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

Perfect. Good afternoon, everyone. I guess it's afternoon in all time zones unless you're in Hawaii at this point for me. So makes my life easier now. My name is Amit Daryanani, the IT Hardware networking Analyst here at Evercore. I'm delighted to have HP Enterprise here for our next fireside chat. And we have HPE CFO, Tarek Robbiati; along with Marcus Kupferschmidt from the IR team over here. We'll keep this fireside chat around 30, 35 minutes. Irvin and I will ask a few questions in the post 20 minutes that we have prepared. And after that, I'm happy to open this up to the audience for any questions. If you have any questions, please feel free to e-mail them to me or better yet, if you want to use a chat function at the bottom of the broadcast, you can use that, and we will incorporate those questions as we go along with our discussion. And before I kick this all up, I think Marcus has to read some safe disclosure statements. So I'm going to [ spend ] it to you, Marcus, before I get in the questions.

Great. Thanks, Amit. Let me take a moment to read our standard disclosure. You will 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 10-Q. Our actual results could differ materially and we assume no obligation to update. More details can be found on our website, investors.hpe.com and our recent Q2 earnings press release. So with that, let me turn it back to you, Amit.

Perfect. Thank you, Marcus. Tarek, before I really get into the questions I have for the session for you, I think it might be helpful if you want to spend a minute or 2 really recapping our recent earnings call. And I think you had some really impressive top line growth numbers, it was around 9%, 10% top line growth. Really good numbers especially in the Intelligent Edge from what I recall. So maybe just spend a little bit of time. What are you seeing from an end demand perspective? What's driving the growth rates over here the way they are? And what's the durability of that? Maybe we'll start with that, and we'll get into questions from there.

Sure. Well, first of all, let me thank you, Amit and Evercore, for having me at your fireside chat, and I want to wish everybody a good afternoon. Yes, it's a good way to start is to recap where we -- what we said at our earnings call. Our second quarter was a very solid quarter from our perspective on revenues but also operating profit and EPS. We posted, in constant currency, 9% top line growth at HPE level with revenues at $6.7 billion. But when you really look underneath the covers and look at where that 9% top line growth came about, it came across the board. And so the Intelligent Edge business grew 17% year-over-year, almost at $800 million, $799 million; HPC MCS grew 11% year-over-year; compute stabilized and started to grow very strongly, 10%; storage, 3%. And with respect to the rest of our company, HPE Financial Services was strong at $839 million of revenue. Much better performance when you really look at the underlying profit drivers in HPFS, particularly around bad debt loss rates, which are really trending back to pre-pandemic levels and a very high return on equity. Overall, the growth was across the board. And back on to your second part of your question, Amit, how much growth is there, and how we peaked, how much runway is there. We feel the growth is sustained. The order levels are pretty high above normal seasonality that we would see, and this holds true for every line of business that we have and geography. So we feel pretty good about the growth prospects. There is one obvious unknown, and it's supply chain. And particularly, the ability that we would have to fulfill every order we get with the right level of supply, so far, so good. We did flag this, by the way. And you know it, at the end of the first quarter, we did flag that we started to see some supply tightness and other players in the industry did so as well. We were saying that for the short term, we didn't have any issue in Q2 and we didn't. But we were trying to work and so for the second half of the year, which we're still working through. And so as a result of that, we -- in our guidance for the full year and second quarter, we factored in that uncertainty and we're guiding our EPS up overall on a full year basis to a midpoint of $1.88 per share for the full year, as a result of uncertainty in supply chain, which so far, we are managing. And also some benefits that we had in our other income and expense line in the first half that won't repeat in the second half. And if you remind yourselves about where we were in terms of guidance, 7, 8 months ago when we started fiscal year '21 with our Securities Analyst Meeting, we guided the company's EPS to be between $1.56 or $1.76. And now we're guiding at a much higher level of EPS than that. We're guiding at an EPS number that is, like I said a moment ago, at the midpoint of $1.88 per share with a range of $1.82 to $1.94. So it's a pretty substantial uplift on the range relative to what we said at $7.56, or $1.76, has shifted up to $1.80 to $1.94. Equally, from a cash flow standpoint, we feel pretty good. We posted record free cash flow in the first half of about $931 million. Again, we upped our guidance on free cash to $1.2 billion to $1.5 billion, so $1.350 billion at the midpoint, which compares to the SAM original guidance of $900 billion to $1.1 billion, midpoint $1 billion. So it's a $350 million increase at the midpoint of the guidance on free cash flow. That's what I would say, I mean as an introduction, hopefully, that puts things into perspective for everyone in , but obviously, we can open up to more detailed questions now.

