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Hewlett-Packard Company 10-Q 2012
UNITED STATES
FORM 10-Q
HEWLETT-PACKARD COMPANY
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 (the "Exchange Act") during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes o No ý The number of shares of HP common stock outstanding as of May 31, 2012 was 1,971,832,590 shares.
Forward-Looking Statements This Quarterly Report on Form 10-Q, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 2 of Part I of this report, contains forward-looking statements that involve risks, uncertainties and assumptions. If the risks or uncertainties ever materialize or the assumptions prove incorrect, the results of Hewlett-Packard Company and its consolidated subsidiaries ("HP") may differ materially from those expressed or implied by such forward-looking statements and assumptions. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including but not limited to any projections of revenue, margins, expenses, earnings, earnings per share, tax provisions, cash flows, benefit obligations, share repurchases, currency exchange rates, the impact of acquisitions or other financial items; any projections of the amount, timing or impact of cost savings, restructuring charges, early retirement programs, workforce reductions or impairment charges; any statements of the plans, strategies and objectives of management for future operations, including the execution of restructuring plans and any resulting cost savings or revenue or profitability improvements; any statements concerning the expected development, performance, market share or competitive performance relating to products or services; any statements regarding current or future macroeconomic trends or events and the impact of those trends and events on HP and its financial performance; any statements regarding pending investigations, claims or disputes; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. Risks, uncertainties and assumptions include the impact of macroeconomic and geopolitical trends and events; the competitive pressures faced by HP's businesses; the development and transition of new products and services and the enhancement of existing products and services to meet customer needs and respond to emerging technological trends; the execution and performance of contracts by HP and its suppliers, customers and partners; the protection of HP's intellectual property assets, including intellectual property licensed from third parties; integration and other risks associated with business combination and investment transactions; the hiring and retention of key employees; assumptions related to pension and other post-retirement costs and 2 retirement programs; the execution, timing and results of restructuring plans, including estimates and assumptions related to the cost and the anticipated benefits of implementing those plans; the resolution of pending investigations, claims and disputes; and other risks that are described herein, including but not limited to the items discussed in "Factors that Could Affect Future Results" set forth in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 2 of Part I of this report, and that are otherwise described from time to time in HP's Securities and Exchange Commission ("SEC") reports, including HP's Annual Report on Form 10-K for the fiscal year ended October 31, 2011. HP assumes no obligation and does not intend to update these forward-looking statements. 3
The accompanying notes are an integral part of these Consolidated Condensed Financial Statements. 4
The accompanying notes are an integral part of these Consolidated Condensed Financial Statements. 5
The accompanying notes are an integral part of these Consolidated Condensed Financial Statements. 6
Note 1: Basis of Presentation In the opinion of management, the accompanying Consolidated Condensed Financial Statements of Hewlett-Packard Company and its consolidated subsidiaries ("HP") contain all adjustments, including normal recurring adjustments, necessary to present fairly HP's financial position as of April 30, 2012, its results of operations for the three and six months ended April 30, 2012 and 2011 and its cash flows for the six months ended April 30, 2012 and 2011. The Consolidated Condensed Balance Sheet as of October 31, 2011 is derived from the October 31, 2011 audited consolidated financial statements. The results of operations for the three and six months ended April 30, 2012 are not necessarily indicative of the results to be expected for the full year. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with "Risk Factors," "Legal Proceedings," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Quantitative and Qualitative Disclosures About Market Risk" and the Consolidated Financial Statements and notes thereto included in Items 1A, 3, 7, 7A and 8, respectively, of the Hewlett-Packard Company Annual Report on Form 10-K for the fiscal year ended October 31, 2011. The preparation of financial statements in accordance with U.S. generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the amounts reported in HP's Consolidated Condensed Financial Statements and accompanying notes. Actual results could differ materially from those estimates. In connection with organizational realignments implemented in the first quarter of fiscal 2012, certain costs previously reported as cost of sales have been reclassified as selling, general and administrative expenses to better align those costs with the functional areas that benefit from those expenditures. HP has made certain segment and business unit realignments in order to optimize its operating structure. Reclassifications of prior year financial information have been made to conform to the current year presentation. None of the changes impacts HP's previously reported consolidated net revenue, earnings from operations, net earnings or net earnings per share. See Note 16 for a further discussion of HP's segment reorganization. Note 2: Stock-Based Compensation HP's stock-based compensation plans include HP's principal equity plans as well as various equity plans assumed through acquisitions. HP's principal equity plans include restricted stock awards, stock options and performance-based restricted units ("PRUs"). Total stock-based compensation expense before income taxes for the three and six months ended April 30, 2012 was $169 million and $344 million, respectively. The resulting income tax benefit for the three and six months ended April 30, 2012 was $54 million and $111 million, respectively. Total stock-based compensation expense before income taxes for the three and six months ended April 30, 2011 was $147 million and $327 million, respectively. The resulting income tax benefit for the three and six months ended April 30, 2011 was $61 million and $104 million, respectively. 7
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 2: Stock-Based Compensation (Continued) Restricted stock awards are non-vested stock awards that include grants of restricted stock and grants of restricted stock units. Non-vested restricted stock awards as of April 30, 2012 and changes during the six months ended April 30, 2012 were as follows:
At April 30, 2012, there was $758 million of unrecognized pre-tax stock-based compensation expense related to non-vested restricted stock awards, which HP expects to recognize over the remaining weighted-average vesting period of 1.4 years. HP utilized the Black-Scholes option pricing model to value the service-based stock options granted under its principal equity plans. HP estimates the fair value of the performance-contingent stock options using a combination of the Monte Carlo simulation model and lattice model, as these awards contain market conditions. HP estimated the weighted-average fair value of stock options using the following weighted-average assumptions:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 2: Stock-Based Compensation (Continued) Option activity as of April 30, 2012 and changes during the six months ended April 30, 2012 were as follows:
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value that option holders would have received had all option holders exercised their options on April 30, 2012. The aggregate intrinsic value is the difference between HP's closing stock price on the last trading day of the second quarter of fiscal 2012 and the exercise price, multiplied by the number of in-the-money options. Total intrinsic value of options exercised for the three and six months ended April 30, 2012 was $55 million and $164 million, respectively. At April 30, 2012, there was $227 million of unrecognized pre-tax stock-based compensation expense related to stock options, which HP expects to recognize over the remaining weighted-average vesting period of 2.1 years. HP's PRU program provides for the issuance of PRUs representing hypothetical shares of HP common stock. Each PRU award reflects a target number of shares ("Target Shares") that may be issued to the award recipient before adjusting for performance and market conditions. The actual number of shares the recipient receives is determined at the end of a three-year performance period based on results achieved versus company performance goals and may range from 0% to 200% of the Target Shares granted. The performance goals for PRUs granted in fiscal year 2012 are based on HP's annual cash flow from operations as a percentage of revenue and on HP's annual revenue growth. The performance goals for PRUs granted in previous years are based on HP's annual cash flow from operations as a percentage of revenue and on a market condition based on total shareholder return ("TSR") relative to the S&P 500 over the three-year performance period. For PRU awards granted in fiscal year 2012, HP estimates the fair value of the Target Shares using HP's closing stock price on the measurement date. The weighted-average fair value per share for the first year of the three-year performance period applicable to PRUs granted in the six months ended April 30, 2012 was $27.00. The estimated fair value of the Target Shares for the second and third years for PRUs granted in the six months ended April 30, 2012 will be determined on the measurement date 9
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 2: Stock-Based Compensation (Continued) applicable to those PRUs, which will occur during the period that the annual performance goals are approved for those PRUs, and the expense will be amortized over the remainder of the applicable three-year performance period. For PRU awards granted prior to fiscal year 2012, HP estimates the fair value of the Target Shares subject to those awards using the Monte Carlo simulation model, as the TSR modifier represents a market condition. The following weighted-average assumptions, in addition to projections of market conditions, were used to determine the weighted-average fair values of these PRU awards:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 2: Stock-Based Compensation (Continued) Non-vested PRUs as of April 30, 2012 and changes during the six months ended April 30, 2012 were as follows:
At April 30, 2012, there was $48 million of unrecognized pre-tax stock-based compensation expense related to PRUs with an assigned fair value, which HP expects to recognize over the remaining weighted-average vesting period of 1.1 years. Note 3: Net Earnings Per Share HP calculates basic earnings per share ("EPS") using net earnings and the weighted-average number of shares outstanding during the reporting period. Diluted EPS includes any dilutive effect of outstanding stock options, PRUs, restricted stock units and restricted stock. 11
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 3: Net Earnings Per Share (Continued) The reconciliation of the numerators and denominators of the basic and diluted EPS calculations was as follows:
HP excludes options with exercise prices that are greater than the average market price from the calculation of diluted EPS because their effect would be anti-dilutive. For both the three and six months ended April 30, 2012, HP excluded from the calculation of diluted EPS options to purchase 50 million shares, compared to 6 million shares for both the three and six months ended April 30, 2011. In addition, HP also excluded from the calculation of diluted EPS options to purchase an additional 10 million shares for both the three and six months ended April 30, 2012, compared to an additional 1 million shares for both the three and six months ended April 30, 2011, whose combined exercise price, unamortized fair value and excess tax benefits were greater in each of those periods than the average market price for HP's common stock because their effect would be anti-dilutive. Note 4: Balance Sheet Details Balance sheet details were as follows:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 4: Balance Sheet Details (Continued) HP has revolving trade receivables-based facilities permitting it to sell certain trade receivables to third parties. In accordance with the accounting requirements under the Accounting Standards Codification relating to "Transfers and Servicing," trade receivables are derecognized from the Consolidated Condensed Balance Sheets when sold to third parties. The total aggregate capacity of the facilities was $1.4 billion as of April 30, 2012, including a $0.9 billion partial recourse facility entered into in May 2011 and an aggregate capacity of $0.5 billion in non-recourse facilities. The recourse obligation is measured using market data from similar transactions and reported as a current liability in the Consolidated Condensed Balance Sheets. The recourse obligation as of April 30, 2012 was not material. For the first six months of fiscal 2012 and 2011, trade receivables sold under these facilities were $2.1 billion and $897 million, respectively, which approximates the amount of cash received. The resulting loss on the sales of trade accounts receivable for the three months and six months ended April 30, 2012 was not material. HP had $725 million as of April 30, 2012 and $701 million as of October 31, 2011 of available capacity under these programs.
