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Hewlett-Packard Company (NYSE:HPQ)

F4Q08 Earnings Call

November 24, 2008 5:00 pm ET

Executives

Jim Burns - Vice President, Investor Relations

Mark V. Hurd - Chairman of the Board, Chief Executive Officer and President

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

Analysts

Ben Reitzes - Barclays Capital

Richard Gardner - Citigroup

Tony Sacconaghi - Sanford Bernstein

Brian Alexander - Raymond James

Kathryn Huberty - Morgan Stanley

Bill Shope - Credit Suisse

David Bailey - Goldman Sachs

Keith Bachman - Bank of Montreal

Jeff Fidacaro - Merrill Lynch

Shannon Cross - Cross Research

Mark Moskowitz - J.P. Morgan

Bill Fearnley - FTN Midwest Research

Maynard Um - UBS

Louis Miscioscia - Cowen and Company

Operator

Good day, ladies and gentlemen, and welcome to the Hewlett-Packard Q4 2008 earnings conference call. My name is [Antoine] and I will be your operator for today. (Operator Instructions)

I would now like to turn the call over to Jim Burn, Vice President of Investor Relations. Please proceed, sir.

Jim Burns

Thanks, Antoine, and good afternoon. Welcome to our fourth quarter earnings conference call with Chairman and CEO Mark Hurd and CFO Cathy Lesjak. This call is being webcast live and a replay of the webcast will be available shortly after the call for approximately one year.

Some information provided during this call may include forward-looking statements that are based on certain assumptions and are subject to a number of risks and uncertainties and actual future results may vary materially. Please refer to the risks described in HP's SEC reports, including our third quarter Form 10-Q. The financial information discussed in connection with this call, including tax-related items, reflects estimates based on information available at this time and could differ materially from the amounts ultimately reported in HP's 2008 Form 10-K.

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 amortization of purchased intangibles, 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 in the third quarter earnings slide presentation accompanying today's earnings release, both of which are available on the HP Investor Relations website at HP.com.

I'll now turn the call over to Mark, with a final reminder to please refrain from asking multipart questions or clarifications during the Q&A.

Mark V. Hurd

Good afternoon. Thanks for joining us. Hewlett-Packard capped off a record year by delivering another solid quarter, with revenue growth of 19% and non-GAAP EPS growth of 20%. These results demonstrate our ability to execute in a challenging market. Great companies excel in tough times, and in tough times, customers turn to great companies. I'm confident in HP's ability to gain share, expand earnings and emerge from the current environment as a stronger force in the marketplace.

In Q4 we continued to benefit from our global reach, broad portfolio of products and services, and numerous cost initiatives. We believe we held or gained share in each of our segments, while continuing to show discipline in our pricing and promotions. Software, HP Services, Notebooks, Blades and Storage each posted double-digit revenue growth, highlighting both our market-leading technology and improved execution.

I'm especially pleased with the results of our Services segment and the solid performance in Technology Services and in HP Outsourcing. Technology Services grew orders and revenue double digits for the year and the HP Outsourcing business had its best quarter in history, with strong revenue growth, record profitability, and significant new wins. The EDS integration is at or ahead of the operational plans we shared with you in September, and customer response to the acquisition remains very positive.

Before I turn the call over to Cathy to review the financials, let me highlight three reasons I'm confident in HP's outlook despite the macroeconomic challenges.

First, our cost structure. Our company is leaner and more flexible than ever and yet we still have more work to do, which is actually good news. As we've said many times before, regardless of the macro conditions, we are eliminating all costs that are not core to the company's success. In 2009, excluding currency impacts, we expect to save more than $1 billion year-over-year through the previously announced initiatives related to EDS and HP's corporate overhead. We expect additional savings through numerous initiatives in each of our segments, and we will be tightening discretionary spending given the environment.

Second, our business mix. We have approximately one-third of our revenue and well over half of our profits from recurring sources, like Services and Supplies. Although not immune to economic factors, the future performance of these businesses is largely determined by the quality and sale of our customer installed base.

Lastly, our execution. We worked hard and invested heavily to improve the quality of our planning and the consistency of our performance. We now run the company on 65% fewer applications and a modernized infrastructure which not only reduces our costs but provides a simpler platform on which we can innovate and improve our business productivity. And this is a big deal for us. While we still have many areas where we can improve, our financial and operational discipline is a competitive advantage in all market environments and especially in challenging ones.

The market is getting tougher and less predictable. That said, an environment like this provides an opening for a company like HP to improve its competitive position and we have every intention of taking advantage of that opportunity.

With that, I'll turn the call over to Cathy.

Catherine A. Lesjak

Thanks, Mark, and good afternoon, everyone. I've got a lot of ground to cover, so let me start by outlining the topics for today. First, I'll revenue HP's overall and business segment performance, then I'll cover the impact of the restructuring activities on the P&L and balance sheet before moving on to cash management. I'll conclude with a discussion of our outlook for the first quarter and the full fiscal 2009.

As a result of the closing of the acquisition of EDS on August 26, HP's Q4 fiscal 2008 results include roughly two months of EDS' financial results. Thus, I will also provide comparisons relative to the HP excluding EDS to facilitate year-over-year comparisons. Let me get started.

Revenue for the fourth quarter totaled $33.6 billion, up 19% year-over-year or up 16% in constant currency. Excluding the impact of EDS, revenue increased 5% or 2% in constant currency.

Looking at revenue by geography, we generated 68% of our total revenue from outside the United States. Revenue in EMEA was up 22%, the Americas increased 17%, and Asia-Pacific increased 14%. Excluding EDS and the effects of currency, EMEA was up 3%, the Americas was approximately flat, and Asia-Pacific increased 6%.

