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Hewlett-Packard Company (NYSE:HPQ)

Q2 2014 Results Earnings Conference Call

May 22, 2014 05:00 PM ET

Executives

Rob Binns - VP of Investor Relations

Meg Whitman - Chief Executive Officer

Cathie Lesjak - Chief Financial Officer

Analysts

Keith Bachman - Bank of Montreal

Toni Sacconaghi - Sanford Bernstein

Katy Huberty - Morgan Stanley

Ben Reitzes - Barclays

Amit Daryanani - RBC Capital Markets

Sherri Scribner - Deutsche Bank

Brian Alexander - Raymond James

Kulbinder Garcha - Credit Suisse

Bill Shope - Goldman Sachs

Rod Hall - JP Morgan

Jim Suva - Citigroup

Operator

Good day, ladies and gentlemen and welcome to the Second Quarter 2014 Hewlett-Packard Earnings Conference Call. My name is Ellen, I'll now 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 second quarter 2014 earnings conference call, with Meg Whitman, HP's Chief Executive Officer and Cathie 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 and 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, margins, expenses, earnings, earnings per share, HP's effective tax rate, 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 reports, including its most recent Form 10-Q. HP assumes no obligation and does not intent 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 the amounts ultimately reported in HP's second quarter Form 10-Q.

Revenue, earnings, operating margin 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 earning release, both of which are available on 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. With the first half of fiscal 2014 close, I'm pleased to report that HP's turnaround remains on track. As you would expect in the turnaround at this scale, there are some businesses performing better than we expected and others with more work to do. We've made significant progress in putting the systems and structures in place to more effectively manage the business. And we are focused on putting the right talent in place to lead the next leg of the turnaround.

Most of all, we stabilized the topline and we are starting to see the benefits of our focus and investments in key technologies. We have more work to do to improve the consistency of our execution and lower our cost structure to drive overall profitability. But I believe we're well positioned as we enter the second half of 2014. Rest assured, sustained profitable revenue growth remains our top priority.

Innovation is at the heart of our strategy to turn HP around. And in the second quarter you saw the launch of several critical elements of our innovation agenda. In cloud, we launched HP Helium, a portfolio of products and services that enables the next phase of our enterprise customers cloud journey. Helium is changing the game in cloud by allowing the integration of public, private, managed cloud and traditional IT environments on an open and secure platform. We are addressing a major pain point for the enterprise customers with Helium and the early interest has been very positive. We also announced further significant business model innovation in our server business with the creation of a joint venture with Foxconn. Together we’re creating a new line of cloud optimized servers specifically targeting service providers.

This partnership brings together the high volume design and manufacturing expertise of Foxconn with the compute services brand and go-to-market leadership of HP. Together, we will redefine the infrastructure economics of the world’s largest service providers. In big data, we unveiled the HP Shark system for SAP HANA. This new converged system is designed to deliver higher levels of performance and availability for in memory computing at upto twice the speed of other solutions.

We saw strong sequential growth in our HANA offerings in the second quarter and we introduced OpenNFV, a comprehensive network function virtualization program. This new program is designed to help telecom customers launch new services faster with less expense and lower risk. NFV is one of the most significant shift that telecommunications industry has experienced in the last 20 years and represents an important opportunity for HP.

As I’ve said before, we continue to see an acceleration of the massive shifts that are transforming the way customers buy, pay for and consume technology. This reality is creating both opportunities and challenges for HP and every one of our competitors. To win, we have to continue to focus and make HP a more nimble, lower cost, and more customer and partner centric company. We have made a lot of progress to that end over the past two years but we still have more work to do in our structure, our systems and our go to market.

In the second half of 2014, we will be accelerating these activities to ensure that we have the right structure in place as we enter 2015. As a result, we now expect up to an additional 16,000 employees will leave the company under the previously announced 2012 restructuring program. This will bring the total number of employees leaving under the program to as many as 50,000. No company likes to reduce their workforce but the reality is that HP must be maniacally focused on continuous improvement in our cost structure.

We believe this further alignment along with the expected [industry] investments in innovation and infrastructure set us up as a force to be reckoned with in the rapidly shifting markets where we compete.

Turning to the second quarter, HP delivered $0.88 in diluted non-GAAP net earnings per share at the high end of our previously stated financial outlook of $0.85 to $0.89 per share. For the second consecutive quarter, total revenue for the company was approximately flat in constant currency. And we once again delivered very strong cash flow, generating $3 billion in cash flow from operations.

Now let me turn to our business group performance in the quarter. Overall, results in Q2 were driven by solid performance in printing, networking and personal systems, as well as disciplined cost management across all of our businesses. In personal systems we had a very strong performance with revenue up 7% over the prior year. Overall, we’re seeing a slowing market contraction and signs of stabilization, particularly in commercial PCs. This is coupled with support from a refresh of an aging installed base and the expiration of Windows XP.

HP executed well in the quarter particularly in our commercial PC segment. Overall PSG operating margins improved and we gained share with good growth in Europe and Japan. We reclaim the number one position in both commercial PCs and in desktops, all against the backdrop of a declining market.

Looking forward, I'm excited about the strength of our product line-up and we will remain focused on profitable growth and continuing to drive further actions on our end-to-end cost structure. For the fourth consecutive quarter, our printing business once again outperformed the market and saw unit placement growth and we held or gained share in every major printing category and region on a year-over-year basis. All while delivering another quarter of excellent profitability.

In enterprise services as expected revenue was down 7% over the prior year as delayed key account revenue one-off from FY13 continued, the operating profit margin in ES was flat over the prior year and up sequentially. We expect to see a continued ramp and margins in the second half and Cathie will elaborate further on this in a moment. We remain focused on our proactive sales efforts in ES and are in the early stages of this transition, but I can feel the increased confidence from our customers.

