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HP Enterprise Q2'16 Earnings Conference Call: Full Transcript

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Operator:

Good afternoon, and welcome to the Second Quarter 2016 Hewlett Packard Enterprise Co (NYSE: HPE) Earnings Conference Call. My name is Annie and I'll be your conference moderator for today's call. At this time, all participants will be in listen-only mode. We will be facilitating a question-and-answer session towards the end of the conference. Should you assistant during the call to conference specialist by pressing the star key followed by zero. As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Andrew Simanek, Head of Investor Relations. Please proceed.

 

Andrew Simanek:Investor Relations:

Good afternoon. I'm Andy Simanek, Head of Investor Relations for Hewlett Packard Enterprise. And I'd like to welcome you to our fiscal 2016 second quarter earnings conference call with Meg Whitman, HPE's President and Chief Executive Officer; Tim Stonesifer, HPE's Executive Vice President and Chief Financial Officer; and joining later Mike Lawrie, Chairman and Chief Executive Officer of CSC. 

Before handing the call over to Meg, let me remind you that this call is being webcast. A replay of the webcast will be made available shortly after the call for approximately one year. We posted the press releases and the slide presentations accompanying today's earnings release on our HPE Investor Relations webpage at www.hpe.com. 

As always, elements of this presentation are forward-looking and are based on our best view of the world and our businesses as we see them today. For more detailed information, please see the disclaimers on the earnings and transaction materials relating to forward-looking statements that involve risks, uncertainties and assumptions. For a discussion of some of these of risks, uncertainties and assumptions, please refer to HPE's SEC reports, including its most recent Form 10-K. HPE assumes no obligation and does not intend to update any such forward-looking statements. We also note that the financial information discussed on this call reflects estimates based on information available at this time and could differ materially from the amounts ultimately reported in HPE's quarterly report on Form 10-Q for the fiscal quarter ended April 30, 2016. Finally, for financial information that has been expressed on a non-GAAP basis, we have included reconciliations to the comparable GAAP information. Please refer to the tables and slide presentation accompanying today's earnings release.

With that, let me turn it over to Meg.

 

Meg Whitman:President and Chief Executive Officer:

Thanks, Andy and thank you to everyone on the call for joining us today. Hewlett Packard Enterprise completed our second full quarter as an independent company, and I have to say that we have delivered the best performance since I joined. In Q2, we saw our first quarter of as reported year-over-year revenue growth since 2011 for the Hewlett Packard Enterprise businesses. We also saw our fourth consecutive quarter of year-over-year constant currency revenue growth. 

We delivered revenue of $12.7 billion, up more than 1% as reported and 5% in constant currency, driven by excellent performance in servers, storage, networking and converged infrastructure, as well as outstanding performance in enterprise services.

Enterprise Group had a fabulous quarter, delivering 7% revenue growth on an as reported basis and 10% in constant currency. In fact, we grew on an as reported basis in every one of EG's hardware business units and in every region. ES grew revenue year-over-year in constant currency for the second consecutive quarter and expanded operating margins more than three points over the prior year. That's the eighth consecutive quarter of year-over-year margin expansion. 

Our Software business also delivered a strong quarter. When adjusted for divestitures and acquisitions, Software delivered its third consecutive quarter of constant currency growth. And in Financial Services, we saw double digit volume growth over the prior year. So, with strong performance across every one of our business segments, HPE delivered non-GAAP EPS of $0.42, at the high end of our previously provided outlook. 

Free cash flow improved in the second quarter to $511 million due to careful management of our working capital. Tim will walk through the drivers of our cash flow and outlook shortly and we are seeing the benefits of our increased R&D and more focused product roadmaps as we take share from our competitors.

In storage, HPE is the only major vendor to gain share in external disk over the last two years, while EMC, NetApp, IBM and Dell lost share year-over-year. Revenue in our 3PAR all-flash business grew nearly triple digits, about two times faster than the market, and is once again expected to be larger and faster growing and pure.