Fourth quarter gross margin for the total company was 22.9%, down 180 basis points from 24.7% one year ago. This decrease in gross margin was driven primarily by the addition of EDS, which reduced gross margins by 140 basis points and, to a lesser extent, by a more normalized impact from commodity pricing compared with a year ago.

Non-GAAP operating expenses for the quarter were $4.3 billion or 12.8% of revenue, down 2 percentage points from a year ago. Adjusting for currency and the EDS acquisition, total expenses dollars also declined due to the continued expense discipline, even as we invested appropriately in R&D; go to market, and customer support.

Non-GAAP operating profit increased 21% to $3.4 billion or 10.1% of revenue, and non-GAAP EPS was $1.03, representing a 20% increase from the prior year quarter. GAAP EPS increased 4% to $0.84, which included $482 million or $0.19 per share in after-tax adjustments primarily due to the amortization of purchased intangibles and restructuring charges that were excluded from our non-GAAP results.

Looking at the performance by business segment, Personal Systems grew revenue 10% or over $1 billion to $11.2 billion. During the quarter, unit shipments grew 19% over the prior year period, with double-digit unit growth in every region as well as our Consumer and Commercial businesses. Growth in PSG continues to be driven by growth in notebooks and emerging geographies. Notebook revenue grew 21% and PC revenue in the BRIC countries grew 29%.

Our innovative product portfolio, combined with over 80,000 retail outlets and 140,000 distribution partners around the globe give us a sustainable competitive advantage. PSG operating profit for the quarter was $616 million or 5.5% of revenue, down 30 basis points versus the prior year, reflecting a more normalized impact from commodity pricing.

Over the last five years, our Personal Systems team has made tremendous progress toward a more flexible cost structure by streamlining its operations, leveraging its scale, and building a more nimble organization. At the same time, they have invested in design and technology, bringing to market a collection of innovative new products. This has enabled them to effectively balance profit and growth and positions them well for continued market leadership.

Imaging and Printing reported revenue of $7.5 billion, down 1% year-on-year. For the quarter, Supplies revenue growth of 9% was offset by declines in Commercial and Consumer hardware revenue of 10% and 21% respectively. Excluding cameras, Consumer hardware revenue declined 15%. Operating margin increased 100 basis points to 15.5% as strong Supplies growth and cost reductions were partially offset by discounting.

We gained share in calendar Q3 while total printer units were down 8% and Consumer and Commercial printer hardware units declined 8% and 9%, respectively. That said, we saw solid performance in key focus segments, in particular, multifunction printer units grew 25%, wireless printers increased 64%, and we gained market share in the over $80 inkjet printer segment.

Within IPG, we are focused on reducing our costs with ongoing initiatives to improve supply chain efficiency and lower product cost. We are investing these savings in targeted growth areas, including the enterprise and graphic arts. We will continue to be prudent in our pursuit of lower end units as well as focus on driving profitable growth and positioning ourselves for the long term.

Enterprise Storage and Servers revenue was $5.1 billion, down 1% year-over-year. Blades continue to be a strong growth driver; total ESS Blade revenue increased 43%. Within ESS, Storage revenue grew 13% driven by our midrange EDA business, which outpaced major competitors with 16% growth.

Turning to our Server businesses, Business Critical Systems revenue declined 10% and Industry Standard Server revenue declined 3% from the prior year. Total ISS units increased 7%, led by strong Blade growth of 39%. ISS grew its market share 2 points, to 35%, while maintaining good productivity. Enterprise Storage and Servers posted solid fourth quarter operating profit of $705 million or 13.9% of revenue.

Revenue in HP Software grew 13% to $855 million. BTO outgrew its primarily competitors, increasing 15% from the prior year as large enterprise customers increasingly deploy our management and automation tools to more effectively enhance the value of their IT investments. Other software, which includes Open Call, Business Intelligence, and Information Management, grew 1% as the strength in the information management business was offset by declines in Open call.

In Q4, Software posted operating profit of $195 million or 22.8% of revenue. For the full year, the Software business more than doubled its operating profit to $461 million, up from $221 million in fiscal 2007.

HP Services, with the addition of EDS, doubled its revenue to $8.6 billion and reported solid operating profit of $920 million or 10.6% of revenue. Excluding EDS, HP Services capped off the year with another strong quarter, delivering revenue growth of 10%, with 15% growth in outsource services, 10% growth in technology services, and 2% growth in consulting and integration.

For the period between the August 26 acquisition date and October 31, EDS delivered revenue of $3.9 billion. EDS performed well as customers across all regions continue to respond favorably to the combined services business. Demand remains solid, with a healthy mix of new and existing customers. From an integration perspective, we are on track with our plans as we begin to capture the cost synergies we discussed at our September analysts meeting. During the fourth quarter, we eliminated over 2,300 positions in connection with the EDS integration.

Technology Services has delivered strong results throughout fiscal 2008, reflecting continued focus on services attach combined with operational improvements from our ongoing efficiency initiatives. HP Outsource Services and C and I showed consistent profit improvement as the year progressed. While we have more work to do, these [break in audio] put us in a much strong position to successfully integrate our HP Services businesses and EDS and realize the synergies of the combined company.

And finally, HP Financial Services had revenue of $691 million, up 5% year-over-year, and generated operating margin of 7.4%. We continue to apply the same rigorous process for assessing the creditworthiness of our customers and the quality of our receivables. We are encouraged with the growth in our financing volume. The overall portfolio is performing well, consistent with the past few years.

Now I'd like to spend a moment to update you on the impact of the restructuring program implemented in connection with the EDS integration. In Q4 we took a $251 million charge in our GAAP P&L and another $1.5 billion purchase accounting adjustment to goodwill on our balance sheet. The cash impact associated with the Q4 charges will be spread over roughly the next two years as the actual headcount reductions occur. We expect additional restructuring charges of approximately $150 million for fiscal 2009 and approximately $130 million in fiscal 2010 and beyond.

