Thoughts on Tech Stocks

As a value investor, I am still amazed at what value names pop up on my screens in various markets. In the early 1990s it was financials, then it was telecom after Worldcom blew up. In the early 2000s it was energy: coal, oil & gas, and power companies were distressed value plays. Then it was financials again in 2008. (OK I was in high school for the S&L crisis, but it was big news in Texas).

There has always been a sprinkling of healthcare too, depending on which medication or device the government decided to cut reimbursements for. But never have I looked at computer and tech companies as distressed or deep value investments. Ever. And perhaps they aren't really deep value, but generally I have never seen so many big, growing, successful blue chip tech stocks trading for ridiculous multiples.

What I hear is that these arent growth stocks anymore. They have been relegated to the bin of cyclicals: companies that just flow up and down with the world economy. And, that is quite true. They dont grow forever. But then again, show me a company that does?

So, yesterday McDonald's got blasted 3%, so I was taking a look. It seemed like the most obvious "grow forever" stock. However, its revenue got hurt in 2009 after being up in 2008. Yea, its countercyclical. Anyway, the stock is going to do $5.00 in EPS in 2010 according to the street, and at 75 bucks a share, is trading at 15x earnings.

Similarly I have been digging into Apple, HP, Intel, Cisco all the blue chip tech bellweather stocks. I mean, CSCO I bought last month, its trading at 8x cash earnings. Apple, taking out the cash (ala Cisco), trades at 15x 2011 earnings. And they grew revenue over 50% last year! Ok that will slow down beyond 2011, but its gotta be far better than 4-5%. McDonalds trades for the SAME multiple on 2011 earnings that Apple trades at, 15x. Astonishing. Everyone should own Apple in their PA.

Similarly, I swapped out of one stock in my personal account and bought some HPQ today, Hewlett Packard. I paid 43.90 thereabout. I didn't really want to add exposure to the markets given where we are, hence selling one of my other names.

So for reference, the market has rallied 25% in the last 6 months, and HP is up 2%. Its gotten crushed on lots of news, including tabloid style tidbits that former CEO Mark Hurd was hitting on a former porn star, etc etc. He got fired last August, and by November he was replaced with Leo Apotheker. Leo formerly spent 20 years at SAP, his last one acting as a relatively forgettable CEO. Hurd was by all accounts a solid CEO, and Oracle quickly hired him after getting fired last August. Primarily that drove the stock down.

Anyway, just last spring HPQ was trading in the $53-54 range, and with the summer correction, really was oversold in my opinion, falling even below $40/share.

So, why am I buying HPQ around $44? First of all, I always do some accounting work to see if earnings are real or not. That means looking at the CF statements, recreating what cash earnings must be to get to a real EPS figure. At first blush, I assumed that HP's reported "non-GAAP EPS" would be some bogus number with so many fake add-backs that real cash earnings were closer to GAAP EPS. And here there is a big difference.

In 2010 (FYE October), GAAP earnings were $3.69 per share. "Non-GAAP EPS" was $4.25. Big difference, so which do you use? Their financials bridge the difference as intangible amortization expenses, plus a smidge of restructuring charges/merger fees (overpaid to some banker like goldman). Since their past acquisitions were cash based, the cash number is already excluded here. Anyway, my point is that on a cash basis, I calculate EPS to be $4.50 per share. In essence, capex spending has been lower than D&A and the company's adding back of intangible amortization is also legit.

So, for 2011, the company has guided to $5.16 in EPS, which is exactly what I get on a cash basis assuming they spend a little more in capex. So, on a $44 stock, that will do well over $5 in earnings, i find this stock to be way too cheap. Thats 8.5x earnings, half the multiple almost of the S&P in 2011. The S&P is around 14x P/E.

Generally speaking, to me an 8.5x multiple of earnings, or a near 12% Free Cash Flow yield is indicative of a business that will decline. Pfizer trades at 8x earnings. But that is because something like 40% of its revenue goes off-patent in the next 4-5 years. Huge revenue declines should follow. As far as HP goes, I dont see high growth, but this isnt declining. 2010 revenue growth was 10%. Next year it should be at least 5%.

As far as revenue risk, 45% of revenue today is Enterprise Revenue. That is servers, storage products and services to businesses. Its not a consumer PC company anymore. In fact only 25% of income is from the PC business. Printers are 20% of the company, and there is a ton of recurring high margin revenue here. Overall revenue has grown from $87BB to $126BB in 5 years. Thats a 15% a year average growth per year. Next year guidance only assumes 5% topline growth. And in fact, the company basically took the january 2011 quarter and annualized it to get to its 2011 guidance. That tells me its pretty likely they'll beat it this year, and do BETTER than the $5.16 EPS number out there.

I am not a techie, never have been. But generally I suspect that the shift to cloud computing is going to be important for these guys. PC sales are under pressure with the increase in mobile computing, but I still think people want a desktop computer at home. Emerging markets are growing, and 65% of HP's revenue is international. This long run will grow at a decent clip.

As far as upside, downside in the stock: I think using a very conservative $5.00 in EPS in 2011 is safe. That's below guidance from the company, and well below the street's estimates of $5.72. At 13x, still below a market multiples, thats $65/share. Downside is that they stay at 4.25 in EPS in 2012 in a recession (EPS was down very small in 2008 vs 2007), and at 9x, that would get you $38 per share. That was also the lows last year. Down $6-8, up $20. Perhaps a more realistic view is high 50s, still good risk reward.

If you are looking at comps, Dell trades at 13x, Oracle 20x, IBM 12x.

I guess the unmentioned problem with this stock, and the true reason for its trading so poorly, is that the market doesnt like how HP uses its cash. One, they have made some acquisitions that were expensive (paid $14BB for EDS in August 2008 at the peak). Two, they pay almost zero dividends, and instead buy back massive amounts of stock with its free cash flow. Oracle had a huge run this year upon upping and announcing their dividend, and that is a big hope here. It could get ugly too if the new CEO, Leo Apotheker, decides he wants to buy SAP, his former employer. It would be tough to pull off, SAP's market cap is 60BB vs HPQ's 100BB market cap. But you never know.