Kenya,
Just checking up on posts here on a yukky rainy day in Chicago. I'm not sure if this is the post you place about Dell vs CPQ, but here's one that might be what you're talking about that I blocked into Word back in August. WARNING to readers, it's very long.
Best regards,
JMaz
Jubak's Journal
Dell vs. Compaq
Which stock is a better buy? Dell's direct-marketing model give it more firepower. But a careful analysis presents a more complicated picture.
By Jim Jubak
Dell vs. Compaq: Head to head, which stock would you buy?
Comparing the fundamentals of the two companies is pretty straightforward. Dell wins hands down.
But turning those fundamentals into a decision to buy is much more difficult. Right now, Dell Computer (DELL) trades at a price-to-earnings ratio of 74 that includes a big premium for the company's amazing performance. At a P/E ratio of 44, Compaq Computer (CPQ) isn't cheap, either. But it's cheaper. The stock is priced like the turnaround story it is.
How do you decide -- especially when you've got to take into account a global financial situation as confused and threatening as the one that spooked the market last Friday?
I can't say I've come up with a cut-and-dried recipe, but I have come up with a method that I think is particularly well suited to the resources that the Internet and the personal computer have given me as an investor. I try to take advantage of the immense amounts of data I now have available to predict earnings and compile a set of potential prices for a stock. As a final step, I use the computer to put those prices together and see what composite picture develops of each stock.
First, calculate the range of potential earnings per share based on the fundamentals.
It's pretty easy to sum up the two companies. Dell is firing on all cylinders. Compaq is still in the garage getting a tune-up.
It's pretty easy to sum up the two companies. Dell is firing on all cylinders. Compaq is still in the garage getting a tune-up.
In its second quarter, which ended Aug. 2, Dell managed a 72% gain in earnings per share on a 54% increase in revenue compared with the same year-earlier period. How did it do that in what was supposed to be a rough quarter for PC makers? The company accounted for more than half of all the unit growth in the industry worldwide. In the U.S. market for desktop computers, for example, Dell's shipments jumped by 72%, a Dataquest survey shows. The total U.S. market for these machines grew by just 12%.
Analysts assumed the company would deliver that kind of growth. What they worried about was any sign that Dell's build-to-order business model was starting to look ragged. Again, the company came through. Gross margins increased to 22.7% from 22.2% in the same quarter of 1997. Inventory stood at just eight days.
Great growth now and great growth in the future, Wall Street concluded. Analysts now estimate that Dell will grow earnings by 59% for the fiscal year that ends in January 1999.
Details
Price 124
Change +4 7/8
Company Facts
3-yr Chart
Press Releases
Earnings Estimates
Earnings Growth Rates
Profit Margins
10-yr. Summary
Price 34 5/8
Change -15/16
Company Facts
3-yr Chart
Press Releases
Earnings Estimates
Earnings Growth Rates
Profit Margins
10-yr. Summary
Compaq, on the other hand, didn't impress anyone on Wall Street when it reported results for its second quarter, which ended June 30. Sales climbed just 5.7% from the same quarter in 1997. And the company earned just 2 cents a share (excluding special charges), a far cry from the 30 cents per share (excluding charges) that the company reported for the year-earlier period.
But again, that's pretty much what analysts expected, and they immediately focused on other numbers. They wanted to see if Compaq had made any progress on reducing inventory. Too many machines in the dealer channel -- Compaq primarily sells through dealers who keep machines in inventory until customers buy them -- had cost the company dearly at the end of 1997 and into 1998. Here, the news was good. Compaq had reduced inventory levels to 3.5 weeks, exceeding the company's target of 4 weeks and a vast improvement over the 8 weeks of inventory that had bedeviled it earlier.
Compaq CEO Eckhard Pfeiffer wrote off the July-September quarter, calling it "transitional." But he promised that despite the need to integrate its purchase of Digital Equipment, the company would be back on track by the December quarter.
So Wall Street analysts estimate one more lousy quarter -- earnings of 6 cents a share -- and then a big bounce to 36 cents in the fourth. That would bring earnings for all of 1998 to 45 cents. In 1999, with the turnaround complete, analysts project $1.73 a share.
