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

Thank you for joining our Virtual Tech Conference today. I'm Wamsi Mohan, IT hardware and supply chain analyst at BofA. We're delighted to have HP Enterprise with us today. From HPE, we have Tarek Robbiati, EVP and CFO, and also Sanjot Khurana from IR. I believe Sanjot has a disclaimer to give first, and then we'll jump into some questions with Tarek. Sanjot?

Yes. This is Sanjot Khurana, Director of Investor Relations at HPE. Before we start, let me take a moment to read our disclosures. You'll hear some forward-looking statements in today's discussion. These are based on risks and assumptions that are described in our annual report on Form 10-K and Form 10-Q. Our actual results could differ materially, and we assume no obligation to update. More details can be found on our website at investors.hp.com, and our recent Q2 earnings announcement press release dated May 21. So with that, let me turn it back to Wamsi.

Thank you, Sanjot. And Tarek, welcome. Under different circumstances, we would be sitting in a room and at the Ritz-Carlton and those are not these times. But happy that you are able to dial in and join us remotely, and we appreciate you taking the time very much.

Well, thank you, Wamsi, for having me. Next time, hopefully, you'll be at real fireside chat -- fireside place, but we'll have the time to figure that one out.

Yes. No, absolutely.

So Tarek, I think let's jump into what's on most people's minds, which is how is the demand environment progressing? How are you seeing the impact of COVID on near-term demand trends? And what's your view on the second half? I mean there's clearly a lot of concern about enterprise demand got pulled forward. And so people, I think, are trying to frame how this year looks, and then longer term, sort of how things shake out. So can you maybe start there?

Sure. It's a great place to start. And thanks for asking this question. Like we said at our earnings announcement, the COVID pandemic is unlike any other crisis we've faced. It has brought quite a significant economic disruption. And this disruption was manifesting itself on both the supply side and the demand side. The supply chain productivity issues morphed during the course of the quarter from being related to a shortage of material to being much more, let's say, an issue, stemming from manufacturing constraints because manufacturing plants could not operate at full capacity due to the pandemic. And so what this has created is, a, excess backlog, or the large backlog that we wouldn't have in normal circumstances. And therefore, on the short term, we will have to fulfill the orders that stand behind this backlog. Now on a much more forward-looking view, it's very hard to predict what the demand environment might look like beyond the backlog, what is the steady state level of orders beyond the backlog. And the reason why this is that it fundamentally depends on the shape of the economic recovery. And we don't believe that this is going to be a quick recovery. The reason why this is, is that there are many economic indicators that point to a longer-term recovery, one of which is, for example, the unemployment level in the United States. It's incredibly high, and it's similar in many other parts of Europe where businesses have struggled. And before those businesses get back to their own level of activity, then that will take a certain amount of time from our perspective. So we don't see a V-shaped recovery. It's probably going to be a U-shaped recovery. The question is how deep is the trough with the U, and how far out the uptick of U will be.

So you mentioned the excess backlog, Tarek, that also came up on the call. What do you think is the pace of converting that excess backlog? I mean, clearly, a U-shape recovery implies that you're not expecting sort of all that backlog to convert in the very near term. Where do you see this backlog? How much of that is sort of HPC, which is predictable, more predictable demand maybe, but harder to fulfill given some of the other restrictions around COVID versus non-HPC that might be more cyclical, that might take maybe longer? Like what's the right way to think about this conversion of this backlog?

