3 Computer Hardware Ideas: Hard To Beat Apple's Appeal

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Includes: AAPL, HPQ, IBM
by: Valuentum
Summary

The computer hardware space is characterized by frequent product introductions and rapid technological advances that can cause dramatic market share shifts.

Computer hardware companies are exposed to the potential slowing of the Chinese economy and the ongoing US-China trade dispute.

Let's dig into three leaders in the computer hardware industry, each of which holds a unique focus and varying levels of appeal. Apple, HP, and IBM are included.

Image Source: Vittorio Giovara

By Valuentum Analysts

Introduction

The computer hardware space, which spans the personal computer to the iPhone and iPad, is highly competitive. The industry is characterized by frequent product introductions and rapid technological advances that can cause dramatic market share shifts. Though some firms benefit from a strong brand, participants often price aggressively, pressuring margins. Firms are also subject to potential component shortages/disruptions, which can punish performance. Obsolescence may be an eventuality for some, and services revenue has become critical for others.

Apple (AAPL) may be the best example of a computer hardware company with robust potential in services revenue. The company's Services revenue, which remained on track of its goal to be doubled over the period from fiscal 2016-2020 and accounted for ~13% of total revenue in its fiscal 2019 first quarter, and growth in this area was helped along by the company's active installed base of devices hitting an all-time high of 1.4 billion in the quarter. We continue to highlight Apple's incredible ecosystem and ability to make its products and applications an integrated part of the everyday lives of consumers. This may, ultimately, be the greatest strength it has, and it becomes even more bonding with consumers when taken with the status symbol that is its brand.

Computer hardware companies are exposed to the potential slowing of the Chinese economy and the ongoing US-China trade dispute. For example, previously enacted tariffs impacted HP's (HPQ) operating profit in its fiscal fourth quarter, results released November 29, as its non-GAAP operating margin contracted by 20 basis points as a result of growth investments in 'Printing' and tariffs and higher commodities and logistics costs in 'Personal Systems' not being able to offset higher volume and average selling prices in 'Personal Systems.' The company believes its plan to mitigate the impact of tariffs is on course and the impact should ease moving forward, barring another change to trade policy such as additional or increased tariffs.

The impact of trade issues should not be taken lightly, but we believe the space holds some intriguing ideas, both in terms of dividend growth potential and capital appreciation. Perhaps more so in the technology space due to the aforementioned rapid technological advances, we favor companies with robust balance sheet health when searching for income ideas, and solid free cash flow generation is a must when attempting to identify long-term dividend growth potential. With that in mind, let's dig into three leaders in the computer hardware space.

Apple - Dividend Yield: ~1.7%

Image Source: William Hook

Apple is as much a brand as it is one of the world's most innovative companies. The firm is no longer known for its iPods and personal computers, as the proliferation of the iPhone over the past decade has been a sight to behold. The company's execution remains top-notch, and we expect it to continue to roll out innovative products in smartphones and wearable technology. Apple's rollout of future iterations of the iPhone should propel its fundamentals higher. Though we're not embedding another blockbuster hit in our model, we wouldn't be surprised if Apple delivers another one from its pipeline.

Apple's growing Services segment bodes well for its long-term gross margin performance, and the segment is on track to hit its goal of doubling its revenue from 2016-2020. Apple Pay is now accepted by ~60% of US retailers, and paid subscriptions totaled 330 million at the end of fiscal 2018. Wearables has been an area of strength, and Apple holds ~45% of global smartwatch market share, according to estimates.

Investors should pay close attention to the firm's gross margin, which fell to just over 38% in fiscal 2018 from 40% in fiscal 2015 and is expected to remain below 40% in the near term. Pricing and cost pressures may be unavoidable and currency exchange rates should not be ignored as Apple generates more than 60% of its revenue outside the US. Revenue in the Greater China region has faced material pressure of late and fell nearly 27% on a year-over-year basis in the first quarter of fiscal 2019. Weakness will likely persist in the near term.

