HP Q4 FY06 Earnings
Conference Call

Remarks by Mark
Hurd and Bob Wayman

Nov. 16, 2006

[Begin Mark Hurd remarks]

Good afternoon, and thank you for joining us. HP closed the year with a strong fourth quarter driven by:

• Solid revenue growth across all of our businesses and geographies
• Share gains in key businesses
• Expense discipline
• Margin expansion, and


• Record quarterly cash
  flow from operations

We saw significant operating margin
improvements in our reportable segments, with a year-over-year operating
profit increase of 68 percent in the Personal Systems Group, 42 percent
in the Technology Solutions Group, and 21 percent in the Imaging and
Printing Group. All of this resulted in our most balanced segment profitability
performance in many years, with the Technology Solutions Group delivering
a similar fourth quarter dollar profit contribution as the Imaging and
Printing group.

Financial highlights of the quarter
include:

• Revenue growth of 7 percent
  year-over-year, or $1.6 billion, to $24.6 billion
• Non-GAAP gross margin
  of 24.3 percent, up from 23.5 percent in the prior year period


• Continued year-over-year
  operating margin expansion in key businesses, with Personal Systems
  margins of 4.3 percent, Imaging and Printing margins of 14.8 percent,
  Enterprise Storage and Servers margins of 10.7 percent, HP Services
  margins of 12.4 percent, and Software margins of 17.2 percent


• Non-GAAP operating margin
  of 9.0 percent, up from 7.6 percent in the prior year period


• Non-GAAP EPS of $0.68,
  representing growth of 33 percent year-over-year, and


• Cash flow from operations
  of $3.2 billion, up from $1.9 billion in the prior year period

The fourth quarter closed out a strong fiscal 2006 for HP. On a year-over-year basis:

• Revenue grew $5 billion, or 6 percent, to $91.7 billion
• Non-GAAP operating margins grew 1.6 points to 8.0 percent of revenue
• Non-GAAP EPS grew 47 percent to $2.38
• Cash flow from operations grew $3.3 billion to $11.4 billion

During the year we also made significant progress to strengthen HP’s long-term competitive positioning in the market, including:

• Lowering our cost structure by substantially completing our restructuring program and beginning to work on other cost initiatives such as our real estate consolidation initiative;
• Freeing up capital for strategic growth initiatives including sales force hiring;
• Beginning to deploy capital back into the business in the form of increased capital expenditures aimed at transforming our IT infrastructure; and
• Strengthening our enterprise software offerings with the purchase of Mercury Interactive, creating one of the most powerful management software portfolios in the industry.

We also simplified our structure, we collapsed matrixes, created greater clarity of responsibility, focused on accountability, attracted talent to our management bench and rewarded our employees for hard work and improved performance.

I’m particularly pleased that we have been able to post another quarter of solid results while continuing to make progress on longer term strategic initiatives.

Now, turning to the business segments and the fourth quarter results, Imaging and Printing had a strong quarter. Revenue grew 7 percent year-over-year to $7.3 billion, with Supplies revenue growth of 9 percent and revenue in Commercial and Consumer up 8 percent and 2 percent, respectively.

Over the past 18 months, we have been focused on accelerating supplies growth by driving hardware shipment growth in areas of high supplies consumption. We executed well against this plan in the fourth quarter, with total printer hardware units up 17 percent year-over-year, driven by commercial printer hardware unit growth of 20 percent and consumer printer hardware unit growth of 16 percent.

Momentum in key growth initiatives continued, with all-in-one unit shipments up 22 percent year-over-year, appliance photo printers up 70 percent – seven-zero – color laser printer shipments up 40 percent and printer-based MFP shipments up 160 percent. HP Indigo Press printed page volume grew 41 percent over the prior year period.

This unit shipment momentum has strengthened our share leadership position in both the inkjet and laser markets and we are confident that today’s results will further extend our lead.

The progress can also be tied back to the acceleration of our supplies growth rate, which, in turn, has helped us drive margins in the high end of our 13-15 percent operating margin range, thereby allowing us to re-invest in pricing and promotional activities as well as further technology advancements and new growth initiatives.

We will spend more time on these initiatives in our forthcoming securities analyst meeting in New York City on Dec. 12.

Segment operating profit was $1.1 billion, or 14.8 percent of revenue, up from 13.2 percent in the prior year period, as supplies strength offset pricing and promotional actions taken to drive hardware placements.

