Hewlett-Packard, Dell, And Xerox: Wandering Through The Tech Dog Pound

Includes: DELL, HPQ, XRX
by: Philip Mause

I am sticking my neck out here and recommending that value investors with a long time horizon start moving into these three widely detested stocks. Let me explain why. One of my investment themes for the next year is that the tech sector has become so beaten down that it now contains some very, very attractive opportunities for value investors. Within that sector (which could now be called the "Dog House" of the market) there are certain unloved stocks which merit special attention. Because, if the tech sector is in the Dog House, Hewlett-Packard (NYSE:HPQ), Dell Computer (NASDAQ:DELL), and Xerox (NYSE:XRX) are in the Dog Pound - treated like unsightly mongrels which have never been house broken, have a history of biting their owners and endlessly drool on expensive carpets. Revulsion has always been one of my key markers for value opportunities and investor revulsion at these stocks is more extreme than the distaste a fastidious home owner would have for a slobbering mongrel who soiled his floors, clawed at his furniture and digested his footwear.

Investors (including investors who thought they were smart "bottom fishing") have lost a ton of money on these stocks and are probably even as we speak reviewing year end portfolios and deciding that a tax loss is the only benefit these stocks will ever generate. This wave of year end tax loss selling may begin to create a "bottom" in the market for these stocks and so they are worthy of our attention.

Whenever I assess a value investment, I look long and hard at the balance sheet. This tells you a lot about the private market value of the company as well as its ability to weather a downturn in its fundamental business. Each of these companies has a somewhat complex balance sheet and I have adopted a methodology which is somewhat inconsistent with the general approach of the analytical community. In calculating net balance sheet cash, I have given each of the companies credit for the fair value of "financing" assets which are essentially the loans made to customers secured by products the company sold or leased to the customers. I have examined the balance sheets to determine that the separate category of "accounts receivable" is roughly equal to accounts payable to be sure that the companies are not just trying to treat all receivables as long term assets. In doing this I believe I am more accurately reflecting the true net worth of the companies. In addition, in each case I have compared the last full year's depreciation with capital expenditures (capex) for the same time period and produced the D - C metric. This provides the investor with a rough guide to cash flow which may be more or less than reported earnings.

There is another characteristic common to each of these companies - they each have certain lines of business (generally sales of equipments) that are in decline and certain other lines of business (generally services) that are growing. This makes aggregate earnings and revenue numbers a bit misleading. As a general matter, if a company derives 50% of its revenue from business that is declining 10% a year and 50% of its revenue from a business which is growing 10% a year, there will be no growth in revenue the first year but in succeeding years the growing business will be a larger and larger percent of the total and the aggregate will grow faster and faster. For this reason, the future of each of these companies may be brighter than the most recent past.

The table below provides Friday's closing price, dividend yield, net balance sheet cash per share based on the above methodology applied to the most recent financial statement ( a negative number indicates that debt exceeds cash), consensus 2012 and 2013 earnings per share as reported by Yahoo Financial and D-C (as explained above) for the most recent full fiscal year.

  Price Div. Yield Net Cash Current Year EPS Next Year EPS D-C Per Share
DELL $9.97 3.2% $3.75 $1.71 $1.67 $.15
HPQ $13.68 3.9% $-1.10 $3.31 $3.48 $.70
XRX $6.69 2.5% $-3.20 $1.03 $1.12 $.60

These stocks are all cheap on a traditional price earnings ratio basis but what jumped out at me was how cheap DELL is on an enterprise value basis. Backing out net cash (calculated as explained above) DELL's enterprise value is $6.22 per share or less than four times earnings. All of these stocks seem to have depreciation in excess of capex although they all tend to use cash flow for acquisitions - some of which have worked out badly. Each of these companies has balance sheet debt but DELL definitely has the best net cash position based on my methodology (which I am sure will generate some controversy). In fact, DELL seems the most ripe for some kind of LBO or takeover because it throws off lots of cash and has an attractive balance sheet when analyzed appropriately.

Each of the companies has had management issues. HPQ has had four CEOs in the last 30 months - Mark Hurd, Cathie Lesjack (interim), Leo Apotheker, and Meg Whitman. This creates inherent issues in the minds of investors but Meg Whitman has been in charge since September 2011 and so investor angst over stability of management may be on the decline. Based on the most recently filed annual report, HPQ certainly has impressive assets - the printer and printing supplies business is a strong cash cow generating over $3.5 billion in earnings from operations in 2012, although net revenue declined by 6.5%. HPQ has a strong position in the PC business as well although the market seems to think that PC's are in the process of going the way of VCRs. In this connection, PC sales were certainly weak in 2012 with HPQ's net revenue from this segment declining by nearly 10%. HPQ is also moving aggressively into the services business most notably through the acquisition of EDs in 2008. Services net revenue did decline 2.2% in 2012 but the decline was only .5% when adjusted for currency and this segment seems to be relatively stable. Notably, financial services net revenue increased by more than 6% in 2012. This revenue is at least partially due to financing income generated by the products sold by other segments and so the overall decline in revenue attributable to product sales or leases may be overstated to the extent that it is legitimate to credit product sales with related financial services income. HPQ's balance sheet is not as bad as it seems at first blush because the financing assets are substantial. HPQ is as not big a bargain as DELL and its size make it a more problematic LBO or takeover candidate. Still it is trading at a very low multiple and yields nearly 4% and so it may be worth waiting for a turnaround.

XRX has been a favorite of value investors for a while; I can remember reading strong conviction articles arguing that even when priced in double digits it was a bargain. At this level, we are getting the company for nearly four times cash flow level. Again, this company may begin to be attractive as an LBO or takeover candidate because the balance sheet is stronger than generally understood and the huge excess of depreciation over capex creates potential for very strong cash flow. Like many other companies, XRX seems to migrating into the services business and revenues in this area have been on the increase. XRX also has an impressive patent portfolio which could enhance its value in a takeover or LBO context.

I would not "back up the truck" and load up on any of these three. On the other hand, at these price levels and with these dividend yields, it may make sense to sink some long term money into all three with the hope that one gets taken over or taken private and at least one of the others finds its sea legs and moves forward. The tech sector is horribly depressed here with growth companies like Apple (NASDAQ:AAPL) trading at below market multiples and cash rich companies like Microsoft (NASDAQ:MSFT) and Cisco (NASDAQ:CSCO) being virtually given away. With stronger growth news out of Asia, a rebound for the stocks in the Dog House may materialize; whether its effects reach the Dog Pound in 2013 is another question. But, in the long run, there is much more upside than downside to these three stocks and their current pricing clearly creates a buying opportunity for the value investor.

Disclosure: I am long HPQ, AAPL, MSFT, CSCO, DELL, XRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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