Hewlett Packard Enterprise Company — Q2 FY2016 Form 10-Q
Reporting period: Three and six months ended April 30, 2016. Amounts are in U.S. dollars; financial statement figures are in millions unless noted. HPE became an independent public company on November 1, 2015. The prior-year figures are combined results from before the separation and may not be directly comparable to HPE’s standalone results.
Business context and reporting period
HPE provides enterprise technology products and services through five segments: Enterprise Group (EG), Enterprise Services (ES), Software, Financial Services (FS), and Corporate Investments. Results include a quarter-over-quarter comparison with the three months ended April 30, 2015 and a year-to-date comparison with the six months ended April 30, 2015.
Financial performance and liquidity
| Metric | Three months ended Apr. 30, 2016 | Three months ended Apr. 30, 2015 | Six months ended Apr. 30, 2016 | Six months ended Apr. 30, 2015 |
|---|---|---|---|---|
| Net revenue | $12,711 | $12,549 | $25,435 | $25,602 |
| Earnings from operations | $492 | $428 | $876 | $1,160 |
| Operating margin | 3.9% | 3.4% | 3.4% | 4.5% |
| Net earnings | $320 | $305 | $587 | $852 |
| Diluted EPS | $0.18 | $0.16 | $0.33 | $0.46 |
| Gross margin | 28.7% | 28.6% | 28.5% | 28.1% |
- Quarter revenue rose 1.3% reported, or 4.9% on a constant-currency basis. Products revenue was $4,971, up from $4,562; services revenue was $7,652, down from $7,898; financing income was $88, versus $89.
- For the six-month period, revenue declined 0.7% reported but increased 4.3% on a constant-currency basis. Net income and diluted EPS fell substantially year over year.
- Quarter operating margin improved primarily with lower restructuring and separation costs and slightly higher gross margin; higher R&D, SG&A, and interest and other expense partly offset the improvement. Year-to-date operating margin declined amid higher R&D, SG&A, restructuring, and acquisition-related costs.
- Operating cash flow for the six months was $1,032, down from $1,756. Investing cash outflow was $1,121, including $1,552 of property and equipment investment; financing cash outflow was $706. Cash decreased by $795 to $9,010. Operating cash flow less gross property and equipment investment was approximately negative $520.
- At April 30, cash and cash equivalents were $9,010; current assets were $31,147 and current liabilities $20,597. Short-term borrowings and notes payable were $965, and long-term debt was $15,247, for total reported borrowings of approximately $16,212. HPE reported $4,212 of commercial-paper program capacity and $1,822 of uncommitted credit lines available, in addition to its $4.0 billion revolving credit facility.
- Outstanding borrowings increased from $15.8 billion at October 31, 2015 to $16.2 billion at April 30, 2016; the weighted-average borrowing rate rose from 3.0% to 3.7%. No senior notes were scheduled to mature in the following 12 months.
- HPE repurchased $1.2 billion of stock during the six months, paid $190 in dividends, and declared dividends of $0.17 per share year to date. It had $1.8 billion remaining under the existing repurchase authorization at quarter-end.
Material changes and segment trends
- Enterprise Group: Revenue increased 6.9% in the quarter and 3.8% year to date, led by Networking and Servers; Aruba contributed to Networking growth. Segment operating margin declined to 11.7% for the quarter from 14.1%, and to 12.5% year to date from 14.6%, reflecting competitive pricing, currency pressure, product mix, and higher operating expenses.
- Enterprise Services: Revenue declined 2.0% in the quarter and 4.1% year to date, while segment operating margin improved to 6.7% and 5.9%, respectively, from 3.6% and 3.3%. HPE cited restructuring-related delivery efficiencies and lower administrative costs; currency, contract runoff, and pricing pressure weighed on revenue.
- Software: Revenue fell 13.2% in the quarter and 11.8% year to date. HPE cited the shift toward SaaS, sales execution challenges, divestitures, and a business transfer to former Parent. Operating margin improved, partly due to a gain from the TippingPoint divestiture and lower costs; this should not be treated as wholly recurring.
- Financial Services: Revenue declined 2.1% in the quarter and 2.7% year to date. Quarter operating margin fell to 9.3% from 10.6%; year-to-date margin rose to 11.1% from 10.9%. Net portfolio assets were $12,746, up 4.0% from October 31, 2015.
- HPE reclassified $4,077 of H3C disposal-group assets and $727 of related liabilities as held for sale. The H3C transaction closed in May 2016; HPE retains a 49% interest in the resulting business. HPE also completed three divestitures during the six months, generating $340 of net proceeds.
Outlook, management commentary, risks, and unusual items
- The filing does not provide specific near-term revenue or earnings guidance. Management said operating results and cash flows for the six months are not necessarily indicative of full-year results.
- On May 24, 2016, after the reporting period, HPE announced a planned tax-free spin-off and merger of Enterprise Services with CSC, targeted for completion by March 31, 2017 and subject to approvals and other conditions. HPE estimated approximately $8.5 billion of value to its shareholders, including an approximately 50% stake valued at $4.5 billion, a $1.5 billion cash dividend, and assumption of $2.5 billion in net debt and other liabilities. HPE expects approximately $900 million of one-time separation costs, most of which it expects to offset with lower costs associated with its 2015 restructuring plan.
- The 2015 restructuring plan is expected to result in approximately 30,000 employee exits by the end of 2018, primarily in Enterprise Services, and approximately $2.6 billion in aggregate pre-tax charges through FY2018. HPE expected approximately $2.5 billion of future restructuring cash payments, including $0.6 billion for the remainder of FY2016.
- Management identified cloud migration, SaaS adoption, competitive pricing, legacy hardware and software transitions, service-contract runoff, and macroeconomic weakness as business challenges. HPE also warned that the planned Enterprise Services transaction may be delayed, fail to close, or fail to deliver anticipated benefits.
- Tax exposures warrant attention: unrecognized tax benefits were $9.3 billion at April 30, 2016, up from $4.9 billion at October 31, 2015, primarily reflecting joint and several liabilities with HP Inc. HPE said up to $106 million of existing unrecognized tax benefits could be reduced within 12 months. It recorded a net long-term receivable of $0.9 billion from HP Inc. for certain tax liabilities for which HPE is jointly liable but indemnified under the Tax Matters Agreement. HPE noted that audit outcomes could materially affect earnings or cash flows.
- HPE reported ongoing litigation and investigations, including India customs proceedings involving claims and penalties, employment classification suits, and other matters. It stated that it had recorded adequate provisions and that, as of April 30, 2016, a material loss in excess of recorded amounts was not reasonably possible; outcomes remain inherently unpredictable.
- HPE’s market capitalization was below book value during the period, but the company concluded no interim goodwill impairment test was necessary. It cautioned that a sustained shortfall or adverse outlook could require a future impairment charge.
Most important facts for investors to verify
- Whether reported revenue and margin trends persist after adjusting for foreign exchange, divestitures, the H3C transaction, and the spin-off separation.
- Whether Enterprise Group growth can translate into improved segment profitability despite pricing, mix, and competitive pressures.
- Whether Enterprise Services turnaround savings and the CSC transaction proceed on schedule, meet closing conditions, and deliver the stated value and cost expectations.
- The scale, timing, and cash impact of restructuring payments, separation costs, and the approximately $900 million estimated Enterprise Services separation expense.
- The resolution and potential cash consequences of tax audits, the $9.3 billion of unrecognized tax benefits, and HP Inc. indemnification arrangements.
- Operating cash generation, capital spending, debt and interest costs, and whether share repurchases and dividends remain supported by liquidity.