HPE has posted two consecutive quarters of stronger-than-expected results. Although the quarterly figures still lag behind the prior year, the recent strength suggests that its business is rebounding strongly off the bottom. As noted by management, HPE’s business portfolio, which sports beefed-up offerings in cloud services, edge networking and high performance computing (HPC), is well positioned coming out of the pandemic as organizations pursue greater flexibility in their IT operations to improve their ROI and seek a more permanent role for work from home. HPE also appears to be benefiting from a catch up in customer IT spending after pandemic-related delays.
A key question is just how much legs this rebound will have for HPE. We will get another reading on June 1 when the company reports its fiscal 2021 second quarter results. If the momentum continues, investors should become more optimistic about HPE’s future prospects.
In my view, a key issue for HPE investors relates to the difference between its GAAP and non-GAAP earnings, which is greater than that of most companies. Most of the difference is due to transformation costs which HPE is incurring to improve its operating efficiency and enhance its go-to-market efforts. These costs are considered to be temporary, which is why they are excluded from HPE’s calculation of non-GAAP earnings. However, they are significant, totaling $2.9 billion over the past four plus years, with another $670 million or more still to come.
This issue is important for valuation purposes. HPE’s stock trades at a very low multiple of non-GAAP earnings (vs. peers and the broader market), but its GAAP earnings valuation is roughly in line with peers. I believe that investors are focused more on HPE’s GAAP earnings; so its in-line GAAP valuation has served to cap the upside in the stock at $16-$18 in recent years, especially given the company’s modest 1%-3% annual revenue growth outlook. Sustained momentum in the rebound of its quarterly net revenue and earnings could conceivably still help the stock move higher over time; but I believe that the stock will continue to face resistance as long as the wide difference between GAAP and non-GAAP earnings persists.
On the other hand, if management were to announce that its business transformation programs were nearing completion, there should be significant upside to HPE’s share price, perhaps to the mid-$20s or higher. In that case, the GAAP between GAAP and Non-GAAP earnings would decline over time and HPE’s GAAP earnings would rise toward non-GAAP earnings. Investors would clearly view the stock as cheaper than peers at the current price level.
At its 2020 Securities Analyst Meeting (SAM), CFO Tarek Robbiati said that HPE expected to reduce operating costs by a run-rate of $800 million by FYE 2022 under its current cost optimization and prioritization plan (COPP); but substantially all (or more) of the savings would be plowed back into the sales effort and research & development to boost the company’s growth. Thus, HPE’s GAAP net earnings should rise, but perhaps not by as much as the after-tax transformation costs.
Assuming that HPE’s “beat-and-raise” quarterly performance continues, I believe that its stock has near-term upside to $20, which is my target price. If, on top of this, the company declares a formal end to the COPP with no plans for a successor program, I believe that the stock could rise to the mid-$20s or higher. (If it follows the pattern of recent years, HPE will probably update its transformation cost estimates in September, ahead of the 2021 SAM)
May 25, 2021
Stephen P. Percoco
Lark Research
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