While total signings were down over the prior year strategic enterprise services bookings growth is encouraging and we saw good new wins in the quarter. For example, the U.S. Department of Homeland Security awarded HP a Cyber Security contract worth up to $32 million and Belgium's Flemish Government awarded a seven year of €500 million contract to HP and Belgacom to offer ICT services to all local and prudential government entities. The program will give citizens, access to information and services through a virtual private cloud solution.

We've made progress, the opportunities remain for improvement in services bookings and we need to move faster and ramping up our cost savings and productivity initiative. However, I'm confident that the leadership team is taking the right steps to get enterprise services back on track. In the enterprise group revenue declined 2% over the prior year, driven by lower technology services and storage revenue as well as the expected decline in business critical systems. This was partially offset by growth in networking and industry standard servers.

We continue to see a very competitive market in enterprise infrastructure, I'm confident that the changes we've made in the leadership and go-to-market execution coupled with cost saving opportunities and our investment and innovation have put this business back on the right path However we expect it will take a few quarters for these changes to consistently take hold.

In addition to the new products that I discussed earlier, I'm very excited about some of the innovations that we'll be rolling out in the second half of the year from our server, could storage, technology services and converge systems team. We're doubling down on innovation in EG, because we believe that it's how we're going to differentiate in this market.

In the industry standard servers revenue grew for the third consecutive quarter. The team continues to make progress on stabilizing this business and improving our cost structure and go-to-market. We continue to see good customer interest in Moonshot with over 100 beta customers and engagements through our discovery labs and over 40 partners in the program. While we are seeing a ramp in Moonshot revenue, we don't anticipate this will become material in the near term. However we believe Moonshot is on its way to becoming a disruptive product in a new category of servers.

The decline in business critical systems moderated in the quarter, revenue was down 14% over the prior year and up 1% sequentially. Storage revenue was down 6% over the prior years, as customers appear depart to assess new products and market innovations. Despite the market, we still expect to gain a point of share overall. We have work to do to improve our go-to-market in this business, particularly our execution in the Americas.

We've invested in additional storage sale specialists, but these take time to ramp to full productivity. Overall we remain very confident in our storage business. We believe our converged storage portfolio is well positioned to address shifting market forces with products like 3PAR, Store Virtual and Store Once.

Networking performed well with an acceleration of growth. Revenue grew 6% over the prior year with strength in switching and raving and we saw growth across all our regions.

As I have said many times in the turnaround having the right people in the right place at the right time is critical. To that end we’ve recently announced that Antonio Neri has assumed management responsibilities for the networking business in addition to his current role leading the server team. Antonio is a proven leader who has done an excellent job guiding our server business over the past several quarters and our technology services business before that. Integrated systems are becoming increasingly prominent in the data center and Antonio’s new role will help us better align our compute and networking product strategies.

In technology services revenue declined 5% over the prior year. The nature of this business means performance typically lagged hardware sales overall, so we expect revenue to stabilize in line with the progress we’ve made in our hardware sales. The leadership team and TS has done an excellent job managing this business and we continue to see very good customer adoption of our new services and margins remain strong.

In software, revenue was flat over the prior year. Performance in the quarter was driven by growth in Autonomy licensing and strong double-digit growth in Security and Vertica offset by softness in our traditional IP management business.

Looking forward we will continue our transition to SaaS while rejuvenating our core portfolio and investing in operational improvements across this business. In addition, I’ve asked George Kadifa to take on a new role as Executive Vice President of Strategic Relationship. In this role George will responsible for leading growth initiatives and alliance programs with key partners, service providers and our largest customers. After leading HP software George has gained a unique perspective on our strategic priorities of cloud, big data, security and mobility. He understands both the customer requirements and the partner ecosystems that must be built to realize the potential of these technologies.

Robert Youngjohns will take over for George as the Executive Vice President and General Manager of HP Software. Robert is a very seasoned technology executive with more than three decades of experience. He joined the company last year to lead the turnaround of HP Autonomy after serving as President of Microsoft North America.

Overall, I am very pleased with the progress we have made but we still have a lot more work to do. Our focus continues to be driving innovation, simplifying our organizational structure to speed decision making and reducing cost. These initiatives are particularly important as we continue to navigate a rapidly shifting marketplace. Against that backdrop, our Q3 outlook for non-GAAP diluted net earnings per share will be $0.86 to $0.90 and for the full year the outlook will be $3.63 to $3.75.

So now let me turn it over to Cathie for a closer look at our performance in the quarter. Cathie?

Cathie Lesjak

Thanks Meg. As Meg said, we feel good about where we are overall as we reach the midpoint of the turnaround. In Q2, total company revenue was in line with expectations with pockets of strength in PCs and networking. Enterprise group revenue was somewhat lower than expected as storage revenue fell although converged storage solutions continued to outperform the market.

Total revenue for the quarter was $27.3 billion, down 1% year-over-year and approximately flat in constant currency. By region, Americas revenue was $11.7 billion down 6% year-over-year or down 4% in constant currency. In the U.S., revenue was impacted by key account run offs in enterprise services plus softness related to jet printing and in most EG business units. This was partially offset by strength in commercial PCs and networking. In Brazil, we experienced weakness across all of our businesses. EMEA revenue was $10.3 billion, up 4% year-over-year or up 2% in constant currency, driven growth in mature western European economies.

