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

All right. I think we're going to go ahead and get started. I'm Matt Cabral. I cover IT, hardware here at Crédit Suisse. And we are very pleased to have HPE here with us. We have Tarek Robbiati, CFO; and also Jeremy Cox, who is SVP of Global Tax, FP&A and Corporate Functions. So thank you, guys, for both carving out a little bit of time to join. The -- just quick on format. Hopefully, you guys are used to it by now. But no live Q&A that we're going to take, but we are available over email. So if there are any burning questions you want me to ask, it's [email protected]. And quickly before we jump into the conversation, I'm going to turn it over to Andy Simanek, Head of IR, for a quick safe harbor.

Perfect. Thanks, Matt. So just before we get started, a few disclosures. So you'll hear some forward-looking statements in today's discussions. 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 these. More details can be found on our website at investors.hpe.com and our recent Q4 earnings announcement press release dated December 1. So with that, Matt, I'll turn it back to you.

Perfect. I guess maybe to start off, understatement of the conference, 2020 has been a bit of a challenging year in a couple of different ways. Maybe just to kick off, Tarek, can you talk a little bit about just customers and how they're approaching budgets as we head into 2021 and just what you think are the biggest priority areas that they're focused on?

Sure. Well, first of all, Matt, thank you and Crédit Suisse for welcoming me and the team. Very glad to be here with you today at least virtually. Hopefully, in the future, it would be in person. But it's a great question to start with. And I think you're absolutely right. It's fair to say that 2020 has been challenging across the board for many companies and industries. There is a good deal of uncertainty with respect to the economic recovery. We did say it would be U-shaped back in May when we saw what was going on with the lockdowns. But things have moved on since then, and we are seeing some good signs of stabilization. And what is a lot more certain as a result of the pandemic is that businesses are forced to rethink and reprioritize and put digital transformation at the very top of what they do. Digital transformation is no longer just something that can be done at one's pace. It has become a clear strategic imperative. It's a must-do for all the companies. And the type of customers we're focusing on, large enterprises and mid-market customers, are really taking a different stance now in terms of the investments they are making to digitally transform. So we've been seeing growing order momentum in the quarters since Q3. This has continued in the last quarter that ended up October 31. We've seen growing order momentum across all our business segments: Compute, HPC, MCS, Storage and the edge. And it's an important indicator for us as we move into our fiscal year '21 that just started November 1 and with the backdrop of the news that vaccines are coming and going to be distributed, hopefully, swiftly and effectively to the entire world population. So from here on, we see gradual improvement. But there are still some degree of uncertainty. In Europe right now, the most recent news point to some countries that are facing harder lockdowns than others. The U.S. is not in great shape either. But overall, we say there is light at the end of the tunnel, and fiscal year -- or calendar year '21 will be different than what we experienced in 2020.

Got it. That's a helpful way to start off the conversation. And on that piece about digital transformation, I think the other area that we've seen and sometimes thought of as a little bit of an enabling technology behind some of that is just an acceleration in public cloud adoption that we've seen this year. Just curious for your perspective on if that trend continues, that sort of accelerated move toward public cloud next year and just if that changes your views on sort of the steady state for enterprise IT and where HPE fits into that world going forward.

