Microsoft, Google, Dell: All Undervalued For Outperformance

by: Takeover Analyst

When it comes to the race for "cool", investors myopically tend to overlook mature companies with successful operating histories and opt for the next flavor. This is most revealed by Apple Inc. (NASDAQ:AAPL), which is now worth 2.3x Microsoft Corporation (NASDAQ:MSFT), 2.7x Google Inc. (NASDAQ:GOOG), and 27.5x Dell Inc. (NASDAQ:DELL). This is less of a testament to Apple's overvaluation than it is to Microsoft's, Google's, and Dell's undervaluation. I recommend investors back all four of these companies, but particularly the three stocks below to outperform broader indices. Below, I review the fundamentals of each company.

Dell Inc.

Dell is one of the most beaten stocks on the market, despite strong free cash flow generation. Last year, the company yielded nearly $5B in free cash flow - around 25% of the valuation. It now trades at a respective 6.7x and 5.8x past and forward earnings. The bar for EPS growth has been set low at 6.1% annually over the next 5 years. To put this into perspective, consider that the company grew EPS 10.6% annually over the past 5 years during the economic recession. Three of the last five quarters have beaten expectations by an average of 9.3%.

Management is taking the proper steps to re-excite the market. The introduction of a dividend yield should attract investors fearful of a "value trap". Meanwhile, the $2.4B acquisition of Quest has dramatically shifted Dell into a higher margin and faster growing business. In 2011, Quest's growth rate was twelve-fold Dell as a whole; margins were 6,300 bps higher than Dell as a whole. The main aim for the company going forward is to meet the demands of higher data growth through cloud capabilities.

One large concern that the company has working against momentum is Microsoft's announcement to build a tablet. This will put downward pressure on Dell's market share of the PC and tablet market. I believe, however, that the worst has been factored in as shares stand well below the 52-week high and near the 52-week low. I recommend buying over time in a dollar cost averaging strategy to reduce risk and investment uncertainty.

Microsoft Corporation

With Apple to compete against, Microsoft has lost much of its luster. Failure to succeed in the search business, failure to succeed in mobile, and failure to succeed in email have led shareholders to forget the company's near monopoly status on PCs. Moreover, the company trades at just a respective 14.7x and 8.8x past and forward earnings. For such a terrific brand to be trading at these low multiples is indicative of a fundamental behavioral anomaly. Recognizing this, analysts rate shares a 1.9 out of 5 where 1 is a "buy" on the Street.

If Microsoft is able to grow EPS by 9.8% annually over the next five years (and it has been a consistent grower), 2016 EPS will be $4.47. At a 15x multiple, the future stock price will be $67.05. Discounting backwards by 10% yields a present value of $41.63, which is at a more than 35% premium to the current market assessment. Combined with a high dividend yield of 2.7%, the risk/reward is extremely compelling.

I am very optimistic about the company's multiple attempts. The migration of Hotmail email users to will be met with increased awareness of the business as a whole. Who would think that Microsoft could become a leader in video gaming through Xbox years ago? If it can achieve that success then surely it is capable of making inroads in email. Ditto for tablets. The company's offerings is just as good, if not better, than Apple's iPad in the sense that it virtually performs the same operations, but more closely mirrors an actual computer. Investors who fail to appreciate the fickleness of consumers will be misled into believing that current hot sales in iPad are indicative of a near "winner-takes-all" model. There are few places where tech can establish sustainable competitive advantages, and Apple's attempts to litigate the market - through Samsung and elsewhere - evidence desperation more than anything else.

Google Inc.

Google is an example of successful technology company that has yielded recent successes where Microsoft has failed. The Android has been a complete success with more users than the iPhone. At the same time, the core search business continues to thrive and extend itself in social networking and YouTube. I strongly recommend investing in this thriving business.

Analysts are currently more bullish on Google than they are on Microsoft - rating the former a 1.8 out of 5. At a 12.8x forward earnings multiple with forecasts for 17.6% annual EPS growth over the next 5 years, Google is a compelling "buy". If the search giant is able to achieve this growth, the stock will be worth $1,205.55 by 2016. Discounting backwards by 10% yields a present value of $748.55, which provides nearly a 20% margin of safety.

Unlike Apple, the company had terrific second quarter results. Consolidated quarterly EPS came out to $10.12 with revenue increasing a staggering 35% y-o-y as core revenue gained 22.5% to nearly $11B. Advertising continues to do well with paid-click-growth gaining 42% y-o-y. By leveraging its mobile position (north of 400M Android devices have been thus far activated and 1M added each day), the company can continue to nuture its reign on search. This will be further aided by the fact that 250M users have upgraded to Google+, which I believe will catch on like wild fire when users realize its synergies on search results, email, and mobile. Some bears have argued that the cost-per-click is weakening, but Google still grew 1% sequentially in this area. Accordingly, Google is a "buy" in almost every respect.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.