Hewlett-Packard Company (NYSE:HPQ) Q2 1010 Earnings Call May 18, 2010 5:00 PM ET
Jim Burns – Vice President Investor Relations
Mark Hurd – Chairman, Chief Executive Officer
Catherine Lesjak – Chief Financial Officer
Kathryn Huberty – Morgan Stanley
Bill Shope – Credit Suisse
Richard Gardner – Citigroup
Benjamin Reitzes – Barclays Capital
Toni Sacchonaghi – Sanford Bernstein
David Bailey – Goldman Sachs
Keith Bachman – Bank of Montreal
Shannon Cross – Cross Research
Scott Craig – BofA/Merrill Lynch
Aaron Rakers – Stifel Nicolaus
Brian Alexander – Raymond James
Welcome to the second quarter 2010 Hewlett-Packard earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Jim Burns, Vice President of Investor Relations.
Good afternoon. Welcome to our second quarter earnings conference call with Chairman and CEO Mark Hurd, and CFO, Cathy Lesjak. This call is being webcast. A replay of the webcast will be available shortly after the call for approximately one year.
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-Q.
The financial information discussed in connection with this call including tax related items reflects estimates based on information available at this time and could differ materially from the amounts ultimately reported in HP’s Form 10-Q. 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 and in the slide presentation accompanying today’s earnings release, both of which are available on the HP investor relations webpage at www.hp.com.
Before I turn the call over to Mark, I want to remind you that we closed the 3Com acquisition on April 12. As a result, the 3Com business contributed approximately $50 million in revenue in Q2. We are in the process of integrating 3Com into the HP networking business. We will continue to report the financial results of our networking business as part of the corporate investment segment for the remainder of this fiscal and we will begin reporting those results as part of the ESS segment beginning in FY ’11.
I’ll now turn the call over to Mark.
Good afternoon and thank you for joining us. Hewlett-Packard had an exceptional quarter. Year over year we added $3.5 billion of growth and over $500 million of net earnings. Revenue of $30.8 billion was up 13% over the prior year. Non-GAAP EPS of $1.09 was up 27% and operating margins of 11.2% were up 80 basis points over the prior year.
Our growth this quarter was broad based. America’s and Asia Pacific each posted solid double-digit growth. Europe also grew double digits, performing better than historical seasonality. After many customer deferred hardware purchases in 2009, we are seeing strong growth in a number of our businesses.
Industry standard service grew 54%, Core growth, 31%, EC’s 21%, Storage 16%, Consumer printer hardware 16% and commercial printer hardware growth 13%. We achieved this growth while investing in sales coverage and R&D, executing our transformation initiatives and absorbing 3Com.
Our Enterprise business had solid growth this quarter fueled by ESS, which grew 31% over the prior year. We have built and acquired many assets over the recent years to serve our enterprise customers. We now have the industry’s premier personal hardware, Software and global services to deliver converged infrastructure and to manage and transform customer’s IT environments.
A good example of converged infrastructure is our Blade platform, which is the industry leader, with over 50% share. An HP Blade chassis can accommodate industry standard blades, mission critical blades, storage blades, even TC blades, all designed to maximize computing density and minimizing wiring and power consumption.
We then can virtualize the networking ports with virtual connect and for all the ports that are needed, we have cache HP networking gear, which has been significantly broadened and enhanced with the acquisition of 3Com. Add to that the Software to automate the data center and global services, and it’s clear we’re uniquely positioned to win.
Our Services business has made great progress integrating EDS and we see the results both in our pipeline of opportunities and improved margins. That being said, we still have more work to fully capture the enormous opportunity.
The Imaging and Printing group delivered a solid 8% growth with double digit revenue growth in consumer and commercial hardware, and 6% growth in supplies. IPG continues to make significant progress in placing units with high page consumption, which is ink in the office, wireless and graphics, each of which grew more than 30%.
We installed roughly 2,400 retail photo kiosks this quarter and expect roughly 7,000 placements by year-end. Managed print services had strong signings and indigo press pages grew 26%. We continue to make significant investments in this business while delivering 17.2% operating margin.
The Personal Systems group had another solid quarter, balancing revenue and profitability. We grew revenues 21% and expanded the operating margins. In Q2, we announced our intent to acquire Palm in order to enhance our intellectual property in the fast growing and profitable connected mobility space.
After closing the acquisition, we expect to leverage Web OS and the apps store beyond smart phones into form factors such as slates and web connected printers.
Before I turn the call over to Cathy to review the financials, let me reiterate the three reasons why I’m so confident in HP’s future. First, our broad market portfolio. HP is the only company with significant IP, global scale and market leadership in servers, storage, networking, Software and services, to deliver the next generation data center. HP is winning in the market, investing in innovation and moving deeper into high growth segments like networking and mobility.
