HPE - Will They Or Won't They? Thoma Bravo And Others Dance The Acquisition Dance With HPE

| About: Hewlett Packard (HPE)


HPE is to report its earnings on Wednesday, Sept 7, 2016.

Most observers are expecting in-line numbers, more or less. Of far more interest is any news that might be offered about the possibility of the company selling its software business.

The rumored top bidder is Thoma Brava although there are other well known P/E shops said to be evaluating a transaction.

The combination of this potential transaction coupled with the pending transactions to spin-off services would create a payday for investors in the range of $11-$12 per share.

The rump has a valuation that would allow for its shares to continue to sell at or near current levels.

Keep your eyes on HPE Software before it disappears and puts money in the pockets of investors.

In our history of a nation, there is one composer of note, George M. Cohan who is perhaps best known for his patriotic compositions which include Over There, Yankee Doodle Boy and of course You're a Grand Old Flag. He was supposedly born on the 4th of July, 1878 and was a highly successful entertainer of his era winding up his life at 993 5th Ave. which features full floor apartments of 15 rooms overlooking Central Park. Well, that is what you can find on the web; I never knew.

I really do not know if there is a more stirring patriotic melody than "You're a Grand Old Flag." I suppose in these days of political correctness it will not appeal to all tastes. It was, after all written and composed in 1906. It was the first song to sell over a million copies of sheet music in an era in which phonographs were still not widely owned by consumers. The chorus, which is what people remember these days, talks about keeping your eye on the grand old flag.

Why investors might want to keep their eyes on HPE shares now!

No political discussion here, but I think it would be wise to keep an eye on Hewlett Packard Enterprise (NYSE:HPE). The company reports quarterly earnings after the market close on Wednesday, September 7. I do not think that the quarter itself is likely to be any surprise one way or the other. The company has not completed the disposition of its services unit and so that will remain a boat anchor in terms of reported numbers. It will be interesting to see how guidance is expressed with the transaction pending in the near future.

So, with the shares at their high since the company split with the old Hewlett Packard, Inc. (NYSE:HPQ) there mightn't seem as though there is any particular reason to buy the shares.

But I think that the rumor which has been making the rounds at the end of last week which suggests that HPE is in negotiations to sell its software unit to private equity has some potential validity and sets up a nice trade potential going into the earnings release. At the end of July, the rumor was that there was a bidding process to take the entire business private.

Now the rumor relates to just the sale of the software business at a consideration that might approach $10 billion, the equivalent of $6/share or about 27% of the company's current share value. Should a transaction come to fruition, and there certainly is more than enough evidence that it might, it would almost certainly lead to a significant share price appreciation for HPE and would, depending on the structure, lead to a massive amount of either share repurchase or a onetime dividend or perhaps some of both.

I caution readers that betting on potential takeovers is inherently risky. None of us have specific knowledge as to what might happen. Investors need to be prepared for nothing happening at all other than some boring earnings when the results of the company's quarter are reported.

But it is not a bad bet. Absent some kind of news on operations that doesn't appear likely, the shares will probably mark time, more or less. Obviously, if a transaction is announced, or even foreshadowed, the shares will appreciate.

In the wake of the renewed rumors on Friday, the shares were essentially unchanged, indicating that there are few expectations as to the potential for a transaction. That is a far better set-up than trying to play with a shooting star. The shares are at a high since they started trading, but the fact is so is the market with the SPY Index (NYSEARCA:SPY) at 218.

Some background

As most investors are aware, Hewlett Packard Enterprise was one part of HP that was split off from the original company with a mandate to sell to the enterprise. It wound up with a rather disparate collection of assets that included a storage business, and a large professional services business. It is perhaps best known as offering servers but it also offers networking products and has a rather massive software offering that basically is composed of a set of disparate infrastructure and analytics offerings.

Since HPE became independent back at the end of last year, it has already announced plans to spin off its services operation, a business that had been shrinking for HPE, and truly could not effectively compete against the outsourcing behemoths, particularly those from India. It is a complicated transaction that will leave HPE shareholders with some cash and some interest in a new company that will be mainly composed of HP Services and the assets of CSC, which is basically the survivor.