We experienced double digit growth in personal systems in EMEA partially offset by declines in printing. APJ revenue was $5.3 billion, up 1% year-over-year or up 6% in constant currency. We experienced revenue growth in China primarily on the strength in enterprise group and printing. In Japan, personal systems revenue was very strong due to the XP migration.

Gross margin for the quarter was 24.2%, up 0.5 points year-over-year and up 1.4 points sequentially. Year-over-year strength in printing and improvements in enterprise services were partially offset by pressure from the strong revenue performance in personal systems and weaker enterprise group margins due to a competitive pricing environment.

Sequentially, most of our businesses improved their gross margins due to good cost management and pricing discipline. Total non-GAAP operating expenses for the quarter were $4.3 billion, up 3% year-over-year, primarily associated with incremental R&D investments. Sequentially, OpEx was up 6% on higher R&D investments as well as a tough compare due the real-estate gains as reported in fiscal Q1.

As a result, non-GAAP operating profit was $2.3 billion or 8.6% of revenue, flat year-over-year and up 0.1 point sequentially. We recorded a $174 million of expense on the other income and expense line. With the 22% tax rate and a weighted average diluted share count of 1.916 billion shares, we delivered second quarter non-GAAP diluted net earnings per share of $0.88. Second quarter non-GAAP earnings primarily excludes pre-tax charges of $264 million for amortization of intangible assets and $252 million for restructuring charges.

Now turning to the business units. In printing, we saw very strong profitability and further traction in key initiatives like Ink in the Office and Ink Advantage as well as in graphics. However, weak toner sales continued to be headwind as the hardware installed based remains under pressure. We are focused on placing value-added units to support the installed based throughout the rest of fiscal '14.

Total printing revenue was $5.8 billion, down 4% year-over-year, driven by a decline in supplies revenues, primarily related to lower toner sales. Commercial Hardware revenue was $1.4 billion, down 1% year-over-year while Consumer Hardware revenue was $566 million, up1% year-over-year. Total hardware unit shipments grew 1% year-over-year.

Ink in the Office and Ink Advantage units and revenue each grow double-digits and we grew share in both ink and laser hardware units. Supplies revenue was $3.9 billion, down 6% over the prior year period and made up 66.3% of printing revenue. Although the mix is down a point year-over-year, ink is a greater part of supplies mix which helps offset the negative impact of lower supplies on overall printing profitability.

Total printing operating profit was $1.1 billion or 19.5% of revenue, up 3.6 points year-over-year. We saw a positive currency benefit of approximately 1.5 points in second quarter margins plus we realized some of the benefit from our focus on reducing non-labor costs and disciplined OpEx management. We expect to reinvest back some of these profits in value added hardware units.

Supplies channel inventory levels remained very slightly above our target range. This was primarily due to softer toner sales in Europe, but we did make progress reducing overall toner channel inventory in the quarter.

The personal systems group had a strong quarter. Despite a contracting PC market, revenue in personal systems was up 7% year-over-year at $8.2 billion, driven by strong growth in commercial desktops and notebooks.

Commercial sales grew 12% year-over-year with consumer sales down 2% although consumer notebook revenue grew slightly for the first time since the fiscal 2010 third quarter.

Total unit shipments grew 10% year-over-year with growth in both commercial and consumer; each segment outperformed the market. Total channel inventory remains well within acceptable ranges. Personal systems operating profit was $290 million or 3.5% of revenue up 0.3 points year-over-year driven primarily by favorable mix partially offset by competitive pricing.

Enterprise group revenue was $6.7 billion down 2% year-over-year or down 1% in constant currency driven primarily by declines in technology services, storage and business critical systems. Operating profit in the quarter was $961 million or 14.4% of revenue flat sequentially and down 1.4 points year-over-year as a result of the continued competitive pricing environment and increased investments primarily in R&D.

By business, ISS revenue was $2.8 billion, up 1% year-over-year with strength in EMEA and APJ. Sequentially revenue declined on lower hyperscale mix after we completed shipping a large deal in the first quarter. Lower hyperscale mix and good pricing discipline drove gross margins up sequentially again this quarter. While the server market remains very competitive we believe we’re taking the right actions to improve our go-to-market strengthen our channel and align our cost structure.

Technology services revenue was $2.1 billion down 5% year-over-year. TS revenue continues to be impacted by past declines in hardware sales but the strategy we have in place remains unchanged and the team is making progress. Penetration rates were up year-over-year driven by storage and networking attach and we’re seeing strong growth in our newer offerings like proactive care and data center care. Profitability in this business continues to be strong.

Networking performed well in the quarter, revenue was $658 million up 6% year-over-year with strength in switching across all regions and we once again outgrew the networking market leader. Storage results however were disappointing. Revenue was down 6% versus the prior year period at $808 million. Converge storage declined 3% year-over-year and 3PAR plus EVA, plus XP also declined but continued to outperform the market.

While it’s clear we aren’t alone in experiencing weakness in the storage market we also have an opportunity to improve execution particularly in the U.S. We still expect converge storage to become greater than half of all storage revenue later this year but we expect Q2 results to pressure overall storage revenue for the full year.

Business critical systems revenue declined 14% year-over-year to $230 million as strength in mission critical x86 help to offset the continued impact from the units declined. Enterprise services was $5.7 billion down 7% year-over-year primarily driven continued key account run off. By business IT outsourcing revenue was $3.6 billion down 7% year-over-year and applications and business service revenue was $2.1 billion down 8% year-over-year.

Operating profit for ES was $144 million or 2.5% of revenues flat year-over-year. Sequentially operating margins were up 1.5 points driven by ongoing cost management and continued improvement in our under performing account.

