Hewlett Packard Enterprise Company (HPE) Earnings Call Transcript & Summary

Good morning. I'm Katy Huberty, and I'm really pleased to welcome Antonio Neri, CEO of Hewlett Packard Enterprise. Antonio has been with the company for over 20 years but took over as CEO in early 2018 and, since that time, has delivered on meeting or beating earnings; but I think, importantly, done so while accelerating investment that you've seen in double-digit R&D growth. So thank you for being here today.

Thanks for having me.

Before we start, let me just say that Morgan Stanley disclosures can be found at the registration desk or on our website. So with that behind us, we can jump right into it.

Antonio, you reported earnings this week. So it's very timely. And the message was that you're still facing some of the demand headwinds that your peers are talking about. And yes, there was some supply chain disruption that impacted the quarter and the outlook. So maybe just take those 2 pieces and talk about what happened in the quarter. But more importantly, how do you see those 2 elements recovering as you move through 2020?

Well, thanks, Katy, and good morning, everyone. So we reported this week, and we reported our fiscal year Q1 for 2020. And I will characterize it as a mix because, obviously, disappointed that our revenue have been down 7%, and that was primarily driven by the compute decline versus the rest of the business, which was a growing story. And in that growing story, our pivot to as a service, which is something that I laid out last year, continued to gain momentum. That business grew 48% in the quarter, last year overall was already up 39%. And we decided this year to give visibility into the metric of what is really recorded in the P&L on that pivot, which is a metric called ARR, the annualized run rate revenue. And that metric shows that we are growing almost 20%, 19%. And that has been consistent for the last 4, 5 quarters on a regular basis. So on the strategic priority of pivot to as a service, we continue to gain momentum. The other thing that was very positive is the return to growth in Intelligent Edge. For us, the Intelligent Edge is all the connectivity and the mobile edge computing and the services that goes with it. That business was up 4%, but the Aruba offerings were up double digits. And all geographies grew. And in particular, North America, grew double digits. So that was a very strong testament that we have a very strong portfolio that's necessary to drive the digital transformation that we all live. And the other news about that business, we outperformed every single competitor in the market. All the peers in that market declined, we were the only one on the positive side. So that gives me a tremendous amount of confidence. And then in the core business, when you put aside the compute, all the other key strategic areas with high value, high margin also grew, whether it's high-performance computing with a combination of now HPE, legacy HPC and Cray, grew 6%. Our hyperconverged infrastructure grew, again, 6%. Our big data storage grew, again, 45%. So let's characterize the decline in compute and then what we see in the market, to your question, Katy. First, the decline in compute was driven by 3 factors, very simply. One is the macro uncertainty, obviously. We continue to see longer sell cycles, customers making some delayed decisions there. But that business actually, relative basis with our peer, did better because if you take our HPC business with our compute business, the net of that is a minus 10% compared to Dell, which was down minus 19%. So relative to our peers, performed better. But the macro uncertainty has an implication. The other one is we -- since the last Q4 and through Q1, we continue to see commodity constraints. That has nothing to do with the coronavirus. And I will explain later on the coronavirus. But the commodity constraints has been a challenge. And I will say we have demand and orders in our books we couldn't ship. And that's why in my commentary during the Q1 earnings, I said, "We enter Q2, which is the quarter that we're in, with a higher backlog than historical we have seen." And so that's the good news and bad news: I have the order, but I couldn't ship it. So that's the second part of this, and this has been a process that our supply has been on the recovery mode. We expect that to continue in the short term, but as the year goes through -- as we press through the year, the commodity constraints should alleviate. And the third thing is, for us, we had to make a consolidation of a site in North America, and that took longer than we wanted. But relatively speaking, that's under our control, under management. And we already took care of that. As I think about the implication of what we see today in the coronavirus. We have not seen yet an impact to the demand outside China. And in China, we have a unique model, which basically, 5 years ago, we decided to do a joint venture with a local Chinese partner where we sold 51% of our assets to the Chinese partner. And therefore, it's an entity called H3C. We actually have rights in the governance, but we collect the dividends of what they do. But we don't sell directly in China. As you can imagine, there will be some short-term impact in China on the demand, but we don't see, as of now, an impact on demand in the rest of the world. On the supply chain side, obviously, we see an impact. And that's where I said in the call because of the uncertainty and because of the time the supply chain will take to recover, we felt prudent, a, to not guide for Q2 because whatever number I give The Street, it will be wrong; and b, is to adjust the free cash flow for the timing of the recovery because as you can imagine, the revenue will take a little bit of time to recover. And then you have the need to augment the inventory as you rebuild some of the buffers because ultimately, you've got to get that motion in place. And I will say I spend a lot of time with my suppliers. In fact, I have spoken to 50 of the top suppliers; and yesterday, to the top 2 suppliers. And I will characterize this as a recovery in progress. Most of the, what I call, the PCAs, PCBs, which are manufactured in China, we expect on the capacity side, recover between the next 2 to 4 weeks. Some of them will be online, they're all -- all of them are online, but there will be a full labor capacity in the next 2 weeks to 4 weeks. The question is the entire supply chain behind them, it takes a little bit of time because you think about the components that these people need to build these motherboards and circuit boards and other components, will take a little bit of time. But from a capacity perspective, between 2, 4 weeks, we expect them to be at full capacity. And then there is all the other stuff we have to worry about, logistics. I was telling Katy before we came here, that -- remember that 50% of the logistics is done through commercial airline and 50% through freight airlines. And when you have no commercial airlines going to China, and therefore, the bellies of these planes are not full or that people are not traveling, it is a challenge that we have been working through. So I think I will say demand side, not a significant impact. We don't see it yet. Supply chain, definitely, and will take 4 to 8 weeks to recover. And ultimately, we expect that to improve as we go along. And then also on the commodity side, we expect that to improve as well over time.

