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Executives

Jim Burns – VP, IR

Mark Hurd – Chairman, CEO & President

Cathie Lesjak – EVP & CFO

Analysts

Rick Gardner – Citigroup

Ben Reitzes – Barclays Capital

Brian Alexander – Raymond James

Katy Huberty – Morgan Stanley

Toni Sacconaghi – Sanford Bernstein

Bill Shope – Credit Suisse

David Bailey – Goldman Sachs

Amit Daryanani – RBC Capital Markets

Lou Miscioscia – Collins Stewart

Keith Bachman – Bank of Montreal

Mark Moskowitz – JP Morgan

Aaron Rakers – Stifel Nicolaus

Shannon Cross – Cross Research

Hewlett-Packard Company (HPQ) F1Q10 (Qtr End 01/31/10) Earnings Call Transcript February 17, 2010 4:30 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2010 Hewlett-Packard earnings conference call. My name is Kiana and I will be your conference moderator for today. 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. Jim Burns, Vice President of Investor Relations. Please proceed.

Jim Burns

Thank you. Good afternoon. Welcome to our first quarter earnings conference call, with Chairman and CEO, Mark Hurd, and CFO, Cathie Lesjak. This call is being webcast 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 most recent Form 10-K.

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 first quarter Form 10-K.

Earnings, operating margins and similar items at the Company level are sometimes expressed on a non-GAAP basis. And have been adjusted to exclude certain items, including amortization of purchased intangibles, restructuring charges and acquisition-related charges.

The comparable GAAP financial information and a reconciliation of non-GAAP amounts to GAAP are included in the tables in the slide presentation accompanying today’s earnings release, both of which are available on the HP Investor Relations web page at hp.com.

With that, I will now turn the call over to Mark.

Mark Hurd

Thanks, Jim. Good afternoon. Thank you for joining us. In the first quarter Hewlett-Packard achieved solid growth, gained market share in key markets and delivered good operating leverage. Year-over-year HP grew revenue by 8% or 5% in constant currency, adding more than $2 billion to the top-line.

We expanded the non-GAAP operating margins for the 19th quarter in a row. We generated $2.4 billion of cash flow from operations and repurchased $2.7 billion of stock this quarter. We also executed on our cost initiatives and reinvested in the business. The net result of these efforts, a non-GAAP EPS of $1.10.

In 2009, despite the recession, digital content continued to grow at an explosive rate. And in HP, we continued to innovate. We delivered new high performing products with compelling value for customers. In Q1, as the server, PC and printer markets returned to growth, HP was positioned to capitalize and gained share in each of these markets.

ESS grew 11% this quarter, fueled by 27% growth in Industry Standard Servers. Our G6 servers give customers a short payback period and are being adopted more quickly than any previous generation. Yet still only a fraction of the installed base has been upgraded. Average selling prices continued to move up and we delivered over 30% operating leverage in this segment.

PSG grew 20% over the prior year. Our innovative line up of notebooks and TouchSmart PCs continued to push our share gains and ASPs higher, as customers vote with their wallet. The U.S. PC market grew more than 20% in the recent quarter and we gained roughly 4 points of share in this market, with expected gains in both consumer and commercial.

In IPG, consumer and commercial printer shipments grew 18% and 11% respectively this quarter. The printing market is improving and IPG is on the attack, focused on aggressively placing units with high page consumption.

In Q1 wireless printers roughly doubled and ink in the office products roughly tripled. Supplies revenue was up 4% in local currency over the previous year and 1% as reported. We expect supplies growth this year of low-to-mid-single digits, despite currency headwinds.

We continue to execute our strategy in management services, retail publishing and digital press. These businesses are strategic to us, given their growth profile, and very high attach rates of supplies.

We saw continued stability in our services business, which was down a modest 1% from last year. The EDS integration remains ahead of plan. We have a large funnel and had key signings in the quarter. Services operating profits grew 21% over the previous year.

Our software business, which was flat from the previous year, had healthy margin expansion of over three points from the prior year period. Financing grew 13% and delivered double-digit return on equity.

Before I turn the call over to Cathie to review the financials, let me make just a few comments about the three areas where we are devoting a lot of effort.

First, our portfolio. I believe HP has the best and the broadest portfolio in the industry. We are number one or number two in virtually every category where we compete. We will continue to invest heavily to ensure that we maintain our technology advantage and align our portfolio to lead the evolution in the marketplace.

The next-generation data center will be delivered by the Company that can best leverage scale, industry standard hardware that is differentiated into software and financed and delivered via global services.

Printer pages will be awarded to the company that can deliver the best quality, usability, speed and affordability. The PC business will be won by the company with scale, innovation, brand and global reach. As I consider the market trends and survey the competitive marketplace, I like HP’s chances to win.

Second, our market coverage. We address a $1.3 trillion IT market. The enterprise market represents roughly half of that. And even though HP’s sales force is roughly 50% larger than when I joined the Company, we want to increase that number.

We also have work to do to address the small and medium business customers, both domestically and abroad, particularly, in emerging markets. We are hiring now and will continue to invest in direct sales and channel partners to better reach these customers.

