In yet another negative blow to the PC market, Gartner reports that PC shipments fell 13.8% year-over-year during the third quarter. The big losers, yet again, were the PC giants Dell (DELL), HP (HPQ), and Toshiba. Of course, the shocking loser was Apple (AAPL), which saw shipments fall 6% (considerably lower than the 25%+ drops of competitors), though market share increased 110 basis points to 13.6%. With the entire industry slumping, who's to blame?
Not surprisingly, we're labeling Apple as the major disrupter in the PC market. Since the inception of the iPhone and subsequent iPad releases, computing has shifted more and more toward mobile consumption, with the wireless providers like Verizon (VZ) and AT&T (T) as the primary beneficiaries. Obviously Dell and HP, both in the midst of turnarounds, have struggled mightily. In fact, Dell trades at forward EV/EBITDA multiple of 3, while HP is valued at 4x EV/EBITDA. View companies with low EV/EBITDA multiples and high returns on capital here.
However, we're not interested in buying either of these names at this time. Both are attempting to become more levered to enterprise hardware and software spending, but the space is incredibly competitive, with heavyweights ranging from IBM (IBM) to Oracle (ORCL) to Salesforce.com (CRM). Let's also not discount the huge presence (and stickiness) of Microsoft (MSFT), which has dominant products such as Office, SQL, and Windows. For an in-depth read as to why we think Microsoft is worth nearly $50 per share on the basis of an extensive discounted cash flow process, please click here.
With the PC makers trading at such cheap multiples, the opportunities in the space look compelling, especially if the PC market bottoms soon and the plans to gain enterprise market share materialize. Yet, we think the PC is heading towards commoditization, so low-margin competitors like Lenovo will continue to gain share, providing downward pressure on the sector's ability to create real value for shareholders. Further, neither of these companies has a viable presence in mobile, or a willingness to compete with Google (GOOG) or Amazon (AMZN) tablets.
Therefore, we think the value in big tech remains in two companies: Apple and Microsoft (we're favorable on Google's value-momentum indicators, too). Oddly enough, the companies took drastically different journeys to their respective market positions, but we think the next generation of computing will be dominated by these two firms.
An investment thesis in Apple requires little more than taking a look at the tremendous growth in usage and popularity of all of its products. We've previously detailed why we think iPhone 5 is already a massive success, and the iPad remains in a class of its own with regards to the premium tablet market. Its traditional computers continue to gain market share, particularly in the US, and particularly with younger consumers. We're not too excited about the prospects of an iPad Mini due to the potential that it cannibalizes iPad sales and weighs negatively on the firm's margin mix, but we also don't ever underestimate Apple's ability to execute. Just a few years ago BlackBerries (RIMM) were the most popular phones, but Apple completely shattered Research In Motion's market position, so we wouldn't be surprised to see it crush the Kindle and the Nook. Apple's execution will remain top notch, and the firm will continue to take traditional computing market share-possibly encroaching on Microsoft's enterprise stranglehold. For an in-depth read as to why we think Apple is worth over $800 per share on the basis of an extensive discounted cash flow process, please click here.
Still, we don't think that means Microsoft is done for. On the contrary, the Apple model provides a clear path to success for the tech giant. In his letter to shareholders released recently, CEO Steve Ballmer outlined his thoughts on Microsoft and its near-term future. Many have labeled it as "trying to be like Apple," to which we say, "great." Though Microsoft deserves some share of criticism for not focusing on a mobile strategy, its partners certainly didn't help. While Apple was making sleek, aluminum-encased computers and phones, OEMs created mediocre, tired styles.
In our view, Windows 8 mobile, for instance, isn't a failure nearly as much as Nokia (NOK) is as a partner. The same goes for tablets, thus far. The Surface is a clear reaction to the failure of its OEM partners to produce suitable competition for Apple or Google. Thus, Microsoft is in the midst of becoming a hardware creator, which may not be a bad thing.
Taking a look at the company's previous hardware adventures, we can point to two very nice devices: the Zune HD and the Xbox 360. Zune HD was a very good MP3 player that simply didn't stand a chance against the iPod or the Apple ecosystem, but it was still a usable, attractive device. The Xbox 360, on the other hand, has become the most popular game console in the United States-so popular that the firm has held off on its next generation console. Microsoft has slowly turned the device from a one dimensional gaming system into a home entertainment hub. However, we'd like to see some hardware improvements-360 isn't known for its reliability.
Critics may point to a preference for iOS or Mountain Lion, but we think the software differences are overrated. Most consumers use computers to access the Internet, write documents, or create spreadsheets, all of which are pretty much the same experience on any operating system. We think the real advantage lies in Apple's huge store network and customer service. There's no worry about going through a third party or having everyone pass the buck when a Mac stops working, which is the exact opposite of a Windows computer or Android phone. Microsoft is already working on creating a store base that we think will house the Surface, the Xbox, and eventually its own computers. Though Apple branding continues to garner a premium, we think vertical integration will help Microsoft become a competitor on all fronts, while the current OEMs become even more commoditized and…dare we say…eventually disappear (if reinvention does not happen).
Ultimately, we're big fans of both companies, and each has acted rationally while focusing on maintaining high margins. Unless Amazon or Google is willing to follow a similar model, we suspect the two firms could come to dominate computing over the next several years. Consumers have shown a willingness to pay a premium for superior Apple devices and services, and we think Microsoft can achieve similar results. People already pay a pretty penny for superior Microsoft products (Office, SQL, Xbox Live), so we don't think it's a stretch that the firm can enter mobile computing and personal computing successfully.
Microsoft looks slightly cheaper on a discounted cash-flow basis, but we continue to hold both it and Apple in our actively managed newsletter portfolios.