Good afternoon, and welcome to the Second Quarter 2015 Hewlett-Packard Earnings Conference Call. My name is Amy, and I'll be your conference moderator for today's call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Mr. Jim Bergkamp, Vice President of Investor Relations. Please proceed.

Good afternoon. Welcome to our fiscal 2015 second quarter earnings conference call with Meg Whitman, HP's Chairman, President and Chief Executive Officer; and Cathie Lesjak, HP's Executive Vice President and 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 1 year. Some information provided during this call may include forward-looking statements that involve risks, uncertainties and assumptions. If the risks or 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 fact, are statements that could be deemed forward-looking statements including but not limited to the execution of restructuring plans and any resulting cost savings or revenue or profitability improvement; any projections of revenue, margins, expenses, earnings, earnings per share, HP's effective tax rate, cash flow, share repurchases, currency exchange rates or other financial items; any statements of the plans, strategies and objectives of management for future operations, including the separation transaction; and any statements concerning the expected development, performance, market share or competitive performance related 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 intend to update any such forward-looking statements. The financial information discussed in connection with this call, including any tax-related items, reflects estimates based on information available at this time and could differ materially from the amounts ultimately reported in HP's quarterly report on Form 10-Q for the fiscal quarter ended April 30, 2015. Revenue, operating profit, operating margin, net earnings, diluted net earnings per share, income tax rate, cash and cash equivalents, operating cash flows, total company debt, capital expenditures 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 intangible assets, restructuring charges, separation costs, 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 web page at www.hp.com. I'll now turn the call over to Meg.

Thanks, Jim, and thanks to all of you for joining us today. With the first half of fiscal 2015 now behind us, I'm pleased to report that, once again, we delivered the results we said we would. We executed well in a tough market environment, and in Q2, we delivered non-GAAP diluted EPS of $0.87, at the high end of our previously provided outlook range. Cash flow from operations was $1.5 billion. Free cash flow was approximately $800 million. And we returned approximately $1 billion to shareholders in the form of share repurchases and dividends. In the quarter, we executed well across Industry Standard Servers, Converged Storage, Personal Systems and graphics, and Enterprise Services improved profitability. We continued to invest in innovation across the company and improve our go-to-market approach. At the same time, we faced significant market challenges due to currency movements, softness in PCs, home printing and IT outsourcing markets and execution challenges in pockets of the business that require more work. But overall, I'm pleased with our progress and the turnaround. Turning to the separation. As you will recall, last October, we announced our plan to separate HP into 2 independent Fortune 50 companies. Today, I'm more convinced than ever that this is the right thing to do. Over the past 6 months, we've seen the markets continue to shift and evolve at a rapid pace. In Hewlett Packard Enterprise, our customers are demanding services and solutions that will help them manage traditional IT better, while planning their journey to a hybrid infrastructure. And we need to move faster and smarter to meet that demand. At HP Inc., we will contain engineering multi-OS devices and immersive computing experiences for business and consumer and ink- and laser-based solutions that provide a faster, more affordable, exciting way to print,…

Thanks, Meg. Overall, we had a solid quarter, despite a challenging market environment. We delivered revenue of $25.5 billion, down 7% year-over-year as reported or 2% in constant currency. Our gross margin was 24%, down 0.2 points year-over-year, driven by competitive pricing in hardware, partially offset by margin improvement in Enterprise Services and Software and favorable mix. Gross margin was up 0.6 points sequentially, in line with normal seasonality. Non-GAAP operating expenses were down 8% year-over-year, driven primarily by currency, with reported declines in both SG&A and R&D. In constant currency though, R&D spend was actually up year-over-year. Non-GAAP operating profit was flat year-over-year at 8.6%. Our non-GAAP diluted net earnings per share of $0.87 primarily excludes pretax charges of $269 million for separation, $255 million for restructuring and $221 million for amortization of intangible assets. We delivered GAAP diluted net earnings per share of $0.55, just below our previously provided outlook range, primarily due to slightly accelerated restructuring and separation charges. We are nearing the completion of our 2012 restructuring plan. In Q2, approximately 3,900 people exited the company, making the total reduction to date approximately 48,000. We are on track to complete this existing program with a total of 55,000 people expected to exit by the end of fiscal 2015. Turning to the results by business. Personal Systems performed well in a softening market environment. Currency moves and the associated price adjustments had some demand impact and weighed on profitability in the quarter. Revenue declined 5% year-over-year as reported, or was flat in constant currency, with 2% unit growth. Profitability declined 0.5 points to 3%, driven primarily by unfavorable currency. Consumer revenue declined 2% year-over-year or grew 3% in constant currency, while commercial revenue declined 7% year-over-year or 2% in constant currency. The commercial market continued to be…

[Operator Instructions] The first question is from Katy Huberty at Morgan Stanley.