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 5: Goodwill and Purchased Intangible Assets Goodwill allocated to HP's business segments as of April 30, 2012 and changes in the carrying amount of goodwill for the six months ended April 30, 2012 are as follows:
In connection with certain fiscal 2012 organizational realignments, HP reclassified $280 million of goodwill related to the TippingPoint network security solutions business from the Enterprise Servers, Storage and Networking segment to the Software segment. During the six months ended April 30, 2012, HP recorded additional goodwill of $224 million in the Software segment due to a change in the estimated fair values of purchased intangible assets and net tangible assets associated with the acquisition of Autonomy Corporation plc ("Autonomy"). HP also recorded a net increase to goodwill of $213 million as a result of a currency translation adjustment on goodwill related to Autonomy subsidiaries whose functional currency is not the U.S. dollar. 14
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 5: Goodwill and Purchased Intangible Assets (Continued) HP's purchased intangible assets associated with completed acquisitions are composed of:
For the first six months of fiscal 2012, the majority of the decrease in gross intangibles was related to $428 million of fully amortized intangible assets which have been eliminated from both the gross and accumulated amortization amounts and a $293 million change in the estimated fair value of Autonomy's purchased intangible assets acquired. The decrease to intangibles was partially offset by a net currency translation adjustment of $165 million on intangibles related to Autonomy subsidiaries whose functional currency is not the U.S. dollar. Estimated future amortization expense related to finite-lived purchased intangible assets at April 30, 2012 was as follows:
Note 6: Restructuring Charges HP records restructuring charges associated with management approved restructuring plans to either reorganize one or more of HP's business segments, or to remove duplicative headcount and 15
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 6: Restructuring Charges (Continued) infrastructure associated with one or more business acquisitions. Restructuring charges can include severance costs to eliminate a specified number of employees, infrastructure charges to vacate facilities and consolidate operations, and contract cancellation costs. Restructuring charges are recorded based upon planned employee termination dates and site closure and consolidation plans. The timing of associated cash payments is dependent upon the type of restructuring charge and can extend over a multi-year period. HP records the short-term portion of the restructuring liability in Accrued restructuring and the long-term portion in Other liabilities in the Consolidated Condensed Balance Sheets. In connection with the acquisitions of Palm, Inc. ("Palm") and 3Com Corporation ("3Com") in fiscal 2010, HP's management approved and initiated plans to restructure the operations of the acquired companies, including severance for employees, contract cancellation costs, costs to vacate duplicative facilities and other items. The total expected combined cost of the plans is $121 million, which includes $33 million of additional restructuring costs recorded in the fourth quarter of fiscal 2011 in connection with HP's decision to wind down the webOS device business. As of October 31, 2011, HP had recorded the majority of the costs of the plans based upon the anticipated timing of planned terminations and facility closure costs. With respect to the Palm plan, no further restructuring charges are anticipated, and the majority of the remaining costs are expected to be paid out through fiscal 2012. The remaining costs pertaining to the 3Com plan are expected to be paid out through fiscal 2016 as fixed lease payments are made. Fiscal 2010 Enterprise Services Business Restructuring Plan On June 1, 2010, HP's management announced a plan to restructure its enterprise services business ("ES"), which includes its Infrastructure Technology Outsourcing and Application and Business Services business units. The multi-year restructuring program includes plans to consolidate commercial data centers, tools and applications. The total expected cost of the plan that will be recorded as restructuring charges is approximately $1.0 billion, and includes severance costs to eliminate approximately 8,000 positions and infrastructure charges. As the execution of the restructuring activities has evolved, certain components and their related cost estimates have been revised. While the total cost of the plan remains consistent, during the first quarter of fiscal 2012, HP reduced the severance accrual by $100 million and recognized additional infrastructure related charges of $104 million. HP expects to record the majority of the infrastructure charges through fiscal 2012. The timing of the charges is based upon planned termination dates and site closure and consolidation plans. The majority of the associated cash payments are expected to be paid out through the first quarter of fiscal 2013. As of April 30, 2012, approximately 7,000 positions had been eliminated. In May 2009, HP's management approved and initiated a restructuring plan to structurally change and improve the effectiveness of the Imaging and Printing Group ("IPG"), the Personal Systems Group ("PSG"), and Enterprise Servers, Storage and Networking ("ESSN") businesses. The total expected cost of the plan was $301 million in severance-related costs associated with the planned elimination of 16
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 6: Restructuring Charges (Continued) approximately 4,400 positions. All planned eliminations had occurred and the vast majority of the restructuring costs had been paid out as of October 31, 2011. In connection with the acquisition of Electronic Data Systems Corporation ("EDS") on August 26, 2008, HP's management approved and initiated a restructuring plan to combine and align HP's services businesses, eliminate duplicative overhead functions and consolidate and vacate duplicative facilities. The restructuring plan is expected to be implemented over four years from the acquisition date at a total expected cost of $3.3 billion. Approximately $1.5 billion of the expected costs were associated with pre-acquisition EDS and were reflected in the fair value of purchase consideration of EDS. These costs are subject to change based on the actual costs incurred. The remaining costs are primarily associated with HP and will be recorded as a restructuring charge. The restructuring plan includes severance costs related to eliminating approximately 25,000 positions. As of October 31, 2011, all planned eliminations had occurred and the vast majority of the associated severance costs had been paid out. The infrastructure charges in the restructuring plan include facility closure and