Third, our cost initiatives. We have made substantial progress in (inaudible) our cost structure and improving productivity, with revenue per employee up double-digits over the previous year. But, there is still enormous opportunities in areas, such as supply chain, overhead and service and support. We remain focused on weeding out these costs and will reinvest a portion of these savings to further increase our competitiveness and to build for the future. While I am proud of what we have achieved, I am convinced that HP’s best days lie ahead.

With that, I will turn the call over to Cathie.

Cathie Lesjak

Thanks, Mark, and good afternoon, everyone. HP delivered strong performance in the first quarter. We increased revenue, expanded margins, strengthened our balance sheet and generated $1.7 billion in free cash flow. At the same time we executed on our efficiency initiatives and invested for growth.

Our results demonstrate the strength of our operating model, both the operating leverage from strong hardware growth and the resiliency of our recurring revenue. Compared with a year ago, total revenue in the first quarter was up 8% or up 5% in constant currency to $31.2 billion.

On a regional basis, the Americas and Asia-Pacific showed strong year-on-year growth, with revenue increasing 9% and 26%, respectively. In EMEA, revenue increased 1% from the prior year.

Gross margins for the quarter were 22.8%, down 60 basis points year-over-year. The decline was due to strong growth in PC and printer hardware revenue, partially offset by rate improvements in services.

We continued to improve our cost structure, reducing non-GAAP operating expenses as a per cent of revenue by 1 point year-over-year to 11.6% of revenue. The structural changes that yield these lower costs drive sustainable improvement and enable us to reinvest back into the business to fund innovation and expand our sales coverage.

Non-GAAP operating profit increased 13% year-on-year to $3.5 billion, with operating margin expansion of 40 basis points. Non-GAAP net income increased almost $400 million to $2.7 billion or $1.10 per share.

Looking at the details of our performance by business, during the first quarter revenue in the Imaging and Printing business grew 4% to $6.2 billion. Supplies revenue grew 1% in dollars and 4% in local currency, and we saw the convergence of sell-in and sell-out on a constant currency basis.

Consumer hardware revenue increased 21% and commercial hardware revenue grew 4% compared with the prior year quarter. Segment operating profit totaled $1.1 billion or 17% of revenue, while driving double-digit hardware unit growth.

Total printer unit shipments grew 16%, the largest increase in three years, with consumer and commercial printer units growing 18% and 11% respectively. We are reinvigorating the core business. The strong growth in our wireless and Officejet products shows that customers value innovation.

In addition to placing more units, we are driving growth in long-term, high-value annuity businesses such as managed print services and digital press, which experienced double-digit growth this quarter.

Operationally, IPG has made great progress in the last year and is well-positioned to grow share in 2010. We will continue to invest for growth and profitability through our commitment to innovation, targeted share gains and a focus on high usage categories and high value annuity businesses.

At the same time we are focused on improving efficiency through initiatives to streamline our supply chain and lower product costs. These improvements create capacity to invest in unit placement, while maintaining industry-leading profitability.

While laser printer availability will be constrained through the second quarter, we do expect to achieve double-digit unit growth for the full fiscal year in both ink and laser hardware.

Services delivered revenue of $8.7 billion, down 1% from the prior year. Within services the IT outsourcing business grew 2%, Application Services declined 8%, BPO declined 3%, and Technology Services declined 2%. We have a solid funnel of deals and continue to deliver strong customer satisfaction.

The EDS integration is going well and this has significantly enhanced our competitive position.

Segment operating profit in the quarter increased $240 million year-over-year to $1.4 billion or 15.8% of revenue, driven by synergies from the EDS acquisition. We remain focused on driving operational improvements in the business via efficiency initiatives, process standardization and automation.

Enterprise Storage and Server revenue was $4.4 billion, up 11% compared with the prior year, and up 4% sequentially, well ahead of normal seasonality. The ESS results were driven by strong performance in ISS, which increased its revenue by 27% from the prior year. The strength in ISS was partially offset by storage and business critical systems, which experienced year-on-year decline of 3% and 22%, respectively.

The latest generation, ISS platform, continues to deliver a compelling value proposition for customers with over 3/4th of server shipment volumes now coming from G6.

Blades also delivered strong revenue growth, increasing 24% from the prior year. And revenue for our innovative Virtual Connect product grew more than 100% this quarter.

With improved performance in the business, we are seeing positive operating leverage in the ESS model. This quarter, the business delivered over $500 million in operating profit and an operating margin of 12.6%, an increase of 230 basis points from the prior year.

HP Software revenue was $878 million, flat compared with the prior year. On the bottom-line the software business expanded its margins 310 basis points, delivering 19 points of operating margin in the first quarter.

Turning to Personal Systems, PSG revenue increased 20% from the prior year to $10.6 billion. The U.S. and emerging countries all delivered strong year-on-year growth and we saw balanced growth across each of our product categories, with particular strength in consumer demand during the holidays.

Total unit shipments increased 26% year-on-year, with notebook unit growth of 37% and desktop systems growth of 13%. Average selling prices declined at a more normalized rate of 5% compared with the prior year.

Segment operating profit totaled $530 million or 5% of revenue, as PSG continues to deliver solid performance and share gains, driven by our innovative product portfolio scale and global reach.

