With all of the buzz surrounding Apple (AAPL) and Facebook (FB), you don't hear too much about Dell (DELL) any more. This is a shame, since I find that the company is significantly undervalued. While I believe that Apple has yet to reach its intrinsic value, this belief is founded on the assumption that the company continues to deliver strong high double-digit growth. Dell requires, in fact, no growth to justify dramatic appreciation.
In this article, I will run you through my DCF model on the company and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Hewlett-Packard (HPQ) and Apple. I find that HP and Dell are the true value plays.
First, let's begin with an assumption about revenues. Dell finished FY2011 with $62.1B in revenue, which represented a 0.9% gain off of the preceding year. This is deceleration off of 2010's 16.2% growth. I model 1% per annum growth over the next half decade or so. This is a projection that I feel is much too conservative in the light of the strong secular trends in technology. But, for the sake of proving my point, I will build that projection into my model.
Moving on to the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I estimate cost of goods sold as 78% of revenue versus 12.5% for SG&A, 1.2% for R&D, and 0.9% for capes. Taxes are estimated at 25% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model).
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 11% (extremely conservative) yields a fair value figure of $26.15. And this only required 1% annual growth to justify! Even at this bearish growth projection, the market seems to be factoring in a WACC of 17.3%, which is beyond absurd - an assumption that should only be applied to really emerging companies.
All of this falls within the context of the company transitioning operations. As management notes:
"The fiscal year 2012 was a strong year with great financial results for Dell. We also made important progress towards our key strategic initiatives. To highlight a few key examples, we continue to enhance our enterprise solutions capabilities by adding important intellectual property from acquired companies like SecureWorks, Compellent and Force10. We improved the cost position, execution and profitability of our client business, building on the success of the past 2 years. We strategically invested in data center capacity and solution center capabilities around the world. And finally, we significantly increased the number of solutions sales specialists and increased our enterprise R&D spending. These investments have helped to reshape our business and will do so over the long term".
From a multiples perspective, Dell is equally attractive. It trades at just 8.8x and 7.5x past and forward earnings versus 18.1x and 12.6x for Apple and 8.2x and 5.2x for HP. Assuming a multiple of 12.5x and a conservative 2013 EPS of $2.15, Dell's stock would hit $26.88 - more or less in-line with my DCF result.
Free cash flow yield is the true driver of value creation. Based on data from FINVIZ, Dell's is at 16.7%. This compares to 6.4% for Apple. Consensus estimates for Apple's EPS forecast that it will grow by 59.1% to $44.03, and then by 14.1% and 16.6% in the following two years. Assuming a multiple of 15x and a conservative 2013 EPS of $47, the stock would hit $705. The main risk for investing in Apple at this point is the "law of big numbers". The multiples are attractive insofar as consensus growth targets are met. Apple's impressive execution, however, is under attack from substantial competition.
Consensus estimates for HP's EPS forecast that it will decline by 17.2% to $4.04 and then turnaround to grow by 9.2% and 7.5% in the following two years. Assuming a multiple of 12.5x and a conservative 2013 EPS of $4.37, the stock would more than double.
As the hype wears thin for Facebook and Apple, I believe more investors will become interested in HP and Dell. Rothschild once said to "buy when there is blood on the street". This advice is echoed by contrarians when they say to "think like a contrarian". If the assumptions going into the models are already bearish (like mine are for Dell and HP), then the bar has already been set low. Apple may still be undervalued; but, again, all of this is based on a rather bullish expectation for growth. The low bar that has been set for HP and Dell, in my view, lays the foundation for higher risk-adjusted returns. As the economy hits full employment in 2013, these gains will be doubly pronounced.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.