consolidation costs and the costs associated with early termination of certain contractual obligations. HP has recorded the majority of these costs based upon the execution of site closure and consolidation plans. The associated cash payments are expected to be paid out through fiscal 2016. The adjustments to the accrued restructuring expenses related to all of HP's restructuring plans described above for the six months ended April 30, 2012 were as follows:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 6: Restructuring Charges (Continued) At April 30, 2012 and October 31, 2011, HP included the long-term portion of the restructuring liability of $301 million and $159 million, respectively, in Other liabilities, and the short-term portion of $273 million and $654 million, respectively, in Accrued restructuring in the accompanying Consolidated Condensed Balance Sheets. Note 7: Fair Value HP determines fair value based on the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants. Valuation techniques used by HP are based upon observable and unobservable inputs. Observable or market inputs reflect market data obtained from independent sources, while unobservable inputs reflect HP's assumptions about market participant assumptions based on the best information available. Observable inputs are the preferred basis of valuation. These two types of inputs create the following fair value hierarchy: Level 1—Quoted prices (unadjusted) for identical instruments in active markets. Level 2—Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3—Prices or valuations that require management inputs that are both significant to the fair value measurement and unobservable. The following section describes the valuation methodologies HP uses to measure its financial assets and liabilities at fair value. Cash Equivalents and Investments: HP holds time deposits, money market funds, mutual funds, other debt securities primarily consisting of corporate and foreign government notes and bonds, and common stock and equivalents. Where applicable, HP uses quoted prices in active markets for identical assets to determine fair value. If quoted prices in active markets for identical assets are not available to determine fair value, HP uses quoted prices for similar assets and liabilities or inputs that are observable either directly or indirectly. If quoted prices for identical or similar assets are not available, HP uses internally developed valuation models, whose inputs include bid prices, and third-party valuations utilizing underlying assets assumptions. Derivative Instruments: As discussed in Note 8, HP mainly holds non-speculative forwards, swaps and options to hedge certain foreign currency and interest rate exposures. When active market quotes are not available, HP uses industry standard valuation models. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit risk, foreign exchange rates, and forward and spot prices for currencies. In certain cases, market-based observable inputs are not available and, in those cases, HP uses management judgment to develop assumptions which are used to determine fair value. 18
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 7: Fair Value (Continued) Short- and Long-Term Debt: The estimated fair value of publicly-traded debt is based on quoted market prices for the identical liability when traded as an asset in an active market. For other debt for which a quoted market price is not available, an expected present value method that uses rates currently available to HP for debt with similar terms and remaining maturities is used to estimate fair value. The portion of the company's fixed-rate debt obligations that is hedged is reflected in the Consolidated Condensed Balance Sheets as an amount equal to the debt's carrying value, including a fair value adjustment representing changes in the fair value of the hedged debt obligations arising from movements in benchmark interest rates. The estimated fair value of HP's short- and long-term debt was approximately $30.6 billion at April 30, 2012, compared to a carrying value of $30.1 billion at that date. The estimated fair value of HP's short- and long-term debt was approximately $31.1 billion at October 31, 2011, compared to a carrying value of $30.6 billion at that date. If measured at fair value in the Consolidated Condensed Financial Statements, short- and long-term debt would be classified as Level 2 in the fair value hierarchy. The following table presents HP's assets and liabilities that are measured at fair value on a recurring basis:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments Cash Equivalents and Available-for-Sale Investments Cash equivalents and available-for-sale investments at fair value as of April 30, 2012 and October 31, 2011 were as follows:
Cash equivalents consist of investments in time deposits, money market funds and mutual funds with original maturities of three months or less. Time deposits were primarily issued by institutions outside the U.S. as of April 30, 2012 and October 31, 2011. Available-for-sale securities consist of short-term investments which mature within twelve months or less and long-term investments with maturities greater than twelve months. Investments primarily include institutional bonds, mutual funds, equity securities in public companies, fixed-interest securities and time deposits. HP estimates the fair values of its investments based on quoted market prices or pricing models using current market rates. These estimated fair values may not be representative of actual values that will be realized in the future. As of April 30, 2012, $17 million of the total gross unrealized losses were related to certain debt securities that had been in a continuous loss position for more than twelve months. The gross unrealized loss as of October 31, 2011 was due primarily to declines in certain debt securities of $21 million that had been in a continuous loss position for more than twelve months. HP does not intend to sell these debt securities, and it is not likely that HP will be required to sell these debt securities prior to the recovery of the amortized cost. 20
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments (Continued) Contractual maturities of short-term and long-term investments in available-for-sale debt securities at April 30, 2012 were as follows:
For the three and six months ended April 30, 2012, HP recognized an insignificant impairment charge associated with debt securities. For the three and six months ended April 30, 2011, HP did not recognize any impairment charge associated with debt securities. During the quarter ended April 30, 2012, HP recognized a $50.7 million impairment charge related to a public equity investment as HP determined that such impairment was other than temporary. HP made its determination based on an average of closing prices for the six months ended April 30, 2012. HP has evaluated the near-term prospects of its remaining equity investments in a gross unrealized loss position in relation to the severity and duration of the impairment and considers the decline in market value of the equity investments to be temporary in nature. Equity securities in privately held companies include cost basis and equity method investments. These amounted to $51 million and $48 million for the periods ended April 30, 2012 and October 31, 2011, respectively, and are included in long-term financing receivables and other assets. HP is a global company that is exposed to foreign currency exchange rate fluctuations and interest rate changes in the normal course of its business. As part of its risk management strategy, HP uses derivative instruments, primarily forward contracts, option contracts, interest rate swaps, and total return swaps, to hedge certain foreign currency, interest rate and, to a lesser extent, equity exposures. HP's objective is to offset gains and losses resulting from these exposures with losses and gains on the derivative contracts used to hedge them, thereby reducing volatility of earnings or protecting fair values of assets and liabilities. HP does not have any leveraged derivatives and does not use derivative contracts for speculative purposes. HP designates its derivatives as fair value hedges, cash flow hedges or hedges of the foreign currency exposure of a net investment in a foreign operation ("net investment hedges"). Additionally, for derivatives not designated as hedging instruments, HP categorizes those economic hedges as other derivatives. HP recognizes all derivatives, on a gross basis, in the Consolidated Condensed Balance Sheets at fair value and reports them in Other current assets, Long-term financing receivables and other assets, Other accrued liabilities, or Other liabilities. HP classifies cash flows from the derivative programs as operating activities in the Consolidated Condensed Statements of Cash Flows. 21
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments (Continued) As a result of the use of derivative instruments, HP is exposed to the risk that counterparties to derivative contracts will fail to meet their contractual obligations. To mitigate the counterparty credit risk, HP has a policy of only entering into contracts with carefully selected major financial institutions based upon their credit ratings and other factors, and HP maintains dollar risk limits that correspond to each institution's credit rating and other factors. HP's established policies and procedures for mitigating credit risk on principal transactions and short-term cash include reviewing and establishing limits for credit exposure and continually assessing the creditworthiness of counterparties. Master agreements with counterparties include master netting arrangements as further mitigation of credit exposure to counterparties. These arrangements permit HP to net amounts due from HP to a counterparty with amounts due to HP from the same counterparty. To further mitigate credit exposure to counterparties, HP may enter into collateral security arrangements with its counterparties. These arrangements require HP to post collateral or to hold collateral from counterparties when the derivative fair values exceed contractually established thresholds which are generally based on the credit ratings of HP and its counterparties. Such funds are generally transferred within two business days of the due date. As of April 30, 2012, HP held $195 million of collateral and posted $40 million through re-hypothecation in association with the counterparties under these collateralized arrangements. As of April 30, 2011, HP held $30 million of treasury securities under those collateralized arrangements. As of April 30, 2012 and 2011, HP did not have any derivative instruments under these collateralized arrangements that were in a significant net liability position. HP enters into fair value hedges to reduce the exposure of its debt portfolio to interest rate risk. HP issues long-term debt in U.S. dollars based on market conditions at the time of financing. HP uses interest rate swaps to mitigate the market risk exposures in connection with the debt to achieve primarily U.S. dollar LIBOR-based floating interest expense. The swap transactions generally involve principal and interest obligations for U.S. dollar-denominated amounts. Alternatively, HP may choose not to swap fixed for floating interest payments or may terminate a previously executed swap if it believes a larger proportion of fixed-rate debt would be beneficial. When investing in fixed-rate instruments, HP may enter into interest rate swaps that convert the fixed interest payments into variable interest payments and would classify these swaps as fair value hedges. For derivative instruments that are designated and qualify as fair value hedges, HP recognizes the gain or loss on the derivative instrument, as well as the offsetting loss or gain on the hedged item, in Interest and other, net in the Consolidated Condensed Statements of Earnings in the current period. HP uses a combination of forward contracts and options designated as cash flow hedges to protect against the foreign currency exchange rate risks inherent in its forecasted net revenue and, to a lesser extent, cost of sales, operating expense, and intercompany lease loan denominated in currencies other than the U.S. dollar. HP's foreign currency cash flow hedges mature generally within twelve months. However, certain leasing revenue-related forward contracts and intercompany lease loan forward contracts extend for the duration of the lease term, which can be up to five years. For derivative 22
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments (Continued) instruments that are designated and qualify as cash flow hedges, HP initially records the effective portion of the gain or loss on the derivative instrument in accumulated other comprehensive income or loss as a separate component of stockholders' equity and subsequently reclassifies these amounts into earnings in the period during which the hedged transaction is recognized in earnings. HP reports the effective portion of cash flow hedges in the same financial statement line item as the changes in value of the hedged item. During the three and six months ended April 30, 2012 and 2011, HP did not discontinue any cash flow hedge for which it was probable that a forecasted transaction would not occur. HP uses forward contracts designated as net investment hedges to hedge net investments in certain foreign subsidiaries whose functional currency is the local currency. These derivative instruments are designated as net investment hedges and, as such, HP records the effective portion of the gain or loss on the derivative instrument together with changes in the hedged items in cumulative translation adjustment as a separate component of stockholders' equity. Other derivatives not designated as hedging instruments consist primarily of forward contracts HP uses to hedge foreign