Yes. So it is -- it was clear to us well before the pandemic that the cloud provided a unique experience that was gaining traction with customers. And for us, the cloud is an experience, it's not a destination. And when we looked at what that truly means for us, is that as-a-service models, wherever they are, whether they are in the cloud or on premises, are the way forward, and we have invested significant amount of resources, people and dollars, to boost our as-a-service offerings on prem, with our HPE GreenLake offerings, as you know. And we do see that the as-a-service on-prem market is buoyant. It is growing faster than the public cloud at a 58% CAGR. We see some substantial workloads that are of different nature than what we were accustomed to in the past, staying on prem as opposed to moving to the cloud. In the past 48 hours, you heard probably Andy Jassy saying that 96% of all workloads are still on prem. Well, I think he is pointing to a wonderful opportunity for him. I don't think it's 96%. It's probably lower than that, but it's still a very high number. There's a lot of the workloads that are on prem. And we feel that we are extremely well positioned to capitalize on the on prem as-a-service world because we have the capabilities that are needed to be able to compete there. And to be able to compete there, aside from the solutions that need to be workload optimized, there is the need to be able to truly offer flexible IT capacity and bill customers for truly what they consume. And so what that means, and this is the first capability that we have and a very critical one, we have the ability to measure the consumption of core CPU power, RAM, storage space. And all of that is effectively metered in such a way that customers only pay for what they consume, and we can flex up on demand, electronically, the amount of IT resources and the infrastructure solution that powers those workloads for our customers. This is unique, and this is what sets us apart. It makes us very different relative to other more traditional players, the Dells and Lenovos of the world who offer a lease on prem. A lease is just a means of payment. It doesn't really allow you to flex the actual solution capacity, which is what we do with our metering solution. So that's our first very important capability. The second very important capability that we would like to highlight is the fact that you need very substantial resources to go install, service, maintain those solutions on prem for our customers. And that's why if you really think about it in terms of Amazon Outposts, Amazon Outposts was there in the making for quite some time, but it's not obvious, to very quickly getting to the on-prem world globally without having an organization like we do, like our Pointnext Services organization that goes and installs and maintains the solutions on prem for our customers, with on prem defined at large being the headquarters of the company or a colocation in a data center that is under the control of our customers. So overall, we feel that the as-a-service business is very much growing. And this is a combination of public cloud and on prem as-a-service. That's why we call that the world will be hybrid, and it's going to be hybrid, on prem and in the cloud. We do feel that the on prem as-a-service world will be still very, very important. IDC effectively expects 70% of the current and future workloads to stay on prem. So we feel good about this, and we feel extremely good about the way we are positioned for that.

On that shift toward as-a-service, I mean, it seems to fit well in a lot of the conversations we have with customers, where much more of the preference is for OpEx these days as opposed to CapEx-based purchasing. It gives you a little bit more flexibility within the budget. I guess the one thing that I've always wondered is just if the shift to more of a as-a-service or consumption-based pricing model is enough to actually grow the pie. So maybe just help us understand a little bit more in terms of just demand elasticity that you've seen as customers have started to make that shift over to more of that kind of metered-based pricing model within your organization.

Yes. So look, it's a -- the ultimate acid test question is exactly that one. Is it additive or is it ultimately cannibalistic to a CapEx business? And the proof is in the pudding, and we will be proving to you, hopefully, that this -- the real driver of this are 2. Number 1, data. Data is exploding. And when data explodes, you have to put the compute power and everything that goes with it where the data is. And what customers are truly seeing is that the cost of egress of the data from the cloud is prohibitive. And therefore, they are wanting to ensure that: A, they have control over the data; B, the performance of their application on prem is better than from a legacy standpoint, in some cases, in some applications, happening when it is under their premises; and three, the cost element is a very critical element to the equation, too. So sovereignty of the data, performance and costs are really the key drivers of this as-a-service business. And so we do believe that there is a shift in terms of what customers truly want, having those 3 things in mind. Some of them don't really want to be managing the complexities of the infrastructure, right? And so some of them are very happy to find a partner like HPE who is taking that off the table for them, but they do want the control. And that's where the as-a-service on prem market opportunity lies. And so we feel very good about this. We feel that there is very strong demand. As a reminder for everybody, we did, in FY '19, say our annualized run rate of revenues would be growing at 30% to 40% per year. We did deliver 30% growth year-over-year on the ARR. We ended fiscal year '20 at $585 million, up 30% from the prior year, so smack on where we said it would be. It's accelerating. And we rolled forward by 1 year the target of 30% to 40% CAGR from '19 to '22, originally, to now '19 to '23. So this is a long-term trend that is at play, and we feel very good about this. And so customers will essentially make the decision based on the factors that we mentioned: performance, sovereignty and control of the data and cost. And if that means for them to actually pay for it over time as opposed to by way of CapEx, it's ultimately, purely a financial decision, but most importantly, from a business standpoint, the drivers of those that we just evoked: performance, sovereignty of the data and cost.

Got it. I want to come back to the near term a little bit. You mentioned in sort of your opening remarks that you're starting to see increased new orders momentum. Just wondering if you could dig a little bit more into that comment and talk about the demand picture that you're seeing, both kind of as we're heading forward into Q1. And then I think you talked about 1% to 3% growth for full fiscal '21. So maybe just how that plays out in the trajectory that helps you get there.

Sure. Maybe the best person to answer this question is our Head of FP&A. So let me hand over to Jeremy, and I'll ask him to answer your question on the order momentum. Jeremy?