Now, let's turn those fundamentals into a set of estimates for earnings per share a year from now. (I'll use earnings for the end of fiscal 1999 for each company because I've got good estimates from Wall Street for that period. Due to different fiscal years, Dell gets credit for an extra month, but the numbers should be close enough for our purposes here.) Wall Street figures Dell will earn $2.70 a share against the $1.73 a share for Compaq. Those are two snapshots to use in my composite, but I'm going to generate a few more.
What happens if Dell keeps eating market share like it has for another year? Clearly possible. Dell could grow sales by 50% this year and 50% next year. That's one alternate snapshot.
On the other hand, the company could falter a tad. I can't see a big decline in sales growth, but Dell does face determined competitors who have solved some of their inventory problems. So let's say Dell's sales growth declines to the company's 40% annual average over the past five years.
Using those two different growth estimates puts Dell's sales at $27.7 billion in January 2000 at the high end and $24.2 billion at the low end. At Dell's average 7.8% net profit margin for all of 1997 (and dividing by the current 639 million shares outstanding), I get earnings per share of $3.38 on the high side and $2.95 on the low side.
The same exercise for Compaq yields a much bigger spread. The company's historical rate of growth is close to 35%, but analysts are projecting just 22% annual sales growth going forward. Even that seems high, given the difficulties of the Digital Equipment merger and the slow growth of Digital's business pre-merger. Using my estimates of 30% sales growth on the high side and 20% on the low (with 1.7 billion shares outstanding and the 7.5% net profit margin the company recorded in 1997), I get earnings per share from $1.83 to $1.56. Two more snapshots for each stock.
I think it's safe to assume that Compaq will be less profitable in 1999 than it was in its great year of 1997.
But let's take another look at those net profit margins. The most recent figures for the two stocks look very different than the annual figures I just used to generate that alternate set of snapshots. Thanks to falling prices for components and lean inventory, Dell has actually increased its margin during the Asian economic crisis. It pulled an 8% margin out of its hat in its second quarter, and if prices continue to fall for the next year or so, Dell might actually be able to increase margins further -- let's say to 8.25%. Using that 8.25% figure and my high and low sales projections, I get two more earnings estimates for Dell: $3.58 and $3.12.
Write-offs and restructuring charges make it hard to get a handle on Compaq's 1999 net margin. It's certainly likely to be less than Dell's, since Compaq's improved inventory position still makes it harder for the company to profit from declining component prices than it is for Dell. I think it's safe to assume that Compaq will be less profitable in 1999 than it was in its great year of 1997. So I'm going to use a 6.5% net profit margin. That gives me earnings per share estimates (again using high and low sales figures) of $1.59 and $1.35.
Next, I estimate a range of P/E ratios that investors might pay for Dell and Compaq in January 2000.
Again, start with the simplest option: Project the current P/E ratios (74 for Dell, 44 for Compaq) into the future.
But there's no good reason to think that either stock will trade at its current multiple in January 2000. Compaq's current multiple is high because the company is at the bottom of a cycle -- it's reasonable to think that the P/E ratio will come down as the company actually produces the earnings that are just projections right now. That's the typical pattern for stocks coming off a bottom. In 1995 and 1996, Compaq traded at as low as 75% of the market's P/E ratio. In 1997, when the company was riding at its highest, the stock traded at the market multiple. So rather than trading at 1.84 times the market's multiple as the stock does now, I'd say Compaq is likely to trade somewhere between 0.75 and 1 times the market's P/E multiple in January 2000.
Rather than trading at 1.84 times the market's multiple as the stock does now, I'd say Compaq is likely to trade somewhere between .75 and 1 times the market's P/E multiple in January 2000.
For most of its recent history, Dell traded at about the same P/E ratio as Compaq -- about 80% of the market multiple. Only in 1997 did the stock gain its current superstar status. That year Dell traded at an average annual P/E ratio 1.55 times that of the market's multiple.