Now on to the balance sheet and cash management. Day’s sales outstanding increased to 45 days in Q4 from 43 days one year ago. Excluding EDS, DSO was down two days year-on-year to 41 days. Day’s payable was 49 days, down one day year-over-year. Excluding EDS, day’s payable was up 4 days year-on-year to 54 days.

One of my focus areas since becoming CFO has been improving our management of the balance sheet. Over the last two years, excluding EDS, total inventory dollars are down despite nearly $23 billion of revenue growth. For the fourth quarter, owned inventory was 27 days. Excluding EDS, days of inventory was down 3 days to 31 days. With regards to channel inventory, we ended the quarter with ESS flat, IPG up half a week, and PSG up a week year-over-year.

Next, property, plant and equipment was up $3 billion year-over-year as a result of the EDS acquisition with $1.1 billion of land and buildings and $2.1 billion of equipment, primarily related to EDS's data center.

Gross CapEx was $1 billion, up 26% from the prior year period. On a net basis, CapEx was $870 million, up 16% year-over-year. Increased capital expenditures were primarily related to growth in our leasing and outsourcing businesses, including EDS.

Cash flow from operations was $3.3 billion for the quarter and free cash flow was $2.4 billion.

Share repurchases in the fourth quarter totaled $1.9 billion or approximately 45 million shares. At the end of the quarter, we had roughly $9.1 billion remaining in the current share repurchase authorization.

Finally, we paid our normal quarterly dividend totaling $196 million.

For the full year, cash flow from operations was record $14.6 billion, up 52% from fiscal 2007, and free cash flow was $12 billion, up 68% from the prior year. During fiscal year 2008, we returned $10.4 billion to shareholders through share repurchases and dividends and invested $11.2 billion of net cash in acquisitions.

We closed the year with a strong balance sheet, including total gross cash of $10.3 billion. Our total debt at October 31 was $17.9 billion, including $7.4 billion associated with HP Financial Services and $7.1 billion in commercial paper.

We funded the EDS acquisition through a combination of cash and commercial paper. Given our strong rating, we have had no problem accessing the CP markets and the interest rates on commercial paper have been substantially more attractive than rates on long-term corporate bonds. Our commercial paper program is backed by approximately $14 billion of committed lines of credit, the majority of which are from banks that have AA minus ratings or better.

Additionally, we have signed up for the U.S. government commercial paper funding facility, which provides us access up to approximately $10 billion of commercial paper with 90 day maturities. We are maintaining the flexibility to term out our debt and will likely do so at some point. Despite seasonal softness in Q1, we are expecting another solid year of cash flow in 2009.

Now, looking ahead to our outlook for Q1 and fiscal 2009, we don't know how the economy will evolve, but at this point we are expecting the market to be challenging in '09, particularly for discretionary IT spending. As a result, we are trimming our revenue outlook relative to typical seasonality. In addition, the dollar has strengthened significantly since our last earnings call, and thus at current currency exchange rates, we expect to have a year-over-year unfavorable impact on revenue going forward of approximately 5 points in Q1 and roughly 6 to 7 points for the full year. Offsetting these impacts will be the positive revenue contribution of EDS.

Taking into consideration the current economic climate, the stronger dollar, and the impact of EDS, we expect 2009 revenue of approximately $32 to $32.5 billion in the first quarter and approximately $127.5 to $130 billion for the full year. Regarding earnings, here are a few variables to keep in mind:

Given the P&L characteristics of EDS, we expect the acquisition to have a negative impact on gross margin and a positive impact on OPEX as a percentage of revenue. As we move through the next two years, the cost structure improvements that we are making in that business will improve both of these metrics, with the majority of the benefit occurring in gross margin.

With regards to cost, as Mark mentioned, it is our plan to cut over $1 billion on a constant currency basis from our cost structure in 2009. Given the current macroeconomic environment for fiscal 2009, we are implementing a number of additional expense control initiatives to ensure that we are well positioned for continued success. A few of these actions are decreasing travel, curtailing hiring, and extending our scheduled holiday shutdown at certain sites. While we will launch appropriate expense management initiatives given the current climate, we will at the same time be making some focused investments that we believe will accelerate our competitiveness in the long run.

Due to a decline in pension asset values, we ended the year with pensions that, in aggregate, are approximately $2 billion underfunded. As a result, we expect to incur an incremental pension expense of approximately $0.06 or roughly $0.015 per quarter.

We expect total after-tax amortization of purchased intangibles to be approximately $0.50 per share in fiscal 2009.

With regard to OI&E, we now expect total expense of approximately $0.05 in the first quarter and $0.18 for the full year.

We expect the tax rate for fiscal 2009 to be approximately 21%.

Finally, we expect to continue to repurchase shares in the coming quarters, with a modest decline in weighted average shares outstanding. With that in mind, we expect Q1 '09 non-GAAP EPS in the range of $0.93 to $0.95 and full year 2009 non-GAAP EPS of approximately $3.88 to $4.03.

With that, we'll open up the call now for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Ben Reitzes - Barclays Capital.

Ben Reitzes - Barclays Capital

With regard to channel inventory, you mentioned that PSG and IPG, I believe, we up half a week year-over-year. With the current slowdown in the environment and whatnot, are you comfortable with that? Is a half a week up year-over-year in this environment actually even more, and how are you managing channel inventory to make sure you hit your numbers?

Mark V. Hurd

All that's included in our estimates that we gave you. Are we concerned about it? I guess we'd rather not have it, but at the same time, we had a little softening of sellout at the end of October, which causes a bit of equational problems in the way you calculate the channel inventory.

