STATE

OF TECH
REPORT:
PERSONAL
COMPUTERS

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Q2 2010 State of Tech Report

Personal Computers (PCs)
July 1, 2010
Paul McWilliams, Editor

As I’ve noted in the past, it’s pretty hard to call Hewlett Packard (HPQ) just a “PC manufacturer.”
And, due to the way Apple Computer (AAPL) has evolved, which led the company to drop its last
name, “Computer,” a few years ago; it’s probably not appropriate to consider it a PC company
either. I guess for that matter Dell (DELL) sells enough other stuff to where calling it a PC
company probably doesn’t make sense either.

Actually, what would probably make more sense here is to term these companies as “ecosystem”
business models. An ecosystem model must have two things. First, it has to be vast in both
scope and scale and in the depth that it permeates the company operating model. Second, it has to
provide multiple points of bidirectional leverage – in other words, leverage points have to work both
ways. The problem is, by these definitions, we could not yet place DELL in the same category as
AAPL and HPQ. While working towards an ecosystem goal and, in fact, making some progress, DELL
is simply not there yet. Therefore, for the time being, we’ll maintain the title “Personal Computers.”

Q1 Q4 Q1 Y/Y Sequential
2009 2009 2010 Change Change
Sales $48,777 $61,760 $59,222 +21.4% -4.1%
Gross Profit Margin 25.2% 26.2% 26.2% +3.7% -0.2%
Operating Profit Margin 12.3% 15.4% 14.7% +19.8% -4.6%
1
Operational Leverage $1.95 $2.42 $2.28 +17.1% -5.9%
NTA / Debt $1.23 $1.89 $1.85 +50.0% -2.5%
Cash / Debt $2.27 $2.48 $2.16 -4.8% -12.8%
NTA / Share $4.93 $7.10 $7.78 +57.9% +9.5%
2
Days of Inventory 17.3 16.5 17.2 -0.2% +4.2%
1. Operational Leverage is a ratio that shows the number of non-GAAP gross profit dollars generated for each non-GAAP
Operating Expense dollar the company invests.
2. Lower inventory levels are generally thought to be favorable. Due to this, declines are shown in green and increases
are shown in red.

Revenue ($ Millions) Gross Profit Margin

Q1 Q4 Q1 Y/Y Sequential Q1 Q4 Q1 Y/Y Sequential

2009 2009 2010 Change Change 2009 2009 2010 Change Change
AAPL $9,084 $15,683 $13,499 48.6% -13.9% 40.2% 41.1% 41.4% 2.9% 0.7%

DELL $12,342 $14,900 $14,874 20.5% -0.2% 17.6% 17.4% 17.6% 0.0% 1.1%
HPQ $27,351 $31,177 $30,849 12.8% -1.1% 23.7% 23.0% 23.7% -0.2% 3.0%

Totals $48,777 $61,760 $59,222 21.4% -4.1% 25.2% 26.2% 26.2% 3.7% -0.2%

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Operating Profit Margin Operational Leverage1

Q1 Q4 Q1 Y/Y Sequential Q1 Q4 Q1 Y/Y Sequential
2009 2009 2010 Change Change 2009 2009 2010 Change Change
AAPL 27.6% 31.4% 30.6% 11.2% -2.5% $3.17 $4.25 $3.85 21.3% -9.4%

DELL 3.8% 6.0% 6.1% 59.2% 0.3% $1.28 $1.53 $1.52 19.4% -0.4%
HPQ 11.0% 11.8% 11.9% 7.9% 0.5% $1.87 $2.06 $2.01 7.5% -2.4%

Totals 12.3% 15.4% 14.7% 19.8% -4.6% $1.95 $2.42 $2.28 17.1% -5.9%
Note: Changes in operating profits listed as “N/A” indicate one of the numbers used to determine the percentage is negative.
A red “N/A” indicates operating profits went from either positive to negative or to a larger negative. A green “N/A” indicates
operating profits went from a negative to a positive.
1. Operational Leverage is a ratio that shows the number of non-GAAP gross profit dollars generated for each non-GAAP
Operating Expense dollar the company invests.

