Sunday, February 10, 2008

Cisco, Intel, Microsoft, H-P: Tech Value Stocks?

No technology? Ever?
It’s no secret that Warren Buffett avoids technology stocks, saying he prefers to invest in businesses he can understand. While nobody can argue with his success, is General Electric (300,000+ employees, 325 mergers/acquisitions in the 1990s) any less complicated than Intel? Regardless of the reasoning, technology companies have come a long way, and many are no longer upstarts. In fact, four out of the 30 DJIA component stocks are technology companies: Intel, Microsoft, Hewlett-Packard and IBM. Over the last 15 years, the first two have matured and become very well respected members of the corporate establishment. Is it possible there could be a value stock lurking in their midst? Let’s take a look.

The fabulous four
For the analysis, I was tempted to choose the four DJIA technology stocks. Instead, I decided to swap IBM with Cisco Systems, primarily because IBM’s business has changed significantly during the last few years and besides, IBM has been around for nearly 100 years (1910). Based on its age (founded in 1939), I was also tempted to swap Hewlett-Packard with Dell Computer, but decided to leave HPQ on the list since they have a broader reach into peripherals and they’re about twice the size of Dell. Some other thoughts:

  • Apple: I’ve analyzed them in recent articles, and besides, they’re much smaller than the four companies above (only 2/3 the size of CSCO)
  • Google: Unquestionably a significant player in technology, but they are still a relatively young company
  • Tech-oriented retailers (EBay, Amazon, etc.): While largely enabled by technology, I see these guys more as retailers than technology companies per se

To summarize, we’re going to look at Intel, Microsoft Corp., Cisco Systems, and Hewlett-Packard. They’re all large (the ‘smallest’, Cisco and Intel, had about $35 billion in sales last year) and stable (as a group, their shares split 21 times during the 1990’s but only four times since 2000).

Measure of value?
To determine if any of the four are value stocks, let’s look at them through the lens of value. This will tell us if they’re the cigar butts that Warren Buffett likes. First by comparing the companies to some well-known ‘value’ yardsticks and then by looking at their intrinsic value vs. current price. This will help us determine if there are some puffs left in the cigar butts. In short, we’re going to look backward at trailing measures and look forward at earnings growth. For the first part, let’s use some fairly standard criteria, based on the work of value investing guru Ben Graham:

  1. Price to book: 1.2x or less (preferably below 1.0)
  2. P/E: 12 or lower (preferably below 10) based on trailing 12 months (TTM) earnings
  3. Little or no debt: Long term debt (LTD) to capitalization less than 30% and under control
  4. Strong balance sheet: Quick ratio > 1.2
  5. EPS growth: Greater than 33% during the last 10 years
  6. Dividends: Does the company pay a dividend?

Right off the bat, none of the companies meet the first or second criteria. All meet the third and fifth criteria. Intel, Microsoft and Cisco meet the fourth criteria. All but Cisco meet the last criteria. Let’s now take a look at intrinsic value.

Estimating intrinsic value, the cash that can be pulled out of a company over its lifetime, can be both complex and subjective. There are analysts who spend all their time estimating and analyzing intrinsic value for ONE of these companies, so I’m really going to simplify things by using a straightforward equation borrowed from Warren Buffett’s mentor, Ben Graham. If we’re off, at least we’ll be consistent and in good company:
Intrinsic Value = EPS * (2r + 8.5) * 4.4/γ


EPS = Trailing 12 months earnings per share
r = Estimated annual rate of EPS growth (e.g., for 10 years)
γ = Yield on AAA-rated corporate bonds

The last variable, which is ostensibly the risk-free rate of return, was estimated at 5%. Using the last five years as a guide, I estimated EPS growth as follows: 20% for INTC and CSCO, 15% for HXP and MSFT. This part of the analysis is subjective and could easily lead to lots of discussion. Here are the results:

  • Intel: Estimated intrinsic value is $50.40/share, about 148% above current levels
  • Cisco Systems: Estimated intrinsic value is $55.10/share, about 134% above current share price
  • Hewlett-Packard: Estimated intrinsic value is $90.80/share, about 117% above current share price
  • Microsoft: Estimated intrinsic value is $28.56/share, about 61% above current levels

Based on this, it looks like Intel is much more undervalued than Microsoft, with Cisco and Hewlett-Packard somewhere in between.

For the most part, these companies are still growing robustly, which is reflected by their high intrinsic value. They are hardly the cigar butts that Warren Buffett talks about. Even at 10% EPS growth, the stocks are priced below their intrinsic value.

None of the stocks meet the P/E and price/book criteria, with Intel and Hewlett-Packard come the closest. To really get in the value stock comfort zone, P/E<12 style="font-weight: bold;">Conclusions

None of the four stocks are priced at value stock levels. While they’re all strong, stable and mature companies, their prices still reflect plenty of future growth. This is very interesting given that the prices for these companies have for the most part been flat since the dotcom bust. What has this accomplished? It has allowed earnings to catch up with share price. To be considered real bargains, shares of Intel and Hewlett-Packard would have to drop about 30%. Cisco and Microsoft would have to drop even more.

Disclosure: The author has no positions in the four stocks mentioned in this article.