Arik Hesseldahl

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HP’s Q3 Conference Call: Lots of Problems, a Few Bright Spots

The aircraft carrier Hewlett-Packard is still trying to turn the corner, but man is it going to take awhile and a lot of patience from investors, shareholders and, frankly, its employees, too.

That’s the message coming from CEO Meg Whitman on the occasion of its third quarter earnings report, which just crossed the wires about an hour ago. Expect more explanations about the state of the turnaround from Whitman and CFO Cathie Lesjak on the conference call with analysts which is set to get under way any minute.

2:03 pm: We’re live and waiting for the peppy hold music to come to an end.

And the call is starting with a word from the operator.

Starting with the preliminaries. Forward looking statements, blah blah blah….

CEO Meg Whitman is speaking. “We have made progress on our turnaround.”

Whitman: We have a lot of challenges, some are macroeconomic, some are about the business and frankly some of these are about HP’s execution.

Whitman: While revenue declined, the trajectory of the decline improved.

Whitman: When you look at our performance during the quarter, there were things we did well and things we could have done better. Storage, networking, printing did well.

Whitman: Good news from 3Par. Networking sales up 10 percent when normalized for a divestiture. (What did HP divest in this area again?)

Whitman: On a less positive note, the mainstream server business declined. Hyperscaling is looking good for the future. She’s also talking about some ink and paper changes in some countries. Also a technology that allows phones to connect to HP printers via Cloudprint.

Whitman: HP has 750 unique cloud systems customers. Also a version of the cloud for airlines. Also we released our first public cloud services.

Whitman: We continue to leverage the IP of our acquisitions: Autonomy, Vertica and others.

Whitman: Now customer wins: Russian Railways engaged HP Software. The U.S. Air Force selected HP to provide PCs and servers. Nascar is a new customer.

Consolidated Graphics, a big printing services provider, bought 10 Indigo printers. These are big printers.

Whitman: There’s nowhere we are not where we need to be. Enterprise Services: She’s going over the personnel changes running Services. “ES is in a multi-year turnaround. Progress will not be linear. We will turn ES around, but it will take some time.”

PCs. The reality is, we’re locked in serious competitive battles, and we intend to win. (She’s looking at you, Lenovo!)

Whitman: Autonomy still needs a lot of attention. HP has instituted a global dashboard to monitor engagements. We crossed a big milestone for Autonomy Vault. I missed the number but I think she said 10,000 customers. Sorry if I got that one wrong.

Whitman: The integration of PSG and IPC (PCs and printers) is under way. We streamlined Enterprise Group sales and management.

Whitman: 11,500 employees will leave the company in fiscal 2012, which is above the 9,000 expected.

Now she’s talking about headwinds.

Whitman: I’ve talked before about the tectonic plates that are moving the industry. HP needs to shift its portfolio, and will require some trade-offs and time.

Whitman: Macro headwinds will continue and keep revenue under pressure. The near-term outlook will be challenged.

Execution: We’ve made some changes that will be a distraction in the short term, but good in the long term.

Whitman is wrapping up her prepared remarks. $2.1 billion in free cash flow and reduction of net debt by $1.5 billion.

2:18 pm: And now CFO Cathie Lesjak is speaking.

Lesjak is running through the numbers, most of which were already in the press release.

Lesjak: PSG Revenue of $8.6 billion, down 10 percent. Total units shipped down 10 percent year on year. Soft in Asia and Americas. Consumer down 12 percent and commercial down 9 percent.

Lesjak: In printers, demand environment remains a headwind. We need to reduce channel inventory through close inspection …

Lesjak: Total printer unit shipments down 17 percent year on year.

Services: We are recording a non-cash pre-tax charge of $8 billion for the impairment of goodwill related to EDS. We do not expect this to incur any future cash expenditures.

Lesjak: We saw strong sequential growth in contract signings for strategic customers.

2:24 pm: ESSN: $5.1 billion in revenue, down 4 percent. 3Par grew 60 percent. There’s a bright spot.

BCS still in trouble. Non-stop server revenue grew double digits, but that didn’t help BCS revenue to grow.

Lesjak: We signed 46 new logos in the quarter.

Lesjak: We have a lot of work to do to improve Autonomy performance.

Lesjak: Capital allocation. We remain committed to rebuilding the balance sheet. Total growth $9.9 billion. Increased the dividend by 10 percent. We have been working to improve our cash conversion cycle, but at 27 days it’s still one day higher than before.

Lesjak: We are in the early stages of our turnaround and restructuring. In services, our diligence around account profitability is impacting our ability to sign new accounts. Some benefits will offset some of the headwinds. Demand continues to be an issue in PSG and IPG. The pricing environment in the hardware business remains competitive. Environment is more challenging than we thought even as recently as two months ago. Currency headwind is up 3 percent year on year.

Lesjak: EPS outlook $4.05 to $4.07 non-GAAP. GAAP will be a loss north of $2.

Lesjak: We expect to provide outlook at the analyst meeting on Oct. 3.

Q&A begins.

First question comes from Barclays: Printing. With channel inventory high, the Street was looking for 13.7 percent operating margin, and it was higher at 15.8 percent. What will the earnings hit be in the future when you pull back inventory?

Lesjak: We continue to face headwinds of lower volumes, and the year-on-year increase in margins was impacted by three things. Last year there was impact from the tsunami. We also had improved hardware margins because of a higher mix of higher-profit printers, and a higher mix of laser to inkjet.

