With all of the love that Apple (AAPL) and Facebook (FB) are receiving, the market has left Hewlett-Packard (HPQ) and Dell (DELL) in the dust. When the dust settles, however, investors will find that HP and Dell actually have good fundamentals compared to what they are valued at. HP generated $8.1B of free cash flow in FY2011, which is an impressive 5.7x the current price. Dell generated $4.9B free cash flow in FY2011, which is an impressive 5.6x the current price. By contrast, Apple trades at 17.6x FY2011 free cash flow and yet, in my view, it is still an attractive value play. Yes, Apple is growing at an impressive growth rate, but four principles are important to emphasize:
First, Dell and HP do not have the "law of big numbers" working against growth. Second, they have been aggressively risk discounted and this is likely to normalize when the macroeconomy nears full employment. Third, and perhaps most importantly, technology has few barriers to entry and just as there is virtually no limitation to competition, there is also virtually no limitation to innovation.
Taking a look at the fundamentals, they are not nearly as worn out as the market makes out. In my DCF model for HP, I make several assumptions: (1) per annum growth of 0.5% over the next six years, (2) operating metrics stay at historical levels, (3) a perpetual growth rate of 1%, and (4) a discount rate of 10%. This leads me to a fair value figure of $42.17, which is at an 82.2% premium to the close trading price on May 12, 2012. The market seems to be factoring a WACC of 15% at these bearish projections. Moreover, in reality, no technology company of HP's stature should grow at a rate of just 1% into perpetuity. That would imply major tech companies grow around 100 basis points lower, annually, than what most economists believe would be the case for the average market. But, of course, this assumption violates my fourth and major principle highlighted in this article. Innovation to capital stems directly from technology and fuels the broader growth; therefore, it couldn't possibly grow slower than the average market, which sums in end markets.
Ditto for Dell. In my DCF model for Dell, I make several assumptions: (1) per annum growth of 1% over the next six years, (2) operating metrics stay at historical levels, (3) a perpetual growth rate of 2.5%, and (4) a discount rate of 10%. This leads me to a fair value figure of $29.17, which is at an 89% premium to the close trading price on May 12, 2012. The 1% explicit growth assumption, again, is low - as is the 2.5% assumption for perpetual growth rate. I even started my model at $3.6B of free cash flow in FY2011, even though this is $1.3B what occurred the preceding year.
In the end, one is left wondering why Dell and HP have been so thoroughly discarded. Much of the reason, in my view, is due to the craze surrounding Apple. Apple is an attractive growth and value play, but it is currently worth more than two Microsofts (MSFT). It is also currently worth more than seven times HP and Dell combined. Technology, again, has few barriers to entry and the benefits of this do not fully accrue to just one player. Even still, Apple has impressive fundamentals, delivered better-than-expected performance, and has a solid balance sheet to acquire benefits that do end up accruing elsewhere. A safe way to then play technology would be to open long positions in both the large titans and the smaller restructuring companies, like Dell and HP. In short, broad diversification is key.
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.
