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Dodge & Cox Finds Value in Tech: Microsoft and HP

Dodge & Cox is a mutual fund firm with over $200 billion in assets under management. Founded in 1930, the firm has historically maintained a long-term investment horizon. Dodge & Cox employs rigorous price discipline, avoiding popular choices that come at price premiums. Instead, the firm continually focuses on the long term, emphasizing a company's underlying fundamentals to find investment opportunities. The firm undertakes rigorous research before selecting its stocks. It selects securities based on the their valuation whilst striving to maintain portfolio diversification. The firm believes that low valuation investments typically reflect low expectations that buffer against significant price decline, providing potential for capital appreciation should investor pessimism turn out to be unwarranted or short-lived. Although Dodge & Cox's Stock Fund has underperformed the S&P in recent years, its ten-year cumulative return of 68.8% trumps the S&P's return of 16.4% during the same stretch. In its second quarter portfolio update, Dodge & Cox added to its holdings in Microsoft (NASDAQ:MSFT) and HP (HPQ).

Microsoft (NASDAQ:MSFT)

Dodge & Cox initiated its current position in Microsoft in the first quarter of 2011, purchasing 22.3 million shares at an average price of $27. In its most recent move, the firm nearly doubled its position, adding another 94.33% to its holdings at the average price of $25.04 to bring total shares to 43,352,521. The move impacted Dodge & Cox's portfolio by 0.64%.

Microsoft develops, manufactures, licenses, and supports a wide range of software products for a multitude of computing devices. Microsoft software includes scalable operating systems for servers, personal computers, and intelligent devices; server applications for client/server environments; knowledge worker productivity applications; and software development tools.

According to Microsoft's fourth quarter report for the period ended June 30, revenue was a fourth quarter record of $17.37 billion, up 8% over last year. For the fiscal year, revenue was $69.94 billion, up 12% over last year. Strong sales in Server and Tools products, the 2010 Microsoft Office system, and the Xbox 360 platform helped lead the revenue increase in both the quarter and the fiscal year, partially offset by lower Windows revenue. Operating income was $6.17 billion for the quarter and $27.16 billion for the year, up 4% and 13% respectively as a result of the revenue increase though operating costs increased. Cost of revenue increased 17% in the quarter and 26% for the year, due to higher costs associated with online offerings, and increased volumes of Xbox 360 consoles and Kinect sensors sold. Overall, net income increased 30% to $5.87 billion for the quarter, and net income for the year was $23.15 billion, up 23% over last year.

Among Microsoft's different business fronts, Microsoft Business Division revenue grew 7% in the quarter and 16% for the year as Office 2010 sales continued their strong performance. Server & Tools revenue grew 12% in the quarter and 16% for the year, the fifth consecutive quarter of double-digit growth, led by Windows Server, System Center, and SQL Server. Windows and Windows live Division revenue declined 1% for the quarter and decreased 2% for the year, largely due to the impact of the prior year Windows 7 launch. Online services Division revenue grew 17% in the quarter and 15% for the year, driven by increases in search revenue. Bing's U.S. search share increased 340 basis points year-over-year. Entertainment & Devices Division revenue grew 30% in the quarter and 45% for the year, carried by the ongoing momentum of the Kinect console and Xbox Live.

Microsoft generated $5.3 billion in free cash flow in the quarter, up 9.4% over last year's $4.8 billion. Overall, the company generated $24.6 billion in free cash flow for the year, up 11.5% over last year's $22.1 billion. Capital expenditures totaled $2.4 billion, up slightly over last year's $2.2 billion. The company's debt-to-equity ratio was .209, improving slightly from last quarter's .223, while the company holds $50 billion in cash on its balance sheet. Return-on-equity was 41.2%, slightly up over last year's 40.6%.

Microsoft has a market cap of $212 billion. Its stock trades with a P/E ratio of 9.5, below its ten-year average. Its P/S ratio is 3.1, also below its ten-year average. Quarterly sales per share have been increasing over the past decade, causing its P/S metric to decline over the same stretch. Its P/B ratio is 3.8, near a ten-year low, and book value per share has almost climbed back to its 2004 peak. GuruFocus has awarded Microsoft a predictability rating of 4.5-stars.

On 8/15/2011, Google (GOOG) announced that it has entered an agreement to purchase Motorola Mobility (MMI) for $12.5 billion. This has fueled speculation as to whether Microsoft will make a move on to acquire a hardware developer in order to match Apple's (AAPL) and Google's model of developing both the hardware and software aspects of their smartphones. Currently, Microsoft has an agreement with Nokia (NOK) when the latter agreed to make Windows 7 OS phones. The move also puts Microsoft in legal conflict with Google over Android patents, as Microsoft and Motorola are already involved in a number of claims on each others' technology.

Hewlett-Packard Company (HPQ)

Dodge & Cox initiated its current position in HP in 2001. By 2006, the firm held more than 125 million shares of HP when the average price was around $32. Between late 2006 and early 2010, Dodge & Cox sold off more than 55 million shares as the price of the stock climbed to highs of $51 on two separate occasions. Since the second quarter of 2010, the firm has been adding to its position. In the first quarter of 2011, Dodge & Cox added 17,970,474 shares at an average price of $44.63. In its most recent move, the firm added another 12,694,973 shares of HP at an average price of $38.06, impacting its portfolio by 0.54% and giving it a total of 105,166,453 shares of the company. The price has since plummeted by more than 30% following its earnings report this past Thursday.

