Description

Intro / Summary

HPE has been written about on VIC effectively twice in the last year - once pre-spin, and once when HPE was trading when-issued. The core thesis of both of those write-ups - HPE is better off alone than w/ HPQ; business is turning around; business is really cheap - is still in-play, but I believe the bull case has expanded meaningfully, with several levers to pull, several potential catalysts, and more tangible signs of turnaround success. Most importantly, the recently-announced spin-off of CSC (to be completed by March 2017) is a significant value-creator and adds a significant component to the bull-case on HPE.

The bull-case boils down to this: HPE and its predecessor versions have been mis-managed for a long-time, with poorly-executed M&A probably the biggest culprit, which is why the company has been mired in a 8x P/E valuation range. Meg Whitman has been righting that ship by cutting significant expenses and divesting all the challenged, low-margin, and/or minimally synergistic businesses, while focusing on the winners (IT hardware and related services) and holding nothing sacred. At the same time, proceeds from divestitures are coming back to shareholders w/ M&A optionality, which though carrying risk, the Aruba Networks purchase was excellent and more of the same would be great.

More important for the near-ish-term. The spin-off and merger of the enterprise services segment (the old EDS business, which was a failure from start) with CSC not only removes a major albatross from the core business, but will also improve the balance sheet and create significant value for shareholders on both the RemainCo and SpinCo sides. Post-spin, I believe RemainCo HPE is essentially another large-cap tech player - in-line with peers - and certainly worth more than ~8x EPS. All-in, I see total value in HPE shares post-CSC spin is ~$25-26/share, implying ~40% upside to current levels.

Description

Hewlett Packard Enterprise (HPE) is an IT hardware and software vendor, focused on enterprise and service provider customers, with offerings encompassing the entire IT stack (i.e., servers, storage systems, networking equipment, and infrastructure software). HPE is generally first or second in all of its primary market - 1st in servers and second in storage, and ethernet switching. In addition to the enterprise group segment (EG; >50% of rev; servers, storage, networking, and related tech services), HPE also maintains an IT services arm (~35% of rev; similar to ACN, IBM, CapGemini, CSC, etc.), with software and financial services (financing HPE hardware purchases) making up the rest of revenue.

Background / Recent Events

Since taking over HP in late 2011, Meg Whitman primarily focused on improving HP’s sub-optimal margins, poor execution, and optimizing the company’s focus and business mix. This has resulted in a flurry of corporate actions and restructuring plans since the beginning of her tenure. Aside from several rounds of restructurings (2012, 2014, 2015; mostly headcount-related), major corporate actions include splitting up the enterprise business (HPE) from the more consumer-focused PC and printer business (HPQ), acquiring wireless networking leader Aruba Networks, selling off stakes in MphasiS (IT services) and H3C Technologies (IT equipment provider in China; sold 51% of its interest to Tsinghua), and, most recently, announcing a spin/merger (i.e. via Reverse Morris Trust) of its Enterprise Services (ES) segment with CSC, to be completed by March 2017.

After all the dust settles, what will remain is an enterprise IT equipment provider of the full IT stack - diversified, but with all the pieces actually fitting together properly. HPE will be the only company with this distinction other than the soon-to-be combined EMC-Dell - IBM lacks servers and networking, CSCO lacks storage, ORCL lacks networking. More important than this intangible distinction, HPE will be growing top-line (albeit in the low-to-mid single-digits), returning a very significant amount of capital to shareholders (mostly via buybacks), and improving margins (even if still below that of several peers). Additionally, Whitman has noted that there are no sacred cows in the HPE portfolio, likely referring to the infrastructure software business, and the openness to pursue attractive M&A opportunities with strong ROI propositions (possibly in security).