Net Tangible Assets Per Share1, 2 Days of Inventory3

Q1 Q4 Q1 Y/Y Sequential Q1 Q4 Q1 5-Year Sequential
2009 2009 2010 Change Change 2009 2009 2010 Average Change
AAPL $26.40 $38.35 $41.83 58.5% 9.1% 5.2 5.7 7.4 6.3 1.7
DELL $0.92 -$0.06 $0.07 -92.4% N/A 7.6 7.8 8.8 6.7 1.0
HPQ $0.18 $1.08 $1.03 484.7% -4.8% 25.1 25.2 24.9 32.9 (0.3)
Totals $4.93 $7.10 $7.78 57.9% 9.5% 17.3 16.5 17.2 20.8 0.7
1. Changes in net tangible assets listed as “N/A” indicate one of the numbers used to determine the percentage is
negative. A red “N/A” indicates net tangible assets went from either positive to negative or to a larger negative. A
green “N/A” indicates net tangible assets went from a negative to a positive.
2. The NTA data shown above includes a deduction for deferred revenues that are carried on company balance sheets
as liabilities. The table below, “Valuation Metrics Based on Forward Earnings Estimates and Balance Sheet Metrics,”
excludes deferred revenue liabilities.
3. When it comes to days of inventory, a negative delta to average indicates the current status is lower than the five-
year average. This is good and shown in green.

Performance and Valuation Tables

In the following tables, red is an indication the number is smaller or the ratio is larger than it was the
preceding period. Conversely, green is an indication the number is larger or the ratio is smaller than
it was the preceding period. In other words, green is good and red is bad. Numbers and ratios
shown in black are unchanged from the previous period.
Q1 2010 Performance Review
Q1 2009 Q1 2010 Perform to Price Price Price
Actual Consensus1 Consensus 4/15/10 6/30/10 Change
AAPL $13,499 $12,030 12.2% $248.95 $251.53 1.0%
DELL $14,874 $14,140 5.2% $16.86 $12.06 -28.5%
HPQ $30,849 $29,800 3.5% $54.23 $43.28 -20.2%
Totals $59,222 $55,970 5.8% $320.04 $306.87 -4.1%
1. The consensus shown is either the midpoint of the guidance provided by the company or the consensus opinion of the
covering analysts.

Paul McWilliams recommended 3Par and Isilon to his readers more

than two months ago. Both have produced triple-digit gains since
then. CLICK HERE for more actionable tech ideas in Next Inning
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Q2 2010 Performance Preview

Q2 2009 Q1 2009 Q2 2010 Consensus Sequential Y/Y
Actual Actual Consensus1 Change2 Change Change
AAPL $8,337 $13,499 $14,151.0 $1,199.1 4.8% 69.7%
DELL $12,764 $14,874 $15,150.0 $717.0 1.9% 18.7%
HPQ $24,451 $30,849 $30,030.0 $280.0 -2.7% 22.8%
Totals $45,552 $59,222 $59,331 $2,196 0.2% 30.2%
1. The consensus shown is either the midpoint of the guidance provided by the company or the current consensus
opinion of the covering analysts. If neither data point is available, the revenue is shown as flat and consensus
change is shown as “N/A.”
2. The consensus change shows the dollar amount (in millions) that the current quarter consensus has changed during
the last 90 days.

Valuations Based on Forward Earnings Estimates and Balance Sheet Metrics

Forward Consensus Price Forward NTA / NCA / Net Cash /
EPS Change 6/30/10 P:E Share2 Share3 Share4
AAPL5 $16.14 +$2.68 $251.53 15.6 $45.61 $39.73 $45.20
DELL6 $1.27 +$0.06 $12.06 9.5 $3.18 $1.71 $3.51
7
HPQ $4.97 +$0.07 $43.28 8.7 $3.74 ($5.60) ($1.45)
1. Forward EPS is based on the consensus of the covering analysts for fiscal years ending between December 2010 and
October 2011. AAPL’s fiscal ends in September 2010, DELL in January 2011 and HPQ in October 2010.
2. NTA (Net Tangible Assets) is calculated by subtracting goodwill and intangible assets from shareholder equity.
3. NCA (Net Current Assets) are calculated by subtracting total liabilities from total current assets. This is often a more
meaningful figure than net cash.
4. Net cash is calculated by adding total cash and cash equivalent current assets and subtracting from that total, all
debt.
5. AAPL’s NTA and NCA exclude $3.77 in deferred revenue liabilities. In addition to this, its NCA and Net Cash include
$20.11 in long-term (non-current) investments.
6. DELL’s NTA and NCA exclude $3.11 in deferred revenue liabilities. In addition to this, its NCA and Net Cash include
$0.36 in long-term (non-current) investments.
7. HPQ’s NTA and NCA exclude $2.71 in deferred revenue liabilities.