Yes. No, that is a really good, helpful, all in terms of what happened last quarter. Maybe I'll just ask you one more thing around the last quarter numbers and EPS. Tarek, you mentioned the full year number has obviously been really good. But there was -- if I think about your July guide and the back half, that did imply some sort of moderation versus the first half trend. Can you maybe just touch a little bit more on the puts and takes? And really what I want to get to is the OI&E line because that's where all the dynamics were shifting. So maybe just elaborate on that a bit.

Certainly. So we did benefit in the first half with about $0.08 of EPS coming in from one-offs. And so what effectively this means, if you look at our guidance at $1.88 for the full year, we posted $0.98 in the first half. $0.8 of that came from OI&E. And so we -- our guidance, from a purely operational standpoint, EPS that is stemming from operating profit improvement would suggest that we are flat half-on-half, if you back out OI&E. And that's fine. And the reason why the guidance is here is not because the demand isn't there. The demand is there, and it's much stronger than we anticipated and the runway ahead of us is very large. But I prefer to remain prudent on a EPS guidance at this stage as we sold through and work through the supply chain issues that the entire industry is actually witnessing as we speak. So that's the story, I mean, it's on the EPS and it's an OI&E benefit that we don't have in the second half. But I think that there is room for improvement on the guidance to the extent that we can address the supply chains.

Fair enough. And then maybe a comparable dynamic we saw was -- not comparable really. I guess, the free cash flow line, right? I think you raised to your point, the free cash flow numbers to $1.35 billion at the midpoint, which is up very nicely, $700 million from the SAM and up $100 million from a quarter ago, I think at the midpoint. Can you just talk about what is embedded? What is driving this kind of free cash flow uplift for you in the fiscal year, fiscal '21? And then importantly, how should we think about what is a steady state free cash flow number look like for HP Enterprise?

Yes. Look, I mean, The free cash flow in the first half was extremely strong at $931 million, which is a record relative to the history. But the history is relevant to some extent. The reality is that normally, our free cash flow would be back-end loaded into the second half. But here is different. And the reason why it's different is, first, we entered fiscal year '21 with a much leaner cost base. So our profitability levels have materially improved, and you can observe that across all margin metrics you choose to look at whether it's gross margin is at record levels, well north of the 34% mark. When you also look at operating margins, we are 10.2% at the half year point. This is a function of our cost optimization and resource allocation program, which is being very, very successful so far and will continue to be. So that is a positive. And the second thing that also influences the cash flow equation aside from the earnings is the working capital. And the working capital is a function of the investments that we make in certain aspects of it, in particular, inventory levels. So we buffered up inventory quite substantially. Our inventory has risen by about $600 million year-over-year at the half year point. And we feel that we need to remain cautious on an inventory-level standpoint because of the supply chain issues that we spoke about. And then also, we have to think about not just fiscal year '21, but there is life after fiscal year '21, as we all know. There's fiscal '22 and I don't want to artificially boost free cash flow in '21 at the expense of what could be a nice run rate in '22. And on to your latter part of the question, what is the normalized or free cash flow? I'd like to remind everybody that the peak of our restructuring costs expenditure is in fiscal year '21. And so even if we were to guide to $1.2 billion to $1.5 billion that is after absorption of restructuring expenditures, which could be up to $700 million in the year. So if you normalize for this, then you can really see the path to a free cash flow level well north of the $2 billion mark, which by the way, in fiscal year '19, we were very close to achieving well north of $2 billion of free cash flow. We did about $1.7 billion in fiscal year '19. After absorption of a $666 million unfavorable arbitration case that was not expected. So this company can generate well north of $2 billion of free cash flow. And we have to find ways to keep doing that so that we can invest that free cash flow to fuel the growth into the new areas that are going to be accretive to margins in the longer term.

Absolutely. You've touched on margins a bit over here. But as I think about your performance, Tarek, not only last quarter, but the last couple of quarters, right, the operating margins have been really impressive. I think Edge and Storage are both money at mid-teens. Compute's really good. Maybe HPC, the one I would say you have right now. But I just talk through when you look at your margin performance from a segment basis, where do you see the biggest room to expand margins? Where is the base upside as you go forward? And then maybe if you could just touch more on the HPC side over here, that would be helpful.

