Why HP stock prices outperformed Dell despite Dell's Super Financials

Summary:

l  Dell’s Return on Sales (ROS), Return on Invested Capital (ROIC), Inventory Turnover, and Working Capital needs all exceeded over HP.

l  This is due to a difference in Dell’s corporate strategy from HP.

l  However, HP’s stock prices outperformed Dell, because of its new business integrated services. This predicts that although in the past Dell’s financials outperformed HP, HP’s ROIC will keep expanding because of the new product and in the future will outperform Dell.

1)    Why is Dell’s Return on Sales more than double that of HP? Because of its strategic choices about R&D and SG&A.

Dell’s ROS (Return on Sales) at 6.39% is more than double that of HP at 2.77%.

This is not because Dell is charging customers a higher markup over its cost of goods sold. Dell’s COGS/sales ratio is higher than HP’s in fact. This suggests that Dell is pricing its products aggressively- that is, they are not being cheap.

However, Dell spends far less on SG&A expenses and on R&D than its rival, HP. This reflects Dell’s choices about where it is spending its money and about its strategies.

Because Dell sells direct, it does not have a big sales forces; hence its SG&A expenses are much lower than HP’s. In addition, Dell has decided not to spend heavily on R&D primarily because it sees itself as being a commodity business. In Dell’s view, R&D is something that its suppliers, such as Intel and Microsoft undertake.

2)     Why the difference in the Return on Invested Capital?
Now let’s have a look at the difference in capital turnover (or return on invested capital). Here, the difference is striking. Dell generates $12.07 of sales for every dollar of capital invested. However, HP makes just $2.14 of sales for every dollar invested. This difference drives most of the difference in ROIC.
Why is Dell so much more efficient than HP in Return on invested capital? There are two reasons:

First, Dell undertakes only final assembly with everything else being outsourced to suppliers. Consequently, it has to invest less in property, plant and equipment (PP&E) than HP.  

Second, Dell is efficient at managing its inventory, which is why its working capital to sales ratio is so much lower than HP’s. This is because Dell sells direct. It can build to order, and it does not have to fill a retail channel with inventory. Moreover, it takes order information received over its website, and through telephone sales, and transmits that instantaneously to suppliers located throughout the world, who then adjust their own production schedules accordingly.

3)    Dell’s Overall Strategy is reflected in rapid inventory turnover

Dell coordinates the entire process so that parts arrive at Dell’s factories just when they are required and not before. There they are quickly assembled into machines and then shipped out. As a result, Dell turns over its inventory much more rapidly than HP does – 88.81 times a year in 2005, compared to just 9.5 times a year at HP.

4)    Dell's Working Capital Needs are lower

Dell’s working capital requirements are reduced even further because many of its customers pay by credit card, and those cards are charged when a machine leaves Dell’s factory, which is long before Dell has to pay its suppliers, enabling Dell to use this money to finance its day-to-day operations. In contrast, due to its lower inventory turnover, HP probably has to pay its suppliers before it receives money from the sale of machines, which raises the companys’ need for working capital.

5)    Despite all these differences resulting in profitability, HP’s stock price outperformed Dell because of its business integrated services. This predicts that HP’s ROIC will eventually expand while Dell’s ROIC will contract.

Despite Dell’s superior profitability, in 2005 and 2006, HP’s stock price outperformed that of Dell. The reason: Dell’s profit growth stalled in 2005 and 2006., whereas HP’s was accelerating, suggesting that down the road, Dell’s ROIC will contract while HP’s will expand. HP was gaining ground on Dell because it could offer business integrated services, which went beyond supplying computer hardware, to embrace designing and installing entire corporate information systems, including software.