Investment Case

Turnaround of Enterprise Group (Servers, Storage, Networking, and Hardware Services)

HPE is one of the market leaders (by share) in its enterprise group business, trailing only CSCO in enterprise switching and routing, trailing only EMC in storage systems, and the market leader in servers. The server business always been a strength for HP - though mostly commoditized and of lower margins - with HP’s size and scale being a significant differentiator, as well as the leverage point for the other infrastructure products. In general, despite the lower margins, server sales continue to grow, effectively in-line with digital growth (for lack of a better term) - more applications, websites, data growth, etc. all require more compute power = more servers. This is particularly in-focus in an increasingly cloud-dominated world, with cloud provides building out data center capacity en masse, with servers as the fundamental building block.  

Much of the networking and storage business are the result of multiple acquisitions over several years (3Par, Left Hand Networks, and 3Com the most prominent). Though the technology itself is solid, the enterprise group had been historically plagued by poor M&A integration and general execution mis-steps. Other than general management changes and other restructuring efforts to get things on track, the acquisition of Aruba Networks in early 2015 has been a home-run thus far, given Aruba’s best-of-breed tech on the wireless side, as well as the excellent management team at Aruba (Dominic Orr has an excellent track record in the networking field) that has taken over HP networking (Orr made a comment recently that when HP took over Aruba, Aruba effectively took over HP). On the storage side, HPE has been aggressive in moving in-line with dramatic changes to the storage market, most notably concerning all-flash storage arrays and hyper-converged storage architectures .

The proof is in the pudding: following 4 consecutive qtrs. of declines, the storage business reached inflection in the April qtr (+2% y/y rptd; +5% in CC), driven by all-flash systems. Mgmt. noted share gains against other industry leaders (EMC, NTAP, IBM, Dell) and that all-flash storage nearly doubled, which is 2x faster than the aggregate growth of the all-flash market, while being both larger and growing faster than the all-flash pure-play Pure Storage (PSTG).

Similarly, on the networking side, organic growth (i.e. adjusting for the Aruba acq) in the April qtr was +17% y/y in CC (much better than comparably-sized networking vendors) and mgmt. noted growth and share gains in switching and routing against CSCO, who actually noted weakness in campus switching during their April qtr. call. Further, in speaking with mgmt., they confirmed that growth should be in the double-digit range for the next few quarters, despite the lapping of the Aruba acquisition. None of CSCO, BRCD, JNPR, or EXTR are growing their networking businesses in the double-digit range.

On the tech services side (i.e., services related to hardware, not the ES business being spun), given the nature of the business (i.e., maintenance/service contracts attached to product sales), mgmt expects growth to return within the next 2 qtrs the recent turnaround in hardware starts to flow through the services side. Not only does this aid top-line, but tech services is also the best margin contributor after HPE’s software business, so inflection there will improve aggregate margins as well.

Altogether, the key / core of the RemainCo is the enterprise group, which comps to most mid and large-cap tech players (CSCO, IBM, EMC, JNPR, ORCL, NTAP, INTC, CA, XRX) and is growing top-line. While the margins of the segment are below most peers, a P/E discount of 4+ turns is excessive. On an absolute basis, a 12-13% earnings yield seems like a great deal to me.

Spin/Merger of Enterprise Services Business with CSC

One of the primary restructuring focuses of HPE and its predecessor was the former EDS IT services business. The ES segment has been in decline forever and generates mid-single digit margins. All-in, it has been a major albatross on the larger HP from nearly every angle, with the only positives being: 1) ES is essentially a distribution channel for HPE equipment (i.e. hardware “pull-through”); and 2) the massive restructuring efforts in ES are starting to show signs of progress, with margins improving and declines moderating, setting up ES to be a source of earnings growth over the next few years.

That said, the spin will allow HPE shareholders to still accrue the benefits of the restructuring efforts to-date, while removing the top-line and margin (and multiple) overhang that the ES business has been responsible for since HP acquired EDS several years back.