Sure. So we did flag, as you know, Wamsi, in our earnings that we had about $1.5 billion of backlog, which is 2x the normal levels we would have entering the quarter. That $1.5 billion is, for the most part, related to our Compute segment. There has been also an increase in backlog in HPC & MCS and Storage, but for the most part, this $1.5 billion pertains to Compute. And so it was really, really important that we take this backlog down. And it's -- our #1 and our #2 and our #3 priority is taking down the backlog over the next few weeks and months. Obviously, the pace of that depends on a couple of factors: one is the availability of the customers themselves that must have resumed their activities. And if you specifically look at HPC & MCS, there, it's the notion that customer must have resumed their activities is even more pronounced because in those sophisticated machines, the #1 requirement is making sure that the customer is accepting the performance of the machine that requires testing and that requires engineers coming on site, on both sides, our engineers and the customer engineers to make sure that the system is compliant. Now the good thing about HPC & MCS is the fact that these are very large contracts. And the entities that typically ask for these contracts are government entities. So there is no risk in our view around the backlog for HPC & MCS becoming perishable. And that's why it is, in a sense, the HPC & MCS side is more a matter of a delay than a risk of a potential missed opportunity. Whereas in the other case, in Compute, there could be a risk of missed opportunity. But so far, so good. We don't see any of these orders that we have in the backlog being canceled, and so -- which is a good sign from our perspective.

Okay. Understood. That's helpful, Tarek. So when we look at sort of you guys brought out this notion of a new normal. And maybe it will be helpful to contextualize that new normal in terms of what is structural within that new normal? And if there are elements that are structural, does that create a change to your longer-term strategy?

Yes. So look, there are a number of trends that we believe we should be cognizant of with respect to the new normal. The most obvious one is the one that we have been experiencing for a while, which is working from home and doing everything from home. And so when you look at this and you look at what's involved in it, for companies, it's very much a matter of deciding, for example, do you want to bring back everybody at home or not? And if so, do you want to bring anybody from home back to work or not? And if not, then what happens to your real estate and your workforce footprint -- real estate footprint? So this is a trend that is actually interesting on multiple fronts: First, it reinforces our Aruba strategy of getting connectivity everywhere and Aruba has benefited from this. And second, it's an opportunity for us to rationalize our real estate footprint. There are other trends of this new normal. So the second one we see accelerating is very much the acceleration and the move to as-a-service. And the reason why we say this it's because we see not only the benefits that an as-a-Service experience brings to our customers, but more so in a context where the CapEx expenditure of our customers were to come under the scrutiny as customers tend to protect their liquidity, they probably will turn to as-a-Service offerings to fulfill their needs, their IT solutions needs and pay for those solutions over time. So we see an acceleration of the as-a-Service shift on-prem amongst our customers. And in any way, we were on that trend some time ago, when we announced our strategy back in October 2019. So it does validate our strategy, tragically, I would say, given the loss of life that has taken care -- that has taken place under the pandemic, but we have to accelerate our pivot, as-a-Service even more as a result of that. Other trends that are very relevant in this new normal are network traffic is truly exploding. This is putting a lot of strain on enterprise networks. We need more capacity. So -- and more remote connectivity and therefore, also security because of remote connectivity. These trends benefit Aruba and they're there stay. Finally, I would call another set of trends out which are related to digitizing pretty much our operations. The days where you have a high-touch sales go-to-market experience that is driven through meetings may not be coming back as much. And so we have to digitize our marketing, our lead generation, and this becomes paramount to everything we do. And this is why we take the opportunity to really think about our restructuring plan as a means to digitize our operations internally to better save our customers from order generation all the way on to fulfillment through the supply chain. So I hope this gives you a flavor of what we feel the new normal to be. But that new normal in summary is very much -- very, very much on our strategy. The only thing that the pandemic has changed is the pace at which we need to execute that strategy, and we have to execute it a bit even faster pace than before.

Okay. Tarek, so when you -- you mentioned restructuring. There's been some investor sort of frustration about the fact that the last one, which was HPE Next was technically supposed to be the last sort of restructuring. And I understand no one could have really foreseen COVID-19, clearly, no one did. So it does create a whole new dynamic. So what is it that from a management perspective that you think will be the benefit ultimately that you can drive with this restructuring, which -- I know you addressed something around digital transformation as well. So how would you say that this structuring is maybe different from HPE Next? And do you anticipate that this will be enough?

