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Hewlett-Packard Company (NYSE:HPQ)

F3Q 2013 Earnings Call

August 21, 2013, 5:00 pm ET

Executives

Rob Binns - Vice President of Investor Relations

Meg Whitman - President, Chief Executive Officer, Director

Cathy Lesjak - Chief Financial Officer, Executive Vice President

Analysts

Mark Moskowitz - JPMorgan

Toni Sacconaghi - Sanford C. Bernstein

Katie Huberty - Morgan Stanley

Jim Suva - Citi Research

Ben Reitzes - Barclays

Brian Alexander - Raymond James

Maynard Um - Wells Fargo

Shannon Cross - Cross Research

Keith Bachman - Bank of Montreal

Ananda Baruah - Brean Capital

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2013 Hewlett-Packard earnings conference call. My name is Adrianne and I will be your conference moderator for today's call. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Rob Binns, Vice President of Investor Relations. Please proceed.

Rob Binns

Good afternoon. Welcome to our third quarter 2013 earnings conference call with Meg Whitman, HP's Chief Executive Officer and Cathy Lesjak, HP's Chief Financial Officer. Before handing the call over to Meg, let me remind you that this call is being webcast. A replay of the webcast will be made available shortly after the call for approximately one year.

Some information provided during this call may include forward-looking statements that involve risks, uncertainties and assumptions. If the risks or uncertainties ever materialize or the assumptions prove incorrect, the results of HP may differ materially from those expressed or implied by such forward-looking statements.

All statements other than statements of historical facts are statements that could be deemed forward-looking statements, including but not limited to any projections of revenue, margin, expenses, earnings, earnings per share, tax provisions, cash flows, share repurchases, currency exchange rates or other financial items, any statements of the plans, strategies and objectives of management for future operations and any statements concerning the expected development, performance, market share or competitive performance relating to products or services.

A discussion of some of these risks, uncertainties and assumptions is set forth in more detail in HP's SEC report including its most recent Form 10-Q. HP assumes no obligation and does not intend to update any such forward-looking statements. The financial information discussed in connection with this call including any tax-related items reflect estimates based on information available at this time and could differ materially from amounts ultimately reported in HP's third quarter Form 10-Q.

Revenue, earnings, operating margins, and similar items at the company level are sometimes expressed on a non-GAAP basis and have been adjusted to exclude certain items including amongst other things, amortization of purchased intangible assets, restructuring charges and acquisition-related charges. The comparable GAAP financial information and a reconciliation of non-GAAP amounts to GAAP are included in the tables and in the slide presentation accompanying today's earnings release both of which are available on the HP Investor Relations webpage at www.hp.com.

I will now turn the call over to Meg.

Meg Whitman

Thank you, Rob, and thanks to all of you for joining us today. as we continue our fix and rebuild year, parts of the business like printing, enterprise services, converge storage and software are making progress, while others like industry standard servers and personal systems have not completely turned the corner.

So overall, I would say, our turnaround continues. We are moving forward against our plans and I remain comfortable with where we are heading. Most importantly, we once again achieved the financial performance we said we would, delivering $0.86 in non-GAAP diluted earnings per share, within our previously provided outlook of $0.84 to $0.87.

During the third quarter, we held our annual HP Discover event in Las Vegas. We brought together more than 11,000 people including more than 120 of the world's top CIOs. These are record numbers for HP. I was encouraged by the interest I heard from our customers about technologies like HP Moonshot, StoreOnce, 3PAR, software-defined networking, Vertica and Autonomy.

At HP Discover, we introduced some very significant new innovations. We announced HAVEn, a big data analytics platforms that leverages our analytics software, hardware and services to allow customers to make decisions in real-time. We also expanded our Converged Cloud portfolio with a common OpenStack based architecture for HP's private, managed and public cloud offerings. And we announced the new partnership with Google to introduce a one-stop shop technology solution for small and medium-sized business customers.

As I said before, HP's turnaround will happen on the back of great products and services. As the benefits of our focus and investment begin to pay dividends in 2014, I expect that you will see increased innovation across HP. From a macro economic standpoint, we see a continued weak enterprise spending environment. Sentiment in the U.S. is improving, although it's not translating to our results yet due to inconsistent execution. I would characterize Europe as challenging and China continues to be soft. We are also seeing acceleration in trends driving customers to the cloud and shifting to mobility.

For the third quarter, our results were driven by solid execution in software, printing, converged storage and enterprise services coupled with the savings from our restructuring program and improvements in our operations. As a result of our focus on operations, we were able to bring our cash conversion cycle down to 18 days, a remarkable achievement compared to 27 days in the prior year. In the quarter, operating cash flow was $2.7 billion, once again another strong performance. As a result, we lowered operating company net debt by $1.7 billion to $1.2 billion.

This represents our sixth consecutive quarter of reducing our operating company net debt by more than $1 billion. Our operating company net debt is now below pre-Autonomy levels and is approaching our goal of approximately zero. We also returned approximately $283 million to shareholders, primarily in the form of dividends in the quarter.

Along with the operational improvements and the workforce restructuring, we are focused on getting the right leadership in place to lead the company to the next phase of the turnaround. To that end, we announced several changes to our executive leadership team during the quarter. In June, Dion Weisler took up our printing and personal system. Dion is more aggressively shifting to a multi-operating system, multi-architecture and multiform factor strategy.

Earlier today, we announced additional changes to our executive leadership team. Bill Veghte, currently HP's Chief Operating Officer will become EVP and General Manager of the Enterprise Group replacing Dave Donatelli who will remain with HP and take on a special assignment. Bill brings a critical set of skills to the management of HP's Enterprise Group. He is a proven technology executive with a wide range of experiences leading sales, services, marketing and engineering at scale.