Forward Valuations Based on Revenue and Dividend Yield

Price TTM TTM PS Forward Y/Y Forward Annualized Dividend
6/30/10 Revenue Ratio Revenue1 Change PS Ratio Dividend Yield
AAPL $251.53 $47,389 4.9 $71,400 50.7% 3.3
DELL $12.06 $55,434 0.4 $61,550 11.0% 0.4
HPQ $43.28 $117,254 0.9 $131,000 11.7% 0.8 $0.32 0.7%
$306.87 $220,077 $263,950 19.9%
1. TTM (Trailing Twelve-Month Revenue)
2. Forward Revenue is based on the consensus of the covering analysts for the fiscal year ending between December
2010 and October 2011. AAPL’s fiscal ends in September 2010, DELL in January 2011 and HPQ in October 2010.
3. The Trailing and Forward Price to Sales Ratios are calculated by dividing the share price shown by the Trailing and
Forward revenue per fully diluted share.
4. Dividend yield is calculated by annualizing the most recent dividend payment made in 2009 and dividing the result by
the share price shown. There is no assurance that the same or any dividend will be paid in the future.

Enterprise Trends

There has been a distinct reversal in priorities for U.S. CIO (Chief Information Officers) during the
last year. A year ago, the Information Week Survey of CIOs showed cutting costs was the high
priority (40%). This year that is down to 32% and the percentage of CIOs saying their priority is to
take a leadership role in product and/or service introductions has doubled from 18% to 36%. This
was the second highest priority behind making IT more efficient (48%). The short story here is CIOs
are on the offensive and have the budgets needed to support the strategy.

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I’ve talked to the CTO from Vanguard Funds and from Nebraska Book Company, a $650M company
that services nearly hundreds of college and university book stores. The theme is the same –
virtualization, Intel (INTC) x86 upgrades and leveraging information for new services.

How are they going to do it? 40% say they will improve collaboration, 34% say they will upgrade
desktop PCs, 31% will consolidate applications (more data center centric services) and 30% will
increase virtualization (once you try it you’re hooked).

These trends play in very well with a number of the products and services the companies below sell
– even Apple (AAPL) will benefit from Vanguard’s new policy that allows employees to initiate and
respond to official company communications via their personal iPhone.

The short story here is, due much to government policies that make it difficult to calculate costs and
risks, employers are not hiring like they normally would at this stage of the recovery. Since demand
and opportunities to grow are expanding, companies are instead increasing IT capabilities that drive
revenue and improve productivity. While there is no doubt this trend could come to a screeching
halt, which seems to be what Wall Street is predicting, I’m hard-pressed to find a tech company that
says it has seen a material drop in demand and most say that demand remains strong or better.

Company Commentary
In the following commentary I’ve ranked investments in one of three categories: Strategic
Investments, Speculative Investments or No Investment.

In general, a Strategic Investment is one that I believe has long-term merit. A Speculative
Investment, on the other hand, is one that I think has upside, but lacks one or more of the
ingredients necessary to qualify as a long-term holding. Please note, all equity investments carry
varying amounts of risk and just because I view a stock as having good strategic (long-term)
potential does not mean or imply it is less risky than a stock that I’ve ranked as speculative. Stocks
ranked as “No Investment” either carry what I view as an unfavorable balance of risk and potential
reward or are ranked as such due to my limited insight.