Well, in life, never say never. Yes. That's a pretty simple truth. Of course, if you don't want -- you don't want to be perpetually restructuring. So I am very sympathetic to the views that you shared with me right now about investor concerns on restructuring. I would say, look, it's -- you heard me say this in the first month I took the job about HPE. For me, there needs to be a discipline in any company, and it's what I call the fitness test. We always have to make sure that we are lean, mean and agile enough to create revenue scale and profit scale. And when the revenue base is fundamentally shifting, it's really important that we rethink the cost base of the company. And that shift has become pretty strong due to the pandemic. It has created a very, very different dynamic. And where our normal fitness test cost takeout could have been spread over time, over 2, 3 years -- 3 years, 4 years, we feel that we have to accelerate this and do it on an 18-month basis, right? And so that's why this falls into a more of a step change in terms of the way we execute this But aside from the fact that we have to rightsize our business for the new revenue reality, there is another opportunity that we did foresee month ago, and it's that opportunity that is visible through the new segmented report that we provide to the market. And what we have learned through that exercise of segmentation, it took us a long time, by the way, to get to the point where we can provide Compute, HPC & MCS and Storage accounts end-to-end all the way on to the operating profit line. The one thing that we have learned is that we -- these businesses are very different in their economics. And therefore, because these businesses are very different in their economics, it's very important that we, through that exercise, understand the sources of revenue growth, the sources of margin growth and the sources of cash for each one of them. And in doing so, realigning our resources through those sources of higher revenue growth, higher-margin growth and higher cash generation is paramount. And that is what this restructuring is intending to do alongside with the usual things you would expect, simplifying processes, the streamlining operations, reigniting innovation in some segments that we may have left underserved. And so from my standpoint, what is different, to answer your question between this and HPE Next is that, that level of granularity and segmentation that we're going to go and chase now is very different and will allow us to execute and allocate resources on a very different basis than before and hopefully, on a better basis than before. And that's why we are doing it.

Okay. That's helpful. So if you think about the cost levers in the organization, can you give us maybe some -- maybe big picture figures that we can think about in terms of where the excess cost sits within the organization? I don't know if you want to address that at the segment level or at a corporate level, but where is it that you see the opportunity? And where is that sort of semi-variable -- I mean semi-fixed and variable cost or maybe even part of the fixed cost that you think that you can go address as part of this restructuring?

So where is the cost? I would say, it's everywhere. Once you simplify the business, you find opportunities for cost reductions everywhere. Is it at corporate or in the segments? Well, I would say, it's in both. As a matter of fact, externally, we don't see the difference because our corporate cost is allocated within each segment. But we do feel it is an opportunity in the corporate costs and an opportunity to better allocate resources and become more efficient in these segments as well. And one of the corporate costs that we feel is our WACC is probably real estate, as we explained. There is a large opportunity there for us that we have to go after and rethink. And that is something that is a little bit of a second quarter opportunity because once you rationalize resources as a first step, you will free up even more real estate space if you see one. So the opportunities are within each segment and at corporate level. And within this segment, another area I want to highlight to fully answer your question is, we have to rethink our product road map in some cases. And we feel very good about that, that we can still cover the market with a reduced and more simplified, more cloudified set of products than before. I just sat through a review of our edge business this morning. And it's quite extraordinary that we were able, over the past few years, to get our edge portfolio to be much more cloudified. So with platforms that are cloud-native platform that manage the hardware and covering the market with a single operating system, which is AOS-CX, that runs on different enterprise switches or different sizes, right? So these are things that come with time, and they are very much at the center of what we do. That recipe has been very successful. And what we got right now, a very, very interesting portfolio that is incredibly well-positioned in the marketplace, we feel.

Okay. That's helpful, Tarek. So one of the questions that I've gotten as part of investor conversations is these savings that you are expecting from these cost actions you're taking, how much of those will you ultimately accrue to the bottom line structurally versus things that will get offset because of things like other secular headwinds? So for instance, if you think about, let's say, there is -- will continue to be hypothetically a big shift to public cloud as opposed to hybrid or something that doesn't give you as much cushion on the demand side, then how do you -- how much of these savings will ultimately accrue to the bottom line? In the near term, clearly, a lot of it can. But how do you think about longer term, the potential to hold on to those savings as opposed to those getting reinvested to be able to just keep up with potential business deterioration?