In networking, we are seeing an acceleration of our business, particularly since our acquisition of Aruba and our game changing partnership with Unisplendour, a subsidiary of Tsinghua in China and our results are in stark contrast with the results Cisco reported last week. In switching, HPE grew 18% year-over-year versus Cisco that was down 3% and we are getting credit from the industry for our innovation, capturing the leading position in Gartner's most recent Magic Quadrant for Wired and Wireless offsetting Cisco's long standing run in the top spot. That is an addition to our leading positions in servers, storage and integrated systems, and we are not taking our foot off the pedal.

Next month at Discover Las Vegas, you'll be hearing more about some significant new innovations across our cloud, IoT and composable infrastructure product lines as well as an update on the machine. Last but certainly not least, earlier today, we made a major announcement that we are planning a tax-free spin-off and merger of our enterprise services business with CSC, which is expected to create a pure play global IT services powerhouse with annual revenue of more than $26 billion. The new company will have more than 5,000 customers in 70 countries and employees in every region around the world. The transaction is expected to deliver approximately $8.5 billion to HPE's shareholders on an after tax basis. 

This includes an equity stake in the newly combined company valued at more than $4.5 billion, which represents approximately 50% ownership, a cash dividend of $1.5 billion and the assumption of $2.5 billion of debt and other liabilities. We also expect the merger of the two businesses to produce first year synergies of approximately $1 billion post close with the run rate of $1.5 billion by the end of year one.

There is also an opportunity for additional synergies in subsequent years. As owners earn approximately 50% of the merged company, HPE shareholders will share and value of the synergies as well as future growth in earnings. The cost to separate ES from HPE will be offset by lower cost associated with the previously announced fiscal year 2015 restructuring program. So, there will be no incremental one-time cash payments beyond what we've already communicated. 

I will serve on the Board of the new company and HPE's Board of Directors will nominate half of the new company's Board. Mike Lawrie, the current Head of CSC will become Chairman and CEO of the new company and Mike Nefkens, the current EVP and General Manager of our Enterprise Services business will become a key part of the new company's executive team and partner closely with Mike Lawrie on building the new organization. Other executives and directors as well as the name of the company will be announced at a later date.

The transaction is currently targeted to be completed by March 31, 2017. For the combined CSC and Enterprise Services, this will create a new company that will be a pure-play global IT services leader. For customers, this means global access to world class offerings in cloud, mobility, application development and modernization, business process services, IT services, big data and analytics, and securities. This is combined with deep industry experience in sectors that include financial services, transportation, consumer products, healthcare and insurance. HPE and this new company will be closely connected moving forward with agreements that will keep the two companies aligned for current customers and grow new business opportunities over time.

For the remaining Hewlett Packard Enterprise, this transaction creates significant incremental value by unlocking a faster growing, higher margin and stronger free cash flow business. HPE will now have $33 billion in annual revenue and will focus on secure next generation software defined infrastructure that leverages a world class portfolio of servers, storage, networking, converged infrastructure as well as our Helion cloud platform and software assets.

By bringing together leadership positions in these key data center technologies, we will help customers run their traditional IT better while building a bridge to multi-cloud environments. Beyond the data center, HPE is redefining IT at the edge with our next generation of Aruba and computing products for campus, branch and IoT applications. In addition, through our Technology Services division, we can deliver consulting and support to customers while HPE Financial Services offers financial flexibilities to customers to maximize their investments.

Finally, we will continue to leverage our portfolio of operations, securities and big data software assets that deliver machine learning and deep analytics capabilities to customers. Mike Lawrie has joined our call today and will have much more to say about the deal in a moment. But first, Tim is going to walk us through HPE's financial performance in detail.

 

Tim Stonesifer:Executive Vice President, Chief Financial Officer:

Thanks, Meg. Overall, we had a great quarter. We grew revenue as reported and in constant currency, generated healthy cash flow, and delivered non-GAAP diluted net EPS at the high end of our guided range. Revenue of $12.7 billion was up 1.3% year-over-year and grew 4.9% in constant currency, our fourth consecutive quarter of constant currency growth and as Meg mentioned, HPE businesses reported absolute revenue growth for the first time in five years. 

