While the Street is more bullish on Dell (DELL) than Hewlett-Packard (HPQ), my sentiment is just the reverse. While HP is leveraging its strengths to navigate a challenging macro environment, Dell is stagnating and spends too little on R&D - thus lacking the vitality. Based on my multiples analysis and DCF model, I would strongly recommend opening a long position in HP over Dell.
From a multiples perspective, HP is the cheaper of the two. It trades at a respective 8.3x and 6.1x past and forward earnings while Dell trades at a respective 8.6x and 8.2x past and forward earnings. In addition, it has less volatility and actually offers a dividend, namely, at 1.8%. Even still, analysts rate the stock a "hold" versus a weak "buy" for its competitor. With Apple (AAPL) trading at a respective 15.5x and 10.9x past and forward earnings while offering an instructive case study on how to spend R&D wisely, there is more room for HP's multiples to expand.
At the fourth quarter earnings call, HP's CEO, Meg Whitman, noted progress in turnaround the business from recent failures:
"We increased our R&D spend in FY '11 by nearly 10%. We launched some outstanding new products and drove innovation into the marketplace. In fact, just 3 weeks ago, we became the first large server vendor to announce new, extreme low-energy server technology code-named Moonshot. This is a revolutionary architecture that uses 89% less energy, 94% less space and 63% less cost. That is meaningful and exciting innovation. And in 2012, we plan to do more of the same and to increase our R&D investment once again.
We've also seen good traction with our recent acquisitions. 3PAR, 3Com, Fortify and ArcSight. All are experiencing strong, double-digit or better growth and are taking advantage of HP's global distribution.
Our software business has now posted several strong quarters in a row, demonstrating our success at integrating these new companies. Our IT Performance Suite and security platform are unique and winning in the industry. And I'm also excited about the future of Autonomy as part of HP".
Furthermore, the company is taking the right step in improving the balance sheet and limiting takeovers to no more than $1B. The lack of the latter prevents dilution and is nicely complemented by Whitman's reiterated interest in returning free cash flow to shareholders. And on the operational side, the company has solid supply chain strength that will allow them to fare better than competitors in handling the HDD shortage. Management expects that the flood impact will dissipate by the end of the first quarter of 2012. The one major risk that the company faces is that cloud software could disrupt demand for IT support and servers.
Consensus estimates for HP's EPS forecast that it will decline by 16.2% to $4.09 in 2012 and then grow by 9.8% and 8.7% in the following two years. Assuming a multiple of 10x and a conservative 2013 EPS of $4.34, the rough intrinsic value of the stock is $43.40, implying substantial upside. Even if the multiple were to plummet to 6x and 2013 EPS turns out to be 5.8% below consensus, the stock would fall by only 6.5%. Accordingly, reward far outweighs risk, in this instance.
As for Dell: Management states that it has secured its own supply, but that industry levels are uncertain for the first quarter. In addition, management is confident that it can drive margins in Services, Enterprise, and Software. While the added focus on margins is attractive, it is disheartening to see the relative lack in top-line considerations. In fact, management is spurning underperforming practices, which will actually have the effect of slowing growth. It appears that this strategy is ending some time in 2012 when ROI from previous acquisition will arise.
Consensus estimates for Dell's EPS forecast that it will grow by 32.7% to $2.11 in 2012, decline by 4.7% in 2013, and then hold flat in 2014. Assuming a multiple of 10x and a conservative 2012 EPS of $1.95, the stock has 17.7% upside. Modeling a CAGR of 8.1% for EPS over the next three years and then discounting backwards at a WACC of 9% yields an intrinsic value of $25.70, implying significant upside. With that said, too much uncertainty surrounds the firm for risk-averse investors.