Apple's cash hoard is more than some of the market caps of the largest firms in the S&P 500. It retains tremendous flexibility, but it plans to take its balance sheet to cash-neutral over time. Its dividend growth potential may be unmatched for now and buybacks have become a focal point in its cash-neutral strategy.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think there could be material upside based on our fair value estimate range (see image that follows):

Key Strengths

Along with being one of the most innovative companies, Apple boasts unparalleled brand strength, giving it a material competitive advantage. We love what it has built through its ecosystem of apps and the presence it has in the everyday lives of consumers. A core tenet of Apple's investment thesis, and its dividend strength, is its massive net cash position, which stood at ~$126.6 billion at the end of fiscal 2018 (inclusive of short term debt). The company's tremendous free cash flow generation allows such a position to proliferate while continuing to pay a growing dividend. It averaged more than ~$56.5 billion in free cash flow from fiscal 2016-2018, well in excess of annual run-rate cash dividend obligations of ~$13.7 billion.

Potential Weaknesses

With such an impressive Dividend Cushion ratio, we have a difficult time finding large drawbacks in Apple's dividend growth profile. Cash flow from operations faced some pressure in fiscal 2016 and 2017, but any transient weakness in its operational performance should not impact dividend health in the near term thanks to its cash hoard. Competing capital allocation options have the potential to impact the pace of dividend expansion moving forward, specifically through strategic acquisitions of differentiated technology and share repurchases. Buybacks came in at an astounding $72.7 billion in fiscal 2018. We're not particularly fond of Apple's decision to go to a cash-neutral balance sheet, but it is far from a concern at this point in time.

Image shown: Apple is currently trading at $171 per share, which is below the lower bound of our fair value range. We think shares are undervalued.

Hewlett-Packard (HPQ) - Dividend Yield: ~2.7%

Image Source: TAKA@P.P.R.S

Hewlett-Packard's recent split has resulted in two independent companies, HP and HP Enterprise. HP provides products, technologies, software, solutions, and services to individual consumers and small- and medium-sized businesses, as well as to the government, health, and education sectors. HP Enterprise provides technology solutions to business and public sector enterprises.

HP remains tied to the PC market as nearly 40% of net revenue comes from notebooks and another 20% from desktops. The global PC market remains under pressure, but some observers see it stabilizing on the back of improved all-in-one PC demand. The potential slowing of economic growth in China and the growing popularity and power of smartphones are underlying factors that continue to work against the market. The firm's market share sits at 22.5% as of the end of fiscal 2018.

However, its 'Printing' segment makes up 70%+ of non-GAAP operating profit despite accounting for only ~35% of net revenue as it carries a ~16% operating margin. HP is working to take part in the disruptive 3D printing industry with its HP Metal Jet, which is designed for mass production. It expects to build up to broad availability of the Metal Jet in 2021, and its Multi Jet Fusion is the most used industrial 3D printer in the world.

Though the company derives roughly 35% of net revenue from the US, it has a nicely balanced portfolio geographically speaking. The Americas account for ~45% of net revenue, followed by the EMEA region at 34%, and the Asia-Pacific and Japan region at 21% as of the third quarter of fiscal 2018.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think there could be upside based on our fair value estimate range (see image that follows):

Key Strengths

Though demand for Hewlett-Packard's products have faced pressure as of late due to a secular decline in the global and US PC markets, the firm continues to generate solid amounts of free cash flow, thanks to its non-capital intensive operations. It continues to evaluate the cost structure of its 'Print' segment, which should benefit its bottom-line and ultimately its dividend prospects. The company is looking to use its size and scale to help it gain traction in the disruptive 3D printing market, which could be a long-term growth driver. We think investors can reasonably expect ongoing dividend increases for the time being, but the secular headwinds in its end markets should give reason for pause despite its impressive Dividend Cushion ratio.

