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

Good afternoon, or good morning. Thank you again for joining us today at the BofA Tech Conference. I'm delighted that you all could join us again. We're halfway done through the day today, and there's been lots of interesting sessions that I've hosted and my colleagues have hosted. So I hope you find these all useful. If you would all take some time to go vote in [ II ], we would all appreciate that very much. So with that, let me welcome HP Enterprise CFO, Tarek Robbiati, who's joining us today on the call. Also, we have Andy Simanek. Andy wants to make a quick opening statement, so let me turn it over to Andy.

Perfect. Thanks, Wamsi. So just really quick before we start. Let me take a quick moment to read our disclosures. So here are 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 make updates. More details can be found on our website at investors.hpe.com and our recent Q2 earnings announcement press release dated June 1. So Wamsi, let me turn it back to you. Thanks.

Thanks a lot, Andy. I appreciate that. So Tarek, to kick it off, maybe we can start off with -- first of all, thank you for being here. To kick it off, maybe you can talk about the most recent quarter. You showed some pretty strong growth. Clearly, the demand environment itself is improving somewhat as the economy is reopening. You also had somewhat easier compares. So how sustainable do you think this growth is?

Well, first of all, Wamsi, thank you for having me and Andy here today with you at the Bank of America Merrill Lynch Conference. I'm very happy to be here with you. Your question is a great way to start. I would say that, overall, our second quarter was very strong, with solid beats across the board. Yes, if you do a year-over-year compare, it looks easy. But what a difference a year makes in terms of where we stand as a company relative to what we were facing a year ago with the pandemic. We're in a much, much different shape now than what we were at in Q2 '20. We have a much stronger performance across the board, not just in a particular area of the business. And every business unit, whether it's the Edge, whether it's HPC/MCS, whether it's the core with Edge and -- with, excuse me, Storage and Compute or the HPEFS, Financial Services business, everything is performing very solidly. It's best to see it on a sequential basis, Q1-on-Q2, our total revenue at $6.7 billion for Q2 was at a level that is a much better level than what we would observe in terms of seasonal Q2-on-Q1 decline. And we beat The Street comfortably on revenue, OP and EPS, as a result. So a really good quarter, but we feel now we are very well-positioned. And what's most important is also to look at the demand, and the demand that is coming is very sustained, very broad across the board. So we feel good in terms of the positioning we have, and we have a solid runway ahead of us for fiscal year '21 H2, but also for fiscal year '22. And part of it is because companies now are really realizing the importance of digital transformation. And this is no longer just a means to deliver simple electronic automation of some processes, but what has resonated with companies is the disruption that a pandemic can bring to their business models and they're looking for ways to strengthen their business models through digital transformation. It's a much more profound necessity and strategic imperative for companies today than it was just 18 months ago. This is what is fueling the demand as to cloud, and we feel very comfortable in terms of where we are and the run rate that we have had.

Okay. That's great, Tarek. So can you maybe talk about -- I mean, you just touched on strong demand. Can you talk about how that demand is shaping out maybe across different regions or by your different sort of end markets and your segments? Can you talk about like where you're seeing sort of the best improvement and where you're expecting more follow-through?

