HPE - Is it Granada I see or only Asbury Park
The introductory lead in is taken from a Cole Porter song titled "At Long Last Love" which comes from a very forgettable musical, "You Never Know" that dates to 1938. The song itself questions whether or not something the leading man sees is real or just a chimera. And after the quarterly results announced by Hewlett Packard Enterprise this past week, the question has arisen in the minds of many investors and analysts as to whether or not the transformation that we though had gotten under way at the end of 2015 when HPE and HPQ parted ways is going to create real value for investors or if it will be just like a vacation in Asbury Park. (Apologies to all those readers who have fond memories or still enjoy the place but… well, attitudes about the place were pretty much the same as long ago as 1938 as they are today.)
While CEO Meg Whitman was emphatic during the call that the transformation process was still on track (what else might she really have said), some investors and analysts were less than convinced and the shares sold down about 7% in the wake of the earnings release. The conference call featured a couple of less than courteous exchanges - even by analysts who have buy ratings on the shares and two brokerages, BMO Capital, and Needham lowered their ratings from buy to hold and almost all analysts lowered their price targets.
The shares had been outperforming the S&P over the past several months, although they had underperformed in the three months prior to this release in the wake of a prior lackluster earnings report, concerns about the spin-merger transactions I will describe later and ongoing concerns about conditions in the storage and server spaces. At the end of the day, while the quarterly results were disappointing and will certainly raise concerns about if this new business is still the "same old HP," of more importance in terms of valuation are those spin mergers, the first of which is scheduled to close in a few weeks. Much of the valuation of the shares in Hewlett Packard Enterprise (NYSE:HPE) will come from the pieces of paper and the cash that investors will get when the transactions close. The quantitative support for the current share price targets is more a function of those transactions than it is a function of how well particular divisions of the company are doing now. And I think considering the value of the spin-mergers to HPE shareholders and the value of the cash on the balance sheet, the residual has been reduced to such a small level that investors can readily sample the water and buy shares. The potential for significant percentage gains from current levels has amplified in the wake of the prior underperformance of the shares and this most recent share price pullback.
Context is often as important as absolute performance
It was never going to be an easy or seamless progression to straighten out HP's hardware business in an era in which enterprise data centers are thought by some to be an endangered species and the fact that issues have emerged is not terribly surprising. There are lots of controversy on that point and I think the linked article above presents a more nuanced view about what is really happening in the marketplace.
I think it is important to present a balanced view of the company rather than to throw up one's hands in exasperation that the results, or more particularly, the guidance were less than expectations and prior company forecasts. And I think that some of the knee-jerk reactions on the part of analysts regarding this company's specific outlook in terms of selling servers and storage seem to be almost emotional rather than analytical. The company's leadership and decision-making have been flawed for years. That's hardly news - well maybe it is down on Redwood Shores. What took years to break isn't going to be fixed in a quarter or two by waving a wand.
More or less since people have been analyzing the enterprise hardware space, it has been traditional to change ratings based on margins that can either be squeezed or bloated depending on component costs. It has not made sense before and it doesn't make much better sense now. Component costs and shortages come and go and will continue to do so.
What's far more important are questions about the long-term viability of a strategy related to selling a hybrid-cloud infrastructure to enterprise IT customers. And the company, which through divestiture will be shrinking itself to less than $30 billion a year in annual sales, is going to need to replace the sales strategies that were appropriate when it was a behemoth, and could use its consulting practice as a lever to promote sales of enterprise servers and storage. The verdict is still out on how the issue of creating a high-performance sales culture where one has never existed will play out. The sales and product management changes instituted last quarter that were said to be disruptive and dysfunctional in the short term had to happen and their results are still in the future and cannot yet be handicapped on some objective standard.
Analyzing the price of DRAMs for a quarter or two is not going to help answer those kinds of questions. When looking at developing a framework for considering an investment in the shares, the price of specific components in the short terms is simply not a relevant part of the calculus.
I have thought that the spin-merger transactions have strong profit potentials for HPE shareholders and that is still the case. Nothing in the quarterly results would have any material impact on such an assessment. I think the impact of the transactions will tend to outweigh the many issues that there are and will be in trying to run a successful company selling hardware to data centers. At this point, the transactions represent significantly more than half of the current value of HPE shares, in my opinion. But before revisiting the spin-merger transactions, I think it is worth taking a look at exactly what HP announced and if the ugliness of the release has been more than discounted by the share price reaction.