We saw revenue growth in constant currency in every region and outright growth in the Americas and APJ. Our Americas performance continues to support cautious optimism for the remainder of the year, amongst an uneven macroeconomic environment. In EMEA, we were still significantly impacted by currency. However, we're seeing encouraging momentum in enterprise hardware and in APJ, China networking drove strong performance.

The top-line currency impact to revenue was 4 points year-over-year, primarily due to hedging gains from the prior year. Going forward, we expect the currency impact to significantly moderate throughout the second half of the year and we continue to anticipate an impact to revenue of approximately 3 points for the full year, as rates are now roughly in line with where they were when we originally guided the year.

Margins were largely stable in the quarter with gross margin of 28.7%, up 10 basis points year-over-year and 30 basis points sequentially and non-GAAP operating profit margin was 7.9%, down 50 basis points year-over-year and 20 basis points sequentially. Total non-GAAP operating expenses of $2.6 billion were up 4.7% year-over-year, primarily due to increased FSC and R&D investments.

We delivered non-GAAP diluted net earnings per share of $0.42, at the high end of our guided range. This primarily excludes $201 million for amortization of intangible assets, a $161 million for restructuring, and $91 million of separation charges. We delivered GAAP diluted net earnings per share of $0.18, a penny above our previously guided range. 

Now, turning to the business results. The Enterprise Group had a strong quarter with excellent top line performance. Our sales motion is hitting its stride aided by the seamless launch of the HPE brand and our marketing efforts. Revenue was up 7% year-over-year or 10% in constant currency and grew in all product groups. 

For the remainder of the year, revenue growth will likely moderate as we will not have the benefit of H3C and begin to face tougher compares.

Profitability in the quarter was 11.7%, down 240 basis points year-on-year. This was primarily due to foreign exchange, heavier Tier 1 mix and to a lesser degree incremental R&D investments. A deal that exemplifies the strength of the Enterprise Group is the recently won project with Woolworths Limited, Australia's largest retail company. Our solution, based on the ConvergedSystem 900 for SAP HANA provides access to real time data, enabling critical business decisions to be made immediately. 

This competitive win against Lenovo, Fujitsu and Dimension Data with Cisco UCS also displays as the current outsource provider with pro and further secures HPE's relationship with Woolworths.

Service revenue grew 7% year-on-year or 10% in constant currency, primarily driven by strong Tier 1 sales in the Americas and core servers in APJ. Based on our performance, we believe we took share in servers overall, density optimized servers and rack. From a regional perspective we took share in the Americas and EMEA and this quarter, we started shipping our Hyper Converged HC 380 which enables midsized and remote office enterprises to easily deploy, manage and support virtual machines in a few clicks. We continue to see servers as a growth drivers, given the strength of our portfolio and anticipate healthy demand for compute through the remainder of the year.

In storage, we grew revenue 2% year-over-year and 5% in constant currency. Converged storage continued its strong growth trend, growing 19% year-over-year in constant currency and comprising 54% of the total portfolio. 3PAR all-flash revenue grew near triple-digits and continues to drive mid range share gains. We estimate that we gain market share in the external disk for the tenth consecutive quarter and expect storage to gain shares throughout the remainder of the year on the strength of the 3PAR portfolio and new logo wins as we take advantage of the uncertainties surrounding the Dell-EMC merger.

Networking revenue grew 57% year-over-year as reported or 62% in constant currency. And when adjusted for a Aruba, networking was still up 17% in constant currency. We had strong execution with growth across all regions. While Aruba continues to drive growth in wireless share, we also expect to take share in switching and routing on the strength of H3C and Aruba campus switching pull-through. 

Leading up to the transaction closed with Tsinghua, H3C grew more than 50% year-over-year, validating the strategic moves we made to collaborate with a strong local partner.

In Technology Services, revenue did decline 6% year-on-year or 2% in constant currency. However, it was only down 1% in constant currency when adjusted for the discontinuation of HP Inc. attach, which remains in the fiscal year 2015 results. TS support, the most profitable and largest segment of Technology Services, grew orders in constant currency. 

Based on this and the order growth we saw last year, we continue to expect TS revenue to return to growth in constant currency, towards the end of the year.