We expect to see continued progress in both of these areas in the half of the year as well as better top line trends as key accounts run off tapers driving the full year operating profit margin within our outlook range of 3.5% to 4.5%. Although total signings were down year-over-year strategic enterprise services signings were double digits once again and we saw encouraging improvement in win rate.

Our trailing 12 month book-to-bill was slightly lower sequentially as we exited Q2. Signings can be lumpy but we anticipate improvement in this metric during the second half of the year. Overall, we're making progress on our sales transformation and are seeing a better mix of new logo, but we still have more work to do to successfully pivot to a more proactive sales approach.

In software, revenue was roughly flat over the prior year period at $971 million with better license revenue due to continued strength in our key focus areas of security and big data offset by lower support revenue. License revenue grew 8% year-over-year with strength in ArcSight, Fortify, Vertica and Autonomy.

Support revenue declined 4% year-over-year as pass license revenue declines continue to create a headwind. Professional services sales grew 1% year-over-year driven by strength in security and big data. SaaS revenue grew 6% over the prior year period and we had strong bookings growth in IT Management and Autonomy.

Operating profit was $186 million or 19.2% of revenue up 0.6 points year-over-year, primarily driven by continued gross margin expansion in professional services partially offset by increased investments in R&D. We completed a small software acquisition in the quarter (inaudible) provide network virtualization technology and had no material impact on our financial results in Q2 and is not expected to materially impact the full year.

HP financial services revenue was $867 million, down 2% year-over-year, operating profit was $99 million or 11.4% of revenue. While revenue continues to be impacted by financing volume shortfalls from fiscal '13, new financing volume grew 12% year-over-year. The health of our portfolio of assets remained strong and return on equity was 18.2%.

Turning to cash flow and capital allocation. We had another strong quarter, generating $3 billion in operating cash flow and $2.3 billion in free cash flow. We continued to focus on working capital and brought our cash conversion cycle down to 13 days in the quarter, helped by a favorable mix with strong personal systems revenue and the expansion of our factoring program.

Consistent with our efforts to improve our payment terms with key partners that I talked about in previous quarters, we increased net utilization in our factoring program by approximately $750 million in the quarter. However, we believe many of our customers would have taken advantage of early payment discounts, so we estimate the actual benefit to cash flow to be approximately 1 to 2 days to our cash conversion cycle.

For the year, we continue to expect some upside to our original cash flow forecast, as I talked about last quarter, driven by working capital efficiencies. We further expect the expanded factoring program to provide some additional benefit.

In Q2, we accelerated our return to shareholders by repurchasing 26.7 million shares in the quarter and paid $298 million in dividend. In total, we returned approximately $1.1 billion to shareholders in Q2 and we are still committed to our plan to return at least 50% of free cash flow to shareholders in the form of share repurchases and dividends for the full year.

We improved our operating company net cash position by approximately $1 billion for the 9th quarter in a row and ended Q2 with operating company net cash of $2.7 billion.

Now looking forward to Q3. In printing, we'll continue to focus on placing value added units and expanding our innovative ink, laser and graphics programs. We expect that toner will remain under pressure for the rest of the year.

In personal systems, we expect the market to remain challenging and that the upward pressure from higher component costs may limit our ability to pursue upside deals as we focus on profitable growth. Also don't forget about the (inaudible) deal from last year that will make for a tough revenue compare in Q3.

In EG, we have a strong team in place that is focused on aligning our cost structure, managing our margin profile and improving our go-to-market execution across the businesses, while investing for long-term success. In ES, as I talked about, we expect the ongoing actions we’re taking to improve our cost structure and our underperforming accounts along with the tapering of revenue run-off to result in better profitability in the second half of the year.

In software, we expect to see continued traction in key growth areas like big data and security while we invest in the business and manage our portfolio transition to SaaS. Across all of our businesses, competing and winning in today’s challenging environment requires lean organizations with the focus on strong performance management. We’re optimizing our workforce and reengineering our business processes to both build a strong operational foundation and create capacity for investments to drive further growth.

Through this ongoing focus, we’ve identified incremental opportunity as I have signaled in the past quarters and we now expect approximately 45,000 to 50,000 people to leave the company under our announced 2012 restructuring program. This is up from our previous estimate of 34,000. We expect the total of approximately 41,000 people to leave by the end of fiscal 2014 with the remainder in 2015.

We expect this to create additional run-rate savings in fiscal ‘16 of approximately $1 billion per year on top of what we previously laid out although we expect some of this will be reinvested back into the business. In fiscal ‘14, we expect approximately $0.02 to $0.03 of incremental savings and estimated incremental charge of approximately $500 million and an additional cash flow impact of approximately $200 million in the second half of fiscal ‘14. We will provide further clarity on the specific FY15 impact to P&L and cash flow when we provide our outlook for the next year at a Security Analyst Meeting in October.

As we said, we won’t do additional restructuring at a corporate level after this program is complete. However, each business will continue to drive workforce rebalancing and will account for those changes within the segment P&L.

With that context, we expect full year fiscal 2014 non-GAAP diluted net earnings per share to be in the range $3.63 to $3.75. For fiscal 2014 Q3, we expect non-GAAP diluted net earnings per share in the range of $0.86 to $0.90. From a GAAP perspective, we expect the full year GAAP diluted net earnings per share to be in the range of $2.68 to $2.80 and GAAP diluted net earnings per for fiscal Q3 is expected to be in the range of $0.59 to $0.63.

With that let’s open it up for question.

Meg Whitman

Thank you, Cathie. Before we go to questions, I am sure you all noticed that earlier today the HP press release with earnings went live before the appropriate time and we are sorry about that and we’ll make sure that that doesn’t happen again. So now we’ll go on to questions.