The disposition of HP Services afforded investors a special dividend of $1.5 billion, or about $.85/share. The buyer, Computer Sciences (NYSE:CSC) assumed $2.5 billion in debt and HP shareholders got an equity stake in CSC that had been valued at $4.5 billion. CSC shares promptly appreciated 40% when the deal was announced based on its likely accretion, so HPE shareholders will actually wind up with about $6.3 billion of value.

The deal was announced in conjunction with the announcement of HPE's earnings for the quarter that ended on 4/30/16. As mentioned, the company's next earnings announcement is this Wednesday and it might be speculated that there would be a predisposition to announce a deal on that date, if there is a deal to announce.

The sale of the services unit mayn't have left HP shareholders with a pot of gold, but ultimately winding up with about $6/share in value for an asset that probably had a limited long-term future was not a bad deal. In the wake of the news of the transaction as well as the release of quarterly earnings, the shares appreciated by more than 20%. In fact, the share, after a Brexit induced dip have continued to appreciate and at $22.23 stand at a high since HPE was divested from its sibling, HP Inc.

This article is not intended to do a deep dive into the different segments of HPE. I initially wrote an article regarding the company and its prospects back on March 5, 2016 when the shares were at $16. Much of the appreciation since that time is most likely a function of the divestiture of the services operation.

Prospects for the balance of HPE really haven't changed all that much since the start of March. Overall, earnings estimates are essentially unchanged over the last 90 days and the earnings last quarter were in line and not more than that.

The potential sale of the software business

It is hard to say that selling software and hardware together has helped the major players that have attempted the trick. Certainly, Oracle's (NASDAQ:ORCL) purchase of Sun has not led to the kind of outcomes that were forecast when the transaction was first consummated.

It is hard to look at ORCL's hardware numbers in isolation because the company had a hardware business of sorts when it first acquired Sun, but in any event, Sun's revenues have shrunk every year since Oracle has owned the property by something in the order of mid-teens percentage and they are still falling at that rate.

The case of IBM (NYSE:IBM) is a bit different, but the message is certainly the same. IBM, other than its operating systems, has been in the software business for something over 20 years now since it first acquired first Lotus in 1995 and then Tivoli Systems at the start of 1996. IBM's hardware business has essentially imploded since 1995 and can hardly be called even a pale shadow of what it once was falling to below 10% of IBM's total revenues last year and to an even lower percentage so far in 2015.

So, the track record of two hybrids trying to sell hardware and software together is not an enviable one to put it mildly. And a third case, which I will not explore in detail has been Teradata (NYSE:TDC) which has seen its revenues fall significantly, more because of the overall structure of the data warehouse business than anything else. Hindsight is 20/20 but the company would have been far better off if it could have figured out an expedient way to split itself into a hardware and a software piece although the mechanics of that would have taken the wisdom of a Solomon to figure out.

In any event, HPE owns a hardware franchise and a software franchise and there is no obvious synergy and many issues to be faced from owning both at the same time. HPE's software business itself, is a mix of a myriad of non-integrated products, mainly acquired through acquisition that lack any kind of unified code base or structure that might make them easy to sell.

In addition, trying to put together a cogent and integrated suite of solutions, then can be readily developed and brought to market in a reasonable period is no easy task. HPE has some excellent solutions that it acquired along the way. The acquisition of Mercury has provided the company with a very strong offering in the application management and delivery space that persists till this time.

Opsware, which was a leader in data center automation when bought, still is and its combination with Mercury has produced synergistic benefits. ArcSight, which HP bought some years ago, remains in the magic quadrant for what is called SIEM (Security Information and Event Management) software.

Of course, there was the misguided acquisition of Autonomy, although it is still producing revenue at some level. One of the greatest scams ever seen in the enterprise software world, entered into by industry pros and vetted by supposedly knowledgeable bankers. Oh well, what is $10 billion amongst friends.