It sounds like there are incremental pressures on cash flow this year, including the weakness in the PC market. So Cathie, can you just clarify what's allowing you to hold the guidance for $3.5 billion to $4 billion free cash flow this year? And then just as a clarification, is the $400 million to $450 million of dis-synergies next year all cash costs, such that it's unlikely you can get back to the $6.5 billion to $7 billion free cash flow target that you had started this year with?

Thanks, Katy. So when we look at the free cash flow for fiscal '15, we have headwinds and we have tailwinds that are really impacting FY '15. And when you kind of net them both together, you get into the range of the $3.5 billion to $4 billion, so we're able to hold. The tailwind that we see is that the cash conversion cycle, given the performance that we've had in the first half of the year, is now expected to be better than the 10 to 12 days that we had previously provided as an outlook. And so that offsets the headwinds around the balance sheet hedging that I mentioned in my prepared remarks as well as some of the pull-in that we've got around -- from 2016 for restructuring and separation costs and then a little bit on the deferred revenue and warranty reserve. And then in terms of the $400 million to $450 million of dis-synergies in '16 and beyond, yes, those are all cash costs. But as I mentioned, we will take approximately $1 billion of gross run rate savings out of the company across HPE and HPI. And so we will offset more than half of those with those cost savings in fiscal 2016, but of course, we will take a GAAP-only charge of about $1 billion.

And let me add one thing, Katy. It's Meg. While the PC market is weaker than we anticipated, we're actually doing better in some of the businesses, like Industry Standard Servers. So while the cash flow might be slightly lower in PCs, depending on how the market evolves, we're actually going to more than make that up. And you can see that in our earnings per share, which is obviously -- we're holding our earnings per share guidance.

And I think it's also important to think about the PC business as yes, there's been incremental pressure on profits. But we have done a great job of executing in the PC market and in fact, have continued to gain really strong share across all of the regions in the world, including China on a year-over-year basis and have outgrown many of our competitors.

The next question comes from Toni Sacconaghi at Bernstein.

I just wanted to clarify. You talked about a $1 billion GAAP charge associated with restructuring opportunities from the separation and potentially $2 billion in GAAP charges associated with streamlining the Services business. So is GAAP a code word for cash charges, because not all GAAP charges are cash charges? So should we be thinking about $3 billion in cash charges? And from a timing perspective, I would imagine that most of the $1 billion in cash charges associated with the restructuring is in fiscal '16, with some in fiscal '17. Can you help us on that, please?

Sure. So Toni, we're not intending that GAAP is code word for cash but -- because there can be GAAP-only charges that are not cash. But these ones are expected to be all cash charges, and so you've got that right. And then in terms of the timing, we really see these cash outflows related to these charges to be taking place over 3 years. So it will be a little bit more front-end loaded to offset the dis-synergies. But we would expect them to be -- both the $1 billion related to separation as well as the up to $2 billion for the Enterprise Services business streamlining to be over 3 years.

Okay. And then sorry, could you just clarify currency? I mean, you brought down guidance for the year last quarter and said that currency would impact you $0.60 and $0.30 on a net basis. Currency is a lot more benign based on current spot rates than what you've reported in the first 2 quarters. Is there an update on what the gross and net impact on EPS is for currency? And I guess the question is why wouldn't your guidance be adjusted upward for that reason?

So Toni, what we do is at the point in time we provided outlook, we take kind of that beginning of that month set of rates and we forecast the rest of the year. And if you actually compare the currency rates at the beginning of May to those at the beginning of February, when we provided the outlook for the year of $3.53 to $3.73, they are roughly the same. They are not materially changed.

Next question is from Maynard Um at Wells Fargo.

Can I just also clarify that Aruba is included in the guide? And I'm curious because I get some accretion for the back half but guidance is unchanged, so I'm just wondering if that implies there's some incremental pressure somewhere offsetting? And then just on the question, I get a lot of questions, as do you, I'm sure, around free cash flow returning to that $6.5 billion to $7 billion. With the sale of H3C, I estimate you'll lose around $400 million to $500 million in operating cash. Half goes away, and then the other half drops to the investing line on the cash flow statement. You'll have some net dis-synergies of about $200 million to $225 million in fiscal '16 and then any incremental restructuring charges if you do find these cost savings post-split. And then presumably, that's offset by the foreign tax credits that come back. No big separation related costs versus this year and then cash flow from Aruba, but it still seems you'd be short of that $6.5 billion to $7 billion. So can you just maybe help bridge that difference? Or how we should think about that? Is it M&A that's making it up from the cash proceeds from H3C and Snapfish? Or is there something else to think about there?

