As an investor, one is most cautious in the week prior to the company’s results, and even more so if the company has not delivered too well in the past. Hewlett Packard Enterprise Co. (HPE, Financial) would definitely make the list of companies that have shown some excellent stock appreciation since the previous results, but have a history of failing to meet analysts' revenue expectations. With its results due next Tuesday, it is a fair question to ask whether investors should continue holding the stock or run for the exit after a mediocre quarter.
Is HP’s fundamental performance good enough?
HP delivered mixed results for the third quarter in August, where it underperformed on the revenue front (revenue of $7.22 billion was below the analyst consensus of $7.27 billion), but outperformed on the earnings front (earnings of 45 cents per share topped the analyst estimate of 40 cents). Interestingly, it was the third consecutive quarter with such mixed results. If one looks more closely into the company’s business, the reason is quite evident.
The San Jose, California-based company has been recording marginally declining growth in its three core revenue-producing divisions – Intelligent Edge, Hybrid IT and Financial Services. However, the decline has been the highest in the Hybrid IT division (about 9% in the previous quarter), which accounts for almost 77% of the company’s total revenue. Clearly, analysts were unable to estimate the significance of the impact that the U.S.-China trade war and the general global economic weakness have had on this division, which is why their forecasts are always on the higher side.
How is HP’s management countering the revenue decline?
Like any logical management team would do, they are investing in an alternative revenue stream - software. HP has been acquiring small software companies like MapR and Blue Data and took its most significant step in the field of software by launching its Container Platform – software meant to help organizations speed up the adoption of hybrid cloud architectures. Its strategic partnership with H3C coupled with the excellent growth shown by its Aruba services is also working in its favor to tackle the revenue decline.
Another aspect where the management is working hard is the cost management and optimization of resources, which is why margins are improving. The Hybrid IT division increased its margins enough to account for almost 89% of total earnings as of the third quarter. This explains HP’s outperformance on the earnings front.
The situation has changed this quarter, however, as the earnings consensus is as high as 46 cents per share, while it was below 40 cents for most of the previous quarters. HP's management will have to beat their own earnings number of 45 cents just to match up to this consensus, which is not going to be easy. They are certainly spending more on the software business, which will eat into the hardware margins.
Why has the stock performance been so good?
There is little doubt that HP has shown excellent resilience in these tough times, and its results have not been impacted as adversely by the trade war as its competitors have. The robustness of the fundamentals in a turbulent business environment, coupled with the strong investor perception about the company’s transition toward a service-based model, explains why the stock has been in excellent demand, particularly over the last quarter.
The share price has risen from around $13 to above $17 and is currently close to a 52-week high. The dividend yield of 2.6% is also very attractive. In fact, investors who entered the stock right after the previous quarter's earnings were released have clearly made phenomenal returns in the three-month period. However, this has increased analyst expectations as well as they are expecting strong margins with a nominal revenue decline in the coming quarter, which might be difficult for the management to achieve.
Key takeaways
When Microsoft (MSFT, Financial) transitioned to a service-based model, its perceived value increased significantly and it went on to become the highest valued company across the globe. The positive investor perception with respect to HP’s transition toward services is already visible, but one must always be aware of the fact that corporate transitions can be long and tough, especially when the matter in contention is the core revenue model. While the long-term view of HP continues to remain positive, investors may experience a hiccup this quarter as the chances of the company beating the analyst estimates seems relatively low. HP investors should be very cautious next week as the bull run on the stock clearly has a big hurdle in its path.
Disclosure: No positions.
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