Intel servers called the crown jewels (for Compaq) in this report.
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JP Morgan Comments on VC and CPQ
By: J.P. Morgan
10/25/00 9:10:56 AM
Morning Meeting Research Notes:
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Visteon Corporation (LONG-TERM BUY)
INITIATING COVERAGE: A COMPANY IN FORMATION
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VC 16.25 0.69
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We think Visteon has the potential to become one of the world’s leading auto parts suppliers. Having been recently spun off from Ford (F/$25.81/Buy), the company inherited many of the key ingredients needed to achieve success in the auto parts industr y: scale, product breadth, and systems integration capabilities. In addition the company has a solid technology base that should keep it at the forefront of several fast-growing product areas like telematics and integrated cockpit modules.
We believe Visteon’s lower than peer group margins provide it with greater than peer group earnings improvement potential. Visteon’s profitability fell earlier this year when Ford imposed a one-time, across-the-board price reduction (of about 5%) in order to, according to the company, bring the pricing of Visteon’s Ford contracts in line with the market. In addition to short-term cost reduction opportunities, we believe that, longer term, Visteon has major portfolio restructuring opportunities that should also boost profitability.
Visteon’s significantly lower than peer group valuation intrigues us. The company’s 2001 P/E (4.1) and firm value/EBITDA (2.5) are 37% and 42% below the now very depressed peer group average. The valuation looks even more compelling considering that Visteon has $10 per share in cash. While we believe the company should trade at a modest discount to its peers given its unproven track record and high single-customer exposure (about 85% of its sales are from Ford), we think the current discount is too large. We find Visteon’s valuation discount to Delphi (DPH/$14.69/Long-Term Buy), its closest comparable, of 36% on P/E and 39% on firm value/EBITDA, excessive, especially as we expect Visteon to post higher earnings growth (15% versus 8% in 2001).
We rate Visteon a Long-Term Buy and set a 12-month price target of $18, 15% above the current price. We arrive at our price target by applying the stock’s current 2000 consensus P/E of 4.7 to our 2001 EPS estimate of $3.81. We give the stock less than our top rating because of the lack of a catalyst. With the auto and auto parts sector currently very much out of favor, it is hard to make a compelling case for a Buy rating for any stock in this sector, no matter how cheap (Visteon being one of the cheapest). In addition, Visteon appears to be a company that is still in formation. While we expect the company’s profitability and valuation to eventually reach industry averages (which we estimate would result in a share price of $36 or higher), we cannot be sure of the timeframe until management articulates a detailed plan to get to these higher profitability levels. When such a plan is announced, and if we find it to be credible, we would look to upgrade the stock.
(J.P. Morgan Securities Inc. acted as co- or lead-manager in an offering of securities for F within the past three years.)
Compaq Computer (BUY)
THE MODEL WORKS; UPGRADING TO A BUY
· Compaq reported earnings a penny ahead, and record revenues up 22%
· Intel servers remain the crown jewel, but there were plenty of other bright spots, like 44% enterprise storage growth
· Locking-in Euro risk by taking a currency adjustment in 4Q that lowers EPS
· Upgrading to a BUY with $40 target on an improved operating profile, diversified revenue base, proven management, strong cash flow, and upside to fiscal 2001 earnings
Yesterday, Compaq reported 3Q earnings of $0.30, excluding investment income of $25 million, a penny ahead of our and the Street’s estimate. This was clearly a very good revenue quarter, up 22% to $11.2 billion, handily beating our forecast by $800 million with strength across the product portfolio. The most impressive result came from Compaq’s crown jewel – Intel (INTC/$42.00/Buy) PC servers, slanted towards the high-end of that business – dense, rack-mounted servers which contributed $1.6 billion up 41%. We had been a little fearful of other businesses being a drag on the aggregate growth, but Compaq did a good job of making sure that didn’t happen. Enterprise storage grew 44%, and is now a meaningful volume of $460 to $475 million, in our estimation. Alpha servers turned in an honorable result of 400 units, commercial PCs turned profitable, and Compaq was successful at finding international customers in the home PCs business. The only area where the company is still coming up short is in services. All told, there were plenty of bright spots in the quarter, with results demonstrating Compaq’s accelerating financial and market performance and a less disproportionate dependency on PC servers. We see a vast improvement in the company’s operating profile, and further progress next year in which we have turned solidly comfortable. On this basis, we are upgrading Compaq from a Market Performer to a BUY with a target price of $40, a 26.8 multiple on next year’s earnings.
As for specifics on the business outlook: Compaq announced it is expecting 4Q to be $0.04 less than current consensus, the entire adjustment being currency-related, as they are electing to hedge exposure to the Euro by locking in a $100 million hit to earnings for the remainder of the year. Given Compaq’s revenue exposure in Europe (a third of total sales; up 21% in constant currency), we are not terribly surprised nor do we believe this is an unreasonable action. In fact, this step allows Compaq to define its risk in a region that is getting increased attention. Our forecast is $0.38 in 4Q, a penny higher than company expectations. In our opinion, Compaq is executing well, fundamentals are strong, and management is delivering sound guidance for 4Q, which leaves room for some upside. For next year, the company still expects to turn in double-digit growth, and is comfortable with consensus earnings of $1.49. We point out that this is equivalent to raising the bar on revenues, which we are increasing in our forecast by $600 million to $49.4 billion, or 14% growth. Fiscal 2001 already includes consideration for currency. We believe Compaq is positioned better than most, if not all the competition, even in a softer market for PCs.
It also appears that Compaq’s cash flow has gotten quite strong. While we are not entirely sure where the company is spending $250 million in capex, we do see strong operating cash flow – increasing to $662 million for the quarter as compared to $176 million last year. This reflects improved gross margins (up 70 points), lower operating expenses (down $132 million), and favorable changes in working capital. Our upgrade is highly attributable to the management of this company, in short, Michael Cappellas has been an immense asset, and the difference in this company’s creativity and energy is as crisp as night and day, compared to prior management. The most apparent effect of this creativity is Compaq’s success in carving out a place of relevancy in Internet infrastructure, something which we feel has eluded a competitor like Dell (DELL/$26.81/Buy). We have ample evidence that Compaq is seeing success bundling across its product offering, particularly at the high-end and with business-critical Proliant servers at the edge of the Internet. We are looking towards improved services growth and announcements of wins bundled with hardware as a key milestone for measuring continued momentum. |