Yes. One of the messages over the course of this past week is that companies believe that the supply chain will come back in the calendar 2Q, calendar 3Q period. And so I've gotten the question, why take down free cash flow guidance if maybe you can see a recovery in some of the working capital as things normalize?

Yes. I mean we felt it was prudent to adjust the free cash flow because, remember, we are in a different fiscal year than the calendar year. So we -- our fiscal year is November through October, and obviously, the calendar year is January to December. And so definitely there is a timing issue there. Second is that because we have a very large transactional business, which is all about velocity, that velocity has to come back. And I give an interesting data point, that we ship 3 servers every 10 seconds. And that's already pretty impressive if you think about it. But now to recover this backlog and getting it all in line by the time you can drive revenue recognition because obviously, you have to ship it, in some cases, you just -- when you ship it, you can recognize; in a lot of cases, that's not the case. You have to ship it. You have to install it. You have to turn it on. The customer has to accept it before you can recognize revenue. And that time line creates a challenge. And a day of working capital is a lot of revenue and dollars. And so this is why we wanted to make sure the ranges are what we felt comfortable guiding. Then obviously, as the time goes by, things will take care of itself. But let's remind ourselves, we have a negative cash conversion cycle, which obviously we collect faster, we pay slower. But on the other hand, that takes time as well. And so in the end, the thesis about our free cash flow has not changed at all. I mean we feel good in the normalized cash flow. It's just the timing and the pressure this thing is putting in the short term because, obviously, the major point here is we don't know what the end of Q2 will look like, and that's why we decided not to guide. But we feel good about the EPS guidance for the year because that is not 100% aligned earnings to free cash flow because of the timing, and we have other levers there. Obviously, one of them that we said is we continue to make our operations more efficient, and that's why the cost aspect of that facilitates the ability to deliver that EPS.

Yes. So as you said, revenue outlook down a bit; free cash flow outlook, down a bit because of the timing dynamics. But you reiterated the EPS guidance. And you think you can get more cost out of the business. I opened up saying that you have reaccelerated investment into HPE, which I think investors think is important because revenue growth matters. Talk about some of the areas where you think you can take out costs without hurting your ability to recover on the revenue side.

