Does This Dow Leader Need A Growth Driver?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It’s hard to believe that Hewlett-Packard (NYSE: HPQ) has been the Dow Jones’ best performer in 2013. The stock has rallied 90% while revenue and quarterly earnings have fallen 10% and 32%, respectively, year-over-year. The reason for its gain relates to the value call, but is Hewlett-Packard really the best option in its space?

The Value Call

After a two-year 65% loss from 2011-2013, investors began shouting that HP was a value investment sometime late in 2012. CEO Meg Whitman came in with ambitious goals, wanting to cut the company’s workforce, focus on its most promising segments, and increase profitability. Therefore, investors turned their focus towards the company’s cash-flow, which has been a major driver in the value call.

Essentially, a company’s bottom line can be misleading, via accounting, but cash flow rarely lies. HP has operating cash flow of $13 billion over the last year, which is the cash it earns through operating activities. Therefore, even after a 90% gain in 2013, HP trades at just four times its operating cash flow – far better than Dell’s 7 times its operating cash flow valuation.

Yet, despite this one metric of promise, the company still has falling fundamentals in virtually every single category. Hence, not one of its five segments saw year-over-year revenue growth in the company’s most recent quarter. For this reason, if I was seeking a value investment in the computing space, I’d go with Western Digital (NASDAQ: WDC).

Sort Of A Competitor

Look, I know that Western Digital and HP are two completely different companies. HP is a diversified technology company with a presence in printers, enterprise software, and computing. Western Digital is a storage company, with its products found in DVRs, computers, game consoles, and in the cloud among others.

However, both companies are in fact tech stocks, and both are currently tied to the overall performance of desktop and laptops. In fact, whichever company thrives will be the one that best expands beyond its reliance on the traditional desktop and laptop market. Therefore, I consider them to be two companies in the same conversation.

Seeking Growth Drivers

To me, the big catalyst that separates Western Digital from HP is a growth driver.

Both companies operate in the struggling PC industry, a market that is declining 20% year-over-year, and with no end in sight. Therefore, options must be identified to produce growth and satisfy investors, and more than just firing employees and having a large cash flow in the case of Meg Whitman and HP.

HP’s master plan is to rely on the “strength” of its server segment to replace the losses from PC sales. This segment created $20.5 billion in 2012, which was more than 20% of its total revenue.

If in fact this was a growing segment it could be a catalyst for the company. However, even this segment is seeing year-over-year declines. The worldwide server market itself has seen total revenue declines in five of the last six quarters. Hence, if this is the best that HP has to boast, then investors have a real problem.

On the other hand we have Western Digital, a company that used to produce nearly all of its annual revenue from the sale of HDDs within PCs and laptops. However, as of its most recent quarter, the company’s non PC related revenue grew to 51% of total sales, which shows that Western Digital is weathering the PC storm quite well, and is finding other segments of promise.

In Western Digital’s last quarter, total revenue fell 21% year-over-year. Automatically, you might notice that this performance is worse than HP. However, it is the company’s investments and their market opportunities that make its recent weakness less relevant.

Ideally, Western Digital is hinging much of its future on the growth of big data and the cloud. Western Digital estimates that these two industries will lead the overall data space to an annualized growth rate of 34% through 2020. Currently, data is a small piece of Western’s total revenue, but as data grows Western stands ready to benefit as a growing leader in the storage space.

Moreover, solid state drives, also known as SSDs, are used to store data in smartphones, game graphics, and in newer technologies where speed is crucial. Western Digital had nearly no presence in this space two years ago, but has since made four SSD related acquisitions. Combined with the growth of digital storage and the entrance into the SSD market, Western is moving forward, while HP is standing still.

Looking Ahead

Regardless of industry, all companies must innovate in order to stay relevant for long periods of time. With HP we are not seeing this innovation, and much of its value argument appears to be driven by price rather than future fundamental performance.

Western Digital is placing its future in a rapidly growing space, and at 5 times operating cash flow, the stock’s pretty cheap. Theoretically, these companies began in the same space, as Western Digital piggybacked off HP’s computing success.

Western Digital is not abandoning the PC space; in fact its market share of the HDD business sits at 45% and continues to grow; but management is smart enough to realize that they must adjust to the market. For this fact, Western Digital is still cheap at 8 times next year’s earnings, but HP may be a value trap at 7.3 times next year’s earnings. 

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Brian Nichols is long Western Digital. The Motley Fool owns shares of Western Digital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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