Lots of moving pieces, not all moving in the right direction or at the right time
Just to reprise the headline numbers, non-GAAP EPS for the period was $.45 up from $.41 in the year earlier period. GAAP earnings also increased. Revenues were $11.4 million, down 4% net of currencies and divestitures, i.e. organic performance and about 2% below prior expectations. CFFO, as reported, was a burn of $1.5 billion. More than all of the burn had to do with changes in other assets and liabilities, which came to $2.7 billion for the quarter of which $1.9 billion was the initial funding payments related to unfunded pension liabilities in association of the spin-merger of the Enterprise Services business with Computer Sciences Corporation (CSC).
CEO Meg Whitman described "normalized" CFFO as $200 million, a significant year-on-year improvement. My own analysis would have resulted in a better metric and I am not all that sure that the quarterly change in other assets and liabilities is of great importance in analyzing CFFO over the course of a year in any event. I am not totally sure how Ms. Whitman's calculation works - but I guess the takeaway is that CFFO is trending positively and not negatively.
The company's GAAP expenses continued to show positive trends. Overall, both the selling, general and administrative line and the research and development line were down both sequentially and year on year. Even gross margins showed nicely positive trends. The non-GAAP operating margin at 9% was slightly above year-earlier levels although below the results of the prior sequential quarter. The difference between GAAP and non-GAAP profits are not based significantly on stock-based comp, which is running at less than 1.5% of current revenues. In all, while the quarter did see a small miss in terms of revenues, it was not, in itself, any particular cause for alarm.
But the results for the quarter were not a particularly pretty picture. Just to quote the CEO, "We saw several external factors impacting our performance that will become more challenging through the remainder of fiscal 2017, and we came up against some execution-related problems that we are now fixing."
The company, like most other large IT companies, had issues with the strengthening dollar. It was able to mitigate some of the impact in the quarter by hedging, but the hedges have been closed and going forward, the impact of the strong dollar will flow through to the P&L as well as impacting revenue performance.
The company is forecasting that it will have issues with the shortages of NAND and elevated DRAM prices. Frankly, many companies in the hardware space are facing the same issues and simply adapted better than HPE. Having written about NetApp (NASDAQ:NTAP) a few days ago and looking at the issues that were faced by that company suggests that HPE could have done a better job of anticipation and securing supplies at a more advantageous cost. Revamping HPE is still very much a work in progress, and the people in procurement haven't yet gotten the message about nimbleness and forward thinking.
Management talked about a difficult demand environment for core servers and storage. It is a tough market and it is not easy to forecast that it (the market) will ever return to significant growth numbers. The only way to deal with a market that seems, at most, to be stagnant or at worst to be in long-term secular decline, is to innovate boldly and perhaps ruthlessly. That again is a discipline that is still a work in progress at HPE. The recent purchase of SimpliVity is perhaps some indication that the message as to what is required to compete is resonating, but there are going to have to be far more deals of that kind in order to successfully deal with a market that simply has minimal growth prospects.
And finally, management talked about what it described as execution issues. HPE has not had what I might describe as a sales-oriented culture in many years. From its founding, this company has never been a sales-focused organization and some of the hires that the company made a decade ago in order to change in that regard proved to be disastrous. Moving from what has been to what needs to be in a quarter or two has proven to be a bridge too far. The number of broken systems within sales at HPE, at least according to my anecdotal contacts, has been enormous. Fixing all of the processes has some of the same parameters as cleansing the Augean stables - to an extent, disturbing one set of settled ineffective practices leads to problems in other parts of the sales process. I think that it was realistic for the company to cut back some of its expectations in that regard for the balance of the fiscal year and not attempt to drive people with incentives on reaching impossible objectives.
This is not intended to be some kind of apologia for ineffective transformation at the company. But as will be seen, the valuation of the part of the company that is suffering is already at levels reflecting the problems both in the environment, with competition and with internal execution. The CEO of the company knows what isn't working and is likely over time to at least fix some of the problems that were highlighted by the results this past quarter. Fortunately, for shareholders, the bet necessary to own HPE shares is basically one with many different components of which the remaining operations is not actually the most important.
I don't think that any of these issues are necessarily fatal or unfixable. And some of the issues are outside of the control of management. And even within the set of problems that the quarterly performance laid bare, there were some bright spots. The company has been in the hyper-converged space for years and it remains a significant player. Most of the publicity in the space has rightfully gone to Nutanix (NASDAQ:NTNX) and most recently to NTAP as well, but HPE does have a solution and the acquisition of SimpliVity is going to improve its competitive position. It represents about $2.4 billion of annual revenues with growth of about 25%, significant in the context of what is going to be left to HPE after the spin mergers have become effective.
