CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings for Hewlett Packard Enterprise Company (HPE), including the 'A-/F2' Long- and Short-Term Issuer Default Ratings (IDR) , on HPE's spin-merger of its software businesses (SW). Fitch's actions affect $20.5 billion of total debt, including the undrawn $4 billion revolving credit facility (RCF). The Rating Outlook is Stable. A full list of ratings follows at the end of this release.
Fitch believes the SW spinoff further reduces scale and diversification, particularly within the context of HPE's pending spinoff of the Enterprise Services (ES) segment announced May 25, 2016 and HPE's focus on accelerating Technology Solutions (TS) business amidst a lower growth hardware demand environment. Nonetheless, pro forma for both SW and ES transactions, HPE's scale will remain significant with approximately $28 billion of annual revenue, higher operating EBITDA margins and only modestly lower annual free cash flow (FCF).
HPE's SW portfolio consists mainly of disparate on-premise offerings with secular new license growth headwinds but solid maintenance and support recurring revenue and cash flow. Nonetheless, Fitch believes filling product gaps, achieving scale and building a significant as-a-service (aaS) business would require significant investments and likely debt-financed acquisitions adversely impacting HPE's credit profile. HPE will spinoff the Applications Delivery Management, Big Data, Enterprise Security, Information Management & Governance and IT Operations Management businesses and retain assets related to the software-defined and cloud business, including OneView and Helion cloud platform.
The spinoffs enable HPE to focus on its strategy of optimizing customers' hybrid cloud environments but Fitch believes the transactions reduce HPE's headroom for operational shortfalls. The company's strategy is underpinned by the TS business, which grew organically in the quarter ended July 31, 2016 for the first time since 2012. HPE is holding share in industry standard servers (ISS), although demand within non-hyperscale markets is muted. HPE's smaller but fast growing all-flash array and software-defined storage (SDS) are providing some offset to the continuation of secular decline for traditional storage solutions. The company's Aruba acquisition continues driving growth in networking, as HPE gains share in campus branch and emerging edge markets. Pro forma for the separations, Fitch expects profitability will remain consistent with growth in higher margin TS and restructuring initiatives offsetting competitive pricing in hardware markets, particularly servers.
On Sep. 7, 2016, HPE announced it will spinoff the SW businesses (SpinCo) and subsequently merge SpinCo into U.K. software provider, Micro Focus. The total transaction value is approximately $8.8 billion. HPE shareholders will retain a 50.1% ownership in the new combined company, valued at approximately $6.3 billion, and SpinCo will make a $2.5 billion cash payment in the U.S. to HPE in connection with the spinoff. HPE will incur $700 million of separation costs related to the SW spinoff, the vast majority of which will be incurred in fiscal 2017. HPE expects to complete the transaction by the second half of fiscal 2017, pending customary regulatory approvals.
HPE also recently closed the sale of Mphasis for approximately $825 million of pre-tax proceeds and will use the vast majority of proceeds for share repurchases. Fitch also expects HPE will use the majority of proceeds from the SW and Services spinoffs, $2.5 billion and more than $1 billion of cash and debt transfers, respectively, for share repurchases. Fitch expects debt levels will decrease by $1.9 billion in connection with the Services spinoff and core leverage (which excludes debt and profitability related to HP Financial Services) should remain roughly at 0.6x - 0.7x, versus 0.6x for the trailing-12-months (TTM) ended July 31, 2016.
KEY RATING DRIVERS
Intensified Hardware Exposure: Fitch believes HPE's transactions increase concentration to slower growing and, in certain cases, commoditizing hardware markets. Pro forma for the spinoffs, hardware sales will represent roughly two-thirds of total revenue but less than 25% of operating profit. Fitch expects ISS to remain a mixed demand market with meaningful pricing pressures. Fitch expects secular headwinds for legacy storage products will continue, constraining growth and profit margins. Networking remains a bright spot with secular campus branch and edge growth, although Fitch expects intensifying competition from a variety of players, including networking market leader, Cisco Systems, Inc.
Recurring revenue and FCF: Fitch expects significant recurring revenue and FCF, pro forma for the spinoffs. Maintenance and support sales represent approximately 30% of total revenue and 60% of operating profit, resulting in substantial recurring FCF. Execution on HPE's optimizing customers' hybrid cloud environments will drive a higher mix of TS sales and recurring revenue growth and cash flow.