I don't know what the market multiple will be in January 2000, but let's take a stab at a number and see what that tells us about the two stocks. Market multiples go down, normally, when earnings growth hits its stride, and then climb again as current earnings fall but the market anticipates better times. Let's assume that the earnings story is pretty grim in 1999 -- Asia is still coming off the bottom, Latin America enters its own time of troubles. But the market believes in an earnings recovery in 2000. So let's say that the market P/E ratio is 26 in January 2000.
That gives me a P/E multiple for Compaq ranging from 19.50 to 26. Dell's multiple ranges from 20.8 to 40.3.
Let's generate one more set of P/E ratios. Analysts are projecting that Dell will grow at 30% annually over the next five years. Currently, Dell trades at about 1.5 times its growth rate. Using that ratio, I get a P/E ratio of 45. Analysts project 20% growth at Compaq. Using the same multiplier, that gives me a P/E ratio of 30 for Compaq.
Now let's pour all these earnings projections and estimated P/E ratios into two Excel spreadsheets, one for each stock.
Dell Computer
Projected stock price based on different P/E and earnings per share assumptions.
Estimated EPS Stock price if P/E is
20.8 Stock price if P/E is
40.3 Stock price if P/E is
45 Stock price if P/E is
74
$2.70 $56.16 $108.81 $121.50 $199.80
$2.95 $61.36 $118.89 $132.75 $218.30
$3.12 $64.90 $125.74 $140.40 $230.88
$3.38 $70.30 $136.21 $152.10 $250.12
$3.58 $74.46 $144.27 $161.10 $264.92
Dell's current price: (8/25/98) $119
Compaq Computer
Projected stock price based on different P/E and earnings per share assumptions.
Estimated EPS Stock price if P/E is
19.5 Stock price if P/E is
26 Stock price if P/E is
30 Stock price if P/E is
44
$1.35 $26.33 $35.10 $40.50 $59.40
$1.56 $30.42 $40.56 $46.80 $68.64
$1.59 $31.01 $41.34 $47.70 $69.96
$1.73 $33.74 $44.98 $51.90 $76.12
$1.83 $35.69 $47.58 $54.90 $80.52
Compaq's current price: (8/25/98) $35.50
Click here for the Excel Spreadsheet. (21k)
The key question for Dell is the future P/E multiple. If it stays near its current 74, the stock will return better than 25% even under the worst-case earnings scenario I constructed.
Now, if I decide how much return I demand from each stock over the next 16 months, I can see how likely I am to get it. Let's say I'd invest in either stock if I could get a 25% return over that period. My target price for Dell is then $148.75 and for Compaq $44.38. I'll highlight in gold all the cells that give me those prices or better.
I'll also highlight in italic all the cells that produce a 25% or worse loss. (You can set these levels wherever you want to reflect your own goals and risk tolerance.)
I draw two conclusions from these tables.
First, I'm not likely to suffer a 25% loss buying either stock. Only if I think Dell's P/E ratio will go from the current 74 to 20.8 do I really have to worry about that stock. Compaq shows even less likelihood -- the P/E ratio and the earnings-per-share numbers would both have to be worst-case figures.
Compaq, on the other hand, doesn't need the best case on either multiple or earnings to beat my benchmark.
On the upside, it's pretty clear from this that the key question for Dell is the future P/E multiple. If it stays near its current 74, the stock will return better than 25% even under the worst-case earnings scenario I constructed. On the other hand, if the multiple falls to 45 -- reasonable for a stock projected to grow at 30% a year -- investors are really betting that Dell's earnings growth will rock.
Compaq, on the other hand, doesn't need the best case on either multiple or earnings to beat my benchmark. I can get there if the company meets analyst estimates and the P/E ratio falls to 26 from the current 44. Looking at this table, I'm actually more worried about earnings than about multiples with Compaq -- in contrast to Dell. The only way the stock winds up disappointing me is if the company can't meet earnings projections.
These tables don't tell you what stock to buy -- your decision depends on how you feel about the reliability of the numbers in any of these cells, as well as your own tolerance for risk and hunger for reward. But they can tell you where a stock is vulnerable as well as how far out on a limb you'd be climbing if you buy shares.
By building a table like this for a stock, you're a lot less likely to be surprised by a specific equity. And at a time when the world has quite enough big-picture surprises to throw at investors, that's pretty important. |