Sure. So as a reminder, and you can certainly refer to the presentation of -- that we put forward for our second quarter earnings, we look at our company and look at our segments in terms of 3 categories: growth, core and as-a-service enablers. And in growth, we include the Edge and HPC MCS. In core, we have Compute and Storage. And then the after-service enablers are HPFS, the financial services business, but also software that we have embedded in our corporate investment and other segment. So when you look at the margin profile and growth profiles of these business units, the Edge is very much at the top of what we said at SAM in terms of top line growth and operating margin profile. I was always asked a question, where do we see the Edge potential and what kind of profile Aruba will have? We see this now as a double-digit growth company with high operating profit margins in the high teens, if not in the 20s. That's not the profile of Cisco. That's a profile of a much faster growth, networking cloud-based companies like Arista, And we feel very, very positive about the trend in Aruba. Now you may say, why is that? And I think that the secret source there is the way Aruba has cracked the ability to deploy Wi-Fi at scale using a cloud-based platform, which is called Aruba Central, which essentially allows customers to substantially lower the cost of ownership of their Wi-Fi infrastructure, manage that infrastructure under the entire control provisioning, access points, isolating them for trouble shooting, et cetera. And they -- that platform is very, very successful in solving by way of software, what is normally very hard to do on Wi-Fi. It's just a little bit like a cellular network. But in a seller network, when you think about deploying a large amount of cells at scale, you have to deal with interferences, cellular networks have that capability built in the Wi-Fi doesn't always do that very well, except if you have a platform that is capable of solving that problem. That's what we have with the Intelligent Edge, and it's very, very successful. We see this business being very, very promising, especially now that we build it inclusive of an SD-WAN solution like Silver Peak that is doing extremely well for us and gives us the end-to-end from -- all the way from enterprise switching, campus switching, to branch with all the connectivity in between security. So that's that one. And with respect to HPC MCS, we're still scaling up the business. This is a business where we see 8% to 10% top line growth on a CAGR basis for multiple years. We delivered 11% in the second quarter. We see that growth being very sustained. This is a different business. It's more lumpy. We explained that multiple times, we have to reiterate it once more. The cycle of HPC MCS for those large exascale contracts in computers is not a quarterly cycle. It's a multi-quarter, if not yearly cycle, by during which you build those systems, deploy them on-premise for the customer and then eventually recognize the revenue. So we feel very comfortable there. We have a more than $2 billion of secured orders for HPC MCS that will materialize in '22 and '23 and beyond, '24. And there is a pipeline where also attacking, which is a $5 billion pipeline that we see, and we keep winning there. 5 out of 6 deals in HPC MCS that come pitch-able in the marketplace are won by us. So we feel very good about this growth business going forward. Compute is a very important business for us because it's 45% of our revenue, more or less. And it's about 47% of our operating profit. So I let you do the math yourself as the implication on cash flow from compute. Compute has to perform. If it doesn't perform, the company doesn't perform. And so we keep a very tight look and focus on compute. And we feel pretty good about this business in its current form, particularly with the backdrop of latent demand that exists in the sector as enterprise spending resumes. And you see more and more emphasis on customers wanting to change their -- the focus of the digital transformation, not just to automate stuff but to really build a more resilient business model for themselves. They need compute delivered with a software stack as a service on-prem, and that's what we're doing with our, also as a service pivot, that is dragging or pooling if you prefer compute with it. Now storage is a -- the fourth segment I'd like to highlight here, Amit. We are growing at 3% in storage and the story will unfold over the upcoming quarters. I'm very optimistic about where we are on our portfolio. We make quarter in, quarter out, $1.1 billion, $1.2 billion of revenue with very substantial operating margins close to 17% in the second quarter. We feel this is a business that can be, again, by using the same recipes, the same cookbook that we deployed in Aruba, we feel this is a business that could be a growth business. I won't sell you a double-digit growth story on storage, but I would say it's a business that could grow durably in low single digits, but with substantial operating profit margins as we pivot the portfolio to be much more software-driven than it has been in the recent past. And so what will fuel ultimately our margins on aggregate at the company level is more and more software in the mix of every single one of our segments, but also the segments that have higher gross margin calories growing faster than the segments who don't. And that's why you will see overall a mix effect playing across the board at HPE with gross margins going up. And as long as we keep a tight lid on discipline and expenditures, operating margins will continue to go up.

