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Executives

Jim Burns – VP IR

Mark Hurd – President & CEO

Catherine Lesjak – EVP & CFO

Analysts

Kathryn Huberty - Morgan Stanley

Richard Gardner - Citigroup

Ben Reitzes - Barclays Capital

Tony Sacconaghi - Sanford Bernstein

Bill Shope - Credit Suisse

Brian Alexander - Raymond James

Shannon Cross - Cross Research

Keith Bachman - Bank of Montreal

Mark Moskowitz - J.P. Morgan

Bill Fearnley - FTN Midwest Research

Doug Reid – Thomas Weisel Partners

Jason Noland – Robert W. Baird

Scott Craig – Banc of America

Hewlett-Packard Company (HPQ) Q1 2000 Earnings Call February 18, 2009 5:00 PM ET

Operator

Good day ladies and gentlemen and welcome to the first quarter 2009 Hewlett-Packard earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Jim Burn, Vice President of Investor Relations; please proceed, sir.

Jim Burns

Good afternoon and welcome to our first 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 Form 10-K for the fiscal year ended October 31, 2008.

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 Form 10-Q for the fiscal quarter ended January 31, 2009.

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, and restructuring charges. The comparable GAAP financial information and a reconciliation of non-GAAP amounts to GAAP are included in the tables in the first quarter earnings slide presentation accompanying today's earnings release, both of which are available on the HP Investor Relations webpage.

Before I turn it over to Mark I just wanted to briefly touch upon a financial reporting item that each year is part of our first quarter annual financial review we review our reported segments and make changes to reflect any organizational shift among our businesses, this year we have moved the revenue and operating profit associated with portions of our former [C&I] business from the services segment into software and IPG. In addition we have moved certain pursuit related costs previously reported in cost of sales to SG&A to better align them to the functional areas they support.

This realignment of costs does not impact segment reporting and relates only to the line item within the P&L in which the costs are booked. A detailed reconciliation of the changes including historical data is available on our Investor Relations website as well as furnished on the Form 8-K filed with the SEC.

I want to be very clear that the changes do not impact HP’s previously reported consolidated net revenue, earnings from operations, net earnings, or EPS. This is just part of the annual fine-tuning of our financial reporting structure to better align it with how we manage the business.

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

Mark Hurd

Well good afternoon and thank you for joining us. In Q1 HP executed well in a challenging market. We grew revenue 1% or 4% in local currency, gained share in key markets, and grew non-GAAP EPS 8%. HP is continuing to benefit from its market-leading portfolio and leaner cost structure. This quarter we effectively balanced expense management with share performance and delivered on our commitments to our customers and our shareholders.

I am particularly pleased with the results of our services segment which attained record profits of more then $1 billion [inaudible]. We now have the second segment with significant recurring revenues generating over $1 billion per quarter of profit and with solid room for margin expansion. The EDS integration is ahead of the operational plans we shared with you in September.

At the end of Q1 we have removed more then 9000 of the 24,700 headcount outlined in our restructuring plan. Customer response to the acquisition remains very positive resulting in a couple of Fortune 100 wins this quarter and a strong deal funnel. Now before I turn it over to Cathy to talk about the financials, I wanted to highlight a couple reasons, actually three of them, that I’m confident why HP will emerge from the current market environment as a stronger force in the industry.

First our cost structure, its reduced, its more variable, its more performance oriented and we have more opportunities ahead of us. We now have more flexibility to be more competitive and with the actions we’re taking we will be yet more competitive in the marketplace. In addition as we have done this work we have not cut into our muscle. We have been able to focus on our sales, R&D, and services strategy to further strengthen our capabilities in the marketplace.

Second our portfolio, as most of your know our portfolio was already strong, number one or two in virtually every market we serve. The scale we’ve attained relative to those positions in the market and the addition of EDS has been a strong addition to our portfolio from a customer perspective. It is a significant improvement in the impact our overall portfolio has in the market. The customer reception has been strong.

Three I would add our executions, we gained share in almost all of our key segments while we lowered and [variablized] our cost at the same time while integrating EDS in an environment of volatile currency and worsening and toughening demand. And in many ways I would tell you Q1 from an execution perspective was among the strongest we’ve delivered.

I’m going to now turn the call over to Cathy.

Catherine Lesjak

Thanks Mark and good afternoon everyone. Before I dive into the details of the Q1 performance let me make a few comments about the business overall. Services and software delivered solid operating profit growth in the quarter with services contributing over one third of the company’s profits.

Services continues to execute effectively maintaining customer service and achieving its EDS integration milestone. We saw pressure on our hardware businesses due to the slowing global economy. We reacted well in this tough market outpacing the competition and gaining share in most segments.

