Merger Mania: The Hidden Risks in Cheap Blue Chip Technology Stocks

by: NakedValue

Even after a historic stock market rally from the March 2009 lows, blue chip technology companies continue to trade at reasonable prices. In a previous article, we highlighted Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) and IBM (NYSE:IBM) as three high priced, but inexpensive stocks. These high flying companies have even captured the attention of the typically technology-weary, value-oriented investors such as David Einhorn at Greenlight Capital. While we agree that many blue chip technology companies trade at reasonable valuations, there are hidden risks. Mainly, most of these companies are not content with their value stock profiles and as such, are willing to make expensive acquisitions to chase growth.

Google recently bid $900 million for a portfolio of 6,000 Nortel Networks (NT) patents. Google thinks that this purchase could shield the company from patent infringement lawsuits as it continues to expand its reach in mobile internet devices. This could turn out to be a great strategy, but it speaks to the nature of future acquisitions. Despite trading with earnings and growth projections that might make it a value stock, it is very much a technology name. As such, many of its future acquisitions will yield uncertain payouts. The current valuation offers investors a margin of safety, but Google's $900 million bid illustrates the hidden risks associated with the high and uncertain price of future growth.

Texas Instruments (NYSE:TXI) recently agreed to acquire National Semiconductor (NYSE:NSM) for a nearly 80% premium to its last traded price. National Semiconductor was not an expensive stock, with a forward P/E of 11.44 and a trailing EV/EBITDA of 6.04, but this deal premium illustrates Texas Instruments' willingness to overpay. Considering that Texas Instruments has a forward P/E of 12.10 and a trailing EV/EBITDA of 7.00, investors will wonder if TI would have been better off buying back its own shares.

Apple has not actively pursued large acquisitions, but during the Q&A session of an October 2010 conference call, Steve Jobs made the following comment after being asked about Apple's intentions for its huge cash balance:

We strongly believe one or more strategic opportunities will come along we're in a unique position to take advantage of," Jobs said. "We don't let the cash burn a hole in the pocket or make stupid acquisitions. We'd like to continue to keep our powder dry because we think there are one or more strategic opportunities in the future.

On the one hand, how can Apple shareholders be anything but grateful for the amazing ride that Steve Jobs has taken them on during the iPod era. But on the other hand, it's reasonable to at least wonder how the company will spend its $50+ billion in excess cash. Apple has been discplined in the past, but investors should be especially cautious if there is a change of management.

Hewlett Packard (NYSE:HPQ) and Dell (NASDAQ:DELL) may beef up cloud computing
Both companies have already shown that they are willing to pay top dollar for an acquisition. During a protracted bidding war for storage systems maker 3Par, Dell Inc. and Hewlett Packard drove the target's stock price from $9.65 to $33.00. To quote Kaushik Roy of Wedbush Securities in San Francisco, "They [Hewlett Packard] way, way, way overpaid."

Dell trades at a forward P/E of 8.05 and Hewlett Packard trades at a forward P/E of 7.08. These are some of the cheapest valuations outside of the retail industry. But despite the valuations, these stocks are not as cheap as their trailing earnings suggest if they continue to acquire companies at any price.

Hewlett Packard and Dell could look to expand in the cloud computing space and if they do so, it will likely come at a heavy cost. With potential acquisitions like Rackspace Hosting (NYSE:RAX), Tibco (NASDAQ:TIBX), Red Hat (NYSE:RHT) and Informatica (NASDAQ:INFA) trading at trailing P/Es greater than 40, Dell and Hewlett Packard may be more expensive than they appear to the typical minority, passive investor.

These companies could very well turn out to be bargains, but investors should be cognizant of the fact that just because these blue chip technology stocks are trading in value territory, it doesn't mean that management will act like value investors when making acquisitions. As is often the case with technology acquisitions, valuations are high and payouts are uncertain. Potential investors should do more than just look at the trailing earnings and future growth projections, they must also be very comfortable with management's acquisition strategy.

This uncertain and often high price of growth is one of the main reasons Warren Buffett has consistently avoided technology names.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DELL, AAPL, GOOG, NSM over the next 72 hours.

Additional disclosure: does not receive compensation to write about any specific stock, sector or theme.