Personally, in the case of a speculative investment I'll tend to hedge using covered calls, thin or
maybe even sell as it moves to the high side of my estimated fair value range. The message here is
the speculation worked and unless there is a fundamental change, it's time to declare victory. This
doesn't mean the price won't go up further - it just means that I don't have data to support the
contention such a rise is merited.

In the case of a strategic investment, I'll tend to tolerate more volatility including over-shoots of my
fair value range. That said, I may over-allocate to a strategic investment (buy trading or speculative
shares). In those cases, I treat those shares (that allocation) as I would a speculative investment.

Apple (AAPL) – Strategic Investment: The price of AAPL is up 182% since being suggested as a
good strategic investment in our report, “Undervalued Tech Stocks for 2009.” That is an amazing
return when you consider the fact that at a market capitalization of $229B, AAPL’s value is the
second highest of all the stocks traded on major U.S. stock exchange. During the last quarter, AAPL
surpassed Microsoft (MSFT) and trails now only Exxon Mobile (XOM).

Number four on the list is General Electric (GE), the only company that was an original member of
the Dow Jones Industrial Average (DJIA) that is still a member of the DJIA yet has a market
capitalization 10% below AAPL’s. Another way to view the magnitude of AAPL’s performance since
we called it a strategic buy is to consider the $147B in value AAPL gained is considerably more than
the combined $125B market capitalization of Dell (DELL) and Hewlett Packard (HPQ). Yet
another way to put this in perspective, the market value of AAPL is roughly equal to the 2009 GDP of
Ireland and larger than the GDP of either Israel or Hong Kong.

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The reason this analysis is important to consider is it gives us perspective. Last quarter I shared
similar metrics with Next Inning readers for the same purpose and pointed out that if the price of
AAPL were to double again its market capitalization value would exceed XOM and that it would be the
most highly valued company in the world. I also noted that somewhere between here and there we
would probably see regulators find reasons to penalize AAPL. Interestingly, during the last quarter
the press is already putting AAPL on trial and regulators are starting to rattle sabers. Sure, we love
a success, just not too much of it and given AAPL’s stead in life, its biggest threat probably isn’t from
Google (GOOG) and its Android operating system, but from regulators finding reasons to stifle
AAPL.

The short story on AAPL is Wall Street has finally caught on to the story and, as a result, pushed the
price of AAPL to where it now trades smack in the middle of the estimated fair value price range I
outlined 90 days ago. Ironically, it was only 18 months ago when I wrote about how Wall Street was
failing to grasp the FASB (Federal Accounting Standards Board) rules that were causing AAPL to push
an absolutely huge percentage of its operating profits into deferred revenue accounts and, to make
matters worse, since AAPL had already collected the cash on these earnings, list the deferred
revenue as a liability on AAPL’s balance sheet. It wasn’t until six or so months later that this very
thing became the hot topic on Jim Cramer’s Mad Money TV show.

My point, which I repeated more frequently than made me comfortable and has since been proven to
be correct, was that we should value AAPL’s value not by arbitrary FASB rules, but by its real
earnings and real balance sheet value. As we subsequently learned, the FASB finally came to its
senses towards the end of 2009 and changed the nonsensical rule.

Sadly, even with this knowledge in hand, Wall Street analysts were still missing the story. As we
moved into the January earnings season the forward earnings consensus for AAPL stood pitifully at
only $7.79. My non-GAAP estimate, which was included in our State of Tech report published last
December was $12 and, based on that, the midpoint for my estimated fair value range stood boldly
at $243. After AAPL blew away the consensus in its calendar Q4 report (reporting even above my
lofty expectations), Wall Street lifted its full-year earnings consensus to $11.73 and I raised my view
to $13.00. As it turned out, AAPL blew out expectations again in its calendar Q1 report leading Wall
Street to lift its consensus again to $13.67; I’ve boosted my estimate to $14.55, but fully expect I’ll
have to raise that again when AAPL reports something around $3.50 to $3.75 for the June quarter.