Question-and-Answer Session

Operator

(Operator Instructions). The first question is from Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

Yes, thank you; I have two if I could. The first one Meg, you are taking some incremental cost out of the system with the additional headcount targets. It clearly says that you are -- it would seem to suggest that you are disappointed in some areas. Where specifically is the headcount coming out of in the system, where are the targets? And then I have a follow up, please.

Meg Whitman

Yes sure. So you will recall that this program goes back to FY12. And we’ve actually increased the number of people who will leave the company a couple of times during this program. And actually on earlier call, we actually signaled that there might be more opportunity. And I am actually not disappointed at all with how we're doing, we just see more opportunities to lower our cost structure, streamline our operations without impairing our effectiveness in fact making us a more nimble and decisive company.

And the longer I've been here, I see opportunities where we can become even better. So that's the genesis of the program. It will be across almost all the business units and across all the geographies and particularly in some of the functional areas that sort of help the businesses grow. So listen I'm not at all disappointed, I think it's the natural course of what makes sense in a turnaround of this size and scale.

Keith Bachman - Bank of Montreal

Okay.

Cathie Lesjak

The other that I'd add really quickly is just it’s going to create more capacity to invest. And I think that's really important to HP, because as Meg has talked many times the turnaround and our success in this turnaround is going to be on the strength of the innovative products and solutions that we bring to market.

Keith Bachman - Bank of Montreal

Okay. And my follow-up that if I could, I wanted to turn to the printing business. I was a little bit surprised to hear you say that the installed base seems to be declining with the good unit placements that you had for last three to four years. And it really speaks to supplies, the supply that was disappointing this quarter and it sounds like you're saying it's going to continue to be under pressure. If you could just flush out a little bit more some of your comments on the printing business in particular? Thank you.

Meg Whitman

Yes. Let me start with the comment about the install base largely relates to laser hardware and the softness in supplies largely relates to toner, actually ink is doing reasonably well. And this actually goes back a number of years, you will recall that we for about seven years didn't probably make the necessary product innovations in terms of the next generation of these machines in terms of multi-function printers. And it's also important managed print services business, we were late to that market and we're catching up fast.

So, we're going to place the right units, we now have the right products not only for multi-function printers to direct customers and to the channel, but also importantly for managed print services.

So, I think as Cathie said, we'll see some softener and toner through the rest of the year. And then I think we'll start to see more normal patterns. And I think Cathie wants to add one thing to that.

Cathie Lesjak

I just, I think the absolute size of the installed base is one dimension, but it’s obviously the quality of the installed base.

So, if we place a unit today that has a much higher usage like an Ink in the Office unit or an Ink Advantage unit and that's replacing a unit that didn't have its high usage, we actually are doing directly what we want to do. So, we've got to be focused on the size of the installed base as well as the quality.

Keith Bachman - Bank of Montreal

Okay, great. Thank you.

Rob Binns

Great. Thanks for the question Keith. If we could have the next question please?

Operator

We have Toni Sacconaghi with Sanford Bernstein. Your line is open sir.

Toni Sacconaghi - Sanford Bernstein

I'm sorry. I wanted to follow up on the last quarter in terms of the restructuring and anticipation of this. It just strikes me as odd that you have a 2012 restructuring plan that is doing significant incremental work force restructuring in 2015. My understanding originally was $27,000 was what was needed to rightsize the company, then it went to $29,000, then it went to $34,000 and now it's going to $50,000. And to me it feels like a whole new restructuring effort and a whole new outlook on the business. And I can't help wondering why something so significant has come up relatively suddenly?

Moreover I’d like to get your input on your confidence for 2015 because clearly a $1 billion in incremental savings is significant and should be applauded, but is that a message that you’re not as confident that you can grow EPS in 2015 without this workforce rebalancing? So in other words, do you think HP will grow in 2015 and is the reason for this incremental workforce rebalancing because you’ve lost confidence or you don’t have as much confidence in the company’s ability to grow top-line in 2015?

Meg Whitman

So Toni let me take that and I’ll let Cathie to talk about guidance because we’re not actually going to give guidance today for 2015. But this actually has nothing to do with our confidence in the business. This has to do with really now understanding the opportunities that we have to make this company better. You’ve got to remember, this company was built over many years by acquisition, has five major business units, we sell through 150,000 [bars], we operate in the 166 countries. And as you look at our processes, as you look at how we go to market, as you look at things like sales reps and marketing and frictional is e-commerce, there are so many opportunities to improve this company.

And we went after the ones that were immediately obvious, but the longer I am here and this management team is here the more opportunities we see and we think that’s goodness. That’s goodness because it makes us easier for customers to do business with, it makes easier frankly for employees to get things done here. And by the way has an added benefit of making us lower cost so we’re better able to compete in a new world order. But my view is I’ve done a number of turnarounds in my carrier, not at the scale I will say, but they are always you see more opportunities the deeper that you get in. And so I am actually quite excited about the opportunities it provides. And Cathie said it well it does give us the capacity to bring money to the bottom line but frankly also invest in the things that are going to have this company grow in a sustainable way over the future.

Cathie Lesjak

And Toni I would add we actually try to signal this at the security analysts meeting and not only earnings call last quarter because we knew we were working [seriously] to understand the reengineering possibilities and what kind of ramification that would have for the headcount that we need to run this company. And really what I view us doing now is just finally getting to the point of quantifying for you all what that looks like. But it’s been worked, it’s been ongoing since last year.

Meg Whitman

And I will just say on in terms of revenue. I think the good news is we have seen revenue stabilization in the last three quarters. I mean it wasn’t that long ago where this company was declining 7%, 6%, 9% quarter-over-quarter and we’ve had three quarters of basically flat growth. To me that’s encouraging because you have got to stabilize before you can grow. And you can see the improvement in virtually all the different businesses.

