Hewlett Packard Enterprise: Growth Should Be Alright In FY23/24 (NYSE:HPE)

Summary

Hewlett Packard Enterprise (NYSE:HPE) backlog is clouding underlying demand conditions, a fact well-known by HPE’s long-term followers. For a long time now, I’ve suspected that the consensus estimates are based on flawed extrapolations of available data and is not sustainable. However, I was still amazed that HPE was able to increase its full-year revenue and earnings outlook thanks to an F1Q beat, a better-than-expected F2Q outlook, and a combination of favorable FX and more resilient orders than expected. That said, given the new development, while I believe the positive effects of HPE’s backlog have kept the company going for longer than expected, I also think that structural drivers from the company’s transformation are contributing to the shown resilience.

I believe HPE is nearing a tipping point where the loss of market share to the public cloud is no longer wholly offsetting the gain in workloads across the market. With this belief, I anticipate that the core Compute and Storage businesses will once again experience expansion. Crucially, I observe several positive developments for 2024. These include the Enterprise server upgrade cycle that is still in progress due to an improvement in the supply, HPE’s plans to increase prices for more advanced configurations, and the continuous adoption of digital transformation by enterprises. To some extent, I think my expectations for FY23 align with management’s guidance, which are backed by a mix of strong growth and high margin. In sum, I believe the current valuation of 7.3x forward PE, together with the positive trends in FY23/24, makes for an attractive long.

1Q23 review

Compute, Storage, and Intelligent Edge revenues tracked better than expected, contributing to the overall revenue result of $7.8 billion, which was higher than the consensus estimate of $7.4 billion. The increase in revenue can be attributed in part to increased supply. I think more importantly, it surprises investors who have been growing increasingly anxious about the state of the Compute/server market. Conversely, gross margins came in at 34.2%, beating the consensus estimate of 33.6%. Operating margins hit a record high, exceeding expectations, thanks to the higher revenue and better-than-expected gross margins, which were partially offset by higher operating expenses. Finally, EPS of $0.63 exceeded expectations of $0.54.

Growth should be alright in the near-term

I think most of the growth is being driven by normalization of the backlog, but it’s hard to tell because HPE stopped disclosing Order metrics in the last quarter. To some extent, I wonder if the current growth strength is sustainable, given that I anticipate some of the current strength to be driven by the easing of the supply chain situation via backlog reductions. Our only clue is that, according to management, the company’s current backlog is still >2x normal levels for the business, with the Intelligent Edge business, HPC/AI, storage, and compute all still seeing backlog above normal levels. There are two ways I see this:

1. Backlog is certainly still at very high levels, so this should continue to support growth for the short-term (maybe till FY24?)
2. Management is using qualitative messaging to appease the market and will slowly adjust expectation moving forward – which we will know in the coming quarters.

Looking back at some of management earlier backlog comments, however, it appears that management is quite successful at reducing backlog. For instance, 3Q22 was five times as busy as usual for Compute, and Intelligent Edge was twenty times back then. Using these numbers as a yardstick, it is clear that management has successfully job in driving down backlog (which drives growth). Based on the available information, I do anticipate HPE reducing its backlog throughout the year as the supply chain continues to improve, suggesting that near-term growth should be fine, but investors should pay close attention to management’s language in the coming quarters.

Conclusion

In conclusion, while HPE backlog has been a well-known issue for long-term followers, the company was able to increase its full-year revenue and earnings outlook thanks to a better-than-expected performance in F1Q and F2Q, favorable foreign exchange rates, and resilient orders. More importantly, I believe that HPE may be nearing a tipping point where the loss of market share to public cloud providers is no longer offsetting workload gains. As such, I remain optimistic about HPE future, particularly in its Compute and Storage businesses, which should experience growth in FY23/24. With a forward PE valuation of 7.3x and several positive developments on the horizon, I believe HPE is an attractive long-term investment. However, investors should pay close attention to management’s messaging (regarding backlog) in the coming quarters.