Perfect. That was a really good order view, Tarek, in the segments. And if I could shift this a little bit on the supply chain, this has been a big topic with every company I've spoken to so far is what's going with the supply chain and the implications there, right? I think personally, it was really notable that HPE has been able to navigate this, not just the last 1 or the last 2, 3 quarters, really in a very impressive manner. And I get this asked -- I get this question asked a fair bits. I want to ask you this. What is HPE doing differently than they manage the supply chain situation in a better manner than a lot of your peers have?

Look, I think there is a lot we can do still, right? I mean -- but if you reflect where we were last year, this time of the year, we're having a very different conversation about our supply chain, if I may. So we were hit pretty badly by the pandemic. And the supply chain was a function of the supply chain issues we have were functions of a couple of self-inflicted wounds that should not have happened. And also the pandemic that played in full swing in our second quarter running from February, March to April of 2020. So we've learned the lessons. And so never, never, never miss the opportunity that a crisis provides you to learn from what the situation is and adapt. And so we've adapted reasonably well, but I would not say that we are completely out of the woods because the practical reality is supply chains around the world in our sector and other sector have to be rethought not just for cost, but rethought and rebuild for resilient . And that calls on a very different set of operational disciplines in our company to get to that point. In the tech sector, you have also a geopolitical reality that needs to be reckoned with, which is the supply chains of, say, the Western world versus the Asia and the Chinese world are bifurcating, and we're no longer living in a world that is flat where globalization dominates. We're going to be moving towards a world. And you all know this, repeating the obvious, that a world that will be a world of clubs and therefore, for global companies like us, we have to adapt in a world of economic clubs with a supply chain that is much more resilient than in the past and geared for agility and speed, not just cost.

Okay. And maybe if I dig into segment into some of the segments a little bit. The performance in Intelligent Edge was -- has been impressive for a few quarters. I think it was up 15%, Tarek, last quarter alone. Just maybe talk a little bit more about what are the product introductions? What are the new products that are enabling that kind of growth in your market? And as you talk about Wi-Fi 6 on the deployment, should we think of this business actually almost doing better as the return to work narrative takes shape and takes form because I would imagine, as you go back to work, the need for life, that would be higher versus lower.

You're spot on, Amit. You're absolutely right. And so that's the reality behind the Intelligent Edge is this. We have the right products that were built for Wi-Fi deployment at scale. And the fact that we can manage multiple access points and roll out those access points fast with a single platform, is what makes the value proposition attractive to customers. However, the backdrop is favorable, too, to your point, which is the back-to-work backdrop is very solid. And companies' campuses, companies' footprints have expanded dramatically. And we work from home, that's the new office. And so therefore, when you have an SD-WAN solution that connects every single virtual office to the office, that also helps. And that's why Silver Peak came about exactly at the right time. And so it's a combination of Silver Peak, plus the platform on Aruba Central. On a macroeconomic backdrop where the enterprise is effectively becoming much more distributed and with a -- and therefore, there is a research and demand that is fueling the Intelligent Edge. And we don't see that relenting particularly because the edge continues to expand. It's not just the office, you have more and more new frontiers for the Edge when you think about 5G and what this is doing. It is going to change fundamentally our society and the way we work. And we feel everybody is extremely well-placed for that.

I wanted to tack on a multipart question on your other growth business, which is HPC and MCS. Although the results tend to be lumpy in nature, what do you think about -- what do you think investors don't understand about this business? And how should we think about your ability to perhaps expand the high-performance computing customer base beyond the sort of traditional public sector and academia verticals? And lastly, can you just talk about the potential to perhaps smooth out the revenue trajectory by offering HPC as a service?

Yes, wonderful questions, Irvin. Thank you for asking them. So we have a bit of a perception issue on HPC MCS, I would say. And the perception issue is this, people think about this as being a business or computers that are run by some crazy physics scientists somewhere in a desert part of the planet and where they're conducting experiments that nobody needs to understand. So look, that crazy scientist view of what HPC MCS is, is a part of the business. Yes, of course, we're building very large systems for scientific purposes in the public sector, but that's not the only thing we do. There are a lot of things and applications for vertical industries like health care, like oil and gas that require more and more computational power to do simulations that cannot be done with normal computer instances or server instances. And so it is becoming much more mainstream because the reality is the fundamental trend behind us is the explosion of data. And when you really think about data and the importance it will continue to have for an enterprise, it is a -- the most precious asset that an enterprise has. And it will be like this for the next decade or 2. And so therefore, harnessing the power of the data requires computational power that is going to be different, and some companies decide to make the investments in large supercomputers, which could be excess scales or non-excess scales just to harness the power of their data and some others. To your point, Irvin, we want to have the HPC as a service offering for them to be able to drive the workloads that are needed with that sort of computational power that they don't want to invest in, but they're prepared to do, to use on an ad hoc basis. And as a matter of fact, the sales motion on HPC MCS already contemplates this because you don't really -- you don't really want to engage such a level of investment on an exascale machine without trying it before. And so there's already that notion that you get out to try before you buy, which is the foundation of any new as-a-service offering. And we're going to be boosting that up over the upcoming quarters, particularly around artificial intelligence, where we see a substantial demand and where we are very active right now with our HPC MCS offerings. There's a lot more to come here. But yes, will you smooth the revenue? Yes, we can, but it will be I would say, a gradual process over time. But it's a happy problem to have. I'd rather have this $2 billion of extra scale contracts today than not. And so we will be gradually smoothing that revenue profile over the next years or so.