Boy, Maynard, I'm trying to follow all those numbers for you. But let me first clarify that Aruba is not in our guide. It just closed the other day, and it is not in our guide for the year. Secondly, in terms of how to think about the cash flow model for fiscal '16, I can't validate all those puts and takes that you've given, but I do -- I will throw out the following for you to think through. First, we think that the cash conversion cycle will be less of a headwind going into '16 than it was going into '15. You do want to take into consideration the fact that the 2012 program restructuring charges will be coming down pretty materially. But of course, we will have the offset to the incremental GAAP-only charges that we've talked about today. We will have significantly lower separation kind of impact to cash flow from separation across basically taxes that we need to pay, the incremental costs associated with that and the CapEx. And then I think currency is a little bit of a complicated topic, for sure. But you need to obviously think about what you think the currency is going to do, but also take into consideration the implications to cash of our broad hedging programs, our balance sheet hedging programs, which I talked a little bit about, but also some of the benefits that we're getting from our revenue hedging program. And then, of course, that's all on top of kind of what you think the outlook is for earnings.

The next question comes from Brian Alexander of Raymond James.

I think you're holding an Analyst Day later this year to go into details about each business post the separation. But as you think qualitatively about the operating profiles of each business beyond the split, Meg, should we anticipate that there might be any meaningful changes in organic growth strategies, investment intensity or the like that could result in a different operating profile than what we're seeing today? Or should it be closer to business as usual and more refinement of existing strategies?

So we will have an Analyst Day as we approach the separation. We haven't exactly set a date yet, but it will be early to late fall, and we will lay out the operating profit -- the operating profile of both companies, both not only from an operating profit, but also a capital structure. Because you'll recall around October 6 when we announced, we thought that HP Inc. would be more YieldCo because of the strong cash flow from Printing business, and Hewlett Packard Enterprise would be more targeted to growth at a reasonable price, or GARP investors, and the capital structure will reflect that. Also, I anticipate both companies will actually be doing acquisitions, but probably more so on the Hewlett Packard Enterprise as that market's growing a bit faster. So we'll lay all of that out for you at the security analysts meeting. And then actually, we will probably be on a roadshow to investors to make sure that everyone has a chance to understand in as much detail as we can provide what the outlook looks like for each company. I don't know, Cathie, if you want to add anything to that

So I wouldn't add anything more other than to say that we will be filing our Form 10 in the July time frame. And in that, while it will not have all of the information that I'm sure you will want in terms of kind of FY '16 forward-looking, it will have a preliminary cost structure review -- or sorry, capital structure -- sorry, capital structure review. So you'll get a first glimpse of that in the early July time frame.

The next question is from Sherri Scribner at Deutsche Bank.

I just wanted to get a clarification on the additional restructuring charges that you talked about this quarter. The $1 billion and the $2 billion, in terms of the impact to the cash in fiscal '16, how should we think about that? Should we think of those cost savings as mostly offsetting those restructuring charges, but because the restructuring charges are a bit front-end loaded, that cash benefit won't come until later in the 3-year period? And then I just wanted to get a little bit of detail on the strength that you're seeing in the Industry Standard Server business, and why you think you're seeing strength there.

Sure. So in terms of the potential GAAP-only charges that we've been talking about, they will be a bit front-end loaded. But you should think about them as being over 3 years. And that, from a cash flow perspective, from the savings, the savings will lag that just a little bit. I think the insight into fiscal '16 that we provided is that the dis-synergies of $400 million to $450 million will be more than half offset in fiscal '16. And so we will obviously get some cash flow benefit from the actions that we will take with these GAAP-only charges in '16.

And then entirely, the $400 million to $450 million, we believe will be entirely offset in '17.

And a bit more than that.

Yes.

So -- but we likely won't get to a full run rate savings from the -- gross savings from these actions until probably the run rate exit of fiscal '18.