Looking at the spin effects with a bit more granularity:

• RemainCo will feature significantly improved corporate overhead costs and FCF gen: First off, ES margins are still below 7% and expected to reach only 9% when fully cleaned up (not exactly a cash flow machine). Additionally, ES carries above-avg. capex and roughly half of HPE’s stock-based comp (which HPE includes in non-GAAP results). Non-operationally, given that ES is in midst of a restructuring program, the spin saves RemainCo ~$1B of cash costs related to the restructuring.

• To avoid any revenue dis-synergies from the spin, HPE and the SpinCo have a 3-year agreement to maintain the ES business’s pull-through of HPE hardware post-spin. In addition, HPE has potential to garner hardware pull-through from legacy CSC customers, as well as the ability to engage other services providers (CapGemini, ACN, etc.)

• As part of the spin (which is tax-free to HPE shareholders), ~$2.4B in pension liability and $1.9B in debt will be transferred to the SpinCo, as well as a $1.5B cash dividend paid from the SpinCo to the RemainCo corporate entity (onshore cash), offset by $1.8B in offshore cash to help fund the transferred pension liability. The net result is a $1.6B improvement in net debt as well as a better mix of onshore to offshore cash. When excluding the financial services business, the estimated HPE will hold a post-spin net-cash position post-spin of ~$5B, or ~$3/share.

Looking at the Spin/MergerCo, the spin is expected to take place by March 2017, with CSC and HPE shareholders each owning 50% of the combined co. HPE mgmt believes $1B in cost-out synergies will be achieved in year-1 post-spin, reaching a $1.5B run-rate by the end of year-1. This is a net (not gross) number and is in addition to the savings from the currently ongoing restructuring program.

Put another way, when making assumptions for what the Spin/MergerCo will look like, the synergies should be extracted from an operating model that assumes ES segment margins of 9%, not 7% (before allocating corporate costs that go with ES when separated from HPE). Additionally, the synergies don’t sound like pie-in-the-sky numbers either - much of the savings is expected to come from facility consolidation and headcount reduction (Whitman noted that the combined co. would have 90+ data centers, which is way more than necessary). On top of this, CSC is also in midst of a restructuring program expected to improve margins. Even without considering this, the $1.0-1.5B in synergies basically increases combined co. EBIT by >50%.

I’ll put more details of the valuation below, but basically I view the HPE share of the Spin/MergerCo earnings to be worth $7/share pretty easily, (already being valued by the market at >$4/share)

Capital Allocation Levers and Catalysts

HPE currently pays a dividend (1.4% yield) and has $4.8B remaining in repurchase authorization (no end date).

Forgetting the authorization for a second (mgmt themselves views it as not all that meaningful of  a number), committed returns include 100% of FY16 FCF (~$2B, ending Oct) between divs ($190M done, ~$190M remaining) and buybacks ($1.2B done, ~$500M remaining). In addition, mgmt has committed to return 100% of the $2B in proceeds from the sale of 51% of H3C Technologies (to Tsinghua), with $1B over the next 2 qtrs. and the remaining $1B over FY17. That comes to $1.5B in share buybacks over the next 2 qtrs = ~80M shares or ~5% of the share base.

Regarding future capital return, mgmt has not yet indicated what it will do with 1) ~$800M in proceeds from the MphasiS sale (to Blackstone, to close in CQ3); or 2) the $1.5B on-shore cash dividend to HPE corporate from the SpinCo. Additionally, mgmt has said it has no interest in sitting on cash (remember, post-spin ex-financial services balance sheet will have $5B in net cash) and will likely update capital return commitments for FY17 at the analyst day later in CY16, likely to be at least 50% of FCF, if not more. Altogether, FY17 capital return could reach ~$4-5B (>15% of market cap post-spin) - $1B from H3C, $800M from MphasiS, $1.5B cash dividend to corp entity from SpinCo and at least 50% of ~$2B in FCF for FY17 = $4.3B

In general, mgmt.’s priority on capital return – as of today – are buybacks, though mgmt. has imparted that were an attractive M&A target to come along, mgmt. would not hesitate to pursue it (though while still sticking to committed buybacks). Additionally, HPE may not be finished divesting assets, with the software business a possible sale or spin candidate that would likely garner ~$8B in cash proceeds.

