Don't Write Off Dell

 | Nov 23, 2012 | 10:00 AM EST  | Comments
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Over the course of the past week, both Dell (DELL) and Hewlett-Packard (HPQ) reported their respective October-quarter earnings results. HP's were an unmitigated disaster. But, while Dell had a modest miss, the company's numbers were generally close to expectations. Dell has also reaffirmed its outlook for the year.

Both stocks reacted poorly, but the underlying issues are actually starkly different. The information-technology industry has certainly become more difficult due to macroeconomic challenges, especially in Europe, and as a result of constrained government spending. But, notwithstanding these external pressures, we believe HP is in deep disarray, whereas Dell is steadily following through on its business-transformation strategy.

Dell's shortfall came primarily from its "end-user computing" operation -- desktops and laptops -- and the company has been under pressure as spending on these products has eroded thanks to growing tablet and smartphone sales -- areas where Dell doesn't play. On the other hand, Dell's enterprise solutions and services business (servers, software, storage, services and so on) have performed adequately overall, even despite macro-induced uncertainty affecting the spending intentions of corporate managers.

It's important to note that, while end-user operations comprise about 60% of Dell's revenue, its enterprise business generates more than half of gross profit. This business is what the future of the company will be.

Overall, Dell's recent acquisitions seem to be performing generally within internal expectations. Margins were adequate for the most recent quarter, and cash flow performance was strong. The company's balance sheet still carries nearly $3 per share in net cash, even following a number of small to midsized acquisitions over the past few years. Critically, Dell has reiterated its earnings guidance for fiscal 2013 (ending January) of at least $1.70 per share.

On the other hand, HP has issues to deal with that relate to management, strategy and operations -- and that's on top of the unforgiving environment. The debacle of the Autonomy acquisition keeps growing: A stunning buyout price last year has now been followed by allegations of deal fraud and another huge asset writedown. While the October quarter put in a slight operational beat, the company has significantly reduced its guidance for the current quarter.

Further, while HP reported solid cash flow this past quarter, its recent acquisitions have left it with a sizeable net debt position. Consistent with management's prior comments from the company's investor day, the turnaround won't likely be in full force until 2016. That's too long for most investors to wait.

Since we last contrasted these two companies in early October, the overall market -- and tech stocks in particular -- have been under pressure. That period has also witnessed a presidential election and increased concerns about the fiscal cliff.

But what of these stocks?  Through Wednesday, the S&P 500 has declined about 4.5%. Tech bellwethers Apple (AAPL) and Microsoft (MSFT) have lost 12% and 9.5%, respectively, and HP has cratered by 17.4%. Yet Dell is down by just 7.6% -- more than the index, but less than its peers, and dramatically less than HP.

In the wake of the earnings announcements, our thinking is unchanged. We are not involved in HP and don't expect to be interested for the foreseeable future.

As to Dell, we like the stock's prospects over the next six months and for the next 12 to 18 months, as well. While the company's headwinds will inhibit a faster transformation, we like Dell's strategic plan and the progress it has made toward it. The dividend yield is a generous 3.5%, which should allow for some patience -- and we believe it will only grow over time.

Adjusting for net cash, the stock trades at 3.6x 2012 earnings, reflecting an apparent conclusion by investors that the personal computer is dead and that, therefore, so is Dell. We disagree. We think PCs will continue to have a place -- and that, besides this, there's much more to Dell's investment case than just PCs.  

Finally, we believe that a below-4x price-to-earnings multiple (adjusting for cash) is simply far too depressed for a company with a rock-solid balance sheet, positive earnings and cash flow, strong management and a business plan that should ultimately lead to a more predictable and growing business.

We reiterate: Stick with Dell; it is not the same as HP.

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