Fundamental Weakness Is Evident Going Into HP Enterprise Q1 2016 Earnings

  • HP Enterprise is facing stiff competition from cloud incumbents.
  • The revenue driver has shifted towards hardware, which has proven to be a low margin business.
  • As such, I view HPE fundamentals as questionable given the deleveraging of margins and weakening sales trends.

Hewlett Packard Enterprise (NYSE:HPE) is in a really tough spot given the massive shift in public cloud and it doesn’t seem like this trend will abate in the near term. For the time being, HP Enterprise has been able to adjust to this environment of migrating the data center out of the enterprise and into public cloud by selling Industry Standard Servers. Of course, there are some drawbacks to this given the negative impact on profitability it has had, as they’re more like white box datacenter vendors who provide their large scale manufacturing capabilities for commodity like margins, which turns HP Enterprise into more of a commodity business model. Of course, they do provide some ancillary services, but the revenue pool around those services is quickly shriveling up as cloud-based apps, and various other third-party services like Windows and Linux Server suck dry the last remaining profit centers of conventional IT firms (Unix Middle Ware in the case of IBM and for Oracle, Fusion Middle Ware).

Also read: Which of the two HP stocks should you own?

It’s really hard to like HP Enterprise given the massive value compression it has experienced. And no, unfortunately, the spin-off hasn’t created meaningful shareholder value, as the two separate companies are just as bad after their split. Competing firms have experienced multiple expansion in that same time frame (Microsoft, Google, and Amazon), whereas HP’s valuation continues to compress due to the weakness in investor sentiment and a pattern of short-sighted execution.

Here’s what HP Enterprise mentioned in their 2015 annual report:

Networking net revenue increased 4% due to higher switching product revenue as a result of growth in our data center products, partially offset by lower revenue from WLAN products. ISS net revenue increased by 3% due primarily to higher volume and higher average unit prices in rack and blade server products driven by higher option attach rates for memory, processors and hard drives.

So, the poor positioning of HPE has now shifted revenue towards industry standard servers, and as they had alluded to in the margin discussion (below), ISS negatively affects gross margins.

Let's go back to HPE’s 2015 annual report:

In fiscal 2015, EG earnings from operations as a percentage of net revenue decreased by 0.1 percentage point due to a decrease in gross margin partially offset by a decrease in operating expenses as a percentage of net revenue. The decrease in gross margin was due primarily to a higher revenue mix of ISS products and unfavorable currency impacts and competitive pricing, the effects of which were partially offset by improved cost management, improved pricing in Storage and a higher gross margin contribution in Networking from Aruba.

It turns out that HP Enterprise's remaining growth business negatively affects margin mix, which is why investors are anticipating profitability to further worsen over the long run. Furthermore, the company hasn’t given investors a compelling narrative for how on premise servers will somehow miraculously recover. In other words, there remains a lot of questions going into the HP Enterprise Q1 2016 earnings report as analysts seem a tad bit optimistic as the consensus anticipates $.40 in EPS. HP Enterprise's fiscal year ends on October 31st, which is why the 1st quarter tends to be more heavily weighted in terms of sales and earnings.

Furthermore, it’s worth noting that currency volatility heightened in Q4’15, which implies that HP Enterprise's top line figure will likely fall below estimates, which will translate into weakening margins even if HPE  were to manage its cost centers more aggressively. It’s also worth noting that Intel’s server units weakened in the Q4’15 timeframe, so if Intel is selling fewer CPUs it’s really up to HP Enterprise to make up for industry specific weakness by gaining market share.

2-17-16 HPE pic 1Source: Gartner

However, HP Enterprise has actually lost market share in terms of unit shipments over the course of 2015, which is blamed on the competitive bidding process of Lenovo and Huawei, which were discussed earlier in the annual report. If HP Enterprise wants to generate more revenue it will have to bid more aggressively against these firms, which implies weakening margins. However, if they maintain pricing there’s no denying that top line figures will likely suffer, which is why I find the F/X and pricing dynamics among third-party vendors to be particularly troubling. Furthermore, there’s no stopping the shift to public cloud, so if HP Enterprise wants to participate than it will have to sacrifice profitability or move more of its operations to China, which helps explain the logic behind the Aruba acquisition.

It’s worth noting that between HPE and HPQ the sell side seems more optimistic on IT as opposed to PC OEMs:

Upon the split we argued in favor of HPE over HPQ stock; relative performance is shown on the next page. Hewlett Packard Enterprise has momentum with expected slight revenue growth in constant currency and an improving operating margin in F16. This outlook was reinforced on the last earnings call. In contrast HP Inc told investors it would be investing for long-term gain. Our initial issue was the unsustainability of printer margins, but then unit demand fell apart last quarter. We remain concerned that HPQ estimates could be too high.

I just can’t get behind the stock right now, and I’m not going to assign a valuation on the company until I’m able to read through the guidance offered by management. The consensus views HP Enterprise as the better play going into earnings, but truthfully speaking both companies present the same weakness in fundamentals. Sure, HPE is more diversified and generates the bulk of its revenue from service level agreements. However, HP Enterprise's service segment declined by 14.1% over the trailing three-year period whereas hardware continues to generate low single digit growth. I’m anticipating hardware to sustain top line growth but at lower margins whereas services will continue to decline given the wariness towards vendor lock-ins. Also, the lack of vendor tie-ins among public cloud vendors moves services agreements to the application as opposed to the infrastructure, which simplifies some of the migration process as it’s easier to support apps as opposed to a homogeneous structure that is inclusive of both hardware and app deployment from some of the major brands.

As such, the dynamics just aren't really compelling as it’s likely that HP Enterprise's service revenue will not stabilize over the near term. Of course these dynamics are hard to anticipate, and many on the sell-side view the near-term shifts as transient as opposed to a permanent shift away from service level agreements. I take the stance that enterprise app developers will become more valuable and that outsourcing of infrastructure will eventually free-up resources for enterprise customers to design enterprise apps in-house, or use pre-existing applications as a part of the AWS marketplace to reduce software license cost in favor of cost per minute on an AWS server instance. I’m referencing AWS, but in reality these dynamics are also playing out among other cloud providers like Azure, Google, and Ali Cloud as well.

These strategic disadvantages and a high degree of uncertainty in Q4 2015 due to macro, industry choppiness and weakening market share creates an unconvincing case for investors. As such, I’m initiating a sell recommendation on HP Enterprise stock.

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