Description

HPQ is a name that everyone loves to hate.  The company has been a constant disappointment over the years with a series of strategic mis-steps including most notably the disasterous acquisitions of Compaq in 2002, PALM in 2010 and Autonomy in 2011. Tech investors don’t want to go anywhere near the stock because of its moderating growth rates, value investors think it’s a value trap, and event driven investors have been burned too many times in recent memory and have become incredibly risk averse.  Our investment thesis is relatively straight forward – HP Enterprise is currently trading in the when issued market at 4.5x FY 2016 EBITDA, 8.6x FY 2016 P/E and a 12.3% normalized free cash flow yield and at an unwarranted discount to almost every one of its comps in every vertical in which the company competes.  We think the pending spin will help erase the HPE's discount, make management focused on growth and drive long term value. Contrary to the comments recently made by a famous short-seller, we don’t think the spin is “financial engineering” in the most commonly used form of shifting capital structures, and actually think HP Enterprise and HP Inc are two very different businesses with different capital needs and potential growth rates.  We think the recent Analyst Meeting may have been a near-term overhang as we think investors may have thought that the company could again use the day as an opportunity to further reduce FY 2016 estimates.  Instead, the company essentially reiterated guidance, and made thoughtful presentations for both the strategic and financial reasons for the spin and the current market opportunities.  We now think there is very little downside in the stock, expect the stock to begin to outperform into the spin-off expected on Nov 2.  As an aside we also like selling the Jan 25 put to buy the Feb 32 call for even money.

HP Enterprise:  HPE will contain the Enterprise Group, Enterprise Services, Software and Financial Services Groups.  The company’s total addressable market is expected to grow by 4.4% over the next 4 years as follows: 2.2% for servers and storage; 3.6% for networking; 3.9% for Technology Services; 4.5% for Enterprise Services; and 7.8% for software. Key areas of potential growth include: converged infrastructure, network virtualization, wireless campus networking, security and cloud software. The Company generated $52.7bn in LTM sales with a blended 9.2% EBIT margin. The company will have initial levarge of 0.7x debt / EBITDA with the following capital structure (excluding the $11 bn of debt held at Financial services) is $10.5bn in cash and $5bn of debt for a net $5.5bn cash position.   The company recently announced a $3.0 billion stock buyback and we think management intends to use its balance sheet to execute small targetted M&A in cutting edge tech in order to reinvigorate its growth rates.  The Autonomy deal continues to cast a dark shadow any time the words HP and M&A are uttered in the same sentence but we would remind investors that Autonomy was not done under Meg Whitman's watch, that recently successful transactions include 3PAR and Aruba Networks, and that completing a $6bn deal on a $30bn company has more meaningful impact on financials than on a $60bn company.   

Enterprise Services:  The segment generated $20.3bn in LTM sales with a 4.9% EBIT margin. From FY 2013-2015 the segment’s revenue declined by ~$4.0bn due to the loss of 3 major customers which accounted for ~65% of EBIT as well as FX headwinds.  As a result the segment has diversified accounts so that no account is currently larger than 10% of EBIT. Margins have expanded for the past 2 years as management has cut $700mn of expenses in 2014 and expects to cut a further $1.4bn in 2015.  The segments long-term margin target is 7%-9% which is expected to be achieved by 2018. 

Software:  The segment generated $3.8bn in LTM sales with a 22.3% EBIT margin.  The TAM is estimated at $53bn with an 8% CAGR through 2018. Approximately 52% of revenues come from support and maintenance, 28% from license fees, 11% from services and 9% from SaaS.  The segment generates 18% of revenues from security, 18% from big data and 56% from ADT/ITOM. Revenues are expected to stabilize in FY 2016 despite the shift to SaaS and other subscription based models which is placing some headwinds on HPE license revenues.

Enterprise Group: The segment generated $27.8bn in LTM sales with a 14.5% EBIT margin.  The company’s revenues are growing in constant currency terms with improving margins.  Recent successful acquisition include 3PAR in storage and Aruba in wireless campus networking.  Post spin, we expect further targeted M&A in the Enterprise Group which should help the company reinvigorate its growth rates.  Areas of growth include cloud, big data analytics, high performance computing, and wireless campus networking.

Financial Services:  The segment generated $3.3bn in LTM sales with an 11.2% EBIT margin.

HP Enterprise Valuation:  HPE expects to generate FY 2015 non-GAAP EPS of $1.83-$1.86 per share and FY 2016 non-GAAP EPS of $1.85-$1.95 per share with the biggest pressure coming from a ($0.24)-($0.25) FX headwind.  The company also expects to generate approximately $3.7bn of “normalized” FCF which excludes $400mn in separation-related cash payments and $1.2bn in restructuring charges.  As our comp sheet below shows, we think the relevant comps include Cisco, NetApp and Juniper for Enterprise,  Accenture, Cap Gemini, CS and IBM for Services and Oracle, CA and Symantec for Software.   A P/E multiple at the bottom of our comps at 12x would generate an HPE value of ~$23.00 or 37% while a 5.5x EBITDA multiple would equal a value of $28.00 per share, or 66% above current levels. 

 
Risks: Further strengthening of the dollar, misguided M&A, moderating growth rates.

Catalyst

Spin off of HPE in Nov 2015.