At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Here, we'll show you whether those bigwigs actually know what they're talking about. We've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
Dell and the paradox of thrift
Once considered the best computer maker in the business, Dell (Nasdaq: DELL) has fallen upon hard times. Enamored of Apple's (Nasdaq: AAPL) shiny new iPhones and -Pads, and the multiple "me-too" offerings from Hewlett-Packard (NYSE: HPQ), Research In Motion, Motorola Mobility, and so on, investors are declaring the plain vanilla PC market obsolete, and pricing Dell for extinction.
Today, a share of Dell will cost you less than 11 times the amount of profit the company earned last year, and less than eight times the amount of free cash flow it generated. Still, thrifty investors are ignoring the cheap price, and focusing instead on Wall Street predictions that Dell will struggle just to outgrow the pace of inflation in years to come, increasing its profit by a meager 4.5% per year over the next half decade.
According to Wall Street investment banker Needham & Co., that's a pretty good reason to buy anything but Dell. "Dell continues to be a paradox," the analyst laments. "At one level, the company is fairly inexpensive, is a major player in corporate PC/notebook, an emerging force in data center server and services, and a likely beneficiary from stronger IT spending this year."
On the other hand, according to StreetInsider.com, Needham worries that until Dell improves its cloud-related offerings and starts addressing its weakness in smartphones and tablets, the company's growth will remain stunted, and "the stock range bound over the next few quarters."
Yesterday, Needham pulled its buy recommendation on Dell, and downgraded the stock to "hold." But was it right to do so?
Let's go to the tape
Judging from Needham's record on similar computers & peripherals picks, it's hard to say. Needham stopped providing its ratings to Briefing.com for independent review sometime late last year. Today, we only learn about the ratings that Needham chooses to publicize. But back before Needham suffered its sudden attack of "shyness," here's how the analyst's record looked:
|
Company |
Needham Rating |
CAPS Rating |
Needham's Picks Beating (Lagging) |
|---|---|---|---|
| Apple | Outperform | *** | 278 points |
| HP | Outperform | *** | (8 points) |
| Dell | Outperform | ** | (51 points over two incorrect picks) |
Most of the computing stocks Needham picked back in the day actually underperformed the market. Now, with its record hidden from public view, I think investors need to approach Needham's advice with considerable skepticism.
One of the main reasons Needham cites for its lack of enthusiasm over Dell is the likelihood that DRAM and LCD computer screens will rise in cost, a consequence of the Japanese earthquake-cum-tsunami-cum-nuclear disaster. Needham sees that triple-whammy constricting supplies of PC components, and increasing Dell's costs. Meanwhile, the analyst argues that Western Digital's (NYSE: WDC) purchase of Hitachi's hard disk drive business will reduce price competition in the HDD market, increasing Dell's cost of buying hard drives.
Thrift and the paradox of logic
But wait! Those component costs will rise for Dell's archrival Hewlett-Packard as well. Needham admits as much, but still argues that you're better off owning HP shares than Dell today: "Unlike Dell, they did not guide for a continuation of the "good times." For this reason, Needham sees risk in Dell -- but little in HP (which the analyst recommends buying).
I disagree. Sure, Dell and HP sell for about the same P/E ratios today. But if Needham thinks Dell's growth estimates are optimistic, and HP's conservative ... well, I'd beg to differ. Most analysts still call for HP to grow at 9.8%, twice Dell's pace. And last I checked, 9.8% growth was a whole lot more optimistic than 4.5%.
Meanwhile, in contrast to Dell, which generates significantly more free cash flow than its GAAP profits let on, HP's reported $9.1 billion annual profit last year actually overstates its true free cash flow by a good 10%. Last but not least, whereas Dell's balance sheet shows the company sitting on $8.4 billion net cash, HP carries a good $10.5 billion in net debt.
Who's thrifty now?
In a contest between HP and Dell, Needham seems dead wrong to recommend the former and diss the latter. With $3.5 billion in annual free cash flow, every dollar you spend on Dell stock today generates a free cash flow yield of roughly 12.6%. Take a walk over to your local banker and ask whether they'll pay you that much on your passbook account. If not, Dell stock may be worth a second look.