While it’s tough to guess exactly how regulators will interfere with AAPL’s business model, amazingly
enough the points of leverage are just now beginning to line up. With huge successes now in cellular
handsets (iPhone) and tablet computing (iPad) as well a vibrant applications and entertainment
download business, AAPL is now ready to add the leverage point of mobile broadcast, narrowcast and
location based advertising / cross branding. This means the AAPL model will build around
advertising and the leverage it can develop from that. This also means that AAPL is a growing threat
for GOOG.

In our valuation estimate we’ll start with fiscal 2010 and use the $13.67 consensus at the low end
and my $14.55 at the high end. In an effort to keep things towards what I think is the conservative
side of the street, I’ll use valuation multiples ranging from 15 to 17 (down one from 16 to 18 last
quarter) times these estimates and add to the resulting number the adjusted net current asset value
shown in the table above. This results in an estimated fair value range (rounded to the nearest
dollar) running from $245 to $287 with a midpoint of $266. However, if we move up to use just the
$16.14 consensus for fiscal 2011 (ends September 2011), the range steps up to $282 to $314 with a
midpoint of $298.

Bottom Line AAPL: About seven months ago, long before Google (GOOG) launched its Nexus
One handset or AAPL made a meaningful purchase in the mobile advertising sector, I wrote that we
would see these two companies more rapidly towards becoming serious competitors. I think this

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trend will accelerate going forward and that in areas where the two compete, AAPL will more often
than not be the victor.

Dell (DELL) – Speculative Investment: After suggesting that readers sell DELL in January 2006
when the stock was trading for roughly $30 and maintaining a bearish view on the stock for nearly
three years, I acknowledged that the stock was being undervalued in December 2008 at its then
current price of $11.68 and stated that there was clearly room for speculators to jump in. Readers
who sold at my $17 target enjoyed a 46% profit, but those who held are up only a scant 3.2%.

Based on my stated belief that DELL would outperform both the consensus for its January quarter
and guide comfortably above the consensus for the April ending quarter, I wrote in our December
State of Tech report that I thought we would see the price of DELL move up from its then current
price of $14.79 to somewhere between $17 and $19. Ahead of our Q1 State of Tech report, DELL hit
a high of $17 on April 16th. I stated then that the easy money had been made and investors holding
for the next leg up would be accepting higher relative risks. DELL went on to hit a 2010 high of
$17.51 the next week before dropping back into the low teens.

If we look back a decade ago when DELL was in fact the king of the PC hill or even as recently as five
years ago, DELL’s greatest strength was its operating model – as a matter of fact that was its
strongest point of differentiation. To put this in perspective, in 2000 DELL often bragged that its
business model was to wait until a product class grew so large that it was a pure commodity; only
then would DELL consider entering the game and, by implication, rule it as it did the predominately
desktop PC market at the time.

While DELL is still an extraordinarily powerful and capable company, it has lost its lead in the PC
market and totally dropped the idea that it can rule the world with only an operating model. In
reality, what happened here was really simple; DELL created an operating model designed to support
desktop PC’s and when the preferences in the PC world shifted to portable PC’s, DELL lost its
leverage and, with it, the position as the sector leader.

In my view, DELL recognized its plight a couple years ago and has been working towards a solution
ever since. DELL would like to strip back the fixed costs of manufacturing capacity that once gave it
strength and now drag on its bottom line, but who wants to buy it? DELL would also like to develop
a footprint in the services business that could rival industry leaders Hewlett-Packard (HPQ) and
IBM (IBM), but considering the huge premium DELL paid for Perot Systems, that will be a long and
bumpy road. However, there are four intersecting factors that I believe will work to DELL’s favor in
2010.

First and foremost is the rising tide of high PC demand that I believe will continue. Second is the
fact that we are entering what I think will prove to be a very robust corporate PC renewal cycle.
While the road warriors working for corporations will undoubtedly want the latest laptop, the workers
relegated to the cube-farms will get new desktop units. While the rising tide of notebooks will
benefit all suppliers including DELL, the thrust in desktop purchases should benefit it considerably
more. However, as I wrote last April, the then current $17 price clearly stated that Wall Street had
finally arrived at a similar conclusion.