Yes. So it's a great question. So if you look back at HPE Next, HPE Next, we committed to deliver $800 million of net run rate savings by fiscal year 2020. We delivered that a year earlier in fiscal year '19. Now you may say, where do I see that? And I got a question from a few investors. So what you will observe, if you look at our accounts on the fiscal year '19 basis, is that the OpEx, i.e., the cost items that are below the gross margin line have increased since HPE Next was launched in FY '17. But that increase was more than offset with an increase in gross margin. That gross profit increase topped, if you look at the trajectory, beginning FY '17 and FY '19, topped the $1 billion mark. And that is what entirely dropped to the bottom line during the course of FY '17 to FY '19. That's why you see those savings. In this case, there will be an element of gross margin improvement. But the fundamental issue here, if we want to be delivering $800 million of net run rate savings, is that we have to drive the OpEx lines as well as the cost of services line to improve total operating profit margin. And that holds on driving high level of productivity across the company with the resources that would be less. And therefore, the goal is to hold on to those run rate savings as long as possible. And the way we achieve those run rate savings in a sticky fashion is to digitize our business to create real operating leverage across the company, right? And that is where it's critical. So the punchline is, you will see and we would like to think that we can deliver those run rate savings that are visible through productivity improvements and digitization of our business moving forward, so that these can truly stick. And so we are going to do a little bit of a reinvestment. And that's why we speak about gross savings of $1 billion and net savings of at least $800 million by fiscal year '22, with a majority of those run rate savings visible by the end of fiscal year '21.

Okay. That's helpful. So when we look at sort of post separation, pre-COVID, you were tracking to a $2 billion annual free cash flow company. What will it take to really go back there?

Look, we were at a $2 billion company last year in terms of free cash flow, right? You know, for example, very well that we generated $1.7 billion of free cash flow after paying $700 million-or-so to DXC for a legal dispute that we have to, right? So the business is perfectly capable of generating $2 billion of free cash flow in a context where the operations are stable. And we were in that context in fiscal year '19. Now in fiscal year '20, this got disrupted with -- by COVID, right? So this quarter, if you look at our cash flow from operations and free cash flow, they were impacted by reduced profitability from the Compute and Storage businesses. And also, one thing you probably would appreciate is, we had a year-over-year growth in financing volumes that our HPE FS subsidiary trigger. This increases the CapEx number in the quarter in Q2, and that took the free cash flow in Q2 to a negative position. I don't want to constrain the volume underwriting of HPE FS just to retain a free cash flow number. I think we've got to let them underwrite volume to continue to grow the book. And doing so -- doing this, particularly in this environment in a way that is prudent from an underwriting risk standpoint. But ultimately, we do feel that in the long run, it's best, you look at our free cash flow by separating the free cash flow generated by Financial Services from the free cash flow generated by the operating company. And I need to show you and the financial market, that separation because you can't really ascribe a free cash flow target to a financing business. That whole model is all around underwriting volumes that depletes free cash flow in the short-term and you recoup your -- that value over time and more, right? So that's that. I also ask to flag to you and everyone on the call that our working capital needs were higher than normal in the past 2 quarters as we shored up inventory. The inventory levels have significantly increased. And you can see that in our operating cash flow. Operating cash flow has lowered by about $1 billion year-over-year. And the reason why this is, it's mainly driven by inventory increases. And yes, reduced earnings as well. But the role of inventory increases was significant. So on the whole, we have to continue to accelerate our strategy and drive the growth harder to restore the operating cash flow to the right levels. And at the same time, make sure that the CapEx equation is very well understood by the Financial Services community, particularly because of our as-a-Service pivot that would increase our capital intensity and that capital intensity would be offset by our Financial Services business. So therefore, it's really important that we explain that really well. And I want to leave no room for doubts as to what drives our cash flow overall, thinking that the HPE FS free cash flow is one thing and the operating cash flow is another for everyone involved.

