On Hewlett Packard Enterprise Co. (NYSE: HPE) is HOLD. Some of the revenue upside in 3Q20 reflected flows from an excessive order backlog that built up in 2Q20 amid supply chain disruptions.
The company’s integrated strategy does not appear to be resonating in a crowded market space, as cloud-first solutions predominate and traditional competitors market aggressively.
Non-GAAP EPS sharply exceeded the $0.23 consensus estimate.
Fiscal 3Q20 results reflect a bounce-back from a poor fiscal second quarter. At that time in May 2020, HPE announced a three-year Cost Optimization and Prioritization plan, to be implemented through fiscal 2022. HPE at the time also announced immediate actions including a 25% reduction in executive officer salaries. The Cost Optimization and Prioritization plan is designed to drive gross savings of at least $1.0 billion and annualized run-rate savings of $800 million. The plan also entails cash costs of $1.0-$1.3 billion over the three-year span.
While the strong sequential recovery partly reflected early efficiencies from the restructuring plan and executive salary cut, much of the sequential momentum was attributable to data demand related to the pandemic.
The company held HPE Discover, its annual customer & partner gathering as a virtual event, even after the CEO’s diagnosis. The company focused on its pivot to as-a-service, and also highlighted the importance of the intelligent edge. As explosive data growth including 5G floods highly centralized cloud platforms, a distributed network edge is required to enable the smooth dispersion of traffic out to end users. HPE’s Intelligent Edge business represents the Aruba enterprise network business.
As the supply chain improved during 3Q20, HPE was able to work down it order backlog, which had reached $1.5 billion backlog at the end of 2Q20 – about twice the size of the average backlog. As much as $500 million of that backlog flowed into 3Q20, contributing to the sizable revenue beat against expectations.
Revenue from operational services, or Advisory & Professional (A & PS), was down 5% in constant currency. Financial services revenue (12% of total) was down 9%, reflecting lower business activity.
Given the good progress in 3Q20, the company resumed providing financial guidance, which includes annual EPS guidance though no revenue guidance. Management now looks for non-GAAP earnings of $1.30-$1.34.
HPE is moving away from sales of stand-alone server and storage gear while pivoting to an as-a-service model. While the portfolio shift is necessary, it represents another operational challenge in a soft demand environment impacted by COVID-19. The aggressive cost-cutting program announced in May 2020 risks cutting into muscle as the company seeks to accelerate this shift while combating competitive threats.
Although HPE has lagged the market during calendar 2020, the company faces uncertain demand prospects and ongoing profit pressures. We believe a HOLD rating remains appropriate at this time.
EARNINGS & GROWTH ANALYSIS
Which was down 6% year-over-year (down 4% in constant currency) though up 13% sequentially. Revenue was far ahead of the prereporting consensus estimate of $6.06 billion.
Non-GAAP earnings for 3Q20 totaled $0.32 per diluted share, down 28% from $0.45 in the prior-year quarter but up by $0.10 on a sequential basis. Non-GAAP EPS sharply exceeded the $0.23 consensus estimate.
FINANCIAL STRENGTH & DIVIDEND
During 2Q20, HPE issued $2.25 billion. During 3Q20, the company issued an additional $1.75 billion. HPE also has an undrawn $4.75 billion revolving credit facility should additional liquidity be needed. The company stated that it has total liquidity, including the undrawn revolver, of about $10.3 billion as of August 2020.
We believe HPE warrants an intermediate-term HOLD rating, while our long-term BUY rating reflects the underlying the underlying quality of the franchise.