Potential Weaknesses

The biggest drawback to Hewlett-Packard's dividend growth profile, and its investment prospects in general, is the secular decline in the global and US PC markets. All-in-one PC demand may rebound in the near term, but the long-term outlook for the global PC markets remains a source of concern. The impact of competing uses of capital on the pace of dividend growth cannot be ignored as share repurchases have been prevalent of late. Though its balance sheet health has improved from the pre-split HP, the firm's debt load does not help its dividend growth prospects, as it held a net debt position of ~$821 million at the end of fiscal 2018 (inclusive of short term debt). We don't expect major issues to arise in the near term due to the debt load, however.

Image shown: Hewlett-Packard is currently trading at $23 per share, which is in the lower half of our fair value range. We think the company's valuation upside potential could reach $29+ based on our estimate of its intrinsic value.

IBM (IBM) - Dividend Yield: ~4.6%

Image Source: Leonid Mamchenkov

IBM solves business problems via integrated hardware/software solutions that leverage IT and its knowledge of business processes. Its solutions help reduce a client's costs or enable new capabilities that generate revenue. Developing and delivering in emerging technologies such as blockchain will be necessary for IBM to remain competitive in helping enterprises tackle increasingly complex business problems. For 2019, the firm expects non-GAAP diluted EPS to be at least $13.90 and free cash flow to be ~$12 billion.

We like IBM's high-margin ~$116 billion services backlog, but fundamentals have been waning of late. Backlog trends haven't been great of late (fell ~3% in 2018 in constant currency), and revenue and operating income haven't fared much better. Management claims a portion of this is resulting from the productivity-based IT cost savings it is providing its customers being reinvested in areas other than IT.

Big Blue is an example of a company with poor earnings quality. Revenue declines, lower tax rates, and aggressive share buybacks to grow EPS represent a classic red flag that not all is well at the tech giant. Its long-term financial model includes revenue growth in the low-single digits, EPS growth in the high-single digits, and free cash flow conversion of ~90%.

IBM has agreed to acquire Red Hat (NYSE:RHT), leading provider of open source cloud software, for an enterprise value of $34 billion in cash, and the deal, which is expected to close in the second half of 2019, is expected to make IBM the leading hybrid cloud provider. Moody's placed IBM's credit rating on review for downgrade.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think there could be upside based on our fair value estimate range (see image that follows):

Key Strengths

IBM's massive high-margin services backlog provides its business with a reasonable amount of support and should continue to help fuel solid free cash flow generation. Its pre-tax income margin has improved considerably over the past decade, but it has retreated from its peak in 2012 as the firm continues to shrink. Its dividend yield is compelling, and management has shown a willingness to raise the dividend, with double-digit increases in each year for more than the past decade. Free cash flow generation averaged ~$12.6 billion from 2016-2018, well in excess of annual run rate cash dividend obligations of ~$5.7 billion. We're expecting ongoing growth in the quarterly payout based on IBM's solid free cash flow generation.

Potential Weaknesses

The ongoing decline in IBM's business will continue to weigh on its dividend growth prospects. Though its Dividend Cushion ratio remains solid, it has fallen materially in recent years. The firm has become the poster child for poor earnings quality, and considerable share buybacks have taken place in recent years; before averaging ~$4.1 billion in 2016-2018, respectively, repurchases ate up $13.6+ billion in capital in both 2014 and 2013. We think there are better uses for cash available, but such buybacks are likely to continue. The company's debt load is a concern as well, as it had a net debt position of ~$33.6 billion as of the end of 2018 (inclusive of short term debt), a risk that is will be enhanced by its Red Hat purchase.

Image shown: IBM is currently trading at ~$137 per share, which is in the lower half of our fair value range. We think shares have the potential to reach $146+ based on our estimate of its intrinsic value.

Conclusion

Apple is far and away our favorite idea within the computer hardware space. Despite the less-than-rosy near-term outlook, we continue to like its shares, which are trading below the lower bound of our fair value estimate as of this writing. The company has unparalleled balance sheet strength, though it may eventually wane as a result of its own strategy and tremendous free cash flow generation, its dividend is among the healthiest we've seen. We're not panicking over short-term weakness in the Chinese market, and the firm's seemingly ever-growing ecosystem of devices and applications appears poised to find itself more and more integrated into the lives of consumers.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Apple is an idea in Valuentum's simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios.