The Case For Dell, HP
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Apple (NASDAQ: AAPL) is a great company. But the 10% miss in 2Q12 and the 2% miss in 3Q12 have caused many investors to reevaluate their bullishness on the fundamentals. Many seem to feel that they are part of some sick "investor exuberance" that is building up a bubble. But if you look at the ratios, the company isn't very expensive in a value-sense even though it is, well, the most expensive company in the world. Apple trades at only a respective 12.9x and 9.8x forward earnings--very reasonable for a high-growth technology company. In addition, the PEG ratio stands at 0.62x, which indicates that future growth has not been fully factored into the stock price. Free cash flow yield stands at a reasonable 7.7% and the balance sheet leads the sector with $31 in cash per share and no debt. EPS has grown by a rate of 62.2% in the past 5 years--can we not expect it to grow by a rate of at least one-third that amount over the next 5?
But there are companies that are in completely different positions than Apple's. Dell and HP are becoming recognized as "junk value traps" because of, fittingly, the kind of innovation Apple is driving. Are they overvalued or are they truly "junk"?
Dell (NASDAQ: DELL): Diversification, Free Cash Flow Warrant A "Buy"
On the surface, Dell looks like a great investment. It has a return on invested capital of 19.4%--well above the cost of capital necessary to drive value creation--and excellent multiples. It trades at 6.5x past earnings and provides a 3.4% dividend yield. Free cash flow amounted to $3.2 billion for the trailing twelve months ending 3Q12, or a 19.3% yield against the market cap. Analysts expect EPS to grow by 5.7% annually over the next 5 years, which should seemingly be enough for the company to move towards reasonable yields. Maxim Group recently rated the company a "buy" with a price target of $13, a 35%+ premium to the current market assessment.
But scratching into the fundamentals, the story starts to change. While the company has accelerated spending on R&D in the last three years, revenue has plateaued. Dating back 10 years ago, revenue growth was outpacing R&D growth up until 2009. While it will clearly be some time till we see the effects of 2012 expenditures, free cash flow has gone nowhere over the past 5 years. It's still a large amount of cash flow, but the trajectory is worrisome. And it is even more worrisome why the trajectory has been flat. The company still has 50% of its revenue dependent on PCs, which are being outcompeted by computer alternatives, like tablets and smartphones.
With that said, Dell is making a transition into products that improve the efficiency and accessibility of technology. Founder Michael Dell has emphasized again and again how his business's future lies in data center software, hardware, and service sales to enterprises. Towards this end, over $12 billion has been spent on 18 buyouts in the last 3 years. Moreover, I even think the demise of PCs is highly exaggerated. As great of a company Apple is, its introduction of the "tablet" is not as big of a game changer as the market it out to be. There will always be a demand for PCs, and with competitors leaving the market, Dell has the potential to expand margins. While the reverse has been true--lower quality computers have eaten away PC business--thus far, the introduction of touch-screen computers and compatibility with Windows 8 provide promise. The transformation should be completed in 2016 and, by that time, investors may have caught on to how much free cash flow Dell is generating relative to its market cap.
Hewlett-Packard (NYSE: HPQ): Board Shakeup Necessary
HP ultimately faces a very similar problem as Dell: PCs are in the decline. It has fallen 58% from its 52-week high. The stock now trades at 3.6x forward earnings, 0.77x book value, and 6.6x free cash flow. But I find that it is in a structurally worse position than Dell given the lack of diversification. Revenue has only grown 11.8% over the last 5 years, and it has started to fall since mid-2011 on a TTM-basis. R&D expenditures have gone down and are 6.4% below where they were 5 years ago. While we can at least say not a lot was spent for poor growth, we should also lament that the company has done so little to stay ahead of the curve.
And the acquisitions that it has made have been, shall we say, disappointing. HP is now accusing Autonomy, a British firm purchased for $9.7 billion in 2011, for misrepresenting its financial position. Management has thus been forced to write down $8.8 billion (an impairment worth 90% of the buyout price) in charges for the flopped acquisition. It was bought out at a 58% premium to the closing month average stock price and well above what Oracle was interested in. 10 of the 11 board of directors voted for this purchase. Unreasonable revenue synergies were forecasted into the buyout model.
For this reason, I believe that HP could be the potential target of a corporate raider or shareholder activist. It would not be very difficult getting shareholders to agree to a board shakeup, but the problem is that the underlying fundamentals are slipping. Simply put, the degree of uncertainty largely precludes a proxy contest. On the other hand, the $9 billion share repurchase program represents more than a third of HP right now, and it will generate substantial EPS accretion given the low P/B ratio and high free cash flow yield.
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!