Description

Hewlett Packard Enterprises

HPE is a $21.5 billion provider of networking, servers, and storage products as well as attached software and services. We believe HPE represents an attractive investment opportunity as the company gains credit for its transformation to higher quality businesses over the last several years and shareholders benefit from the cash generation from operations and divestitures. We see upside to $29/share or 35% IRR through 10/2025.

Business Overview

HPE recently held a Security Analysts Meeting (SAM) which provides a helpful overview of its business segments and is worth reviewing. The company has historically presented through four major segments, but recently re-segmented the business but hasn’t provided historical financials, so I think it makes the most sense to look at the business through the old segments.

Compute: General-purpose servers for multi-workload computing and workload-optimized servers to deliver the best performance and value for demanding applications. HPE believes the compute segment will benefit accelerating AI inferencing needs and the move to Proliant Gen 11 servers. Compute has historically been HPE’s largest segment by EBIT, until it was recently taken over by Intelligent Edge. Alongside headwinds, HPE aims for stable revenue with 11-13% operating margins.

Intelligent Edge - Portfolio of secure edge-to-cloud solutions operating under the Aruba brand that include wired and wireless local area network ("LAN"), campus and data center switching, software-defined wide area networking, network security, private 5G, and associated services to enable secure connectivity for businesses of any size. Additionally, HPE sees opportunity to leverage its position in SD-WAN and recent Axis Security acquisition to expand into SASE. The primary business drivers for Intelligent Edge solutions are work from anywhere environments, mobility, and IoT.  HPE has outlined low double-digit CAGR (from FY22) and ~25% operating margins for this business through FY26.

HPC / AI – Servers, software, cooling infrastructure (Apollo), and networking (Slingshot) for high performance computing requirements in AI, analytics, and large transaction workloads. Through the acquisition of Cray in 2019, HPE has acquired IP and assets to deliver and manage many of the largest computing environments in the world. Through the recent boom in AI – HPE has secured $3.6B in orders for Cray XD APU and Cray EX APUs, increasing from $100M in early 2023. HPE has outlined double-digit growth and 10% operating margins for this business by FY26.

Storage / Greenlake (Hybrid Cloud) – Primary and secondary product and services sold through hardware, software, and As a Service models through HPE Greenlake. Notable acquisitions overtime include Nimble Storage, and Simplivity as well as acquisitions Opsramp (AI Operations), Zerto (Backup), and Ezermal (Data Fabric). HPE expects Storage to grow sales at a 7% CAGR from FY22 to FY26 and achieve mid-teens operating margins. The Greenlake as a Service offering is expected to grow Annual Recurring Revneue at 35-45% through FY26.

Investment Thesis

1. HPE earnings power has shifted to higher quality, and higher growth businesses in recent years

• Compute and Finco has declined as a percentage of profits from 65% in FY22 to 50% in FY23
• Aruba is a well-positioned networking business with strong business momentum and quality ratings from analysts
  • Intelligent Edge sales have grown at a 15% CAGR since 2019 and operate with 25% margins
  • Management expects the Intelligent Edge to continue to grow despite 40% growth in FY23
  • HPE has invested $6bn in the Intelligent Edge / Aruba business since HPE acquired Aruba in 2015
  • Acquisitions subsequent to the Aruba purchase  have been focused on strengthening portfolio and serving growth markets such as SASE, Network as a Service, and Private 5G
• Storage business is also increasing in quality
  • Greenlake ARR has increased to $1.3bn or over $200M at Hybrid Cloud’s target EBIT margins, which equals nearly 50% of Storage’s FY23 EBIT levels

AI wave has potential to provide an earnings tailwind to the compute, HPC, and storage businesses

• AI has driven considerable upside in share prices of compute peers Dell, SMCI, etc. as well as data center networking companies
• HPE has relevant HPC and AI offerings that will see tailwinds from AI
  • Slingshot was acquired through the Cray acquisition in 2019, which is an ethernet based interconnect used in many of the world’s largest super computers allowing for multi-GPU approaches to AI training
  • Apollo is a cooling infrastructure used by existing super computers that will benefit as enterprise scale AI data centers
• Compute already in a downcycle with Q4 revenues declining 30% and EBIT declining 55% from peak quarter revenues in October 2022
  • Management indicated they are seeing stabilization in the compute market
  • Compute expected to benefit from AI as demand shifts from training to inference
  • HPE has recently announced a partnership with Nvidia for out of the box solutions that enables enterprises of any size to quickly customize foundation models using private data and deploy production applications anywhere, from edge to cloud
• Storage / Hybrid Cloud segment to benefit as Enterprises look to control data in AI era

HPE will generate half of its market cap in cash over the next three years and we believe management is more likely to return substantial capital to shareholders

• Over the next three years, we believe HPE can generate over $10bn in free cash flow through operations and proceeds from sale of H3C equal to half of the current market cap
  • Management has guided to free cash flow conversion increasing over the next few years from 70% in FY23 to 85-90% in FY25 and beyond
• Management increased return of capital targets from 60% to 75-85% at the recent SAM
  • Company responds to questions of cash from H3C sale by pointing towards their updated return of capital policy

Positive Near Term Set up With Recent guidance helps de-risk the company’s FY24 Outlook

• M&A has been focused on bolt-on acquisitions in recent years that have continued improving HPE’s portfolio
• Guidance for FY24 assumes H3C proceeds will be used for debt pay down – leaving upside to guidance if the sale takes longer to complete, management completes an accretive acquisition, HPE buys back stock, or HPE invests the cash in a higher yielding asset
• HPE has a considerable backlog in its intelligent edge segment, which provides a profit tailwind into FY24
• HPC was non-earning in FY23 despite ~$4b in sales and will begin to contribute profits to the group starting next fiscal year

We believe HPE is Much Cheaper than Most Investors Realize

• Bloomberg and FactSet both consolidate the financing company’s net debt but don’t give any credit for the financial company’s assets
  • With $325M of EBIT contribution vs $11bn in financial company debt, using the Bloomberg / Factset numbers creates a large negative overhang to HPE’s valuation
  • While some of the debt has claims on the operating company we believe the correct approach should be to value the finco and opco standalone or net the lease assets against the finco liabilities
• Financing Company headwind prevents investors from using an TEV based SOTP valuation methodology which we believe would make sense given the breadth in quality of HPE’s portfolio
  • HPE has varying segment quality – ranging from Intelligent Edge on the high end to Compute on the lower end
• While many sell side analysts value HPE using P/E ratios, some use TEV metrics and HPE is unknowingly being comped against much more levered companies on a P/E basis
• Using the book value of the financing company and the operating company’s net debt, we arrive at just 4.5x EBIT vs peers trading at significantly higher EBIT multiples
• The company has been made aware of the discrepancy and is looking for ways to update financial data providers

Financials

Valuation

We value HPE using a PE multiple using the weighted average of peers for each division, which benefits HPE’s overall multiple as higher quality segments in Intelligent Edge, HPC / AI, and Greenlake increased their contribution to earnings. We assume capital will be deployed according to management’s guided capital allocation plan with excess funds being deployed in M&A at 15x EBIT, which we view as conservative.

Catalyst

Capital Return in H1 CY24 - We believe the receipt of H3C proceeds and any subsequent capital return will be a key catalyst for the stock, which we hope proves management will use the opportunity to return capital to shareholders.

Enterprise Value Update – Any changes to how HPE’s enterprise value is presented within Factset / Bloomberg / Cap IQ would be a positive.