All in all, another excellent quarter in Imaging and Printing.

Moving now to Personal Systems, which had a strong quarter characterized by solid revenue growth, market share gains and record operating margins. During the fourth quarter, revenue grew 10 percent year-over-year to $7.8 billion, driven by unit growth of 16 percent.

We continue to see strong performance in our notebook business, with revenue growth of 24 percent over the prior year period, driven by double-digit revenue growth in both consumer and commercial notebooks. Revenue in desktops was flat year-over-year, while revenue in workstations grew 10 percent.

We continue to execute well in our consumer business, leveraging a competitive product line-up and strong retail partnerships. Revenue in Consumer clients increased 19 percent year-over-year, with revenue in Commercial clients up 4 percent.

Our top line momentum has driven market share gains in recent quarters, and, according to preliminary data, HP took the No. 1 share position in PCs during the third calendar quarter.

But more importantly, we gained share while driving margin expansion. During the fourth quarter, segment operating profit was $336 million, or 4.3 percent of revenue, up from 2.8 percent in the prior year period. This represents our highest Personal Systems operating margins in a number of years.

You should expect us to continue to balance revenue growth and profitability, by being disciplined on cost and leveraging our strength in notebooks, in consumer, in the commercial and retail channels, and in international markets.

Moving now to the Technology Solutions Group, where we continued to drive significant margin expansion, giving HP some of the best balance of segment profitability we’ve had in many years.

We posted a solid quarter in Enterprise Storage and Servers, with revenue growth of 4 percent year-over-year to $4.7 billion, and segment operating profit of $502 million, or 10.7 percent of revenue, up from the 9.0 percent in the prior year period.

This margin represents our highest levels in a number of years and I’m pleased with the progress we have made in the last 12 months as we align ourselves to better compete in growth markets and better harvest the more mature markets in which we compete.

Within ESS, we saw an acceleration of growth in industry-standard servers, with revenue up 9 percent year-over-year, driven by 38 percent growth in blades.

Revenue in Storage grew 1 percent, with growth of 11 percent in our midrange EVA offerings offset by declines in the high-end array and tape businesses. While the growth profile of our Storage business is negatively impacted by our mix toward a declining tape market, we are not happy with our Storage growth in the fourth quarter and we need to do a better job driving top line momentum in the coming year.

Business-critical systems revenue decreased 4 percent year-over-year, with Integrity server revenue growth of 77 percent, offset by revenue declines in PA-RISC and Alpha. During the quarter we began shipping Montecito-based Integrity servers and this positions us well for growth in the coming quarters. We closed the year with approximately 9,700 ISV applications ported to Itanium and with Integrity representing 45 percent of Q4 business-critical systems revenue.

We had a solid quarter in HP Services, with revenue growth of 5 percent year-over-year to $4.1 billion, led by Managed Services and Consulting and Integration growth of 16 percent and 7 percent, respectively. Revenue in Technology Services was essentially flat over the prior year period.

I’m pleased with the solid improvement in HPS margins. The segment posted fourth quarter operating profit of $505 million, or 12.4 percent of revenue, up from 8.3 percent in the prior year period.

Over the past 3-4 quarters we have spent considerable energy working on various cost and efficiency levers within HP Services. We have made significant progress reducing the unit cost of service delivery and strengthening our portfolio of standardized and automated offerings.

At the same time, these efforts were supported by the other company-level cost initiatives that served to reduce the cost burden allocated to the various segments within HP, and given the size and headcount intensity of HP Services, the segment benefited proportionately.

I am confident that we are in a better position to drive the appropriate operating leverage in this business, and while we have more work to do, I feel we are now in a better position to grow and compete in the market at acceptable margins.

We had a strong quarter in HP Software, where revenue grew 14 percent over the prior year period to $349 million, driven by OpenView growth of 28 percent, which did benefit from the Peregrine acquisition. Revenue in HP OpenCall declined 11 percent from the prior year period.

Software reported an operating profit of $60 million, or 17.2 percent of revenue, up from a profit of $28 million, or 9.2 percent of revenue in the prior year period, reflecting the improvements we have been making to our model and associated operating leverage that comes with our scale.