Rob Binns

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

Operator

We have Katy Huberty with Morgan Stanley.

Katy Huberty - Morgan Stanley

Thanks. Given services signing are coming in slower than expected, is this an area where it makes sense to acquire for growth? And then just as a following up to that, full year services, margin guidance requires you to exit the year around 6%, Cathie can you just talk in more detail around where that meaningful improvement comes from over the next couple of quarter?

Cathie Lesjak

Let me speak to the signings and the revenue growth. I think as we said at SAM and as we said quarter-over-quarter. We are in the early innings of the sales transition to drive a much more proactive sales approach. And while total signings were down a bit year-over-year, the places that we want to grow what we call strategic enterprise services signings were up double-digit once again and we saw very encouraging improvement in win rates and actually signed over 200 new logos which is actually a big turnaround for the sales organization over there.

So we’ve got more work to do, but I’m feeling confident that we're pivoting the sales organization to be more proactive. And I think we're being invited to a lot more -- a lot more bids if you will than we had in the past, because I'm seeing it every day, customers are much more confident in HP and much more confident in our services business.

Meg Whitman

And Cathie, let me address the margin question. We've made good progress in improving both our underperforming accounts as well as really realizing good savings out of productivity initiatives. And we expect that this progress will continue in both of these areas throughout fiscal '14. And then if you couple that with better top-line trend, we do expect that we will operate -- have operating profit margins in the 3.5% to 4.5% for the year.

Again, we've got to continue to execute well, we've got to take advantage of the restructuring that we -- the previous restructuring that by the way is a bit accelerating as well as this incremental program, but we are starting to get labor out of some of the protected [GOs] which tends to be higher costs. And we're also focused not just on labor savings, but also non-labor savings that come from better efficiency across processes, consolidating service centers, looking at data center automation, all of which that will help us reach these margins of 3.5% to 4.5%.

Rob Binns

Thanks, Katy. Next question please.

Operator

We have Ben Reitzes with Barclays.

Ben Reitzes - Barclays

Hi. I got to just ask you to clarify your answer to Toni's question, because with you're getting $0.40 in run rate savings by 2016 with such a big increase in the headcount reductions, I mean what are we supposed to do here? I mean are we supposed to raise our out year numbers? We can't just wait for the Analyst Day. We kind of need to know what you guys are thinking.

The $0.40 in 2016 kind of means we have to raise our estimates unless something really changes with topline. So, I know you want us to wake for the Analyst Day but a lot of us got to make a decision by tomorrow. So, we really need some clarity there. And then I just would also like to know on the free cash flow side, your preference for buybacks versus acquisitions at this point of outperformance. Thank you.

Meg Whitman

Ben, I’m not exactly sure how to answer that question. You know that we don't provide guidance for the future until we get to our Security Analyst Meeting and that's really no different than what we've ever done. What I will say is that the gross savings of a $1 billion is incremental to $3.5 billion to $4 billion that we announced for the 34,000. Those are gross savings. They are -- there is cost to migrate some of that work. And so those are not the net savings. In fiscal ‘14, we do expect that the net savings from this incremental program is $0.02 to $0.03. And stay tuned for fiscal ‘15 update at the Security Analyst Meeting.

Rob Binns

Thanks Ben. Next question please?

Operator

We have Amit Daryanani with RBC Capital Markets.

Amit Daryanani - RBC Capital Markets

Thanks a lot. Good afternoon guys. I just have a question on the PC side. You've had -- you’ve seen nice growth in the last two quarters in a row, especially on the commercial side. Could you really just talk about how much of that growth do you think is earned by Windows XP going end of life versus maybe more other factors in play as you go through rest of the year?

Meg Whitman

Yes. I mean for the market overall, we’re seeing some good signs of stabilization, particularly in commercial PCs which was up 2% year-over-year. And by the way there is some strength in [EMEA] flat year-over-year for the first time in seven quarters. So the market is definitely stabilizing. I think we are benefiting from the migration from XP to Windows we saw that in [space] in Japan, the very, very strong quarter in Japan as that migration took place. We actually think that migration is going to extend for some period of time, maybe another 12 months to 18 months. But we also see some momentum in what I would call a long overdue PC refresh and frankly the fact that companies are realizing there is a need for a productivity tool that’s different than just a tablet.

So listen, I think we expect over time this is still to be a low growth to slightly negative growth category. But I think we actually have a bit of wind at are backs over the next year to 18 months. I also actually have to call out credit to our team, our leadership team led by Dion Weisler. I mean they have focused on profitable growth creating incredibly compelling products, very good market segmentation, leveraging our distribution strength in commercial and go-to-market and really focusing on only doing profitable growth, not share for share sake. So it’s a combination of all those things I think.

Amit Daryanani - RBC Capital Markets

That’s helpful. Let me just follow-up on the cost cutting initiative that you’re expanding this quarter. What’s the comfort level that this is the final number? And there shouldn’t be another expansion to this because since you started in May of 2012, this number has closely doubled in terms of headcount. So maybe just talk about the comfort that this is it? And secondly, how does this play out for the morale of the company given the headcount cut seem to almost [x-rayed] a little bit over the every six months?