Second, our ability to leverage scale and global reach. The global demographics are rapidly changing with the fast growing middle class population migrating to large cities in emerging markets. In fact, over the next 20 years, the pace of urbanization is estimated to be at the rate of about 60 million people a year.
This class of people will expect to be seamlessly and securely connected to the global community with mobile devices and the underlying infrastructure. As the largest IT Company in the world delivering products and services in over 170 countries, we are well positioned to capitalize on this opportunity.
Third, our track record of successfully transforming ourselves. Over the past five years, numerous transformational initiatives have helped HP better serve our customers and profitably grow our business. The results speak for themselves.
However, we still have a lot of work ahead of us, and that’s good news. Ongoing transformations in areas like supply chain, sales coverage and service delivery offer outstanding opportunities for growth and for margin expansion.
We’re proud of what we’ve achieved. We’re investing aggressively in the future to create a meaningful competitive advantage for years to come.
With that, I’ll turn it over to Cathy.
Thanks, Mark and good afternoon everyone. HP delivered exceptional performance in the second quarter. We increased revenue by $3.5 billion, expanded margins, strengthened our balance sheet and generated $3.1 billion in operating cash flow.
At the same time, we executed on our transformational initiatives and invested for growth. Our results demonstrate the strength of our operating model and the consistency of execution. Compared with a year ago, total revenue in the second quarter was $30.8 billion, up 13% including four point of favorable currency impact.
On a geographical basis, we delivered double-digit growth in every region with the Americas and EMEA each growing 11% and Asia Pacific increasing 19%. On a constant currency basis, the America’s, EMEA and Asia Pacific were up 9%, 7% and 10% respectively.
The second quarter gross margin was 23.5% flat with the prior year. Sequentially the gross margin increased 70 basis points, in line with normal seasonality.
Turning to expenses, we are investing in a number of strategic initiatives to expand our sales and go to market capabilities while continuing to drive productivity. Operating expenses increased 5% to $3.8 billion, demonstrating both our operating leverage and the acceleration of our investments to drive long-term growth including building out our enterprise sales force and further strengthening our product portfolio.
Non-GAAP operating profit increased 22% year over year to $3.5 billion with operating margin expansion of 80 basis points. Non-GAAP net income increased over $500 million to $2.6 billion or $1.09 per share.
Looking at the details of our performance by business; during the second quarter revenue in the Imaging and Printing business grew 8% to $6.4 billion. Consumer hardware revenue increased 16%, commercial hardware revenue grew 13% compared with the prior year quarter, and Supplies posted solid 6% growth.
Segment operating profit totaled $1.1 billion or 17.2% of revenue. Total printer unit shipments grew 9% with consumer printer units up 15%. Commercial printer units declined 8% reflecting constrained product availability.
During the quarter, laser printer average selling prices increased as we focused on placing high value units. We expect laser jet system availability to improve significantly in Q3 with more than 30% year over year unit growth next quarter. For the year, we still expect double-digit unit growth for both in ink jet and laser jet printers.
We continue to gain significant traction in our growth initiatives with management services, retail publishing and commercial graphics, each delivering double-digit growth. Management services had multi-million dollar wins in every geography across diverse industries including Financial Services, telecommunications and transportation.
HP’s management service offering is being recognized by customers and industry analysts for its industry leading management tools and infrastructure and its ability to deliver focused solutions for customers.
Retail publishing has had several large wins, installing approximately 2,400 systems this quarter. In our commercial graphics business, growth accelerated across the portfolio with digital press impressions up 26% from prior year.
Services delivered revenue of $8.7 billion, up 2% from the prior year. Within services, the IT outsourcing business grew 6% with strength in the government and Financial Services sectors. In addition, we continue to see a significant increase in the level of product pull through into our accounts.
Revenue in both technology services and business process outsourcing was flat compared with prior year and applications services declined 2%. That said, both application services and BPO saw solid signings in the quarter.
Services segment operating profit in the quarter increased $208 million year over year to $1.4 billion or 15.9% of revenue driven by synergies from the EDS acquisition.
Over the last 18 months, we have made significant progress with EDS integration. We have extended our customer relationships, improved utilization and expanded our operating margins. That said, we have more opportunity to transform this business.
We will continue to invest in delivering innovative service offerings for our customers while at the same time, driving efficiency, process standardization and automation to further enhance our competitiveness.
Enterprise storage and server revenue was $4.5 billion, up 31% compared with the prior year with balanced growth across every region. The ESS results were driven by exception performance in IASA, which increased its revenue by 54% from the prior year. This was partially offset by the business critical systems revenue decline of 17%.