currency balance sheet exposures. HP also uses total return swaps and, to a lesser extent, interest rate swaps, based on the equity and fixed income indices, to hedge its executive deferred compensation plan liability. For derivative instruments not designated as hedging instruments, HP recognizes changes in the fair values in earnings in the period of change. HP recognizes the gain or loss on foreign currency forward contracts used to hedge balance sheet exposures in Interest and other, net in the same period as the remeasurement gain and loss of the related foreign currency denominated assets and liabilities. HP recognizes the gain or loss on the total return swaps and interest rate swaps in Interest and other, net in the same period as the gain or loss from the change in market value of the executive deferred compensation plan liability. For interest rate swaps designated as fair value hedges, HP measures effectiveness by offsetting the change in fair value of the hedged debt with the change in fair value of the derivative. For foreign currency options and forward contracts designated as cash flow or net investment hedges, HP measures effectiveness by comparing the cumulative change in the hedge contract with the cumulative change in the hedged item, both of which are based on forward rates. HP recognizes any ineffective portion of the hedge, as well as amounts not included in the assessment of effectiveness, in the Consolidated Condensed Statements of Earnings. As of April 30, 2012 and 2011, the portion of hedging instruments' gain or loss excluded from the assessment of effectiveness was not material for fair value, cash flow or net investment hedges. Hedge ineffectiveness for fair value, cash flow and net investment hedges was not material in the three and six months ended April 30, 2012 and 2011. 23
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments (Continued) Fair Value of Derivative Instruments in the Consolidated Condensed Balance Sheets As discussed in Note 7, HP estimates the fair values of derivatives primarily based on pricing models using current market rates and records all derivatives on the balance sheet at fair value. The gross notional and fair value of derivative financial instruments in the Consolidated Condensed Balance Sheets was recorded as follows:
Effect of Derivative Instruments on the Consolidated Condensed Statements of Earnings The before-tax effect of a derivative instrument and related hedged item in a fair value hedging relationship for the three and six months ended April 30, 2012 and 2011 were as follows:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments (Continued)
The before-tax effect of derivative instruments in cash flow and net investment hedging relationships for the three and six months ended April 30, 2012 was as follows:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments (Continued) The before-tax effect of derivative instruments in cash flow and net investment hedging relationships for the three and six months ended April 30, 2011 was as follows:
As of April 30, 2012, HP expects to reclassify an estimated net accumulated other comprehensive gain of approximately $47 million, net of taxes, to earnings in the next twelve months along with the earnings effects of the related forecasted transactions in association with cash flow hedges. The before-tax effect of derivative instruments not designated as hedging instruments on the Consolidated Condensed Statements of Earnings for the three and six months ended April 30, 2012 and 2011 was as follows:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 8: Financial Instruments (Continued)
For the balance of HP's financial instruments, accounts receivable, financing receivables, accounts payable and other accrued liabilities, the carrying amounts approximate fair value due to their short maturities. Note 9: Financing Receivables and Operating Leases Financing receivables represent sales-type and direct-financing leases resulting from the placement of HP and third-party products. These receivables typically have terms from two to five years and are usually collateralized by a security interest in the underlying assets. Financing receivables also include billed receivables from operating leases. The components of financing receivables, which are included in Financing receivables and Long-term financing receivables and other assets in the accompanying Consolidated Condensed Balance Sheets, were as follows:
Equipment leased to customers under operating leases was $4.0 billion at April 30, 2012 and October 31, 2011, and is included in machinery and equipment. Accumulated depreciation on equipment under lease was $1.5 billion at April 30, 2012 and $1.3 billion at October 31, 2011. Due to the homogenous nature of the leasing transactions, HP manages its financing receivables on an aggregate basis when assessing and monitoring credit risk. Credit risk is generally diversified due to the large number of entities comprising HP's customer base and their dispersion across many 27
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 9: Financing Receivables and Operating Leases (Continued) different industries and geographical regions. The credit quality of an obligor is evaluated at lease inception and monitored over the term of a transaction. Risk ratings are assigned to each lease based on the creditworthiness of the obligor and other variables that augment or diminish the inherent credit risk of a particular transaction. Such variables include the underlying value and liquidity of the collateral, the essential use of the equipment, the term of the lease, and the inclusion of guarantees, letters of credit, security deposits or other credit enhancements. The credit risk profile of the gross financing receivables, based on internally assigned ratings, was as follows:
Accounts rated low risk typically have the equivalent of a Standard & Poor's rating of BBB- or higher, while accounts rated moderate risk would generally be the equivalent of BB+ or lower. HP closely monitors accounts rated high risk and, based upon an impairment analysis, may establish specific reserves against a portion of these leases. The allowance for doubtful accounts balance is comprised of a general reserve, which is determined based on a percentage of the financing receivables balance, and a specific reserve, which is established for certain leases with identified exposures, such as customer default, bankruptcy or other events, that make it unlikely that HP will recover its investment in the lease. The general reserve percentages are maintained on a regional basis and are based on several factors, which include consideration of historical credit losses and portfolio delinquencies, trends in the overall weighted-average risk rating of the portfolio, and information derived from competitive benchmarking. The allowance for doubtful accounts and the related financing receivables were as follows:
28