Okay. That's helpful. So Tarek, we hosted Michael Dell earlier today, and he was sort of talking about how they have a competitive advantage with having a broader portfolio. How do you view HPE's ability to compete longer term? Do you see that there might be risk of being a provider of server storage, networking gear, but not necessarily broader pieces of the enterprise software stack or infrastructure stack in a more consolidated fashion like your competitor is? And if you think that you cannot, then is the answer just lie in doing more M&A and consolidation in the space? And if the answer is you can, then what gives you the confidence that you can?

So from our standpoint, look, I want to reiterate, our strategy is to deliver everything as a service from edge to cloud. And what our customers are telling us is that they want their infrastructure solutions to just simply deliver business outcome. And they use the word solutions because it's a combination of hardware and software. And very clearly, we know that from a financial standpoint, staying [ inclined ] to the domains of hardware is, at a time where all the hardware is getting commoditized, particularly in Compute, is something that we can't do. So we will have to expand to deliver workload optimized solutions, that are a combination of hardware and software, some of which we can do organically. And we've done very well in some cases, in AI machine learning solutions with the new data platform that we call, The Element. This has been very, very encouraging. And we need to continue to do so in bringing in more software-driven solutions through Q4 and to deliver those to our customers. By the way, if you think about the evolution that Aruba has gone through, the cornerstone of Aruba, for example, is the delivery of a simple-to-use secure management platform that unifies network management for wired, wireless, wide area networks and soon 5G and edge computing. And so that is where the value in Aruba Solution is and we'll continue to expand those cloud-native software-driven platform. So we see, for example, there, proof points of those solutions that we continue to build at our workload optimized for a specific purpose. So anything if you carry on and you look at our portfolio, the same holds true in the Storage category, right, where InfoSight and Nimble software is a platform. InfoSight is something that is adding tremendous value to our customers and enable them to manage their storage in a way that is quite unique. We added to that MapR. Remember, MapR was added to them. And this is why we have very strong margins in Storage through those software components that make the value of the solutions we provide to our customers. Equally, in HPC & MCS is the area where we have the BlueData platform I explained to you a moment ago, but above that, you have Cray. And the interesting thing about Cray is that it use utilities, fully superbly optimized solution with a hardware that is quite unique. But that hardware is working with a software stack that is proprietary and that is enabling very, very complex calculations with extremely high levels of compute performance. So we feel very good about this, but we need to continue in that direction. We feel we have a good portfolio. We need to continue to enhance that portfolio and take it to the next level.

Great, Tarek. We are actually out of time, but I do want to ask you one question that I've gotten a lot from investors, which is how safe is the dividend? And what is the trigger that, that will create a resumption and buybacks? And I know we're completely out of time. So I really want to thank you for taking the time and answering all these question so candidly, and we really appreciate it. And we look forward to talking to you soon again.

Sure. So let me be quick on the dividends given the given time. Look, our plan is to continue to pay dividends. Remember, the dividends are at the discretion of the Board and determined and declared on a quarterly basis in arrears. We did announce our Q3 dividend, and it's going to be payable in July 2020. With respect to our Q4 dividend, we will make a decision about that dividend towards the end of our fiscal year Q3, so end of July, early August. Dividends while in this quarter remain a very important part of our capital return strategy, and it's something we do acknowledge the importance of for the benefit of our shareholders.

All right. Great. Well, Tarek, thank you so much again. We really appreciate the time and look forward to hopefully doing this in-person sometime soon.

Thank you very much, Wamsi, for having me and Sanjot on the call. And it's been a pleasure talking to you, like always. And we look forward to doing in-person next time.

Thanks, Tarek. Thanks, Sanjot.

Thank you.

Thanks, Wamsi. Take care. Bye-bye.