Why HPE Is Earning Less Than Peers

#HewlettPackardEnterprise ( #HPE : NYSE) By #MorganStanley ($17.30, Aug. 15, 2017) An analysis of peer margins suggests normalized Enterprise Group margin of 13.8%, implying Hewlett Packard Enterprise is underearning by 12% given current fiscal 2018 estimates. But competitive pressures are delaying recovery to a normalized environment to fiscal 2020, driving fiscal 2020 earnings per share to $1.45, which when discounted back leaves our $18 price target unchanged.  Looking back to the years prior to HPE’s (ticker: HPE) spinoff from HP (HPQ), Enterprise Group (EG) operating margins averaged close to 15%. However, pressure from cloud adoption, competition from lower-cost original design manufacturers (ODMs), and overhead costs slowly eroded margins to 12.8% in fiscal 2016. Now, rising memory costs, a difficult pricing environment, exchange-rate headwinds, dilution from recent acquisitions and stranded costs related to the Enterprise Services spin (and soon the Software spin) have weakened margins further, driving a 300 basis points year-over-year decline in fiscal-second-quarter EG operating margin, to 8.8%.  Due to these factors, we believe that EG is currently underearning relative to peers. Our deep dive analysis into competitor margins across servers, storage, networking and technology services, the segments that collectively make up EG, suggest a “normalized” base-case EG operating margin of 13.8%. Substituting our normalized base-case EG operating margin of 13.8% into our current fiscal 2018 estimates, keeping all else equal, would drive fiscal 2018 EPS of $1.31, 12% higher, to $1.47. How did we arrive at our conclusion? In our analysis of HPE’s closest peers in servers, storage, networking and services, we calculated a low, middle, and high normalized operating margin for each business unit, and then created three scenarios -- a base, bull and bear case, that help contextualize the impact a normalized margin environment would have on HPE financials. Our 13.8% operating margin base case assumes low-end-of-peer margins across hardware segments with continued competitive pressure from both cloud and emerging vendors. However, we believe services, recently renamed PointNext, already runs at peer average margins, which should continue. To the extent lower-margin consulting and advisory services make up an increasing mix of services and/or HPE fails to improve its positioning in servers and storage, we see a bear-case normalized margin of 12.2%. On the other hand, if recent acquisitions and [Intel (INTC)] Purley server refresh improve the company’s competitive position, midrange of peer margin across the portfolio drives our 16.1% bull case margin forecast. While we expect some of the factors pressuring EG margins to dissipate in the near term (e.g., dilution from recent acquisitions), we also believe a recovery to normalized margin levels will take a number of years due to accelerating cloud adoption, whitebox competitors taking further share, and higher memory costs continuing into fiscal 2018. As a result, we model EG operating margins recovering to our base-case normalized level in fiscal 2020. After lowering corporate unallocated costs to consider incremental restructuring actions next year, our fiscal 2018 EPS increases to $1.31 (up from $1.26) but our $18 price target, based on 11 times fiscal 2018 EPS plus $4 a share for the Software assets, remains unchanged. Discounting normalized fiscal 2020 EPS of $1.45 (up from $1.42) by HPE’s approximate 7.5% weighted average cost of capital (WACC) implies a similar $18 price target.

http://www.barrons.com/articles/why-hpe-is-earning-less-than-peers-1502877088