But no, we feel comfortable; we feel it's all inside our estimates and we'll go from there.

Ben Reitzes - Barclays Capital

So you calculate it on a forward basis?

Mark V. Hurd

We do. Well, because you look at - what you do at the end, it's a bit of a complicated equation, but what happens is if there's a little softening of the sellout at the end, it causes a little bit of the equation, so it's different - I'm trying to make this less complicated - you can wind up in a situation where even though it shows up half a week, the dollar calculation is less if it happens to be because of a sellout change in the way the equation works. That's sort of the way our model works, so it's sensitive to that.

So in dollars, it isn't as big as you might think, given the half a day. That's really the point, Ben.

Operator

Your next question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

I was hoping that you could give us a sense, Cathy and Mark, of the market's reception to the price increase on Supplies that you put through in July and August.

Catherine A. Lesjak

Well, certainly one way to answer that question is to talk a little bit about the fact that we did have 9% Supplies growth this quarter, and roughly 2 points of that growth came from price increases. A little bit of the 2 points is due to channel fill in advance of the effective date of the price increase, but the reality is for Q4 we only had one month - October - and that was only in countries where we sell supplies in U.S. dollars that actually had the price increase in it.

Mark V. Hurd

Yes, I mean, I think, Richard, at the end of the day, right, when you've got the kind of growth rate we've had in Supplies, our costs have gone up as everybody's has and we passed it through in the price increase. And we had strong revenue in the quarter in relationship to Supplies, so I think overall pretty good numbers. And very little, you know, no negative reaction out of the channel that I'm aware of at all.

Richard Gardner - Citigroup

Okay, it's probably a little early to tell, but nothing that concerns you about customers potentially moving more toward remans or third-party toner cartridges.

Mark V. Hurd

You know, Richard, it's an interesting question because I would tell you that over the past two or three years, that was a big issue, say, when I came to HP several year ago. I would tell you that we've consistently been gaining share relative to the aftermarket over the past several years.

Our actual biggest issue right now in Supplies is counterfeiting. So if you ask us what keeps Cathy and I awake at night in the Supplies market share, counterfeit way outweighs - and we're doing a lot to combat it. We had probably one of our best years from a counterfeiting or an anticounterfeiting - that's probably the right way to describe it - effort, but that's a much issue to us than the reman. But no, we haven't seen any effects of that at the current time.

Operator

Your next question comes from Tony Sacconaghi - Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

Mark and Cathy, if I look at your guidance, you're calling for about zero percent revenue growth at constant currency ex EDS. You did about 5% in ‘08; you did about 2% in Q4, so it does seem to factor in an economy that's certainly not getting any better, maybe at the margin getting a little bit worse. But you yourselves, I think, said look, we're not economists, we don't really know what the economy will do.

The question is: Let's say that the IT spending environment turns out to be 2 or 3 points worse than you have budgeted. Are you still confident in the EPS range that you gave? Will you be able to cut incremental costs so that you can still hit that range, say, if IT spending is 2 or 3 points worse than you forecasted?

Mark V. Hurd

So, Tony, I'm not going to get you into a per point basis, but let me say this: I understand your question. First of all, I think your numbers are - because I often tell you when I think they're not  and your numbers, I think, are exactly right with what you're describing. And yes, you know, we can certainly can sustain some different answer than the one we've given because we've got a lot of variability now in our cost model.

I won't take you down to what if its 2 points less or 3 points less or 4 points less, but certainly, we have some resiliency in our capability to still hit those numbers, and we wouldn't have given them out if we didn't think we could hit them.

And I think suffice to say, we are more confident on the bottom line than we are on the top line. And, you know, we're not going to - Tony, I'll just add more color to it - just to make the top line, we're not going to run around and take bad deals. And there are plenty of those in the marketplace. So unless a situation for us has a real long-term or aftermarket benefit for us that's long-term good for the company, we probably aren't going to go spend a bunch of time chasing it.

That said, we've done a lot of cost things to buttress the bottom line, so we are more confident in the bottom than we are the top and we could sustain some different answer on the top and still hit those estimates we gave.

Operator

Your next question comes from Brian Alexander - Raymond James.

Brian Alexander - Raymond James

In IPG, what's happening to the installed base in Consumer and Commercial hardware in light of the unit declines and how do you see replacement cycles and Supplies consumption trending next year given the tougher economy? It just seems like maybe your earnings guidance for FY '09 incorporates IPG margins that are above your long-term model.

Mark V. Hurd

Yes, I mean, I think, Brian, to your point, the installed base is staying installed longer. I mean, that's clearly what's going on and you can see us gaining share. We believe our installed base is sort of - depending on what country and what segment and what price category - we believe we're doing quite well.

Certainly, you're seeing a trend towards wireless in the home, which in some cases has fewer units doing just as much printing as the home used to, so for us, that's not necessarily a bad answer. We sort of like the answer, where we can sell less hardware to effectively print as much as the ecosystem has been printing.

So, again, for us, we have to be cautious here because when we get too aggressive on price, in many cases we're accelerating the movement of our own installed base. And as I know you know, Brian, the reason we put the installed base out there is to print. So for us, lower unit growth is not necessarily bad unless it means we're losing share.

So we look at the quarter and we look at it as we gained share in the quarter. We look at installed base as being installed longer. We look at the growth we've described in wireless printers - which, again, is a very strategic segment to us as, again, being material - and so, you know, as a result, I can't tell you I like the answer, but in the end it's not necessarily, Brian, to us a bad answer with the dynamics we're seeing today.

Catherine A. Lesjak

In fact, Brian, as long as people continue to print on HP printers so that we have a healthy installed base, having them hold on to their printers longer and delay upgrading is actually positive for earnings for us. They're buying the same amount of supplies and we're not having to make that kind of next investment in terms of placing a hardware unit that’s either at a negative margin or at a very low margin.