Rounding out the segment, HP Financial Services continues to deliver strong consistent results. In the first quarter, financing revenue grew 13% to $719 million, and generated operating margin of 9.3%, up 290 basis points from the prior year.

Now on to the balance sheet and cash flow, our balance sheet remains strong and we made solid improvements in working capital management year-over-year. We closed the quarter with total gross cash of $13.7 billion. Our Q1 cash conversion cycle was 16 days, down 13 days from the year ago and our channel inventory is in good shape.

Compared with a year ago, we more than doubled our cash flow, generating $2.4 billion in cash flow from operations and $1.7 billion in free cash flow during Q1.

We continue to actively repurchase shares, returning $2.9 billion to shareholders through share repurchases and our quarterly dividend.

And now a few comments on our outlook. For the second fiscal quarter, we expect revenue to be approximately $29.4 billion to $29.7 billion. And our non-GAAP earnings per share in a range of $1.03 to $1.05.

Included in these estimates for Q2 is approximately $0.04 of OI&E expense, a tax rate of approximately 22%, and an expectation for a modest decline in weighted average shares outstanding.

Turning to the full fiscal year, we are raising our revenue and earnings outlook. We now anticipate revenue of approximately $121.5 billion to $122.5 billion, representing roughly 6% to 7% growth, up from our prior outlook of 3% to 4% revenue growth. Non-GAAP earnings per share is now expected to be in the range of $4.37 to $4.44, representing an increase of 14% to 15% over the prior year.

In summary, we are winning in the marketplace, executing on our cost initiatives, and investing for growth. With that, we will now open the call for your questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question is going to come from the line of Rick Gardner. You may proceed with your question.

Rick Gardner – Citigroup

Hi, Cathie, I wanted to ask you about component constraints and whether they had a material impact on the top-line in the quarter. And then could you also comment on whether the working capital gains that you saw in the quarter are sustainable or was there some one-time benefit there, as a result of supply constraints or other nonrecurring issues in the quarter? Thank you.

Cathie Lesjak

Thanks, Rick. In terms of the working capital improvement, the 16 days in the cash conversion cycle is sustainable. We didn’t have anything from a sequential perspective that was particularly different from normal seasonality. The year-on-year improvement, of course, is off of Q1, which was obviously a high point last year.

In terms of the commodities environment, we definitely saw tightness and pricing pressure in commodities, particularly in memory. To be frank, we expected that. I think we called that out actually in our Q4 earnings call. We were able to increase some prices to adjust for that. And you did see sequential ASP improvement in PCs, as an example, and also in Industry Standard Servers.

In terms of commodities going forward, we expect it to continue to have upward pressure. But I will remind you that in tight supply environments we actually tend to do pretty well. In fact, we gain more share in these types of environments, simply because we got a real competency around managing our supplies. We’ve got great relationships with suppliers and we’ve got the scale that matters. So we anticipate the uptick for the rest of the year, but we’re well able to manage it.

Rick Gardner

Thank you.

Operator

Our next question comes from the line of Ben Reitzes of Barclays Capital. You may proceed.

Ben Reitzes – Barclays Capital

Yes, thanks. Can you guys comment a little more about what’s going on with printers, 16% growth? Can you talk about how much the constraints are impacting the Laser Printer segment and talk about what’s going on as we go throughout the year with printer growth? Is this the actual low point for the year in terms of printers in terms of the progression?

Mark Hurd

Hi, Ben, it’s Mark. Listen, we worked real hard on IPG in 2009 and in a strange way I think 2009 was a blessing for us. It really got us operationally focused and obviously as you see by the unit growth, probably our best unit growth number in a long time. To be blunt, I wish we had more stuff. We could have placed more lasers. We could have placed more ink units in the quarter. We did our best to handle the demand that we saw. Demand was linear, and was good across the quarter.

I would tell you that supplies, as you have seen on a sell out basis. Now this is local currency. Make sure I’m clear, Ben. Local currency sell out was also the best number we’ve seen in a long time. So we got to mid-single-digits there. It’s a bit complicated, because you have the local currency, 4% growth and then because of our hedging you get to a 1% reported growth.

It’s important to note what we’ve said today, we’re actually raising that 1% in reported dollars higher even with that currency headwind. So the unit placements are part of that. And frankly, the fact that we’re able to deliver at the high-end of our profit range in the context of being able to deliver this 16% unit growth is something that very bluntly two years ago we couldn’t have done. And I think it shows the kind of strategic work we’ve done to get the segment in the position we’ve had.

We had tremendous demand in the wireless segment. The wireless segment roughly doubled. And I think, importantly, with some of the laser issues that you’ve heard, our Officejet business tripled. So, our ability to put ink into the office has been a really pleasant thing for us overall.

So when you look at the whole market, the supply sell out on a local currency basis, you look at the demand on the printing units, you look at our ability to perform relative from an operating profit perspective, relative to all that, we feel IPG is in strong shape.

Ben Reitzes – Barclays Capital

When did the –?

