Dell? Not Yet

July 14, 2006 - The Motley Fool By Vitaliy Katsenelson, CFA

Dell (Nasdaq: DELL) is hitting multi-year lows and, at 16 times trailing earnings, is attracting value investors that have coveted the stock from afar for years. Some of this latest decline can be traced to the company's recent downward revision of earnings estimates. And this is precisely the noise that a contrarian investor looks to capitalize on.

But are Dell's problems short-term in nature? Though the valuation appears alluring on the surface, I don't yet own the stock. Here's why.

Almost no recurring revenues With the exception of small service and printer cartridges businesses, Dell has no recurring revenues -- none! To grow a computer business 10% year over year, it has to sell as many computers as it sold last year, plus 10% more -- not an easy task with computer prices on a steady decline.

The upgrade cycle It is the last inning of the usual four-year PC upgrade cycle, and that's not great news. However, Microsoft's (Nasdaq: MSFT) Vista is likely to provide a new engine of growth for computer makers. It shifts a lot of processing from the CPU to the video and network cards, which will -- in theory -- improve the computer's performance. To reap the benefits of improved functionality, users will need to upgrade to brand new, redesigned computers -- great news for Dell. But will consumers and corporations looking to upgrade take a wait-and-see approach to Vista? Or will they install Vista on top of their existing, relatively new PC?

Laptops are still hot Laptops are a bright light in the Dell story for several reasons. First of all, as more and more people switch to laptops from PCs, the upgrade cycle will get shorter -- since a laptop's useful life is about half that of a PC's -- good news for all PC manufacturers. Second, laptops are a less commoditized product. While PCs have been mostly impersonal commodities bought mainly on price or availability, laptops are a more personal product, with features that vary from one manufacturer to another. Dell got the laptops right. And as Wi-Fi becomes more of an everyday staple throughout the world (I assume), laptops could overtake PCs.

Eroding advantage? Dell's competitive advantage as a low-cost producer, which helped the company become what it is today, has been shrinking. But it is still there; Hewlett-Packard(NYSE: HPQ) and its competitors have been squeezing suppliers, becoming much more competitive on price. In Dell's defense, it still has a distribution advantage, since it sells its computers directly to customers, allowing the company to capture extra margin instead of sharing it with distributors and retailers. And it maintains much lower inventories, a very important competitive advantage. Dell is still the only manufacturer with a negative cash conversion cycle -- it sells a computer and doesn't need to pay for the components for more than a month, resulting in great free cash flows.

Converging prices Back when a decent computer would cost a couple thousand dollars (seems like decades ago, doesn't it?), price was a very important factor. But the prices of computers have declined so much that a $30-$50 price difference is not a very persuasive argument to go with Dell versus HP or another respected manufacturer. However, this may be a very U.S.-centric perspective. For consumers and corporations in developing countries -- Dell's source of future growth -- $40-$50 is still a meaningful amount. New products Life beyond computers is uncertain. Dell has done a decent job of expanding beyond computers to printers and ... really nothing else, at least not yet. It is an extremely efficient manufacturer, but not an innovator. It is too early in the game to determine if Dell will succeed or not, but the deck is stacked against it, insofar as it is competing against a new breed of innovative companies like Sony(NYSE: SNE) and Toshiba. Poor customer service To cut costs, Dell has dropped the ball on customer service. I've talked to many people who've had a terrible customer service experience. While I give management credit for realizing the problem and announcing plans to hire more customer service people in the United States, I wonder how this will affect the company's margins. Is the damage irreparable? Not likely. Will it have to spend more money on advertising (further affecting thin margins) to convince consumers that things have changed? We'll see. Financials are still strong Dell has a 58% return on capital, about 15% of its market capitalization is in cash, and its free cash flows are to die for. However, its core earnings, as calculated by Standard & Poor's, stand about 30% lower than reported, thanks to significant stock option expenses. Tempting, but will you regret it in the morning? After reading this, the reader may find that the positives and negatives are pretty close. But two negatives in particular prevent me from buying Dell (at least at this price): lack of reoccurring revenues and a good possibility that the growth of PCs will slow down and laptop growth will not be able to make up the difference. Glancing at the P/E, the stock appears to be inexpensive, especially in relation to its historical P/E. However, based on my discounted cash flow model, a GDP-like 4%-5% sales growth is priced into the stock. And at today's price, I think that provides little margin of safety if the above scenario plays out for at least couple years. This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Telecom New Zealand: Bull or Bear?

