Hewlett Packard Enterprise - Enterprise Service Spin-Off Makes Sense, Reveals Value Of The Core

| About: Hewlett Packard (HPE)

Summary

HPE is spinning off its enterprise service segment in a deal which creates real value for shareholders.

The remainder of HPE looks much healthier as a shrinking and low-margin business will be gone.

A strong pro-forma balance sheet and the value being created with the spin-off of enterprise services, reveals an attractive valuation for the healthy core business.

If shares dip in the near term, I am eager to initiate a modest position.

Hewlett Packard Enterprise (HPE) announced a major move alongside its quarterly results. The company will spin-off its troubled enterprise service segment, as that business will consequently be merged with CSC (CSC).

The spin-off, and consequent merger of the service business, appears to be value enhancing for investors in HPE. The company will reinforce its balance sheet and get rid of a struggling business unit. Investors will obtain nearly $5 in value per share through a special dividend and equity stake in CSC.

The improved, but smaller core of HPE looks quite promising, creating relative good appeal at current levels. This is certainly the case as second quarter revenue trends looked quite robust.

News Flow, Spinning Off Enterprise Services

HPE announced that it will spin-off the enterprise service segment in a deal valued at $8.5 billion. The consulting business is facing real pressure as revenues fell by nearly 12% in 2015 to $19.8 billion. While the business managed to report an increase in segment earnings, which rose towards $1.0 billion, the real profitability has been much lower. It is important to realize that segment earnings do not factor in the allocation of sizable corporate costs.

The $8.5 billion deal tag is comprised out of three separate items. Investors in HPE will see a special dividend of $1.5 billion, which is equivalent to roughly $0.85 per share. CSC will furthermore assume $2.5 billion in debt and other liabilities, as investors will get a $4.5 billion equity stake in CSC.

The $4.5 billion value equity stake in CSC was based on a share price of $35 per share. The huge increase in CSC's stock price, in response to the merger with HP's service segment, means that the value of the stake is now valued at around $6.5 billion. This increases the effective value of the deal to roughly $10.5 billion.

The Pro-Forma Business

HPE was once part of Hewlett-Packard of course, a business with over $100 billion in sales. Following the spin-off into HPE and HP Inc. (NYSE:HPQ), sales fell back to $52 billion in 2015. With the divestiture of the service group, pro-forma revenues fall towards $33 billion.

The main activity of the new HPE is the enterprise group which posted sales of $28 billion in 2015, reporting flattish sales trends. Roughly, half of these sales are derived from servers, complemented by technology services, networking and storage solutions. Segment earnings for the unit came in at $4.0 billion, for margins of roughly 14%.

HPE furthermore owns a $3.6 billion software business, which is struggling in terms of its top line. Despite these headwinds, the unit appears to be solidly profitable, with segment margins coming in at 22% of sales. The finance business of HP generates sales of little over $3 billion, with margins amounting to 11% of revenues.

Segment earnings of these three businesses combined came in at $5.1 billion in 2015, but this is before the allocation of significant corporate costs. HPE has furthermore been reporting structural losses on "corporate" investments, with losses amounting to roughly half a billion in 2015.

All the other corporate costs totaled roughly $4.0 billion in 2015, being comprised out of items like stock-based compensation expenses, amortization expenses, restructuring charges, and separation costs. If I generously exclude the restructuring charges, pension related charges and costs of the separation, all the other costs totaled some $2 billion in 2015.

Given that the enterprise service segment made up roughly 40% of total revenues in 2015, I estimate that "recurring" corporate costs for the remaining three businesses amount to roughly $1.2 billion a year.

If that assessment is correct, the "clean" EBIT number of the new business comes in at $3.4 billion. This is the result of the $5.1 billion in "segment" earnings. Subtracted from these earnings are half a billion in corporate investment losses, as well as a $1.2 billion corporate cost allocation.

The Valuation And Earnings Power

The results, as being calculated above, seem like a reasonable starting point going forwards. This is certainly the case as the second quarter performance has been good, certainly in terms of sales developments at the core enterprise group.

HPE ended the second quarter with $9 billion in cash and equivalents. Total debt stood at $16.2 billion, while the company had $2.2 billion in employee obligations as well. These obligations most likely represent normal salary accruals as well as certain pension-related obligations.

The good thing is that the company has $3.0 billion in short-term financing receivables, as well as an unspecified number of long-term financing receivables as well. These long-term financing receivables stood at $3.6 billion by the end of 2015. To further complicate the financial picture, HPE reported $3.5 billion in pension-related liabilities by the end of 2015 under the category "other liabilities."

As a result, I note that total debt stands at $16.2 billion, while pension related liabilities could come in at around $5 billion. These $21 billion in liabilities are largely offset by cash holdings of $9 billion as well as receivables of another $6.5 billion. This leaves a net debt load of some $5.5 billion. As part of the deal, CSC will assume $2.5 billion in debt and pension-related liabilities, reducing the effective net debt load towards $3 billion.

This suggests that the new HPE has roughly $3 billion in net debt. With gross debt amounting to roughly $15 billion on a pro-forma basis, internet expenses come in at $600 million if I assume a 4% cost of interest. This means that the EBIT number of $3.4 billion will result in profit before taxes of $2.8 billion. With an effective tax rate of around 30%, this yields net profits of $2 billion a year.

Adding It All Up, Worth Considering

Shares of HPE are now settling at around $17 following the news flow, as there are some 1.75 billion shares outstanding. We can now calculate the value being attributed to the remaining core operations.

Investors in HPE stand to receive a special dividend of $0.85 per share on the back of the $1.5 billion cash component of the deal with CSC. Investors will furthermore obtain roughly 0.08 shares of CSC going forwards. In total, HPE shareholders will hold roughly 138 million shares in CSC, a number which needs to be divided by the 1.75 billion shares outstanding in HPE. The 0.08 share of CSC represents roughly $4 in value given that those shares have risen towards $50 in response to the deal.

The value of the special dividend and equity stake in CSC comes in at nearly $5 per share. With shares trading at $17 per share, HPE's core is thereby valued at $12 per share, or $21 billion in actual dollar terms.

As calculated above, the new core is quite stable and should be capable of earning $2.0 billion after taxes, while it operates with a very modest amount of leverage. This mere 10 times earnings multiple looks relatively attractive as sufficient resources are available to further boost the core operations, or engage in more share buybacks. It can furthermore not be ruled out that more mergers or spin-offs could be embarked on by HPE's management.

The core enterprise group can largely be compared to Cisco's activities, although it is less profitable. Realize that all of HPE's operating assets are valued at merely $21 billion after the spin-off is complete. With enterprise sales amounting to $27 billion a year, and real operating margins coming in at around 10%, this unit can be quite valuable.

Just have a look at Cisco (CSCO). While this business is much larger and profitable, both businesses operate in similar markets. The difference is that Cisco's trades at roughly 2 times sales (if you back out the large cash holdings), although it is much more profitable with margins coming in at 14%. Cisco's assets trade at roughly 10 times operating earnings. With a similar multiple, HPE's enterprise group could be worth $25 billion, even after taking into account the corporate costs.

That even excludes the value which can be attached to the financing unit, as well as the software unit. While the financing business will likely not be very valuable, a mere 1-2 times sales multiple for the software business could imply a valuation of $3-6 billion on top of that of the enterprise business. That implies that the core might be sold at $30 billion in a conservative sum of the parts calculation, or $17 per share. That excludes, of course, the $5 value of the special dividend and stake in CSC.

All in all, I see sufficient reasons to get constructive on the shares. If shares dip towards $16, I am eager to initiate a position.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HPE over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.