Hewlett Packard Enterprise Company — Q2 FY2017 Form 10-Q
Reporting period: Three and six months ended April 30, 2017. Amounts are in U.S. dollars; financial figures are in millions unless noted. Results include continuing operations unless stated otherwise. HPE completed the separation of Enterprise Services and its merger with CSC, now DXC Technology, on April 1, 2017; the former business is reported as discontinued operations, limiting comparability with prior periods.
Financial performance
| Metric | Q2 FY2017 | Q2 FY2016 | Six months FY2017 | Six months FY2016 |
|---|---|---|---|---|
| Net revenue | $7,445 | $8,509 | $15,001 | $17,041 |
| Gross margin | 33.8% | 35.8% | 35.0% | 36.2% |
| Earnings from continuing operations | $182 | $451 | $638 | $923 |
| Net earnings (loss) from continuing operations | $(487) | $322 | $(232) | $684 |
| Net earnings (loss), including discontinued operations | $(612) | $320 | $(345) | $587 |
| Diluted EPS, total | $(0.37) | $0.18 | $(0.21) | $0.33 |
- Q2 revenue fell 12.5% year over year (11.7% at constant currency); six-month revenue fell 12.0% (11.1% constant currency). Products were the largest revenue category, at $4,128 in Q2, down from $5,017.
- Continuing-operations operating margin was 2.4% in Q2 versus 5.3% a year earlier, and 4.3% for the six months versus 5.4%. Gross margin pressure reflected H3C divestiture impacts, component costs, competitive pricing and currency.
- Q2 tax expense was $588 despite $101 of pretax continuing-operations earnings. The quarter included a $473 valuation allowance on U.S. state deferred tax assets and $110 of other taxes related to the DXC transaction. The unusually high reported effective tax rate was 582.2%.
Segments and material changes
- Enterprise Group: Q2 revenue of $6,243, down 12.8%; operating earnings of $548, down 35.3%. Lower Tier 1 service-provider server demand and the H3C divestiture were major factors; servers, networking and storage all declined.
- Software: Q2 revenue of $685, down 11.5%; operating earnings of $181, down 5.7%. License, support and professional-services revenue weakened amid the shift to SaaS and preparation for the planned Micro Focus transaction. SaaS revenue grew 3%.
- Financial Services: Q2 revenue of $872, up 10.7%; operating earnings of $78, up 6.8%. Revenue benefited from higher operating-lease volume following the DXC transaction, while portfolio margins were lower.
- HPE completed five acquisitions in the first half, including Nimble Storage for approximately $1.3 billion, SimpliVity for $651 million and SGI for $349 million. Acquisition cash payments totaled $2.05 billion.
Cash flow, balance sheet and liquidity
- Six-month operating cash flow was negative $828, compared with positive $1,032 in the prior-year period. HPE cited approximately $1.9 billion of pension funding associated with the DXC transaction as a principal use of cash.
- Investing cash flow was negative $3,810, including $2,050 of acquisition payments and $1,681 of property, plant and equipment purchases. Financing cash flow was negative $248. Cash declined $4,886 to $8,101 at April 30, 2017.
- Cash and cash equivalents were $8,101; total borrowings were approximately $13,914 ($2,010 current and $11,904 long-term), versus approximately $15,695 at October 31, 2016. HPE reported $4,157 of commercial-paper program capacity and $1,802 of uncommitted credit lines available.
- Current assets were $20,273 and current liabilities $17,578 at April 30. HPE reported total assets of $67,470 and stockholders’ equity of $29,047.
- HPE repurchased $1.31 billion of shares in the first half and declared dividends of $0.195 per share. Remaining repurchase authorization was approximately $2.0 billion.
Outlook, risks and unusual items
- Management said it expected internally generated cash flow, cash balances and access to capital markets to cover anticipated near-term needs, while noting access to capital markets and borrowing costs could be affected by business and market conditions. HPE expected to refinance approximately $1.1 billion of notes due in October 2017.
- The planned Software separation and merger with Micro Focus was anticipated to close September 1, 2017, subject to customary conditions. HPE expected approximately $700 million of one-time separation costs and a $2.5 billion cash dividend from the transaction. Completion, timing, benefits and tax treatment were uncertain.
- HPE identified cloud adoption, SaaS transition, competitive pricing, weaker traditional server and storage demand, supply constraints, sales execution, foreign exchange and macroeconomic conditions as business risks. The planned Software transaction could also disrupt sales and operations.
- Restructuring charges in continuing operations were $118 in Q2 and $234 for the first half. HPE estimated approximately $700 million of future restructuring cash payments, including $200 million in the remainder of FY2017.
- Unrecognized tax benefits were $11.5 billion; management said these tax matters could affect earnings or cash flow and estimated up to $2.7 billion might be reduced within 12 months. Separately, the MD&A reported $4.6 billion of recorded liabilities and related interest and penalties for uncertain tax positions.
- HPE disclosed multiple legal matters and indemnification arrangements. It stated it had recorded adequate provisions and that a material loss beyond recognized amounts was not reasonably possible as of April 30, 2017. The Oracle litigation had a $3 billion jury verdict for HP Inc., under appeal; any recovery would be shared under the separation agreement and recorded when received.
- Management concluded disclosure controls were effective and reported no material change in internal control over financial reporting during the quarter.
Investor verification priorities
- Assess the underlying revenue and margin trajectory after the DXC separation, particularly Enterprise Group demand, pricing and the effect of divestitures.
- Verify the timing, conditions, costs, tax consequences and expected proceeds of the planned Micro Focus transaction.
- Reconcile recurring operating cash generation with pension funding, acquisition spending, restructuring payments, repurchases and debt maturities.
- Review the assumptions and potential cash exposure behind deferred-tax valuation allowances, uncertain tax positions and separation-related indemnities.
- Track refinancing of October 2017 maturities, leverage and liquidity needs, as well as the outcome of material litigation and contingent claims.