Operationally we did a good job managing costs with operating expenses down over $0.5 billion from the prior year. We will be taking additional steps this quarter to further [variablize] our cost structure and enhance our flexibility in this dynamic environment. We remain focused on optimizing our profitability, market share and cash flow, so that we can continue to drive innovation, and strengthen customer relationships to expand our market leadership.

Turning to our Q1 results, revenue was up 1% year over year as reported or up 4% in constant currency reflecting a full quarter impact of the EDS acquisition. Looking at revenue by geography, including the addition of EDS, Americas’ revenue increased 11% year over year, EMEA was down 3%, and Asia Pacific decreased 11%.

Excluding the effects of currency revenue was up 13% in Americas, 1% in EMEA, and down 9% in Asia Pacific. While there were pockets of organic growth the slowdown in IT spending was global. Gross margins for the company were 23.4%, down 130 basis points from 24.7% one year ago. This decrease was driven primarily by the addition of EDS which has lower gross margins.

Non-GAAP operating expenses for the quarter were $3.6 billion, down $569 million or 14% from a year ago despite absorbing EDS. In addition to benefiting from the stronger dollar this decline highlights the work we’ve been doing over the last few years to make our cost structure leaner and more flexible.

During the quarter we took a number of actions to reduce expenses including extending the December holiday shutdown, significantly reducing travel and eliminating other discretionary spending. We will continue to take actions to create a more variable cost structure including reducing base pay and certain benefits across the company beginning in Q2.

Consistent with our philosophy for pay for performance we intend to increase variable pay in total if HP meets its FY09 financial objectives. These actions will increase the company’s flexibility to more effectively scale our expenses to our revenues in this difficult environment.

Non-GAAP operating profit increased 10% year over year to $3.1 billion driven by strong expense management and solid contributions from services and software. On the bottom line this was offset by the unfavorable swing in OI&E of $304 million which included $99 million in expenses due to currency hedging losses related to forecast deviations.

All in all we delivered solid non-GAAP earnings per share of $0.93. Now moving onto the details of our performance by business, personal systems business revenue declined 19% year on year to $8.8 billion while delivering operating profit of $435 million or 5% of revenue.

Total unit shipments declined 4% from a year ago with no booked unit growth of 8% offset by desktop systems decline 15%. Average selling prices declined more steeply this quarter due to product mix, competitive pressures and passing through of the lower commodity costs in the form of pricing. PSG continues to execute well in this softening demand environment. We responded quickly by managing inventory and preserving margins while gaining share.

Imaging and printing revenue for Q1 was $6 billion, down 19% year on year due to a tough economic environment. Segment operating margin increased 300 basis points to 18.5% as favorable supplies mix and cost reductions were partially offset by hardware discounting. Compare to first quarter last year total printer units were down 33% and commercial and consumer hardware revenue declined 34% and 37% respectively. Supplies revenue declined 7% as lower end user demand more then offset the benefit of recent supplies price increases.

Customers are extending the life of their printers and our installed base remains stable. We maintained strong market position in printing and will continue to invest in market leading innovation focused on high page value segments and drive the conversion to digital printing.

Enterprise storage and servers revenue was $3.9 billion down 18% year over year with declines across each of our business units. Operating margin was down 3.7 points to 10.3% driven by lower volumes and an unfavorable mix shift to lower margin products. ESS blade revenue increased 4% compared to the prior year period.

Storage revenue declined 7% driven primarily by unfavorable currency exchange rates and market condition. EVA was down 7% with growth in the Americas offset by declines in EMEA, and Asia Pacific. Turning to our server businesses, business critical systems revenue declined 17% and industry standard server revenue declined 22% from the prior year even as we gained almost three points of share in X86 market in calendar Q4.

Our results reflect the current market environment and in particular the slowing we saw in January as customers reevaluated their spending and delayed purchases of equipment. HP software revenue declined 7% from the prior year to $878 million due to softening enterprise spending as the quarter progressed. BTO was down 4% from the prior year and other software declined 14%. The port performance was solid across the portfolio reflecting strong maintenance renewals and the sustained business value of our solutions.

For the quarter software operating margins increased 10.7 points to 15.9% due to a favorable mix and solid expense management. Services including the addition of EDS delivered revenue of $8.7 billion. On a year on year basis operating profit in the quarter more then doubled to $1.1 billion or 12.8% of revenue reflecting our sustained efforts in reducing the costs of service delivery as well as the addition of EDS.

Drilling down into the services businesses we will now report sub segment revenue performance by four business units, for Q1 revenue was $3.9 billion in IT outsourcing, $2.5 billion in technology services, $1.6 billion in application services, and $743 million in BPO. The EDS integration is ahead of schedule. We have made significant progress combining the business units and are on track with our country level merger plans. Cumulatively through Q1 we have eliminated over 9000 positions and are on plan to achieve the cost synergies we outlined in September.