ESS blades delivered strong revenue growth, increasing 45% from the prior year and the virtual connect revenue more than doubled. We continue to be the market leader in servers with 37% market share in X86 servers, in share again year over year.
Our G6 platforms delivered strong performance and we recently launched our G7 platform as customers continue to demand a differentiated performance based on industry standards that HP is uniquely positioned to provide.
Storage revenue increased 16% from the prior year driven by solid growth in high end and entry storage arrays and significant growth in our scale out I Skuzzy products based on technology acquired from Left-hand Networks.
With improved performance in the business, we are seeing positive operating leverage in ESS model. This quarter, the business delivered $571 million in operating profit and an operating margin of 12.6%, an increase of 540 basis points from the prior year.
With the close of 3Com this quarter, we are accelerating our investments in networking. HP networking, which is reported in the corporate investment segment recorded organic growth of 31% or 58% growth including a partial quarter of 3Com results.
HP Software revenue was $871 million, down 1% compared with the prior year. License growth improved this quarter with particular strength in the BTO applications portfolio. On the bottom line, the profitable business expanded its margins 80 basis points, delivering 18.6 points of operating margin in the second quarter.
Turning to Personal Systems, TSG revenue increased 21% from the prior year to $10 billion with Notebook and desktop revenue up 17% and 27% respectively and work station revenue up 47%. Regionally, we saw balanced growth across every geography. Total unit shipments increased 20% year over year with notebook unit growth of 19% and desktop systems growth of 23%.
We entered in several new consumer and business products this quarter including a new consumer all in one desktop with 12 core Z200 work stations and our lightest elite book commercial note book to date.
Segment operating profit totaled $465 million or 4.7% of revenue as PSG continues to deliver solid performance driven by our innovative product portfolio, scale and global reach.
Rounding out the segments, HP Financial Services continues to deliver very strong, consistent results. In the second quarter, financing revenue grew 18% to $755 million and generated operating margin of 9.1%, up 190 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 $14.3 billion. Our Q2 cash conversion cycle was 17 days, down seven days from a year ago, and our channel inventory is in good shape.
We generated solid cash flow in the quarter with operating cash flow of $3.1 billion and free cash flow of $2.3 billion. We continue to actively repurchase shares returning $1.8 billion to shareholders through share repurchases. Finally, we paid a quarterly dividend totaling $196 million.
And now, a few comments on our outlook for the third quarter and the full year. The currency markets have been volatile and we are assuming that exchange rates stay roughly where they were last week with the Euro in the mid 120’s. Taking into consideration our hedging strategies and exposure to a wide basket of currencies, we now expect third quarter revenue of $29.7 billion to $30 billion and a full year revenue growth of 8% to 9%.
Included in this outlook are unfavorable sequential currency impacts of approximately 2% from Q2 to Q3 and approximately 1% from Q3 to Q4.
Regarding earnings, our outlook includes both the absorption of the $0.03 incremental legal settlement recorded in the first quarter but not previously included in our full year outlook and the diluted associated with the 3Com acquisition. While we have not included the revenue impact of 3Com in our outlook we expect t be able to absorb the dilution associated with the acquisition in our full year non-GAAP earnings.
The other variables to consider in our earnings outlook are; an expected expense of about $0.04 per quarter, a tax rate of approximately 22% and weighted average shares outstanding to decline slightly in the second half of fiscal ’10.
With that in mind, we expect third quarter non-GAAP EPS in the range of $1.05 to $1.07. For the full year, we are raising our outlook and now expect non-GAAP EPS in the range of $4.45 to $4.50 representing growth of 16% to 17% for the year.
With that, we will now open the call for your questions.
(Operator Instructions) Your first question comes from Kathryn Huberty – Morgan Stanley.
Kathryn Huberty – Morgan Stanley
As it relates to the revenue guidance, if I net out the second quarter incremental headwind and the benefit from 3Com, you’re actually raising core revenue growth by about two points versus the guidance in February. So I wonder if you could just go into more detail around where that upside is coming from either by geography or business segment.
I think the best way to think about it is we basically took our strong performance in Q2 and layered on basically normal seasonality, and then added in the 3Com revenue as you mentioned, and that’s really how you get to our guidance.
Kathryn Huberty – Morgan Stanley
What expectations have you made around the demand impact in Europe from some of the macro catalysts over the last few weeks?
Again, if you think about it, by taking the Q2 performance and layering in the normal seasonality, implicitly we’re assuming normal seasonality for EMEA and again, that’s a change in position for us because going into Q2, our expectation was that EMEA wasn’t quite at the point where we could call for normal seasonality, and so we’re feeling better about Europe and definitely taking into consideration the currency impact in our through process around that.