Meg Whitman

So listen, I don’t anticipate an additional program. And after this, the end of this program, obviously we are in the process of building productivity into the HP DNA and to our business unit function DNA. And so that productivity that ever ongoing quest for efficiency will be borne by the P&L of each of these different business units. But again, I would just say that this company had been through a lot, the acquisition of Compaq, the acquisition of the EDS, 11 to 20 software acquisitions, a lot of change. And part of what we are doing is we are integrating, we are streamlining, we’re putting in new ERP programs, we’re investing in systems and technology to automate processes that frankly had not been in a while. And so I actually think this is good news that we are continuing to take advantage of the opportunities that we see. But what I will tell you is I don’t anticipate an additional program after this.

Cathie Lesjak

And let me address the second part of Ben’s. I apologize I didn’t catch that one. So Ben I think your question was around capital allocation and how we are thinking about that. We are still committed to the capital allocation approach that we outlined at our security analyst meeting which means that between dividends and share purchases, we do anticipate returning 50% of our free cash flow to investors in fiscal ‘14. And we will see the timing of the share activity levels will vary quarter-to-quarter. But I think it’s really important that given the attractiveness of the valuation of HP shares as well as our anticipated cash flow generation levels, our approach to capital allocation will have a bias towards share repurchases. When we then shift to kind of what about M&A. As we’ve talked about, we will evaluate any M&A using a returns based framework. And any of the near-term considerations in terms what types of things we might be interested in are absolutely going to be in our strategic focus areas such as cloud, security and big data.

And let me answer your question about morale. So listen, no company likes to decrease workforce. And we recognize that it is difficult for employees. What I will tell is I think our employees live it every single day. The environment that we're in, our employees know that there is ways we can be more efficient. They are in sideways the biggest source of ideas on what we can do differently.

So I think everyone understands, the turnaround we're in, everyone understands the market realities, everyone understands they need to create financial capacity to invest in innovation which will be our point of difference and making sure that we have the right salesforce coverage in every geography. So I don't think anyone likes this, but I think actually we've done a good job explaining where we are in the turnaround, what the strategy is and what's going to be required to get HP to where we all want it to be in the industry.

Rob Binns

Okay. Thanks for that Amit. And just a reminder if we can try and keep the follow-ups to a minimum so we can get through more questions that will be helpful. Could we have the next question please?

Operator

We have Sherri Scribner with Deutsche Bank.

Sherri Scribner - Deutsche Bank

Hi, thank you. I wanted to get a little more detail on the pause in the positive storage business. You did give us some detail, but I guess I was little surprised to hear that the converged fees actually saw some deceleration. So maybe some more detail on do you think you're losing share, do you think there is something more systemic is going on in the industry right now? Thanks.

Cathie Lesjak

So we actually think we'll gain a point of storage in this market. I think what's going on here and listen I'm not sure anyone has total clarity on this. But as I have talked to customers here is what I've learned when I talked to our sales team is effectively there is an efficiency thing going on here around compression and [thin] provisioning. And then of course flash is on the horizon in a much more important way than it has been in the past. And then what's interesting is the high-end, you can now get high-end performance for mid tier pricing. And so there is I think a lot of choices now in front of storage buyers, whether it's small to medium-size to the big enterprises.

And so my sense of the situation is there is a pause trying to figure out what the right thing to do is. And that this market will come back in the second half. Obviously we have to wait to see that happened, but that is what most of our customers and our partners are telling me.

And the good news is we are completely perfectly positioned for where this market is going. And 3PAR is the exact right product, the flash product is exactly the right product. And we are, I think we're really well positioned for where the market is going. Obviously no one knows exactly what's going to happen, if this market doesn't rebound in next half and there is another situation that we're facing, but I don't actually think that's the case. And again, we'll gain probably a point of share in this calendar quarter.

Sherri Scribner - Deutsche Bank

Thank you.

Rob Binns

Thanks for the question Sherri. Next question please.

Operator

We have Brian Alexander with Raymond James.

Brian Alexander - Raymond James

Okay, thanks. Good afternoon. Maybe back to the M&A question. Given the stronger cash flow outlook that you expect this year, I'm just curious how that impacts the appetite make larger acquisitions than what you previously discussed? I think you said in the past small to medium-sized, but with the cash flow continuing to outperform, how should we think about deal size now? Thanks.

Meg Whitman

Well, first and foremost, I'll just reiterate what I've said; is we expect to be returns focused in our approach to acquisition. And as I said before, we don't feel the need for large transformative acquisitions. We haven't put a specific size range or limits on this, but I'd say they are most likely in the range from the small low hundred to millions to mid-sized deals. And we'll largely be in the area of the strategic focus for HP, which would be largely cloud, security, big data that we think will advance our positions in those businesses.

Rob Binns

Thanks Brian. Next question?

Operator

We have Kulbinder Garcha with Credit Suisse.

Kulbinder Garcha - Credit Suisse

Thank you for the question. Again on restructuring, I guess for Meg, maybe if I ask the question this way. How is your revenue visibility for this business over the medium term or the growth outlook that you’ve had, wherever that might have been in anyway significantly changed in the past six months that may have prompted some of this incremental restructuring you’re pursuing? And then linked to that and previously you made it very clear, both you and Cathy that you’re going to reinvest a large part of the initial round of savings, would the retention of savings be significantly high on this next round or you’re just essentially evaluating them?

Meg Whitman

Yes. So, I’d say my outlook has actually not changed in terms of where we are in the turnaround, what my view is of the revenue trajectory. We obviously live in a market that’s shifting at warp speed. This is the fastest market shift I’ve seen in my career. And by the way you know I grew up mostly in the consumer space which tends to move faster than the enterprise space. I would actually say, I am feeling more confident because we have seen a stabilization of revenue, the very high single digit declines are over. We’ve had three quarters of pretty good stabilization. And I really like our product roadmap.