Lesjak: The yen will remain strong year on year. That’s not going to help HP in the current FX.

Lesjak: The printer sellout in July left us with more inventory that we expected.

Question from Goldman Sachs: Given comments you made about being aggressive in PCs, who should we think about ASPs and gross margins in PSG?

Lesjak: The opex for PSG was 4.7 percent, which is down year over year, but it’s in the range we’ve been targeting for some time.

Lesjak: Commodity parts prices were unfavorable, LCD and DRAM prices are going up slightly. We do expect the demand environment to remain challenging.

Whitman is speaking: We are under attack by very strong competitive pressures. We’re responding with product lineup, thin and light notebooks, Windows 8 tablet for the enterprise, tablets combined with laptops for consumers. And also streamlining. Putting PSG and IPG [together] has helped control costs and things like freight and logistics. We’re going to defend our No. 1 position in the marketplace. (Hear that, Lenovo?!?)

Question from Toni Sacconaghi: Missed the first part of it. Given launch of Win 8 at the very end of FY12, how do you expect inventory of PCs to change?

Lesjak: Channel inventory at IPG is down on a dollar basis. Sell-through drove weeks of inventory higher than we think acceptable.

Toni is now trying to drill down on printer supplies inventory.

Lesjak: We are not expecting anything cataclysmic in Q4. We will continue to work on bringing down channel inventory.

Question from Morgan Stanley: Can you comment on linearity in other business? Can you comment on signs of stability that Cisco saw?

Lesjak: We don’t have a significant linearity difference. The entire quarter was fairly weak.

2:41 pm: Question from BMO: Revenue trends in IPG and PC division, but talk about HP in total relative to normal seasonal expectations.

Lesjak: Several key considerations in Q4 guidance are related to revenue. The macro is softer than expected in Q3 and we don’t expect it to get better in Q4. We expect to see well below normal seasonality. Challenges persist in legal situation with Oracle and getting software licenses up.

The realignment of the sales force, while creating problems in the short term, will pay back longer term.

Lesjak: We are maniacally focused on cost reduction. We’re going to get the benefits from the charges we’ve taken.

2:44 pm: Question from Stifel Nicolaus about servers: You talked about broad weakness. What are you seeing competitively in light of the product transitions to eighth-gen servers?

Whitman: We have some business model innovation that is required to compete in that business. Right now the hyperscale business is dilutive to ISS margins. We are still seeing weaknesses in mainstream ISS (ISS = industry standard servers). It’s an important business for HP and we have some action items to address problems in that business.

Question from Raymond James: Should we think about the $8 billion writedown based on past problems or future deterioration?

Lesjak: There’s a number of different factors, the trading value of HP shares are a factor. It doesn’t result in any future cash expenditures.

Whitman: I think I’ve said from the beginning, this was a business in need of a turnaround, I decided to make a leadership change. This is what we need to do to get the business on a better track. The account basis of accountabiilty got diffused across the organization. The person in charge needs to be in charge.

Whitman: I feel better about that business now than I have at any time in the last 12 months.

Q: I see a three-cent benefit to EPS.

Lesjak: Some of the benefit will counteract the headwinds, but that is the guidance.

Question about 2013 and the pace of reinvestment. Will that require EPS to decline?

Whitman: We’ll give guidance in early October. But here’s the situation as I see it. First we are facing macro economic trends. Western Europe and China for one. There are challenges for PCs and printers, and price pressures across the board. The competitor (Lenovo) is not losing money. Also, we have some execution challenges. There are still some very serious execution issues in this business.

Whitman: We set up a very crisp strategy in printers, we are the acknowledged market segment and we have some weakened competitors and we need to go after them.

When we look at 2013 we’re going to tumble all the pluses and minuses. There are going to be puts and takes.

Question from Wells Fargo: Talk about whether you can really focus on the long term while you’re working so hard on the near term.

Whitman: We have to focus on the short and the long term. If we don’t fix long-term problems we won’t have money to invest in longer-term problems. Our product portfolio is vast. My deeply held belief is that focus is going to be important. Behind the curtain there are smaller initiatives where we could get bigger bangs for the buck. I feel like we’re much farther along than we were nine months ago.

Whitman: We have lots of little initiatives within the company, some of which we may shut down. They’re not big dollar programs.

Lesjak: This is more focused attention. We need to focus more, not less.

Question from Credit Suisse about free cash flow, which looks to be $5 billion this year. If this is the rate of cash you can generate, it may take two more years from where we are now to give more cash back.

Lesjak: We generated $2.1 billion this quarter. At the same time, we reduced shares outstanding by 17 million shares and increased the dividend. We are making progress.

2:57 pm: Question from Shannon Cross (always interesting). What are you seeing in China?

Whitman: Let me elevate to BRIC: Russia and India were good, Brazil was mid to mixed, China was not so good. We are rebuilding the business in China with a new team there. We are also rebuilding our channel in China. This is also where we’re rebulding our channel with the enterprise business. But we are seeing a slowdown in China. At the same time, we can still improve our execution in China. There’s a regime change coming there, and we’ll see what the stimulus and public sector spending will look like.

And we’re done with the call.

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The problem with the Billionaire Savior phase of the newspaper collapse has always been that billionaires don’t tend to like the kind of authority-questioning journalism that upsets the status quo.

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