During his tenure at HP, he has run HP Software, held the responsibility of Chief Strategy Officer and for over 15 months has served as HP's Chief Operating Officer. As COO, Bill helped to create HP's blueprint for the future and deeply understands the strategic challenges and opportunities facing both the company and its customers. As hardware becomes more standardized, leadership solutions are increasingly differentiated by the software layer that drives the hardware.

This is true for both traditional IT and cloud environments. Bill will retain his current responsibility for the pan-HP cloud initiative, and Bill's experiences in software and in the enterprise combined with HP's infrastructure leadership will help HP accelerate innovation in converged infrastructure, cloud and the emerging area of software-defined data centers.

In a separate organizational move, Henry Gomez, EVP and Chief Communications Officer will assume the additional responsibilities of Chief Marketing Officer. By combining marketing and communications, we will accelerate programs that will drive sales, build brand royalty and help customers embrace the new style of IT. HP's current CMO, Marty Homlish will become Chief Customer Experience Officer, a new role that will focus on driving more consistent and high value interactions with customers across all business units.

Now let me turn to our business group performance in the quarter. As you would expect in a turnaround, there are areas where we are doing well and areas where we have to improve. Let me start with the parts of the business that performed well in the quarter.

In printing, we once again delivered a solid quarter. Business initiatives like Ink Advantage and new products like Officejet Pro X continue to take hold with strong customer adoption. As a result, we are seeing strength in our Ink in the Office program. Overall, we grew hardware unit sales for the first time since 2011, gaining one point of share in both Ink and Laser over the prior year and five points of share in Laser over the prior quarter. The printing team has done a very good job executing the strategy we laid out last October.

Although revenue is down, profitability is inline with our expectations and the topline is stabilizing. Printing revenue was down 3.6% over the prior year and 1.4% in constant currency while margins were 15.6% essentially flat over the prior year. In Enterprise Services, the business is stabilizing as we continue to execute well against our recovery plan. Revenue was down 8.7% over the prior year, better than the FY13 outlook range we previously provided.

We saw add-on business offset the anticipated revenue run-off from the four exceptional accounts we identified at our Security Analyst meeting last October. Margin in the quarter was 3.3% bringing enterprise services year-to-date margins to 2.4% at the high end of our FY13 outlook range.

We continue to see improvements in signings but they are mostly renewals. Going forward we are focused on strengthening our go to market capabilities dedicated to strategic enterprise service solutions in areas like cloud, big-data and apps modernization and new account wins. As we outlined in October, this will be a multi-year journey.

Enterprise services was able to secure some major wins in the third quarter. We announced that enterprise services and its partners were awarded the United States Department of the Navy's Next Generation Enterprise Network contract value at up to $3.4 billion over five years. The contract is being protested but we have every confidence in the Navy's evaluation and the ultimate selection of HP.

In the Enterprise Group, we are making progress in executing our vision of converged infrastructure based on HP intellectual property and the software defined data center. We see near-term revenue pressures in ISS and some parts of storage where we face aggressive pricing and competition.

Customer interest in our revolutionary HP Moonshot product has been strong. We are working hard to ramp this product in the market. We are currently in testing and development with many key customers and expect to rollout a number of new innovation on this platform over the next few quarters.

In storage, we are seeing the planned portfolio shift continued with strong performance in our converged storage business which was up 37% over the prior year, being offset by weakness in traditional storage. We continue to see solid growth in our mid range 3PAR products that were launched in the first quarter.

While we were pleased with our networking performance in China, revenue was essentially flat and we must grow this business faster. Going forward, we are focusing on new channel plays and improved go-to-market actions to accelerate growth.

Enterprise group had a number of significant customer wins in the quarter. HP was selected as the official technology partner to Oriental DreamWorks, the joint venture between the China Consortium led by China Media Capital and DreamWorks Animation.

In software, we saw good performance and improved execution. We grew revenue nearly 1% over the prior year and 4.3% sequentially. We saw continued improvement in operating leverage as margin expanded 2.5 points over the prior year and 1.4 points over the prior quarter and achieved an operating margin of 20.5%.

Performance in software was driven by strength in security which saw double-digit revenue growth, strong momentum in Vertica which saw triple-digit growth and sequential license revenue growth in Autonomy. In addition, we saw pockets of improvement in IT management, although we saw continued pressure from the shift to SaaS coupled with a portfolio that is weighted towards services and support.

Now let me turn to where our performance needs to improve. Overall, the enterprise group's performance was very disappointing. Enterprise group profitability was pressured by lower revenue, particularly in ISS, resulting in an operating margin of 15.2%, down 1.9 points over the prior year and 0.7 points sequentially. ISS continues to experience near-term business model challenges impacting our competitiveness in the hyper-scale market.

In addition, mainstream server weakness was driven by execution challenges, competitive pricing and a misaligned go-to-market model. This impacted our revenue and profitability. The net impact of these execution challenges is an expected loss of five points of market share on a revenue basis. Fixing execution across enterprise group will be Bill Veghte's top priority in his new role.

In our personal systems business, we are seeing continued PC market contraction as HP revenue declined 11% over the prior year. On a positive note, in the third quarter we saw relative strength in market share gains in growth markets like Asia-Pacific and in commercial PCs. According to IDC's second calendar quarter results, HP has achieved its highest ever PC share in India with 34.1%, leading in every category of the PC market. Overall margin for the quarter was 3%, down 0.2 point sequentially and down 1.7 points over the prior year.

Looking forward, we are focused on driving profitable growth in personal systems. It's going to take time to get margins to our desired levels against the back drop of a changing marketplace but we are confident that our differentiated approach from competitors including our focus on beyond the box innovation will pay off over the long term.

