Large Cap Hardware Stocks - Do Return Ratios Justify Acquisitions?

Large-cap hardware companies follow an inorganic growth strategy to improve or maintain the returns they generate on a sustainable basis. However we rarely have data or any disclosures as to how effective these strategies are. After a year, the older acquisitions are forgotten and the media/analyst community tends to focus on the latest acquisitions or targets.

Thesis and Methodology

While thinking about this, I decided to see if I could do some analysis and infer some insights in this regard. I decided to concentrate on just four large-cap hardware stocks:

1. EMC Corporation(NYSE:EMC)
2. Dell Inc(NASDAQ:DELL)
3. NetApp, Inc.(NASDAQ:NTAP) and
4. Cisco Systems, Inc. (CSCO)

I chose to ignore HP (HPW) and IBM since they also had a significant services business and therefore were not pure-play hardware stocks. I then looked at the financial performance of these companies for the last six fiscals - FY03:FY08 (both inclusive). The idea was to look at these stocks over an entire boom-bust cycle rather than have a narrow 'few quarters' perspective. My thesis is as follows:

• Any deterioration on ROA (Return on Assets) coupled with an increase in monies spent on acquiring assets would provide some clues on the 'acquired asset' performance.
• I then check the net profit and profit margins over the last 5 years to see if the acquisitions have made an impact on the margins per se even without factoring the 'asset purchase' cost. For companies which have not spent their cash on acquisitions, have they been able to generate better returns through organic growth?
• Shareholders would be interested in the ROE (Return on Equity). Therefore I compared the ROE across periods for a company and across companies over time.
• However ROE and ROA are looked at together so that any ROE improvement through stock repurchase etc does not cloud the analysis.

Analysis

We first look at the return on assets performance over the last six years for the four stocks under comparison. The chart below indicates that Cisco has the best ROA among the four and continues to maintain that lead. EMC and NTAP have both seen a decline in the recent fiscals indicating that profit generation has slowed down significantly for them.

click to enlarge

We now try to co-relate this with the actual money spent on acquired assets. The chart below shows the cash spent on acquisitions by these companies. Looking at the money spent and returns earned, EMC's performance looks less than satisfactory. While it has cumulatively spent around ~$5B on acquisitions, these assets have not helped it improve the returns it generates on its assets. In fact EMC was generating better returns without these 'acquired' assets in 2003. This is worrisome because in the technology space, most of the intangible assets would probably have a useful life of 3-5 years. On the other hand, NTAP has hardly spent anything on acquisitions and continues to generate the lowest yields. Cisco on the other hand has been able to hold its yields at close to historical levels despite spending the highest on acquisitions - ~$11B on acquisitions in the period 2003-08.

Cisco's performance becomes all the more impressive when we consider the profits generated and the profit growth achieved in these periods. The charts below show why Cisco has been the standout performer. Cisco has grown from a larger base and generated more profits in 2008 than all the three - EMC,NTAP and DELL put together. The profit growth for Cisco has been more consistent than the rest. While Cisco could see the worst decline this fiscal (it has a July ending fiscal and Sep08-till date has been the worst period for hardware companies), it has performed better than others in the long term and that gives the confidence that Cisco can overcome short-term challenges.

We now look at the ROE performance (chart below) since this is an important metric from a shareholder perspective. Dell outperforms the rest due to its aggressive share repurchase program. Net of stock issuance for options, Dell has spent ~$20B in the last six years for stock repurchase and has reduced its share count by ~20% to ~1.9B shares outstanding at the end of 2008. If we add this back to equity, the 'effective' ROE (excl. share repurchase) would be ~20%. But that would be true for all these companies which is why we need to look at ROA and ROE together rather than in isolation.

Looking at the ROE and ROA trend lines, it looks like Cisco and Dell have performed better than EMC and NTAP. So EMC, which has been more aggressive than Dell, in terms of acquisitions has failed to generate better returns, putting a question mark on EMC's strategy. While Dell looks pretty impressive from a ROA/ROE perspective (relatively), absolute profits have been on a decline since 2005 indicating that Dell could see a deterioration in the future with stagnant/declining profits unless it identifies/acquires additional revenue streams. NTAP looks the worst of the lot and has performed poorly on all fronts.

Summary

The analysis gives some interesting insights into the long-term growth model for these large-cap hardware stocks. While Cisco seems to have followed an 'effective' acquisition strategy that helped it grow and generate returns on assets/equity close to historical levels, the others seem to be hitting a roadblock in terms of growing profits or generating better returns on their assets/equity.

(Charts' Source: Gridstone Research)

Disclosure: No positions