Cathie Lesjak

Ben, just real quickly, let me address kind of the year in terms of unit prices. We do expect that for the full year both ink and laser will grow double-digits. Q2 will be a bit tougher. We still have constraints in the laser space. But, for the full year we do expect double-digit for both ink and laser.

Ben Reitzes – Barclays Capital

And the constraints alleviate in the back half?

Mark Hurd

They do. They do. But, listen, Ben, I got to tell you, we’ve got work to do, because demand is high and as we have improved our availability, demand has improved with the availability. So I’m cautious to answer the question the way you asked it. Let me say it the way I would say it. We will have more availability in the back half of the year. So we’re clearly ramping up in both segments. While you’re on IPG, I would add to it. We also had a very good signings quarter in managed print services. It was a very strong quarter yet again for us in that segment. And we began the retail photo kiosk roll out at one of the very, very large retailers on the planet. So, we got a very good start now on retail photo kiosk. As you know that getting the graphics, retail photo kiosk in MPS segments, which are high annuity, supply connect kind of businesses are very strategic to us. They don’t yet have as big an impact from revenue perspective, as they will in the future, but they are very strategic to us.

Ben Reitzes – Barclays Capital

All right. Thanks for all the detail.

Mark Hurd

Thanks, Ben.

Operator

Our next question comes from the line of Brian Alexander of, Raymond James. You may proceed.

Brian Alexander – Raymond James

I guess to follow-up on that clarification, are you actually expecting an acceleration in supplies growth in local currency or is the dollar growth improvement you’re expecting in supplies a function of a more muted currency headwind going forward?

Cathie Lesjak

No, we expect an acceleration both in local currency and in dollars. So, in dollars we are calling for kind of low-to-mid-single-digits this year. And the currency headwind that we’ve seen year-on-year, this quarter pretty much continues the rest of the year.

Mark Hurd

It’s a literal improvement, Brian. And I know it’s against your better instincts, but if you wouldn’t run away from my guidance, I’d appreciate it. But, it is a literal improvement in terms of the actual to your point I think well said the sellout on a local currency basis we actually think improves.

Brian Alexander – Raymond James

And then the question I have on ESS, the leverage enormous, 33% contribution margin despite all the growth coming from ISS, which I presumed has less leverage than BCS or storage. What are the key drivers of that leverage? Is it mostly driven by the higher ASPs you’re getting on the G6 servers? And given your comments that we’re early innings on that upgrade cycle, do you expect that kind of leverage to continue?

Mark Hurd

Yes, I think, Brian, you said it. It is both a growth issue and it is an ASP issue. So, by the time we get the growth and our ability to scale and leverage the cost that we have in the business as well as the fact that ASPs went up we haven’t seen the kind of ASPs that we had in Industry Standard Servers in a long time. In fact, I can’t remember what I have seen the ASP.

Cathie Lesjak

They were up both year-over-year as well as sequentially.

Mark Hurd

Which is a good news. And so, I think it actually has, Brian, very more strategic question that we’re dealing with is that more and more of customers’ strategic jobs and strategic apps are going under these kinds of architectures. And so we find that, that our ability to now compete for a different type of application is important. And that has an impact on ASPs.

Brian Alexander – Raymond James

Thanks a lot.

Operator

Our next question comes from the line of Katy Huberty of Morgan Stanley. You may proceed.

Katy Huberty – Morgan Stanley

Thanks, good afternoon and congrats on the quarter. As it relates to revenue growth, much of it came from the transactional hardware businesses in the quarter. There were obviously a number of catalysts through December. Can you talk about whether that, that demand strength continued into the month of January? And whether you saw anything different between the commercial and consumer segments in the month of January?

Mark Hurd

Katy, just to make sure I’m specific the way you asked the question. Demand was linear across the months of the quarter. That doesn’t say our supply was always linear, just to be clear on that. Because of some of the questions got asked earlier on a laser printer or something like that, but demand was linear across the quarter.

Katy Huberty – Morgan Stanley

And it sounds like you did not catch up with supply fully by the end of January.

Mark Hurd

I guess the way I would say it is we exited the quarter in a position we like from an inventory perspective in the channel. Demand was linear and we did our best to catch up everywhere that we could. And we did a little better in some segments than others. I’d probably leave it at that.

Katy Huberty – Morgan Stanley

And then just lastly, when would you expect the later cycle businesses, like services to return to growth?

Cathie Lesjak

Katy, in terms of the funnel that we’re seeing, we’re starting to see more activity in the software and the services space. And so, we’re continuing momentum that we saw in Q4. But it does come a bit later in the cycle than the hardware uptick.

Mark Hurd

I would say to you, overall, to Cathie’s point, if the market is better, we will do better. Our view is right now the market is better. But, at the same time we think we’re giving prudent guidance, given what we’re seeing. And in services we’re sort of predicting more of what we saw in Q1 at this point.

Katy Huberty – Morgan Stanley

Okay, that’s clear.

Mark Hurd

Thank you.

Jim Burns

Next question, please.

Operator

Our next question comes from the line of Toni Sacconaghi of Sanford Bernstein. You may proceed.