Now let me turn to our future outlook. As you know, I stated in May that I believe that company level revenue growth was still possible in fiscal 2014, particularly given the challenges I just highlighted in enterprise group and personal systems as well as the fact that 2013 revenue from key accounts in enterprise services is running off more slowly than anticipated. We now expect that total company year-over-year revenue growth in fiscal 2014 is unlikely.

That said, I remain confident that we are making progress in our turnaround. We are already seeing significant improvement in our operations. We are successfully rebuilding our balance sheet. Our cost structure is more closely aligned with our revenue. We have reignited innovation at HP with a focus on the customer. So I do expect that we will see pockets of year-over-year revenue growth across certain parts of the business in 2014.

As is our normal practice, we will give a more comprehensive outlook on 2014 including EPS at our Security Analyst Meeting on October 9 and I look forward to seeing you all there.

Now let me turn it over to Cathy for a closer look at our performance in the quarter. Cathy?

Cathy Lesjak

Thanks, Meg. Good afternoon, everyone. Total revenue for the quarter was $27.2 billion, down 8% year-over-year and down 7% in constant currency. Overall, our results came in largely as expected with some variance in performance among the business units.

Enterprise services came in slightly ahead of expectations and printing and software were broadly in line. However a weak PC market and increasingly competitive pricing pressured personal system and execution challenges and aggressive pricing impacted industry standard server performance. I will go into more detail on each segment shortly.

By region, EMEA remains weak, particularly in consumer, with revenue of $9.6 billion, down 10% year-over-year and 8% in constant currency. Revenue in the Americas of $12.4 billion declined 7% year-over-year as reported and in local currency, partly driven by weakness in U.S. public sector spending as well as soft demand in Brazil and Canada.

APJ was mixed with strong growth in India due in part to our recent educational PC win in the State of Uttar Pradesh, partially offsetting weaker China performance. APJ revenue was $5.2 billion, down 8% year-over-year and down 5% in constant currency.

Turning to gross margins. Improved enterprise services and technology services margins combined with a favorable mix from software, printing and personal systems offset a highly competitive pricing environment across most of our hardware businesses. Gross margins were flat on a year-over-year basis and down 30 basis points sequentially.

Non-GAAP operating expenses were $4.1 billion down 4% year-over-year and 2% sequentially driven by expense benefits from restructuring actions and lower R&D investments in business critical systems. Non-GAAP operating profit of $2.3 billion was 8.4% of revenue, down 80 basis points year-over-year.

We recorded a $146 million of expense on the other income and expense line. With a 22% tax rate and roughly flat share count of 1.9 billion shares outstanding, we delivered non-GAAP diluted earnings per share of $0.86. Our non-GAAP EPS excludes pre-tax charges of $356 million in amortization of purchased intangibles, $81 million of restructuring charges and $4 million in acquisition-related charges.

Turning to the business groups. I will start with printing. We continue to execute on our strategy and the group delivered solid results in the third quarter. Revenue of $5.8 billion was down 4% year-over-year. Total unit shipments grew 5% year-over-year as we took advantage of a depreciating Yen to place more units and partially offset other currency headwinds. Operating profit of $908 million or 15.6% of revenue was down 0.2 points from last year.

Commercial hardware revenue declined 3% year-over-year, while units increased 12%. We experienced strength in low-end laser sales, while high-end revenue declined due to a mix shift in the value segment. We saw good growth in managed services and Indigo sales. Consumer hardware revenue was flat while units increased 2% against the prior year, driven by strong Ink in the Office and Ink Advantage sales.

Supplies revenue declined 4% against prior year and made up 66% of printing revenue. Our overall channel inventory has moved slightly above of our target range. This was partly driven by supplies demand from our channel partners seeking to maintain service and reliability levels to their customers. We need to bring down channel inventory in the fourth quarter.

Personal systems continues to face a challenging environment. Revenue was $7.7 billion, down 11% over the prior year led by weakness in consumer. Total unit shipments declined 8% year-over-year. We saw a broad-based regional softness lead by EMEA.

Consumer sales declined 22% year-over-year, while commercial performed much better down just 3%. Commercial unit shipments outpaced the market by 8% year-over-year and we maintained our number one market share position in this category. Continued pricing pressure and currency headwinds drove an operating profit of $228 million or 3% of revenue, down 1.7 points over prior year.

Personal systems contributed just 9% of HP's segment operating profit. We remain focused on improving profitability in this business over the long-term.

Turning to enterprise group. Results were weaker than expected with revenue down 9% year-over-year to $6.8 billion. We continue to see positive momentum with our converged storage solutions but we faced extreme competitive pricing in industry standard server and storage and continued weakness in traditional storage demand. We were also working to address execution challenges across ISS and as Meg noted, we need to improve the go-to-market fundamentals across Enterprise Group.

Operating profit was $1 billion or 15.2% of revenue, down 1.9 points from last year. Higher margins in technology services helped offset weakness in the other businesses, primarily ISS and storage.

By business unit, Industry Standard Servers revenue declined 11% year-over-year to $2.9 billion. We saw double-digit declines in mainstream and Hyperscale. Hyperscale results partially reflected a tough compare over the prior year. Storage revenue declined 10% year-over-year to $833 million. We remained excited about our converged storage offerings which grew 37% year-over-year.

3PAR was up double-digits again and StoreOnce continue to do well. Together, 3PAR plus XP, plus EVA, a metric that adjust for the planned product transition outgrew the market.

Business Critical Systems revenue declined 26% year-over-year consistent with expectations at $284 million. We continue to face Itanium pressures and the overall units market secular declines persisted. This more than offset solid growth in mission-critical x86 sales.