Yes. Great. Thank you, Tarek. And again, Matt, pleased to be here with you guys in this conference. So as Tarek did mention, we did see increased order momentum that grew quarter-over-quarter across all our segments. And we reduced backlog to normalized levels through our strong supply chain execution that we saw largely in the second half. Now orders growth quarter-over-quarter, excluding China, for Compute was up 2%. Storage was up 9%. HPC/MCS was up 24%, and edge was up 12%. So total HPE, excluding China, was up 8%. So pretty strong order momentum that we saw from Q3 into Q4. And we're also pleased with the revenue rebound that we saw in Q4 as we saw -- as we see this gradual improvement occur. But again, we do remain somewhat cautious due to the uncertain pace and shape of the recovery from the COVID-19 pandemic, as Tarek mentioned earlier. So back to FY '21, as you -- again, normalized for the excess backlog reduction in Q4 that was approximately $250 million, we expect Q1 revenue to be in line with our normal seasonality, which is generally down roughly mid-single digits from Q4. For FY '21, we expect total revenue to be in line with our long-term financial target of 1% to 3% CAGR, as we presented at SAM. And with that, we expect to be able to deliver that through continuing a focus on our strategy, which, again, is to transform and stabilize our core, again that's within the Compute and Storage segment; and double down strong in our key growth areas like HPC and edge, where we're seeing the strong momentum in Q4 and expect to see that going forward. And then finally, as Tarek has talked about over the last few minutes, the acceleration of pivot as-a-service is expected to be an accelerant for us as well.

Got it. That's helpful. And digging a little bit more into the businesses. I think coming out of the quarter, HPC/MCS was one of the biggest upside surprises. Can you just talk a little bit more about what drove that significant uptick that you saw in Q4 in there, in particular?

Sure. I'll...

So do you want to go for that, Jeremy? Go ahead, please.

Yes, yes. I'll pick that one up as well. So again, HPC has been a great story for us. We're well positioned in the HPC and MCS area. The team has done really a fantastic job where we converted existing backlog and new orders in the context of a really strong pipeline. In Q4, we delivered record levels of revenue of near $1 billion, which was growing quarter-over-quarter 50% and 25% year-over-year. So really pleased with that performance. In that quarter, we saw strong performance across really the whole portfolio, in Apollo, MCS and Cray products, with Cray now being part of our operational -- integrated into our Operational Systems within HPC, within the company. We maintain a #1 market share position in HPC, with 37% market share as of Q2 data, which is 10 points above our next closest competitor, which is fantastic. According to the list of the top 500 supercomputers that was released last week or 2 weeks ago, Cray and HPE make up 39 of the top 100 systems and many -- much more than any other company. So at SAM, we talked about we already have more than $2 billion of exascale contracts in the pipeline that we signed during Q4 and including a pre-exascale system design win that we had with the European high-performance joint undertaking for $160 million. And as we think forward, the pipeline in exascale contracts is substantial with the pipeline that we see of over $5 billion to be awarded over the next 3 years. And our performance in this space has been fantastic to date, with us winning 5 of 6 deals in this space recently. So we see tremendous opportunity that lies ahead, and we're really excited for the growth prospects in this business. From an outlook perspective, we've noted previously in SAM that we expect to grow this business 8% to 12% over the next 3 years. And we think the pipeline and our trend supports that expectation. I'd also note that we expect margins in this space to continue to expand. We saw in Q4 that margins were at 12 point -- our operating profit was at 12.2% in Q4. And we do see a line of sight to grow that well into the teens as the revenue momentum continues over the next couple of years, and we see further synergies with Cray as we're integrating into HPE.

Got it. And specific to Q4, I mean, I know there's a little bit of nuance around how you can actually recognize revenue within this business. I know that the customer has to actually accept this system. And that was something you guys talked about that was holding back the business a little bit in Q2, Q3. Is there any way to think about just the contribution from those delayed installs in Q4 and how big of a factor that was? And if we should still be thinking about some delayed installs that are going to be a bit of a tailwind as we go forward into Q1 as well.

It's a great question, Matt. Let me also reiterate what Jeremy said. You remember when he was talking about the order momentum, and we saw a 24% sequential growth in order momentum for HPC/MCS. These systems take time to be built. The orders that you get in a quarter translate into revenue, very often, in subsequent quarters, so there is a fair bit of momentum there. And this category is new. And what drives this category is this explosion of data that requires ever-increasing amounts of computing power. So the old image that people may have about exascale systems that are powered by a crazy scientist somewhere in the planet is no longer applying. The practical reality is this ever-increased demand for high-performance compute is dictated by the explosion of data. So the momentum there is going to be sustained. And you heard from Jeremy the pipeline, that we are seeing $5 billion over the existing win of $2 billion that we can point to today that will translate into revenue over the next 2 to 3 years. We're going to go after that $5 billion. It's a very substantial opportunity, and our win rates are very high. Jeremy pointed out to 5 out of 6 deals won by us. So we feel very good about the momentum carrying into fiscal year '21 on HPC/MCS. This is a $3 billion-plus business growing at 8% to 10% per year. And we feel comfortable about this for the foreseeable 2 to 3 years at least.