Got it. Got it. While we're on the topic of as a service, HP has been early in offering its entire portfolio as a service via the GreenLake offering. Can you talk about some of the strategic benefits to your customers? And then maybe perhaps strategic benefits to yourself? And so far, what are some of your channel partners saying about the offer?

Yes. So this is just the beginning. We have a long way to go there, but we feel very optimistic about it, and here is why. Our ARR for the second quarter was $678 million, and it's growing at 30% year-over-year with orders that are growing even faster than the ARR metric that we've posted. Orders growth was 41% in the second quarter, and it continues to accelerate. And the fundamental reason why it continues to accelerate is because customers like the cloud as an experience, and they like the simplicity of it. They like the fact that you can dial up or down the capacity as you see fit. However, we're starting to see a number of customers who are saying, "Look, there are some side effects with the cloud." The side effect number one is cost. The second side effect is, in some cases, performance because you have latency constraints that don't really suit very well certain applications. And the third one is this loss over the data, the egress cost of the data, bringing back the data from the cloud back to on-prem are really daunting as customers figure that out, once they got hooked on to the cloud. And so they need to control the data. And aside from the fact that you want sovereignty over data, you need to control it. You want to know where it is. You want to be able to protect it. You have a big issue around cybersecurity that needs to be guaranteed around this. This is more and more top of mind for our customers. Now we have the opportunity here to leverage with a different business model, our as-a-service offerings to really take a big, big chunk of the share of that as-a-service offering on-prem. As a service always winds with the cloud, but now it's not just with the cloud. It's an experience. It's a service contract that customers enter with, either cloud providers or players like ourselves. And you see some of our main competitors like Dell and Cisco's copying what we're doing on-prem because they realize that customers want to see that experience happening for them. In our ARR, the composition of the ARR is changing. So I want to let you finish and take away the following point. When we announced in November -- October '19, November '19, our Pivot as a Service at SAM in those days. I was asked the question, "What the difference between as a service and hardware leasing?" Well, the fundamental difference is what is making up the ARR. It is not just hardware that you pay for over time. It is operational services and most importantly, software. right? And that is where the magic truly happens. Leveraging platforms, just like the ones I've mentioned for the Edge. We're producing the same stuff to accelerate the buildup of the ARR with materially more software solutions that are significantly improving the experience that customers have on-prem for those instances. So it's a different model in the cloud because it's a on-prem, under control of the customer, but it's very differentiated because of that. And that's where the beauty of it is and where the potential is for our company. We have not explained the economics of the ARR just yet in full, but we will explain them better over time. And we'll talk more about that at SAM 2021. But suffice is to say that the gross margin of that ARR revenue stream that you're seeing quarter in, quarter out, is substantially above the gross margin that we have as a blended company today.

Perfect. I'm going to look forward to the next SAM to get an update on the profitability on these ARR metrics now. And I know we're up on our time, Tarek, so I will stop on our end, but I want to turn the mic back to you and see if there's any closing comments. Anything Irvin and I did not touch on that you want to make sure investors are aware about as you think about HPE? I'll turn the mic back to you for some closing comments.

Well, let me thank you, Amit and Irvin. You know us well, very well, actually, as a matter of fact. I think your line of questions were very thorough, very complete. There isn't anything that we haven't touched upon. I just want to leave you all with saying goodbye and selling date for Q3. And hopefully, we'll show you there's been further progress in Q3 and as we progress towards the full year. Thank you.

Thank you. Look forward to that. Thanks a lot for your time, Tarek.

Thank you.