Kathryn Huberty – Morgan Stanley
Is it fair to say in the last couple of weeks you haven’t seen anything in Europe that scare you around the back half of your fiscal year.
Let me say this. I think that we try to talk about the quarter, primarily as opposed to what’s going on now in our Q3, but obviously we’re sitting here today, giving you guidance and so when we look at the EMEA picture, I think we saw the demand picture improve in Europe during the quarter.
I think it’s important to note we saw the demand picture improve in Europe across countries. It wasn’t four or five countries. It was across countries and it was across segment, product segment. So it was very broad based for us and so we went in also, and ended the quarter in a very attractive channel position in Europe as well.
So I think overall we felt good about it and I can tell you when I haven’t felt good about Europe, which is over the past several quarters in terms of its behavior relative to what we’ve seen in the America’s and Asia, so I think we feel good about that.
So I think this guidance is again, what we see with normal seasonality and us factoring in the lower currency and that’s what we’re giving you.
Let me just add because I’m sure this is a question on people mind, is really around the Euro. Obviously, our business prefers a stronger Euro than a weaker Euro, but in total the Euro exposure is only about a fourth of our revenue and then you layer on top of that the fact that we’ve got local currency costs that represent natural hedged, and then we basically hedge.
We hedge out longer and to a greater degree in the lines of businesses where we have less flexibility to raise prices for currency. So the actual impact of volatile currencies on our P&L, especially the Euro, is much more muted than you might believe.
I think the net net of it is, I wouldn’t want to be confusing, a higher Euro is good for us with our business in Europe, but a bad Euro isn’t probably as negative as some of the things that at least I’ve seen written because of the description that Cathy gave. So I think that’s probably the best way to think about.
You're next question comes from Bill Shope – Credit Suisse.
Bill Shope – Credit Suisse
Can you walk us through your strategic rational on the Palm deal and then going forward, should we still assume that most of your future acquisition focus will be at least more enterprise focused than consumer?
In enterprise, our history has been more acquisitive certainly in the enterprise. But again, like we’ve said before, all of our acquisitions regardless of where they are, have a pretty extensive filter in terms of making they’re strategically sensible, financially sensible, and that we can actually operate and get some incremental leverage in operating performance out of it.
So it’s got to get all three filters. I think in this case of Palm, and our planned acquisition of Palm, it really has more to do with the intellectual property and in the fact that when you look across the HP ecosystem of interconnected devices, it is a large family of devices.
When we think of printers, you’ve now got a whole series of web-connected printers that as they connect to the web, need an OS. We prefer to have that OS in our case to be our IP where we can control the customer experience as we always have in the printing business, and that’s a big deal to us.
You could certainly make the same case for smaller form factor products in the mobile world like Slate and some other products. And again, I don’t want to tell you that we’re not going to have – Microsoft is probably one of the best relationships we’ve got in our company, and they’re still extremely important.
There are a couple of form factors though that are very attractive for us and small form factors where we think the IT can be very additive to us. So it isn’t precisely built a smart phone play. I’ve seen some people that clearly it’s a $45 billion total available market that is growing, so that is an attractive market.
But it is for us strategically broader in the context of the number of HP interconnected devices where we can leverage the IP, and that’s what we plan to do.
You're next question comes from Richard Gardner – Citigroup.
Richard Gardner – Citigroup
I was hoping you could give us an update on the 3Com integration just in terms of your plans and your progress with sales specialist hiring, getting the sales force trained on the new product portfolio and getting the product in front of customers in the U.S. and Europe and any color on early customer reception to the portfolio and how many customers are willing to take a look at it now that it’s under the HP umbrella.
Let me give you a quick trip through HP networking so I can try to give you context and fit 3Com into it.
Again, we have a continuation of strong performance in what we call pro curve HP networking. Edge products, wireless products saw 31% in the quarter. That’s organic, obviously very strong for us.
Simultaneously, it’s important to note that we’ve been building software capabilities in ESN. We talk about this product call Virtual Connect. It is nothing more complicated that – most of the networking market is sold by number of ports. Those ports aren’t always fully utilized. Virtual Connect actually virtualizes those ports.
So as a rudimentary example, if a customer is usually buying 10 ports, we can virtualize them and perhaps reduce that by 30% to 40% so they now need six ports. Our strategy is then to come in with the best performing products and the best TCO in the industry to then actually work with the customer on those ports.
Historically, we’ve been on the edge of wireless. Now with 3Com, we can do the exact same thing in the data center. So for us, we’ve had a very good start with 3Com. We have been aggressive in hiring, hiring has started, and hiring is ramping.
