bit higher than in Q3.
  
• We are pleased to report the strong performance in HP Software with revenue of $764 million, up 17% compared with the prior year led by 29% license growth, 22% service revenue growth and 8% support revenue growth. We see tremendous opportunity in our security portfolio and in our recent acquisition ArcSight, Fortify and Stratavia.
  
• In fact, we gained almost a point of market share in the security and vulnerability market. Second quarter operating profit was $154 million, or 20.2% of revenue.
  
• Turning to personal systems. PSD delivered revenue of $9.4 billion, down 5% from the prior year. We are firm traction on the recovery in China and PSD revenue in China was up several digits sequentially and roughly flat year-over-year.
  
• We also gained nearly two points a share sequentially in China and have a good mix of new products in the channel. Across all geographies, however, we continue to see softness in the consumer PC markets that offset the strength in commercial clients. By form factor, desktop revenue was down 4% and notebook revenue was down 9% year-over-year both impacted by the consumer. Total consumer client revenue was down 23% versus the year-ago quarter.
  
• In commercial, the refresh continues. Commercial client revenue grew 13% led by another strong quarter in work stations which generated 28% growth. Segment operating profit totaled $533 million, or 5.7% of revenue up 100 basis points year-over-year as PSG benefited from favorable component pricing and product mix.
  
• Moving on to POD which is included in corporate investments. There is a lot of anticipation about the upcoming launch of the touchpad and the buildout of the WebOS ecosystem. We remained in the investment phase in terms of completing the software build, working with the developer community on the application ecosystem and making sure that we get the product right. We are on track to ship the touchpad this summer as previously announced.
  
• The imaging and printing business delivered solid performance in the second quarter with revenue growth of 5% to $6.7 billion led by commercial revenue growth of 7% and supplies revenue growth of 7%. Segment operating profit totaled $1.1 billion, or 17% of revenue while we continue to invest in innovation and growth. Total printer unit shipments increased 12% with commercial and consumer printer units up 41% and 4% respectively as we gained market share in laser printer hardware.
  
• We are seeing solid momentum in our growth initiatives as we continue to lead market with innovative new products. Indigo Digital Press page volume was up 22% year-over-year. Our color laser and multifunction printer units grew 26% and 60% respectively while Business Inc. [ph] unit shipments increased several digits from the prior year and shipments of wireless per unit more than doubled.
  
• HP financial services continues to deliver strong consistent results. In the second quarter financing revenue grew 17% to $885 million. Financing volume increased 14% and net portfolio assets increased 18%. Operating profit of $83 million is up 20% year-over-year to 9.4% of revenue.
  
• Now on to the balance sheet and cash flow. Our balance sheet remains strong. We closed the quarter with total gross cash of $12.8 billion. Our second quarter cash conversion cycle was 25 days, up 8 days from the year-ago period due to a higher proportion of sales occurring late in the quarter.
  
• In Q2 day sales outstanding increased 10 days from the prior year. Inventories were up one day and days payable increased three days year-over-year.
  
• Channel inventories in each business ended the quarter within acceptable ranges. We continue to generate strong cash flow with operating cash flow of $4 billion and free cash flow of $3 billion each up over 28% from the prior year.
  
• We are expecting a temporary near-term impact to revenue and operating profits due to the events in Japan. We expect revenue to decline due to reduced demand in Japan and certain supply chain constraints in crimping hardware and supplies. The total impact will be roughly $700 million of company revenue or about 1% of company revenue in the second half with about two-thirds of the impact in the third quarter.
  
• Due in part to the expected supply chain impact from the earthquake and tsunami in Japan as well as continued softness in consumer PCs, we now expect Q3 revenue of $31.1 billion to $31.3 billion. For the full year we expect revenue to be $129 billion to $130 billion.
  
• With respect to earnings keep in mind the following: first, we have revised expectations for the operating profit in the Services business of 13.5% to 14% of revenue in Q3; second, OINE [ph] expense of approximately $150 million per quarter; third, a tax rate of approximately 22%; and finally, weighted average shares outstanding for fiscal 2011 of $2.175 billion.
  
• Thus we expect third quarter non-GAAP earnings per share to be approximately $1.08. For the full year we now expect non-GAAP EPS to be at least $5 per share.
  
• (Q&A) Lo, you talked in your opening remarks about companies that will fail because they protect legacy businesses. And with two guidance resets in a row, is it time, in your view, for HP to reconsider whether you really need to participate in some of the businesses that are dragging down performance? Or do you think you can invest fast enough in new growth segments to offset declines that we're seeing like in PCs right now? (A) Yes, good morning. At HP we do a regular portfolio review to assess the performance of each one of our businesses. And we assess these businesses according to their contribution to the business and their contribution to our strategy and the value it can generate to our customers. It's interesting that you point out PCs. If you look at the performance of PCs it has a two-faced approach and a two-faced execution. On the one hand, on the commercial side, we see a continuous demand for PCs; 12% growth again and we are the market leader in this business. And we see some weakness on the consumer side. We believe that we have a great strategy to execute towards our connectivity approach and we are very excited about our top spreads [ph] coming out in particular in the summer. And as we all believe that there will be a convergence of these different form factors over time such that PCs, et cetera, and in particular Notebooks, we believe that it is a great opportunity for HP to participate in this. Of course we will continue to assess the value of each element in the portfolio as we continue to look at our business, but right now I believe we have a balanced portfolio.
  
• And just as a follow-up to that, any sense for timing as to when we could see you step up and make some acquisitions? (A) We are at the same time as we look at the portfolio, of course are looking at acquisitions as well; in particular in areas we want to growth faster such as software, but we will not abandon our prudent M&A approach. We want to make sure that we are financially prudent and strategically wise and that we are mindful of shareholder value; but we are scanning the market we are actively engaged in. As in the past we will be looking at acquisitions for the portfolio or at organic growth or at both.
  
• Lo, you recently laid out $7 earnings figure for 2014 after doing $5 this year, I think it takes12% EPS growth each year to get there. So my question is can you still get there based on what we've heard today? And how? And then I just was hoping Cathy could clarify the near-term guidance? It seems like the cut for 3Q versus the Street is two-thirds services, one-third Japan and consumer. I just wanted to clarify that? (A) So let me answer your question first. We are making tough decisions today to set us up for the future. And in the long-term we have multiple levels to drive our EPS growth. But the investments we're making today will help create sustainable growth including sustainable EPS growth, and we are focused on improved business mix and continued operational excellence, including a better mix in each one of our businesses. For example as Services has demonstrated by today's public decision. Our long-term model is to grow operating profits faster than revenue and EPS faster than operating profits. So yes. I can confirm that we are maintaining our $7 EPS target.

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