Dell And HP: Value Stocks Or Value Traps?

by Morgan Smith

The latest quarterly results released by personal computer companies have reaffirmed the secular slump caused by competing mobile devices. Tablets and smartphones are here to stay and are cutting into laptop and desktop market share. Investors should be very careful when picking cheap PC stocks to distinguish value from value traps.

Out-of-Favor Personal Computer Companies

Firms in the Microsoft (MSFT) Windows-Based PC industry are scrambling to redefine themselves as PC sales stagnate. Dell’s (DELL) guidance for the third quarter was weak, including a forecast of a 2% to 5% drop in revenues. This range is between $13.8 billion and $14.2 billion, a far cry from analysts’ targets of $14.85 billion. Second quarter revenues for Dell also fell short of analyst expectations. Dell is looking to implement a restructuring strategy which will slash supply chain and sales costs while refocusing on business computing needs. Dell’s interest in Quest Software (QSFT) demonstrates that the firm is looking to bolster its database and server businesses.

Hewlett-Packard (HPQ) has also reported rough quarterly results. The company suffered a mammoth $8.9 billion quarterly loss, sending its combined trailing twelve months of earnings into the red. This was largely due to a massive $13.9 billion write-down of Hewlett-Packard’s acquisition of Electronic Data Systems. Slowing PC sales have prompted management to offer guidance at the low end of analyst estimates for the remainder of the year. Like Dell, Hewlett-Packard is engaging in a restructuring program with a goal of emerging like IBM (IBM) as a computing and technology solutions firm.

As the 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.

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 the new Intel x86 processor. Because of the company’s focus on productivity, the company expects this tablet to compete with laptops rather than tablets used for primarily recreational pursuits such as the iPad.

Watch Out for Value Traps

Jim Chanos made news when he analyzed Hewlett-Packard (HPQ) as a short candidate. The legendary short-seller claimed that computer companies like Hewlett-Packard are in trouble in the wake of an Apple (AAPL) led movement from personal computers to mobile devices. 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.

Checking Valuations

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:

The Hewlett-Packard and Dell are trading at dramatically lower price-to-sales multiples than Microsoft, IBM, or Apple.  Dell is also cheap on the basis of its price-to-earnings ratio. 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 acquisitions 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:

These numbers for adjusted free cash flow after acquisitions highlight how IBM, Microsoft, and Apple are cash generating juggernauts. Between Hewlett-Packard and Dell, Dell has the best track record of cash outflows while the others are sporadic.

Conclusion

Dell emerges as a better turn-around bargain than Hewlett-Packard. Dell is attractive at current valuations and is currently profitable. It has a history of healthier cash outflows after acquisitions than Hewlett-Packard. 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.