- Hewlett-Packard beat estimates with revenue higher year over year on a constant currency basis.
- PC sales are strong thanks to market share gains among business customers, providing a halo effect for other units.
- Strong printer sales will help supply sales going forward.
- HP has repaired its balance sheet with a net cash position and strong cash flow.
- At 10x 2014 non-GAAP earnings, HPQ is worth about $37.50.
Hewlett-Packard (HPQ) shares were flat after-hours as investors digested another solid quarter (press release available here). Over the past 12 months, shares have surged about 50% as investors increasingly buy into the turnaround led by CEO Meg Whitman. Given this rally, it isn't surprising that shares didn't soar further on the strong results. Nonetheless, shares continue to trade at an extremely attractive valuation, and HPQ is an excellent purchase for long-term investors, though shares may take a breather in the immediate term.
In the quarter, Hewlett-Packard earned $0.90 on revenue of $28.15 billion while analysts were looking for $0.84 on $27.14 billion in sales. HP resoundingly beat estimates on both the earnings and revenue front. Further, we are starting to see some signs of growth. EPS was up 10% year over year, and while revenue was down 1%, it was slightly higher on a constant currency basis. This is the first quarter in 10, HPQ has delivered constant currency year-over-year revenue growth. Whitman's turnaround is starting to take hold, and she has stopped the bleeding. For all of 2013, HPQ revenue should be roughly flat on a constant currency basis and is positioned to start growing revenue (albeit slowly) in 2015.
Hewlett-Packard has also been focusing on cutting costs, mainly through headcount reductions. An increased focus on services has also been accretive for margins. Cost of sales was down $300 million and SG&A was down $90 million. As a consequence, non-GAAP operating margins increased year over year to 8.5% from 7.9%. Further, operating cash flow increased 17% to $3 billion. Under Marc Hurd, HPQ cut R&D spending and innovation slowed, which is partly responsible for the problems HPQ has had the past 36 months. While Whitman is cutting expenses, she is not starving R&D, which was up 2.1% to $811 million. Continued investment in R&D will be critical for HPQ to gain a foothold in services and restart revenue growth on a consistent basis.
Thanks to improved operations, Whitman has greatly improved the company's balance sheet. HPQ's net cash position has improved by over $1 billion in each of the past eight quarters. In this quarter, the net cash position improved by $1.6 billion. Excluding HP financial services, HPQ has a net cash position of over $1 billion. Thanks to strong cash flow and an improved balance sheet, HPQ has been increasing capital returns. In the quarter, HPQ paid $278 million in dividends (with a current yield of 2%) and repurchased $565 million in stock. In 2014, HPQ should be able to generate $7-$7.5 billion in free cash flow, so I expect HPQ to continue to return more cash to shareholders. I expect HPQ to accelerate its return pace to $4.5-$5 billion this year. With strong cash flow, HPQ will continue to increase its dividend and repurchase shares.
Importantly, HPQ reported relatively strong numbers in most segments. Its personal systems unit, which sells PCs, saw revenue jump 4% year over year with a decent 3.3% operating margin. Notebooks were up 5% while desktops were down 3%. We continue to see weaker consumer than enterprise demand with consumer down 3% while commercial was up 8%. With Dell facing increased costs thanks to its large debt load upon going private, HPQ has been able to compete aggressively on price and gain share among business customers who tend to be more stable.
Hewlett-Packard hopes that increased PC sales to enterprise will benefit its other units, essentially acting like a "halo effect" as businesses find it easier to buy IT services and equipment from one company. We did see enterprise group revenue up 1% thanks to server growth of 6% and networking growth of 4%, though legacy businesses like critical systems continue to struggle at down 4%. Printing revenue was disappointing at down 2% as supply revenue dropped 3%. Importantly, hardware volume increased 5%. Obviously, hardware sales are a leading indicator of supply sales, so that trend should improve towards the back end of the year. Enterprise services and software continue to be weak at down 7% and 4%.
Overall, PC sales were strong thanks to improvements at enterprise while printing should get better with improved supply revenue in the pipeline. HP's efforts to provide new technology to enterprise is showing some promise with standard servers and networking showing growth though legacy businesses continue to be weak. Thanks to these numbers, HPQ increased the low end of its guidance and now expects to earn $3.60-$3.75 this year on a non-GAAP basis. Its Q2 forecast of $0.85-$0.89 was mildly disappointing (analysts were looking for $0.89). With share buybacks and improvements at PCs, I continue to target $3.75 +/- $0.05 this year. On a GAAP basis, HPQ is expecting $2.85-$3.00.
At $30, HPQ is trading at 8x non-GAAP 2014 earnings and about 8.1x free cash flow. While shares have rallied quite a bit, they continue to be exceedingly cheap especially with revenue starting to stabilize. Given its strong balance sheet, growing capital returns, and turnaround plan that is going as scheduled, HPQ should be trading at least 10x earnings and free cash flow. This would suggest fair value in the $37-$38 range. While there will still be bumps in the road, HPQ has made tremendous progress and continues to offer significant upside.