Customers are responding positively. Our total pipeline is growing and we have already seen the benefit of our joint capabilities in wins this quarter including significant signings at two Fortune 100 companies.

And finally HP financial services had revenue of $636 million down 1% year over year and generated operating margin of 6.4%. We continue to apply the same rigorous process for assessing the credit worthiness of our customers and the quality of our receivables and the overall portfolio is performing well.

We are encouraged with the growth in our financing volumes despite a currency headwind. Now onto the balance sheet and cash management, we closed the quarter with a strong balance sheet including total gross cash of $11.3 billion. Days sales outstanding increased to 46 days in Q1 from 39 days one year ago. Days payable was 46 days down one-day year on year while owned inventory was down two days to 31 days.

With regards to channel inventory we ended the quarter with PSG up half a week, ESS up a week, and IPG up one and a half weeks compared to a year ago. The increases in weeks of inventory were primarily due to weaker aggregate sales out compared to a year ago. Sequentially total channel inventory dollars declined.

We expect further reductions in inventory levels as we adjust to a softer demand environment. Gross CapEx was $828 million up 36% from the prior year period. On a net basis CapEx was $676 million up 29% year over year. Increased capital expenditures were primarily related to the growth in our leasing and outsource services businesses including EDS.

Cash flow from operations was $1.1 billion for the quarter and free cash flow was $450 million. Q1 cash flow was unfavorably impacted by the softening economy. ESS and PSG responded quickly to the change in demand while IPG inventory levels remained above planned. We will be working to bring down both our owned and our channel inventory in the coming quarters.

share repurchases in the first quarter totaled $1.2 billion or approximately 34 million shares. At the end of the quarter we had roughly $7.9 billion remaining in the current share repurchase authorization. Finally we paid our normal quarterly dividend totaling $193 million. Now looking ahead to our outlook for Q2 and fiscal 2009.

In providing our guidance for the second quarter and the full year we are assuming market conditions we saw in Q1 will persist. In addition we expect the currency exchange rates will have a negative effect on revenue of seven or eight percentage points year over year for both the second quarter and the full year.

Finally we expect OI&E expense of approximately $0.05 per quarter, a tax rate of approximately 21% and a modest decline in weighted average shares outstanding. With that in mind our second quarter EPS guidance is based on Q2 revenue declining 2% to 3% from the prior year including EDS. At these revenue levels we expect our non-GAAP EPS to be approximately $0.84 to $0.86.

For the full year our EPS guidance is based on the assumption that our revenue may be down 2% to 5% as reported including the benefit of EDS. At these revenue levels we project 2009 non-GAAP EPS of approximately $3.76 to $3.88. While we don’t know how the economy will evolve, assuming that our revenue is roughly within the ranges I have described, we remain confident in our ability to forecast EPS given our line of sight to significant cost saving opportunities and our increasingly variable cost structure and our track record of disciplined executions.

With that we’ll open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Kathryn Huberty - Morgan Stanley

Kathryn Huberty - Morgan Stanley

The rate of deceleration in BRIC countries was particularly alarming, could you just talk about whether you did anything on the financing front or with channel inventories that exaggerated the down tick and maybe just touch on whether you’ve seen a stabilization in demand in areas like China where there is some government rebates going into place.

Mark Hurd

No we didn’t do anything to accelerate the deceleration. I would tell you that what we have seen is very [inaudible]. Its sort of remarkably consistent across the markets. There are a couple of exceptions, Brazil was an exception but the rest of the BRIC companies behaved pretty uniformly. I would say in China to your point we see a [pail] that’s a little different. We see a little more, I’ll use the term negativity in our softness [inaudible] enterprise. So to your point about some of the things that would have been done in China we do see some impact on the enterprise segment.

We really did nothing to decelerate that. Russia was a particular issue in the quarter. Those that did well [inaudible] and we certainly saw that in Russia as well.

Operator

Your next question comes from the line of Richard Gardner - Citigroup

Richard Gardner - Citigroup

The question is on EDS, you talked about cost synergies related to the deal being ahead of planned but can you talk about revenue dis-synergies and how that’s trending versus your expectations. It did look like revenue for EDS was much lower then we expected in the quarter given a full quarter benefit there.

Catherine Lesjak

If you actually look at EDS on a combined company basis, getting them in the base for last year and also this year for the quarter revenue declined roughly 15%. About half of that drop was due to currency so they have a significant exposure, or we have a significant exposure to the British pound where EDS was strong in the UK and so we were definitely hurt by that. There was also a few points of headwinds related to the accounting policy and convergence and purchase accounting and that was probably slightly behind what we had anticipated. And then we had, the rest was basically real demand declines and that was predominantly in the area of application services where there are more discretionary services that we sell.