The price of DELL spiked in early June when CEO and founder, Michael Dell, boldly stated that he was
considering taking the company private. However, it fell off just as quickly when we learned that
DELL would restate its April quarter results to include a $100M settlement with the SEC. It
weakened further with news that its manufacturing partner, Foxconn responded to complaints of low
wages and poor working conditions with a promise that it would radically raise wages for qualified
workers and take steps to improve both working conditions and living arrangements for its hundreds
of thousands of laborers who live in company dorms. DELL has come under further pressure this
week regarding allegations it covered up material faults in some of its PCs that could lead to failure
and, in some cases, fire.

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Bottom Line for DELL: In spite of the drama enveloping DELL today, the stock is trading at a low
enough valuation to where I think there is room for speculation. If we use a forward earnings range
running from the consensus of $1.27 to my estimate of $1.35, and a valuation multiple range of 11
to 13, down from 12 to 14 last quarter, plus adjusted current assets of $1.71, DELL’s estimated fair
value range runs from $15.68 to $19.26 (midpoint of $17.47). Personally, if I were going to
speculate here I would set an exit target somewhat below the $17.47 midpoint.

Hewlett-Packard (HPQ) – Strategic Investment: Including $0.48 in earned dividends, the price
of HPQ is up 25% since it was listed in our report “Undervalued Tech Stocks for 2009” as a good
strategic buy. The simple lesson here is “management matters.” After years of beating its head
against the wall, HPQ finally turned its failed CEO loose and allowed its current CEO Mark Hurd free
rein to turn the monstrous ship around; and by every measure, Hurd has been a resounding success.

If you look back in the Next Inning archives, you’ll see that I jumped on the Hurd bandwagon only
months after he took the job, when HPQ was trading in the mid-$20’s. The simple story here is that
Hurd hit the ground running and after only a few strides it was obvious to me he was making the
right decisions, decisions that would leverage the HPQ assets his predecessor allowed to languish to
the point of decay.

Hurd has since turned HPQ into a viable ecosystem company that rivals IBM (IBM) in the services
business and established HPQ as one of the market leaders in virtually every one of the company’s
major business segments. However, what’s even more important than that is, as we look towards
the future, Hurd has created a viable ecosystem with multiple points of bidirectional leverage that
will fuel the company as it moves more decisively into the data center markets and enters the
handset sector via its acquisition of Palm. What I think is possibly being underestimated here is the
ability these changes will give HPQ to grow profitability notably faster than revenue. While these
new points of leverage will certainly benefit the top line, I think the real strategy here is to capitalize
on the economies of scale and relationships HPQ has well established in ways that will improve its
operating efficiencies and, with that, its non-GAAP operating margin.

Interestingly, we’ve seen the fiscal 2010 (ends October 2010) earnings consensus move up exactly
one nickel during the last quarter. That matches perfectly with the low end of the range I offered
last April. However, while I’m not going to adjust my range, which tops out at $4.54, I continue to
believe that’s where we’ll see HPQ come in at the end of October.

However, we’re far enough through the year now that it’s time to lengthen out focus to fiscal 2011
(ends October 2011). There we can see the consensus sits at $4.97; my early range runs from
$5.10 to $5.30. If we use what I see as a conservative forward valuation multiple range running
from 12 to 14 (down one from 13 to 15 last quarter) times the FY 2011 consensus on the low side
and the high side of my estimate range at the upper end and then adjust the result by the negative
net current asset value, the resulting estimated fair value range runs from $54.04 to $68.60.

Bottom Line for HPQ: At its present price, HPQ trades for only 9.8 times the forward earnings
consensus adjusted for net current assets. If we use the more popular Wall Street adjustment of net
cash, the ratio drops to 9.0. In my view, on an absolute basis, that is too low, but on a relative
basis, it is more or less in line with how we see the broader market being valued today. The short
story here is fear is clearly ruling values and as famous investors running from Warren Buffett to
Peter Lynch have said in the past, the best time to buy quality stocks is when investors are fearful.

Disclosure: At the time of this publication, out of the stocks discussed herein, Paul McWilliams had
long positions in AAPL and INTC. In addition to these, he also had a short position in INTC January
$25 calls.

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