Toni Sacconaghi – Sanford Bernstein

Yes, thank you. Mark, you commented on the need to invest heavily going forward. I think if you just looked at R&D dollars it looks like you’re actually going to spend less on R&D in 2010 than HP did in 2000. HP’s revenues were less than $50 billion in 2000 and will be more than $120 billion today. So how do we think about that? Is that just that you have a lot of wasteful R&D spending before or your portfolio is really different or how do we reconcile those statements? And more importantly, what is the right level of R&D for this Company going forward and how do you think about that?

Cathie Lesjak

So, Toni, in terms of our R&D investments, one of the things you got to look at is that there are inputs and outputs. And the outputs in R&D really are helping to give us win in the marketplace. The innovation that we see, whether that’s around the G6 Blades, the Slate products that we’ve announced, the Web-connected printer, kind of on and on.

We’ve got good new products coming out that are helping us win in the market, and our market share gains frankly prove that. But then that there are also the inputs into R&D. You want to make sure that you are investing in the most efficient way that you can. And what we have found is that there are real opportunities to think about R&D as a series of processes and make sure that we are doing those processes in an efficient way.

For example, if you think about labs, you’ve got a bunch of little ones all over the world with a bunch of equipment in them; you basically got depreciation expenses in. That’s one kind of flow. If you go to a more virtualized environment, that’s going to be a much more efficient flow. It didn’t change the amount of innovation that the R&D engineers are doing. It’s just simply changed the process and the dollars associated with that process. So, you’ve got those types of savings that you get in R&D.

And then R&D gets allocated both real estate and IT expenses. And as those have come down at the total Company level, obviously, R&D benefits from that. The key here is that we’ve got good roadmaps, going forward. We continue to put in the right level of investment into the innovation in our R&D spend.

Mark Hurd

Toni, Cathie gave you a lot of data there, and the key to it is our overhead is down and that shows up in R&D. R&D was one of the biggest consumers of overhead in the Company. That’s one point. Second point, we’re in a mode to look for processes that we can standardize. Simple things like testing, QA, how many development tools we’ve got. All of these have been, because of acquisitions, very random and very unique, and very, if you will, siloed.

So our ability to get standardized on those processes gives us an opportunity to take out cost. And the way we look at R&D is we don’t look to Cathie’s point, we look at R&D in the context of overhead, maintenance and innovation. What we are trying to do is get the innovation dollars up. So when you look at the total R&D spend, it’s down, and yet the yield to the product road map is up. So, when you look at the number of introductions of products that have had meaningful change in share positions, that number is actually up for us. And that’s what we want to measure. We want to get more innovative products into the market sooner.

So I think the way you should think about it it’s just like somebody asking me if more field selling cost means more sales people. And the answer is no, because you have to break down all of the costs that sit in the R&D bucket or the field selling cost bucket. We’ve had times in the Company historically, where field selling cost goes up, but sales head count doesn’t. And you have to peel back these numbers to understand. So I give you a long answer to just simply say, we feel good about our opportunity in R&D to get innovative, exciting products to the market, like what we’ve seen this year that have gained share.

As we talked about salespeople, we have a lot of opportunity to get our great portfolio in front of more customers. And that’s why it’s important to us. And you may actually have seen parts of field selling cost go down at the same time sales head count go up. And it’s the same phenomena of us making sure we’re as effective as we can be and we have our money in the right place.

Toni Sacconaghi – Sanford Bernstein

If I could just follow-up on a separate topic, you had entered the year talking about market IT spending being zero or 2%, we feel very confident about our share position. And if the market does better, we will do better. Clearly you are taking up guidance here. Are you ready to declare that the market might be a bit better? Clearly, it sounds like it might be a bit of both in terms of the market and your performance. But, can you comment on that and how you’re thinking about overall IT spending and how HP is performing relative to your expectations, a quarter ago?

Mark Hurd

I think, Toni, that we’re probably not going to declare as definitive point as you’d like. I think that our view in the quarter was that we saw an improving Asia. We saw an improving U.S. again. We saw a mixed story in Europe. I could tell you stories in Europe that were a little better in terms of markets, and markets that actually showed some rebound and some that look stagnant to us. And so, I think for us to really look at the world is as having a robust IT environment, whatever that might be, we would like to see Europe a little more broad-based trajectory than what we’ve seen today.

What we do feel committed to times is that whatever that market does hand us, we will do better. We feel very confident in our position, confident in our R&D line up, confident in our acquisitions that we’ve made, we do have opportunities for more sales people in the Company, that whatever that market hands us, we think we’re going to be pretty well-positioned to take advantage of it. Probably, right now we’re going to want to see the whole quarter of Q1 close calendar wise, get all that data, before we make a call on true IT growth for the year.

Jim Burns

Thanks, Toni. Let’s move on. Next question please.

Operator

Our next question comes from the line of Bill Shope of Credit Suisse. You may proceed.

Bill Shope – Credit Suisse

Okay, thank you. Looking at the PC segment, PC upside, in particular, you noted that you saw particular strength in the consumer market, which I think is in line with what most of us saw within the industry. But can you give us a little more detail on what you’re seeing in the commercial segment? There has been lots of talk, obviously, of a refresh cycle this year. Are you seeing any evidence that corporations and even smaller businesses are starting to upgrade their PCs? And if you’re not actually seeing the orders come in, are you starting to see RFPs or the pipeline building there?

