Thursday, September 14, 2006

The Best of: Dell, Not Yet?

Since there are lot of new visitors to this site, I am reposting some of my older articles that I believe are still relevant today.
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.

3 Comments:

Anonymous Investorial said...

Good analysis of Dell. Wondering what you think about their treatment of stock option compensation? Here's a link to a Forbe's article that uses Dell as an example.

http://www.forbes.com/2006/09/14/dell-options-expensing-in_ja_0914soapbox_inl.html

9/16/2006 05:54:00 AM  
Blogger cheapstockhunter said...

Thoughtful analysis. I too have been wrestling with the correct entry point for Dell. Although to date, my thesis has proven wrong, I am more bullish than bearish at this price level.

My basic reasoning is that Dell has significant amount of earnings "levers" that it can use to reaccelerate growth. There is a tremendous amount of evidence that the market "pays more" for high ROIC over earnings growth, but at a certain level, the incremental ROIC becomes less meaningful. Essentially what I mean is that while you should get meaningful multiple expansion when ROIC goes from 10% to 20%, but when you go from 50% to 60% that incremental return becomes less meaningful, and the focus becomes more on growth and the sustainability of above avg. profitablity. I would argue that Dell could see significant multiple expansion if, by making slight adj. to business model, Dell could sacrifice some ROIC, and reignite earnings growth. As an investor, I would pay alot more for a company earning 30% ROIC, and growing at 20%, over a company earning 50% ROIC growing at 8%. I think it makes sense that Dell "loosens up" some of its efficiencies to generate more earnings. For example, while its inventory turns (6 days) would be stretched Dell could seek additional distribution channels, i.e. selling computers at Best Buy. Loosen credit standards, offer 0% financing for 12 months, etc. This will dampen the AR turns, but surely drive topline growth. Invest more in service and marketing, will lower margins, but drive growth. While these "levers" will hurt ROIC, they could certainly drive growth. