Healthy margin growth, a solid cash-flow outlook and a low bar are helping HP Enterprise's shares rally following a mixed earnings report.
After the bell on Tuesday, HPE reported July quarter (fiscal third quarter) revenue of $7.22 billion (down 7% annually) and non-GAAP EPS of $0.45 (up 7%). Revenue missed a $7.28 billion consensus analyst estimate, while EPS beat a $0.40 consensus and was above HPE's prior guidance range of $0.40 to $0.44.
The IT hardware giant also guided for October quarter EPS of $0.43 to $0.47, which compares favorably with a consensus of $0.43. And in spite of a $666 million arbitration payment to IT services firm DXC Technology (DXC) - Get DXC Technology Company Report that was disclosed last week, HPE reiterated guidance for fiscal 2019 (ends in October) free cash flow (FCF) of $1.4 billion to $1.6 billion, as well as fiscal 2020 FCF guidance of $1.9 billion to $2.1 billion.
HPE's stock rose close to 6% in after-hours trading Tuesday following the company's report and was rising 3.8% to $13.42 in pre-market trading on Wednesday. Low expectations are helping: HPE had gone into earnings down 21% over the prior 12 months, and less than a dollar above a 52-week low of $12.09. In addition, recent disclosures from NetApp (NTAP) - Get NetApp Inc. Report , Intel (INTC) - Get Intel Corporation Report and others had already pointed to soft enterprise server and/or storage demand.
A big reason why HPE beat EPS estimates in spite of a revenue miss: Its non-GAAP gross margin rose by 1.7 percentage points sequentially and 3.4 points annually to 33.9%, soundly beating a consensus estimate of 32.0%. On HPE's earnings call, CEO Antonio Neri indicated that about half of HPE's sequential margin growth stemmed from commodities (i.e., lower DRAM and NAND flash memory prices), and that half came from shifts in HPE's revenue mix towards higher-margin offerings.
"We continue to believe there is further upside long-term" for gross margins, CFO Tarek Robbiati said during a talk with TheStreet that followed HPE's earnings call. In addition to product mix improvements and additional commodity pricing tailwinds, Robbiati forecast that HPE's margins will benefit from greater supply chain efficiencies and its efforts to automate manual work done by its Pointnext IT services unit.
Macro Pressures and Cloud Adoption
Much like rivals NetApp and Cisco Systems (CSCO) - Get Cisco Systems Inc. Report , HPE says macro uncertainty has begun impacting its enterprise sales and deal closings. "It's a new reality. The tide is different...it's no longer the heyday of [fiscal 2017 and fiscal 2018]," Robbiati said about the current spending environment.
HPE's "compute" (server) revenue fell 10% annually during its July quarter -- aside from macro pressures, the company blames efforts to reduce sales of low-margin hardware to major cloud service providers and HPE's H3C Chinese JV -- while its storage and Pointnext revenue respectively fell 3% and 4%. The company's Intelligent Edge (networking product and service) segment, which HPE has previously said is being hurt by North American sales execution issues, saw revenue drop 3%.
In addition, while HPE's server business continued seeing growth for its high-performance computing (HPC), composable infrastructure and hyperconverged infrastructure (HCI) offerings, growth rates slowed relative to the April quarter. When asked if HPE expects growth for these businesses to re-accelerate in the coming quarters, Robbiati declined to give a forecast, but did add that HPE is making new salesforce investments to drive additional growth. He also noted HPE's $1.3 billion deal to buy supercomputer maker Cray (CRAY) - Get Cray Inc. Report , which is now expected to close by the end of its October quarter, will act as a growth driver heading into fiscal 2020.
And -- in line with comments made following HPE's April quarter report -- Robbiati insists that the impact of public cloud infrastructure adoption on HPE's sales is restrained by a preference among CIOs to keep data-intensive workloads on-premise. He added that while cloud migrations continue, HPE believes "the low-hanging fruit" has already been picked. For their parts, public cloud giants Amazon Web Services (AWS), Microsoft Azure and the Google Cloud Platform (GCP) are still seeing strong double-digit growth.
No Plans to Sell the H3C Stake
While some U.S. multinationals have reported seeing Chinese sales pressures as the trade war continues, HPE's H3C JV, which is 51%-owned by Chinese firm UNIS, is still seeing healthy growth. HPE, which receives dividend payments related to H3C's profits, notes in its earnings presentation that it has a put option (priced at 15 times H3C's trailing 12-month earnings) to sell part or all of its H3C stake to UNIS that doesn't expire until April 30, 2022.
When asked if HPE is open to selling the H3C stake, Robbiati made it clear that his company has no plans to do so, while noting it's in HPE's strategic interests to maintain exposure to the world's second-biggest IT market.
"We don't get recognized for the value of that stake," he added. "[We] want to highlight it as a source of value." H3C's growth has helped UNIS' shares rally on the Shanghai exchange in recent months; the company now sports a $10 billion market cap.
Save 57% With Our Labor Day Sale. Join Jim Cramer's Action Alerts PLUS investment club to become a smarter investor! Click here to sign up!