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Hewlett Packard Enterprise's $1 Billion Cost-Cutting Plan Is Bold, but Raises Questions

Credit has to be given where it's due. Hewlett Packard Enterprise (NYSE: HPE) navigated a chaotic quarter about as well as any comparable company could. The coronavirus outbreak first rattled its supply chain, and then part of its customer base. By the time COVID-19 reached the United States, the world was simply winging it. Hewlett Packard Enterprise's 16% year-over-year sales decline for the quarter ending on April 30 could be considered a relative victory.

The company's plans to cut annual expenses by $1 billion, however, are not only aggressive but may also not be enough to matter. If the impact of the pandemic lingers, even if the virus itself doesn't, the company could lose more than that in annual sales, and far more than that in potential earnings.

Well-established spending habits

Hewlett-Packard Enterprise's three-year cost optimization and prioritization plan aims for "estimated gross savings of at least $1 billion and annualized net run-rate savings of at least $800 million."

Image source: Getty Images.

It sounds great. Except that's not a huge amount of cost-culling for a company of Hewlett-Packard Enterprise's size. It's also an aggressive goal given the company's existing cost breakdown and history.

For perspective, last fiscal year's (ending in October) top line of $29.1 billion was paired with $12.5 billion worth of spending just on the manufacture of physical products. The technology outfit spent another $6.8 billion supplying revenue-bearing services. Research and development cost another $1.8 billion, while selling and administrative costs consumed $4.9 billion. Those four items alone cost the organization more than $26 billion. Throw in other ancillary and one-time costs, and Hewlett-Packard Enterprise shelled out nearly $28 billion to drive that $29.1 billion in sales.

Image source: Hewlett-Packard Enterprise 2019 annual SEC filing. All dollar figures are in millions.

The overarching question: From which of those costs is the company going to find another $1 billion worth of yearly savings it hasn't found yet?

Remember, the corporate overhaul referred to as HPE Next put into place beginning in 2017 already removed plenty of unnecessary costs. CEO Antonio Neri commented during the quarterly conference call held nearly three months ago, "We have extended the program [HPE Next] through fiscal year 2021 and expect incremental savings, while maintaining the original net cash impact." Another billion dollars in savings is hardly incremental, assuming it's achievable at all.

That being said, it's still not entirely clear HPE actually made any meaningful cost cuts while executing its HPE Next plan.

Measured as a percentage of revenue, selling and administrative expenses haven't abated. The cost of goods sold fell a little last year, boosting EBITDA for a short while. But those costs were on the rise again a couple of quarters ago, and EBITDA was plateauing. Net income as a percentage of sales seemed to level off right around 8% in 2019 before COVID-19 was even on the radar.

Data source: Thomson Reuters/Refinitiv. Chart by author.

It leaves one wondering how, or even if, new cost-cutting will make an impact. Never even mind the prospect of cutting too much. Every dollar being spent now is being spent because at one point it seemed like a good idea. Things change, but things don't always change.

Not fixed costs, but variable with a footnote

Working to the company's advantage is the fact that those four aforementioned costs are scalable. This is particularly true for manufacturing and service costs. They may not be scalable dollar-for-dollar as revenue ebbs and flows, but the company can do something to curb them.

Still, consider last quarter's results. The top line itself fell by more than $1 billion, from $7.1 billion in the fiscal second quarter of last year to just a little over $6 billion this time around. The total cost of sales fell accordingly, but R&D as well as selling/administration costs didn't fall to nearly the same degree, on a sequential or a year-over-year basis. It all ultimately translated into what was just a bit better than an operating breakeven, versus an operating profit of $434 million for the same quarter a year earlier.

Image source: Hewlett-Packard Enterprise's Fiscal Q2-2020 Quarterly SEC filing. All dollar figures are in millions.

If last quarter represents the new normal as the world digests the fallout from COVID-19, $1 billion worth of gross cost cuts, or $800 million worth of annualized net cost cuts, isn't going to move the needle much.

It's probably not the new normal, of course. Neri explained during Thursday's call that the company's priorities are to "continue to streamline our product portfolio, implement a new digital customer engagement models, and optimize our workplace size strategy and experiences." CFO Tarek Robbiati added later in the call that measures would include "reductions in pay across our workforce, unpaid leave in places where pay reductions are not legally permitted, and hiring restrictions." The company's management team is even taking a pretty big pay cut. Anybody at the executive vice president level or above will see their base salaries reduced to the tune of 25% through 2020. That won't get Hewlett Packard Enterprise to its $1 billion goal, but it's a fair start. It should all help whittle selling and administrative lines of the income statement down a bit. In the meantime, R&D spending could be contained.

If the bulk of the intended cost cuts are to take shape on the cost-of-service or cost-of-product front, though, just bear in mind it will mostly reflect a similar decline in total revenue. We saw a glimmer of this reality last quarter. It was a dubious cost-cutting victory.

Bottom line

The qualified doubts about Hewlett Packard Enterprise's potential to trim more fat may ultimately prove unmerited. Neri made it clear that last quarter's revenue headwind was mainly rooted in supply chain constraints and not so much rooted in waning demand. The order backlog of $1.5 billion in place as of the end of the second quarter was about twice the company's average. The continued lifting of coronavirus-related lockdowns could ease the company back into its regular production and sales pace.

Though, if the fallout from the damage COVID-19 has already done gets worse before it gets better -- and HPE's intended $800 million reduction (net) in annual spending becomes an imperative -- it's a mighty tall order to find all of that money outside of direct revenue costs.

Investors may want to temper their expectations, especially considering Refinitiv says the quarter currently underway is going to be the one that really hurts. All told, the research firm believes the S&P 500's per-share profit for the second quarter of 2020 is on pace to fall 42% year over year. That could still prompt a bunch of corporate buyers to rethink the tech purchases they had planned for the remainder of the year.

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