In the quarter, 3Com, we closed two fortune logo accounts with 3Com products in the data center. We also had a number of very significant wins on what you would think of as the traditional pro curve line, and had a very strong virtual connect quarter as well.
So the reason I bring that up to you is to give you context that our networking strategy isn’t a 3Com strategy. It’s not a pro curve strategy. It’s not a virtual connect strategy. It’s an all of those capabilities brought together across the HP portfolio and it’s why we talk about this converged infrastructure; that the ability to leverage IT from the server family, the storage family and the networking family became so integral to our overall story.
So we think a very good start, we’re very excited about it. We’ve installed products. The 3Com technology is now in our data centers and is now performing our networking tasks. We plan to do more and more of that and so we feel very excited about it, and specialist hiring is ramping.
The other point that I would just add is that we also got a very key asset in Tipping Point, which is around network security, also a product that is very well respected in the market and basically being used at HP at this point in time.
You're next question comes from Benjamin Reitzes – Barclays Capital.
Benjamin Reitzes – Barclays Capital
Could you talk about what’s going on in printing? I was kind of stunned by the guidance for laser printers next quarter, up 30%. It would seem like there was a significant deferral or push out. Last quarter you said that the constraints would be over by this quarter. Now it’s by next quarter. I’m just wondering if this is a firm target or a moving target and then just how we reconcile the printing units for the year that way.
I think we’ll have a strong quarter in Q3 in terms of unit placements for lasers. I’m not thrilled with the Q2 unit numbers, but I am pretty pleased with the types of units we put in the market. The ASP’s were up significantly in lasers, so the units we could get, we got the right units from a printer placement perspective.
So I think you should expect a very strong back half in laser and a very strong Q3 and we have good line of sight and good visibility of that going into the quarter. Demand has continued to be strong.
I think when you talk about the broader printing business, a very strong quarter for us. Obviously in placements again. We felt very good about our ink lineup of products. The growth in wireless printing and web-connected printers continues to be very strong. So I think IPG very strong in ink.
As we mentioned in our script, and our opening messages, the position in retail photo kiosks is a big deal. We installed as many retail photo kiosks in the quarter as we had for the entire life of the product, so for us this was a doubling of that base. We plan to exit at over 7,000 as we exit the year.
Managed print services had another very significant quarter, and again, the importance of those two businesses for us are, those are long-term businesses. Management services, five-year contracts, retail photo kiosks nine to ten years, 100% connect of supplies for those products and they are becoming, beginning to be a meaningful part of our portfolio.
So I think across IPG, when you look at the supplies growth we reported which is the dollar number as opposed to the local number, and the local number would have been yet higher. Overall, we felt very good about the IPG quarter.
We’ve worked hard to get the business in a position to be able to do what we’ve just reported. The one thing we really want to the get done is what you opened with. We want to get the laser printer number into a position where we’re driving unit growth and the demand is there.
Benjamin Reitzes – Barclays Capital
It sounds like you’re guiding for acceleration in the segment.
Yes, I think we feel good about the position of the segment. Now, as you know, the acceleration of the segment sometimes comes with a price and as we place more units when we see the demand opportunity, but that’s one of the reasons we worked so hard on the supply chain to put ourselves in a position to actually get that acceleration, or seize that acceleration when the opportunity presents itself and I think that’s the position we put ourselves in.
The other thing I would add is we did say at the end of Q2 and we still believe this is the case, that we will get double digit growth in laser units and ink units for the full year. And if you actually look at the results that we keyed up in terms of laser unit placements in Q2, they were not materially different than what we had expected going into Q2.
You're next question comes from Toni Sacchonaghi – Sanford Bernstein.
Toni Sacchonaghi – Sanford Bernstein
Your services growth rate has been about 10 points lower than the company average in each of the last two quarters and been negative in total at constant currency. I think you’re long outlook is for services to grow roughly in line with the company average at around mid single digits. You’re not a year and a half into EDS. Do you still have high conviction in that and I understand there’s a cyclical part of services but much of your services business, namely your support and your outsourcing businesses are backlog driven so they don’t change very quickly. Can you give us your perspective on how we should think about the longer term services growth rate and to the degree that we are going to see something that’s closer to the company average, when do we begin to see that and why?
I think the answer to your question is yes. We feel really good about the services business. Now, remembering that you’ve got a blend of technology services and what you would think of more as outsourcing services around absent ITO in the same bucket there. The maintenance piece of the business does react more to the hardware sales and there’s a lagging affect on hardware sales as a result in terms of growth. So that’s sort of one point.
Second, we’ve been spending a lot of time getting the business right. We have seen very strong improvement in our pipeline. We exited the year with very strong signings. We expect to have a very strong signings year this year, so when you look at our pipeline and you look at where we’re at, we feel very good about the position of the business.