Mark V. Hurd

So that's why - and Cathy's point - it's a little different in a mature market than it is in a new growth market. So for us, we look very hard at where the new printing infrastructure is going versus where the existing market is going, where the existing market is a replacement market and the emerging market may be a brand new infrastructure market. So that's why, for us  I won't take you through a lot of complexity, which is our job not to do that - but we actually like in the mature markets the answers that we're seeing. To Cathy's point, we're having to invest less money to be able to get the same printing done.

Operator

Your next question comes from Kathryn Huberty - Morgan Stanley.

Kathryn Huberty - Morgan Stanley

R&D expense is at the lowest level over the last six or seven years. Which product segments did it come down the most in the quarter and is the new level sustainable?

Catherine A. Lesjak

R&D came down in kind of two segments. It certainly came down in IPG, and what we're doing in the IPG area is, frankly, we're not really driving to a lower number explicitly. What we're looking at is getting rid of all of the favorite science projects that are going on and making sure that every dollar is being very well spent in IPG. And as a result, it did come down.

And then also we're making conscious efforts in the Enterprise Storage and Server space around OPEX in general, but specifically in R&D to make sure that we've got the right cost structure for a more industry standard server segment.

Mark V. Hurd

And I think, Katy, your point, yes, I think the current level is sustainable. And R&D is like, you know, there's many different dimensions inside R&D, and so when we talk about cost initiatives, just to give you an example, you have to separate R&D into true innovation R&D and into maintenance R&D.

And when you go look at maintenance R&D, for example, Cathy brought up IPG. One thing you have to do in IPG is understand how much R&D you're spending just to keep different SKUs alive, numbers of different pieces are firmware that you - all testing, regression analysis work, all the categories I'm describing to you would be determined to be maintenance R&D streams, different from inventing a new product that's going to change the market.

So you've got to be very cautious when you look at an aggregate number like R&D because it breaks out into many segments. We're trying to reduce the non-value-add parts of R&D and increase the value-add parts of R&D, and that's, to your point, a separate issue than mix.

So yes, we think it's sustainable. But we are trying, within the R&D envelope, to increase our amount of innovation R&D while bringing total R&D in some cases down. So I wouldn't want you to come away from that point that Cathy brought up, that we're trying to reduce R&D. We're trying to reduce bad R&D or non-value R&D.

Same thing goes on in software, for example, where we've bought many companies. And when you buy those companies, every company had their own development environment. They had their own development tools. They had their own quality testing. And so as a result, when you add those up across multiple acquisitions, the team in software has had to take out multiple pieces of this maintenance infrastructure so we could spend more money on BTO innovation. That might cause R&D aggregate dollars to go down, but the innovation percent of the new R&D is up. So that's what we're trying to get up.

Operator

Your next question comes from Bill Shope - Credit Suisse.

Bill Shope - Credit Suisse

Mark, I was wondering if we could get your updated views on the Netbook market and how you think it may impact the PS3G strategy in '09 and, over the longer term, whether or not potentially in the near term this could be a material contributor to [inaudible]?

Mark V. Hurd

I don't know in the short term, Bill, that I would call it material. We're going to have to see how it comes out, because there's at least a couple dimensions to it. One, we've got to look at the market, is it really an incremental market. Our early tests show that parts of the market are incremental, which is good news. There's no doubt there'll be some blending of it, though, between incremental and being somewhat of a cannibalization of existing markets. And we're not exactly sure on the margin how those will line up.

Adoption has been okay and we're obviously coming out with some pretty - we've released a string of products that we're very excited about that we think will do well. As you probably know, in the early part of the year when we released our first Netbook product, we sold out as quick as we announced it. But I think it's still too early for us to give you enough definition and enough specifics to be able to give you the answer to that. I would not call it material in the short term, but we'll see how it goes over the next several quarters. And we're pretty excited about our lineup of products in that area.

Operator

Your next question comes from David Bailey - Goldman Sachs.

David Bailey - Goldman Sachs

On the PC side, Intel has a pretty dire outlook for PCs in the final calendar quarter of the year. Is HP seeing something meaningfully different from what Intel is from a demand perspective and, if so, what do you think's causing the disconnect?

Mark V. Hurd

Well, Intel doesn't show their stuff to us, so I don't know. I know what they reported and I know what they said about October in the public markets. We saw some things that, to be very blunt, David, were just different in our numbers, and that's why I always caution, David, when people ask us for macro commentary, all we know is what we're seeing.

And in some cases I would tell you we did not know our share numbers would come out as strong as they have, to be very open with you. And we've seen that over the past several days. I think if you look at the Netbook market that Bill was referencing earlier, if you take the Netbook market out of the PC market, you're going to see a pretty strong share position for HP. If you look at what's happened in Industry Standard Servers, we obviously gained share there. We did very strong in the Storage business, which isn't directly related to Intel.

So, David, I can't specifically answer that to you, although we are aware of what they're seeing and we are aware of what Microsoft is seeing. And all I can say is, we'll do our best to be as competitive as we can be, given the market that we are given and given the competitive position that we bring to the market.

Operator

Your next question comes from Keith Bachman - Bank of Montreal.

Keith Bachman - Bank of Montreal

Cathy, in your prepared remarks you indicated you thought cash flow or free cash flow for '09 would be very strong. I was hoping to pin you down a little bit to see if you could give us some thoughts on what you thought free cash flow targets would be for HP for '09?

Catherine A. Lesjak

Well, let me give you some puts and takes. I'm not going to give you kind of an overall number, so let's talk a little bit about working capital. If you look at working capital and how we ended this quarter, we ended actually very strong. You've got to take out; by the way, you've got to take out the EDS impact, which is about 5 days negative on the cash conversion cycle. So the cash conversion cycle for us, pre-EDS is 18 days.