Mark Hurd

I would say, I would tell you that revenue issues there relative to local currency no sort of big deal. What you got was the pound didn’t go in line obviously with the Euro and so the currency hit was material. That’s where it starts, that’s a big part of it and then the convergence on policy. The place where we saw a little softness was the typical add on business that you’d see on top of a contract to Cathy’s point and that was probably the only softness we saw in the quarter otherwise if you looked at it net of net it was roughly what we expected.

Catherine Lesjak

And if I were to quantify that it’s a few points of the 15% decline was the add ons.

Richard Gardner - Citigroup

But you’re happy with customer retention there.

Mark Hurd

I would tell you we have seen a customer reaction that probably is, make sure I keep this calibrated, but its just better then we expected and the funnel is strong and you know in many cases the services market moves a little bit counter cyclical to the economy so the interest now in an IT outsource inter [nap] services. I would also combine that to be, to be open with you what happened with some of the companies or with [Satium] for example has created interest as well and so we have a pretty strong funnel right now.

What we really have to do is make sure again we’re very disciplined about the deals that we go pursue. There are more deals then, we need to just make sure we’re properly doing the right thing and going after the deals with discipline. The funnel is strong, the customer reception is strong, and I think what we said earlier we have gotten ahead of the integration plan which is a positive but we have more work to do and we know that. We feel real good about it though.

Operator

Your next question comes from the line of Ben Reitzes - Barclays Capital

Ben Reitzes - Barclays Capital

If I’m calculating this right, quickly you’re revenue outlook for the year you have kind of cut off taking the midpoints roughly $13 billion in revenue versus what you said three months ago, but only cut your EPS range by about $0.102. Could you kind of bridge the gap for us, what, you said you had a billion dollars before you bring to the bottom line, can you talk about how quickly that’s hitting and then anything in particular segments that you feel you’re getting more efficiencies to give us confidence that you can hit this new range.

Mark Hurd

I think you saw how the model worked, if you just do your math in Q1, relative to that math on revenue to what it dropped in earnings and you know I think it’s a good question particularly if you take for example PSG, I hope what investors see in this quarter is the resiliency of the PSG model and the variability of that expense structure. And I’d add to it they had another headwind in the quarter which was the speed the currency impact, in a normal world doesn’t really have a huge impact on the results of PSG but when the speed of the currency declines like what we saw in October and November it can have an impact on the margin as you try to adjust price and the PSG model is proven now to be extremely resilient.

So the variabilization of that cost structure is extremely material to us not just in terms of earnings but in terms of our ability to compete and the ability it gives us in the marketplace as we go out and deal with what we have to go through. From a services perspective I think hopefully what you’ve seen in this quarter is evidence when you look at the combination of an EDS who’s prior year was in the five and change operating margin range combined with technology services and the fact that the combined businesses produced 8% operating profits showing the kind of leverage that we have in our services business and now the incline in recurring revenue that we have within in.

I could go on segment by segment but I’ll give you those couple of pieces of color. In addition to that as we mentioned in the last call, we’re taking out more cost in 2009 then we were in previous years and that has not been, again a one trick quarter thing, this is the culmination of several years of work and as you know well I’m not a big believer in short-term cost take outs that you have to put back two quarters from now and I want to be clear there is a little bit of that in what Cathy described in the discretionary piece of some expenses like travel that sooner or later you add back in to your model. But the bulk of what we’re telling you is structural costs that’s sustainable in our cost model so we’re not big on throwing out a bunch of earnings guidance that we don’t think we can make so I think in the range that Cathy described the revenue, the range of earnings that we told you we believe we can make.

Catherine Lesjak

And the discretionary costs actions that we took in Q1 actually have a build as you go out into Q2, Q3 and Q4 they actually get larger on a year on year, so we have that cushion as well.

Ben Reitzes - Barclays Capital

but to clarify the number of cost out is over a billion now based on all these things you’re doing.

Mark Hurd

Definitely and let me, I just want to make sure we’re clear, we are taking down the number of engineers that we have in R&D, we actually this quarter I think headcount in actual engineering headcount is up. Sales headcount we’re not trying to purposely take down unless we have a performance issue related to sales headcount or we’re shifting people from a back end part of sales to a front-end tip of the spear part of sales. We’re trying to incline and improve our level of service so I don’t’ want any of that cost being confused with some material part of the innovation, the creation of demand and the servicing of demand. We’re actually not only trying to reduce that cost but shift into what we think are the core parts of the technology business and that’s what we’re doing.

Operator

Your next question comes from the line of Tony Sacconaghi - Sanford Bernstein

Tony Sacconaghi - Sanford Bernstein

I wanted to follow-up on your commentary about supplies, if we look at supplies growth over the last three quarters prior to this one it had been 9 to 11%, this quarter it was minus 7 so about a 16 to 18% swing negatively and yet you should have begun to enjoy 2 5% supplies price increases, so if your installed base is the same and the usage is ultimately what’s changed, are you really seeing about a 20% change in supplies usage in one quarter, is that effectively what you’re seeing or is there other stuff behind it.

