Notes and Analysis from HPE’s Analyst Meeting

Key takeaways:

  • Through its HPE Next transformation plan, HPE will spend $1.1 billion over the next two years to achieve annualized cost cuts of $1.5 billion by the end of 2020. It will reinvest about half of the savings to beef up global sales and marketing efforts.  HPE Next will streamline the company and make it more responsive to customers.
  • HPE’s key strategic emphasis is to accelerate growth by offering high margin services and solutions driven by its innovations in hybrid IT and the intelligent edge.
  • Management offered pro forma non-GAAP EPS guidance of $1.00 for 2017 and $1.15-$1.25 for 2018.
  • Longer term, HPE has set as targets 0%-1% annual revenue growth,4%-5% operating profit growth and 7%-9% EPS growth.
  • At 14.3 times pro forma 2017 EPS and 12.0 times projected 2018 EPS, HPE is cheap to the market and its peer group.

The focus of this year’s analyst meeting for Hewlett Packard Enterprise Company (HPE) was on its plans and outlook for its primary remaining business, Enterprise Group (EG), which offers technology infrastructure and services to optimize enterprise IT systems.  (HPE’s other business, Financial Services, provides customers with flexible IT consumption models and customized investment solutions.  There is some overlap, but Financial Services also has significant business away from EG.)

HPE currently has three strategic pillars:  Hybrid IT (i.e. integrating on-premises and cloud IT capabilities); the Intelligent Edge (beefing up network services for mobile and Internet of Things (IoT) applications; and value-added Services.

HPE Next.  A key component of its plan to “re-architect” the company is HPE Next, which is intended to streamline and simplify the organization and its product offerings, make HPE more responsive to its customers and partners and promote innovation.  Although the company says it started with a “clean sheet,” it has almost certainly built upon the parts of its organization and product portfolio that are working well, while at the same time moving to restructure or jettison those products, services and geographies that have little chance of becoming sufficiently profitable.

HPE will cut its higher volume product offerings (e.g. “white box” unbranded servers and other commodity-like products) from 26+ platforms with 50,000 active configurations to 10 platforms with 10,000 configurations.  It will cut its value product and service offerings from 27 platforms to seven.  Similarly, HPE will reduce its manufacturing base from 17 locations to seven.  In services, it will reduce the number of supported languages from 33 to ten and reorganize its diffused “silo” locations around the world into centralized hubs to promote greater coordination and accountability.  Internally, HPE will reduce its IT applications from about 950 to 350 and its ERP systems from ten to one.

Organizationally, HPE will reduce the number of layers between the CEO and each country head from 6-7 to 3-4.  Large countries will report directly to HPE’s worldwide head of sales.  At the same time, HPE will simplify complex regional organization structures.  Decision-making will be pushed closer to the front lines.  HPE will focus on standardizing solutions for customers and deploying them consistently across its geographic markets.  It will also reduce the number of sales compensation plans from more than 400 to 25 core plans and the number of people eligible for a bonus on a given sales transaction from as many as 30 to only three.

HPE will narrow the number of countries in which it operates from around 111 to 76.  Those 76 countries currently account for 99.5% of revenues.  In countries where it is exiting, HPE will be represented going forward by channel partners.

Across customer and market segments, HPE has ceased selling custom-designed, commodity servers (known as “white box” servers) to its Tier 1 customers (large cloud service providers like Amazon Web Services, Google and Microsoft).  This business had little or no profitability, but did help to cover manufacturing overhead.  For the first nine months of 2017, server revenue from Tier 1 customers fell $956 million or roughly 9% of total server revenue, but gross margins improved.

HPE expects to gain market share with Tier 2/Tier 3 customers by offering standardized SKUs of its Cloudline servers, which utilize open standards and industry standard components that are designed for smaller cloud providers operating in a multi-vendor environment.  With this move, HPE expects to gain share without sacrificing profitability.

HPE will also standardize and reduce SKUs across many of the rest of its product lines, including those offered to Large Corporate/Government and SMB customers.

Through HPE Next, HPE will promote innovation through its large product pipeline.  New offerings are in the works in IT consumption, automation, big data analytics, hybrid IT and intelligent edge solutions.

The financial implications of HPE Next are given in the Financials section below.

Hybrid IT.  HPE is generally recognized as a Hybrid IT leader.  The term refers to the integration of on-premises networks with cloud services, which adds complexity to IT operating environments.  Through its offerings, HPE aims to make hybrid IT simple for its customers, in part by bringing public cloud efficiency and economics to on-premises infrastructure through software-defined intelligence.  Through Project New Stack, HPE will offer a hybrid-as-a-service platform, which gives customers the ability to compose infrastructure, applications and data across cloud environments.

In modular servers and solid-state arrays, HPE is a Gartner Magic Quadrant leader, ranked tops in its industry for completeness of vision and ability to execute.  It is also a leader in Forrester’s rankings of private cloud providers.  Its acquisition of Simplivity this year leapfrogged it into a leadership position in Forrester’s rankings for hyperconverged infrastructure.  Its recent acquisition of Cloud Technology Partners beefs up its capabilities for helping customers move their IT operations to cloud service providers, like Amazon Web Services.

The total addressable market for hybrid IT infrastructure worldwide is projected to grow at a four percent compounded annual rate through 2020.  Certain niches within that market – including high performance computing, hyperconverged infrastructure and all flash array storage – are expected to grow at a combined 14% annual rate over that period.  Hyperconverged’s annual growth rate is pegged at 36%.

HPE has strengthened its position in these faster-growing segments through recent acquisitions.  Besides Simplivity, HPE has acquired SGI, a leader in high performance computing, and Nimble, a leader in all-flash array storage.  Adding these new businesses to its existing capabilities in technology services will make the company a more formidable competitor.

Enterprise IT departments are moving increasingly toward a hybrid IT environment to speed the delivery of new products and services, run their existing operations more efficiently and reduce infrastructure costs.  451 Research has predicted that 40% of IT enterprise customers will soon rely on hybrid IT interoperability.  The road between on-premises infrastructure and the cloud is not a one-way street.  Thirty-four percent of customers surveyed by 451 Research migrated applications back from the public cloud in 2017.  With the growth of IoT, more data will be generated at the network edge.

HPE is addressing the Hybrid IT opportunity by offering a different approach to each of the three market segments: volume, value and growth.  Through its product and service offerings like HPE Pointnext, Project New Stack, and HPE OneView, it is providing advisory services, multi-cloud management and the ability to automate and compose IT services from a single console.  This makes it easier, for example, for customers to create and manage virtual networks; utilize the capabilities of “the Machine,” an HPE supercomputer; manage industrial and transportation equipment in far flung locations, secure additional computational capacity on short notice and reduce IT operating costs.

The Intelligent Edge.  Aruba Networks has been a very successful addition for HPE.  Since its acquisition in 2015, Aruba’s revenues have grown at double-digit rates, due to its differentiated product offerings, “white-glove” customer support and HPE’s global reach.  From the 2016 fourth quarter to the 2017 second quarter, Aruba gained nearly five share points in enterprise wireless local area networks (WLANs) to 20.8%, according to 650 Group; with about two points of market share taken from Cisco’s Meraki, the market leader.

Aruba WLANs utilize an open, multi-vendor architecture that offers integration of wired and wireless networks, embedded location services and best-in-class network access control.  In mobile and IoT applications for the intelligent edge, HPE is augmenting the Aruba platform by beefing up its security architecture and developing software defined wide area network (SD-WAN) capabilities that will offer customers a single control point for Wi-Fi, WANs and switching.  Aruba has been a Gartner Magic Quadrant leader for 11 consecutive years.

So far in 2017 (through the third quarter), Aruba’s WLAN revenues were up 21% and gross margin increased 3%.  Its LAN switching revenues were up 5% and gross margins up 2%.  HPE has not provided actual financial figures on Aruba.  However, networking represents an estimated $2.2 billion or 8% of HPE’s $28 billion of pro forma revenues.  As a guess, Aruba probably accounts for as much as $1.1 billion or up to half of HPE’s networking revenues.

Aruba sees a total addressable market (TAM) of $22 billion of revenues by 2020, including $7 billion for WLAN and $15 billion for LAN switching.  WLAN TAM is growing at 8% per year; while LAN switching TAM is growing at 1%.  Aruba also sees another $6 billion of TAM from adjacencies such as cloud networking, SD-WAN, network security and IoT.

HPE Pointnext is the new brand name for HPE’s technology services business.  Pointnext is therefore the glue that binds HPE’s products and enables specific services tailored to individual customer needs.  HPE Pointnext utilizes the services of 25,000 IT experts in 80 countries. It provides a full range of advisory, professional and operational services.  HPE’s services business regularly earns high marks for customer satisfaction.

In fiscal 2017, HPE Pointnext will generate approximately $7 billion of revenue.  Through the first three quarters of fiscal 2017, its revenue was up 3% over the prior year. Eighty-five percent of its revenue is recurring.

Through Sept. 30, its (proactive) operational orders were up 5%, and advisory and professional service orders rose 12%.  Its services intensity – i.e. service revenue per hardware unit shipped – was up 7% year-to-date.

Through its three-pronged, go-to-market strategy, HPE Pointnext aims to:

1)  grow market share in core operational services, which generate $6 billion or 85% of HPE’s total services revenue, by growing its installed base and winning service contracts on new solutions;

2)  lead with profitable advisory and professional services, especially in hybrid IT, data analytics and the intelligent edge.  Together these three services generate $1 billion in annual revenue, currently growing at 8% annually; and

3)  drive recurring revenue from delivering better client outcomes.  In recent years, HPE has steadily added new service capabilities, such as flexible capacity, infrastructure automation and software defined solutions (e.g. big data-as-a-service, backup-as-a-service, etc.)

Financials.  At the analyst meeting, with only a couple of weeks left to go in its fiscal year (ending October 31), HPE anticipated pro forma revenue growth (i.e. excluding the spin-offs) of 5% and EPS of $1.00.  It expects a free cash burn (i.e. negative free cash flow) of $1.8 billion, including $1.9 million of pension funding related to the Enterprise Services spin-off.  HPE has also returned $3.0 billion during this fiscal year to shareholders in dividends and share buybacks.

Besides the spin-offs, HPE completed $2.0 billion of five acquisitions during the year, including Simplivity and Nimble, reduced its unfunded pension obligations by $2.5 billion, including the $1.9 billion Enterprise Services pension payment, and raised its annual dividend by 18% to $0.26 per share (which equates to a 1.8% dividend yield at the current quote).

After the spin-offs, HPE has $28 billion of pro forma revenues, as previously noted.  About one-third of those revenues and two-thirds of its operating profits are recurring (i.e. service contracts and financial services income).  In Technology Services, HPE is offering new consumption-based pricing models which are generating incremental recurring revenue.  Its lease portfolio has an average term of three years with loss ratios of less than 0.5%.

Management anticipates that HPE Next will generate significant savings at an attractive return on investments.  It is targeting $1.5 billion of gross cost savings over the next three years; but will reinvest $0.8 billion of those savings in marketing investments, operational improvements and research & development to drive top line growth.  HPE Next will require $1.1 billion in cash funding going forward, including $100 million of residual payments associated with the spin-offs and $100 million associated with previously-recorded restructuring charges in fiscal 2018.  The company anticipates that HPE Next-related cash outflows will total $800 million in fiscal 2018 and $300 million in fiscal 2019.

Management sees non-GAAP EPS improving from $1.00 in fiscal 2017 to $1.15-$1.25 in fiscal 2018.  At the midpoints of the respective ranges, it expects that currency will add $0.09 to 2018 EPS, acquisitions $0.045, share count reductions $0.055, and net cost takeout (from stranded costs, fiscal 2017 restructuring and HPE Next) $0.215, for a total improvement of $0.41 per share.  That improvement will be offset by $0.205 of commodities pricing headwinds, including higher DRAM costs.

Management also sees GAAP EPS of $0.43-$0.53 per share in fiscal 2018.  The difference of $0.72 per share between GAAP and non-GAAP EPS primarily relates to transformation costs, amortization of intangible assets and separation costs.  Amortization of intangible costs have been running at an annual rate of roughly $0.25 per share for fiscal 2017.  Assuming a similar run rate in fiscal 2018, transformation and separation costs would be $0.47 per share.  At an assumed marginal tax rate of 28%, pre-tax transformation and separation costs would be just over $1.1 billion for fiscal 2018.  While it is conceivable that HPE could book all estimated HPE Next pre-tax costs in fiscal 2018, it is somewhat surprising that it continues to book separation costs, since the spin-offs are now complete.  I am guessing that separation costs will be at most $250 million ($0.11 per share) in fiscal 2018 and should drop to zero in fiscal 2019.

The gap between fiscal 2018 estimated non-GAAP and GAAP EPS is wide, but management guidance indicates that it will improve meaningfully over fiscal 2017.  Unless HPE makes other significant moves during fiscal 2018, such as major acquisitions or additional divestitures, the non-GAAP – GAAP gap should decline even further in fiscal 2019 as HPE’s organization transformation nears completion.  This narrowing difference between non-GAAP EPS and GAAP EPS should be well received by investors.

