Based on widely-touted substitution of mobile devices for traditional PCs, investors are presented with the following question: is Dell (DELL) trading at a value discount in the light of bad news, or is it a value trap which has suffered irreversible damage in the midst of a secular market change? At current price levels, is there an advantage to investing in the battered Dell, the resistant Hewlett-Packard (HPQ), or the triumphant device makers like Apple (AAPL) and Google (GOOG)?
More Devices and Less PCs
Mobile device sales are seen as direct competition for desktop and laptop computers. Jim Cramer recently said, "That's the reason why notebooks and netbooks seem to be going the way of the typewriter." Mr. Cramer seems to be exactly right in this assessment. Mobile devices are not purchased in addition to new computers, but as substitutes for new computers.
This trend was evident earlier this week when Dell's quarterly results did not meet expectations. As a result, Dell shares plummeted over 15%. The sentiment that Apple's gains in mobile devices are the cause of Dell's lost revenues is common among Wall Street analysts.
Hewlett-Packard is another traditional PC maker which announced radical restructuring which will lay off as much as ten percent of the firm's employees. These deep cuts will slash 27,000 jobs over the next two years. Though Hewlett-Packard is still the world's largest PC maker, its dramatic reinvention of itself demonstrates that the industry is changing. HP has essentially admitted that these are drastic times which require drastic measures.
Are Dell and HP dead? Of course not, these companies are not value traps, but each have growing concerns. They in no way resemble mortgage lenders on the eve of the financial crisis, or other value trap scenarios where demand and sales drop to zero instantaneously. Moreover, with the right product launches it is entirely possible that either company could come into favor and become more popular than Apple or Google in the future. It could happen. However, it is not likely to happen, and investors should demand a discount for investing in such companies.
Current Price Multiples and Growth Prospects Favor Apple
Though Apple is trading at greater price multiples than Dell or Hewlett-Packard, but is still reasonably priced and has impressive growth trends and growth forecasts:
Company | P/E | P/FCF | EPS past 5Y | EPS next 5Y | PEG |
Apple | 13.91 | 11.96 | 65.0% | 18.9% | 0.74 |
Dell | 6.64 | 4.54 | 10.6% | 7.6% | 0.88 |
18.47 | 16.65 | 24.5% | 18.5% | 1 | |
Hewlett-Packard | 7.45 | 7.79 | 8.9% | 4.8% | 1.57 |
Clearly, growth investors should jump on Apple since it offers outstanding growth prospects at reasonable valuations. Though that may appeal to growth investors to Apple, should it also attract value investors? Using growth projections, let's take a look at forward price-to-earnings multiples based on today's share prices and earnings projections over the next five years:
Forward P/E Ratios Based on Analyst Growth Forecasts | ||||||
Company | P/E Y0 | P/E Y1 | P/E Y2 | P/E Y3 | P/E Y4 | P/E Y5 |
Apple | 13.9 | 11.7 | 9.8 | 8.3 | 7.0 | 5.8 |
Dell | 6.6 | 6.2 | 5.7 | 5.3 | 5.0 | 4.6 |
18.5 | 15.6 | 13.2 | 11.1 | 9.4 | 7.9 | |
Hewlett-Packard | 7.5 | 7.1 | 6.8 | 6.5 | 6.2 | 5.9 |
The same analysis can be performed by forecasting earnings growth by extrapolating past earnings growth from the past five years to the next five years:
Forward P/E Ratios Based on Historical Growth | ||||||
Company | P/E Y0 | P/E Y1 | P/E Y2 | P/E Y3 | P/E Y4 | P/E Y5 |
Apple | 13.9 | 8.4 | 5.1 | 3.1 | 1.9 | 1.1 |
Dell | 6.6 | 6.0 | 5.4 | 4.9 | 4.4 | 4.0 |
18.5 | 14.8 | 11.9 | 9.6 | 7.7 | 6.2 | |
Hewlett-Packard | 7.5 | 6.8 | 6.3 | 5.8 | 5.3 | 4.9 |
These forward price-to-earnings multiples discover important information for value investors. First, Google is more expensive, even after factoring in growth, than Apple, Dell, or Hewlett-Packard. Investors should ignore Google since it is inferior to Apple on a growth-at-reasonable-price basis, and it clearly does not match the immediate value offered by HP or Dell.
Second, Apple's fantastic historical earnings growth trend and its excellent growth prospects make it at least comparably priced to Dell and Hewlett-Packard on a multi-year basis. Since Dell and Hewlett-Packard are facing headwinds in a changing industry, they would have to be trading at significant discounts in terms of future expectations to compensate investors for this risk. Since Apple is competitive (or better) on a forward earnings basis, investors ought to stick with Apple.
Wait for Cheaper Dell and Hewlett-Packard Valuations
Value investors seeking deep discounts should not settle for current Dell and HP prices. Their prices and price multiples should drop low enough so that they offer substantial compensation over a medium-term horizon relative to Apple's prospects. After all, analyst forecasts and the extrapolation of historical growth trends for Dell and HP assume that their next five years will resemble their past five years-and this is clearly not going to be the case! Wait for analyst earnings growth estimates to flatten out for these two firms before considering them as value plays.
It can be sensible to back a dark horse, but only if that dark horse has higher payouts.
To make an analogy, investors should wait for Dell or HP market sentiment to approach the dismal outlook for Research In Motion (RIMM) today. Research In motion currently trades at a 5.0 price-to-earnings ratio, and analysts forecast a -0.5% average annualized earnings decline over the next five years. Such sentiment for PC makers is entirely possible, and would mark an appropriate time for value investors to buy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