Mark Hurd

I think, Bill, that’s a fair way to describe it. I think we saw a pretty strong consumer. We expect that to continue a bit through the first part of the year. We do think there will be a corporate refresh in the back half of the year. We are beginning to see momentum around RFPs to your point. Again, the only thing, I mentioned earlier in my prepared comments that we still want to delineate between market improvement and share gains. We have had some share gains that have been impressive. Though I think you know, I don’t always feel as good about those as some might think I would, because we actually want to see a market strengthening as well as we want to execute into it. So, I think we will still be a little bit cautious on it. But, I do think you’re right. We think that there is a corporate refresh coming in the back half of the year.

Bill Shope – Credit Suisse

Okay, great, thank you.

Mark Hurd

Thank you, Bill.

Operator

Our next question comes from the line of David Bailey of Goldman Sachs. You may proceed.

David Bailey – Goldman Sachs

Great, thank you very much. I was wondering if you could just give us a little bit more detail on the sequential increase that you saw in internal inventory this quarter. And are there some strategic buys in there?

Cathie Lesjak

So, David, we feel pretty good about our inventory position frankly. We’ve improved it both year-on-year and it’s roughly up a tiny bit sequentially, but normal seasonality. We do have strategic buys in there, but frankly, we have strategic buys every quarter. They are up a bit quarter-on-quarter, but it’s not really something that I would call out significantly. It’s basically playing the game the way we have been.

David Bailey – Goldman Sachs

Okay. And then moving onto your storage business, it seems to be lagging some of your other ESS categories. Are there initiatives you have underway there to jump start that business?

Mark Hurd

We have our top guys working on it. So, I think for us, we think again there is going to be a pretty strong convergence in the server and storage market. We think there is a move towards more internal storage, away from external storage, which we think strategically really benefits the position we have in the server market. And we had a very strong quarter in the left hand product line, very strong. So, there’re elements within storage that we actually feel quite good about. As I said, we got pretty strong push strategically on getting this lined up across the entire ESS product line as well as within storage itself.

Cathie Lesjak

The linkage in storage basically had a more storage demand in the higher tiers of storage, which also plays very well to our hand, where it’s more industry standard, lower cost that really, again, like I said, plays to our hand.

Mark Hurd

We think that trend is going to continue, strategically. So, we just need to take advantage of the opportunity. But, we feel good about the market direction and the position we’ve got. We just, frankly, have to do a better job from an execution perspective.

Cathie Lesjak

The areas where we are building out coverage is in the storage space. And that is one of the pieces of execution that we’re working on.

David Bailey – Goldman Sachs

Thank you.

Operator

Our next question comes from the line of Amit Daryanani of RBC Capital Markets. You may proceed.

Amit Daryanani – RBC Capital Markets

Hi, guys, I just have a question. Looking at your full year revenue guidance, we’re looking at sales to be down about 5% sequentially. Historically, the trend, if I include Compaq and EDS as being flattish, can you just talk about where you guys are seeing the delta that’s making us a little bit more cautious beyond the EMEA region you’ve discussed?

Cathie Lesjak

So I think what you got to do is you’ve got to add EDS in the mix. And once you add EDS in the mix, the local currency kind of normal seasonality declines about a point. And then we do have the currency headwinds. And that pretty much takes care of what’s going on from a revenue guidance perspective, once you layer in the prudence around the EMEA recovery.

Amit Daryanani – RBC Capital Markets

Got it, thanks.

Jim Burns

Next question please.

Operator

Our next question comes from the line of Lou Miscioscia of Collins Stewart. You may proceed.

Lou Miscioscia – Collins Stewart

Okay, thank you. I’ve got two questions. Both of them are on services. I guess, Mark, last quarter, you talked about strong momentum in signings and that signings were substantially above revenue. How long it take for that to kick in? And then my second question, hopefully, doesn’t confuse things here is on British Sky Broadcasting. There was a law suit in the UK that was, recently, I guess, went their way. Maybe if you could just talk a little bit about that, if there is any other ones just lingering from the old EDS days before you all acquired them?

Mark Hurd

Okay, let me take the first one. Listen, I think signings, when you get them they feather in. And so some of the signings we had in Q4 began in Q1. Some frankly are just getting started in Q1. Some didn’t start until Q2. So you have a lag affect in how these starts occur. Again, as you grow, the services business, particularly, the outsourcing deals are like a portfolio. Typically, when you start they don’t have much of a profitability impact. In fact, some cases, they can be negative as you go through the transition cost. So it does take a little bit of time for those to kick in.

To Cathie’s point earlier though, the funnel is robust. So, we have a pretty strong funnel right now. And obviously, we got to convert it. But, if we execute properly this could be a good year for us. We will obviously have to have a couple more quarters to tell. And we tend to not really look at the thing on a quarter. We tend to look at the trailing 12 months and then we look at the full year forecast, because signings really impact over a longer period of time. But right now, funnel is encouraging. We just have to go execute and convert.