Enterprise Services had another great quarter as we continue to see the benefits of our restructuring cost actions and improving sales motion. A great example of the deals we are winning is our recent selection from five other competitors for a 10-year $0.5 billion contract to provide IT services including infrastructure, mission critical systems, and applications to the U.S. Strategic Command. Revenue declined 2% year-over-year but grew 1% in constant currency. When adjusted for the Deutsche Bank win last year, both new business TCV and total TCV grew year-over-year. 

Strategic Enterprise Services is gaining strength in both overall revenue and mix, delivering mid double-digit growth year-on-year. ABS continues to improve with the third consecutive quarter of year-on-year constant currency revenue growth and ITO also grew in constant currency, the first time since the first quarter of 2012.

Operating profit improved 310 basis points year-over-year to 6.7%, as the team continues to execute productivity improvements in delivery and sales. We're also seeing the benefits from improving location mix as well as increasing sold margins and healthy add-on sales. We continue to track well against our longer term goal of 60-40 low cost, high cost headcount mix, and completed the quarter with 47% of our headcount in low cost centers. The progress made on cost improvements, sales strength and normal quarterly seasonality, provides us with confidence that operating profit margins for the full year will now be towards the high-end of our original 6% to 7% outlook.

Software declined 13% year-over-year as reported or 10% in constant currency. However, was up 2% in constant currency when adjusted for acquisitions and divestitures. Sales strength in security and big data was partially offset by declines in IT Management. On a product level, we had encouraging results in Voltage, Fortify and IDOL. 

The team continues to focus on disciplined cost control, decreasing OpEx dollars year-over-year and growing operating profit dollars. Operating profit margin expanded 7 points year-over-year. However, the largest contributor to OpEx and margin improvement was a one-time benefit from the TippingPoint divestiture.

HPE Financial Services revenue declined 2% year-over-year, but grew 1% on constant currency. Operating profit declined 130 basis points year-over-year to 9.3% as lower residual sales pressured margin rates. Financing volume grew 15% or 19% in constant currency, primarily due to favorable movement in our cost of funds which has enabled us to price more competitively. Return on equity was down 230 basis points year-on-year to 12.7%.

Cash flow was strong in the quarter due to judicious working capital management. Cash flow from operations was $1.1 billion, up 101% year-over-year on an adjusted basis. Free cash flow was $511 million, up from negative $106 million last year, again on an adjusted basis. When adjusted for the sale of H3C, the cash conversion cycle was 27 days, down 4 days, quarter-over-quarter. 

The largest contributor to cash conversion cycle improvement was DPO, which increased five days sequentially, adjusted for H3C, as we continue to improve payment terms with our vendors. This was partly offset by DSO, which increased two days sequentially, while DOI was flat through the quarter. Given the momentum in our working capital initiatives, we now expect our cash conversion cycle will reach the low 20-day range by the year-end.

Now, let's turn to capital allocation. In the quarter, we returned $109 million of cash to shareholders. Due to the ES CSC transaction, we were largely prohibited from repurchasing shares and only bought back $15 million of shares. We also paid $94 million as part of our normal dividend. 

We continue to see our shares as very attractively priced and will be back in the market this month. Along those lines, our Board of Directors recently increased our share repurchase authorization by $3 billion, which now stands at $4.8 billion remaining.


During our Q1 earnings call, we committed approximately $2 billion of the proceeds from the H3C transaction to share repurchases. We now expect to complete roughly half of those this fiscal year with the remainder to be completed in fiscal year '17. As you recall, share repurchases resulting from the H3C transaction are in addition to our commitment to return 100% of our original fiscal year '16 free cash flow outlook to shareholders.

Now, I'd like to provide an update on recent M&A activity. First, we announced the sale of our majority stake in Mphasis to Blackstone, as we continue to refine our capital strategy and make improvements to our go-to-market model. We expect this transaction to close in the fourth quarter of this year. In addition, during the quarter, we closed the sale of 51% of H3C to Tsinghua at the beginning of May.

Remember that our prior guidance did not include the impact of this transaction. We now think that we can offset the EPS impact with the share repurchases we completed in the first quarter and the incremental share repurchases to be completed later this year. Going forward, we will recognize only 49% of H3C earnings and receive a corresponding cash payment. This will reduce cash flow by approximately $200 million on the second half of fiscal year '16. 