Sure. So let's take the segments one by one. So first, the Edge has delivered an, I would call it, impressive double-digit growth in the second quarter, 17% in constant currency. I feel very good about this level of growth. And this is across the portfolio, whether it's switching, wireless, LAN. And it includes also, obviously, the contribution from Silver Peak. What stands behind it is the notion that the footprint of the enterprise is expanding, right? And we are now more and more working -- for a moment, it's not going to go away, it's going to be a reality. And there's more and more data collected at the Edge, which therefore requires connectivity and Aruba benefits from. One of the reasons why Aruba benefits from it, I would argue more than others, is because they have built the solutions that are cloud native, that allows them to deploy WiFi connectivity at scale. It's not easy to do that. The reason why it's not easy is if you look at a comparable, which is -- a comparable industry, which is the financial services -- and excuse me, the telecom industry, you will see there that when you roll out our network on a wide scale like this, then you have to deal with interferences. And this is much better dealt with by way of software. It is embedded in the standards of the telco wireless space. It's not entirely always done well in the WiFi space. And Aruba, with Aruba Central, has done a tremendous progress in this, and they build a platform that is performing extremely well. We have a lot of SaaS revenue coming through that platform in Aruba. We'll talk about that more, it is our ARR, by the way, which is great, and it is partly the reason why the operating profit margins in Aruba are so high. And so the fundamental financial profile of Aruba has changed to one of a company that is double-digit growth with OP margins in the teens, high teens, possibly 20s. And we feel very good about Aruba, given, a, the strength of their portfolio and their positioning; and b, the demand that we're seeing in the marketplace. So that's Aruba. With respect to HPC/MCS, it's a slightly different cycle that we have to account for. Given the nature of the business with the exascale contracts, it's better measured over a couple of years or 3-year cycle. The growth rate there is very sustained. We feel very good about it. We have a large pipeline of 2 billion committed orders that we have in hand. We have to deliver on them on time. And there is a further $5 billion pipeline there. We win 5 out of 6 deals in HPC/MCS. So this is very promising for the future and the growth we'll see in '22, '23 and beyond. And HPC/MCS also has a mix effect with MCS, which is Mission Critical Systems, that ebb and flow on a different path. They are high-margin businesses. But really, what drives the top line performance in HPC/MCS is the -- our Apollo business and exascale contracts. You would have to look at it on a longer cycle. So we feel good about that. And the trend there is different than what we experienced in the past. There was this view that HPC/MCS or exascale contracts was very much more the domain of public sector scientists who were in the remote desert somewhere, inventing things that are quite unique. There is some of that. But there is a lot more need for big data, AI, machine learning applications in the private sector, and these are what are fueling the demand for their systems. And so we're moving very swiftly to capture the opportunity in the HPC/MCS space. And also, that demand is appearing to us very sustainable because it is a function of the proliferation of data and data is in explosion mode across every sector in the economy. So then when you look at our core segments, which are Storage and Compute, they also are doing very well there. Storage is a mixed story between our portfolio, which is becoming much more software-driven, software-led than ever before. This is why you have a strong demand and operating profit. We are well within the financial targets that we have announced at SAM, if you recall, Wamsi, at SAM 2020. And we feel that there is potentially more upside in Storage. I won't say to you that Storage is a high-growth story, but we can grow Storage with a very different composition of the revenue mix, with high profit margins overall and we feel good about it. Compute, which has been always a little bit cyclical and will continue to be cyclical, is 45% of our revenue and about the same percentage of operating profit. It's doing much better as more demand comes in from customers and the economy is in an upward trend, booming, so we feel good about this. And finally, Financial Services. It's never been performing as well, with return on equity north of 18% and bad debt levels that are very contained, dropping back to pre-pandemic levels. And also, most importantly, what's interesting is supply chain shortages are effectively benefiting our Financial Services business too, longer and that is benefiting our Financial Services business, who has more end-of-contract or end-of-term income there, too. So that's the overall picture, Wamsi, there.

Okay. That's super helpful. I actually didn't think about your Financial Services business benefiting in that way. So when you think about that, does that give you a view into sort of asset usage as well in terms of like where -- how much people are sweating their assets and a view into their refresh cycle? And what can you share about that?

Yes. I mean I would say, on average, residual value realization tends to be very high in this business. We are a company that takes an active stance on asset utilization. And we don't see residual value as a risk, but we see this as an opportunity where we can take a calculated risk through realized profits through our asset management business. And it's proving very, very thoughtful or very good, particularly if you take into account that in FY '20, we had to extend or rewrite hundreds and hundreds of contracts for our customers in HPEFS. And as a result of that, those extensions did have, in the short term, a drop impact on revenues, but benefited tremendously the bottom line and will continue to benefit the bottom line for an extended period of time. And so we see some upside there for HPEFS in that asset management business. It's a really, really strong story. And this is why you are at the return on equity that is north of 18%.

Yes. That makes sense. So Tarek, maybe -- I know you're a huge believer in growing gross profit dollars, right, GP dollar growth. And so can you maybe help the investment community think about how is it that HPE is going to be able to do that?