Let me go further just to give you a little bit more color. We have spent a lot of time over the past year and a half really operationalizing the business, getting underneath issues in the business, opportunities in the business. And I think the team for the most part has done a very good job. We certainly improved our profitability, improved our cost structure, and better aligned our costs with our revenue.
That said, as what happens in most things, as we’ve gotten deeper into details, the opportunity we think is even better, and we’re in a process of working through this right now. These are things like how we automate and drive forward on our data centers, how we align and drive our tools strategy going forward.
And I won’t go into too much detail because of the time on the call, but I will at a future period of time. There are material opportunities for us in the business to improve it and we will invest into that to get that right, and we think that plays along with our opportunity to grow the business and our opportunity to scale the business.
So don’t take anything away from this other than we think we’ve got a major opportunity in the business and we feel very good about the position. And I think you are right, in your analytic. I wouldn’t necessarily ascribe it to this hardware result in terms of driving the services business and those kind of growth rates, but we certainly expect it to grow at and above market.
Actually, for this quarter we believe we grew roughly in line with market. We saw the acceleration in ITO. We were up 6%. That’s really reflecting the strong signings growth that we had basically coming out of 2009. On the app services side, it’s been softer, although as I mentioned in my prepared remarks, the signings in application services this quarter were up significantly, and so we should see an acceleration from a revenue perspective in that space as well in the second half.
Toni Sacchonaghi – Sanford Bernstein
Can you share with us your assumptions on what dilution to non-GAAP earnings will be from 3Com and for Palm? What are you including in your forecast and then for currency, what’s your year over year currency assumption at a 125 Euro for Q3. Your impact from currency this quarter was significantly different than I had modeled so I’d like to try and understand how you’re thinking about a 125 Euro all in for the company year over year and Q3.
On the 3Com, we are in our guidance we’ve got about $0.01 of dilution in Q3. For Palm, it’s mostly in Q4 and it’s the few cents we talked about. It’s completely included in our guidance, so you don’t have to worry about anything running away from a dilution perspective on Palm.
In terms of our currency assumption, we have modeled our business on a go forward basis at basically a mid 120 Euro, and that gives us a sequential headwind from Q2 to Q3 of roughly two points and a sequential headwind from Q3 to Q4 of roughly one point.
You're next question comes from David Bailey – Goldman Sachs.
David Bailey – Goldman Sachs
What are you seeing right now that makes you more or less confident that we’ll see a corporate PC upgrade cycle starting this year and how should we think about the ramp in demand through the end of this year and into next year?
I’ll give you a couple of data points and then Mark can add to it. Basically, we saw commercial clients grow 19% this quarter and that was led by 47% workstation growth. The workstation growth was heavily financial services industry, which they tend to be more early adopters and then broadly around commercial more in the S&B space. And we’ve always thought that the refresh would start with consumers then go to S&B and then go to corporate.
I think we’ve seen this already going on a bit and we expect to see some more of it. We obviously had very strong workstation growth in the quarter. We had very strong desktop business, desktop growth in the quarter.
When we look at what’s coming up from a data perspective, we gained eight points of share in the U.S. enterprise in the last quarter. That’s the second or third quarter that we’ve seen very large gains in terms of enterprise share, and that puts us in a pretty good position we think that if this corporate refresh accelerates, this will be very good news for us.
What we modeled is more of the same. We have not modeled some big corporate refresh coming that’s sort of sequentially better than what we’ve seen. What we have seen though is some improvements in our funnel, some improvements in our performance in the areas that I’ve described, some quicker times to decisions. That’s a very important thing, and the fact that decisions seem to be getting made a little bit faster than they were a year ago.
But if there is a spike, obviously given the share position and the things that we’re describing, this certainly would be good news.
You're next question comes from Keith Bachman – Bank of Montreal.
Keith Bachman – Bank of Montreal
I wanted to ask two questions on margins. The first is related to the last comment. It seems like ASP erosions on PC’s with perhaps Netbooks slowing a little bit has slowed and how does that make you think about your PC margins as you look out over the next couple of quarters with mix and ASP’s impacting and the second question is similar on services. If in fact the services business picks up a little bit, as you alluded to, how should we be thinking about the services margins as we look out through the balance of the year?
A couple of points, and I think again, you don’t want to react to any one single metric in these businesses, but I agree with your conclusion that ASP’s have improved. Some of that is frankly the commodity environment and the commodity environment as you can imagine in 2009, many of the commodity providers particularly memory providers, really clamped down on CapEx.
So when you look at their capacity today, their capacity is well as demand is increasing. That of course increases the price in some of the commodity areas. Typically, as you know, we do very well in environments like this from a procurement perspective and alignment of supply. That said, there is a passing through of those commodity prices which you’ve seen across the board from those companies in the industry and that is having some effect on ASP’s.