Catherine Lesjak

I think your math is roughly right. There’s lots of puts and takes in terms of what goes into what’s driving the decline in supplies. We certainly had a benefit of pricing and we’ll have that benefit in Q2 to Q4 as well and in fact in increasing benefit. But the bottom line is the end user demand for supplies is down and we actually expect with the change in channel inventories that we want to make in Q2 and that’s included in our guidance already but with that change that supplies growth will go yet even more negative then 7% in Q2 and Q3. So we do think there are significant headwinds still ahead of us on supplies growth and that that won’t turn around until the economy starts to rebound and at that point in time we do believe we get back to a market that’s going to grow in the mid single-digits but we do need the economy to start to turn around so that folks start printing more and frankly start stocking their pantry again because we do think there’s a certain amount of that going on in the consumer homes as well.

Mark Hurd

We do a lot of work on this as you know and there’s definitely an alignment between or at least some alignment between GDP and unemployment and printing and so when you get down to the end of the day, when you don’t have a job you’re not printing as much is typically how it works and we’ve got a pretty set of sophisticated models. But there is also these other issues that we described, we’re trying to get the inventories in the right place and with the speed as we mentioned in our script, we got some work to do. The price increase to your point is a positive but to be very blunt with you I’m not entirely happy with how the inventory got distributed within the context of the quarter meaning that we have the right thing at the right place at the right time.

And we’ve got some work to do on that part of it. So some of it, the external factors that we went through, we’ve got some internal stuff to just get right to as we get back to this sort of range that we described.

Tony Sacconaghi - Sanford Bernstein

Can you just comment on aggregate supplies inventory then in dollar and weeks terms how they changed in the quarter, I know you had made some comments about printing overall in your prepared comments can you make any comments on supplies given that it sounds like that’s an issue you’re going to be working on.

Catherine Lesjak

Channel inventory weeks were up year on year across both hardware and supplies. We definitely saw channel dollars decrease sequentially but what you’re really seeing with the weeks of supply and it applies to hardware as well as to the supplies piece is a significant decline in sales out in Q1 so typically we would see an uptick in sales out from Q4 to Q1. This time we saw double-digit declines and part of the execution challenges that I think we had especially in EMEA are from the fact that we did not respond quickly enough with our channel inventories to the demand environment that was upon us in Q1 and that’s a piece of the execution that we absolutely are focused on getting fixed in Q2.

Mark Hurd

What we’ve made the decision that the revenue guidance we’re giving you is because we just don’t want to bank on the fact that the economy is going to get better. We just don’t see a catalyst to change it so we’ve chosen to say we want to get our channel inventory levels in line with that and most of our businesses got that done in Q1 so that’s a good thing but we want to get it done in supplies as well.

I hope it gets better in Q2 then we’re modeling, I hope its better in Q3, I hope its better in Q4 but that’s not how we decided to run the company. We decided to be prudent and we’re deciding to lean out the channel and make sure we’re in a lean position as we go forward so that’s included in these models that we’re giving you and I guess in this context I’d say I hope it turns out better then what we’re telling you but right now we think its prudent for us to go lean out the channel.

Operator

Your next question comes from the line of Bill Shope - Credit Suisse

Bill Shope - Credit Suisse

I wanted to follow-up on that IPG question how should we, given the environment and given the fall off in consumables, how should we think about the margin profit here as we progress through 2009. It looks like this quarter you certainly had a boost in margins partially from weaker hardware performance but I’m assuming you don’t want that type of a margin boost to persist, you don’t want hardware to continue to deteriorate, how does the math play out here and how should we think about that.

Mark Hurd

I think your point this quarter and in our models that we’ve included in the guidance we’ve given you it is probably a small softening of IPG margins as part of how you go through the year, but still probably given the way this economy plays out a little higher then our traditional models give you. So I hate to give you an exact number because we’re going to try to be nimble in the context that if we see more units in a certain segment we’re going to try and go get them. So we maintain that flexibility in the model but I would tell you given what we’re seeing right now and given what we’ve modeled, it will be a little bit higher then what you’ve seen in the past.

In fairness they are also benefiting from some of the lower cost structures across the whole company so it isn’t just purely IPG but the bulk of it is, modeling just a little higher then what you’ve seen in the past given the mix that we’re seeing right now.

Operator

Your next question comes from the line of Brian Alexander - Raymond James

Brian Alexander - Raymond James

I was just wondering if you could be a bit more specific in terms of how far ahead of plan you are in integrating EDS, at the analyst day you talked about $700 million in gross savings, what does that number look like now for this year and next year and beyond.