Cathie Lesjak

In terms of the BSkyB, we put out a press release when, I guess, the judge gave his first conclusions on the liability in that case. And we do believe that we are appropriately accrued based on the ruling. But we still need to get to the settlement piece of the case and there hasn’t been any damages yet assessed. You may have read there was an interim payment made to the tune of about 200 million pounds that we made in Q2. And obviously, if there is anything materially different than what we’ve accrued, we’d call it out to you all.

Lou Miscioscia – Collins Stewart

Great, thank you.

Jim Burns

We’ll take the next question please. Thank you

Operator

Our next question comes from the line of Keith Bachman of Bank of Montreal. You may proceed.

Keith Bachman – Bank of Montreal

Hi, thank you. I wanted to ask a question about the Enterprise Storage and Server division, essentially the composition of growth. How long is the x86 cycle, Mark? How long do you think that lasts? It appears it’s sustainable for 2010. Is that a double-digit growth for the balance of 2010? And on the other side of that is, when would you anticipate seeing better results in storage. I know, Cathie, you mentioned sales coverage, but EVA was down again, which I would have assumed to have been better. So, just wanted to get a little more color on the composition of the ESS growth, please.

Mark Hurd

Yes, Keith, let me start. I think that we do see a pretty robust server refresh cycle through the year. What quarter hits at what time, what companies do what at what point in time, I can’t exactly prognosticate to you. But we expect it to be pretty robust. And that’s contained in our guidance. And for what we can see in our funnels, looks very attractive to us. I also mentioned, the payback on these G6 installations, the TCO returns on that are just extremely attractive. So, even in a timeframe of tight budgets, these look like very good deals. So we see a pretty strong uptake on it. As far as we can see, at least during this year, we think it will continue.

Keith Bachman – Bank of Montreal

And then, Mark, just to follow-up on the EVA side or storage more broadly, I guess.

Mark Hurd

I think again we feel good, if you look at our segments, you got multiple segments. You got the high-end of storage, you got the mid range and then I hate to call up the low-end, but it’s the lower tiers and more industry standard part of storage. And what you have for us is really strong growth in the industry standard part of storage. Very mediocre performance in the mid range that we think we can improve and then not a lot of growth in the high-end. And we think that reflects market trends as well that you got to get, we got to get more of our offering into that industry standard part of the market and have more coverage in relationship to that part of the market.

So the good news for us is it’s a big opportunity. The good news is we’ve got a supply chain leveraging industry standards that are extremely scaled. We believe we now have a better line up than we have had before and we believe we have a team that’s capable of helping us build the answer so we look at it as an opportunity, because we think the markets move it our way and we want to take advantage of it.

Keith Bachman – Bank of Montreal

Okay, thanks, guys.

Operator

Our next question comes from the line of Mark Moskowitz of JP Morgan. You may proceed.

Mark Moskowitz – JP Morgan

Yes, thank you, good afternoon. Couple of questions here and a clarification. As far as the clarification, Mark, did you say that all the server ASP improvements were related to the richer configuration of G6 or is there any impact there from benign pricing as well? And then as far as the question I was just curious in terms of the full year revenue outlook boost, is there any sort of impact from the pull-through effects that EDS contributing to the outlook yet or is that more of an upside potential for 2011 and beyond?

Mark Hurd

So let me try to give you simple answers. I think G6 is the primary driver. I can’t tell you there isn’t a bit more of a benign pricing environment out there, but I think you should look at the bulk of it being G6. And I think you should look at that as upside as it relates to your second question.

Mark Moskowitz – JP Morgan

Okay, thank you.

Jim Burns

We’ll take two more questions please.

Operator

Our next question comes from the line of Aaron Rakers of Stifel Nicolaus. You may proceed.

Aaron Rakers – Stifel Nicolaus

Yes, thanks, guy. Couple of questions real quick. First, on the Imaging and Printing segment, 17% operating margin, despite what looks to be a meaningful snapback in the hardware versus supplies mix. Just kind of curious in terms of what you guys have done internally there around the supply chain and the manufacturing processes to change that cost structure and whether we should be thinking 17% is the right number versus the low-end of your guidance of 15% to 17% going forward? And then quickly, if you can, any update on pending 3Com acquisition in terms of closure?

Cathie Lesjak

Let me start with the IPG question. So we have done a lot of work to get our cost structure in a better position in IPG. And to be frank, we are not done yet. So we have made progress. We made a lot of progress last year on the OpEx side. We are starting to get the results from the work that we did on the supply chain side coming through. And it’s a combination of those that have really enabled us to go out and put out 16% increase in units and still deliver on 17% operating profit. That should suggest to you that we’re probably going to be at the higher end of the margin range for most of the year, since we’ve still got more savings opportunities and we’re going to continue to put double-digit units out there.

Mark Hurd

The only caution I give you on the, Rakers, I think your question is obviously a good one. We did perform at the high end of the guidance with a very high unit growth. That said, we are gaining share in supplies and we want to continue to do that. We believe there is more market coverage, believe it or not, in printing that we actually can go get. And we want to continue to place units. So I say to you, I think it’s very encouraging that we could put 16% unit growth out there, have the kind of signings in MPS that we had, etc., etc., Because remember, those MPS signings are a lot like an outsourcing deal. They have transition costs built into them and we actually absorb those and the unit growth in the quarter and deliver the profit we did.

