Hewlett Packard Enterprise: Can They Fix Those Margins? Asks Street

Wall Street Has had a full day to digest the fiscal Q2 report on Wednesday evening by Hewlett Packard Enterprise (HPE), including the sharper-than-expected decline in profit margins, a source of concern to many.

The shares continue to be under pressure. Shares today are down 43 cents, or 2.5%, at $17.09.

Following the call, chief executive Meg Whitmantold me that she believes the margin issues will pass for the company as the year goes on, and that at some unspecified point in time, the mix of new business - things such as Nimble Storage equipment - will lift overall company profit margins.

The debate between bulls and bears is whether indeed the margin problem can be fixed - or even fix itself - and how much it is a long-term structural problem that's not going away.

From the bulls, Kulbinder Garcha of Credit Suisse is inclined to look past the margin issue, reiterating his Outperform rating and writing that "We see HPE has multiple levers to optimize its cost structure and believe our estimates of RemainCo EPS power of $1.25 will prove conservative […] We believe the margin pressures should ease as transitory drivers go away."

Some other bulls are not as forgiving. Bernstein's Toni Sacconaghi reiterates an Outperform as well, writing that "overall results masked a significant, further erosion in Enterprise Group (EG) profitability."

"We believe the majority of the sequential pressure was due to incremental competition," writes Sacconaghi. "HPE is taking material, incremental cost cuts to compensate for the shortfall."

"A key question," he writes, "is what are normalized EG margins over time?"

Our analysis suggests that servers, storage and networking collectively had negative operating margins in Q2, which we believe is not sustainable. By hook or by crook (rightsizing, scaling back unprofitable businesses, etc.), we believe HP should be able to get normalized hardware margins to be positive and believe total EG margins of ~12% is not unreasonable.

Still, Sacconaghi believes " risk-reward on HPE is attractive," and that investors should "use any pullback in the stock to add to positions."

For the bears, Josep Bori with Berenberg bank reiterates a Hold rating, and a $17 price target, writing that the "most concerning" thing "are the worsening margin profile of the core IT infrastructure business and the apparent difficulties in the Tier 1 service provider market segment, which we consider to be an unresolved strategic issue for the company."

"As such, while valuation is undemanding, we fear HPE shares will become a value trap."

HP's problems in server computers are structural, he contends, and not easily fixed:

Core Enterprise Group revenue declined by 7% yoy on a like-for-like basis, largely driven by the 14% decline in Servers and 13% in Storage, which together account for ~60% of the group. Management noted this was driven by a single Tier 1 service provider client, and intimated that it was reconsidering its participation in this low-margin market. Given that we expect the ongoing shift of enterprise IT workloads to the public cloud (ie Tier 1 service providers) to continue unabated, we view HPE's difficulties in operating profitably in this market as a fundamental strategic issue, especially now that it has divested all the other business divisions. Further, in part due to the above trend, as well as the storage market weakness and commodity cost increases, the division's operating margins contracted sharply (to 8.8% versus 12.7% in Q1).

Even harsher is Barclays's Mark Moskowitz, who reiterates an Underweight rating, and lowers his price target to $17 from $18, writing that the company is "kicking the can" down the road.

"This maelstrom presents an opportunity for long-term and value-based investors to take profits in a more meaningful way as the napkin-math financial engineering of the spins gives way to the reality of a legacy asset being hit by the cloud and increasing competition."

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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