Don't Shy Away From Dell

 | Oct 09, 2012 | 9:00 AM EDT  | Comments
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At last week's investor day presentation, Hewlett-Packard (HPQ) disappointed when stacked against the expectations of nearly the entire investment community.

CEO Meg Whitman and CFO Cathy Lesjak outlined a plan that envisioned 2013 as a reset year, 2014 as a rebound year, and 2016 as the year of full recovery to normal growth and margins. This was well beyond the time horizon of the majority of what investors had in mind, and the stock promptly fell to lows not seen in 10 years, closing the week at $14.73. It is now trading at one of the lowest price-to-earnings multiples in the entire S&P 500.

The knee jerk reaction, and the question for many, has been this:  If HP is faring so poorly, why shouldn't Dell (DELL) be performing similarly? Not surprisingly, that stock has traded off in sympathy, though not to the same degree, and Dell's valuation is barely above that of HP.

Is the market getting it right? Is Dell set to follow the same path as HP, or  is it differently situated?

The reality is that, while these two companies are in the same general businesses, there are a number of differences. First, Dell may have already taken its medicine, and is setting up for a better 2013, and perhaps a better long-term strategy. Here are some other key differences.

● Dell had previously acknowledged the difficult demand environment due to the sluggish macros during its second-quarter earnings report in August, and the stock was punished at that time. So HP's comments about the market environment were catching up to those of Dell.

● Dell has less relative exposure to Europe and more to the U.S., which should help.

● By HP's own admission, the management and strategic turmoil at the company has been disruptive to business execution and customer loyalty. In comparison, Dell has been quite stable since Michael Dell's return in 2007. The strategy of the latter has been developing in a well-thought-out sequence without a stunning "big splash" acquisition.

● HP's financial strength has been significantly impaired, most recently with the dubious purchase of Autonomy for $11 billion. The company's balance sheet has gone from $10 billion in net cash to $10 billion in net debt. On the other hand, Dell has maintained a strong net cash position, even after a series of smaller acquisitions that have cost more than $5.5 billion this year.

● Dell has been responsive to shareholders. It has initiated a cash dividend, now yielding more than 3.3%; it has increased its total shareholder distributions to between 20% and 35% of free cash flow; and it is evolving its business mix more toward solutions for enterprises and away from end-user computing.

● HP essentially trashed the coming year, taking earnings guidance well below its $4 line in the sand for 2012. Dell's management argues strongly that 2013 can be a growth year, assuming current economic conditions, even in end-user computing. Even though the company is still significantly exposed to personal-computer demand, its enterprise customers will complete their migration to Microsoft's (MSFT) Windows 7 as support for Windows XP ends in 2014. If Windows 8 is well-received, and if Dell's new laptop, tablet and convertible products get any traction, any resultant benefit would be gravy.

While HP could ultimately get its act together and see its stock rise in 18 to 24 months as a long-term program develops, there is too much uncertainty in it for us. Its valuation does not compensate for the risk. HP's continuous management upheaval seems to have caused a lot of damage to its franchise, and currently we believe there are better places to make money.

Conversely, we like Dell for the next six months, as well as the next 12 to 18 months. While the company will be facing some headwinds, much of its strategic plan is within its control. Dell management is remaking the company with a greater focus on higher-margin businesses (enterprise software, storage and solutions) that have better long-term growth prospects. While this transformation is taking place, shareholder returns are being increased. The company should be in increasingly good shape, and the stock is dirt cheap.

Not all computer companies are the same. Stick with Dell. It is not HP.

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