2023-10-26 07:40:55 ET
Summary
- Hewlett Packard Enterprise is well-positioned to benefit from the ongoing AI revolution in the computing industry.
- High-performance computing and AI division can generate significant hyperscaler orders.
- HPE's valuation is favorable compared to peers, with a lower forward P/E and higher dividend yield, making it an attractive investment option.
- Growth in high-margin segments projected to prop up profit margins.
Hewlett Packard Enterprise (HPE) is a rare value pick in today's computing industry, as it is well-positioned to prosper from the ongoing AI revolution. HPE can benefit through multiple ways from the changes going in the computing industry as it maintains solid positions in the high-performance computing and AI (HPC&AI) segment, edge computing, cloud, and SaaS segments. In my opinion, it has been overlooked by analysts and is ripe for a potential expansion in its P/E multiple similar to what Dell (DELL) experienced in late August.
The recent Securities Analyst Meeting 2023 revealed substantial growth opportunities among HPE's three main growth drivers Intelligent Edge, hybrid cloud and AI, with total addressable market expected to increase by nearly $100 billion to $340 billion by 2026. However, the HPE's revenue guidance disappointed markets as HPE projects only 2%-4% CAGR revenue growth over FY23-FY26, while EPS growth adjusted for the disposal of H3C in FY23 ($0.17 impact in FY23) is estimated to grow at 7%-9% CAGR over the same period.
I think HPE's revenue guidance remains quite conservative and sets the company for potential upside surprises going forward. HPE can tap many growth opportunities and has the potential to become a drastically different company in terms of its revenue mix in 3 years' time. According to the 2022-2026 guidance provided by the company, TAM is expected to grow by double-digits in both Intelligent Edge and HPC&AI, while in hybrid cloud it is expected to grow by 7%. Moreover, operating margins will improve tangibly as the company moves away from its low-margin, low-growth traditional server business.
Guidance for selected indicators in FY22-FY26 (HPE SAM 2023)
Valuation Remains Favorable Compared To Peers
HPE trades at 7.13 forward P/E compared to 10.46 for and 14.92 for Super Micro (SMCI), which is a stock market's favourite so far this year with its price almost tripling year-to-date. In addition, HPE has a much higher dividend yield of 3.15% compared to 2.12% for Dell and no dividend for SMCI.
When it comes to long-term growth, HPE is projected to be in the same ballpark as DELL, but both companies cannot keep up with SMCI. SMCI hasn't published a long-term growth outlook, but its revenue is projected to surge by around 40% in full year 2024 led by an opening of a new production line in Malaysia.
To put HPE's valuation in historical perspective, the company currently trades at a lower forward P/E multiple when it became public in late 2015 despite the huge opportunities created by AI and other technologies. I think this clearly shows that a lot of buyers remain on the side-lines and the stock clearly hasn't been taken aboard the AI hype train yet.
Comparison between HPE and peers in server market (Company reports and Seeking Alpha)
HPE Fully Capable To Win Sizable Hyperscaler Orders
HPE's supercomputing unit Cray has unique expertise to build supercomputers as it has the ability to work with different hardware manufacturers, including Nvidia (NVDA), AMD (AMD) and Intel (INTC). HPE Cray constructed the world's first exascale computer in 2022, Frontier, which remains the world's fastest supercomputer as of June 2023, according to the TOP 500 list . In fact, HPE Cray constructed 3 out of the 10 fastest supercomputers in the list. In addition, HPE Apollo Systems manufactures a wide variety of servers optimised for GPU computing. These capabilities will help HPE win sizable orders in the coming quarters from hyperscalers, which are at the forefront of the AI computing revolution.
Total backlog of HPC & AI orders exceeded $3 billion as of end-July, which is roughly comparable to the entire revenue in FY 2022. In comparison, Dell reported $2 billion backlog of high-performance XE9680 AI servers in its Q3 results . Overall, I think HPE has better ability to win hyperscaler orders than Dell due to its rich experience in building supercomputers.
CEO Antonio Neri outlined a strong pipeline of HPC orders in the Q3 conference call, but warned that orders may be slow to translate to revenues due to rampant shortages for AI chips and slow revenue recognition process. Shortages are likely to alleviate in 2024 and unlock higher revenues for the HPC & AI division. For instance, Nvidia is projected to triple the supply of its hotly sought-after H100 chips in 2024, according to an article in the Financial Times from late August. Quanta, a key Nvidia partner in the AI space, expects that its AI server sales will double in 2024, Bloomberg wrote in late August .
