Hewlett Packard Enterprise - Bonds Look Best Hedged Via CDS Now

| About: Hewlett Packard (HPE)

Summary

HPE is a hardware, corporate IT-focused company after the Enterprise Services spinoff to CSC.

HPE's bonds are trading in sync with the HPE common but can be rich or cheap depending on the day.

The credit's 5-year CDS looks cheap as HPE's credit metrics improve.

Key Issues:

After spinning off from Hewlett Packard Inc. (NYSE:HPQ) in November 2015 and then spinning off its Enterprise Services segment into a 50/50 JV with Computer Sciences Corp. (NYSE:CSC) this past month, Hewlett Packard Enterprise (NYSE:HPE) will be focused going forward on selling hardware and corporate IT using multiple types of servers, storage, and networking products.

  • HPE is the largest seller of servers with 25%+ market share (vs. Dell, IBM (NYSE:IBM) and Cisco (NASDAQ:CSCO)) but all branded server makers face increased competition from non-branded, lower cost original design manufacturers and hyper-scale cloud vendors (Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Microsoft (NASDAQ:MSFT)).
  • HPE's server revenue is half its Enterprise Group segment revenue, which until the Enterprise Services spinoff, was 55% of total revenue. HPE's server sales surprised to the upside in Q2'16 ended April with sales of new Cloudline servers to Tier I telecom carriers but faces difficulty sustaining server sales to corporate clients opting for public over private cloud systems. Enterprise Group margins declined as sales flattened over the past 4 quarters, a sign of the headwinds HPE faces in its most important segment (see financial summary below).
  • HPE's networking and storage segments, also housed within the Enterprise Group, benefit from increased use of public cloud computing but both are too small to make up any slowdown in HPE's server sales/margins. However, the Enterprise Services Group spinoff saves HPE admin and other costs while preserving services revenue. HPE is forecast to attain an 8.4% operating margin in the current quarter (well within its goal of 7-9%) from cost savings created by the Enterprise Services Group spinoff.

Bond Technicals:

HPE has $16.2 billion debt outstanding but a low, 1.4x net leverage credit. Its most widely traded bonds are the HPE 4.90 Senior Notes due '25 Baa2/BBB with $2.5 billion principal amount outstanding. Also popular are the shorter-term HPE 3.60 Senior Notes due '20 and the long-term HPE 6.35 Senior Notes due '45 (all unsecured, all Baa2/BBB rated, stable/stable).

HPE 4.90 due '25 traded cheap through Friday to the HPE common based on 6-month regression: with HPE common closing Friday at $19.12 per share, the HPE '25s were expected to be worth $105 (versus their $103.65 closing level). The correlation is a 78% r-squared. With Monday's 1.8% drop in the common price, that long bond-short stock trade disappeared. What hasn't disappeared is the bond's negative basis vs. CDS (-58 bps per last check). HPE bonds due '17 and '18 also trade at a negative basis. In other words, there are likely still hedge-able ways of owning HPE credit.

HPE 5-year CDS, priced around 175, is quite wide to IG-rated credits (those average 81 bps) and most tech credits with tradeable CDS, even if it is closer to its 150 bps low than its 249 bps high over the past 6 months.

Conclusion:

There will be multiple opportunities to go long HPE bonds and hedge with common - the securities trade pretty much in tandem based on 6-month correlations and HPE common moves around more than average (30-day volatility is 31.5% on HPE common vs. the S&P 500 (NYSEARCA:SPY) 30-day volatility of 9.7%). Alternatively, a purchase of HPE '25s can be hedged with CDS - you buy bonds and buy 5-year CDS at a negative basis, taking advantage of buying the HPE CDS while it is trading toward the cheaper side of its trading range.

HPE Bonds Price Histories Graph:

HPE Bonds Click to enlarge

HPE Financial Summary:

$ millions

Q3'15

Q4'15

Q1'16

Q2'16E

Q3'16E

Q4'16E

3 mos end

7/31/15

10/31/15

1/31/16

4/30/16

7/31/16

10/31/16

Revenue

12,981

13,448

12,724

12,711

12,661

13,176

CGS

9,276

9,463

9,112

9,068

SG&A

3,235

3,866

3,228

3,151

Operating Income

470

119

384

492

1,064

1,369

Interest exp

27

29

80

129

Non-Op L(G), net

141

-20

-15

0

Tax Exp (CR)

41

-1,275

52

43

Inc bef XO items

261

1,385

267

320

598

611

XO Loss , net

0

0

0

0

Min Int

0

0

0

0

Net Income

261

1,385

267

320

598

611

Rev Grw Seq

4.0%

3.6%

-5.4%

-0.1%

-0.4%

4.1%

Oper Margin

3.6%

0.9%

3.0%

3.9%

8.4%

10.4%

EBITDA

1,457

1,106

1,373

1,452

1,942

2,212

EBITDA Mgn

11.2%

8.2%

10.8%

11.4%

15.3%

16.8%

EBITDA/Int

54.0x

38.1x

17.2x

11.3x

LTM Revenue

-

52,107

51,778

51,864

51,544

51,272

LTM EBITDA

-

5,470

5,122

5,186

5,873

6,979

LTM CF

-

-

-

-

7,203

7,497

LTM CapEx

-

-

-

-

-2,918

-2,907

LTM FCF

-

-

-

-

4,285

4,590

Cash & Equiv

11,500

9,842

8,505

9,010

Tot Debt

15,845

15,794

16,139

16,212

Min Interest

408

383

385

390

Market Cap

n.a.

27,644

23,620

28,722

Ent Value

n.a.

33,979

31,639

36,314

EV/EBITDA

6.2x

6.2x

7.0x

Tot Debt/EV

0.5x

0.5x

0.4x

NDbt/EBITDA

1.1x

1.5x

1.4x

Seg Rev:

Enterp Grp:

7,007

7,358

7,051

7,010

-Servers

3,520

3,772

3,568

3,561

-Tech Svcs

1,880

1,862

1,810

1,823

-Networking

823

905

863

874

-Storage

784

819

810

752

Enterp Svcs:

4,976

5,020

4,688

4,723

-Infra Outs

3,036

3,068

2,874

2,839

-App & Bus

1,940

1,952

1,814

1,884

Fin Svcs

807

801

776

788

Software

901

959

780

774

Corp Invest

1

1

1

2

Interseg Adj

-635

-691

-572

-586

Seg Op Mgn

Enterp Grp

12.6%

13.6%

13.4%

11.7%

Enterp Svcs

5.7%

8.2%

5.1%

6.7%

Fin Svcs

10.8%

10.9%

12.9%

9.3%

Software

20.5%

29.9%

17.4%

24.8%

Click to enlarge

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.