That said we see opportunities in the market now in printing that frankly we haven’t seen for a while. And we want to take advantage of it. So I think back to the guidance, I know the math, there would be an interest in running north a little bit on these estimates. My view would be to stay with us here. Let us go take advantage of the opportunity, invest in the market, because we believe it gives us long-term more meaningful growth that brings leverage to the business and that’s what we’re going to go do.

Cathie Lesjak

And actually, as we get our costs down, especially on the supply chain side, that opens up additional units that can be attractive to us that with a higher cost structure just weren’t that attractive to us. And so that also gives us opportunities to grow more in the unit space.

Mark Hurd

This is a really important point that Cathie just brought up. As we bring down our supply chain costs and bring down our average unit costs, a placement of a unit that didn’t look attractive to us over the course of two years with the supplies connect that didn’t look attractive, now looks attractive. And so it actually not only do you bring your supply chain costs that creates more competitive position for you in the market, it actually opens up more market for you. And so this for us is just, as we have mentioned before, very strategic to us. I think the team has done a good job, but I’d be remiss if I didn’t tell you, we got a lot of work left to do.

Aaron Rakers – Stifel Nicolaus

Great. Any update on 3Com?

Mark Hurd

Sure.

Cathie Lesjak

So from a 3Com perspective, we still expect to close in our second fiscal quarter. We have gotten regulatory approval from the U.S. and the EU. We still got a few more places where we are going through the regulatory process, but do expect it to close in our fiscal Q2.

Aaron Rakers – Stifel Nicolaus

Great, thanks.

Jim Burns

Take our last question please.

Operator

Our last final question comes from the line of Shannon Cross of Cross Research. You may proceed.

Shannon Cross – Cross Research

Thank you very much. Made it under the wire. Question for you, first, on the currency, Cathie, how should we think about your hedging programs? Clearly, currency hedging hurt you in IPG for supplies. And how are you balancing overall hedging programs shall we say? And how should we think about it for 2010 for both the Company as well as on the supply side?

Cathie Lesjak

Typically, what we do on the supply side, as well as on the services side, is we hedge over a longer period of time. And that’s why you see the headwind that you see in supplies, but you don’t see that at the Company level. At the Company level the other product businesses are typically much shorter term. And this is a pretty consistent hedging strategy that we’ve had now for a number of years.

Shannon Cross – Cross Research

Okay, great. And then, Mark, if you could just talk on 3Com, just as you sat back and started to look at it, clearly it hasn’t closed yet, but how are you thinking about the networking opportunity? Where do you think your first position will be? Has there been any changes in the last few months since you announced the deal?

Mark Hurd

I think the only I know the changes is ProCurve has continued to gain share, both imports and in revenue. We’re obviously very encouraged by that. As we mentioned in previous calls, it’s an area we’re investing into. We think we get a lot of leverage out of our supply chain, a lot of leverage out of our go to market. Interestingly, 3Com has been gaining share simultaneously separate and apart from HP. As we told you, we are obviously very enamored with the technology. The R&D work they have done has been fabulous. So we think the leverage of the two is an extremely powerful combination. We think the market trends tell us that separately. We think together they are going to be a very powerful force in the industry.

So to your point, we’re just excited about the opportunity. We just think it’s a pretty cool thing to be able to come to the market with such a strong line up of technology and products. And when you integrate into our services capability and leverage it across the rest of the ESS, from what we hear from customers, they want us to come help them and that’s what we’re going to try and do.

Cathie Lesjak

Customers are very excited about the 3Com acquisition and the technology that it brings. Just as we went through the process of wondering whether or not what the technology really was and then getting more and more excited about it, we’re actually finding that with customers as well. So we are very excited about getting this closed and getting the proofs of concept out there for customers.

Mark Hurd

That’s a real important point, Shannon, Cathie made that we are getting customers asking us for proof of concepts and we are going to have to get that lined up and we have to integrate 3Com into the Company, which we will. We are real excited about all the people and capability they bring. But give us the time to get the integration right, get the proof of concepts out there, because we’re in this for the long-haul and we think this can be a real cool segment to add to our already strong position in ESS. Why don’t we close up? Listen, I think for us, we feel like it was a strong quarter for Hewlett-Packard. We think we advanced our strategic position. We think we executed well within the context of that strategy.

As we’ve mentioned, we are going to raise our guidance based on what we saw in Q1 and our visibility for the rest of the year. And we feel like for us the most important thing right now is to continue to execute on our agenda, which is what we’re about to do. I probably would close and I know it’s maybe not the place for an analyst call to just thank everybody at HP. I can tell you this was a real team effort on the part of people across the Company. And I can’t tell you how proud I am with them. Thank you.

Operator

At this time, I would like to turn the conference over to Mr. Mark Hurd for final remarks.

Cathie Lesjak

That was it.

Operator

With no final remarks, I would like to thank you for the participation in today’s conference. This concludes the presentation. You may now disconnect. And have a great day.

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Source: Hewlett-Packard Company F1Q10 (Qtr End 01/31/10) Earnings Call Transcript
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