Yes. So when I became the CEO 2 years ago, in February 2018, I had 3 priorities for myself. One is our customers and partners, how we'll become even more customer-centric in everything we do. And I will say right now, for the customers we serve and the new ones we acquire, we have the highest NPS scores we ever had. The HPE GreenLake business, which is our flagship offering as a service, has an NPS score of 92, and the renewal rate is 99.9%. And they keep adding more business into that recurring side of the equation because it is a very differentiated value proposition where I can give you a true hybrid experience from edge to cloud as a service and you pay only what you consume. And therefore, that business keeps adding and adding in a cloud-like experience, whether it's on-prem, off-prem or all the way at the edge. So that's a good example of driving innovation into the business, which is an innovation we have been driven for the last 6 years. But customers and partners, and let's not remind -- forget that 70% of our business go through our channel partners. Channel partners are distributors, value-added resellers and solution integrators and so forth. Second piece is innovation. I'm an engineer at the core. And we only compete with the best innovation and the best talent. And so for us to stay in the forefront of that innovation in the segments of the market where we have the right to play and win, that's where we make investments, whereas the next big opportunity is the edge where we believe the vast majority of the data is created today. 75% of the data is created in places like this. Everybody is typing, collecting notes. It's not created in the cloud, in the public cloud. It's not created in the on-premise of the data centers. And what that means is that because of the digital transformation, the amount of data we created starts with connecting things, so connectivity is the first step to drive that digital transformation; and by computing things. And the computing side of this is this cloud experience that we need to bring where the data is because from an economics perspective, it's easier to bring the cloud to the data, not the data to the cloud. It's just physics and cost. So we think that's an opportunity. That's why our Aruba Central platform, which is a cloud experience where we can provision any type of multi-protocol connectivity: Wi-Fi, LAN, WAN. Soon this year, we're integrating 5G. So we can provide one single control plane for any type of connectivity with the same security protocols is an opportunity for us. And then add there the mobile edge computing side, which ultimately is this cloud experience. So that's an area of investment which I decided in 2018 to invest $4 billion over 4 years. The other piece of this is, obviously, the pockets of growth: AI, machine learning, big data analytics, simulation and modeling, are areas we're growing. And ultimately, it's all data-driven. And this is where the combination of HPE assets plus Cray is a unique setup because AI machine learning needs high computational capabilities to do the type of work they need to do. And we have proven with the Cray acquisition, we have an entire stack, it's not commoditized, it's actually, in many ways, specialized compute with intellectual property in the silicon and software. And now we have it all in a fully integrated stack between the 2 companies. And a testament of that is the government has awarded us more than $2 billion already in projects. And yesterday, we made a big announcement with the Lawrence Livermore Lab where we announced we're going to build what is called El Capitan, because this system has a name, and that system is going to be able to process that exascale. In fact, it's going to be 2 exaflops. Think about it, a billion-billion per second transaction. And the way I explained this is very simple. If the entire humanity today, which is 8 billion people, go to a calculator and does some sort of computation all at the same time, it will take 80 years to calculate that. And this system, which is the size of 2 basketball courts, and if you stack all the compute power in the number of servers, it's taller than El Capitan, which is a famous rock, in term of length. But the reality, it will take 1 second to do that calculation. So you can see the power of the technology that we can bring together. We think about solving the most complex problem. In the case of the Lawrence Livermore Lab, it's about a dealer with a nuclear stockpile because they need to certify every year that nuclear stockpile is safe and could be managed. At the same time, they have to modernize it. But in other cases, like the Argonne Lab or the Oak Ridge Lab, they use it for data science. And because of the coronavirus, they ask us, can we deploy in the short term some large HPC clusters because if you watch the news, Anthony Fauci, which is the Director of the National Institute for Diseases (sic) [ National Institute of Allergy and Infectious Diseases ], they are processing with researchers the cure for this coronavirus and the vaccine. And so this is how we think about it. That's why, as a company, we have a purpose to advance the way people live and work. But those are areas of innovation that we decided to make investment, whether it's organic or inorganically. And the third piece that I think is important. Sometimes, we don't get a credit, is the culture because in the end, culture is everything in a company, and the culture, the core is our employees and how we do business. So that's how we have been doing this. But HPE Next, as you talked about it, Katy, was a program I launched in 2018 to streamline everything inside the company to make us more agile, more nimble, more cost-effective. And that is a redesign of the business processes in IT because since the Compaq merger between HP and Compaq, there hasn't been any streamlining of the operations. There has been either bringing operations together or cloning operations because this split in this space -- in the spin offs. That's what we have done. But now we have the opportunity to really rearchitect the company and take cost out, which has been a very important aspect of the gross margin expansion. We have had 9 quarters of consecutive gross margin expansion. And despite the pressure on revenue in Q1, we expanded margins by 210 basis points. And so -- and to your comment you made at the beginning, we achieved or exceeded our guidance on EPS every single quarter. And our EPS in the last 2 years have been up more than 82% from end of 2017. And then obviously, we returned $7 billion of free cash flow to our shareholders.

On the margin discussion. Last year, about half of it was driven by mix in these new innovation areas that bring with it higher value and higher margin. And the other half or so was lower commodity costs. As memory prices come up this year, how do you see that netting out in terms of your ability to continue expanding gross margin?

Yes. So when we talk about AUPs in general, and this is the question I get all the time in the server business, 2/3 of that AUP has been structural, 1/3 has been the variation in commodity cost. And the reason why we should talk about structural is because as these systems become more dense with the latest technologies, what happens is you can attach more memory and more storage to these CPUs or accelerators or GPUs. And as I think about the generations we have gone through the server, we are on what we call generation 10 right now. Go back to the first generation, was in the late '90s because every generation has been between 18 months and 2 years apart. But that generation made an incremental step in improving the structural ability to attach more options to that server. As we go along here, we're going to be, at the end of the year and the next year, into 2 new generations. We'll call it 10.5 and 11. These new chipsets and microprocessor capabilities, will allow us, in the same form factor, add more memory. Remember, the first server was maybe 8 gigabits, then we attached 16 gigabits, we attached 32, 64, we are going up. It's the same form factor, but every gigabit you add is an incremental dollar you sell through the same server. It doesn't mean the units are going up, although this quarter, we grew single digits of units. But the same number of units, you attach more, which means the AUP is going to go up. That's point number one. And we expect that to continue. In a simple server today, you can ship now 1 petabyte of storage, which is remarkable in a very small server. But as we -- going through the back of the year, all our indicators tell us that the commodity cost, particularly on flash, will increase. And that's a function of cyclicality and capacity and demand. And to your point, in the last 6 months, we have seen a decline of that. And now we start seeing a stabilization in the curve turning the other way. I always make is analogy. When the cost goes up, it's like when you take off with the plane, the costs go up quickly and we price it quickly. When the costs come down, it's like when you land the plane. It takes longer to materialize that cost decline into your pricing. Therefore, the pricing elasticity is different. So this is why, ultimately, people want less footprint, less number of racks and servers, but they want way more compute power. And that's good for the energy consumption and total TCR in term of cooling and space and so forth. But from the AUP perspective, the AUPs over time, as this thing turns, will probably start increasing. And then you will get another structural improvement on top of that.

Great. You did a good job walking through some of the innovation internally around, and through acquisitions, in HPC and big data, et cetera. How are you thinking about M&A as a driver of returning the company to sustainable growth?

Well, let's talk about how we think about innovation first. I think about innovation in 3 forms. Organic, which obviously is the preferred way. And a dollar spent on our balance sheet on an organic innovation is a better return for our shareholders. And we have done a lot -- done all that. I mean whether it's the Composable Cloud as an example of that, from $0 to $1.5 billion in 2 years, is a point of we can innovate in the right place. And that's basically bringing the public cloud experience and economics on-prem and be able to run a multi-workload in the same infrastructure, whether it's legacy workloads, whether it's bare-metal virtualization or now cloud-native on containers. That's a great example. HP Apollo has been the air-cooled solution which is basically the legacy HPC business. That solution now is deployed in many, many large enterprises and obviously, in large governments because HPC is used particularly in governments, in specific verticals, weather and research and academia. Now we always think about what are the complementary technologies in intellectual property that goes with it and talent that we need to bring in the organization because the reality, you cannot innovate every day. And since 2015, I have done 15 acquisitions, starting with Aruba, which has proven to be incredibly successful; and finishing just a quarter ago with Cray supercomputers. Although this quarter, we did a small one called Scytale, which is in the security space, particularly as we think about open source in the end point in this new, what I call, cloudless model. So for me, it's important that we continue to do that, but it has to be in the context of a very stringent return on invested capital discipline that we have in this company. And be accretive. And if it's not accretive, how we get it accretive quickly because sometimes, you have to do that. But I argue, all the acquisitions we have done has been very strong for our portfolio and very good for our shareholders. And last, the third leg of the stool is the partnerships. We have very unique partnerships that complement the ecosystem. So I think, for us, M&A is a tool to continue to drive innovation, bring the right talent. But at the same time, not lose sight what is the best return on invested capital of our balance sheet.

Your strategy is edge to cloud platform as a service. And so 2 questions. If we separate that, what positions HPE to be best able to deliver that edge to cloud from a product standpoint? And then second, you mentioned this transition to as a service. What makes you think that customers at scale want to buy in that way? And what's differentiated about the way that HPE is approaching that in the market?

Yes. So from our portfolio perspective, as I said, the digital transformation includes 3 aspects: one is the technology, the second is the people and the third is the economics. On the technology side, that first step is connectivity, no question about it. We live in a hyper-connected world, whether it's your laptop or your tablet, your mobile phone, now things. We are going to go from billions of people and devices to trillions of things. That's a challenge, but also, it's an opportunity. And this is where we have really doubled down with our Aruba platform to provide the right connectivity to the right use case to drive that mobile-first, cloud-first experience at the edge. And because we are doing it in a cloud orientation in a subscription-based model, today, we have now more than 58,000 customers being run in the cloud, which by the way, can be run on-prem in your own environment or it could be in AWS or it can be in Azure. Those are the 3 instantiation. Or we can provide that connectivity through some of our partnerships with MSPs, whether it's AT&T, with Telefónica in Europe or other customers like Telmex here in Mexico as well. So that, to me, is the first step. And we do it with simplicity and cost in mind but, at the same time, full automation, which ultimately customers don't want to deal with any of this. What they want is to deliver an outcome through connectivity. We see an opportunity there because of the trends I talked before about the data, to move the cloud to the data. And this is where, as the 5G infrastructure gets deployed, we see an opportunity to bring the mobile edge computing in the form of cloud to that data. And we already have many use cases, whether it's smarter manufacturing or whether it is autonomous vehicles or whether it is, for example, in some of the very analog-driven industrial side where the convergence of operational technology and IT are coming together. And we have technology in that space with our edge line systems and other distributed systems that we can deploy. But ultimately, it's to provide the full end-to-end experience with the hardware and silicon all the way to the software stack and then open the ecosystem for developers to develop in this new environment. At the core business, obviously, what's happening is less about compute and storage, it's more about workload optimization. So if I have a workload, whether it's legacy or new cloud-native, how to optimize the full end-to-end infrastructure from the bottom of the silicon with security at core. And this is where we have invested in new technologies to provide that, particularly at silicon root of trust all the way to exposing the right services at the top of that stack. And this is where workload optimization is number one. And there is, again, simplicity in cost, but then be able to deliver all of this as a service. And we have technologies in software that allows us to meter every aspect of the consumption. One of the things that CIOs have told me, "Antonio, we do this. But I don't want to be in the run side of the business. I want to be in the innovation side of the business. So if you can automate everything and you can manage it for me, even in my own on-premises, I'm [ going with it ] because I want to focus my people on the data." Ultimately, outcomes come from data and workloads, not from running infrastructure, and that's where the power of GreenLake, and with the latest announcement of GreenLake Central, you can actually have a console where you can go procure, deploy and manage, or we can manage it for you, and pay only for what you consume. And one of the differentiations we have there is the technology at the top, which is software, and experience. And number two is the HP Financial Services because HP Financial Services is the financing engine inside that offer that allows you to free up capital from your balance sheet through upcycling. Take all the legacy infrastructure out, modernize it and shift it to a consumption model because HPFS is captive company inside our company. We have $13 billion under net asset management. We have an incredible return for our shareholder and return on equity of more than 15% and a loss ratio of 0.4%. And it's good for the circular economy because in the end it's good for environmental. We are able to manage those assets with sustainability in mind.

That's great. Let me stop there and see if there are any questions in the audience. If not, let me just ask you one more. What do you think is most underappreciated by investors about the HPE story, your stock price?

Well, that is for sure. I think, for me, is the fact that -- I understand the fact that 42% of our revenue is compute. And people say, "Well, if compute doesn't grow, the company doesn't grow." I get that. But the fact of the matter is that, let me be clear, I mean our compute business is a $13.5 billion business that delivers between 9.5% and 10.5% operating margin. Technically, it should be a commoditized business, but it still delivered 10% operating margin, and we have improved that over time. Our HPC business is a growing business. It has been growing. And the capability of Cray will add even more growth. And we have an enormous backlog in front of us to go deliver. And we don't see that stopping. The one thing that is also very underappreciated is our storage business. Our storage business is a $5 billion business that delivers 18% operating margin. Let me clear, if you put that next to NetApp, it's as big and more profitable than NetApp. So we are not confused about that. So we are not getting the credit for that and the innovation that we get in that business. Second is Aruba. I mean Aruba is a $3.2 billion business, obviously, growing. And we are growing in the areas where we have higher margin, which is the Aruba portfolio. And that business is critical to deliver these edge to cloud experiences. And the last but not least, I think there is this thinking, well, "Antonio, can you make this transition to as a service?" And I think you commented that before, Katy, nobody in the hardware business kind of has done that. We already have under our contract, more than 800 customers. Probably, the total contract value of that business already is in excess of $3 billion. In-quarter, yearly annualized revenue is in excess of $500 million. That business this quarter grew 48%. And we have a multiyear advantage. And when I think about my competitors and what they're trying to do, we know one of our largest competitor is trying to see how they're going to compete with that. And there is no easy answer because in that business, it's not about [ packaging thing ], it's about driving innovation through software that deliver that experience. So I think for us, it's always the same question of can you grow and can you expand free cash flow. I will argue that we have expanded EPS. We had expanded free cash flow, and the assets we have underneath are as good or better than any of our competitors, and I think we have better innovation. It's just we need to make sure we pivot this company in the long term because when you look at the total addressable TAM, which is $658 billion today, we see that going to $728 billion, but the mix of that will be all consumption-driven, and the on-prem aspect of that is very attractive and very profitable. And this is where it will be a multiyear journey, but we believe in that. And bringing that innovation to that need is the key.

Very clear message. Thank you so much.

Well, thank you for having me. Bye.