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Morningstar | HPE Misses our 1Q Expectations, but Raises Fiscal 2019 EPS Outlook; Maintaining FVE of $15

No-moat Hewlett Packard Enterprise reported a 2% year-over-year revenue decline, below our expectation for a flattish period. Although doubling its operating margin to 6% year over year, we expected HPE to post results closer to 7% through more controlled expenditures. On a positive note, HPE increased its fiscal 2019 EPS guidance by $0.15 per share on a GAAP basis. Since we still expect pressures in HPE's traditional markets, such as commodity servers and disk-based storage, to drag potential growth avenues, we are maintaining our fair value estimate of $15 per share and we advise investors to wait on a wider margin of safety for this name.

HPE's compute business shrank year over year by 3%; however, excluding the company's purposeful exit from the Tier 1 cloud providers, compute revenue grew by 3% (and total HPE revenue grew by 1%). High-performance compute grew by 59% and hyperconverged infrastructure products increased by 70% year over year. The intelligent edge division's revenue increased 5% versus the previous year, with Aruba products increasing by 3% annually. Aruba services increased by 20% year over year, which is a marginal increase over the previous quarter. Sales within the storage division grew by 3%, led by demand strength for all-flash arrays, which grew by 20%. HPE Pointnext sales declined by 6% as the company ceases advisory and professional services in lower-margin geographies. Financial services revenue increased by over 3% year over year.

We expect strong growth in the areas of hyperconverged infrastructure and all-flash storage to help offset declines in traditional areas and we model an incremental revenue increase in 2019. In our view, gross margins will continue slight expansion as HPE exits competitive arenas and moves toward more higher-margin product and software sales. We expect HPE to come in at the higher end of its second-quarter EPS guidance of $0.19-$0.23.

The first quarter's gross margins of 31.1% should be sustainable, in our view, as Tier 1 cloud sales decrease while HPE sells more software and higher performance products that demand a premium. HPE increased its R&D by 20% year over year (6% sequentially) as the company commits resources to nascent IT technologies like edge computing, wireless systems, and software-based networking. We welcome this additional spending as a prudent measure to keep HPE's innovation pipeline on par with industry peers also moving toward more software-based products, solutions for flash-based arrays, and wireless systems.

HPE's 2019 EPS guidance is now $0.88-$0.98 per share, up from $0.73-$0.83, on a GAAP basis and $1.56-$1.66 per share, increased from $1.51-$1.61, for non-GAAP. From a non-GAAP perspective, HPE beat its first-quarter guidance by $0.07 per share at the midpoint, so its full-year non-GAAP EPS increase of $0.05 per share is not a cause of elation, in our view. Alongside some expected operating margin expansion, we believe that HPE's EPS benefits from the company buying back $800 million of shares in the first quarter. We model HPE to exceed its earnings guidance for the year. In the quarter, HPE paid out about $200 in dividends.

HPE made reporting structure adjustments that were implemented starting in this quarter. The DC networking business was moved under the HPE Aruba product and services groups from Hybrid IT. The edge computing business was moved to Hybrid IT from HPE Aruba products. Lastly, the communications and media solutions group was transferred to the corporate investments unit from the HPE Pointnext business. These changes should create a more congruent product offering per group and potentially increase cross-selling opportunities, in our view. In the quarter, HPE closed acquisitions of BlueData, a provider of big data and machine learning workloads for containers, and QuattroLabs, a data center management services firm. We view these tuck in acquisitions as in line with HPE's strategic shift toward cloud-based services and software solutions.