Mark Hurd

My quick answer would be no. So I’m not going to lay out the plan any more then we have but to tell you that the team has done a good job and I think we, in May I was excited when we announced it, in September I was very pleased with the work to be done, I tell you today I’m thrilled with the work and, but we have more to do. Certainly we had given ranges that would take us five to six quarters to get much of this work done. I still think we’ll be doing work five to six quarters from now to get the entire model where we’d like to. I do think you’ll see us probably operate a little faster then we’d planned when we look at it against the total, meaning as a percent of the total but we still have work to do as we go out over the next several quarters but we are ahead of schedule.

Brian Alexander - Raymond James

The payables were down about $1.5 billion sequentially, it had a pretty large negative impact on the cash flow in the quarter, just a bit more color and what’s behind that and how we should think about that going forward.

Catherine Lesjak

I actually think the issue isn’t the payables, the payables came down the way you would expect the payables to come down given the revenue declines that we saw. What really was the negative impact on cash flow was that inventory didn’t come down the way it needed to come down. And this gets back to the execution issue and challenges that we’re having with, in the IPG business. Again we need to get that inventory down. We did a good job in PSG and ESS and we’ve got work to do to fix that in Q2 and Q3 for IPG but that is really what the issue is with the decline in cash flow. Payables came down as you would have expected them to.

Operator

Your next question comes from the line of Shannon Cross - Cross Research

Shannon Cross - Cross Research

A question on cash flow, for 2009 how should we think about cash flow given the reduced guidance, the opportunities on working capital and also how do you see the capital structure of the company as you look through the year.

Catherine Lesjak

When I think about the cash conversion cycle I really go back to what I said in Q4 when I was asked about the cash conversion cycle—

Shannon Cross - Cross Research

Just in terms of cash flow for 2009, how do you think about that.

Catherine Lesjak

In terms of the cash conversion cycle for 2009 if you remember I talked at the Q4 earnings call about the fact that I still thought there was opportunity and I gave you some puts and takes on that, I said that basically DSO was a basic headwind and we’re seeing that happen. You saw our DSO basically come up this quarter again and it’s the headwind of more enterprise extended payment term type customer business, folks not taking advantage of the cash discounts in the channel but that’s all basically what we built into our plan and then where the opportunity is is on days of inventory and I’m talking about opportunity beyond getting just the IPG inventory fixed over the next couple of quarters. I think there’s still opportunity there to really streamline our supply chain especially in the IPG space and then also with respect to payables, I also see that there’s still some opportunity there.

We are getting much better at managing our payables but we have not done all of the things that we can do and we’re in the process of implementing them so I do think that from a working capital perspective things are going to continue to progress in 2009 and then you can look at what our earnings are based on the guidance that we provided to get a sense of where the cash flow should come out in 2009.

Mark Hurd

We think overall we’ll have a good cash flow year. I think one thing and it probably relates better to Brian’s question earlier, one thing that hit us on the cash flow was we bought early in the quarter from a days of inventory perspective and we didn’t buy late so PSG obviously was going towards a number and then didn’t and as they realigned their days of inventory so much of that cash flow comes back over time. We would see a pretty reasonable cash flow again it starts with earnings, we’ll get the days of inventory and when you look at the broader year given that the conditions stay similar to Q1 which I hope they’re better, but if they stay similar to Q1 we’ll get the days of inventory right as we go.

Operator

Your next question comes from the line of Keith Bachman - Bank of Montreal

Keith Bachman - Bank of Montreal

I was hoping you could talk a bit about the services operating margin, I know you didn’t want to talk about the costs associated with it or the opportunities there for cost relief, but I wanted to see if you could talk a bit about the services operating margins, how we should be thinking about that going forward particularly against the next couple of weeks seasonal periods, and then I just wanted to see if I could add a footnote to the previous question on cash flow if I could in that this quarter your buyback was substantially above your free cash flow and just how you think about the use or the free cash flow that you’ll generate during the course of the year buyback versus debt relief.

Mark Hurd

We think services margins will improve. So I think that’s probably not the level of detail that you’re looking for but I would tell you that we’ve gotten deep into this now as you can imagine. We started really getting inside our models in September, late August as we closed the transaction with EDS. We [inaudible] to see a lot more some four our five months later, I would also add this is the culmination of a lot of work in what we call our technology services business as well which is more of our hardware support business which we did a lot of work on in 2008 so its really the culmination of all that work in what we call TS and this integration of EDS combined and I would tell you that while we’re pleased, I’m sure optically the 12.8 looks very strong, I know it does, we actually think there’s improvement in that operating margin over time because of the work that we’ve done, we’ve already done that we know will line up with the remainder of this year into next year.