In that number, looking out into next year, I look at inventory and we've made great progress on inventory. Do I think there's a little bit more to be done there? Yes, I do think there's a little bit more to be done there. I think on the AP side, we've made good progress over the last couple of quarters, and I think there's some room to improve in that number.

Where I think we've got a headwind is more in the accounts receivable and it's really the uncertainty that we have as we look out into '09 around liquidity, whether or not channel partners will take the cash discount or not take the cash discount, and obviously, also, then, the layering on of EDS that brings with it an enterprise customer base that typically pays on longer terms.

So I think those are the kind of puts and takes that I think you need to think about with respect to working capital. And then with respect to CapEx, there's really two ways we look at CapEx. We look at it kind of the investments that we make in the infrastructure and the bulk of those investments over the last two or three years have been investments to save. Those are flattening out. And then the other context, of course, is the CapEx investments that we make to grow, and those are really in our leasing business as well as, obviously, our Outsource Services business. And those, of course, we would expect to grow. In fact, we want them to grow.

And so those are kind of the ways I think about what are the puts and takes for cash flow for next year.

Mark V. Hurd

Yes, and I think, Keith, it starts with we've just got to make our operating plan. If we make our operating plan, the cash conversion stuff, I mean, just, you know, Cathy's brought a tremendous operating cadence to the inventory side. The good news I can tell you is that we've made a lot of progress. The better news is we're still messed up. And I mean that in the context that we have a unique opportunity in that we can compare supply chains across various businesses, and we have some businesses that are extremely efficient and we have other businesses that just aren't. And the working capital we have tied up in days of supply in owned inventory give us opportunities to improve.

But at the same time, to Cathy's point, there's no question we're going to get more pressure from the channel and from our commercial customers for more DSO at the same time as we'll be pressuring on the DPO side. So I think we're getting better in this area. We still have room to improve.

And Cathy's point about the separation of CapEx is a key one, because we look at CapEx very different whether its infrastructure build out or growth.

Operator

Your next question comes from Jeff Fidacaro - Merrill Lynch.

Jeff Fidacaro - Merrill Lynch

Mark, could you talk a little bit about the big picture demand for services in this environment? We saw core HP services ex EDS about 10%, you know, down a little bit but mostly in line with the last three quarters, so are you seeing any elevated levels of contract rescoping or pricing pressure?

Mark V. Hurd

First of all I would tell you that the reception to the EDS deal - probably the wrong thing for me to say; I've been doing this a long time, and I would tell you that it's pretty strong. On the demand side, it's just given us an opportunity to compete that we just didn't have, and I think that part's very positive. We have to be disciplined about the fact that we qualify well where we go compete and not get brought into too many things at the same time.

I think in this environment services in many cases is countercyclical, so what you have is people trying to take cost that could be capital and outsourcing that to somebody else so that they actually take the cost for them and in some cases variablize the cost where it makes sense, so that becomes an attractive value proposition for our customers.

And certainly we've done a lot of work in Technology Services. That's a market where our attach rate and our capture rate of the HP ecosystem - meaning the existing HP hardware and infrastructure that's in the marketplace today - has simply been too low and the opportunity for us to increase our attach rate and then, through technology, the fact that we're able to now solve our customers' problems without a specific labor touch to it is a tremendous competitive opportunity for us.

So Technology Services, this is not a new story, by the way, in Q4; it's been a fairly steady incline of our performance in Technology Services. And HP Outsourcing, separate from EDS, has been on a path over the past three to four years improving its cost structure, improving its customer delight, and being able to grow. And so we're pretty excited about the opportunity for the aggregate services business to drive a lot of value for HP.

Operator

Your next question comes from Shannon Cross - Cross Research.

Shannon Cross - Cross Research

A question with regard to the pricing environment for PCs and printers. You're obviously in a strong position and Mark said you're not going to follow people down, but are you seeing much in terms of irrational pricing and, specifically within the printer business, it seems as if maybe there was some pretty aggressive pricing there.

And then if I could just sneak in a second one, Cathy, can you just talk a little bit about COGS pressure from the yen as it relates to the laser business?

Catherine A. Lesjak

Let me hit that one first. The yen is definitely a headwind on the profit side for IPG, and as a result of that, I mean, that's really one of the primary reasons why we've increased prices in supplies is to basically adjust for the fact that it's gotten a lot more expensive. And so you just see that in price increases. We've done some price increases in Q4 and we've got more planned in Q1 for price increases in Supplies to address that pressure.

Mark V. Hurd

Pricing environment, I mean, I tell you that if I looked at the PC market, we didn't see extraordinary changes in ASPs if I look over the past several quarters, so that would be the way I would describe the PC environment.

The printer market, Shannon, is very different by market and by segment. So while I can give you the PC market on a more global basis, I'm gun shy to give you one answer because if I went to an emerging market or I went to a BRIC country, depending on what category I go to, I could tell you about aggressive pricing and I could tell you about pricing that, frankly, hasn't been that aggressive.

So it's sort of a multiple set of dynamics there and something that I probably shouldn't generalize on other than say it's sort of averaged out to being an okay pricing environment, I guess, in printers, but probably more aggressive than perhaps we've seen sequentially. That's probably the best way I can describe it, but I wouldn't run too far with that either because I can show you markets where there wasn't a very aggressive market.

Now it's important to note, we're being aggressive on the cost side in IPG, so for us, because of some of the areas that have been mentioned earlier, we think we're in pretty good position, as you mentioned, to be able to go deal with that if appropriate. Our biggest issue is we don't want to go - we've got to look at this on a more micro sort of specific basis because we don't want to go in with a broad aggressive pricing that churns up our own installed base that is already doing the printing. So it requires a degree of precision to get this right.