However, roughly half of that will be received as a cash payment in fiscal year '17.

Finally, I'd like to discuss the cash impact of the ES CSC transaction to HPE. There will be no incremental one-time uses of cash beyond what we've already communicated. We expect total one time separation payment of around $900 million with $300 million in fiscal year '16 and the reminder in fiscal year '17. As an offset, we will reduce the $2.6 billion of restructuring payments associated with our 2015 restructuring plan by roughly $1 billion as we are achieving our targeted savings more efficiently and will no longer need to fund ES actions after the transaction closes. 

We have gained valuable experience in HPE, HPI separation that gives us confidence in executing the spin quickly and efficiently. In total, the fiscal year 2016 free cash flow will be reduced by $300 million due to the H3C divestiture and current year ES separation payments that will be partly offset by working capital improvements.

Let's go to guidance. We expect non-GAAP diluted net earnings per share to be $0.42 to $0.46 in Q3 of 2016 and continue to expect full year fiscal 2016 non-GAAP diluted net earnings per share of $1.85 to $1.95. We expect GAAP diluted net earnings per share to be $1.10 to $1.14 in Q3 of 2016 and now expect full year fiscal 2016 GAAP diluted net earnings per share of $1.68 to $1.78, reflecting the new ES separation charges and gain on sale of H3C and we now expect full year fiscal 2016 free cash flow of $1.7 billion to $1.9 billion.

With that I'll turn it back over to Meg. 

 

Meg Whitman:

Thanks Tim. Now, I'd like to go into more detail on the deal we announced today with CSC, which I think will be very beneficial to customers, employees and shareholders of both companies. As today's results confirm, Enterprise Services is a stronger and more robust business than has been in many years. As a result of customer diversification efforts and other improvements, ES delivered stable constant currency revenue for the first two quarters of fiscal 2016, which were the first quarters of year-over-year constant currency revenue growth since fiscal 2012.

Overall, ES is on track to achieve its long-term goal of a market competitive cost structure and operating margins. So, by bringing together the best of these two organizations, we will create a pure-play services leader ready to compete and win against all the current players. The new company will have greater agility, focus, and the ability to drive faster outcome for our customers. It will also have a top notch management team, quite literally the best in the business, and that management will be a 100% focused on ensuring a smooth transition with no disruption for ES and CSC customers.

With that, let me turn it over to Mike Lawrie. Mike and I've gotten to know each other quite well, and I can tell you he is a world class CEO with incredible talent and unbridled passion for his business. Once the deal closes, I look forward to working with him to build our new company. Mike?

 

Mike Lawrie:Chief Executive Officer, CS

Thank you, Meg. I'm excited about the great potential this merger brings to our people, to our clients, to our partners, and investors, both at CSC and HPE's Enterprise Services division and let me tell you why. Over the past few years, our two organizations have been embarked on critical turnarounds and broad-based transformations. Not everyone is aware of this but Meg and I joined our respective companies within about six months of each other and I'm pleased to be able to say that recent years, both our organizations have been on upward trajectories with significant improvements in financial performance and in client satisfaction scores, and the progress has been real and it has been measurable.

Both of our companies separated last year, within a month of one another into more client-focused pure-play entities, aimed at specific markets and core industries and today's announcement, the coming together of these two organizations is the next logical step, building on their progress to-date and significantly accelerating their transformation. The new company will be a global top three leader in IT services, one that's uniquely positioned to lead clients in their digital transformations. Our organizations are highly complementary. HPE Enterprise Services has a proud legacy and brings focus and agility and the ability to drive faster outcomes for clients, along with the first rate sales organization. 

The CSC brings deep industry expertise, innovation and next generation technologies and an exceptional partner network among other strengths. And together, as an agile, technology independent services pure-play, we will be better positioned to innovate and compete and win against both emerging and established players. 