That's a great question. So there are several drivers that underpin our performance in gross margin terms. The first driver is within each one of the segments, you have the contribution from Pointnext OS. Pointnext OS is our most profitable recurring revenue for the company, and it has stabilized to a point where it is 2 quarters now that we've seen it slightly growing above positive line relative to the past where it was in decline. So stabilization of Pointnext OS is great. The second aspect of Pointnext OS is also the automation that we built into it. So we reduced cost as part of our cost optimization and resource allocation program, and this expands the gross margin of Pointnext OS within each one of Compute, HPC/MCS and Storage. That's the first driver. The second driver is within each segment or swim lane, if you prefer, you have mix effects that are at play. And particularly, if you look at Compute, sometimes, the mix effect is favorable; sometimes, the mix effect is unfavorable. We have legacy platforms that were rich in margins, passing on for later platforms like RAC, which is where the industry is, that are maybe lower margin than Blades, and so the old platforms. But on the whole, you get more growth in that segment because of that shift in configurations. And within that, the fact that people buy richer and richer configs also helps this time, not in terms of our headwind but our tailwind, every single price point of every RAC we sell is richer. The actual unit cost on commodities is also either helping or not helping, but we feel that in this current environment, where there is some degree of shortage of supply, we can pass on that by way of price increases, and we have done so. So for Compute, if you really look at the dynamic there, in the second quarter, there was a unit growth because the demand is there, low single-digit unit growth. AUP was a touch on the decline because of the mix between old platforms and more recent platforms. But we feel that on the way forward, we feel pretty good about the gross margins we're going to see there. So that's one mix effect within the swim lane. The other mix effect that you see, and for example, in Storage, is our portfolio is shifting from being much more software-driven with our own IP rather than not. That is beneficial to gross margins and growth overall. Watch this space. There will be a lot more coming from Storage. We did a big announcement with the [ Altera ] platform -- excuse me, Alletra platform that we launched a couple of weeks ago, and it's very promising and looking particularly good. So the second, in summary, the second driver there for gross margin improvement is the gross margin improvement within each of the business unit segments. And, of course, there is a mix effect, which is the third RAC. And the mix effect is fueled by a higher-calorie business unit growing faster. Like we said, the edge, very high gross margin, a lot of software baked into it, and that is helping quite a bit across the board. And finally, the fourth driver for everyone involved is the fact that we're pivoting to more and more towards as a Service with the ARR. Our ARR is, today, growing at a 30% CAGR. And we see no end in sight for this. We said, 2 years ago, we would grow for -- 30% to 40% per year for the next 3 years. We keep shifting that window of 3 years forward. We maintained the 30% to 40% growth. Orders are strong. The ARR has been growing at 30%, orders at 41%, which is good to feed the ARR in the future. But the ARR composition is also changing, whereas before, it was -- and mainly Pointnext OS, which is high margin, it is going to get higher margin because a lot more software will be baked into the ARR moving forward. And if you looked at our presentation in Q2, we put some emphasis on how much software goes into the ARR. And we'll talk about this a lot more when we get to SAM 2021. We will highlight to you a little bit more the economics of our as a Service business. So in summary, 4 drivers that drive gross profit. The first one is Pointnext OS. We talked about that. The second one is changes in the mix within each one of the business units. The third one is revenue mix across the corporation. And the fourth one is the as a Service business.

Okay. That's very helpful context, Tarek. So when I think about HPE, there's you, along with a lot of the other companies, have been talking about sort of shortages, and you just alluded to some shortages as well. How are these shortages impacting the business? What are the plans you have in place to mitigate some of this impact? And then with respect to sort of the inventory, which seems to be going up on everyone's balance sheets, like how do you think about that? How are you managing that? Any color that you can share?

Yes. So we did see shortages of supply coming back at the end of fiscal year '20. And when we reported our results at the end of Q1, we said we didn't have short-term concerns because we did take steps in terms of buffering our inventory levels to cater for the short term. We said we would be working for the second half, and we're still working through the second half. We feel reasonably good about our inventory levels. We buffered. We have increased our inventory levels by about $600 million year-over-year. It's a large increase. And we don't believe that the supply situation is going to ease off before a few quarters. And it could lead us into 2022. It has repercussions on cash flow. But that's okay. What we need to think about is sustainably managing levels of inventory to be able to deliver the right P&L benefits quarter in, quarter out. So we're not losing sleep over it. But in simple terms, what we did acknowledge in the guidance we put forward to you all, Wamsi, is there's uncertainty that comes from supply and we've explained that hopefully clearly for the analysts and investor community in our second quarter call. We think it's important that we remain prudent, and our guidance may look a bit conservative as a result for the second half because when you normalize for the OI&E effect, we would be flat on EPS half-on-half. But at this stage, I would rather be prudent than not. We're monitoring the situation so far so good. I could tell you that our demand in Q3 remains very strong, and we're fulfilling it as much as we possibly can. And we will advise at the end of Q3 where we stand on each.

Okay. That's helpful, Tarek. Also, you mentioned the various drivers of growth, right? And you mentioned about how much you are better sort of seasonally in 2Q. But when you look at the next quarter, you have a headwind coming up, which is from last year, you had sort of this post-COVID or COVID recovery, sort of how the demand trajectory played out in Compute, especially where you had a $500 million sort of realization last year in the Q3 -- fiscal Q3. So how should investors think about that? Is that just a transitory 1 quarter sort of tougher compare in the context of the growth that we're talking about? Like what's the right way to think about that? And I just want to make sure that investors are keyed in on the fact that there is sort of this not, call it, a headwind to demand, but really headwind to the compare.