In terms of Industry Standard Servers, we are seeing very strong momentum, I think, driven by a couple of things. First is I think it's our best-ever product line and very, very solid sales execution that is actually playing into a pretty healthy market as well. I mean, as I said, ISS revenue grew 11% year-over-year as reported and 17% in local currency. And we expect to gain share when the Q1 results are out. And I think it's our products like Gen9, which is off to a very fast start, Cloudline and Apollo are resonating well with customers that are purpose-built for specific workloads to deliver business outcomes. So we've got the workload and the business outcome lined with the right infrastructure. And then there's another little tailwind, which is the Windows Server 2000 and refresh -- our 2003 refresh, the ramp of our Foxconn partnership and improved win rates, frankly, against Lenovo as they take over the IBM server business. And I'll say one thing, we haven't talked much about cloud on this call because there was so much to cover here. But we're pretty pleased with the results of our Cloud business. And what you have to remember, it shows up. The success of Cloud shows up in 4 places in the -- 3 places in the HP P&L. One is Industry Standard Servers because we are, by far and away, the leader in private cloud, whether it's Gartner or IDC or whoever, so that shows up in ISS. Our virtual private cloud or managed cloud services shows up in Enterprise Services. And then CSA, the Cloud Service Automation and orchestration software that knits it all together, shows up in Software. So we may, over time, break out or run alongside sort of overall cloud revenues as opposed to just having it show up in the individual businesses. But for the moment, probably through the end of this year, we'll report it in the different businesses. So I just thought I'd say a word about that's another reason that ISS is strong as private cloud.

And let me add just a couple more things. On the quarter, the win rate that Meg talked about is up relative to the previous quarter low-double digits, so really strong improvement there. We are bringing on hundreds of new customers that haven't bought from HP in the last 12 months. So we're making really good progress against kind of the Lenovo lineup. And then in terms of the rest of the year for ISS, we've got a really nice wind at our back. We've got -- we're going into the second half with a strong backlog, so a better backlog, frankly, than we normally see going into Q3. As Meg said, we do have the Windows Server 2003 also coming up and, as you may recall, that is expiring in I think it's July of this year. And then Meg mentioned the Gen9 momentum.

Our next question comes from Amit Daryanani at RBC Capital Markets.

I was hoping if you could just talk a bit about the $2 billion of potential restructuring you have to do for the Services business. It seems like it's 10% of your revenue stream over there. So what are the challenges you're seeing there that you need to take that big of a new restructuring charge to get the 7% to 9% margins? And do you think potentially the piece of this portfolio that's just unprofitable and you may be better walking away from it? So maybe if you can just talk about what's leading the charges in the revenue stream, that'd be helpful.

Yes. I think there's a couple of things going on in our Enterprise Services business. First is we are making progress towards the long-term goal of 7% to 9% operating margin. But the ITO industry challenges have accelerated and are driving risk in the sustainability of this profit level if we don't do further cost reductions. And I'd say there's a couple of sort of large-scale secular trends that are impacting that ITO business. First is the government austerity programs have forced a business model transformation both here as well as in Europe. And basically, the public sector business has gone from buying in a fixed fee model to a cost-plus model, so that put some pressure on. And then secondly, there are -- is a definitely accelerated move to a consumption model, which is going to require us to make a faster labor mix shift to low-cost resources and, frankly, the transformation of the physical data center footprint to much more streamlined footprint that are far more automated. So there's real market shifts going on here. And basically, the additional savings plan that we mentioned today would derisk our plan for ES to reach that 7% to 9% operating margins but, more importantly, would enable us to sustain that level of profitability over time. So we've got more aggressive labor pyramid shifts that has to take place onshore, offshore locations to make sure that we stay competitive in that market. And the market's changing dramatically. That said, our apps business and our business process outsourcing business and our strategic Enterprise Services businesses are looking healthier. But remember, ITO is a big chunk of our Enterprise Services business.

And let me just give some -- I guess, some data that supports that. If you look at our ITO business in this quarter, it was down 20% year-over-year, and it had about 6 points of currency, so it was still down 14% on a constant-currency basis. Now there is an impact from the top 3 runoff, but it is still a lot softer than what we had been seeing. And so we're definitely starting to see the pressures in the ITO space. On the app side, we really -- we saw declines of 8% as reported in revenue, but only 2% in constant currency. And if you adjust for currency, we had a couple of our regions that actually were flat to slightly up, and we see that progressing as we go into the second half. So it really is much more of an ITO challenge and the change in the market dynamics.

And then let me -- you've kind of asked a strategic question, I'm going to interpret it as sort of how does services fit? And if you pull the lens back, let me give you my perspective on this business. As our customers are requiring business outcome solutions as opposed to a migration, which used to be they used to buy on a point product solution basis, we are going to have to lead with Services because our customers are asking for transformation services, for business outcomes, for cost, efficiency, better return on invested capital of their assets, and both our Services business in ES as well as our TS consulting businesses are becoming more strategic to the future of Hewlett Packard Enterprise. And my view is that if we don't have a healthy Services business, that will actually compromise our overall business as we go forward because increasingly, Services is becoming the tip of the spear in how we go to market, not only to direct customers but, frankly, our partners and VARs are seeing the exact same thing. So the combination of ES plus TS consulting is going to be a really important strategic weapon, I think, for HP going forward.