Got it. I want to shift over and talk about Compute a little bit. It's a bit of a challenging year from a supply chain point of view. And I know that the backlog was a factor built earlier in the year. You guys cleared that over the last couple of quarters. I know you talked about orders momentum improving sequentially. I guess though, if I look excluding the backlog, it still, on a year-over-year basis, was down double digits, if my math is right, over the past couple of quarters. Maybe just help us understand what you're seeing in terms of underlying demand on the Compute side and just what the path back to growth for Compute looks like going forward.

Sure. So first, it's really important to choose the right comparison, right? So if you look -- you step back and look at what we said in the past. We said the tide had come down in fiscal year '20 relative to the highs of fiscal year '18 and so on and that we did expect a year-over-year gradual improvement, right? So the reason why I'm emphasizing the year-over-year full year comparison is because of the shifts in quarterly revenue recognition that we've experienced as a result of the backlog issues, right? So comparing a quarter of fiscal year '20 to the past is not the best comparison because it's abnormal in its making. So the best way is to look at normalized revenue when you normalize it for backlog conversion in Q3 and Q4. So strip out $500 million in your Compute revenue in Q3, strip out $250 million in Q4, look at the underlying performance. And also, quite frankly right now, the backlog issues are behind us. We're much more back to normalized levels. And the order trends that we spoke about a moment ago with Jeremy in Compute are positive. Our order trends are very encouraging. Compute, excluding China, was up 2% from an order momentum standpoint sequentially. And this is pointing to further stabilization of this business. So overall, I would say our strategy in Compute is to continue to transform the business; to further stabilize it through several actions such as continuing to grow share in the most profitable segments, optimizing our R&D, continue to make great strides in our supply chain delivery; and to deliver the lowest cost per compute workload. This is absolutely critical. And then, of course, pivot our compute infrastructure software management to SaaS as part of our as-a-service transformation, and we're doing that as we speak. So from there on, on Compute, key message, we expect gradual improvement moving forward. Look at the sequential trends more than the year-over-year trends. Or if you do want to look at the year-over-year trends, look at the full year year-over-year trends as opposed to the quarter year-over-year trends.

Got it, got it. And one more on Compute and maybe also broadening out to a wider discussion on margins. I know some of the backlog has driven a bit of a headwind on margins in that segment in particular. Maybe just talk to us a little bit about what was going on there. And then bigger picture, I know you talked about 15% to 20% operating income growth next year. Just the biggest factors that get you comfortable with that sort of a trajectory as we go into fiscal '21.

Yes. So let me tackle first pricing. So pricing depends on the segments, right? So you see very dynamic pricing in Compute. Compute is a high-velocity, high-volume, high-volatility business, so price swings are very much a function of commodity -- underlying commodity cost swings, right? So we're managing now Compute in a much more dynamic fashion than ever before. And so when you really look at our gross margin in Compute, it has been affected by the backlog. So the backlog in both orders were pertaining to Q1 and Q2 which were fulfilled in Q3, Q4. We had to honor the pricing of those orders. But in the meantime, commodity costs moved adversely for those orders, and therefore, the gross margin that came from those historic backlog orders was lower than the gross margin we realized in Compute from the more recent orders. And the more recent orders involved price hikes that we were able to effect. And moving forward, when you really look at our performance on margins, we feel very good about this. We're now much more on a steady-state basis, no more noise from backlog moving forward. So that is actually a positive. So as we look into fiscal year '21, we expect gross margins to expand. And we will continue below the gross profit line to optimize the cost structure of Compute, looking at optimizing R&D, optimizing also our go-to-market in that particular segment. And we should be seeing more scale returning back as demand resumes, so more revenue, and optimized costs. And therefore, we do expect to achieve in Compute operating margins of 10% to 12%, just in line with the outlook we provided you, Matt, at SAM. So that's the story specifically for the Compute segment. Now overall for the company, we do expect to achieve operating profit growth of 15% to 20%. That is coming from the 3 core priorities that we have for our businesses and also our cost optimization and prioritization plan, the priorities being: stabilizing the core, we talked about that; doubling down in the growth businesses of HPC/MCS and the edge; three, accelerate the pivot as-a-service. The as-a-service business margins are significantly above the corporate margins and should expand further as we add more software and intellectual property in those. So as long as we execute on those 3 priorities, we feel very good about our gross margins trends and our operating margin trends. And our operating margin trends will also be positively impacted by the cost optimization and reprioritization plan that we have been executing ever since we announced it in May of 2020.