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 9: Financing Receivables and Operating Leases (Continued)
Accounts are generally put on non-accrual status (cessation of interest accrual) when they reach 90 days past due. The non-accrual status may not impact a customer's risk rating. In certain circumstances, such as when the delinquency is deemed to be of an administrative nature, accounts may still accrue interest when they reach 90 days past due. A write-off or specific reserve is generally recorded when an account reaches 180 days past due. Total financing receivables on non-accrual status were $197 million and $157 million at April 30, 2012 and October 31, 2011, respectively. Total financing receivables greater than 90 days past due and still accruing interest were $116 million and $71 million at April 30, 2012 and October 31, 2011, respectively. Note 10: Guarantees In the ordinary course of business, HP may provide certain clients with subsidiary performance guarantees and/or financial performance guarantees, which may be backed by standby letters of credit or surety bonds. In general, HP would be liable for the amounts of these guarantees in the event HP or HP's subsidiaries' nonperformance permits termination of the related contract by the client, the likelihood of which HP believes is remote. HP believes that the company is in compliance with the performance obligations under all material service contracts for which there is a performance guarantee. HP has certain service contracts supported by client financing or securitization arrangements. Under specific circumstances involving nonperformance resulting in service contract termination or failure to comply with terms under the financing arrangement, HP would be required to acquire certain assets. HP considers the possibility of its failure to comply to be remote and the asset amounts involved to be immaterial. In the ordinary course of business, HP enters into contractual arrangements under which HP may agree to indemnify the third party to such arrangement from any losses incurred relating to the services they perform on behalf of HP or for losses arising from certain events as defined within the particular contract, which may include, for example, litigation or claims relating to past performance. Such indemnification obligations may not be subject to maximum loss clauses. Historically, payments made related to these indemnifications have been immaterial. 29
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 10: Guarantees (Continued) HP provides for the estimated cost of product warranties at the time it recognizes revenue. HP engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its component suppliers; however, product warranty terms offered to customers, ongoing product failure rates, material usage and service delivery costs incurred in correcting a product failure, as well as specific product class failures outside of HP's baseline experience, affect the estimated warranty obligation. If actual product failure rates, repair rates or any other post sales support costs differ from these estimates, revisions to the estimated warranty liability would be required. The changes in HP's aggregate product warranty liabilities for the six months ended April 30, 2012 were as follows:
Note 11: Borrowings Notes payable and short-term borrowings, including the current portion of long-term debt, were as follows:
Notes payable to banks, lines of credit and other includes deposits associated with HP's banking-related activities of approximately $343 million and $355 million at April 30, 2012 and October 31, 2011, respectively. 30
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 11: Borrowings (Continued) Long-term debt was as follows:
31
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 11: Borrowings (Continued)
32
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 11: Borrowings (Continued)
As disclosed in Note 8 to the Consolidated Condensed Financial Statements, HP uses interest rate swaps to mitigate the market risk exposures in connection with certain fixed interest global notes to achieve primarily U.S. dollar LIBOR-based floating interest expense. The interest rates in the table above have not been adjusted to reflect the impact of any interest rate swaps. HP may redeem some or all of the Global Notes set forth in the above table at any time at the redemption prices described in the prospectus supplements relating thereto. The Global Notes are senior unsecured debt. In May 2009, HP filed a shelf registration statement (the "2009 Shelf Registration Statement") with the SEC to enable the company to offer for sale, from time to time, in one or more offerings, an unspecified amount of debt securities, common stock, preferred stock, depositary shares and warrants. The 2009 Shelf Registration Statement replaced other registration statements filed in March 2002 and May 2006. HP's Board of Directors has approved a $16.0 billion U.S. commercial paper program. HP's subsidiaries are authorized to issue up to an additional $1.0 billion of commercial paper, of which $500 million of capacity was available as of April 30, 2012 to be used by Hewlett-Packard International Bank PLC, a wholly-owned subsidiary of HP, for its Euro Commercial Paper/Certificate of Deposit Programme. HP has a $3.0 billion five-year credit facility that expires in March 2017 and a $4.5 billion four-year credit facility that expires in February 2015. Commitment fees, interest rates and other terms of borrowing under the credit facilities vary based on HP's external credit ratings. The credit facilities are senior unsecured committed borrowing arrangements primarily to support the issuance of U.S. commercial paper. HP's ability to have a U.S. commercial paper outstanding balance that exceeds the $7.5 billion supported by these credit facilities is subject to a number of factors, including liquidity conditions and business performance. Within Other, including capital lease obligations, are borrowings that are collateralized by certain financing receivable assets. As of April 30, 2012, the carrying value of the assets approximated the carrying value of the borrowings of $215 million. 33
