Legendary short-seller Jim Chanos made news on Wednesday when he assessed Hewlett-Packard Co. (HPQ) as a short candidate. He claims that in the wake of an Apple Inc. (AAPL)-led movement from personal computers to mobile devices, companies like Hewlett-Packard are in trouble. Mr. Chanos is concerned that Hewlett-Packard will refuse to age gracefully and instead will acquire other companies in desperate attempts to acquire lost market share.
This prognosis is actually very useful for value investors, who can use the symptoms of this condition to diagnose value traps by recent financial performance.
Out-of-Favor Apple Casualties
There is a long list of companies, which Apple's mobile devices have displaced. First and foremost is Nokia Corporation (NOK). Adding insult to injury, after multiple versions of the iPhone, many would call many of Nokia's old products "dumbphones."
Next is Research in Motion Limited (RIMM). This company is letting go of a third of its employees and closing down several production sites. Management even consented to selling its nine-passenger midrange company plane as part of a plan to eliminate $1 billion from business costs. The company hopes to sell the jet for $6 million or $7 million. This sale is part of an effort to cut down the operating budget as BlackBerryes become less popular and lose sales.
Firms in Microsoft Corporation's (MSFT) Windows-based PC industry are also scrambling to redefine themselves as PC sales stagnate. Dell Inc.'s (DELL) interest in Quest Software, Inc. (QSFT) demonstrates that the firm is looking to bolster its database and server businesses.
Then of course, there is Jim Chanos's short pick, Hewlett-Packard. As the company's new CEO, Meg Whitman has her work cut out for her. She compared her challenge to Larry Schultz's revitalization of Starbucks which began in 2008 when he re-assumed control as CEO. Whitman warns that getting back on track is a long process which could extend as long as five years.
There is hope for investors. Weeks before Chanos's short call, Whitman asserted that she will not pursue enormous acquisitions. She stated, "I don't see the need for a big, transformative acquisition. In the near term we're focusing on what we have."
Instead, Hewlett-Packard has chosen to appeal to the tablet market based on productivity rather than media usage with their new Intel x86 processor. Because of their focus on productivity, the company expects this tablet to compete with laptops rather than tablets used for purely recreational pursuits such as the iPad.
First, investors should check to make sure that these beaten firms are cheap. After all, the common factor of bargains and "cheap for a reason" value traps is that they trade at low valuations. If they are pricey, it's clear that investors should stay away. Since many of these firms are essentially chum in the wake of the Apple shark, investors should demand very attractive, bargain basement valuations for these firms. Consider the following:
Research In Motion
The displaced device makers Nokia and Research In Motion are trading at dramatically lower price-to-sales multiples than personal computer companies Dell and Hewlett-Packard, which in turn are trading at dramatically lower price-to-sales multiples than Apple. Research In Motion and Nokia are cheap based on the price-to-book value, which ignores internally-developed intellectual property altogether. These firms would be cheap even if all assets were included in this calculation - the internal branding and R&D of these firms are icing on the cake.
Dell, Hewlett-Packard and Microsoft are also cheap on the basis of price-to-earnings valuations. Thus, all the firms on this list are at least cheap enough to qualify as bargains. However, the question remains: value investment or value trap?
Screening for Value Traps
Mr. Chanos warned that R&D spending, which is immediately expensed according to US GAAP (Generally Accepted Accounting Principles), is largely capitalized in an acquisition. This salient point would allow firms which engage in acquisitions to keep earnings free from R&D expense. Their peers, which internally develop their brands and technology, would be at a disadvantage vis-à-vis accounting rules, since their earnings would be lower after expensing research and development costs. (Apple, for example, does not have an explicit acquisition cash flow item, while all the other firms on this list do.)
This means that investors should pay careful attention to acquisition expenditures and free cash flow adjusted for acquisition payments. Net acquisition cash flows were subtracted from free cash flow below:
(Values in millions of dollars for all firms except Nokia whose values are in millions of euros)
Free Cash Flow
Research In Motion
Acquisition Cash Flow, Net
Research In Motion
Adjusted Free Cash Flow
Research In Motion
These numbers for adjusted free cash flow after acquisitions highlight how Microsoft and Apple are cash generating juggernauts. Of the remaining firms, Dell has the best track record of cash outflows while the others are sporadic.
Microsoft emerges as a value gem from this analysis. It is both a cash generating machine and a cheap purchase based on its price-to-earnings ratio. Dell is also attractive at current valuations and has a tolerable history of acquisition-adjusted free cash flows. Research In Motion, Nokia and Hewlett-Packard are all different beasts whose near-term choices to dispose of assets or acquire them will dramatically impact their prospects. To properly heed Mr. Chanos' warning, investors must have extra assurance that Hewlett-Packard will not binge on acquisitions in a desperate attempt to reshape the company at any cost.