In addition to your point, some of this better performance you’re seeing in some areas like business desktops and work stations, that mix is also affecting the aggregate ASP as well, so that is also a benefit that you’re seeing going on in the quarter and what’s transpiring.
In terms of margins, we’ll continue to balance growth and profitability and make sure we hit the right optimal point within it. Remember for us, we think about the PC business more broadly than we do the PC business just in isolation. The PC business really is the procurement arm for almost the entire company from a product perspective.
We leverage the common parts across almost all of our infrastructure, so for us we think about it not just in the context of operating performance, but the leverage and the position it gives to the entire company.
So I think it’s generally good news in terms of the growth that you’re seeing in the market, the ASP improvements that you’re seeing. There is a tighter commodity environment and we’ll continue to balance it as we go forward in terms of optimizing growth and profitability.
You're next question comes from Shannon Cross – Cross Research.
Shannon Cross – Cross Research
Could you talk a little bit about what you’re seeing, or your thoughts on what you’re seeing in the software industry with regards to the acquisitions. You had SAP. It sounds like Symantec is taking out their security business. How are you thinking about software and your position and where you might want to go?
I think we continue to be very excited about the opportunities that fit in the management space; management of servers, management of PC’s, the management of storage, the management of networks, the security around it. We think these are big – remember, when we talk about security we don’t just talk about a product. We talk about a whole gamut of capabilities.
Cathy mentioned earlier Tipping Point on the data intrusion side, but its security on the product level, on the services level, on the architectural level. So we continue to focus in these areas.
Some of the acquisitions that you’ve described, and I won’t go into them, are frankly not that intriguing to us and are not that relevant to our strategy, which really is around this whole automation management place where we think, directly affects our converged infrastructure business on side, and also helps automate our services on the other.
So our software business has three strategic objectives for HP. We try to sell them as individual products and data center transformation. We try to integrate them with our converged infrastructure. At the same time, we try to use them as the baseline for our tools capability to automate our services.
We try to do all three at the same time and will continue to look for organic ways and other ways to continue to improve our capabilities in those areas, and that’s what we’re thinking about.
Shannon Cross – Cross Research
Could you talk a little bit about your thoughts on the tablet given what we’re seeing on the iPad and then clearly your Palm acquisition?
I think we think there is a market there and we expect to be a participant in that market, so we feel very good. Again, we’ve never felt like the market was one products or one device would become ubiquitous. We believe that the world is going through a series of more and more mobility, not less, and more and more differentiation between what users want to have in terms of capability all the way from a purely voice product up through a smart phone capability through a tablet through a Notebook, and we expect to play across that gamut of capabilities the customers want, and that’s where we expect to go.
You're next question comes from Scott Craig – BofA/Merrill Lynch.
Scott Craig – BofA/Merrill Lynch
Can you look at the IPG margins over the next couple of quarters as you see the hardware increasing perhaps as a percentage of sales particularly given the laser growth you’re looking at? How does that impact the margins of that business and your thought process around the range of what possible margins could be in there throughout the rest of the year?
I’m not really going to update the guidance for the full year beyond the 15% to 17% that we think are kind of the margins for IPG this year. We believe we can definitely manage anything that’s coming down the pipe right now in that range. The hardware unit placements can uptick significantly. We can still absorb it and that’s because we’ve just done a great job of frankly making operating IPG in a tighter way and getting supply chain costs and OpEx costs out of the cost structure so that we’re able to absorb these unit placements and still maintain industry leading profitability.
I think to Cathy’s point, it’s a big point. In a very strange way, 2009 was really a blessing for us, and I’ll emphasize in a strange way, because it really got us sharper, and IPG is a really good example of that. We thought we were going in pretty sharp and we certainly sharpened up.
Our ability now to deal with some of these issues has just given us more flexibility. If we do the kind of unit performance that we’ve talked about the full year, forget about this quarter or that quarter, but when you look at the full year unit performance, and the opportunities we have in terms of placements, we’ve done this while investing and placing these retail photo kiosks.
So I want to make sure this is not trivial issue, that we’ve been able to absorb the start up of the management print services businesses. We’ve been able to install these retail photo kiosks, which are very similar to the printer model, but bigger units. We forecast a growth of, take the unit growth ink jet. The forecast we have in laser, and do all that within the targeted margins that we described.
This has given us a level of flexibility that frankly, if you went back three or four years, we simply couldn’t have done this. So this is a big deal for us.
It’s not just about the P&L. It’s also about working capital management. We’re able to operate with much lower channel inventory levels today because we’ve improved our efficiency on that side, and then the owned inventory levels are down significantly year over year again this quarter.