Got it. We have a little less than 5 minutes left. I want to kind of broaden out the discussion a little bit and talk a little bit bigger picture about the portfolio. The company hasn't been afraid to divest over the past several years. I know -- I mean a lot of that was before your tenure. But curious for your perspective on the portfolio as it stands today and the opportunity for further refinement. And maybe as part of the question, just your latest thinking around H3C and what that means to the business going forward.

Look, we are happy with our position in H3C. This has been quite a unique setup. No one has that setup in China. We benefit from it greatly. Other players in China -- if you compare us to Cisco, their business or Dell, for the matter, suffered badly. It's an important market for us, and we have the right set up there. We do have an ability to monetize our stake in H3C all the way on to April 2022 with a put option. When we look at this, we continue to see the value accreting. And so we're in no rush. We just want to make sure we make the right decision at the right time. Our fiscal year '20 equity interest contribution from H3C grew 20% year-over-year to $212 million on a full year basis, which is a great result. And so we continue to observe and monitor the situation. And then we'll form a view as to how to extract value, realize value out of that at the right time, if we feel like it. So no change there. We keep monitoring. Happy with the value accretion.

Got it. And maybe the flip side of the question is just your thoughts around M&A. I mean I know you guys have been active in the marketplace. But curious for your perspective on capacity and the ability or the desire to do a larger deal. And if that is something that you could see as part of the picture, just what would interest you most as you think about M&A going forward?

Sure. So we jealously protect our investment-grade credit rating. It's very important. So I'm pretty determined to ensure that this doesn't change. And we have fair bit of cash on our balance sheet, about $4.2 billion. We repaid $3 billion of debt in October of 2020. We also paid the Silver Peak acquisition. So on the whole, we have about $9 billion of liquidity, if you include our revolving credit facility of $4.75 billion. So we feel very good about our financial strength, right? And so now we keep enhancing it. We keep pushing the ABS program to refinance higher-cost unsecured debt with ABS financing for our HPFS subsidiary. This feels very good. We'll continue to do that. So enhancing our balance sheet strength and liquidity profile is paramount. With respect to M&A, large deals that are highly dilutive are not something we'd like to do. I was flabbergasted looking at the multiple paid for Slack just 24 hours ago. I thought there was some confusion between the revenue multiple and the PE multiple, but I got that wrong. So what's very important for us is to maintain the discipline on the M&A front, look for acquisitions that are accretive to revenue and also to EPS. And if we do find something that is interesting to enhance our revenue growth profile and that is within the framework that we have in mind with respect to returns that we expect from any acquisition, yes, we will execute -- continue to execute M&A deals, just like we did with Cray, which is proving to be a wonderful deal; just like we did with Silver Peak, which we believe is going to be equally as good as Cray. But we'll retain the discipline in doing so. So from a capital management standpoint, I'd say to you, Matt, this. We have to invest to ignite the growth in this business. Our stock price is not satisfactory to us, to Antonio and I. We feel that a lot of what's in the stock price is the lack of growth, so we have to reignite the growth. That's #1 priority. In doing so, we have to make the investments, organic and inorganic, with discipline. But also, we have to recognize that dividends are an important part of the return to our shareholders. So we keep the focus on dividend. We never stopped the focus on dividends. Even during the pandemic, we kept paying dividends because it was an important thing for us to do for our shareholders. And we've declared a $0.12 dividend payable for Q1 '21 on January 6, 2021. So these are the priorities: investment in growth, organic or inorganic; dividends. And then with respect to share repurchases, they make sense once the growth is there. But if you really think about where we stand right now, we were not going to resume share repurchases until such time that we are back in a position of excess cash after reigniting the growth and returning dividends to our shareholders.

Perfect. Well, that was really helpful. Unfortunately, time flies. We could go on for another half hour, but we're out of it. So Tarek and Jeremy, thank you guys both for taking some time and joining me for the conversation.

Thank you.

Thank you. It's been a pleasure. Thank you.