Projections.  Management’s fiscal 2018 outlook assumes revenue of $28 billion (adjusted for the loss of Tier 1 business), a non-GAAP operating margin of 9.5%, $300 million of interest and other expenses (including income from equity investments) and a non-GAAP tax rate of 20%-22%.  Assuming fiscal 2019 revenue growth of 5%, an operating margin of 10%, similar interest and other expense and a tax rate of 25%, my EPS projection for fiscal 2019 is $1.32, which is a 10% improvement over the mid-point of management’s non-GAAP EPS outlook for fiscal 2018.  It should be noted that my assumed 0.5% improvement in operating margin translates into pre-tax cost savings of roughly $140 million, which is well below management’s total estimated net cost savings of $700 million for HPE Next (targeted for the end of fiscal 2020).

On a longer-term basis, HPE’s financial model targets revenue growth of 0%-1%, operating profit growth of 4%-5% and EPS growth of 7%-9%.  Cash flow is expected to track earnings.  Capital distributions will be ROI-based and pegged at 75% or more of normalized free cash flow.  Share repurchases will be valuation-based and the company expects meaningful annual increases in its dividend.  While this long-term financial model does seem to fit HPE’s current situation well, it should be noted that the company will not be able to grow EPS at a mid- to high-single-digit rate indefinitely with little or no revenue growth.

Valuation.  At the current quote of $14.28 (10/27), HPE shares are trading at 14.3 times pro form fiscal 2017 EPS of $1.00 and 12.0 times projected 2018 EPS of $1.20.  I estimate that large cap peers – like Brocade (BRCD), Cisco (CSCO), Alphabet (GOOG), IBM, Juniper (JNPR), NetApp (NTAP), Oracle (ORCL) and VM Ware (VMW) – are currently trading at average forward multiples of 16.8 times 2017 EPS and 15.2 times 2018 EPS.  On the other hand, smaller cap computer services companies, like ACI Worldwide (ACI), Accenture (ACN), CACI, Cognizant (CTSH), DST Systems (DST) DXC Technology (DXC), Forrester (FORR), Gartner (IT), SEI Investments (SEIC) and Teradata (TDC) are trading at an average of 24.2 times 2017 EPS and 22.5 times 2018 EPS, according to my calculations.

HPE is obviously cheap relative to both groups.  If the company can achieve much of the net cost savings anticipated under HPE Next and narrow the difference between its non-GAAP and GAAP EPS over the next two years, then I believe that its P/E multiple will increase to its large cap peer levels at first and could go higher, if it can also generate consistent and meaningful revenue growth.  My current price target of $24 per share assumes a valuation multiple of 18 times projected fiscal 2019 earnings of $1.32.

HPE should benefit from management’s complete attention on the Enterprise Group business.  It seems reasonable that the company should be able to achieve the targeted cost savings under HPE Next; but it may have to share some of this savings with customers if the competitive environment remains challenging.  A more focused organization should also allow HPE to capture business from its existing customer base that previously slipped through the cracks.  The company should become an even tougher competitor.

Yet, HPE still generates a considerable portion of its revenues from commodity-like products, including servers (42% of pro forma revenues) and storage (11%).  The company undoubtedly wins a lot of this business by packaging these products with its high value-added technology services.  It should therefore be able to retain a significant portion of this business going forward.

But this legacy business will still be pressured, and its overall revenues will probably be flat at best.  As a result, generating consistent and meaningful topline growth on a consolidated basis will likely prove to be challenging, even with the investments that HPE has made in niche growth businesses with double-digit growth profiles.  This is probably why CEO Meg Whitman said recently that in a Fortune Magazine article (Oct. 1, 2017, p. 90) that HPE may need “a couple more years to sort of prove out the revenue growth thesis.”

Despite the challenges, HPE’s low valuation and decent dividend yield make it an attractive investment.  While valuations across the entire market, and especially in technology, now seem stretched, this is a stock that looks cheap and still has meaningful upside potential.

My previous article on HPE is available here:
HPE’s Transformation Continues with the Seattle Spin-Off

October 27, 2017

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

© Lark Research, Inc.  All rights reserved.  Reproduction without permission is prohibited.

This entry was posted in HPE, Technology and tagged . Bookmark the permalink.