Friday June 30, 1:14 pm ET

By Vitaliy Katsenelson, CFA

Every trade has a buyer and seller taking opposite sides. They often have different risk tolerances, time horizons, and beliefs about the direction of a stock. And before purchasing any stock, investors should build a good bull case that refutes the bear case. In that spirit, I'll spend the next few paragraphs making both a bullish and a bearish case for Telecom New Zealand (NYSE: NZT - News), and I'll let the reader decide which argument is more convincing.

Bull case In the past couple of days, Motley Fool Income Investor recommendation Telecom New Zealand announced that it will voluntarily separate its operations into retail and wholesale units.

The company will have two independent units. Wholesale would still be a regulated monopoly, not unlike Telecom New Zealand today, selling retail providers access to its network. Telecom's retail operation would be one of the providers (likely an unregulated one) buying services for the same price as the rest of the retail competition from the wholesale division. This is a very logical route for the company to take.

I have to hand it to Telecom's management. This is a brilliant move on many fronts, and here is why:

• It will preemptively get the New Zealand government off its tail. It is hard to go medieval on a company that is trying to promote competition and become friendly.
• This separation of wholesale and retail operations was a very likely outcome of the Kiwi government's future actions. Now it will be done on mostly Telecom New Zealand's terms, not the government's. Similar to a child that eats a forbidden cookie, as a parent you would not punish the child as hard if he or she comes to you first and suggests a punishment. Telecom New Zealand did just that.
• Once the telecom market was opened to competition, a new type of strategy was needed to effectively compete in the "new" marketplace. Separating and managing retail and wholesale operations will allow the company to manage each division appropriately: Wholesale operations will likely be managed for asset and free cash flow maximization -- attempting to get as much as possible from the existing assets. It is still a regulated monopoly with somewhat limited revenue upside, after all. And since competition instead of government will be breathing down the neck of its retail operations, a relatively new development for this company that has operated (at least on the wired side) in a competition-free vacuum, the retail operations will require a very different approach -- a marketing touch.

Other considerationsThe threat of competition may be overblown. If the deregulation happened in any other place, new competition would likely bring down the prices and compete away "the monopolistic profits" from the incumbent. However, New Zealand is not the rest of the world. The country's unique geography -- two mountainous islands in the middle of the South Pacific and a relatively small population of 4 million people -- is likely to prohibit new entrants from achieving a much-needed scale to become formidable competition.

The relatively small market size will very unlikely invite the big fish. Telstra (NYSE: TLS - News) is busy with its problems in Australia, and Vodafone (NYSE: VOD - News), a wireless competitor in New Zealand, doesn't have wired business outside Germany, though this could change, and it is a viable risk. (I discussed this issue in a previous article.) The smaller competitors will likely play a similar role that Apple (Nasdaq: AAPL - News) played so well for Microsoft (Nasdaq: MSFT - News) for a long period of time -- its existence and small market share in the desktop market has kept the government (mostly) off Microsoft's back.

The government has absolutely no intention of destroying Telecom New Zealand it is one of the country's largest employers, and the stock represents close to 25% of its stock market's entire market capitalization. The government wanted to introduce some competition into the marketplace and lower the broadband prices, and it has achieved that. Politicians can safely declare a victory and move to the next page on their agenda.

The separation will not change company's cost structure. However, it probably will incur some upfront costs going through the separation, which will amount to tens of millions -- a drop in the bucket for this giant. The business will not really change that much, as wholesale and retail divisions are already operating on quasi-separated basis.

Bull conclusion Telecom New Zealand will likely come out of this debacle stronger than it came into it. The appearance of competition will keep politicians off its back, and it will have two operating companies that appropriately will have two different sets of managements and very different competitive strategies.

Most importantly, the dividend should be intact. In the worst case, the reduction to the dividend will be very small. Telecom's dividend is set to be 85% of its net income. The net-income figure used in the dividend calculation is a somewhat subjective measure as one-time charges and noncash items are added back in it. Despite all of the negativity surrounding this company, it still generates (and will likely to continue to do so) an enormous amount of free cash flow, it has a strong balance sheet, and it is underleveraged.