Networking sales were flat year-over-year at $644 million. We continue to make strides in wireless LAN and [attack] the strong customer interest in our new software-defined networking solutions that we introduced earlier this year. That was offset by weakness in U.S. public sector spending.

Finally, in Technology Services, revenue declined 7% year-over-year to $2.2 billion, driven by hardware decline, particularly in DCF in traditional storage. We are focused on improving our attach rate on our newer products.

Turning to Enterprise Services, revenue of $5.8 billion declined 9% year-over-year as public sector austerity measures continued to pressure discretionary IT spending particularly in the U.S. and U.K., but performance was still ahead of where we expected due to incremental business offsetting expected runoff.

Operating profit of $192 million, or 3.3% of revenue was down five points year-over-year due to the higher operating expenses on a tough year-over-year compare, offsetting improvements in resource management and cost controls and our handling our underperforming contracts.

By business units, IT outsourcing revenue was $3.7 billion down 7% year-over-year and Applications and Business Services revenue was $2.2 billion, down 11% year-over-year. Both business units were significantly impacted by contractual run-offs.

Strategic Enterprise Services revenue continues to grow double digits driven by cloud, security, application modernization and big data solutions. We are pleased with the execution progress across ES. Our signings were up double digits both, year-over-year and sequentially, driven by renewals. However, our ability to grow sales beyond traditional offerings needs to improve. Growing our bookings at SES by better embedding in our large deals and winning smaller deals remains a top area of focus.

Software had a solid quarter with revenue up 1% year-over-year to $982 million. We are especially pleased with the continued performance in our strategic areas of cloud, security and big data. Sales of our security solutions grew double digits while Vertica revenue was up triple digits. At the same time, we continue to prune our professional services portfolio which tampers revenue growth, but improves profitability.

Operating profit for the quarter was $201 million or 20.5% of revenues. This was up 2.5 points year-over-year and 1.4 points, sequentially, showing real signs of improved operating leverage.

License revenue was flat year-over-year, while support revenue grew 4% over the prior year. By design, professional services revenue declined 11% from last year and SaaS revenue was up 4% on prior year which is below our expectations, but bookings growth was solid in the quarter. Across software, we saw better sales execution this quarter with improved license conversion, but we still have work to do and building our pipeline and continuing to improve our sales execution.

HP Financial Services revenue declined 6% year-over-year to $879 million due to Enterprise Services volume decline offsetting solid direct business growth. Financing volumes were down 9% year-over-year with net portfolio of assets of $12 billion, down 4%. Operating profit was $99 million or 11.3% of revenue. The return on equity in HP Financial Services continues to be strong.

Moving on to our balance sheet and capital allocation for the quarter. We continued to execute our strategy of driving free cash flow and strengthening our balance sheet. Operating cash flow was $2.7 billion in the quarter, down 6% year-over-year and free cash flow was $2 billion, down 2%. We continued to see improvement in working capital with the cash conversion cycle down nine days year-over-year to 18 days. The year-over-year reduction was driven primarily by improvements in days payable.

Sequentially, the reduction of three days was in line with typical seasonality for days payable and days inventory where we were able to offset the increases from the large deals I noted last quarter with other inventory improvements. Day sales outstanding was better than normal seasonality as a result of strong collections as well as better usage of cash discount.

I want to take a minute to comment on our share repurchase program. In Q3, we spent just $3 million on repurchasing 168,000 shares in the quarter, well below our historical levels. During the quarter, we had material non-public information that prevented us from putting in place a share buyback plan as we typically do.

However, we have developed the plan for Q4 that will ramp up our spending to offset dilution from Q3 and Q4 but will remain inline with our broader FY13 goal of rebuilding our balance sheet. We will provide an update on our capital allocation priorities for fiscal '14 at our Security Analyst meeting in October. We remain committed to overall capital distribution to shareholders and we have paid out $280 million in dividends in Q3.

Gross cash at the end of the quarter was $13.7 billion. Operating company net debt was $1.2 billion, down another $1.7 billion from the last quarter and down $10.6 billion from the peak in the first quarter of fiscal 2012. I am pleased with our progress in reducing operating company net debt and on August 1, we have further reduced gross debt by paying off a $1.l billion maturity.

Looking ahead to the fourth quarter, we see mix trends. At a macro level, we expect consumer demand weakness in the PC industry will likely continue to impact personal systems and we expect continued pricing pressure in printing, personal systems and industry standard servers. At the same time, we expect to see a more favorable trends and demand for commercial PCs relative to consumer. We expect printing to continue to perform well as we utilize Yen tailwinds to place more unit, but as we mentioned, we do have a little bit more work to do to bring down supplies channel inventory.

For enterprise services, contractual run-offs continue but we expect the overall full year revenue decline to be in the 8% to 9% range less than the 11% to 13% range we indicated in the Q2 earnings call. For the year, we continue to expect margins to be at the high end of our zero to 3% range that we provided last October.

Software will have a tough Q4 compare due to the large General Motors deal we noted last year. We still expect to see improved execution and strong customer demand across our big data, security and cloud offerings. Finally, we anticipate one point of currency headwind to revenue in Q4.

With that context, we expect full year fiscal 2013 non-GAAP earnings per share to be in the range of $3.53 to $3.57. We expect full year fiscal 2013 GAAP earnings per share to be in the range of $2.67 to $2.71.

Finally, although we don't typically update our cash flow outlook quarterly, we think it makes sense to update our expectations given our Q3 cash flow performance. We now expect free cash flow to approach $8 billion for the full fiscal year 2013. We did better than expected in Q3, but we believe that Q3 cash conversion cycle was below what we consider to be at sustainable long-term rate. So we expect some pull back in Q4.