Bear Case

Server business fundamentally poor

There are a few angles to this arguments, but they generally include: 1) servers are commoditized; 2) growth is coming from cloud service providers (CSPs), who have pricing power and further hurt margins; 3) the generally lower margin aspect of servers - even without pricing pressure from CSPs - puts HPE at a structural margin disadvantage vs. other IT stack peers.

I don’t really argue any of these points. That said, HPE is the clear server market leader and the business is a good leverage point for its other hardware products. At the very least, it keeps HPE relevant with CSPs where a lot of other IT stack players may have trouble in that area. It’s not a terrible business in my opinion, but I admit its a negative point in certain respects vs. peers. Even so, how much of a discount should that deserve on multiple? One, maybe two times if you are super bearish? That’s what I assume in my valuation and the returns are still very nice.

Plethora of restructuring is killing FCF

Also, another criticism that has a few factors, generally along the lines of: 1) earnings quality has been low given the FCF drain from restructuring charges; 2) pro-forma / non-GAAP reporting distorting reality; 3) further restructuring would further constrain cash. From a quality of earnings perspective, none of these charges are recurring costs and the restructurings should be largely done by the time the spin occurs (which is why I’m looking at post-spin earnings power). In the meantime, FCF is still solid ($2B this year with all that restructuring charges aint bad) and the fact that HPE includes SBC in non-GAAP results is a major plus in my book, since basically no one else does that and it distorts true business costs when excluded.

FS business deserves lower multiple

I don’t like the FS business either, but IBM does the same thing, with just as much restructuring going on, and probably a less optimized mix of businesses right now (with their huge service albatross) and is still trading 3-4 turns ahead of HPE.

History of poor execution in networking and storage

Hard to argue but very backward-looking. Aruba guys know what they are doing and so far are doing a great job in the networking piece. Storage has been coming together recently, so give credit where credit is due.

Rev dis-synergies post ES spin

With a 3-year agreement in place to continue hardware pull-through post-spin, this won’t be an issue - if its ever a material issue, for a while.

Estimates / Valuation

Given the spin and the gist of the thesis, sum of the parts is how I value this.

HPE RemainCo

Looking at top-line and segment margins of the remaining businesses, EG should do ~$29B in revs for FY16, easily growing to >$30B over next-12-months (i.e., when spin will occur). EG margins are currently around 12%, with mgmt guiding to 12-14% near-term goal, and margin tailwinds from rev share moving away from servers and toward services and networking over next few qtrs. I put the business at a 13.5% segment EBIT margin. Software is expected to stabilize over next few qtrs and has been running close to $3.4B annually, with margins in the low-20s. I assume $3.3B run-rate by the time spin happens and 22% margin. Financial services runs at ~$3.2B and 10-11% segment margins, so I assume $3.2B and the low-end of 10% margin. I also assume corporate investments stay at the general range of $400M / year.

Mgmt has given fairly good detail on what ES will remove from RemainCo. Other than the obvious of the revenue and segment EBIT, HPE’s corporate overhead costs are ~$1B annually, of which ~$500M is stock-based comp. Roughly half the stock-based comp leaves with ES, while the other $500M in cash corporate costs are roughly commensurate to revenue share, with ES close to 40% of current total revs = $200M in cash corporate costs. Together with half of SBC (i.e. $250M), ES corporate costs are ~$450M, shrinking RemainCo corporate costs to ~$550M.

Additionally, the spin removes ~$1.9B of debt, which mgmt estimates should shrink interest expense an implied 3-4% interest rate on the $1.9B, lets call it a round $60M/annually. HPE interest is currently running at ~$280M/annually, putting RemainCo interest at ~$220M.

