After the bell on Tuesday, Hewlett-Packard (NYSE:HPQ) delivered a truly impressive quarter, especially after the weakness at Cisco (NASDAQ:CSCO) and IBM (report available here). While there obviously remain issues at its PC unit due to consumer shifts to tablets and smartphones, HPQ is managing this decline well and making headway into enterprises services, which should propel HP into the future. Non-GAAP EPS of $1.01 bested analyst estimates by a penny and was down an improving 13% year over year. Impressively, revenue of $29.1 billion exceeded expectations by a whopping $1.2 billion and was down a narrow 3% year over year, outpacing the 7% annual decline. HP's business is in the process of bottoming, and I expect the first half of 2014 to be the turning point as CEO Meg Whitman brings back growth at the tech bellwether.
If we turn to HP's operating segments, there is reason for optimism, especially as the company continues to make inroads into enterprise. Personal services were down 2% with commercial revenues up 4% and consumer revenues down 10%, though total units were up 3%, which suggests a lower average selling price. After Dell's LBO, that company faces an extreme debt burden and interest payments that eliminate much of its financial flexibility. I expect HP to use Dell's financial weakness as an opportunity to undercut the firm on price to gain share among enterprise customers. If HP can win enterprise customers for PCs, more profitable printing, server, and networking revenue will follow. The Dell LBO provides an opportunity for HP to regain PC share, which can carry it to incremental revenue growth elsewhere.
Printing revenue fell 1% hurt by supplies revenue falling 4%, though printing units sold were up, which should translate to better supply revenue going forward. HP remains staunchly within 2-D printing, though speculation has mounted it is planning a foray into 3-D printing, which has seen tremendous growth over the past three years. HPQ is not disclosing its plans for a potential expansion into 3-D. It would be extremely time consuming and difficult to build a 3-D platform itself, meaning an expansion into the space would most likely be through an acquisition where Hewlett-Packard has a pretty spotty record. I don't believe HP needs to move into this space and hope it doesn't overpay for a 3D Systems (NYSE:DDD) or similar company. Given how prudently Whitman has managed the balance sheet (more on that below), I doubt she will do an expensive acquisition just for the sake of doing it. Any deal would force another look at HPQ stock though.
With HP moving into forward looking IT services for enterprise, I was pleased to see Enterprise Group revenue up 2% with networking up 3%, server revenue up 10%, and storage revenue up 1%. Enterprise Group now accounts for 26% of HP's revenue. I would look for accelerating growth in this unit in 2014 as it becomes a bigger piece of HP's business.
With progress in enterprise and slowing declines in HP's legacy business, I am increasingly optimistic about Hewlett-Packard's future, especially as a highly-levered Dell gives HP an opportunity to take share. The company also did not see the steep declines in emerging markets that IBM and Cisco did, suggesting that Whitman is winning the company new business and picking up share in higher growth areas. Management is looking for non-GAAP EPS of $3.55-$3.75 in 2014 up from 2013's $3.56. With some unit growth reported in its fourth quarter, I expect HP to deliver towards the top end of the range and believe management is providing some slack in this guidance and am looking for $3.70-$3.80. This guidance gives the stock a forward multiple of 9.6x even after the 5% after-hours pop.
Investors also need to recognize that Whitman has really cleaned up Hewlett-Packard's balance sheet. She has improved the company's net cash position by $1 billion or more in each of the past seven quarters. After a $1.3 billion improvement in this quarter, the operating company (HP excluding financial services) actually has an overall net cash position. HP also delivered free cash flow of nearly $9 billion this year and is trading 5.7x free cash flow. With a cleaned-up balance sheet and tremendous free cash flow, we are moving into the next phase of the HP value story: returning capital to shareholders. Last quarter, HP returned $734 million to shareholders. I expect HP to double the pace of capital returns with a $4.5-$5 billion buyback and incrementally growing dividend that currently yields 2.3%. As its business bottoms, investors will profit from the excess cash its business provides. These buybacks will be especially accretive to investors, given the stock's extremely low 5.7x free cash flow multiple.
Hewlett-Packard delivered an impressive quarter as the company's business is bottoming. Whitman is delivering on her promise to turn around its operations, and we should start to see a return to growth towards the second-half of 2014 as legacy businesses become a smaller piece of the pie. With $3.75 in earnings power, the stock could trade into the mid-30s without facing valuation issues. Increasing returns to shareholders will help to fuel the rise. After this quarter, it is clear the rally in HPQ is far from over.