On Nov. 6, we closed the acquisition of Mercury, which significantly increases our scale and strengthens our software offerings. Given Mercury’s traditional fiscal year end is Dec. 31, we have decided to operate it as stand-alone, wholly-owned subsidiary of HP until early 2007.

However, we are focused on integrating Mercury as quickly and effectively as possible, and work is already under way on sales tools, go-to-market programs and cross-training to enable HP OpenView and Mercury sales force to sell a combined portfolio in February. We expect to launch an integrated product roadmap with 90 days of the close, and we have joint product teams working on product integration planning for HP OpenView and Mercury.

We are pleased to see the improvements in our core portfolio, and believe that the combined strengths of HP and Mercury position us to help CIOs [chief information officers] enhance the value and optimize the business outcomes of IT investments.

Executing against these goals will enable to us to drive further revenue growth and margin expansion opportunities in HP Software.

Finally, bear in mind that the operating margin of the software business will be impacted by the write-down of deferred revenue and other integration costs associated with the acquisition of Mercury in the coming quarters.

I’ll conclude my segment comments by reiterating that we had a solid fourth quarter across the entire portfolio. I’m pleased with the progress we have made over the past 18 months, and we know that we have opportunities for further improvement ahead.

With that, I’d now like to turn it over to Bob.

[Begin Bob Wayman remarks]

Thanks, Mark, and good afternoon, everyone.

I’ll begin with a review of the performance of our Financial Services business.

Revenue for HPFS during the quarter was $545 million, up 6 percent year-over-year and 5 percent sequentially. The revenue increase reflects increased financing volume, which was up 1 percent year-over-year and 12 percent sequentially. End of lease transactions contributed to the sequential increase. Portfolio assets increased 4 percent year-over-year and 2 percent sequentially and are now at their highest level in several years. Operating margin was 6.4 percent, down from 10.1 percent in Q4 of last year and 6.7 percent in Q3. The year-over-year margin decline reflects the release of certain accounts receivable reserves in the prior year period.

While we are encouraged with the growth in financing volume over the last several quarters, we know we have more work to do and are focused on continuing volume momentum.

Before getting into the key elements of the P&L let me remind you that fiscal 2005 results, including cost of sales, operating expenses, operating profit, net income and EPS did not include the impact of FAS 123R stock-based compensation. Consistent with last quarter, to assist you in comparing results vs. prior periods, we have included a quarterly historical EPS trend in the financial tables accompanying the earnings release. This should allow you to view the results as though all stock-based compensation had been included in previously reported results.

Non-GAAP EPS for the quarter was $0.68, including approximately 4 cents from stock-based compensation, up from $0.51 a year ago, which again excluded the impact of FAS 123R.

GAAP EPS for the quarter was $0.60, which included $208 million or 7 cents in after-tax adjustments that were not included in our non-GAAP results. The adjustments primarily relate to restructuring charges and the amortization of purchased intangibles.

A quick update on restructuring, during the quarter approximately 4,200 positions were eliminated related to the July 2005 announcement, bringing the cumulative total to about 14,200. While the restructuring program is substantially complete, we do expect to eliminate approximately 1,000 remaining positions in Q107.

Now on to the P&L. Revenue of $24.6 billion for the quarter was up 7 percent year-over-year and up 6 percent when adjusted for the effects of currency. On a regional basis, revenue was up 8 percent in the Americas, up 7 percent in EMEA and up 6 percent in Asia Pacific. When adjusted for the effects of currency, revenue was up 7 percent in the Americas, 3 percent in EMEA and 7 percent in Asia Pacific.

Now on to gross profit. Gross profit was $6.0 billion for the quarter, or 24.3 percent of revenue, up from 23.5 percent a year ago and down from 24.8 sequentially. Gross margins improved year-over-year in each of our non-financing business segments, reflecting improved operational effectiveness in key areas including option attach, delivery efficiency, utilization, and discount controls as well as favorable mix in certain businesses.

Non-GAAP operating expense totaled $3.8 billion for the quarter, or 15.3 percent of revenue, down from 15.9 percent a year ago and 17.2 percent sequentially. In dollars, operating expenses were up 3 percent year-over-year and flat sequentially. Adjusting for currency, expenses were up 2 percent year-over-year and flat sequentially. The year-over-year increase primarily reflects volume growth, the inclusion of FAS 123R expenses and investments in growth initiatives such as the continued hiring of sales resources as well as demand generation, offset by position eliminations as part of our restructuring program.