I know everyone wants to hear our view on n fiscal '14, but we will provide our detailed outlook at our upcoming Security Analyst Meeting on October 9. We look forward to seeing you all then.

With that, let's open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions). We have Mark Moskowitz with JPMorgan on the line with a question. Please go ahead.

Mark Moskowitz - JPMorgan

Yes, thanks, good afternoon. Meg, the first question is for you. I was curious regarding this commentary around execution. Can you give us little more specifics, particularly in context of today's management changes, how much is driven by technology deficiencies go-to-market or both and how we should think about that trajectory and that there is a lot more R&D required going forward and then I had a follow-up for Cathy if I could around the services business. I hear you on the revenue decline that was expected at last October's analyst meeting. How should we think about some of the services slippage going forward as these expansions for some of these four exceptional services customers unwind? Will be there any sort of operating margin hit down the road that we should prepare for?

Cathy Lesjak

Great. Well, let me take that first one. So, we were disappointed as I said in [EG] performance this quarter and there are a couple of issues. This is less technology than it is a number of other areas. First is, we've got to have the right products targeted to the market segments that we choose to go after with the right cost structures and we've got some more work to do on having the competitive cost structure around supply chain as well as our manufacturing strategy.

We also have got to simplify and make more effective our selling motion. This is a very big, very complicated sales motion. Frankly, we've got to simplify it and then we've got to see our channel programs that we've put in place earlier this year and some changes to the partner compensation program in August have got to work. Actually there are some bright spots there, but my view is we have got some operational excellence work that needs to be done here. I actually I'm quite confident in our technology, I'm confident in our next-generation blades, in Moonshot. I think, we can turn the corner on this, but we have a bit more work to do.

Also, on the services business question in terms of the slippage, I am not trying to call it slippage. That sounds unplanned in some way. We have been working closely with these top-four accounts and at least one of them is completely done, but the three that remain and we are working very methodically to make sure that their transition works well. Frankly, that gives us time to come in into a couple of things, A, get our cost structure in line for now the new run rate business, but also it's enabling us a chance to come in and sell a bit more on a sell and bill basis within the quarter and we saw that this quarter, so this quarter.

So, this quarter we had just had the run-off from these exceptional accounts and we hadn't been able to bring in some additional revenue then the reduction in revenue would have been much higher and much worse and so I think that's giving us time. I think actually letting these things take a little bit longer to transition has been good for us.

Rob Binns

Right, thanks Mark. Next question please?

Operator

We have Toni Sacconaghi online with question. Please go ahead.

Toni Sacconaghi - Sanford C. Bernstein

Meg, I was wondering if you could comment a little more on the management changes. In the last two months, you have changed leadership of business units that comprise more than 80% of your profits, so you outlined some of the things that you were dissatisfied with. Perhaps, you can comment on what are the specific marching orders to the new executives.

Can you also comment on why you are not working to attract talent from the outside? I think in your press release, you said the imperative is to rapidly respond with fresh ideas and bold execution. Fresh ideas often come from the outside and all the management changes that have occurred recently have included promotion solely from within, so marching orders, recruiting outside talent and I have a separate follow-up please.

Meg Whitman

Okay. So, this as I have said for a long time, is a five-year turnaround with appropriate milestones along the way. But, we are entering the next phase of the turnaround and my view is we need to accelerate into the next turn. And, my job is to get the right people in the right job, at the right time, with the right experience and domain expertise. As I evaluate the performance of each of these businesses, what I think is necessary, then I have a got a match the right executive to the challenge at the time.

I am excited about the make-up of this new team, and you are right Tony. I have relied more on promote from within, because we've got a lot of very talented executives in the company who have been in second or third level jobs, who are more than capable of stepping up in the case of Dion Weisler, the result in APJ for our PPS are really quite good. It takes a long time to learn how HP does things and understand the business.

In the case of Bill Veghte, he had been our Chief Operating Officer, had helped plot the blueprint for the future and brings a tremendous amount of software expertise to a business that has relied more on software to differentiate the hardware than the bare metal. He also has tremendous expertise in selling, ran Microsoft North America and one of our big weakness here is our selling motion and our sales go-to-market.

So it's always a balance. I have brought some new people in from the outside but you are right. I tend to want to go with people who I think have the fresh ideas and the energy and the enthusiasm but also don't have to start at the beginning of a learning curve.

Rob Binns

Great, thanks for that, Toni. Next question please.

Operator

We have Katie Huberty from Morgan Stanley online with a question. Please go ahead.

Katie Huberty - Morgan Stanley

Yes, thank you. Cathy can you talk a little more specifically about the cash cycle improvement in the quarter and importantly why you don't think that's sustainable? Whether mix or timing situations this quarter that won't to continue?

Then also, can you reconcile the fact that printer hardware unit growth was the best in a couple of years and yet printer supplies growth declined this quarter, which was a deterioration from last quarter and you are sort of down ticking on outlook around printer supplies as well? Thank you.

Meg Whitman

Thanks, Katie. On the cash conversion cycle, first off, we are very pleased with the performance that we have delivered both in Q3 as well as, frankly, throughout the year around cash flow. What is showing up in the numbers is the work we did to educate everybody in the company, help them understand how they can contribute to improving cash flow. Then, frankly, also embedding in a more significant way cash flow into the executive bonus metrics doesn't hurt either.

So we have seen that kind of improvement. Specifically in Q3, one of the big drivers of the year-over-year improvement was in days payable and that was the result of some purchasing linearity in the quarter. When we step back and we look at what is a long-term sustainable cash conversions cycle for the company, we think it's more in the low-20s and that's really where the pull backs that we expect to see in Q4 as well. So that's on that side.