HPE bought what had been Silicon Graphics last November. The company CEO believes that there is still a market for very high-end computing and that not all data and all computing will migrate to AWS (NASDAQ:AMZN) and to Microsoft (NASDAQ:MSFT). This is, no doubt, a tendentious point and I am the last to suggest that there is a clear right answer. The latest market research projection which is linked to from this article suggests that the market is growing at 8% and its size is around $30 billion. Overall, high-performance compute grew by almost 10% organically for HPE and by 30% including the revenues acquired with the SGI merger.
The company is also continuing to make bets on its security products built around its Aruba ecosystem. HPE bought a business called Niara, which uses behavioral analytics designed to identify threats before data is actually stolen. It is a slightly different take on advanced threat protection and is designed to promote differentiation. Aruba continues to outperform the security market and many other smaller security vendors with growth of 20%.
The company is also promoting an interesting variant on third-party cloud offerings with something it calls Flexible Capacity. It is said to be a unique consumption model that enables HPE customers to manage IT infrastructure in their own data center but pay for it as a service. Part of the solution is based on a company recently acquired called Cloud Cruiser, a tiny startup, which gives users the ability to analyze their IT usage and spend and suggests strategies to optimize their investment in IT technology.
But these bright spots were outweighed in the quarter and competitive share losses were very visible and not something that can be readily ignored. HPE saw a 12% decline in overall storage revenues despite modestly respectable performance in AFA. Clearly, the emergence of NetApp as a strong competitor in the AFA market is having an impact. NTAP grew in triple digits in AFA while HPE grew by 29% in the same space. Management talked about its storage business being supply constrained. I am sure that's true but many observers will be struck by how well NetApp seems to be managing through the supply constraints in NAND and achieving triple-digit growth in AFA to a level significantly greater than that posted by HPE last quarter. And server revenues declined by 11%, partly because of overall market condition but exacerbated by a decline in HP's largest tier 1 customer.
It is probably not worthwhile exploring the results of the two revenue streams that will be spun off later this year, software and enterprise services. ES declined noticeably in revenue while improving its margins, mainly by moving headcount to lower cost locations. Software showed consistent year-on-year revenue performance on a constant currency basis, and saw a 400 bps improvement in margins.
The tale of those two revenue streams will soon be told by other organizations as will be reprised below. The transaction to spin HPE Enterprise Services to CSC is expected to close on or around 4/1 and the transaction with Micro Focus (MCRO.L) is scheduled for closing on 9/1. As mentioned earlier, these transactions represent a significant part of the reason to own the shares and continue to do so even in the wake of some of the operating difficulties highlighted in the quarterly earnings and discussed above.
I do not think anyone imagines that what will remain of HPE in the wake of its divestitures is a growth business. There are some growth components in otherwise stagnant spaces. The company has yet to demonstrate that it can execute at the speed necessary to exploit the opportunities it has and to make the right choices in terms of allocating its resources in what are difficult markets. Fortunately, for investors, one can own the shares, I think, without expecting miracles of execution or strategic decision making.
A current review of the spin-merger transactions
I have written about the spin-merger transactions in the past and just want to touch the highlights in reviewing what is expected to happen and how the transactions will affect current HPE shareholders. The spin merger of HPE Enterprise Services with CSC was announced back in May of 2016. The transaction is a bit complex compared to a standard sale. At the time the transaction was announced, it was said to be worth $8.5 billion, or about $5/HPE share. That probably significantly understates the value of the transaction to HPE shareholders. HPE shareholders are going to receive a cash dividend of $1.5 billion and the company will transfer $2.5 billion of debt to the new enterprise. That is straightforward enough.
HPE shareholders will receive a stake in a new company, called DXC Technology. The new company will have revenues projected to be about $24 billion. HPE shareholders are going to have a stake equivalent to about 50% of the value of the new business.
The "buyer" in this transaction, CSC released the results of its Q3 early this month. Results were considered to be strong and the shares increased to a new all-time high. The current enterprise value of CSC is $11.5 billion and its current revenue forecast is a bit less than $7.8 billion. HPE is contributing about $16 billion of revenues (current run rate) to the new business on which its non-GAAP profits were $283 million showing noticeable year-over-year growth despite the revenue decline.