Catherine Lesjak

In terms of free cash flow and share repurchase the way we actually think about our share repurchase program is we look at first offsetting zero dilution and then being opportunistic and definitely have seen the cost of zero dilution coming down and that’s why you see the share repurchases coming down a bit as well. We haven’t really tied it directly to I’m only going to spend whatever the free cash flow is in a particular quarter and we look at, and even when we do look at the free cash flow we look at it over a longer time frame and so that’s really what drives our share repurchase activity.

Operator

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

Mark Moskowitz - J.P. Morgan

On the defensibility of your recurring revenues you seem very constructive about the services contribution, I want to see if you can first just talk about the services contribution to recurring revenues and are you starting to see customers try to rescope or change the economics or the time horizons of your recurring piece there and then what about the other parts outside of services in terms of recurring revenues how defensible.

Mark Hurd

In terms of the market right now most of that services revenue is contracted so when you say change scope no, in fact if anything what you’ve got in the market right now is customers trying to, I’m making a generalization, I’m not talking for every single customer, but more customers are trying to add things on. So what customers will be doing, saying instead of just doing this could you do this and of course customers are always looking for three things every time you get into a service transaction. They want to know how can you lower my costs, how can you accelerate my transformation, and how can you get me higher service levels and those three things always trade off with each other any time you go at a services transaction.

So customers right now are leaning harder on the cost take out piece then perhaps they would have a year and a half ago so that actually gets a bit of an incline in your funnel as you look at it.

Catherine Lesjak

And then with respect to recurring revenue when we said last quarter that roughly a third of our revenue was recurring and it generated over half the profits of the company, what we did was we actually didn’t add, just take services and add in supplies and add in HP financial services, we actually scrubbed those numbers because if you actually add up those revenues in each of those segments you would get something on the order of 40 odd percent recurring. What we did was we scrubbed them and specifically with respect to services and consumables on the IPG side of the house is that we basically looked at how they have acted in the past recessions and scaled them back and came up with that one third.

So I actually feel very comfortable that the one third or roughly one third is very defensible.

Operator

Your next question comes from the line of Bill Fearnley - FTN Midwest Research

Bill Fearnley - FTN Midwest Research

I had a question for you, when you look at PSG how you look at the whole netbook segment now when you look at the average selling price is it being cannibalized, are the netbooks cannibalizing your mainstream notebook business, how is it effecting ASPs and margins this quarter and then how do you think its going to effect you here in the next few quarters.

Mark Hurd

I’ve seen in print from people who claim expertise that 80% of netbooks is net new, no pun intended and 20% is a cannibalization of the low end of the notebook market. We’ll have to see over time how that evolves. I say this, we feel pretty good about our lineup of netbooks and it is, its done well for us in what we’ve done so far. Now we’re just out, just out being defined as the last several months so I think we’ve got some time before I can really give you a good metric and good consumer data back on where this lands so I hate to sort of duck your question but I’d like to have a bit more data before I give you anything and I hate to recite to you what industry people are saying because I’m not giving you any new insights.

Bill Fearnley - FTN Midwest Research

But you had hinted to average selling price declines in PCs then so with sharp declines in your traditional products on the notebook—

Mark Hurd

I wouldn’t go there, because I think you’ve got different factors occurring when you look at the overall ASP of PSG, ASPs in the marketplace. You have a mix issue even within the mix so what’s really seen is not a move to notebooks that’s cannibalizing certainly in this quarter of results. What you have is somebody who is buying a more thickly configured notebook now buying a more thinly configured notebook and we’re seeing mixes within the mix actually changing and that’s what’s driving most of the ASP not a shift down to netbooks.

That data I give you within the context of our quarter, so that is not a, there is no significant phenomenon of ASPs in the HP lineup caused by netbooks.

Catherine Lesjak

The other items that are effecting ASPs on a year-to-year basis are currency as well as just general pricing. So the commodity environment, commodity prices have come down and that is getting taken in the prices down to the streets and that wasn’t happening as much a year ago where some of the softness in the commodity cost environment was actually basically being, stayed in our pockets and didn’t go to the streets.

Mark Hurd

But again when we say pricing I want to make sure I’m clear with this, that we’re not seeing any abnormal competitor pricing environment, this is more of a mix within the product family and the commodities now adjusting as we’ve gone through time. So again I know I’m giving you a complicated answer because there is a lot of data here but it is not a netbook phenomenon driving those ASPs its more the mix within the mix that’s really behind this.

Operator

Your next question comes from the line of Doug Reid – Thomas Weisel Partners

Doug Reid – Thomas Weisel Partners

Just wondering if you could comment on the degradation in operating margin in the ESS segment year over year looks like its down 370 basis points, could you give some color on the break out there, competitive pricing, product mix and maybe currency impact.

Catherine Lesjak

The margins were down mostly because of, on a year on year basis, mostly because of competitive pricing environment. It was again, if you look at last year we had a situation where the commodity pricing environment was just not as competitive so you were able to keep a lot of the commodity cost declines and maintain your prices. This year we’re passing way more of that through to the customer and we also have a change in mix where again like PCs more customers are moving to lower end less configured less business critical systems mix, that type of thing that drives margins down as well.

