I’m sorry, but I don’t get the rally in Hewlett-Packard Company (NYSE:HPQ) shares. In just the last month, shares are up more than 35% because of “better than expected results.” Let’s get this straight, the company comes out and says it’s going to do terrible, but when they do less terrible than they thought, the stock is suddenly worth 35% more? I’m not buying this rally and there are four numbers that say investors should take profits now.
You Either Spend In This Area, Or You Get Left Behind
There is one category of spending that separates the industry leaders from the pretenders in the technology sector. Companies that spend on research and development have a much higher probability of success than those that don’t. If you want proof of this, look at a comparison of the R&D spending at the leaders Cisco Systems, Inc. (NASDAQ:CSCO) and EMC Corporation (NYSE:EMC) and the pretenders Hewlett-Packard Company (NYSE:HPQ) and Dell, Inc. (NASDAQ:DELL).
In the networking and storage industries, Cisco and EMC dominate their competition. Both companies are able to maintain their dominance because they spend money on R&D. In fact, Cisco spent 12% of their sales on R&D in the current quarter, while EMC spent 10.99% of their sales. By comparison, Hewlett-Packard and Dell spent 2.8% and 2.14% of their sales on R&D respectively. It’s no surprise that these two companies have fallen on hard times recently. In the technology field, if you don’t invest in future growth, you can’t compete.
Low R&D Spending = Lower Margins
A direct result of spending less on R&D is lower margins. If a company invents a unique product they should be able charge a higher price. Companies that play the “me too” game, and just create similar products, have to compete on price.
Many technology companies are increasing their focus on the enterprise space, as growth has been better in this sector. Dell has been pushing to grow in the enterprise business, but their operating margin of just 5.29% is the lowest of their peers. The company’s lack of R&D spending could be a key reason. Hewlett-Packard Company (NYSE:HPQ) is only doing slightly better with an operating margin of 7.9%, which was down from 8.6% last year.
Looking just at Hewlett-Packard’s enterprise business, their operating margin in this division was 15.5% in the last three months. By comparison, the enterprise focused Cisco Systems, Inc. (NASDAQ:CSCO) and EMC reported operating margins of 23.05% and 21.04% respectively. I have to believe it’s Cisco and EMC’s heavy R&D spending, that leads to the pricing power their margins suggest.
Lower Margins Can Also Come From Too Much Inventory
There aren’t many industries where too much inventory isn’t a big deal. When a company has relatively more inventory than their peers, investors should worry.
If we look at Hewlett-Packard Company (NYSE:HPQ)’s inventory versus their current quarter sales, they have the highest percentage of inventory to sales of their peer group. The company with the most efficient use of inventory is Dell, with inventory at 9.65% of current quarter sales. Cisco Systems, Inc. (NASDAQ:CSCO) and EMC come in second and third, with 13.01%, and 19.92% of inventory to sales. Hewlett-Packard comes in last, with a 22.54% inventory to sales percentage.
With potentially too much inventory, it’s possible Hewlett-Packard will see their margins compress further. If the company has to cut prices to clear out this excess, the company will make less money, hurting earnings and cash flow.
Price Cuts To Clear Inventory = Lower Cash Flow
Hewlett-Packard said that operating cash flow increased, but smart investors should do the math themselves. If you look at Hewlett-Packard’s net income plus depreciation, or what I call “core cash flow,” this measure was actually down 13.57% year-over-year.
The only reason the company could report operating cash flow increased, was because of a $686 million lower adjustment in Accounts Payable. Since this adjustment is a non-cash change on the balance sheet, this isn’t the great news the company seemed to think it was.
The Worst Value Of The Bunch
Hewlett-Packard Company (NYSE:HPQ) stock may sell for only 6.5 times earnings, but they also are expected to see EPS contraction in the next few years. The company’s 2.32% yield is well supported with a free cash flow payout of just 14.64%. However, ask yourself this, do you really want a company paying a 2.32% yield that is expecting negative growth?
Dell may be taken private, but I don’t believe at the price that has been put forth. The stock sells for just 9 times earnings, and EPS is expected to grow by 8.43% in the next few years. When you add a 2.26% yield to the mix, the value seems appealing relative to Hewlett-Packard.
Long-term investors should give serious consideration to Cisco and EMC. Both companies lead their industries. Both companies spend a significant amount on R&D, and have leading margins. Cisco Systems, Inc. (NASDAQ:CSCO) pays a 2.56% yield and is expected to grow at 8.4%, and EMC is expected to grow even faster at 13.23%.
The bottom line for Hewlett-Packard Company (NYSE:HPQ) investors is, this rally is probably short lived. A company with low R&D spending, low margins, negative growth, and too much inventory, is just not a bet I would make.
The article 4 Numbers Say This Rally Is Short Lived originally appeared on Fool.com and is written by Chad Henage.
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