HP, Dell Both Surprisingly Undervalued
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Sometimes a stock's underly asset value is overly discarded by the market. While Dell (NASDAQ: DELL) and Hewlett-Packard (NYSE: HPQ) may both be participating in dying businesses, they still have attractive assets that could be auctioned off into larger tech firms. While the sector is often too complex for a predictable path to prosperity, Dell and Hewlett-Packard are worth much more "as is" than what the market gives them credit for. Even Warren Buffett has expressed how he prefers to stay away from technology, because he doesn't understand the market.
A wise singer-songwriter once said: "Don't criticize what you can't understand." The truth is, Dell and Hewlett-Packard are free cash flow kings. Dell trades at 6.4x past earnings - well below its historical 5-year average of 12.8x - despite excellent momentum. Free cash flow has taken off from $3.7 billion for the TTM ending April 30, 2011 to $4.2 billion for the TTM ending April 30, 2012. Profit margin has also meaningful reason from a low of ~2.3% around December 2010 to 5.1% today. At a $18.8 billion market cap, the free cash flow easily makes Dell an attractive takeover candidate.
The story is admittedly worse for HP. Trading at only 4.3x forward earnings despite a historical 5-year average PE multiple of 12.5x, HP generated $5.2 billion in free cash flow for the TTM ending 2Q12. As disappointing as this performance was, it still came at a terrific 14.6% yield to the current market capitalization.
Stock valuations, however, are based on the future and not the past. With that said, HP and Dell would have to experience significant earnings erosion to justify the current valuation. Considering the positive trend at Dell and the strong brand name at HP, the firms won't fall much below their 5-year average annual free cash flow generations. They survived during the recession and will do so again during the recovery. This time, however, investors will be more willing to back them as fears dissipate over a double dip.
To be fair, HP is looking a bit desperate, and investors only gave Dell attention when it introduced a dividend yield. The former's CEO recently stressed the need to offer a smartphone. WebOS has given HP so much of a black eye that the tech producer is discontinuing the business. But the innovation is simply not there, and many are starting to associate the business with Research In Motion (NASDAQ: BBRY). RIM has been a too-little-too-late story that has been associated with a "value trap." The talk about it being a "value play" has been largely dismissed by media commentary arguing that the stock is a "value trap." At first glance, the company's valuable patents and fact that it trades at 0.4x book value may be enough to induce an investment. But the company is in a vicious death spiral as it is forced to spend ever-greater sums of money to help kick back sales in BlackBerry, to say nothing about new products.
HP, however, is significantly different from RIMM. HP appears to have hit a bottom after weak guidance was given during the Q2 earnings call. But from cutting 27K jobs to expanding into business process outsourcing, the company is positioning itself for higher margin operations that maximize the value out of economic activity.
Dell, however, has already delivered impressive performance. Analysts expect just 4.9% annual EPS growth over the next five years, despite the fact that 10.6% annual returns were generated over the past five years. Assuming expectations are merely met, 2016 EPS will be $2.08, which, at a 12.5x multiple, translates to a future stock value of $26.13. It would take nearly a 20% discount rate under this (1) low multiple and (2) low growth assumption for the stock to be fairly valued. At a 12% discount rate, the stock would be worth $14.83 in today's dollars. That's an attractive margin of safety on strong already weak growth prospects.
Although it may seem like there is nothing but misery ahead for HP and Dell shareholders, I encourage you to consider the effect that a full recovery may have on the mindset of new investors. These new investors will be more willing to put their money into risky operations with the hope for strong returns out of "surprise earnings." HP and Dell have already delivered stronger free cash flow than what is typically associated with their market caps. Accordingly, I recommend buying shares from a market correction.
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