HOLD-rated Hewlett Packard Enterprise Co. (NYSE: HPE). The enterprise solutions provider in 4Q20 maintained sequential momentum from 3Q20 following a weak first half to fiscal 2020. Reflecting volume leverage and operating efficiencies from its restructuring program, HPE also delivered sequential margin improvement and non-GAAP EPS expansión.
Fiscal 4Q20 revenues were slightly below year-ago levels, and negative volume leverage resulted in fiscal 4Q20 non-GAAP profits declining on a double-digit basis year-over-year. The company offered guidance suggesting sequential momentum for fiscal 1Q21 non-GAAP
EPS, but another negative bottom-line comp. HPE is likely a few quarters away from positive top-and bottom-line comps against soft prior-year periods.
Even after significant prior streamlining efforts, HPE remains a provider of solutions across multiple enterprise IT niches. That makes for an engineering-heavy operating budget and perennial pressure on margins.
HPE is moving away from sales of stand-alone server and storage gear while pivoting to an as-a-service model. While the portfolio shift is necessary, it represents another operational challenge in a competitive environment crowded with cloud-first rivals. The company’s integrated strategy appears to be gaining some success in a dynamic market space, but we expect competition from cloud-first solutions and traditional rivals to remain intense.
The aggressive cost-cutting program announced in May 2020 risks cutting into muscle as the company seeks to accelerate this shift while combating competitive threats. Although HPE has lagged the market during calendar 2020, the company faces uncertain demand prospects. Full-year FY21 adjusted profit guidance bakes in a strong second-half demand recovery, which may not materialize. We believe a HOLD rating remains appropriate at this time.
HPE rose 20% in 2019, compared with a 39% gain for the Argus Information Processing & Storage peer group. HPE declined 8% in 2018, compared with a 15% decline for peers. The predecessor company, HP Inc., retains the corporate identity and trading history of the old Hewlett-Packard Inc. For Hewlett-Packard Enterprise, stock performance data from prior years is not meaningful.
For fiscal 4Q20, Hewlett Packard Enterprise reported revenue of $7.21 billion, which was flat year-over-year (flat in constant currency) and up 6% sequentially. Revenue was ahead of the prereporting consensus estimate of $6.88 billion; HPE does not guide on revenue. Non-GAAP earnings for 4Q20 totaled $0.37 per diluted share, down 23% from $0.49 in the prior-year quarter and up by $0.05.
HPE grew its focus businesses year-over-year; these businesses include Intelligent Edge (Aruba) and High-Performance Computing & Mission-Critical systems (HPC & MCS). HPE also grew revenue in the Americas by 4% in constant currency. The company’s volume businesses declined, however. This includes Compute and Storage, which together comprise two-thirds of revenue. Overseas business also declined on a year-over-year top-line basis.
Earlier in the year, CEO Antonio Neri tested positive for COVID-19 while showing just moderate symptoms. The CEO was pleased to report fiscal 4Q20 revenue returning to pre-pandemic levels.
These priorities include stabilization of core businesses, ‘doubling-down’ in areas of growth, and accelerating the company’s pivot toward an as-a-service model in the enterprise space. Simultaneously, HPE seeks to improve its agility and strengthen its financial foundation.
After a buildup in the backlog related to inability to meet demand, backlog returned to normalized levels in 4Q20. Component scarcity and supply chain bottlenecks remain a challenge but have abated somewhat. The backlog peaked at $1.5 billion at mid-year fiscal 2020 – about double the normal level. Working off that backlog contributed to revenue performance in the fiscal 2020 second half.
The company accelerated its pivot toward as-a-service with good growth in HPE Greenlake services orders, following record orders in 3Q20. Annualized revenue from as-a-service of $585 million rose 30% annually and 11% sequentially.