We expect continued improvement in that space and so it’s really the entire ecosystem of the IPG business, both the income statement and the balance sheet and our partners.
You're next question comes from Aaron Rakers – Stifel Nicolaus.
Aaron Rakers – Stifel Nicolaus
On the enterprise side of the business, obviously, we saw an even stronger mix towards your industry standard servers and we’re still generally sitting in front of what looks to be a high end product cycle in that product category going forward, yet you did a 12.6% operating margin versus your target of 11% to 12%. So I’m trying to understand. Do we think about 11% to 12% or do we think about a sustainable trend above that and if not above that, why might that not be?
Actually if you look at the quarter, we had roughly 30% operating leverage in ESS this quarter and that’s about what we had last quarter too. I think it was about 33% last quarter. But obviously, exactly how much that continues will depend on the mix in the business because the gross margin profile of industry standard servers is very different than business critical systems which by the way, is very different from virtual connect which is also in the enterprise server and storage group.
I think you’re right in what you say though. The fact is we’re introducing a new business critical system. It is in Q3 though, mostly the mid range part. The new Super Domes actually show up at the end f Q3 really more of Q4, and I think to Cathy’s point, you’re going to continue to see a mix, a combination of we think very strong growth in the industry standard server blade market combined with virtual connect.
There’s also a transformation going on in storage as I mentioned earlier. We’ve got a very strong growth going on in I Skuzzy part of the market, which we think is a very attractive part of the market where we’ve seen significant growth occurring.
I do think you’re right. We’ve feel very good about the new product release. That probably has more of an impact to us in the back half of the year than it does in Q3. But again, I emphasize, when you get 30% leverage like we’re seeing, ESN has done a lot of what we described in IPG, working hard. They’re not quite to the same position as IPG is now, but they’re on the same path to do more work in its operations and its supply chain that we can get more flexibility and more leverage as we bring in an assortment of products we think the market are pretty darn exciting.
You're next question comes from Brian Alexander – Raymond James.
Brian Alexander – Raymond James
Could you be a little more specific on what caused the core laser units to be down 6% after growing 11% last quarter while the market growth was actually accelerating. What specifically needs to improve? It seems like the product constraints have been prevalent for multiple quarters, so is any of this intentional seeding of market share due to low price points by competitors. And then if you could comment on supplies, did the growth in local currency accelerate in line with your expectation and do you think that will continue for the balance of the year as placements for lasers pick up?
On the laser side, it’s really capacity, just inability to get as many laser units as we wanted and the demand that we had for them. So two things have happened. One is demand had picked up and improved more than what we had expected. That’s good news and it’s also bad news because we haven’t been able to get the capacity.
We have a very strong backlog coming out of Q2, and like I said earlier, what happened in Q2 in terms of the laser unit decline, is not really a surprise to us. It’s materially what we had expected going into Q2. This was always going to be a back half, very strong back half unit placement for lasers in order to get to the double digits for the year that we believe is very doable.
I think this is where we expected to be roughly speaking. There was no surprise to us. I would characterize it differently. We would like to have had more. That’s probably the better way to think about it.
And let me make sure I’m clear with you. No, we did not do any hold back because of price points. Quite the opposite. We were pushing as hard as we could towards the end of the quarter and we’re pushing as hard as we can right now. The demand is strong.
So to Cathy’s point, that’s the good news. The bad news is we haven’t been able to fulfill as much as customers want. The brand loyalty to HP is just, unless you’re here feeling it, you wouldn’t get it. I mean, it is just amazing how our partners and our customers stick with us on this, and we’re going to get better at this and I’m telling you, I think Q3 will be a turn.
To your point about supplies, it’s been strong. It’s good news. And I think it’s also not just the unit placement. As we’ve talked before, getting the right units placed is actually more important than the number of units that get placed and to some degree, I think you saw that show up in Q as well.
When you look at the ASP’s in the laser business, let me flip it around. What we were able to focus on, was getting the right units out and that did pay dividends within the context of the number that we just clearly wish was better.
Okay, let me wrap it up here. I think the conclusion of it for us is we feel very good about the broad based growth in the quarter. 13% growth we think for us is a good result. Not only the fact that we grew 13% but the fact that it was contributed to across regions and across our businesses, we think was extremely positive.
We are a stronger company today, and I want to emphasize that based on our portfolio, our scale and our consistent execution. At the same time, we have more work to do to transform ourselves to reach our potential, so as good as we feel in some respects about what we’ve done, we are still not to our full potential, and we feel good about our position which gives us the confidence as we’ve described to raise our outlook from where we previously had it.
So thank you all for joining us. We do appreciate it.
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