Correct. And you're absolutely right, Wamsi. And what effectively happened last year is in Q1 and Q2, we had orders we could not fulfill due to backlog and supply chain issues. These orders were all fulfilled in Q3 and Q4. So in Q3 of last year, we "benefited" from a shift of orders fulfilled in Q3, mainly for Compute, in the amount of $500 million in Q3. And the remainder backlog -- of the backlog, $250 million, was delivered in Q4. So year-over-year compares, Q3-on-Q3 and Q4-on-Q4, will have to take into account this effect. It's a -- not a headwind, but as you say, it's a compare, arithmetic exercise. You're absolutely right. And I think what I would like to let investors -- leave investors with as a thought is look at the growth across the portfolio in areas that didn't have the backlog. So mainly in areas other than Compute that had this backlog issue. And we feel comfortable that the overall demand for our products and services is strong and it will continue to gain traction in -- across the board, and the Edge, HPC/MCS were not affected by that last year, Storage. And yes, we will continue to perform in Compute. It's more important to look at, in conjunction with the compare, look at the sequential view of each of the segments. And we feel comfortable about it for Q3 '21.

Okay. That's helpful, Tarek. I do want to touch on H3C, the put option you have over there. We get a lot of questions around it. So I was wondering specifically a couple of things. One, is what are the options to extend or renegotiate this option? And secondarily, if you were to exercise this put option, how confident are you about your ability to collect given that Tsinghua has actually defaulted on certain debt tranches. So curious if there is some structure in place that allows you to definitely collect on that.

So yes, so it's a great couple of questions on H3C. So H3C is a very important business for us. We have -- although we are a 49% shareholder, we have substantial management rights on H3C. The Chairman of the Board is a member of my team. And we appoint the CFO and we jointly appointed the CEO with our partner shareholders, Tsinghua and -- Unigroup and Unisplendour. And so we are in full view of what's going on in China. And we understand exactly what the situation is with H3C, and every option is on the table, not just the exercising of the put for them, potentially an extension or potentially a different way of monetizing it. And I think that the situation that Tsinghua Group, as you pointed out, is witnessing makes H3C extremely valuable for our Chinese partners. If you really look at the troubles in Tsinghua, they were everywhere but in H3C, which continues to represent north of 85% of the net income of UNIS, who is the parent company that owns H3C. We own directly 49% in H3C. Our partners own 51% through Unisplendour. The debt issue has not affected Unisplendour, which is well capitalized, and they can raise money. It's publicly listed and traded. The debt issue is at even a higher level in the ownership structure at the Unigroup level. And if you look through the structure, you will observe that Unisplendour is very well-capitalized, can raise money in the public market. And we feel very good about our position in H3C as a result of that. So we're monitoring it also because it's strategically important that we think carefully what to do in China. It's not an easy market to enter. And when you exit, if you do exit, it takes a long time to come back into a market that is now the second largest in the world for IT products and services. So our position is strong. We are in full visibility of what's going on. And I feel that there are ways we can extract value if we need to and there are ways we can continue to crystallize existing value if we want to as well.

Okay. That's helpful context. Turning to free cash flow. I know you've been very, very focused on driving strong free cash flow. Pre-COVID, you were already on a very strong recovery trajectory in free cash flow, and there was a lot of initiatives put in place. COVID obviously created a speed bump for everyone that could not be foreseen. As you think about a post-COVID world, like what is the ceiling, so to speak, on free cash flow? How should investors think about the nominal level that this business can generate on an annual basis?