At the beginning of the fiscal 2020 year, Hewlett-Packard Enterprise adjusted its segment reporting to better align with its end markets and customer needs. The new categories consist of Compute (general purpose servers and related operational services); PC & MCS (high-performance computing and mission-critical servers); Storage (flash, disc, and hybrid arrays; Advisory & Professional Services (consultative and other services); Intelligent Edge (Aruba products & services and data center networking); and financial services.
HPE is at heart a server company; its total servers include mainstream x86 rack and blade servers as well as high-performance computing solutions and mission-critical systems based on UNIX or Linux. On an all-in server basis, revenue of $4.15 billion (58% of total) was up 1% annually and 3% sequentially in GAAP. Given market dynamics, HPE believes it gained share in the quarter and for the fiscal year.
On a segment basis for fiscal 4Q20, Compute revenue of $3.2 billion (44% of total) was down 4% annually; all segment sales comparisons are in constant currency. Compute was also down 6% sequentially, against a tough 3Q20 comp in which sales were bolstered by catch-up revenue from supply chain recovery. HPE continues to see strong demand for VDI (virtual desktop infrastructure). On the lower sales base, segment profit contracted 58% annually, causing margin to compress to 6.1% for 4Q20 from 13.9% for 4Q19.
HPC & MCS revenue of $975 million (14% of total) was up 25% year-over-year and 50% sequentially. After experiencing COVID-19-related delays in installations and customer acceptance, this business is now benefiting from Cloud SP investments in AI data centers to meet explosive data traffic growth. For the long term, the Cray supercomputer within HPC & MCS has been awarded over $2 billion of business to be delivered through 2023. Segment profit jumped 51% annually, while margin of 12.2% for 4Q20 expanded by 200 bps from 4Q19.
Storage revenue (17% of total) declined 3% in GAAP and constant currency, but was up 7% sequentially. Storage was the largest single operating profit contributor in 4Q20, and segment margin of 16.8% expanded from 12.9% for 4Q20; Storage operating margin did decline from 17.4% for 4Q19. Quarter-over-quarter growth was driven by Big Data, by the services business of the all-flash Nimble business, and by reduction of backlog to normalized levels.
Intelligent Edge revenue (11% of total) was up 5% year-over-year in constant currency, and up 15% sequentially. HPE believes it is gaining share in campus switching and wireless LAN while expanding segment gross margins. The Silver Peak acquisition contributes to Aruba’s SD-WAN growth and enables HPE’s edge-to-cloud platform-as-a-service initiatives.
Advisory & Professional Services (3% of revenue) declined 9% as COVID-19 disruptions cut in the on-site consulting business. Financial services (12% of revenue) was up 4% in constant currency, as business activity improved; A&PS margin of 7.7% declined 70 bps year-over-year.
The company issued guidance for fiscal 1Q21 and updated preliminary fiscal 2021 full-year guidance.
For all of fiscal 2021, management guided for non-GAAP earnings of $1.60-$1.78 per diluted share; that was up from initial guidance of $1.56-$1.76. At the guidance midpoint of $1.69, adjusted profits would be up 25% from FY20 non-GAAP EPS (which declined 24% from FY19 EPS).
HPE is moving away from sales of stand-alone server and storage gear while pivoting to an as-a-service model. While the portfolio shift is necessary, it represents another operational challenge in a soft demand environment impacted by COVID-19. The aggressive cost-cutting program announced in May 2020 risks cutting into muscle as the company seeks to accelerate this shift while combating competitive threats.
Although HPE has lagged the market during calendar 2020, the company faces uncertain demand prospects. Full-year FY21 adjusted profit guidance bakes in a strong second-half demand recovery, which may not materialize. We believe a HOLD rating remains appropriate at this time.
EARNINGS & GROWTH ANALYSIS
Non-GAAP earnings for 4Q20 totaled $0.37 per diluted share, down 23% from $0.49 in the prior-year quarter and up by $0.05 on a sequential basis. Non-GAAP EPS exceeded the $0.34 consensus estimate.
