Despite Progress, HPE’s Shares Struggle

Hewlett Packard Enterprise Co. (HPE) has reported solid progress on its strategic initiatives, including streamlining its worldwide operations (under its HPE Next program), emphasizing value vs. volume and targeting high growth market segments, such as the intelligent edge and high performance computing. The company posted fiscal 2018 revenue growth of 6.9%, GAAP EPS of $1.23 (up nearly six-fold) and non-GAAP EPS of $1.56, up 10.6%. It also bought back $3.6 billion of its shares and raised its dividend by 50%.

Despite this progress, however, its shares delivered a total return of -7.2% in 2018, worse than the S&P’s -4.9%. On price alone, HPE shares fell 9.6% in 2018, worse than the S&P 500’s 6.7% decline and the Dow Jones U.S. Software and Services Index’s gain of 1.7%. With that decline, HPE’s stock is valued at just 8.9 times projected 2019 non-GAAP earnings of $1.56 and 17.7 times projected 2019 GAAP earnings of $0.77. The difference between projected GAAP and non-GAAP earnings is most likely one of the contributing factors to HPE stock’s poor relative performance.

Before digging deeper into HPE’s valuation, let’s review the company’s achievements over the past few years.

Since its separation from HP, Inc. (HPQ) in 2015, HPE has spun off two major business segments. In April 2017, its Enterprise Services business merged with Computer Sciences Corporation to form DXC Technology Company (DXC). In September 2017, its Software Business was acquired by Micro Focus International plc (MFGP).

Since then, HPE has been implementing HPE Next to simplify its operating model and improve its execution and flexibility. Under HPE Next, the company is reducing the number of countries in which it has a direct sales presence from 150 to 76. It is also consolidating manufacturing and sales locations. In 2018, it reduced its product platforms and SKUs by 75%, eliminated three layers of management, reduced the number of sales compensation programs by more than 90% and began consolidating its various IT systems. These changes will help the company continue to shift its investments toward higher growth and higher margin products and services.

HPE Next will not be complete until (the end of) fiscal 2020. So far, the company has incurred $0.789 billion of net charges (“transformation costs”) associated with the initiative, including $1.22 billion of management, restructuring and other costs, offset in part by $433 million of gains on real estate sales. (These transformation costs account for roughly half of the non-GAAP adjustments that HPE has made over the past two fiscal years.) After a complete review of HPE Next by the HPE’s Board of Directors in September, the company now estimates that it will incur $1.4 billion in total charges (I assume net of gains or losses on real estate sales) through the program’s completion in fiscal 2020.

Although HPE Next is still a work in process, HPE has demonstrated improvement in its financial performance. For example, its non-GAAP earnings from operations (i.e. operating earnings before unusual items) and non-GAAP operating margin both increased in fiscal 2018 from fiscal 2017 levels, as shown in the chart below:

At its 2018 Securities Analyst Meeting, held in October, management provided guidance for HPE’s fiscal 2019 performance. It expects GAAP diluted EPS of $0.73-$0.82, down from $1.23 in fiscal 2018 and non-GAAP diluted EPS of $1.51-$1.61, which at the midpoint of the range, would be up 7.6% from adjusted non-GAAP EPS of $1.45 in fiscal 2018.

(HPE’s fiscal 2018 non-GAAP diluted EPS was originally reported to be $1.56. However, the company now intends include in its non-GAAP adjustments non-service pension costs (aka non-operating pension costs) on a go-forward basis. These costs (including the related tax effect), totaled $0.08 in fiscal 2018. In addition, HPE is increasing its structural tax rate for non-GAAP reporting purposes from 11% in fiscal 2018 to 13% in fiscal 2019. The change represents a $0.03 per share adjustment to fiscal 2018 non-GAAP EPS. Thus, HPE’s revised fiscal 2018 non-GAAP EPS, adjusted for pensions and taxes is $1.45.)

There are three factors, I believe, that are contributing to the underperformance of HPE’s shares: (1) The continuing wide difference between its GAAP and Non-GAAP EPS, (2) Large and complex fiscal 2018 tax adjustments; and (3) Market skepticism about the company’s ability to generate sustainable growth in revenues and earnings.

Non-GAAP Reporting. The first, as highlighted above, is the company’s non-GAAP reporting. HPE’s non-GAAP adjustments are large and multifaceted. There are nine separate line items included in these adjustments. Obviously, there is merit to them, given the complexity of the company’s transformation over the past few years, including the two spin-offs, HPE Next related charges and acquisitions made to strengthen the company’s portfolio in key growth areas. However, the wide difference between HPE’s reported GAAP and non-GAAP earnings was expected to be temporary and it has continued longer than I (and I believe other analysts who follow the company) originally thought.

Fiscal 2018 Tax Adjustments. In fiscal 2018, HPE’s non-GAAP adjustments also included tax-related items associated with HPE’s separation from HP, Inc., the spin-offs and the Tax Cut and Jobs Act. These tax-related adjustments are the second factor that I believe has contributed to HPE’s most recent share price underperformance.

The adjustments associated with the settlement of pre-separation tax liabilities between HP and HPE, Inc. are especially confusing. To begin with, HPE recorded a $1.4 billion (pre-tax) “tax indemnification” expense (as those pre-separation tax liabilities apparently came due in fiscal 2018) and an offsetting $2.0 billion tax benefit related to the settlement with HPE, Inc.

Since its financial statements were audited, there should be little doubt that the accounting for the settlement is correct; but it certainly seems like the two items should have been netted out in the income statement, instead of being reported as two separate line items. The classification of the tax indemnification as an expense does not seem quite right because HPE is the party who was indemnified. Largely as a result of the accounting for this tax settlement, HPE’s fiscal 2018 pre-tax income was reduced by $1.4 billion and its effective tax rate was -650.7%.

The accounting for the impact of the Tax Cuts and Jobs Act (TCJA) also generated some big numbers with a smaller net effect on HPE’s fiscal 2018 results. Besides lowering HPE’s statutory tax rate to 23.3% (21.0% for fiscal 2019 and beyond), the company recorded a provisional estimate of $1.7 billion of income tax expense on deferred foreign income not previously subject to U.S. tax. It also booked a $1.7 billion net expense related to the remeasurement of deferred tax assets and liabilities; but these two items were mostly offset by a $3.7 billion tax benefit related to the reversal of previous deferred tax recognized on foreign earnings and profits. Related perhaps to this reversal was the booking of a large deferred tax loss carryforward associated with its international operations and a corresponding (and offsetting) increase in the valuation allowance. Finally, HPE increased its deferred tax allowance by nearly $700 million against its U.S. deferred tax assets as a contingency against future effects of the TCJA.

Components of Fiscal 2019 Non-GAAP Adjustments. These non-GAAP tax adjustments will presumably not be repeated going forward. Nevertheless, the company does anticipate that the difference between its GAAP and non-GAAP earnings will increase in fiscal 2019. Most of the increase is due to transformation costs associated with HPE Next. The rest is due to amortization of intangible assets (booked on recent acquisitions) and an expected adjustment in earnings from equity method investments.

The difference between management’s guidance for fiscal 2019 GAAP and non-GAAP EPS amounts to roughly $0.78 at the midpoint of the ranges. Amortization of intangible assets, according to HPE’s disclosures, has been running at about $0.19 per share pre-tax (or an estimated $0.17 per share after-tax at an assumed tax rate of 13%).

That leaves roughly $0.62 per share for HPE Next and the earnings adjustment from its equity method investment. HPE has disclosed that it expects to spend $500 million or an estimated $0.32 per share (at the assumed 13% tax rate) on restructuring in fiscal 2019. As noted above, HPE has disclosed that it currently expects aggregate costs of $1.4 billion for the HPE Next Program. Since it has spent $784 million on HPE Next to date, that leaves an estimated $616 million, including I assume the $500 million for fiscal 2019 and $116 million for fiscal 2020.

Adjustment to Earnings from Equity Method Investments. Excluding the $0.17 per share for amortization of intangible assets and $0.32 per share for HPE Next, the remaining $0.29 difference between the company’s fiscal 2019 GAAP and non-GAAP EPS guidance is attributable to the equity method investment’s earnings adjustment. An adjustment this large – I estimate it to be $450 million pre-tax – would most likely be attributable to some type of asset write-down, probably goodwill.

HPE’s equity method investment consists primarily of its 49% equity interest in “new” H3C Technologies. In 2016, HPE sold a 51% stake in H3C and its China-based server, storage and technology services business to Tsinghua Holdings Co., Ltd. Upon the sale, it recorded as an asset the $2.5 billion difference between the carrying value of its investment and its proportionate interest in the net assets of new H3C, $2.42 billion of which was classified as goodwill and intangibles. Although HPE has received small cash distributions from H3C, it has posted mostly small losses on its equity method investments over the past three years. It would not be surprising therefore to see the company record a partial write-down on the carrying value of this investment.

The Importance of the GAAP-Non-GAAP Gap. The persistent difference between HPE’s GAAP and non-GAAP earnings is of appropriate concern to investors. The non-GAAP earnings tell us what the company would earn, if and when the unusual items go away. Investors should not be willing to pay full price today for earnings that will be achieved in the future. These unusual charges (mostly restructuring charges) would not be ignored in a discounted cash flow valuation. In its disclaimer language at the end of every earnings press release, HPE acknowledges that it relies primarily on its GAAP results and uses the non-GAAP financial measures only as a supplement.

While the large difference between GAAP and non-GAAP results is understandable in light of the company’s significant transformation over the past few years, that difference should shrink over time, as the expenses associated with remaking the company go away. After the completion of the sale of the Software business and the adoption of the HPE Next program in September 2017, I had expected that these restructuring and transformation charge would begin to trail off by the end of fiscal 2018. In September 2018, however, HPE’s Board of Directors approved another round of restructuring under HPE Next that would result in an additional estimated $616 million in charges through fiscal 2020 (and $1.4 billion in total charges). My analysis, as given above, suggests that most of this remaining cost will be incurred in fiscal 2019.

If HPE’s forward price-to-GAAP earnings ratio is a more appropriate measure today (as I think it is), then the stock seems fairly priced at 17.7 times expected GAAP earnings of $0.78 (at the midpoint of the range). However, the stock is also valued at 8.9 times projected fiscal 2019 non-GAAP earnings of $1.56, which does seem cheap, given that the bulk of the non-GAAP adjustments should go away in fiscal 2020. If indeed the HPE Next program will end in fiscal 2020 and there are no more unusual charges going forward, I would expect that HPE’s stock will benefit from an expansion of its forward multiple during the course of fiscal 2019, as the company confirms that it plans are on track and gives clearer signals about what to expect in fiscal 2020 and beyond.

Market Skepticism About HPE’s Future Performance. Consequently, that low forward non-GAAP P/E multiple must also reflect skepticism about whether the company can deliver on its vision of HPE Next and achieve a sustainable, if only modest, rate of growth in revenues and earnings going forward.

HPE started life as an independent company in 2015 with a base of business that was centered around mature products and services, such as servers, storage and computer services. Although it has made strides in investing in niche businesses that offer superior growth potential – such as the intelligent edge, hybrid IT (and its offshoots like hyperconverged infrastructure) – it still derives a significant portion of its revenues and presumably its profits from those legacy businesses. Those businesses are also facing tough competition as the many of these products and services are being increasingly commoditized.

Besides its growth investments, HPE has also sought to emphasize value over volume in its more mature businesses. In fiscal 2017, for example, it said that it would cease selling custom-designed commodity (“Tier 1”) servers, while standardizing certain designs on its higher value Tier 2 and Tier 3 servers. Tier 1 had been providing lots of volume with comparatively little profit margin. Yet, it presumably was contributing to the consolidated company by absorbing overhead. Some investors and analysts questioned whether HPE could make the shift successfully.

For fiscal 2018, however, the company reported that a decline in selling volumes in its Hybrid IT Compute business due to lower Tier 1 sales was more than offset by an increase in average unit prices on other industry standard servers. Tier 1’s share of HPE’s Compute sales has declined from 20% in 2016 to less than 10% currently. Yet, the Hybrid IT business overall posted a 16.7% increase in pre-tax profits in fiscal 2018.

HPE’s Competitive Advantages. HPE still has a lot of work to do to reshape its business to secure its position in an increasingly competitive marketplace. Yet, the company’s customer value proposition gives it a number of competitive advantages. HPE believes that it has (1) the strongest portfolio of enterprise solutions in the industry; (2) an intellectual property portfolio, research and development capabilities and the ability to identify and acquire businesses that are positioned to win in emerging market segments, all of which should help keep it at the forefront of product and service lifecycles; (3) a distribution and partner ecosystem that helps customers implement complex IT solutions worldwide and (4) the ability to craft custom financial solutions to address specific customer needs. One key question that will affect HPE’s ability to deliver in the years ahead will be the duration of the global economic recovery and its effect on the global competitive environment.

The Stock’s Upside Potential. Assuming, however, that the economy will not be an issue in 2019, the question will then be whether HPE can deliver on its fiscal 2019 guidance and also whether its revised HPE Next plan can be completed by fiscal 2020. If it delivers on both, then HPE’s stock should have solid upside potential – as its non-GAAP forward P/E multiple rises toward its current GAAP forward P/E multiple. A move back to 14 times forward non-GAAP earnings with moderate mid- to high- single-digit EPS growth gives the stock a fiscal 2019 year-end target price of about $22-$23 per share.

January 5, 2019

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 975-0250

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