The next question is from Shannon Cross at Cross Research.

Meg, can you talk a bit about the China JV, why you included both the servers as well as storage and networking with the JV, how you see it sort of running in conjunction with HP Enterprise? And just -- we kind of understand what was behind the sale of the Networking business, but how you think you're going to be working together with them?

Yes. So first of all, I think we have a terrific partner in Tsinghua. As many of you know, Tsinghua is sort of the Harvard and the MIT of China rolled into one, with incredible R&D capability and very much a part of sort of the Chinese community, if you will. And so obviously, H3C was going to be rolled into this joint venture, but frankly, increasingly, servers, storage, technology services and networking, they are converging in China, just like they are here. And we thought it made sense to take all our Chinese enterprise assets and put them into this joint venture. As I said, it will be owned 51% by Tsinghua, 49% by us, and we're excited about the future possibilities. I will tell you already, the H3C and the China HP employees are pretty psyched up about this. They woke up to this news this morning. They're pumped up. And I think this is going to unleash a whole host of business in the Chinese market. So the things that will remain outside of the Tsinghua JV is our Enterprise Services business, which is primarily a business that serves multinational customers. So for example, if we're serving P&G in China, that would be Enterprise Services. The other is our cloud business, HP Helion cloud business, as well as our Printing and PC business. And then, of course, Software, which is a very, very small business in China. So the bulk of our Chinese business goes into this JV with the exception obviously -- we have a very big Printing and PC business but that's a completely different business. So that was the thinking behind it.

Will the JV sell to any other countries besides China? Or are they just limited to China?

So Shannon, we're going to be their distributor for all of the networking products in the rest of the world. So they will not be selling any of the products that are developed in China to the rest of the world except through us as distributor.

Exactly. So the real point of this JV is in China for China for the Chinese market, and obviously, the Networking products, we'll distribute globally, as Cathie said.

Our last question is from Keith Bachman at Bank of Montréal.

Meg, I was hoping you could review your perspective on what Win 10 may do for the market, the timing. And if you could include any comments, your profitability was down a little bit in PCs today. And I know Cathie mentioned FX was a part of it. But how would that impact profitability, if at all, and also the revenue side? And I wanted to sneak one in to Shannon's question on the Chinese JV. How do you protect your IP in that JV?

Yes, okay. Well, I actually happen to have Dion Weisler here. So Dion, why don't you talk a little bit about Win 10 and what you expect on profitability? And then, I'll come back on the China JV and the IP.

Sure. Look, I think in the consumer segment, we obviously are expecting and are hopeful that Windows 10 will provide some stimulus for the marketplace. I think that will be ahead of some tapering off of demand, just ahead of the Windows 10 launch. In the commercial segment, we see slower acceptance always in new operating systems, as evidenced, I guess, by the XP migration, which was largely completed towards the end of FY '14. And therefore, we don't really anticipate a significant impact on the commercial business, either positive or negative. Yet on the consumer side, we expect that towards the back end of this year, it will provide some stimulus.

Yes.

And does that impact your profitability, Dion? Or is 3% the right run rate?

Look, we obviously don't guide by segment. But I think it's fair to say that this is a transition, just like similar transitions that we've seen in the marketplace. There's a consolidating market going on at the moment. We believe that it will remain a competitive marketplace. We think we're outperforming our competitors, and that profitability will run according to that.

Yes, yes.

And the profitability in Q2 was heavily impacted by currency. But offsetting some of the currency benefits were really strong operating efficiencies because Dion's businesses are also very much focused on streamlining and staying maniacally focused on costs, as well as a favorable commodity environment. And we do expect that, that commodity view will persist into Q3. And then the other thing I just -- I think I should have pointed out before is that the XP refresh kind of peak quarter was Q3 of last year. And so the entire market is going to come up against very tough compares when you look at our numbers in Q3.

Especially markets -- like markets like Japan.

Yes.

Let me answer the IP question. So we develop IP in China and have for some time in the context of H3C. And then, as we move our server and our storage business, obviously, into this new JV, we'll have an OEM agreement from HP to H3C Tsinghua JV. And obviously, we've been very focused on protecting the IP. I think we've got an excellent framework agreement. We're not naïve, but we've got an excellent framework agreement. And I think -- I will say I think Tsinghua in this regard is a very, very good partner. So we're optimistic about it, and I think it is going to accelerate the business in China.

Thanks, Keith, and thanks, everybody, for your questions. I think we're done with the call. Thank you.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.