Dell and HP: A Question of Value

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

Things have not been going well for PC OEMs Dell (NASDAQ: DELL) and Hewlett Packard (NYSE: HPQ). PC shipments in the US dropped by 10.6% and global PC shipments declined by 0.1% in the second quarter of year 2012 (IDC). The rise of Apple (NASDAQ: AAPL) iOS devices and Google (NASDAQ: GOOG) Android devices have been cannibalizing PC sales. In the first quarter of year 2012, smartphone shipments grew by 44.7% year over year. In addition, tablet shipments are projected to grow annually by 28% until 2015 (NPD DisplaySearch).

The sharp decline in PC sales in the US is logical. The PC market in the US is saturated and for a long time PCs were the only way to access the internet. Since mobile devices are internet capable, people who use PCs for the sole purpose of accessing the internet have a strong incentive to buy mobile devices instead. After all, mobile devices are more portable and cheaper than traditional PCs.

Further complicating the matter for OEMs is Microsoft's (NASDAQ: MSFT) Surface tablet. Surface is an integrated tablet computer that will be released by Microsoft at the same time as Windows 8. Thus, OEMs who planned on releasing Windows 8 tablets to stem declines in PC sales will be facing not only Apple, Google, and Amazon, but Microsoft as well. It is a monumental task.

While the situation looks bleak for Dell and HP, the question is actually about value not survivability. Dell and HP will survive. In year 2011, PC sales only accounted for 23% and 31% of Dell’s and HP’s total revenues, respectively. Most of their revenue comes from other business segments such as servers, services, peripherals, and software.

Furthermore, PCs are still essential. While mobile devices are sufficient for many consumers who only perform basic tasks such as browsing the web, mobile devices are not sufficient for processor intensive tasks such as 3D modeling. Thus, Dell’s and HP’s PC revenues will not completely disappear. Therefore, the question boils down to “how much is Dell and HP worth?”

Using year 2011 as a baseline and assuming PC sales will decline by 25% (this is an extreme case), the net income for both companies can be estimated. As the following table shows, profit for Dell and HP would decline to about $3.29 billion and $6.49 billion, respectively.

<table> <tbody> <tr> <td>2011</td> <td>Revenue ($ millions)</td> <td>Net Income ($ millions)</td> <td>Revenue (25% PC Decline) ($ millions)</td> <td>Net Income (25% PC Decline) ($ millions)</td> </tr> <tr> <td>Dell</td> <td>62.071</td> <td>3.492</td> <td>58.54</td> <td>3.29</td> </tr> <tr> <td>HP</td> <td>127.245</td> <td>7.074</td> <td>117.35</td> <td>6.49</td> </tr> </tbody> </table>

Using discounted cash flow analysis, assuming perpetuity, and adding tangible book value, Dell and HP have intrinsic values of about $34.5 billion and $52 billion (market caps), respectively. Comparing to their current market caps of $21.32 billion and $37.09 billion for Dell and HP, respectively, the companies are undervalued by 38% and 29%, respectively.

Comparing these two companies, Dell seems to be the better investment because HP does not have a good balance sheet. HP has a negative tangible book value of about $13 billion, $30 billion in total debt, and only $8.311 billion in cash. In comparison, Dell has a tangible book value of about $1.55 billion, total debt of $9 billion, and $12.814 billion in cash. In summary, PC OEMs are bruised not dying. Investors looking to buy a PC manufacturer should consider Dell or HP with Dell being the slightly better investment.


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