It's a Downside Story For These Tech Stocks

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

As tech markets undergo significant change, investors are starting to revise their preferences. Apple, hitherto the market's darling, has fallen significantly from its high as sales failed to live up to expectations. Dell and HP, on the other hand, have fallen due to fundamentals that are, ironically, weakening because of Apple. Which stock should you end up buying?

A Downside Story For Dell (NASDAQ: DELL)

With the company down nearly 50% from its 52-week high and containing tremendous free cash flow generation, Dell is either a value trap or in for significant returns. While free cash flow has sky-dived from $4.9 billion in 1Q12 to $2.6 billion in 2Q12--the latter figure is still at at a 15.7% yield against the market cap. This, complemented by the low debt holding, supports the 3.4% dividend yield. Even UB, which rates the company "neutral," has a price target on the firm that is more than 30% above the prevailing price. RBC Capital Market's price target is at more than a 50% premium!

But in the most recent quarter, Dell missed expectations by $0.01 with EPS of $0.39 (although guidance did not change). The company has become very vulnerable to pricing pressure in PCs, and even emerging markets are faring worse than expected. The downside story is reflected in the numbers: notebook sales fell 26% year over year, large enterprises fell 8%, software sales fell 11%, storage sales fell 16%, and gross margins fell 70 bps sequentially. Fundamentals are weakening, and the shift towards enterprises solutions, which gained 3%, has been painstakingly slow.

So where does this leave investors? While I find the stock quite cheap for the amount of free cash flow it is generating, I would hesitate to buy. Businesses that tend to be showcasing a widespread decline that misses out on secular changes (in Dell's case: tablets and non-PC solutions) are unlikely to turn around in the absence of an obvious catalyst.  While the company has been introducing a variety of innovative solutions in its software segment, such as offerings in applications, security, and systems management, competition is eroding opportunities. 

Hewlett-Packard's (NYSE: HPQ) Fundamentals Weakening, Falls To Apple (NASDAQ: AAPL) 

HP is in a similar position to Dell. Its free cash flow has plummeted from $10 billion in 2Q 2011 to $5.2 billion today--but that's still a 20.2% yield against the market cap! Its stock is down 55.6% from the 52-week low, but now trades under book value. Cash currently represents 37% of the market cap, so the downside has a floor contrary to what the bears say. It's incredible that price targets were around $30 range earlier this year, and now the latest analyst report gives a price target of $15--still a meaningful premium when you factor in a 4% dividend yield.

A recent report by Barclays, however, illustrates why the company is on the decline: it expects the PC sales to decline between 50 million and 100 million units by 2015 as a result of mobile competition. By contrast, tablet sales are expected to rise to 182 million units next year and 300 million by 2016. That's a tremendous secular change that HP is not only missing out in but being destroyed by. Does this mean you should start buying Apple, the company that brought you the tablet, instead?

Apple's free cash flow momentum has soared the stock to stratospheric levels. In just December 2007, the company generated $5.6 billion in FCF. By 2Q 2012 (ttm), that figure rose to $45.7 billion--a still strong 9.2% yield against the market cap. Yet, a series of misses in 2Q 2012 and 1Q 2012 (10% and 2% below EPS expectations, respectively) have sent shares plummeting 25.1% from the 52-week high. With no debt, a treasure trove of cash, and an excellent brand name, competition is not as great of a concern for Apple for it can either (1) out-innovate or (2) buyout rising stars. The question then is whether or not the company could execute well enough to drive meaningful value.

At a respective 11.9x and 9x past and forward earnings, I believe the value is compelling enough. Analysts currently rate the stock a "buy," and I do too. While I don't think it's a "buy-and-hold" given the "law of big numbers," I believe the stock will bounce back from the decline from the next catalyst launch, such as Apple TV. The downside is relatively low given how depressed multiples are, so the risk in waiting for this next big launch is outweighed by reward.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple and Dell. 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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