Notes and Analysis from HPE’s 2019 Securities Analyst Meeting

At its 2019 Securities Analyst meeting (SAM) held in New York City on October 23, the senior management of Hewlett Packard Enterprise (HPE) said that the company was poised to enter the third phase of its evolution: pivoting to sustainable, profitable growth.

Since it was spun-off from HP, Inc. in November 2015, HPE has completed the first two phases of its evolution.  Phase 1 was focusing the business.  This was achieved by spinning off its Enterprise Services and Software businesses and divesting other non-core assets to focus on its core hybrid IT, intelligent edge and financial services businesses.

Phase 2 of HPE’s Evolution.  HPE is now nearing the end of Phase 2 of its evolution: refining the foundational vision. For nearly the past three years, the company has concentrated on reducing operating costs, improving organizational flexibility and strengthening its product and service offerings. 

Over the past two fiscal years, under its HPE Next restructuring initiative, HPE has streamlined its  business operations by reducing its direct sales presence in 74 countries (from 150 to 76), consolidating manufacturing and services support locations and IT systems, eliminating 3-4 layers of management and streamlining its product offerings and sales compensation packages.

Restructuring was the main cost component of HPE Next.  By my estimates, HPE Next has incurred $1.1 billion of net costs to date, including $1.5 billion of costs partially offset by $0.4 billion of gains on the sale of real estate.  The largest cost component has been $970 million of restructuring charges, mostly for employee severance.  Based upon its previous estimates which have been updated as of July 31, 2019, HPE anticipates that total restructuring costs under the program will be $1.38 billion; so it still intends to incur $410 million of additional charges from July 31, 2019 through October 31, 2020, the end of fiscal 2020, which is the targeted completion date for the program.

Besides the significant costs associated with HPE Next, HPE has broadened and deepened its product and services portfolio through organic investments, strategic partnerships and targeted acquisitions. 

Service offerings that have been developed or scaled organically (sometimes after an acquisition) include HPE Simplivity (hyperconverged infrastructure: storage, computing and networking), HPE Greenlake (workload processing delivered as-a-service), HPE Infosight (advanced analytics and machine learning) and HPE Primera (intelligent storage for mission critical applications), among others.

Strategic partnerships have been forged with cloud and managed service providers (e.g. Microsoft Azure, Rackspace and Google Cloud), software firms (e.g. Microsoft, VMWare, Red Hat and SAP), consulting firms (e.g. Accenture, Deloitte and Infosys), back-up and storage providers (e.g. Cohesity, Veeam and Nutanix), application developers/platform providers (e.g. PubNub, Weka.io and Pensando) and digital industrial solutions providers (e.g. ABB, Schneider Electric and PTC).

Recent acquisitions have helped HPE expand its capabilities in strategically important areas, including artificial intelligence/big data/machine learning, intelligent edge and cloud computing offerings.  They include QuattroLabs, a cloud-based data center management as-a-service (AAS) provider; BlueData, whose software platform utilizes Docker Container technology; Cape Networks, which provides a sensor-based service assurance solution for measuring and monitoring Software AAS (SAAS) applications and network services; (the assets of) MAPR, a data platform for artificial intelligence (AI) and analytics applications that utilize scale out, multi-cloud and multi-protocol file system technology; Plexxi, a provider of data center software-defined networking solutions and Red Pixie, a cloud services and software provider for Microsoft’s Azure cloud.

In September 2019, HPE completed the purchase of Cray, Inc. for $1.4 billion, its largest acquisition to date.  Cray provides high-end supercomputing solutions designed to handle data-intensive workloads.  It is a leader in exascale systems, which are capable of at least one billion calculations per second (i.e. one exaflops).  The acquisition bolsters HPE’s high performance computing (HPC) portfolio, a key component of its growth strategy.

With the rapid growth in internet-connected devices and information systems, demand for applications such as AI, machine learning and big data analytics that provide customers with insights from huge data sets is expected to grow (by about 9% per year through 2021, according to sources cited by HPE).  HPE has expanded its portfolio of HPC products and services significantly in recent years through organic investment and acquisitions.

As a market leader in HPC, HPE offers customers greater flexibility and choice, as well as superior performance.  It offers high touch service and support.  It also has sufficient scale in R&D to create innovative products and solutions.  Over time, HPE is aiming to offer HPC-as-a-service and AI and machine learning analytics through HPE GreenLake.

Growth Trends.  With the proliferation of internet connected devices, including the Internet of Things (IoT) for industrial applications, computing at the edge (i.e. closer to the location of the internet-connected devices) will see continued rapid growth in the years ahead.  The demand for computational and data storage capacity at the network edge along with the ability to move data from the edge seamlessly, rapidly and securely through corporate data centers to users of the data (to monitor equipment performance and gain insights from product usage) will continue to grow rapidly in the years ahead.  IDC has predicted that 55 billion devices will eventually be connected to the internet worldwide.  Gartner says that 75% of all data will eventually be created at the edge, outside of traditional data centers and the cloud.  HPE sees its ability to offer users a complete set of products and services from the edge to the cloud as a major market opportunity.

Digging deeper to see how this opportunity is being operationalized, HPE has the following observations:  The IT market is increasingly hybrid, built on a combination of on-premises capabilities and public and private clouds.  The rapid growth of edge devices is enabling new customer experiences.  Data, as already noted, is migrating to the edge and increasingly drawing computational workloads there as well (to process the data in some form before sending it on).  Applications are increasingly being deployed in containers (which have all the resources necessary to run the software efficiently in various locations).  More and more, applications are also workload optimized (i.e. with the optimal mix of compute, storage and network resources) and vertically integrated.  On top of this, consumption-based models (rather than outright purchases of equipment, software and services) are emerging as the preferred option of customers.  For HPE, these trends are compelling and validate its vision of the evolution of the IT infrastructure and platform software market.   

Focus on Higher Value-Added.  A key aspect of HPE’s strategy has been to discontinue its offerings of low margin, commodity-like products, like standardized, low cost Tier 1 servers, and focus instead on higher value-added products and services.  At the same time, it has been following the playbooks of other technology companies by emphasizing sales of services and solutions that create a more subscription- or annuity-like revenue stream.  At its Discover 2019 conference, HPE announced its plan to offer its entire portfolio “as-a-service” by 2022.

The movement to “as-a-service” gives customers flexibility and choice in their use of IT services.  It also helps them maximize their return on investment.  Before committing to significant investments in infrastructure and solutions, customers can utilize IT AAS to test and refine configurations to arrive at their optimal hybrid IT configurations (i.e. their ideal combination of on-premises equipment and public and private cloud infrastructure).  As-a-service offerings can also help customers meet temporary needs without having to make large upfront investments.

HPE anticipates, with the help of IDC and Gartner, that total worldwide spending on IT infrastructure and platform software will increase from $627 billion in 2019 to $787 billion in 2022 or at a compounded annual rate of 7.9%.  The “as-a-service” portion of this category is expected to grow from $288 billion (or 46% of the total) to $460 billion (61% of the total), or at a 16.9% compounded annual rate over this same time frame.

HPE expects growth in its AAS-related revenues to exceed the growth of the overall market.  It anticipates that the fiscal 2019 fourth quarter run rate of AAS revenues to be approximately $460-$470 million, or roughly 1.5% of total revenues, with an annualized growth rate of 30%-40% at least through fiscal 2022.

HPE Financial Services will play a key role in determining the rate of revenue growth, since AAS will essentially be offered as leases.  Whether customers opt for finance-type or operating lease structures for their AAS commitments will impact revenues and revenue growth.  (Finance leases generate higher revenue because they typically include interest and a higher principal component.)

While this growth is impressive, it is important to note that a significant portion of the AAS revenues will be replacing sales of traditional IT infrastructure and services.  HPE has not said what it expects net growth to be.  However, its companywide financial model – which anticipates total revenue growth of 1%-3% through fiscal 2022 (up from 0%-1% two years ago), implicitly assumes that revenues in key growth areas, like HPC, AI and AAS, will be substantially but not entirely offset by declines in other areas.  At the same time, operating margins should improve because the growth businesses are higher value-added.

Help from Financial Services.  With the expansion of its offerings of IT infrastructure and solutions, HPE has a broad product portfolio and a wide range of solutions to assist customers in achieving their objectives.  Once they determine their optimal IT configurations, HPE Financial Services is there to customize financial packages that best meet customer needs.  Its offerings include leasing, financing, capacity and consumption pricing and asset management services.  It offers a wide array of investment solutions for large enterprise customers and channel partners that give them greater flexibility in managing the cost of their IT purchases.  It also offers a variety of financing options for governments, educational institutions and small and medium business enterprises.  HPE views its Financial Services capabilities as a strategic advantage that will play an increasingly important role in winning new business in the future. 

Phase 3: Pivoting to Sustainable, Profitable Growth.  With the benefits flowing from HPE Next and the evolution of the company’s product and service offerings, HPE has been positioning its businesses for a sustained improvement in profitability.  Through HPE Next, the company has achieved $800 million in annual cost savings ahead of schedule.  Lower costs and the shift to a more profitable product mix have produced steady gains in non-GAAP operating profits.

HPE’s non-GAAP earnings per share from continuing operations improved from $0.96 in fiscal 2017 to $1.56 in fiscal 2018 and is expected to be within the range of $1.72-$1.76 in fiscal 2019 (which ended on October 31).  Management has raised its outlook for non-GAAP continuing earnings now for seven consecutive quarters.  For fiscal 2020, it anticipates non-GAAP EPS of $1.78-$1.94, which at the midpoint of the ranges would be up 7% over fiscal 2019.

Management says that an increase in gross margin has led the advance in non-GAAP earnings.  This has been achieved, as noted, through cost cutting and the shift to a higher value-added product mix, but also from an easing of input costs, such as DRAM prices.  HPE anticipates a fiscal 2019 gross margin of 32.5%-33.0%, up from 30.0% in fiscal 2017.

Higher gross margin has in turn driven an increase in non-GAAP operating profit.  Management anticipates fiscal 2019 non-GAAP operating profit of $2.7 billion, up from $2.2 billion in 2017.

Likewise, HPE has seen improvement in free cash flow generation.  Its free cash flow (which I define as cash flow from operating activities plus cash used in investing activities excluding acquisitions) swung from negative $1.1 billion in fiscal 2017 to positive $1.1 billion in fiscal 2018 and is expected to be between $1.4 billion and $1.6 billion in fiscal 2019.  For fiscal 2020, management anticipates free cash flow of $1.9 billion to $2.1 billion.  Beyond fiscal 2020, management expects that free cash flow will grow commensurately with earnings.

Although free cash flow is itself a non-GAAP measure, it does include the cash impact of the unusual or non-recurring items that are excluded in the determination of non-GAAP earnings.   As such, it is a measure that is akin to GAAP.

Accordingly, while the steady improvement in free cash flow is encouraging, it is also important to dig deeper into the causes of the improvement in free cash flow to determine whether they are indicative of improvement in operating performance or from temporary sources.

The swing in free cash flow from negative $1.1 billion in fiscal 2017 to positive $1.1 billion in fiscal 2018 was due about half to improvements in profitability and most of the remainder to tax-related items, including the net impact tax indemnification adjustments associated with the tax agreement between HPE and its former parent, HP, Inc.  The year-to-date fiscal 2019 improvements in free cash flow appear to be due mostly to non-operating items, except that profitability was negatively impacted from the one-time arbitration award of $666 million to DXC Technology, associated with the spin-off of HPE’s former Enterprise Services business and subsequent merger with Computer Science Corporation.  While some of the free cash flow improvements for the remainder of fiscal 2019 and beyond may be due in part to working capital adjustments, HPE’s guidance anticipates that they will be due mostly to increases in its profitability.

On top of its fiscal 2019 and fiscal 2020 guidance, HPE offers a financial model that highlights its targets through the end of fiscal 2022. The financial model anticipates revenue growth of 1%-3%, non-GAAP operating profit growth of 5%-7% and non-GAAP EPS growth of 7%-9%. The faster rate of EPS growth is driven by expected share buybacks.

HPE also intends to grow free cash flow in line with earnings and to distribute 50%-70% of free cash flow to shareholders in the form of dividends and share buybacks.  

GAAP vs. non-GAAP earnings.  Despite the steady improvements in non-GAAP earnings, HPE’s GAAP earnings show no discernible trend.  GAAP earnings were $0.26 in fiscal 2017, $1.35 in fiscal 2018 and are expected to be between $0.65 and $0.69 in fiscal 2019.  For fiscal 2020, management anticipates GAAP earnings of $1.01 to $1.17.

Unlike non-GAAP earnings, HPE’s GAAP earnings fell short of guidance in fiscal 2018, due primarily to the impact of tax reform, and its GAAP earnings guidance was cut in the fiscal 2019 third quarter, due to the impact of the DXC arbitration award.