Mark Hurd

We saw a lot of movements in the quarter from people buying a 2P industry standard server now buying a 1P. Somebody buying a less configured blade so very similar phenomenon you saw in PSG and so again when you looked at the margin of the actual product that was being sold and compared it to the margin of the exact same product a quarter ago, you did not see a material erosion in that margin, what you see is a shift of what’s being sold within the overall portfolio of revenue shifting to the lower end and so these are all things that were, we’ve taken into consideration in the models that we’ve given you is that you actually see people that are trying to buy actually trying to buy as little as they can buy in the context of getting what they need to get done.

I would also tell you that take industry standard servers, we gained 2.5 points of share in the quarter and to be very frank we weren’t pushing hard on the street price so I think you’ve got an environment that really is demand driven and its demand driving a different mix that’s having an impact.

Catherine Lesjak

We did have a bit of an offset to that in the fact that we did manage our expenses very well and did get operating leverage, expenses were actually down year on year more then revenue was down so we did a good job on that side as well trying to offset some of the margin pressure.

Mark Hurd

Since we just got on this one, I think ESS probably is going to go out gaining share in virtually every segment they compete and they did a pretty good job in the quarter, maybe not quite as quick as PSG got its inventory and its channel inventory lined up but they were running a close second with them. So they came off getting their expense structure lined up, gaining share, it wasn’t for us operationally a bad quarter in the ESS at all.

Operator

Your next question comes from the line of Jason Noland – Robert W. Baird

Jason Noland – Robert W. Baird

On the hardware refresh delays if you could talk about visibility that you’re given from customers, do they just say its indefinite, do they say its going to be a few quarters just generally across PC server and print.

Mark Hurd

I could tell you lots of long stories about what they tell you but I’ll give you a data point, I think there was a question earlier about recurring revenues, one of the data points that we saw early in the quarter was the renewal rate in technology services and that being our hardware support business and the renewal rates were very high. And we service and material, obviously part of the HP base and we actually service their porting hardware as well. So I think you’ve got a lot of company in saying I’m going to hang on to my installed base longer. They can only do that for so long but I think you’ve got a couple of factors going on right now. New projects are being scrutinized very very hard for ROI and short-term ROI. Second people are taking their existing base and telling the IT department or the CIO can’t you just do without a refresh a month longer or two or three months longer and they’ll continue to do that until the TCO makes sense.

At some point this will create a big refresh opportunity and obviously we want to be in a position to capture that, but at this second I can’t give you a date, I can’t give you a specific metric on when this thing is going to turn. It will turn and we hope to be in a position to garner a material piece of it.

Operator

Your next question comes from the line of Scott Craig – Banc of America

Scott Craig – Banc of America

On the inventory side you spent a lot of time talking about the IPG group there, and the issues, but both ESS and PCs were up a week and half a week respectively so when you think about sort of a normal range of channel inventories for those two groups, where are we there, are we towards the higher end, mid end, low end, if you could provide a bit of color there.

Catherine Lesjak

With respect to PSG channel inventory the year on year compare we are up a week but last year we were at the very low end of our range and so we feel good about the PSG channel inventory. There are no concerns on the PSG channel inventory, its up only a half a week. ESS being up a week, its near the top of the range and so we would like to bring that down and we’ve got that factored into the operational plans for Q2 as well as in our guidance.

Mark Hurd

All the channel inventory stuff will get nailed and that’s all within the guidance that we’ve given you.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Mark Hurd

Appreciate all your time on the call. I think we had solid performance in a tough market. We gained share in most segments while delivering margins and dragging our cost structure we think into a more advantaged position, both lowering it and variabilizing it. We’re ahead of plan on the EDS integration and our service business has delivered as planned. Our strategic moves and operational execution we think position services as a significant player in our overall portfolio.

As in terms of the market, we’ve modeled the market to get really no better for the rest of the year. We view it, what we saw in Q1 is roughly what we’ll see for the rest of the year. We see the opportunity here for us to put the company in a better position, to [lever] the strength of our model, expand our penetration in the market, and accelerate our cost actions.

I want you to be confident in our ability to execute and deliver the EPS guidance within the revenue ranges that we’ve spelled out. The questions I think that you’ve brought up about cash flow, cash flow will come back as we execute on the capital metrics that we’ve set in place. We have baked in basically all the factors we’ve described including the supplies factor that we described earlier into the models that we’ve given you.

So we’re going to get about the job of executing and we’ll talk to you at the end of Q2, thank you.

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Source: Hewlett-Packard Company F1Q09 (Qtr End 01/31/09) Earnings Call Transcript
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