Catherine A. Lesjak

Shannon, let me also just take up your question around the yen up a level because, if you actually look at the total HP, the revenue that is yen-based roughly offsets the costs that are yen-based at the total company level, so we've got a nice natural hedge at the total company level. Again, that's different at the IPG level and so, as I mentioned, we increased Supplies prices to adjust that as well as aggressive expense reductions.

Operator

Your next question comes from Mark Moskowitz - J.P. Morgan.

Mark Moskowitz - J.P. Morgan

I want to get back to the confidence regarding the bottom line, Mark and Cathy. Can you help us understand what is happening potentially with your recurring profit base? Are you seeing anything structurally different that gives you more confidence in terms of either your market share gain, some of your cost structure initiatives, either on the core business or EDS, that lends to some of your confidence out for the next 12 months in terms of maybe a higher level of recurring profits?

Catherine A. Lesjak

Certainly with EDS we have a higher level of recurring profit and revenue, right? I mean, that clearly adds to it. We think that roughly, I think it was in, actually, Mark's early remarks, that roughly a third of our revenue is recurring, and so that obviously give us more confidence than if we didn't have a third revenue recurring.

Mark V. Hurd

Yes, and Mark, we break down our revenue by business, by category, and so when we say recurring, we don't mean it's in a segment that's recurring or that's got most of its revenue recurring. We actually mean contracted.

So when we get down to it, there's a percent of our revenue that's actually just contracted where we know the answer, so we understand that piece. Obviously, we have hedges that also go into some of our businesses, where we know the answer. And then we have some parts of our business where we don't necessarily know the answer, and we have well more than half of our profits that come out of a pretty healthy installed base.

Then you get into a debate in some of our product businesses, where you can get more volatility. Some of those product businesses in some cases actually carry negative gross margins. So in a strange way, it's actually a positive to the earnings model. It may not be the greatest long-term thing, but in case of the guidance we're giving you, it may be short-term a good thing.

As we mentioned earlier about the length of the printer installed base, as long as that installed base stays HP and as long as people are still printing, which all the numbers tell us it is, that's actually good news for us as it relates to the models that you can go deploy.

So there are a lot of dynamics, but I guess the only thing I would tell you is we do study this in a fair amount of detail and we think we understand what the dynamics are of the various components of the revenue and earnings portfolio.

Catherine A. Lesjak

And Mark, I'd just add a couple of comments. We spent a lot of time, obviously, over the last few years to get our cost structure to be as lean as it can be. And we've still got opportunity in that, as we've talked about taking over $1 billion more out of the cost structure. But also within that cost structure we've also been working on making it more variable so that, if revenue, you know, doesn't perform the way we think it's going to perform, we have levers to basically take down our cost structure.

And some of the things we've done in that context are using more contracted labor, using a lot of contract manufacturers and ODMs, moving our total rewards or our compensation base from not being so heavily dependent on salary and more on performance-based variable comp. So those are some of the things that we've done. We've also done a lot more in the marketing program to take away from fixed headcount in marketing, and we've done a lot of these across all of our segments. It gives us, again, some opportunity to move down if revenue isn't as we're expecting it to be.

Mark V. Hurd

You're probably getting more data than you wanted here, but it's important to note that we're still not happy where we need to be and it's taken us, you know, several years to get to this point. Do we feel better than we ever have? Yes, we do. Do we have more work to do to get to where we think we can get to? The answer's yes. But yet we think we understand the decomposition, if I can use that term, of the revenue and the impact it will have across segment and earnings and then, again, what it would look like at the HP level.

So we have some resiliency - I guess that's the way to describe it - that are in the models we're describing to you.

Operator

Your next question comes from Bill Fearnley - FTN Midwest Research.

Bill Fearnley - FTN Midwest Research

If I could ask another question here on IPG, how should we be thinking about the balance between IPG margins and unit growth here for laser and inkjet? I mean, should we expect negative unit growth here for the near term and an operating margin target of 15.5% plus? Is that reasonable for FY '09?

And looking here near term, you have the benefit of a really good installed base, but could others get a lot more aggressive to grow their installed base as they get more desperate and promotional to grow their units, to drive their [inaudible] going forward?

Mark V. Hurd

So I think, you know, yes, yes, and maybe. You know I think, you know, to the point of do I think you're going to see negative unit growth with the trends we're seeing, I think the answer is possibly. And it's probably more of a probable than a possible at this point.

Do I think that'll have an effect on IPG margins, because there are a couple of effects going on in IPG? They're getting the benefit of lower overhead costs at Hewlett-Packard. Second, they're lowering their own costs as they go to market. They have some unfavorability, as was mentioned earlier with the yen, that we're describing earlier. And they're getting the benefit of the installed base continuing to print and not having to place as many units.

So the key issue, Bill, to the earlier point is IPG gained share in total printer units in the quarter and did that with lower unit growth while the installed base continued to print. To your point, could somebody try to change that dynamic, the answer is sure, but it's going to depend on what competitor and what segment and what market. And we'll respond and try to respond within the degree of rationality. I guess that's probably the best way that I can describe it.

Bill Fearnley - FTN Midwest Research

Does irrationality become a near-term risk here as you face the double whammy of a heavy consumer end of year here in December going into January and an end of year going for the enterprise as well? Do you think that things will get crazy?

Mark V. Hurd

Well, we tried to blend in some of that into our model. So, you know, we can never - I'm not sure you and I on the phone can calibrate degree of craziness and I don't know how to do that particuarly, but I do think that what we've tried to do is get variability into IPG and, with that, achieve some level of flexibility in IPG, to get aggressive as it would be appropriate.