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 11: Borrowings (Continued) As of April 30, 2012, HP had the capacity to issue an unspecified amount of additional debt securities, common stock, preferred stock, depositary shares and warrants under the 2009 Shelf Registration Statement. As of that date, HP also had up to approximately $17.5 billion of available borrowing resources, including $16.2 billion under its commercial paper programs and approximately $1.3 billion relating to uncommitted lines of credit. Note 12: Income Taxes HP's effective tax rate was 19.5% and 20.3% for the three months ended April 30, 2012 and April 30, 2011, respectively, and 19.5% and 20.7% for the six months ended April 30, 2012 and April 30, 2011, respectively. HP's effective tax rate decreased due to an increase in the percentage of total earnings earned in lower-tax jurisdictions. HP's effective tax rate generally differs from the U.S. federal statutory rate of 35% due to favorable tax rates associated with certain earnings from HP's operations in lower-tax jurisdictions throughout the world. HP has not provided U.S. taxes for all of such earnings because HP plans to reinvest some of those earnings indefinitely outside the United States. In the three and six months ended April 30, 2012, HP recorded discrete items with a net tax benefit of $25 million and $74 million, respectively, decreasing the effective tax rate. These amounts included net tax benefits of $22 million and $50 million, respectively, from restructuring and acquisition charges, and other miscellaneous tax benefits of $3 million and $24 million, respectively. In the three and six months ended April 30, 2011, HP recorded discrete items with a net tax benefit of $56 million and $157 million, respectively. These amounts included net tax benefits of $53 million and $112 million, respectively, from restructuring and acquisition charges. In addition, in December 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 was signed into law. HP recorded a tax benefit of $43 million arising from the retroactive research and development credit provided by that legislation in the first quarter of fiscal 2011. As of April 30, 2012, the amount of gross unrecognized tax benefits was $2.4 billion, of which up to $1.1 billion would affect HP's effective tax rate if realized. HP recognizes interest income from favorable settlements and income tax receivables and interest expense and penalties accrued on unrecognized tax benefits within income tax expense. As of April 30, 2012, HP had accrued a net payable of $186 million for interest and penalties. In the three and six months ended April 30, 2012, HP recognized $4 million of net interest expense on net tax underpayments, net of tax, and $19 million of net interest income on tax overpayments, net of tax, respectively. HP engages in continuous discussion and negotiation with taxing authorities regarding tax matters in various jurisdictions. HP does not expect complete resolution of any Internal Revenue Service ("IRS") audit cycle within the next 12 months. However, it is reasonably possible that certain federal, foreign and state tax issues may be concluded in the next 12 months, including issues involving transfer pricing and other matters. Accordingly, HP believes it is reasonably possible that its existing unrecognized tax benefits may be reduced by an amount up to $297 million within the next 12 months. HP is subject to income tax in the United States and approximately 80 foreign countries and is subject to routine corporate income tax audits in many of these jurisdictions. In addition, HP is subject to numerous ongoing audits by state and foreign tax authorities. The IRS began an audit of HP's 2008 34
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 12: Income Taxes (Continued) income tax returns in 2010 and began its audit of HP's 2009 income tax returns during 2011. HP has received from the IRS Notices of Deficiency for its fiscal 1999, 2000, 2003, 2004 and 2005 tax years, and Revenue Agent's Reports ("RAR") for its fiscal 2001, 2002, 2006, 2007 and 2008 tax years. The proposed IRS adjustments for these tax years would, if sustained, reduce the benefits of tax refund claims HP has filed for net operating loss carrybacks to earlier fiscal years and tax credit carryforwards to subsequent years by approximately $626 million. HP has filed petitions with the United States Tax Court regarding certain proposed IRS adjustments regarding tax years 1999 through 2003 and is continuing to contest additional adjustments proposed by the IRS for other tax years. The United States Tax Court has recently ruled against HP regarding one of the IRS adjustments. HP currently intends to appeal the decision. HP believes that it has provided adequate reserves for any tax deficiencies or reductions in tax benefits that could result from the IRS actions. With respect to major foreign and state tax jurisdictions, HP is no longer subject to tax authority examinations for years prior to 1999. HP believes that adequate accruals have been provided for all open tax years. Tax years of EDS through 2002 have been audited by the IRS, and all proposed adjustments have been resolved. EDS has received RAR's for exam years 2003, 2004, 2005, 2006, 2007 and the short period ended August 26, 2008, proposing total tax deficiencies of $320 million. HP is contesting certain issues and believes it has provided adequate reserves for any tax deficiencies or reductions in tax benefits that could result from the IRS actions. The IRS began an audit of HP's U.S. group of subsidiaries providing enterprise services, for its 2008 and 2009 income tax return in 2010 and 2011, respectively. That group of subsidiaries has received an RAR for the short period ended October 31, 2008 proposing a total tax deficiency of $17 million. HP is contesting certain issues and believes it has provided adequate reserves for any tax deficiencies or reductions in tax benefits that could result from the IRS actions. The breakdown between current and long-term deferred tax assets and deferred tax liabilities was as follows:
Note 13: Stockholders' Equity HP's share repurchase program authorizes both open market and private repurchase transactions. In the three and six months ended April 30, 2012, HP executed share repurchases of 13 million shares and 43 million shares, respectively. For the three months ended April 30, 2012, repurchases of 13 million shares were settled for $350 million. For the six months ended April 30, 2012, repurchases of 35
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 13: Stockholders' Equity (Continued) 43 million shares were settled for $1.1 billion. HP had approximately 1 million shares repurchased in the second quarter of fiscal 2012 that will be settled in the third quarter of fiscal 2012. HP paid approximately $2.7 billion in connection with repurchases of approximately 63 million shares during the three months ended April 30, 2011 and paid approximately $5.0 billion in connection with repurchases of approximately 117 million shares in the first six months of fiscal 2011. As of April 30, 2012, HP had remaining authorization of $9.7 billion for future share repurchases. The changes in the components of other comprehensive income ("OCI"), net of taxes, were as follows:
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Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 13: Stockholders' Equity (Continued)
The components of accumulated other comprehensive loss, net of taxes, were as follows:
37
Notes to Consolidated Condensed Financial Statements (Continued) (Unaudited) Note 14: Retirement and Post-Retirement Benefit Plans HP's net pension and post-retirement benefit costs were as follows:
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