Hewlett Packard is one of the leading global providers of computing and imaging solutions and services for business and home. The company is focused on capitalizing on the opportunities of the Internet and the proliferation of electronic services. Its major businesses include Imaging and Printing Systems, Computing Systems, and Information Technology Services.

HP made significant headlines this past Thursday, announcing that it will shut down its mobile devices business, pay $10 billion for business software maker Autonomy Corp., and possibly spin off its PC business. This was part of the company's transformation plans to "move HP into higher value, higher margin growth categories; sharpen HP's focus on its strategic priorities of cloud, solutions, and software with an emphasis on enterprise, commercial, and government markets; and increase investment in innovation to drive differentiation." The strategy will take "several quarters" to implement as the company considers the effects of tablet sales on PCs. If HP does indeed spin off its PC business, it will effectively leave the consumer market and adopt a business model similar to that of IBM's (NYSE:IBM).

HP announced it will discontinue its webOS devices, specifically the TouchPad and webOS phones, which "have not met internal milestones and financial targets." HP acquired webOS last July in a $1.8 billion deal with Palm. The company will incur a $1 billion charge to write-off with the hardware businesses, concluding HP's unsuccessful attempts to enter the smartphone industry as webOS devices failed to make waves against the more popular iPhone and Android devices.

HP stated that it will "continue to explore options to optimize the value of webOS software," though it may be challenging to find a hardware company to license webOS as multiple other platforms are available, including Google's Android and Microsoft's Windows Phone. Companies may also be averse to purchasing webOS knowing that it would require substantial effort in the form of popular devices and strong marketing to compete with Apple, Google, and possibly even Microsoft, given webOS's lack of sway on consumers. One upside for HP is that it might be able to sell webOS and Palm patents, as recently companies have paid significant premiums for intellectual property, including Nortel's $4.5 billion patent sale and Google's $12.5 billion purchase of Motorola.

HP also announced that it would acquire Autonomy Corp. for roughly $10 billion. Autonomy's software should help HP's renewed focus on its enterprise business, as its addition will "accelerate HP's ability to deliver on its strategy to offer cloud-based solutions and software that best addresses the changing needs of businesses." HP will be paying 64% more than Autonomy's close yesterday, a significant premium to its market price that is causing initial reactions to question whether HP is overpaying for the acquisition.

Finally, HP announced that it will explore "strategic alternatives for the company's Personal Systems Group," which includes the possibilities of a spin-off or a sale of its PC division. PC sales make up approximately 30% of HP's revenues and 16% of its net income, although its PC segment generates the lowest profit margins. HP became the market leader in PC sales after acquiring Compaq Computer for $19 billion in 2002. However, with the emergence of Apple's iPad, tablet sales have significantly cut into PC and laptop numbers, and worldwide PC sales have slowed down in past months. Shedding the PC division would improve the company's overall margins and mark its exit from the fiercely competitive PC market, signaling HP's shift away from consumer devices towards software and enterprise. Ultimately, it is unclear whether or not HP will ultimately make such a move, as it is only considering the possibility for now.

According to HP's third quarter report for the period ended July 31, net revenue was $31.2 billion for the quarter, up 1% over last year although down 2% when adjusted for currency. Net earnings was $1.9 billion, up over last year's net earnings of $1.8 billion. Diluted EPS was $0.93, up over last year's diluted EPS of $0.75. However, excluding amortization of purchased intangibles, restructuring charges, and acquisition-related charges, adjusted net earnings actually decreased to $2.3 billion, down from last year's $2.6 billion. Adjusted diluted EPS was $1.10, a slight increase over last year's $1.08.

HP's Commercial businesses saw revenue growth of 5% year-over-year, but HP's Consumer businesses were collectively down 15% year-over-year. Among the different business groups, Services revenue grew 4%. Enterprise Servers, Storage, and Networking (ESSN) revenue grew 7% over last year, with Networking, Industry Standard Servers, and HP Storage growth offsetting decreases in Business Critical Systems. ESSN revenue also benefited from triple-digit 3PAR revenue growth, which HP acquired last year for $2.35 billion. HP Software revenue grew 20%, driven by strong growth in licenses and services of 29% and 30% respectively. Personal Systems Group revenue decreased 3%, with Commercial Client revenue up 9% and Consumer Client revenue down 17%. Imaging and Printing revenue declined 1%, with Commercial revenue down 7% on 1% unit growth and Consumer printer hardware revenue up 1% on 7% unit growth. Finally, Financial Services revenue grew 22%, driven by double-digit growth in lease volume and improvement in portfolio assets.

HP generated $3.2 billion in cash flow from operations in the third quarter, up over last year's $2.2 billion. Inventory ended the quarter at $7.4 billion, with days of inventory flat year over year at 28 days. Accounts receivable of $18.1 billion was up 6 days year over year at 52 days. Accounts payable ended the quarter at $14.5 billion, down 3 days from the prior-year period. During the quarter, HP repurchased approximately 128 million shares of common stock for $4.6.

HP stock prices fell tremendously over the past two days following news of its dramatic strategic changes. HP has a market cap of $49.0 billion. The stock trades with a P/E ratio of 5.8, a new historical low, and its P/S ratio of 0.5 is also near its historical low. Its P/B ratio is 1.5, nearing its historical low as well.

This is part of GuruFocus Real Time Picks report, which reports the stock trades of Gurus within the last few days. For more information, go to Real Time Picks.

Rating: 2.7/5 (11 votes)


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