At this point, the lead bidder for HPE is said to be Thoma Brava although other bidders include TPG Group, Carlyle and Vista Equity Partners. Like most of these situations, there is a bid/offer spread with the best bids allegedly coming in below $8 billion compared to HPE's expectations of receiving $10 billion.

I have no way of handicapping the end result of the negotiations. It clearly would make sense in terms of maximizing shareholder values for HPE to sell its software group. It is unlikely to achieve any future synergistic benefits selling hardware and software together and it creates confusion in the sales operation and conflict between the different units as regards to which sales belong to which unit.

The company has reported sales of its software business to have been up 2% on the basis of adjusting for acquisitions and divestitures as well as for currency. But in real dollar terms, software revenues fell 13% last quarter which presumably means that they are running at a rate of about $3.1 billion.

Operating margins in the software group increased by 700 bps and if the software group can't grow revenue, it could become far more profitable. The major factor behind the large increase on operating margins was the result of a divestiture of Tipping Point.

Overall, getting between $8-$10 billion for the software business, which would be in the range of 3X actual revenues would be a great day's work for CEO Meg Whitman. It would be a bonanza for shareholders although in the current interest rate environment, investors are willing to pay far higher valuations than historical norms.

So how might the math work when it is all over?

I think that if HPE gets to sell its software group it will be at less than the asking price. And I can't be sure, if there is a transaction how it might be structured. But I think that adding the value of the services divestiture together with the possible divestiture of the software business, will produce $11-$12/share in realizable value for shareholders.

After the transactions, one announced, one perhaps putative, the shareholders will be left with a hardware business doing about $30 billion/year and which should have reasonable levels of both cash flow and profitability although it is difficult to forecast pro-forma expectations with the information currently available.

The company currently has an enterprise value of $45 billion although it should be pointed out that within that $45 billion are almost $15 billion of financing receivables which might readily be converted to cash. Many analysts would subtract a large percentage of the $15 billion from the enterprise value.

How much should the stub of HPE be worth in the wake of the divestitures. IT hardware companies are not highly valued these days. I suppose the closest analog transaction is the pending acquisition of EMC by Dell which is being done at about 2.5X including the value of VMware (NYSE:VMW). That being said, the concentration of EMC's assets in enterprise storage as compared to servers may be more attractive to some, although why that might be so in the current environment is hard to say.

But using 1.2X EV/S + $12 billion for the finance receivables, yields a potential value for the rump of close to $50 billion, or $27. Excluding the finance receivable entirely from the transaction would yield $20/share. Using .8X EV/S on the rump sales would still produce a valuation of $14/share. Obviously, the finance receivables have a value and they could be readily sold to many private equity vendors or to finance units of financial services operations.

I think the net here, is that the potential sale of the software unit, if it happens at rumored prices, will unlock a fair amount of shareholder value for investors and create loads of positive alpha with a relatively modest degree of risk.

Recapitulating the investment case for buying HPE shares into the numbers.

  1. HPE will report its quarterly results on Wednesday Sept. 7th.
  2. Of far more interest than the results, will be some possible discussion of a well-rumored process to sell the software assets of HPE to private equity.
  3. This would be the second asset divestiture since HPW was split from its sibling.
  4. The two deals combined, would produce $11/$12 share in value for current HPE shareholders.
  5. The rump to be left would be a profitable business selling $30 billion of IT hardware products including servers and storage to the enterprise. In addition, the rump would almost have $15 billion of finance receivables.
  6. IT hardware vendors are not valued at high levels, particularly in the wake of the cloud and trends for more and more companies to give up their own data centers.
  7. That being said, Dell was willing to pay more than 2.5X to acquire EMC which would be the closest analog to the rump of HPE.
  8. Even at values as low as .8X EV/S, HPE shares have room to appreciate and would almost certainly do so if a deal were to be announced.

The risk rewards of owning HPE shares at this point seem heavily weighted in favor of investors. There is little or no current deal premium and a deal is certainly possible and indeed logical. That grand old company might soon be producing significant positive alpha.

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.