In terms of the hardware units, again what we did this quarter was, we were able to use the Yen tailwinds that we have in our cost structure to really go after more units. We saw that with units being up 5% year-over-year, in the commercial space up 12% year-over-year, in the consumer space up 2%. So we are really pleased with having that opportunity to get those units out for exactly the reason that you raise, is that in a fairly short amount of time that's going to drive additional supply consumption.

In terms of the specifics around the quarter for supply this quarter, we do expect that supplies will continue to be relatively volatile quarter-to-quarter. Our strategies for the long-term are really to drive units out there that will ultimately use more HP branded ink. Those strategies, I think, like Ink in the Office, Ink Advantage, Ink Subscription, multifunction printers, managed print services, those are all really designed to drive more supplies per unit and while it is still early days, the early indications are encouraging that those strategies are going to bare out.

Kathryn Huberty - Morgan Stanley

Thank you.

Rob Binns

Thanks for that, Katie. Next question please.

Operator

We have Jim Suva from Citi Research online with a question. Please go ahead.

Jim Suva - Citi Research

Thanks very much, and Meg, a quick question. It seems like a while ago, you were talking with a lot of confidence about the five year program, especially with the revenue growth next year. It seems like now that the confidence is downshifting a little bit and maybe I misinterpreted the tone of your voice recently or maybe it is true. If it is true, is it mostly due to PCs or how should we think about your confidence and how low can this five year program changing at all?

Meg Whitman

So, listen I am very confident that our turnaround is working. As you would expect, in any turnaround, some businesses are performing better than you would think and some are somewhat performing not as well as you would hope. But what has changed about 2014's revenue outlook for me is a couple of things.

First is, Enterprise Group's performance, especially during the last quarter. I would say that weak execution has amplified the market challenges that we know exist and it's been a very aggressive pricing environment.

The server market growth rates have come down in the last quarter. The PC market has not stabilized as much as I had anticipated it would. That stabilization is yet to occur. Then finally, Enterprise Services, which is good for this year is, the revenues running off more slowly this year, which is good for this year but creates growth challenges for next year, so I am confident that we can address the challenges. There are some segments that will absolutely grow next year and we will deliver very good performance, but I think it is unlikely given the changes that have occurred over the last quarter or so that we are going to see growth in 2014 as I had hoped.

Jim Suva - Citi Research

Okay. That's on the revenue side, but then also on the profitability side cash flow is better and restructuring is progressing well I think on the earnings side you could see growth at the top line is so much pressured?

Meg Whitman

We are being very smart about this as smart as we can in a dynamic market, which is it did not rose at any cost. We want to manage the margin revenue tradeoff here and we will give you a lot more insight to that in our Security Analyst meeting, where we are going to talk about our earnings per share projections, capital allocations, the investments we need to make and where we think the growth is going to come from next year by market segment.

Rob Binns

Great, thanks, Jim. Next question please.

Operator

We have Ben Reitzes from Barclays on line with a question. Please go ahead.

Ben Reitzes - Barclays

Hi. Can you talk a little bit about the Technology Services business? That has been pretty stable and it kind of dipped down 7%, inflected and I think that's your most profitable business in the whole company even more profitable than software. Then just one clarification, I wanted to know, Meg, that the server business ISS has been declining for several quarters. I believe this is the seventh or eighth in a row, or sixth or seventh in a row, and I was like wondering why now? Why didn't we hear about this a couple of quarters ago and what actually came to light to make the decision happen now on this call rather than over the last year. Thanks.

Meg Whitman

Let me start with the Technology Services question that you have. One of the things that we are absolutely seeing in Technology Services is the need to really improve our attach rate on some of our newer products. So, as some of the older products like Business Critical Systems, which has very strong attach and penetration rate as that has a long tail, but it is coming down and hardware in general has been coming down. That's starting to impact technology services, so what we are doing about that is trying to improve our attach in the newer products and then also coming out with new innovative service offerings like what we call Proactive Care or what we call Datacenter Care, kind of coming out with these new offerings to somewhat cushion the pressure that we are seeing, because hardware sales are declining.

If you go back and you look at fiscal 2011 and fiscal 2012, we were able to improve the penetration rates in storage and in networking over 300 basis points, each. In this year, we have had a little bit of step back and particularly in this quarter we were down a little bit on rates and that's really do the mix. We have got to get the tax rate up on the newer products.

Cathy Lesjak

Let me take the question on our Enterprise Group performance overall. The Server business has been under pressure for some time. The pricing in the marketplace is as intense as I have seen it since I have been at HP, but the revenue share loss this quarter was bigger than we had anticipated. I said in this script there was five points of share loss on a revenue basis, and we have got to move faster on our Hyperscale initiatives and Moonshot will be the disruptive force there, so we have got to move that faster.

Then we must see networking grow faster. We are the upstart in this business, so a flat networking performance is not what we need to see. Then frankly, our Storage business, the converged storage part is going well, but the decline in tape and other areas of XP, we can do better than that. My job as I said is to make sure that we are positioning these businesses for the future and what I ask of our Senior Executive to sort of double back to Toni's question that I didn't answer directly as I could have is, listen, set realistic targets, deliver on your commitments while keeping an eye on the long-term. I have said for long-term. We are not here for this quarter or for this year. We are trying to set HP up for another really great run here.

You have got to decide where you are going to play and how you are going to win because this isn't all about revenue growth. This is a margin revenue trade-off business and we have to be very clear about where we want to play and how it is that we are going to win. Then make sure that you have done a perfect job of segmenting your market and marrying the right products to that market segmentation.

If you do that and manage your cost structure, we will have a very successful business here. So, that's what I am looking for. This is something historically HP has done really well but it is not being done as well as it could be in all parts of the business. It needs to be a real strength of the company going forward, especially as we are navigating these incredible shifts in the industry. It's not business as usual in our industry and we have to be better at it than we have been in the last year or two.