The difference between management’s fiscal 2020 GAAP and non-GAAP EPS guidance is $0.77 per share, down from $1.07 expected for fiscal 2019.  If all of the remaining $410 in HPE Next-related restructuring costs are incurred in fiscal 2020, that would account for about $0.30 of the GAAP-non-GAAP difference.  Another $0.20 or so will come from amortization of intangible costs.  The remaining $0.27 will likely come from some combination of acquisition costs, tax effects, non-operating pension costs or other items.

Importantly, HPE management says that it does not anticipate a successor program to HPE Next after the initiative is completed at the end of fiscal 2020.  Consequently, barring any more surprises, like the DXC arbitration award, the difference between GAAP and non-GAAP earnings should shrink.  For a short time at least, the growth in GAAP earnings should therefore exceed the growth in non-GAAP earnings.  According to HPE’s financial model, this suggests that GAAP EPS should grow at faster than the 7%-9% targeted rate for non-GAAP earnings growth.

Competition and the Economy.  A continuing tough competitive environment and the possibility of a global economic slowdown are the primary risks to HPE’s 2020 guidance and longer-term financial model.  There is little doubt that HPE improved its competitive position with the changes that it has made to its product portfolio and streamlining its operations, but the competition is not standing still.  Competition is increasingly global and includes major Chinese and Japanese companies, as well as a formidable array of U.S. competitors across all products and services.

So far, concerns about a weakening global economy, due in large part to heightened trade tensions, have not had much impact on HPE’s financial performance.  Recently, there has been increased optimism about the prospects for improved global economic growth as a result of at least a preliminary resolution to the U.S.-China trade dispute.  Nevertheless, it seems unlikely that all trade tensions will fall by the wayside.  A weaker global economic outlook could cause many companies to delay or even cancel their plans for upgrading the IT infrastructure or expanding capacity.

Recent share price performance.  Since the beginning of calendar 2018, HPE’s share price has outperformed both the S&P 500 and the Dow Jones U.S. Computer Services index.  From the beginning of 2018 to November 1 of this year, HPE shares have advanced 14.9% vs. 14.7% for the S&P and 3.0% for the DJ U.S. Computer Services index.  Year-to-date for 2019, HPE is up 24.9% vs. 22.3% for the S&P and 19.7% for the Computer Services index.

Despite the year-to-date outperformance, HPE’s stock has had a wild ride this year, rising from around $13 at the beginning of the year to nearly $17 in February and then falling to a low of $12.50 in August (following the 19Q3 earnings release, which included the DXC charge.  Since the end of August, the stock has rebounded back to around $16.50, helped by an analyst upgrade prior to the 2019 SAM.    

Market signals and valuation.  Despite the persistence of the GAAP-non-GAAP gap, the solid relative performance of HPE shares over the past 22 months suggests that market has given HPE some (but not much) credit for the steady improvement in non-GAAP earnings.  Its one-year forward multiple has improved slightly from 8.9 times at the beginning of 2019 to 9.0 times currently, despite the decline in fiscal 2019 GAAP EPS guidance.

The stock still trades at a significant discount to its peer group (which includes, according to my definition, CSCO, EXTR, GOOG, IBM, JNPR, NTAP, NTNX, ORCL, PSTG and VMW).  Excluding GOOG and VMW, whose stocks trade at relatively high forward multiples, I calculate the peer group average forward multiple at roughly 15 times anticipated 2019 and projected 2020 earnings.

In my view, investors would likely pay a higher multiple for HPE’s stock, if HPE is able to narrow the difference between its GAAP and non-GAAP earnings.  With the expected completion of HPE Next in fiscal 2020, I think that is a distinct possibility, but the market reaction to the DXC arbitration award – a non-GAAP item – suggests that investors are still on edge about the possibility of future one-time or non-recurring surprises.  Still, if HPE avoids those surprises and narrows the difference between its non-GAAP earnings, it is not unreasonable to think that its stock’s valuation multiple could approach the peer group average, which gives the stock upside potential to the mid-$20s from the current quote and earnings base.

Even if it is not able to reduce the impact of non-GAAP adjustments, however, HPE’s financial model suggests that the stock should be able to deliver low double-digit returns, around 11%, consisting of the 7%-9% non-GAAP earnings growth plus the dividend yield of 2.7%, as long as there is no deterioration in the stock’s forward valuation multiple.

November 4, 2019

Stephen P. Percoco
Lark Research
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Linden, New Jersey 07036
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