We will have substantial scale to serve customers more efficiently and effectively worldwide. We will have a highly competitive cost structure to take advantage of our distinct growth opportunities, resulting in the capital capacity to invest and grow, both organically and inorganically. We will strengthen and grow client relationships to cover more than three quarters of the Fortune 500 with less than 50% overlap across our top accounts. We will leverage a combined portfolio that will include leading solutions in areas like managed securities, cloud IT, enterprise applications, and big data and analytics, along with combined BPO leadership in healthcare, in insurance, in banking and capital markets.

But most importantly, this great leap forward in our transformation will enable our people to better innovate to compete and adapt to an ever-changing marketplace. Employees will become part of a very strong and focused global enterprise that is positioned for success, one that enables them to take advantage of the diverse career development and growth opportunities of a larger global enterprise. And as a pure-play services leader, our new company will be able to operate independent of any single hardware provider, establishing the right partnerships for success. And at the same time, CSC and HPE will have long-term agreements in place to ensure that current customer commitments continue to be met and our relationship will be stronger and our collaboration deeper.

Now before I hand it back to Meg, I'd just like to take a moment to thank the teams at both companies for their hard work and resilience in driving our respective transformations. Through your efforts, we are in a place where we can bring our two great organizations together. That includes our team at CSC and also the HPE Enterprise Services team under Mike Nefkens. And I'm pleased that Mike has agreed to stay with the company in a senior position, reporting to me and that he will be playing a crucial role in helping build and grow our new company. 

And I'm looking forward to working with Meg as a member of the new company's Board.

So, let me just reiterate my excitement about our two organizations coming together to better serve clients around the world and deliver value for our shareholders. We recognize that we're just at the beginning of this process with a lot of work to do. By staying laser focused and working in the same collaborative spirit that has gotten us to this point, we can get to the finish line faster and in a great position to launch the new company. My colleagues at CSC and I look forward to working with everyone at HP Enterprise Services.

So, now, let me hand it back to you, Meg.

 

Meg Whitman:

Thank you, Mike. I look forward to a close relationship and what I believe will be a game changing new company in the global IT services market. Mike will stay with us during the Q&A portion of the call. Now, I'll open it up to questions.

 


Question & Answer

 

 

Operator:

We will now begin the question-and-answer session. To ask a question you may press star then one on your touch tone phone. If you are using a speaker phone please pick up your headset before pressing the keys. To withdraw your question please press star then two. 

You also request that you'll only ask one question and one follow up. Our first question is from Maynard Um at Wells Fargo.

 

Maynard Um:Wells Fargo:

Thanks, Meg, Can you just talk about the remaining portions of your business. It seems it's definitely more transactional. Do you anticipate that we should think about more transactions happening here, whether it's accelerated M&A or spinoffs or sale, how should we think about that and then I have a follow-up.

 

Meg Whitman:

Well, thanks, Maynard. So, we are actually very excited about what would become a standalone Hewlett Packard Enterprise. Our focus is going to be on next-gen software defined infrastructure with a world class portfolio of servers, storage, networking, converged infrastructure, hyper-converged, Helion our Helion cloud platform and our software assets. And you probably have guessed by now that I am now a devotee of focus. 

And this is going to be a laser light focused company that as I think you know is higher growth, higher margin with more robust free cash flows and it's going to be well-capitalized. So, we don't necessarily think there is a need for acquisitions. But, if we find the right companies, we certainly will move. And let me just recap the kind of acquisitions that have worked well for this company in the past. 

Complimentary technologies that we can put through our excellent distribution and support system, so think 3PAR; 3Com; Aruba, all three of those acquisitions have been fantastic for Hewlett Packard Enterprise and so, we will keep our eyes out for those kinds of acquisitions. Unfortunately, there aren't a lot of those around, but to the extent we see them, we won't hesitate to move.

As Tim said, remember, our capital allocation strategy is returns based. Right now, we really think there is incredible value in our stock price and Tim announced, we're going to be buying back using a 100% of our free cash flow, in addition to half of the H3C proceeds and we just got an increase and authorization of share buyback from our Board.

 

Maynard Um:

Great, And then, just on the margin outlook for ES and servers, how should we be thinking should we be thinking more along the lines of 7% to 9% margins now for the ES business and low teens digits on the server side? Than

Posted-In: Earnings News

 

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