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Avoid "Value Traps" - Sell Dell, HP

This article is more than 10 years old.

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Is Dell a good "Value Stock?"

In "Screening Large Cap Value Stocks" 24x7WallSt.com tries making the investment case for Dell.  And backhandedly, for Hewlett Packard.  The argument is simple.  Both companies were once growing, but slowed growth leaves both more mature companies migrating from products into services.  They have mounds of cash, and will soon start paying a big, fat dividend.  So investors can rest comfortably that these big companies are a good value, sitting on big businesses, and less risky than growth stocks.

Nice story.  Makes for good myth. Reality is that these companies are a lousy value, and very risky.

Dell grew remarkably fast during the 1980s and early '90s.  Dell innovated computer sales, eschewing expensive distribution for direct-to-customer marketing and order-taking.  Dell could sell individuals, or corporations, computers off-the-shelf or custom designed machines in minutes, delivered often overnight.  Further, Dell eschewed the costly product development of competitors like Compaq in favor of using a limited number of component suppliers (Microsoft, Intel, etc.) and focusing on assembly.  With Wal-Mart style supply chain execution Dell could deliver a custom order and be paid before the bill was due for parts.  Quickly Dell was a money-making, high growth machine as it rode the growth of PC sales expansion.

But competitors learned to match Dell's supply chain cost-cutting capabilities. Manufacturers teamed with retailers like Best Buy to lower distribution cost. As competition copied the use of common components product differences disappeared and prices dropped monthly.  Dell's advantages started disappearing, and as they continued to follow the historical cost-cutting success formula with more outsourcing, problems developed across customer service.  Competitors wreaked havoc on Dell's success formula, hurting revenue growth and margins.

HP followed a similar path, chasing Dell down the cost curve and expanding distribution.  To gain volume, in hopes that it would create "scale advantages," HP acquired Compaq.  But the longer HP poured printer profits into PCs, the more it fed the price war between the two big companies (and others like IBM/Lenovo.)

Worst for both, the market started shifting.  People bought fewer PCs.  Saturation developed, and reasons to buy new ones were few.  Users began buying more smartphones, and later tablets.  And neither Dell nor HP had any products in development where the market was headed, nor did their "core" suppliers - Microsoft or Intel.

Defensive actions won't protect historical results when markets shift

That's when management started focusing on how to defend and extend the historical business, rather than enter growth markets.  Rather than moving rapidly to push suppliers into new products the market wanted, both companies extended their PC "base business" by acquiring large consulting businesses (Dell famously bought Perot Systems and HP bought EDS) in the hopes they could defend their PC installed base and create future sales. Both wanted to do more of what they had always done, rather than shift with emerging market needs.

But it wasn't only product sales that were stagnating.  Services were becoming more intensely competitive - from domestic and offshore services providers - hampering sales growth while driving down margins.  Hopes of regaining growth in the "core" business - especially in the "core" enterprise markets - were proving illusory.  Buyers didn't want more PCs, or more PC services.  They wanted (and now want) new solutions that neither Dell nor HP is offering.

So the big "cash hoard" that 24x7 would like investors to think will become dividends is frittered away by company leadership - spent on acquisitions, or "special projects," intended to save the "core" business.  When allocating resources, forecasts are manipulated to make defensive investments look better than realistic.  Then the "business necessity" argument is trotted out to explain why acquisitions, or price reductions, are necessary to remain viable against competitors, even when "the numbers" are hard to justify - or don't add up to investor gains.  Instead of investing in growth, money is spent trying to delay the market shift.

There is no doubt people are quickly shifting toward smartphones and tablets rather than PCs.  This is an irreversable trend: Chart source BusinessInsider.com

Slow growth companies over-invest in what they know, and under-invest in what customers really want, while new competitors steal growth with new solutions

Look at Microsoft's recent acquisition of Skype for $8.5B.  As Arstechnia.com headlined "Why Skype?" This acquisition is another really expensive effort by Microsoft to try keeping people using PCs.  Even though Microsoft Live has been in the market for years, Microsoft keeps trying to find ways to invest in what it knows - PCs - rather than invest in solutions where the market is shifting.  New smartphone/tablet products come with video capability, and are already hooked into networks.  Skype is the old generation technology, now purchased for an enormous sum in an effort to defend and extend the historical base.