Benjamin Reitzes - Barclays Capital

Great, thank you very much.

Rob Binns

Thanks, Ben. Next question please.

Operator

We have Brian Alexander from Raymond James online with the question. Please go ahead.

Brian Alexander - Raymond James

Yes, just on the leadership change. Do you expect trends in the enterprise business to deteriorate further as you go through this transition and at what point, Meg, would you actually hope that this business would start growing again? And with the change in responsibilities for Dave Donatelli, how should we think about HP's emphasis on returning to M&A as a key growth driver given you now have two very senior executives focused on early stage opportunities? Thanks.

Meg Whitman

Yes. So listen, we are in a happy position now from a capital allocation perspective of being able to, our capital allocation strategy has been very clear. Return cash to shareholders in dividends, buy back enough shares to offset dilution and pay down debt. So we now have an opportunity to say where can we use strategic acquisitions to further our overall objectives as a company and we will be back in the market as we think about acquisitions that can further our objectives. Again we will be incredibly measured and disciplined. We are very mindful of the event that we just came off with Autonomy.

So, don't worry about that. We are very focused and disciplined. But I think as we see these big tectonic plate shift, there is no question that acquisitions are going to have to be a part of how we turn this company around. So, listen, there is a lot of changes going on in the marketplace. The good news about EG, someone asked me the question earlier, do you think it's a technology problem? In other words, you are not spending enough in R&D.

Actually, I don't think that's the case. I think we have the right technology. We have got to work on go-to-market. We have got to work on cost structure and we got to work on market segmentation, which frankly are easier more near-term things that can be fixed as opposed to hoping that we are going have the right product two or three or four years from now based on what's in the labs today. I am less worried about that and much more focused on what I would call more prosaic execution.

Brian Alexander - Raymond James

Thank you.

Rob Binns

Thanks for that one, Brian. Next question please.

Operator

We have Maynard Um from Wales Fargo online with a question. Please go ahead.

Maynard Um - Wells Fargo

On your go-to-market, I am just curious, your partner changes were put in place on May 1 or somewhere around there. So you have had about three months since implementation. So is the go-to-market change a function of not having had it right initially? Or is it something else? I am just curious how long, you seem to imply that these are short term things, I am just curious if it really is a short term thing or if these are changes in the channel that needed to play out over a period of time, multi-quarters? And if not, why it's a short-term phenomenon? Thanks.

Meg Whitman

So whenever you make changes to your go-to-market selling motion, these take a while to work through the system and our channel partners have just gotten their first cheques from the new compensation program that went in, in June. Actually there is some light at the end of that tunnel. We feel good about the changes we have made to our partner selling motion.

But go-to-market is more than just a coverage model. It is our ability to price. It is our ability to provide the specialist and a solution architect that are needed to sell. It is about our ability to provide compelling bundles of server and storage, like an appliance for some of our software elements.

So it is a holistic view of go-to-market. I think there is some real light at the end of the tunnel. We have had our AGMs and our AEs in place now for a number of quarters. In fact, a number of years now. So there is more account consistency, but there is still work to do here and, frankly, my view is, we made this is a bit more complicated than we need to have and simplicity, in my experience in sales organization is simplicity and clarity of role and the right people against the right opportunities is critical.

Rob Binns

Great. Thanks. Next question please?

Operator

Yes. We have Shannon Cross from Cross Research on line with question. Please go ahead.

Shannon Cross - Cross Research

I have two questions. One was a follow-up. The first is, can you talk a little bit about strategy in terms of profit versus your willingness to price and take share. Obviously, some of your competitors have been extremely aggressive in certain areas. Is this is a situation where you just don't want to follow them down and so you're going to continue to give up share or how are you sort of weighing that? Because, obviously in printers, you are willing to do that when you have the yen benefit, but I am thinking in some of the other categories where you have seen some share slippage?

Cathy Lesjak

Shannon, our focus whether it's an industry standard service, which Meg talked a little bit about a few minutes ago or in PCs that we talked about for a long time same thing in printers is that we are focused on long-term profitability. So, if in the short-term there are reasons to make an investment that we think will give us a good return, then we will do that deal and it may not always make money at least on the fully loaded basis, but our goal is long-term profitability and we believe that ultimately the way we are going to get there is investing in our own IP, driving products and services that have a strong value proposition for customers and we will then enable us to compete very effectively. You saw in PCs this quarter we were able to do well from a profitability perspective and also gain share, so we gained share both, year-over-year and quarter-on-quarter, but ultimately the decision is what's the best thing for this business over the long-term and how we are going to drive profitability.

Shannon Cross - Cross Research

Then can you just talk a bit about what you have seen in China? Is there are any more details you can give in terms of demand, enterprise, government, consumer, linearity during the quarter? Just any color you can provide on what's going on over in China.

Meg Whitman

Well, I will make some top level comments and Cathy can chime in. China is softer than we had anticipated and it is actually across the board. We are seeing more rapid growth in Tier-4 through Tier-6 cities, a little less in the big areas, but it is reasonably soft demand across the board at least as we see it. Do you want to add anything to that Cathy?

Cathy Lesjak

Let me give you just some data points. Networking in China for us was very strong. We saw a very good growth on year-over-year in networking in China. And, you all may not focused on this, but we do. We are the leading market shareholders in China for networking, so we are pleased with the result in networking. Then in printing as well on a local currency basis year-over-year, we grew revenue as well. That's in the context of what Meg said is that, overall the economy does seem to be slowing a bit.

Rob Binns

Great. Thanks, Shannon. Next question please?

Operator

We have Keith Bachman from Bank of Montreal on line with the question. Please go ahead.

Keith Bachman - Bank of Montreal

Thank you. I wanted to see if you could give us update on the restructuring and the cost opportunities that still have yet to show up. The reason I asked the question, it's not apparent that HP is getting material benefits from the cost restructuring activities. So if I look at the guidance for this fiscal year, your operating profit dollars are going to be down roughly $1.5 billion and that's assuming that you are getting cost savings that are falling to the income statement of about $1.5 billion. So why aren't we seeing more of this show up in terms of the income statement? Because I know, Meg, you said that you are making some investments but it seems like an extraordinary amount. Then how much still has yet to be delivered in terms of the cost actions and will we see any of that show up? That's it for my question. Thank you.

Meg Whitman

Keith, let me give some update on the restructuring program. Of course, we've got two dimensions to it. Of course, we have got the labor and the non-labor. From a labor perspective, the restructuring remains on track. We had roughly 3,800 people leave under the program in Q3. On a program-to-date basis that's roughly 22,500 people have left under the program and we are on track to hit the 26,000 roughly exiting under the program by the end of fiscal 2013, so I would say good progress on the labor side.

On the non-labor side, we are on track in most areas and ahead in others, so we are feeling good about the non-labor progress as well and it's really both, the labor and the non-labor savings that's enabling us to compete and price more effectively in the market.

I think that, that gets to your second question. If you go back to our EPS guidance implied for Q4 specifically, that's roughly normal seasonality at the EPS line but we don't have the same seasonal growth in the revenue line and the difference between that is basically the savings that are getting generated under the labor and the non-labor restructuring effort. That's what cushioning the bottomline. If it weren't for those savings coming through, the results will be materially lower.

Keith Bachman - BMO Capital Markets

I guess, Cathy, just a follow up, if I could. But the challenge here for investors is when the cost cuts run out, the pricing in the market will presumably still remain. How do we reconcile that with HP being able to grow it's earnings overtime? Then sorry, I will seat the floor.

Cathy Lesjak

Well, I think Keith, part of the challenge obviously is the macro and our execution issues. These savings are, frankly, giving us the, if I can call it, air cover or room and time to actually fix execution issues and hopefully, overtime, the macro environment starts to become a little bit easier. We are not planning on that when we think about '14, but it does give us this time to fix some of our execution issues.

Keith Bachman - BMO Capital Markets

Okay, thank you.

Meg Whitman

The other thing I would add here is that while we are making these cost cuts, we are making investments that we think will result in revenue growth overtime and we have three segments of businesses. We have got businesses that are growing, businesses that are maintaining roughly flat and then we have declining businesses. The mix is now quite heavily weighted toward declining businesses. Overtime, that mix will shift because of the investments we are making and frankly the market shift.

So our mix of business is not helping us right now, but we think overtime, take storage for example. So our converged storage business is growing very rapidly. The traditional storage business is shrinking. At some point, the converged storage gets bigger than the traditional storage and then you have a growth story in storage. That actually is a metaphor for the whole company.

So it's a financial architecture that actually works in our favor overtime, but to your point, we have to continue to be vigilant about cost. We have to restructure our business. We have to make this very large company as lean and efficient as we possibly can. And some of the organizational changes that I announced today, I think there is more efficiency that we can gain from combining marketing and communications.

And we need to think through new models for delivering what our customers want and being laser like focused on that and not doing a lot of other things that aren't laser like focus about the places that we can win and then how we are going to win there.

Keith Bachman - BMO Capital Markets

All right, thanks, okay. Thanks, guys.

Rob Binns

I think we have probably got time for maybe one more.

Operator

Thank you. We have Ananda Baruah from Brean Capital online with the question. Please go ahead.

Ananda Baruah - Brean Capital

I guess to that end, can you give us a little bit of sense, maybe a preview if you will, of what the opportunity for cost savings might be going forward? Presumably we are going to get market forces that are going to continue to be pretty aggressive across a number of segments. So even if you give us something anecdotal that would be helpful. Thanks.

Meg Whitman

So listen, we have done, I think a very good job of identifying areas of cost savings. Cathy very accurately described the labor savings. We have a non-labor program also in place. We continue as we are in place and consistency of leadership for Hewlett-Packard is so important because you actually have one year to the next of learning behind you and an ability to see things that you might not have seen even two years or three years ago.

So listen, I think there is still opportunities for us in how we support the sales force. Sales operations is an opportunity for us. How we are organized between product marketing and category management and product management versus what takes place in the field versus what takes place in the business units. How do we leverage our key accounts, our big accounts between ES and Enterprise Group?

So there is a next generation, if you will, learning how we can be more efficient. You also have to remember this company was the product of the many acquisitions going all the way back to Compaq, EDS, Arcsight, TippingPoint, Fortify, Opsware, you name it. While there were many acquisitions that I think were integrated well, not all of them were fully integrated in such a way that we had the right ERP systems, et cetera. So, I think you will see pockets of growth over the next year as we continue to work on this and I think we continue to take out costs.

Cathy Lesjak

And we will talk a lot more about this at our Security Analyst meeting in October when we really lay out all of the different elements of the fiscal '14 plans and continued cost reduction will certainly be prominently featured.

Meg Whitman

But let me. Are we done? Rob, I think we are ready to close. Okay. So, listen, I feel very confident in our turnaround. This is a journey. We have a achieved a lot of milestones along the way and I am confident we are on the right track and I am really excited about this new management team and what we are going to accomplish for the benefit of customers, shareholders and employees. So I feel like we are on track and things are headed in the right direction.

Rob Binns

Great, I think we are done. So with that, we will conclude the call. Thanks very much everybody.

Operator

Thank you, ladies and gentlemen, this concludes our call today.

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