Many folks who have been around HP for many, many, many years have said this is the product line up, best product line up we’ve had in a decade. So I feel confident in it. What I will say is that we need to run this company more efficiently, not only for the benefit of cost which is good because then we can reinvest and things that will make us stronger but frankly in terms of ease of doing business, ease of working here and faster more nimble decision making. We’re going to have to be quicker and faster and more nimble to compete in this new world order. And by the way having a lower cost structure is an added benefit to that.

Cathy, do you want to add anything to that?

Cathie Lesjak

No, I think you are exactly right.

Rob Binns

Thanks Kulbinder. Next question please?

Operator

We have Bill Shope with Goldman Sachs.

Bill Shope - Goldman Sachs

Okay great, thanks. I have a question on the printing segment. Even excluding the end tailwind you discussed, your operating margin strength is fairly substantial given a 6% decline in supplies. Can you give us a bit more detail on the components of the printing margins and particularly what’s occurring within hardware margins? I understand you have more ink mix on the supply side but what’s going on within hardware margins and what do you view as sustainable outside of the yen impact?

Meg Whitman

Thanks Bill. So the increase in margins year-over-year is 3.6 points, the currency is about 1.5 points and then the rest is really strong cost management. And it’s across the portfolio it’s not a hardware comment versus a supply comment. It is a comment about making sure that we’ve got the right cost structure and then offsetting that a little bit is unfavorable mix. But it’s really important that we step back a bit. And we talked about it at the Security Analyst Meeting in October the fact that we expected from IPG $0.07 to $0.11 of incremental EPS and that was before incremental investment that we talked about at the time of being $0.12 across the company and now we’ve upped it to $0.14. So we’ve got to stay -- we’ve got to remain focused on investing for the long-term in this business that means placing units, that means continuing to invest in R&D. We think there is a real opportunity to increase the amount of print specialists across the world, so we’re focused on doing that and it’s also really exploiting these new business models. Ink advantage; Ink in the Office; our multi function printer lineup; and our managed print services, those are all really important points that we have got to stay focused on. And then finally I would say that we’ve got to continue to be very competitive. The market is tough, we've got Japanese competitors who have an even bigger, war chest as a result of the yen depreciation. And so, we will be more aggressive where we need to be.

Rob Binns

Thanks Bill for the question. Next one, please?

Operator

We have Rod Hall with JP Morgan.

Rod Hall - JP Morgan

Yes, hi guys. Thanks for taking the question. I just wanted to ask you guys, if you could talk a little bit about some R&D increase. I know you gave a little bit of color. But could you give us a little bit more color in that area as to what you’re increasing, what you’re focusing on with the additional R&D? And then I know it’s a question been asked a bunch of times but the $0.02 to $0.03 that you expect to realize in net savings here at the last part of this year, can you talk to us about the phasing of the savings over the periods or is most of that two, three coming in fiscal Q4 or is it coming linearly across the two quarters? Just help us kind of understand how that's ramping through the back end of the year. Thanks.

Cathie Lesjak

Okay. So let me start with that last question. Those $0.02 to $0.03, there is a little bit that happens in Q3 and a little bit that happens in Q4. If you actually go and look at the guidance that we provided for EPS, the mid-point would suggest that and we've got a flat sequentially, normal seasonality would suggest that it would be down about a point. The restructuring savings are actually bringing it to being flat sequentially. So that will give you a little indication of what's going on from a Q3 perspective. And I'm sorry, I’ve lost track of your first question. R&D?

Rod Hall - JP Morgan

Yes.

Cathie Lesjak

In terms of R&D, the increase in R&D year-over-year is actually very broad based. Just about every business that we have is increasing R&D on a year-over-year basis. Obviously it's focused in strategic areas, cloud; big data; security; page wide array; 3D printing kind of across the board we are increasing R&D. So it's really not a specific comment for a particular business.

Meg Whitman

And I'd just say that that actually we've increased R&D in servers. We love our road map, we love the opportunities there, and we're pretty excited about some of the innovation that's coming down the pipe there.

Cathie Lesjak

Yes, so we've got R&D increases in EG, in storage, within that we've got storage, we've got industry standard servers, I mean it's really broad based that we're making incremental R&D investments year-over-year.

Rob Binns

Thanks for that one Rod. One final question please?

Operator

We have Jim Suva with Citigroup.

Jim Suva - Citigroup

Thank you very much. Meg, when you think about a lot of things are changing in the industry on the server side, you got Lenovo, or just saying the IBM X86 series, I think that there is a lot of disruption going on and opportunity for HP to gain share in servers as well as seeing a lot of CTOs kind of confused and not sure how that all pain out. Can you help us to confirm if indeed you expect to gain some shift (inaudible) and this execution step at least bigger than take advantage of this on a very near term is an opportunity?

Meg Whitman

So, we're focused on this. And there are some early signs that show that we're making some progress. As we've seen an increase in win rates attributable almost directly to the uncertainty in the marketplace around the IBM business moving to Lenovo and we're building pipeline for future incremental deals.

So, good win rates, good pipeline, feeling good about this. It's a longer sales cycle than you think, particularly in blades and some of these other areas. This takes a bit of time, but I think we've got the sales team focused on this, they are pretty excited about it and its open door that we're running through.

Jim Suva - Citigroup

Thank you very much.

Rob Binns

Great. Thanks for that Jim. And with that I think we’ll conclude the questions.

Meg Whitman

Great. Thank you very much for joining us today.

Cathy Lesjak

Thank you.

Operator

Ladies and gentlemen, this concludes our call for today. Thank you.

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Source: Hewlett-Packard's (HPQ) CEO Meg Whitman on Q2 2014 Results - Earnings Call Transcript
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