Assuming tax rate stays at the 23% range and shares move down to at least 1,650 (which is conservative given committed buybacks over next 2 qtrs and assuming ratable buybacks of $1B committed to FY17 from H3C proceeds), that puts RemainCo earnings power at the time of spin at ~$1.85/share. I put a 10x multiple on that, which is still a discount to the peers I mentioned above (CSCO, IBM, EMC, JNPR, ORCL, NTAP, INTC, CA, XRX) on 2016 P/E (and even 2017 P/E for that matter), but at least what I consider a normal mutiple for a low-growth (but not declining) large-cap tech player. That puts HPE RemainCo at $18-19/share

Spin/MergerCo

At the very least, the market is already valuing the SpinCo at $7B, based on what CSC’s market cap has risen to since the spin announcement and the explicit mechanics of 50/50 ownership between the shareholders of each (i.e., if the CSC piece is being valued by the market at $7B, that implies that HPE-ES piece is valued at the same level). $7B to HPE (using 1,650 shares) comes to >$4/share.

However, looking at the earnings of the combined company, the value should be much higher. Combined rev for the two companies should be $26B according to mgmt ($18B coming from HPE ES, which is less than what the income statements show because it adjusts for the MphasiS divestiture and a small piece of services staying with HPE). Assuming ES achieves the 9% EBIT rate expected to be reached sometime next year (already improved to 7% in most recent qtr), less the $450M in corporate costs it takes with it from HPE, less ~$155M in combined co. interest expense (~$95M existing at CSC, plus the $60M being transferred from HPE), CSC stays at roughly 7.5% EBIT margin, and add the $1B in year-1 cost-outs, the combined company should have EBT of $2.6B. Assuming a 23% tax rate (mgmt believes the combined co. will probably be a bit higher than simple merger modeling would suggest), net income comes to $2B.

Prior to the spin announcement, CSC (which is lower margin and lower rev than HPE ES) was trading at a bit more than 11x 2016 EPS. Assuming the same multiple, that puts the combined co. market value at $22B. With 50% owned by HPE shareholders, thats $11B (vs. the $7B being given by the market currently), or ~$7/share (using the 1,650 est. at-spin share count for HPE used above).

Altogether, thats $18-19 for RemainCo and $7 for SpinCo = $25-26 / share in value, or ~40% upside from today.

Catalysts

• Continued execution in the enterprise group (i.e. earnings)

• Fulfilment of buyback commitments

• Close of MphasiS stake sale and disclosure of what the proceeds will go toward

• Disclosure of what FY17 FCF proceeds will go toward (at analyst day later in CY16)

• Execution of ES spin

• Disclosure of what the proceeds of SpinCo dividend will go toward

• Execution of SpinCo synergies (i.e. earnings)

Risks to Thesis

• Execution mis-steps at either or both of HPE and CSC before the spin happens

• Further downturn in enterprise IT spending (already reported to be soft during Q1 earnings across the market)

• Bad/dilutive M&A

• Divestiture of software or FS at low valuation

• Inability to achieve post-spin cost-outs at SpinCo in expected timeframe

Accelerators

• ASR from some/all of incoming proceeds (MphasiS, FY17 FCF, SpinCo div)

• Special dividend from some/all of incoming proceeds (MphasiS, FY17 FCF, SpinCo div)

• Accretive M&A

• Divestiture of software business

• Divestiture of FS business

Catalyst

Catalysts

• Continued execution in the enterprise group (i.e. earnings)

• Fulfilment of buyback commitments

• Close of MphasiS stake sale and disclosure of what the proceeds will go toward

• Disclosure of what FY17 FCF proceeds will go toward (at analyst day later in CY16)

• Execution of ES spin

• Disclosure of what the proceeds of SpinCo dividend will go toward

• Execution of SpinCo synergies (i.e. earnings)