Executive teams locked-in to defending their past spend resources over-investing in the old market, hoping they can somehow keep people from shifting.  Meanwhile competitors keep bringing out new solutions that make the old obsolete.  While Microsoft was betting big on Skype last week Mediapost.com headlined "Google Pushes Chromebook Notebooks."  In a direct attack on the "core" customers of Dell and HP (and Microsoft) Google is offering a product to replace the PC that is far cheaper, easier to use, has fewer breakdowns and higher user satisfaction.

Chromebooks don't have to replace all PCs, or even a majority, to be horrific for Dell and HP investors.  They just have to keep sucking off the growth.  Even a few percentage points in the market throws the historical competitors into further price warring trying to maintain PC revenues - thus further depleting that cash hoard.  While the old gladiators stand in the colliseum, swinging axes at each other becoming increasingly bloody waiting for one to die, the emerging competitors avoid the bloodbath by bringing out new products creating incremental growth.

There are no "value stocks." Only risky "value traps"

People love to believe in "value stocks."  It sounds so appealing.  They will roll along, making money, paying dividends.  But there really is no such thing.  New competitors pressure sales, and beat down prices.  Markets shift wtih new solutions, leaving fewer customers buying what all the old competitors are selling, further driving down margins.  And internal decision mechanisms keep leadership spending money trying to defend old customers, and defend old solutions, by making investments and acquisitions into defensive products and projects extending the business - but that really have no growth - creating declining margins and simply sucking away all that cash.  Long before investors have a chance to get those dreamed-of dividends.

This isn't just a  high-tech story.  GM dominated autos, but sold its investments in growth (EDS, Hughes) and frittered away its cash for 30 years before going bankrupt.  Sears once dominated retailing, but now it's an irrelevent player burning through cash trying to preserve declining revenues (did you know Woolworth's was a Dow Jones company until 1997?).  AIG kept writing riskier insurance to maintain its position, until it would have failed if not for a buyout.  Kodak never quit investing in film (remember 110 cameras? Ektachrome) until competitors made film obsolete. Xerox was the "copier company" long after users switched to desktop publishing and now paperless offices.

All of these were once called "value investments."  However, all were really traps.  Although Dell's stock has gyrated wildly for the last decade, investors have lost money as the stock has gone from $25 to $15. HP investors have fared a bit better, but long-term trending has mostly seen the stock move from about $40 to $45.  Dell and HP keep investing cash into trying to find past glory in old markets, but customers shifting to new markets causes that money to be wasted.

When companies stop growing, it's usually because markets shift.  After markets shift, there isn't any value left.  Management efforts to defend the old success formula with investments in extensions simply fritter away investor money.  That's why they are really value traps.  They are risky investments, because without growth there is little likelihood investors will ever see a higher stock price, and eventually the stock always collapses - it's just a matter of when.  Meanwhile, riding the swings up and down whipsaws most investors into losses - and you sure don't want to be long the stock when the final downturn hits.

Links:

How some thought Dell was a good value play in 2009, and why signs clearly showed it wasn't

Investor importance of spotting trends early, and how Dell didn't

How to know when to change course rather than doubling down on history including Dell example

Why acquisitions are "quick fixes" and how both Dell and HP invested poorly in service companies

How Dell's lock-in portended investors could not win in 2006 - multiple quotes

HP's bad CEO selection in 2010

How the HP Way hurt the company, killing organic growth after 2004 stall

HP slumps on forecast cuts 5/17/11 Marketwatch.com

Questions develop around HP's new CEO direction 5/17/11 Marketwatch.com

HP valuation drops to lowest point in a decade 5/17/11 Marketwatch.com