Significant Shareholder Returns: Fitch expects shareholder returns will remain significant, particularly considering the vast majority of cash and majority of cash flow (a Fitch estimated two-thirds) is offshore and would give rise to tax liabilities upon repatriation. Fitch expects HPE will continue returning at least 100% of pre-dividend FCF to shareholders. The company will fund nearer-term shareholder returns with domestic cash flow, proceeds from spinoffs and other divestitures and some tax efficient repatriation. Over the longer-term, however, Fitch believes HPE will need to borrow to sustain similar shareholder return levels.
Conservative Leverage: Fitch expects HPE's core leverage will remain conservative through the intermediate-term. Fitch expects core leverage below 1x through the nearer-term forecast period and that management will curtail shareholder returns to maintain core leverage below 1.5x through the intermediate-term.
Significant Installed Based: Fitch expects HPE's significant installed base will provide the aforementioned maintenance and support streams but also growth opportunities. TS's advisory and consulting practices should enable customers to migrate workloads across on-premise and cloud environments, both public and private, and attach additional HPE hardware and maintenance and support services. TS' revenue will represent roughly 25% of total revenue and was approximately $7.7 billion for fiscal 2015 with $2.5 billion of operating profit and meaningfully higher than corporate-wide 33% operating profit margins.
Potential Debt-Financed Acquisitions: Fitch expects ongoing acquisitions to strengthen HPE's hybrid cloud environment strategy. Given Fitch's expectations for the continuation of shareholder returns equal to 100% of pre-dividend FCF and that a Fitch estimated two-thirds of pre-dividend FCF is offshore, Fitch believes acquisitions likely will be debt financed, potentially straining credit protection measures through the subsequent intermediate-term.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for HPE include:
--HPE completes the spinoffs of the Services and SW businesses in fiscal 2017;
--Low-single digit organic constant currency revenue growth through the intermediate-term;
--Operating EBITDA margin expands to the high teens from the spinoffs, restructuring and growth in higher margin TS;
--HPE separates $1.9 billion of debt and $3.2 billion of operating leases and pension liabilities in connection with the Services spinoff;
--HPE will use $4 billion cash dividends from the spinoffs ($1.5 billion from Services and $2.5 billion from SW) to support domestic liquidity, likely emphasizing share repurchases.
RATING SENSITIVITIES
The ratings could be downgraded if Fitch expects:
--Negative constant currency organic revenue growth, likely from weaker than expected performance in TS or share losses or intensified pricing pressures in HPE's hardware businesses;
--HPE will not sustain operating EBITDA margin in the high teens, pressuring FCF and core leverage; or
--Shareholder returns intensify, requiring incremental debt to support domestic liquidity and resulting in core leverage above 1.5x.
The ratings are unlikely to be upgraded in the absence of Fitch's expectations for:
--Sustained positive low single digit or greater organic constant currency revenue growth, driven by clear technology leadership;
--Annual FCF will more than double and become less transactional in nature, providing the company with greater visibility and enhanced financial flexibility to fund acquisitions and invest in next generation offerings and
--Commitment to maintaining core leverage below 1x.
LIQUIDITY
Fitch believes HPE's liquidity is strong as of July 31, 2016 and supported by:
--$10.1 billion of cash and investments, excluding cash related to HPFS. The vast majority of HPE's cash is located outside the U.S.;
--An undrawn $4 billion RCF that fully backstops CP programs in the U.S. and Europe.
More than $1.5 billion of annual FCF also supports liquidity.
Total debt was $16.1 billion at July 31, 2016 but core debt, which excludes excluding debt associated with FS, was roughly $8 billion.
Fitch affirms the following:
Hewlett Packard Enterprise Co.
--Long-Term IDR 'A-';
--Short-Term IDR 'F2';
--Commercial Paper (CP) Rating 'F2;
--Senior unsecured RCF rating 'A-';
--Senior unsecured debt rating 'A-'.
Hewlett-Packard International Bank PLC
--Short-Term IDR 'F2';
--CP at 'F2'.
Electronic Data Systems LLC
--Long-Term IDR 'A-';
--Senior unsecured debt 'A-'.
Date of Relevant Rating Committee: Sept. 7, 2016
Summary of Financial Statement Adjustments - Fitch backs out profitability and debt, representing a 7:1 leverage ratio of finance assets, related to the HPFS to calculate core EBITDA and core debt, ultimately arriving at core leverage. This reflects Fitch's focus on HPE's true operating results that are comparable across its peer group.
Additional information is available on www.fitchratings.com.
Applicable Criteria
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/site/re/869362
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