So the nominal level, to start from the end of your question, the nominal level of our free cash flow for this business is north of $2 billion of free cash. We were very close at -- to this level in '19, where we posted $1.7 billion of free cash flow in spite of a $666 million adversary arbitration case that landed wrongfully for us, right? So we were well north of $2 billion, $2.3 billion, $2.4 billion back then. Then the pandemic hit us in '20, and we dropped to a level of free cash flow that's still positive in a pandemic, but it wasn't easy to navigate through that. As the business resumes back and returns back to a revenue base that is reasonable, you also have to factor in the operating leverage benefit from the cost optimization and resource allocation program, which has expanded margins, right? So we are now expanding gross margins at record levels at 34.7, and then operating profit margins were north of 10%. And so they are historic high levels. And what we need to do is to keep the discipline and continue to drive the gross profit with the 4 levers that we discussed on this call, Wamsi, a moment ago, and then really be focused, laser-focused on productivity and making sure that we don't revert back to being a little bit lax on cost structure, but contain cost expansion to selective areas where we need to invest to fuel growth such as R&D and sales and marketing dollars. And that's what we did in the second quarter. And you could see that sales and marketing as a percentage of revenue was a touch down, but the absolute dollars were up because it's really important to continue to fuel the growth. So from a cash flow standpoint, the enhanced operating profit expansion points to a healthy cash flow generation. Couple that with better discipline on working capital, I'm comfortable we will achieve $1.2 billion to $1.5 billion of free cash flow this year in '21. And this is after absorption of restructuring costs that are substantial in fiscal year '21 and that will recede in fiscal year '22. So we will be back to levels of free cash flows that are materially higher in '22 than what we said in last year for '22, given our current performance. I see some upside there. And as long as we keep the discipline -- and believe me, this is what I do every day. I spend a lot of time making sure that we don't get too exuberant in the context of the recovery because we don't want to go from one boom cycle to another bust cycle having to restructure. It's unfortunate, but it's also the nature of businesses that are cyclical. Now we're moving away from cyclicality across the board towards having less cyclicality across the board, more confining to the Compute area and leaving the other business units to perform on a sustainable profitable growth basis, just like we've done with the Edge, and you can expect that to continue.

So Tarek, just talking about restructuring for a second. I mean obviously, COVID, no one could have foreseen, and there was a whole bigger program that Antonio led before that on HPE Next. Would you say that sort of in this post-COVID world, there is incremental need to restructure? And is the cloud the fundamental reason for that? Or is there other reasons that you would cite around restructuring? And what's your thoughts on any incremental, other than what you already sort of announced? I mean we know that there are charges that are layered in here, but...

So if you look at what our share price implies, run some math, our share price implies a per annual restructuring of $500 million per year, which is obviously ludicrous, right? This is no -- not an assumption that makes sense. But today, if you reverse-engineer what's in our earnings multiple, we come up with a number that is about that. And so we are very conscious of it, and we believe we are emerging out of 2 rounds of restructuring. One was HPE Next, as you pointed out. And then the second one we did on the COVID. We had no choice. We don't do these things because we like to do them. We unfortunately are -- we're taking these steps because we did see, at the end of Q2 last year, that the world was going into a very dark place, and that's why we intervened to equip ourselves to emerge out of it in a much leaner and much more nimble company than we were. And so now, it's all about keeping that nimbleness and making sure that, that cyclicality, as I described it to you, is a lot less in our portfolio and a lot more controllable, with a great focus on productivity and operating leverage, which I am constantly, constantly spending time on with the entire management team. Restructuring is not something you want to do. It's an expensive way to manage the business. If you can avoid it, you should avoid it. And that's what we are going to be focused on. We are at the end of it, of -- our next-gen IT program is pretty much complete. So that will start to yield some very different benefits for the company in '22. And the rest is all around resource allocation and leaning further into the areas of sustainable growth like Edge, Storage, as a Service, HPC/MCS. And we feel pretty good about our prospects to continue to expand gross margins moving forward, which is key because the more focused you are on gross margin, the more investment capacity to -- you have to hold and service an OpEx cost base. If you don't have that headroom at the gross margin level, then it becomes a different discipline. But I feel very good about the trends where we stand -- that we stand on for '22 on gross profit realization.

Okay. That's great. Tarek, I know we're almost out of time, so maybe I'll let you just talk to the investors dialed in here and just address sort of what gets you most excited about the investment opportunity in HPE.

So I think if you look at where we are right now is we're trading at $16 per share, more or less. If you look at the midpoint of the guidance, that would suggest we're trading at 8.5x earnings and which is, in my mind, a ridiculously low level, but everyone has his own opinion about this. The one thing that I would point out is, yes, although our share price has appreciated since the bottom of October 2020, the runway ahead of us is pretty long given the economic recovery. And from a P/E ratio standpoint, we're driving the earnings, but we have yet to drive the P in the P/E equation, and that will happen over time as we drive more into the parts of the business that are higher gross margin and that involve a more sustainable profitable growth than before. So as an investor, I would recommend you, form your opinion onto how much progress we're making across our portfolio, moving into the high-growth businesses with that sustainable profitable growth length. I think the progress is good. But of course, there's a lot more we can do. And it's one quarter at a time, one step at a time journey that we are on, but we're firmly on it.

Perfect. Well, Tarek, thank you so much for taking the time to be here today. We really appreciate it. And I hope to talk to you soon again. And once again, thank you all for joining us today. And Tarek, thank you so much for doing this.

Thank you, Wamsi, for having us. It's been a pleasure. Thank you.