Non-GAAP EPS of $1.35 per diluted share for fiscal 2020 declined 24% from $1.77 for fiscal 2019. For fiscal 1Q21, non-GAAP EPS is forecast at $0.40-$0.44 per diluted share; at the guidance midpoint, adjusted profits would be down 4% year-over-year.
For all of fiscal 2021, management guided for non-GAAP earnings of $1.60-$1.78 per diluted share; that was up from initial guidance of $1.56-$1.76. At the guidance midpoint of $1.69, adjusted profits would be up 25% from FY20 non-GAAP EPS.
FINANCIAL STRENGTH & DIVIDEND
The H3C (Tsinghua) transaction added approximately $2 billion to cash, which was partly used for stock buybacks. The sale of ES did not generate any cash for HPE; sale of Autonomy software added about $2.5 billion in cash. A roughly $1.4 billion cash outlay was used to acquire Cray.
Total debt was $15.9 billion at 4Q20, down from $19.5 billion at 3Q20 though up from $13.87 billion at the end of 1Q20. Total debt was $13.82 billion at the end of FY19.
In February 2018, HPE announced a $7 billion shareholder return program. In April 2020, HPE suspended its share buyback program.
In November 2016, HPE hiked its quarterly dividend by 18% to $0.065 per common share. We expect HPE to pay dividends of $0.48 in both FY21 and FY22.
MANAGEMENT & RISKS
Antonio Neri succeeded Meg Whitman as CEO in February 2018. Tarek Robiatti became CFO in October 2018. HPE has announced a three-year restructuring plan that aims to reduce run-rate costs by $800 million annually. The company has already engaged in past restructuring efforts, including HPE Next, that have presumably captured all low-hanging fruit in terms of perating costs. The company risks cutting into muscle as it seeks new cost economies while seeking to compete in a cloud-first world.
Any C-Level executive change entails risk. The CEO changeover is now more than a year past. Market response to the new CEO has been positive, given the tightening focus on profitable strategies and end-markets. Meg Whitman, while being a household name in Silicon Valley, ultimately presided over a sluggish company. Investor impatience has grown under CEO Neri, and if the current restructuring program does not produce results, shareholder pressure for leadership change could build.
Additionally, HPE’s digital solutions including cloud and data center infrastructure, intelligent edge networking, and HPC facilitate secular trends in the digital economy such as social media, remote workspaces, and growth in streaming traffic, that have been accelerated during the pandemic.
Hewlett Packard Enterprise has lost the steady cash flow from PC & printing operations and is becoming structurally smaller with the ES-CSC and software deals; HPE will also maintain equity stakes in those businesses. We believe that HPE is positioned to use its comprehensive offerings to maintain market share and eventually grow in a tough market environment.
Hewlett Packard Enterprise was spun out of Hewlett Packard Inc. (now known as HP Inc.) in November 2015. Hewlett Packard Enterprise provides core IT gear including industry standard and business critical servers; storage equipment; networking gear; and technology and financing services. In 2017, HPE spun off its IT outsourcing, BPO, and applications services unit and its non core software business. Niche acquisitions include Nimble (all-flash storage), SimpliVity (converged infrastructure), and Cray (super-computing).
Peer group analysis indicates that HPE is trading at a discount to peers on absolute and relative P/E, price/sales, EV/EBITDA, and PEGY. Our analysis derives a peer-indicated value of $12-$13, moving down from peak levels.
Steep drops in fair value are consistent with additional stock price challenges ahead, in our view. HPE is facing both cyclical headwinds related to COVID-19 and secular headwinds related to cloud transformation. The company is seeking to pivot its enterprise IT solutions to as-a-service even as it is further reducing its operating cost framework.
Despite multiyear underperformance, the company faces uncertain demand prospects. As such, we believe HPE will at best track the market going forward. We believe HPE warrants an intermediate-term HOLD rating, while our long-term BUY rating reflects the underlying quality of the franchise. On December 2, HOLD-rated HPE closed at $11.52, up $0.32.