What is going to be the enterprise value of DXC when it starts trading? Regardless of the overall results that HPE reported, there was nothing particularly unusual or alarming about the results of Enterprise Services. I think it is hard to believe that the new company will not be worth $22 billion valuing the profits coming from HPE Enterprise Services at 10X the Q1 annual run rate. That, of course, ignores the forecast cost synergies which would actually increase operating profits another $1 billion in the first year after the completion of the transaction. So, based on the current valuation of CSC, the cash consideration, the debt assumption and the value of the new business, it would seem that HPE shareholders will wind up with far more than the amount forecast at the time the deal was put together. Overall, the way I see it at this point and ignoring the debt assumption, I think that HPE shareholders are likely to get cash and shares with a value of around $7.50/share with a significant probability of upside to that estimate.
The spin-merger transaction with Micro Focus is going to be harder to handicap because Micro Focus itself has been built as a company that has built a portfolio of solutions through a variety of acquisitions. It's most current results were published in December of 2016 and covered the period through 10/31/16. At that point, the company had a revenue run rate of about $1.4 billion and generating adjusted EBITDA of about $650 million with cash flow from operations reaching $202 million. Currently, the company has 221 million fully diluted shares outstanding and at current share prices, it has a market capitalization of just short of $5 billion. Given how the company has been built and its strategy, the fact that it has a relatively substantial net debt position of $1.3 billion is probably not surprising and yields an enterprise value of $6.3 billion, which itself is quite a bit higher than when the spin-merger transaction was initially announced.
How much is this new company going to be worth? HP is contributing a software business that is double the size of in terms of revenues of Micro Focus although far less profitable. So, there will be a new business with revenues of $4.2 billion and non-GAAP operating profits on a run rate basis of $900 million. HPE shareholders are going to receive a dividend that is $1.40/share. The forecast presented at the time of the announcement of the transaction was that Micro Focus would be able to realize 2,000 basis points of margin improvement on the revenues contributed by HPE, which would raise after-tax profits to $1.5 billion. It should be noted, when considering the probability of achieving this aspirational goal that raising margins on acquired companies, junk or not, is to raise their profitability. It has done that over the years and been very successful at doing it. It has the ruthlessness and the nimbleness to act in ways that HPE has never seen. That is why investors have valued the shares as they have.
What might that be worth? At 10X earnings, the equity would be worth $15 billion and the share attributable to HPE shareholders would be $4.40 per current HPE share.
When I look at HPE, I see shareholders receiving cash and new securities worth a bit more than $13/share, with more upside than downside to those numbers. So, the question becomes, what's the balance of HPE worth.
What's the balance going to look like?
There are some observers who think that the balance of HPE is going to look something like the picture of Dorian Gray. That seems to me to be a gross over-simplification that suggests there will soon be a world without data centers other than those owned by the cloud vendors. There will be readers and other observers who will cite specific examples of large companies who have chosen to abandon the management of any of their data and who will move all workloads to the cloud. It is a debate that cannot be solved by me and certainly not in this article.
Just on the surface, the remainder of HPE is going to be a company with 1.7 billion shares outstanding. It is going to have about $10 billion of cash outside the debt it has incurred to support its financing business. And its run rate revenues are going to be around $28 billion. Its Q1 non-GAAP operating profits were a bit less than $900 million in the segments it is retaining. There are simply too many puts and takes on the balance sheet to produce a reasonable estimate for either CFFO or free cash flow. The cash on the balance sheet is the equivalent of a bit less than $6/share. Is the rest of HPE worth $4/share, even in the wake of the disappointing numbers reported last quarter?
I really don't think there are that many analysts who want to take the negative side of that discussion. There are, to be sure, those who will find objections to raise in some element or the other of my spin-merger analysis although I certainly could have found as many avenues to reach higher as well as lower valuations. There will be some who might feel that the current $10 billion cash balance will be committed to other projects and cannot be counted on in a sum of the parts analysis. And there will be, no doubt, be concerns expressed about what the real "steady state" cash flow will be for this business which is not terribly easy to determine. But that presents a decent setup for making a commitment to the shares. One can stretch some contrarian wings when more than half of the analysts who cover the name rate it a sell or an underperform. But I have to believe that with $28 billion of revenues, regardless of the ugliness of the quarter and the ugliness of some of HPE's markets, that the assets HPE will retain are likely to be worth significantly more than $7 billion ($4/share). And that is why I am adding to my HPE positions and feel that there is significant positive alpha potential, some of which is likely to be realizable for investors soon after shares of HDX start to trade at the end of March.
Disclosure: I am/we are long HPE.
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.