Non-GAAP operating profit was $2.2 billion, or 9.0 percent of revenue, up $470 million year-over-year, despite the inclusion of approximately $140 million of stock-based compensation in the current period.

Non-GAAP Other income and expense was pre-tax income of $190 million, or roughly 5 cents per share after tax, above the 3-4 cents per share we had guided coming into the quarter. The excess reflects the favorable impact of currency and real estate gains.

Our non-GAAP tax rate was 20.5 percent for the quarter, slightly above our guidance.

One other item of note in the P&L. Unallocated corporate costs excluding stock based compensation increased approximately $25 million year-over-year and $103 million sequentially. The sequential increase primarily reflects an increase in lease volume and a change in the operating lease mix within HPFS. Intercompany profit on operating lease transaction is eliminated in this line item. As such, as volume and operating lease mix increase, the unallocated balance will grow as more eliminations are booked. Increased legal expenses also contributed to the increases both sequentially and year-over-year.

Next, the balance sheet.

HP owned inventory came in at $7.8 billion, up $873 million year-over-year and $286 million sequentially. Inventory days of supply stands at 38 days, up from 35 days last year and down from 41 days sequentially. The year-over-year increase in inventory reflects volume growth, strategic buys and supply chain changes designed to optimize our cost structure. The sequential increase is in line with normal seasonality.

I know there is a lot of interest in channel inventory, so I will add some additional perspective this quarter. Overall, we are very comfortable with channel inventory levels. PSG ended the quarter at roughly 4 weeks, ESS at roughly 4 and a half weeks and IPG at roughly 5 and a half weeks. PSG weeks are flat year-over-year and both ESS and IPG weeks are up slightly. In terms of channel inventory dollars:

• ISS, which makes up the majority of ESS dollars, are up in line with revenue growth
• PSG channel dollars are up only slightly compared to 10 percent top line growth
• IPG channel dollar growth slightly outpaced revenue growth reflecting increased supplies associated with significant hardware unit growth over the past year
• Total company channel
  inventory dollars are up roughly in line with top line performance and
  our outlook for the first quarter.

Trade receivables ended the quarter
at $10.9 billion, up $970 million year-over-year and $1.2 billion sequentially.
DSO now stands at 40 days, up from 39 days year-over-year and flat sequentially.

Next, Property, plant and equipment
was up $412 million year-over-year and $494 million sequentially at
$6.9 billion. Gross cap-ex was $965 million, up 85 percent year-over-year
and 55 percent sequentially. On a net basis, cap-ex was $868 million,
up 95 percent year-over-year and 123 percent sequentially. The year-over-year
increase in cap-ex reflects incremental investments in IT as well as
increases in financing assets. Net PP&E as a percentage of revenue
now stands at 7.5 percent of revenue, up from 7.4 percent year-over-year
and 7.1 percent sequentially.

Regarding accounts payable, days
payable closed the quarter at 59 days, up from 52 days year-over-year
and 58 days sequentially.

Now, some comments on cash.

Cash flow from operations and free cash flow were both strong at $3.2 billion and $2.4 billion, respectively, for the quarter. For the full year, cash flow from operations was $11.4 billion and free cash flow was $9.4 billion, both up over 40 percent from fiscal 2005, which was a record cash flow year.

During the quarter, we repurchased $1.0 billion in stock in the open market or approximately 30 million shares. In addition, we received approximately 13 million shares under the prepaid variable share purchase program that we entered into earlier this year. So, a total of 43 million shares were acquired during the quarter. For the full year, we repurchased 190 million shares in the open market and received an additional 34 million shares under the prepaid plan. In addition, we paid out $219 million in the quarter for our normal dividend and $894 million for the full year.

We closed the quarter with gross cash of $16.4 billion, up from $13.9 billion from last year and $16 billion sequentially. Net cash was $11.2 billion, up from $8.7 billion from last year and $9.2 billion sequentially.

In terms of cash usage for fiscal 2007, a significant bonus pay-out will occur in the first quarter, related to the strong operating performance of the company in fiscal 2006 and this will put pressure on operating cash flow in Q107. Beyond impact on operating cash flow, we had a net cash outlay of approximately $4.5 billion earlier this month related to our acquisition of Mercury. In addition we expect fiscal 2007 gross and net cap-ex to trend at or above fiscal 2006 levels as we continue to build out our data centers and deploy capital to consolidate and upgrade our real estate facilities.