Even after the company pays for capital expenditures and its enormous dividend (yielding nearly 10% at today's price), it still has several hundred million dollars of discretionary cash flows. Therefore, even if the company is faced with unplanned expenses that come with separation, its abundant and very stable cash flow should cover them without needing to dip into the dividend. The next couple of years will be bumpy for Telecom New Zealand, but the current stock price appears to appropriately discount the drop-off in profitability.

Now, the bear case New Zealand government has so far shown complete disregard to what will happen to Telecom New Zealand. Even though it is the largest employer and the largest company on the New Zealand stock exchange, the government's core focus has been to reignite economic growth (assuming that lowering the prices for telecommunications services would accomplish that), even if it meant driving Telecom New Zealand stock into the ground.

The actions of the New Zealand government have been fairly draconian to date -- the latest ruling allowing Vodafone wireless customers free calls to Telecom New Zealand customers speaks volumes to that effect. It was hard to see the light at the end of this tunnel, and with uncertainty written all over the stock, it is hard to know what other bad news will emerge. And since the latest news from New Zealand only got worse with time, investors naturally expect more bad news.

Before this latest ruling in its favor, Vodafone was just a bystander competing with the incumbent in the wireless segment, happily enjoying its cozy duopoly in the New Zealand wireless market. This latest news is another piece of the puzzle explaining the Telecom New Zealand stock's precipitous decline. Though the small competitors are unlikely to have a significant impact on Telecom's market share, Vodafone's existing significant market presence in the New Zealand wireless market may provide the needed scale to compete with Telecom in the soon-to-be-unbundled land line and DSL businesses. Vodafone could start by bundling a DSL and voice over Internet protocol (VoIP) products with a wireless service plan.

However, Telecom New Zealand is likely to make it a very difficult task for Vodafone. Since it will take about 18 months to two years for the laws to be passed and all regulatory kinks to be worked out, Telecom New Zealand will use this window of opportunity to roll out a very aggressive marketing campaign in an attempt to capture as much market share in DSL, and switch customers to a feature reach VoIP product.

Once it captures a very large market share in the DSL and VoIP markets, it will take a very sweet offer from competitors for customers to leave Telecom New Zealand. This will be a smart move on Telecom's part; however, it is also likely to put additional pressure on earnings, at least over the next two years as marketing (i.e. TV, radio, and print advertising) doesn't come cheap. There is still an issue of land-line customers dropping that service for the soon-to-be much cheaper wireless service. The cellular service is not an optimal substitute for a landline service for the majority of customers; for a household with several family members, every person would need to have a cell phone otherwise, if someone leaves the house and takes the cell phone, the rest of the family will be phoneless. We are likely to see the highest migration to the cell-phone service among college students, singles, and families without children. Satellite-TV subscribers and customers that have a security system will still require a landline, though it doesn't necessarily have to be a Telecom New Zealand line. In addition, phone calls outside the local area should still be expensive, unless the government changes pricing structure there as well.

The separation of regulated wholesale business and unregulated retail business may work out well for the company. However, success or failure lies in a small but very important detail: the price the government will allow the wholesale division to charge for its services. If the price is high enough, then even if the company loses market share in the retail space, it will still be able to be a very profitable business on a combined basis (retail and wholesale). So far, the government has not shown its kind side to Telecom New Zealand. A sliver of bright light is that the pricing will be decided not by politicians but by a regulator that doesn't (at least in theory) have a political agenda. Bear conclusion Neither American nor New Zealand investors like uncertainty, and the uncertainty over the company's future profitability has driven this stock off the cliff. Future regulation, the state of future competition, company profitability, and the dividend are uncertain at this point. The government's behavior to date has surprised most investors, including myself. Will the government go even more draconian on the company? Though logic tells me "no," logic was not a very useful tool in predicting the New Zealand government's actions over the past couple of months. I ask myself: what did I miss? Why didn't I foresee the large stock decline? The answer (not an excuse, but a mere observation) has to do with the timing of the news cycle. On a standalone basis, the events that transpired over last couple of months are not earth-shattering, considering the unique natures of New Zealand's geography and industry structure. However, once all of these events are put together, their impact on the company's future profitability could be very significant.

Fool contributor Vitaliy Katsenelson is a vice president and portfolio manager with Investment Management Associates, and he teaches practical equity analysis and portfolio management at the University of Colorado at Denver's Graduate School of Business. Vitaliy and his company own shares of Telecom New Zealand and Microsoft. The Fool has an ironclad disclosure policy. This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

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