According to the HPE's Q3 earnings results , HPC & AI revenues increased by 17% y/y to $2.7 billion in the nine months ending June 2023, however, the segment failed to turn a profit and posted an $8 million operating loss in the same period. The poor profitability stems from the current high cost pressures in the sector, supply chain issues, and also sizable investments into R&D. As supply chain issues normalize, demand grows and R&D investments pay off, the HPC & AI division will become a driving force of profitability, in my view.
HPE's performance by segment (Q3 earnings presentations)
Edge Computing And Hybrid Cloud Supplement High-Performance Computing
Edge computing, which relates to the processing of data "at the edge" where data is collected, is a potential winner of the emergence of AI hyperscalers that rely on large amounts of information to create generative AI models. Emerging technologies such as IoT, Industry 4.0, smart cities and 5G are also important drivers of growth for edge computing. Unsurprisingly, edge computing is projected to grow explosively by 35% CAGR by 2032, with North America being the largest market, according to a recent report .
It should be noted that HPE is currently cheaper than key players in the edge computing industry such as Cisco Systems ( CSCO ) and Juniper Networks ( JNPR ) which trade at 13.05 and 11.43 forward P/E, respectively. HPE's Intelligent Edge division has been performing stellarly in recent quarters, posting 53% revenue growth and 13.2pps y/y growth in operating profit margin in Q3. Intelligent Edge is already a significant part of the company, as the division's operating profit accounted for 49% of total non-GAAP operating profit, while revenues accounted for 20% of total company revenues. Importantly, Intelligent Edge contributes to significant expansion of the profit margin as it had an operating margin of 29.7% compared to 10.3% margin for the entire company.
That said, Intelligent Edge revenues have benefitted from the fulfilment of a large backlog of orders related to the going-back-to-work trend and the adoption of Wi-Fi 6. However, if growth in the sector proves secular as predicted by some, HPE will experience a significant earnings bonanza. At any rate, the strength in the Intelligent Edge sector has offset some of the weakness in Compute, proving that the company did well buying Aruba Networks in 2015 and diversifying its core business.
Compute Revenues Remain Under Pressure, But Light Seen At The End Of The Tunnel
In my opinion, the main reason why HPE remains cheaper than peers relates to its considerable reliance on the traditional server business, where Dell is the clear market leader. The Compute segment accounted for 37% of revenues in Q3 and 34% of operating profit. Demand for traditional servers is expected to remain stagnant in the coming years as firms prioritize investment in AI servers. On the bright side, HPE plans to update its ProLiant Gen11 servers with a focus on AI inference workloads, which should revitalize sales as it is a segment that may see strong growth going forward. Demand for servers specialised in AI inference is expected to grow by 22% CAGR in 2025-2026, according to HPE.
HPE Getting Beaten By Rivals Remains Primary Downside Risk
In my opinion, the main downside risk for the stock remains that HPE will be beaten by rivals as it will not be able to take advantage of the opportunities created by AI, and it will not be able to keep up with sizable investments needed to do that. When comparing R&D spending, HPE's R&D expenses amounted to $2.0 billion in FY22 compared to $2.6 billion spent by its main rival Dell in FY22 which has more than two times its market cap. However, HPE will increase its dividend payout ratio to 65% to 75% of its Free Cash Flow in the 2022-2026, compared to 60% in FY23, which will reduce the company's capacity to invest in high-growth opportunities.
Looking at HPE's ability to compete in the global server market, its market share has declined only marginally from 17.2% in 2017 to 16.6% in 2022, according to Statista data . Thus, the company has been capable to defend market share despite strong pressure from Dell.
In addition, there are risks that Compute revenues will not bounce back and will experience a long-term slump, while the Intelligent Edge revenues will revert to their mean. Nonetheless, I think some of the downside risks are already accounted for in the price.
Conclusion
I think HPE is undervalued compared to peers because it has strong exposure to trends set by AI and other emerging technologies, but its valuation is more attractive than Dell and SMCI. The slump in the traditional server demand has likely bottomed and will become less of a drag on earnings. I think there is potential for both multiple expansion and strong earnings growth in the coming year that overshoots guidance.
In my view, investors will eventually recognize HPE's potential as an AI play, which will lead to a multiple expansion. I think that HPE can bridge half of the gap between its P/E ratio and that of Dell and will start trading at around a forward P/E of 9. This suggests some 23% upside from the current level and sets my price target at $19 per share. At any rate, I think that HPE deserves a place in any AI portfolio as it offers much better value compared to peers, while offering solid growth prospects.
For further details see:
Hewlett Packard Enterprise: Rare Value AI Play Ripe For Multiple Expansion