Now, a few comments on our outlook.

Historically revenue declines a bit over 2 percent from Q4 to Q1 in constant currency. Given where rates are today, we do not expect a significant sequential currency effect.

On Nov. 6, we closed the acquisition of Mercury and you should therefore begin to incorporate their results into your estimates for HP. However, as we indicated at the time that the deal was announced, purchase accounting rules required a significant write-down of deferred revenue.

As such, based on our expectations for Mercury and the results of the purchase accounting entries, we expect approximately $800 million in revenue associated with Mercury in fiscal 2007.

Taking these factors into account, we estimate Q107 revenue will be approximately $24.1 billion - $24.3 billion, and revenue for fiscal 2007 will be approximately $97 billion.

Regarding earnings, there are a few variables to consider.

• Given the software P&L characteristics of Mercury, we expect the acquisition to have a positive effect on total company gross margin of approximately 50 basis points and a negative impact on total company expense ratio of approximately 50 basis points. On an overall basis, the Mercury transaction is expected to be approximately $0.04 dilutive to non-GAAP per share earnings in fiscal year 2007.
• We will continue to fund investments to drive long-term growth initiatives.
• We expect FAS123R expenses of approximately 4 cents in Q107 and 14 cents in FY2007, up slightly from 13 cents in fiscal 2006. Although we have reduced the number of options granted relative to prior year levels, the fair value of each option granted in fiscal 2006 and expectations for fair value in fiscal 2007 grants have significantly increased, reflecting the rise in stock price and a slight increase in volatility from 2006 to 2007. This has caused related expenses to be higher than previously anticipated, notwithstanding the reduction in option grants.
• With respect to restructuring, as we continue to look for ways to optimize our cost structure, we expect expenses associated with any future actions to be absorbed by our business segments, barring any significant transaction or change in our business model. Accordingly, such expenses will be accounted for as normal business activity and will be included in our non-GAAP results. Any adjustments to previously announced restructuring plans will still be treated as an adjustment to non-GAAP results.
• We estimate non-GAAP OI&E
  to be about 3-4 cents per share per quarter for FY07, which primarily
  reflects baseline net interest income given projected cash and debt
  levels. We will call out deviations from this baseline as appropriate.
  Bear in mind that given the significant outlay of cash related to Mercury,
  we expect interest income to be at the low end of the 3-4 cent guidance
  in Q1.


• We expect a non-GAAP tax
  rate of approximately 20 percent for Q107 and the full year.


• While we expect to continue
  to repurchase shares in fiscal 2007, given the current share price and
  our expectations for option exercise patterns and the impact on common
  stock equivalents, we expect a modest decline in shares in Q107 with
  shares somewhat flat for the remainder of the year.

With that in mind, we expect Q107
non-GAAP EPS of $0.60 to $0.62, which includes approximately 1 cent
dilution from Mercury.

For FY07, we expect non-GAAP EPS
of $2.48 to $2.53, which includes approximately 4 cents dilution from
Mercury.

So, all in all, we closed FY06 positively and our increased outlook for 2007 reflects our progress to date.

With that, we will take your questions.

[End of Wayman remarks]

… Q&A portion of call …

[Resume Hurd remarks]

OK, thanks for your questions. Let me summarize today’s call by saying that I’m pleased with our execution in the fourth quarter. HP:

• Delivered solid revenue growth;
• Gained market share in key businesses;
• Drove significant growth in key initiatives;
• Expanded our margins across
  our segments;


• Delivered our most balanced
  segment profitability; and


• Posted record quarterly
  cash flow from operations.

We did do this while:

• Continuing to make progress
  on our cost structure by substantially completing our restructuring
  program;


• Making further progress
  on strategic initiatives that will strengthen HP’s long-term competitive
  positioning; and


• Increasing non-GAAP EPS
  guidance for the fifth consecutive quarter.

All in all, it was a solid quarter
for HP closing out a strong fiscal year 2006. We do have more work to
do though. That said, we’re well on
our way to building a stronger, more competitive HP and I’m encouraged
by our progress to date.

Finally, we look forward to seeing
you in New York City for our annual securities analyst meeting on Dec.
12. Thanks again for joining us on the call.

[End remarks]