After the close last night, Hewlett Packard Enterprise (HPE 16.15, -0.08, -0.49%) issued first quarter results, highlighted by a solid $0.07 beat on the bottom line ($0.42 vs. $0.35), driven by an impressive boost in margins as favorable product mix and cost reductions provided a lift. Also, its Intelligent Edge segment, in which HPE has staked much of its future, performed well in the quarter, although, the growth rate did decelerate from last quarter. The company's 2015 acquisition of wireless networking company Aruba led to the creation of this increasingly important segment, which has been a primarily growth catalyst for HPE.
During last night’s earnings call, the cloud computing, storage, and networking company stated that despite some ongoing uncertainties around the world, demand remains steady and the overall IT spending environment remains healthy. Furthermore, HPE stated that the IT investments its customers make are critical to their businesses, especially as the amount of data continues to grow, insulating it from some of macroeconomic volatility. That said, the economic slowdown in China did indeed have a negative impact on its results. Specifically, revenue in the Asia Pacific region fell by 9%, mainly due to weakness in China. That represents a further decline from Q4's 4% slide in APAC.
Another blemish is that HPE's Hybrid IT segment, weakened materially in the quarter, down 3% yr/yr. It is worth noting that much of the softness in revenue growth is actually by design. To explain, we first need to rewind back to December of 2015 when HPE partnered with Microsoft (MSFT), making it the preferred vendor for its storage data center hardware.
After that partnership was forged, HPE became heavily reliant on MSFT to drive sales. Unfortunately for HPE, during that time period, massive data center companies like Amazon (AMZN), Google (GOOG), and Facebook (FB) began buying custom servers from manufacturers in Asia at lower costs. Additionally, some of these data center companies began developing their own hardware. This put HPE in a bind, and, by late 2017, it had made the decision to exit the "tier one" business, as it calls it, no longer selling commodity servers to companies like MSFT and AMZN.
Instead, HPE would turn its focus towards higher-end equipment, such as its hyper-converged portfolio. In essence, the company has prioritized margin and profit expansion at the expense of some top-line growth. However, competition is still very strong in this arena. For instance, AMZN and VMWare (VMW) recently partnered up, allowing Amazon Web Services customers to buy the same type of hardware that AMZN uses for their data centers through a service called "AWS Outposts." Additionally, IBM (IBM) has been investing heavily in its higher-value server products, including hybrid cloud platforms.
1Q19 Overview and Outlook
For the quarter, HPE posted EPS of $0.42, exceeding the $0.35 consensus, with revenue falling by 1.6% to $7.55 bln, missing the $7.65 bln expectation. The highlights for the quarter came on the margin and profitability side of the equation: Non-GAAP gross margin was up 280 basis points yr/yr, Non-GAAP operating profit climbed by 19% to $669 mln, Non-GAAP EPS was up 31%, and cash flow from operations surged 169% to $382 mln.
As noted above, HPE's strategy to exit the "tier 1", commodity server business was a major driver for the improved margins. The company also achieved some cost efficiencies through its "HPE Next" initiative, which it implemented in 3Q17. The goal of this program is to consolidate its manufacturing and support service locations, streamline its business systems, and reduce the number of countries in which it has a direct sales presence. The company seemingly executed well on this strategy as total costs and expenses fell by 4.6% to $7.1 bln. The HPE Next initiative is expected to be implemented through fiscal 2020.
Taking a look at the top line, revenue was up by 1% when excluding the tier one business. Similarly, while revenue was down 3% for its Compute products (part of its Hybrid IT segment), it would have been up 3% without the negative impact from the decline in tier one orders. In total, its Hybrid IT segment (79% of revenue) was down 3%, but, operating margin improved by 200 basis points to 11.3%. That was due to strong sales from its higher-margin categories like hyper-converged (+70%) and its All-Flash Arrays (+20%).
In its newer Intelligent Edge segment (9% of revenue), revenue was up 5% to $686 mln with Aruba products experiencing 3% growth. That is a sizable decrease in growth from last quarter's 17% increase, which is not the most encouraging development, considering HPE is really prioritizing this business. Edge computing relates to bringing storage and memory closer to where the action physically is, whether in a warehouse, store, car, oil rig, etc. Edge is often mentioned alongside "Internet of Things" technology.
Intelligent Edge has been an outperformer in terms of growth ( 13% vs. 6% in Hybrid IT in FY18) but the drop in growth this quarter is notable. That said, the Aruba business recently launched two new products, 510 Campus Access Points and 8325 switches, which HPE believes will be catalysts this year.
In terms of its outlook, HPE guided for Q2 EPS of $0.34-$0.38, in-line with the $0.36 consensus, and FY19 EPS of $1.56-$1.66, also in-line with the $1.58 consensus. Along with the optimistic commentary regarding the global economy, the inline outlook probably came as a relief to investors.
Overall, HPE is executing its margin-expansion strategy well. It has taken costs out of the business and its decision to exit the lower-cost server business, while focusing on higher-end products, has paid dividends for the company. The question, however, is how much runway does HPE have in terms of driving more margin growth? Its Intelligent Edge segment saw a notable drop in growth this quarter and HPE will soon be lapping more difficult yr/yr comparisons in terms of margins as the tier 1 business completely drops off. Furthermore, competition only continues to ramp up in the hybrid cloud market. So, while the company has done an admirable job of turning things around, its growth prospects are still uncertain.