That said, this market has the consumer hanging on to their installed base longer for the benefit of trying to put out this or that. And frankly, the consumer is not reacting to the couple dollar promotion and continuing to print.

So, listen, could those dynamics change? That's what we're seeing right now and we'll have to see how that trend continues as we move forward.

Jim Burns

Why don't we take two more questions, Operator.

Operator

Your next question comes from Maynard Um - UBS.

Maynard Um - UBS

Can you just talk about the impact of currency to pricing and margins in your PSG business internationally, and in particular, as your short-term hedging rolls over and given the big swings in currency, can you just talk about how much of the gross margin impact you can actually offload to either your suppliers or contract manufacturers or offset by raising price without impacting demand?

Catherine A. Lesjak

Well, Maynard, just to clarify, you were talking about Personal Systems Group, PSG, right?

Maynard Um - UBS

Yes.

Catherine A. Lesjak

Okay. So PSG is actually one of the businesses that the prices adjust fairly quickly to the strength of the dollar, and so we're seeing that take place in the market now. If you look at kind of the competitive landscape for Personal Systems, it's heavily driven by companies that are going to be motivated by dollar results, and that, of course, gives us an opportunity to also increase prices and kind of flow that through the market, and you've seen us do that.

Maynard Um - UBS

So even with a 20%, 30% swing in the currency, you would still be able to raise your prices by that amount to offset the currency?

Catherine A. Lesjak

In essence what we've really been doing is holding prices and not taking them down as much as we would have otherwise with the commodity decline, so effectively it's a price increase, and so far have had no difficulty doing that.

Mark V. Hurd

I think that it's true, Maynard, too, you can extrapolate to many of our other businesses that are on short cycle times, so to speak, where the pricing environment, as we've said, doesn't give us tremendous lift and it doesn't hurt us tremendously. There are other areas where you have a different effect, where you have, you know, contracted backlog, for example, which is going to be a different answer. If the currency goes up, we actually have to deliver at a higher cost. For example, if we take an outsourcing deal or a TS deal at a lower currency level, we'll actually have to deliver at this price.

So there are multiple dynamics as it relates to currency, but PSG, most of it flows through pretty quick.

Operator

Your last question comes from Louis Miscioscia - Cowen and Company.

Louis Miscioscia - Cowen and Company

Mark, can you give us some idea what your conversations with customers have been, I guess, over the last couple of months? I guess obviously September and October were crazy. Here, we're almost done with November. Does it seem like things are starting to get back to normal? Obviously, the numbers that you just printed and you're guiding to really suggest that maybe things aren't that bad or, as you mentioned before, maybe you guys are just gaining a ton of share.

Mark V. Hurd

Well, I think things are different, Lou, so I don't think things are normal. I think people are prudent. I think they're thinking about what they spend money on. I mean, I think our guidance has been, again, as was mentioned earlier, we've continued to guide down as it relates to local currency rates. We've gone to what's basically - I think Tony said it correctly - zero in local currency growth, and yet we have some segments that are growing well and some markets growing well. So we're really giving you, we hope, a fairly realistic, we think, revenue base to grow on. And no, I'm not hearing people all excited about spending and thinking that November is a lot better than October.

Now, that said, we have a different environment, Lou, than we had, say, back in 2001. We don't have the infrastructure build out that we had at that timeframe, and I think people are more cognizant that at a TCO level, keeping stuff too long is not a great thing either from a total cost perspective.

In addition to that, I think the portfolio of offers that we bring to the market primarily have cost reduction at the core of what our value proposition is that we bring to IT, whether it's in the Service segment - that was brought out earlier - whether it's in the virtualization of infrastructure, that's what's driving our Blade sales that you see, or the radical move we're trying to make in Storage, if you will, bringing a more industry standard approach to storage, the left-hand acquisition that we brought, the Extreme Storage Release that we announced, the fact that we bring the ability to have some flexibility and innovation in our printing and PC solutions.

So we feel like we bring a pretty attractive portfolio that's helping the customer think through how they lower their cost, and those are the conversations that I'm having, Lou, which is customers saying I know I have to make some changes, what can you do to help me lower my overall cost as I do it? And that's where you're seeing traction in the marketplace today.

So I would not say that you're seeing customers saying, hey, I have some extra money; how can you help me invest it? It's all about how I lower the total cost of my operation over time. And those are the conversations that we're having.

Louis Miscioscia - Cowen and Company

Are customers able to get funding? It seems, obviously, credit's been tight. It seems like its still, though maybe that's not affecting you all as much.

Mark V. Hurd

It depends who the customer is, Lou. I mean, I think it depends what market you're in. I think if you get - certainly if I was to make a broad macroeconomic issue, certainly the moves that have been made in the CP market have been very extremely favorable. You know, you've seen liquidity return in many areas, and that has helped particularly in the mid-market. We had some period of time, I think in early October, where we definitely saw some challenging times.

I don't want to tell you everything's getting great, though, Lou. I mean, I think in time - we've got some time to work through in this economy. We're certainly seeing it, otherwise you wouldn't see us guiding sort of down on a rate basis the way we have over the past couple of quarters. We do think in the context of the world that's there we feel well positioned relative to it.

I'm going to summarize from there. Listen, first, I think we feel like we had solid market performance. We showed good financial discipline. We continued to make progress on the cost initiatives that we've described. I think - the last question - I think market conditions are tougher. It's possible they could worsen. We see this period as an opportunity, however, to leverage the strengths of our model, to expand our penetration in the market, and we will accelerate our cost actions. Our confidence in the EPS guidance given is based on our cost savings, the EDS integration, which is going well for us, and our diverse and recurring business mix.

So I thank you for your attendance and obviously we'll look forward to talking to you all again soon.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect.

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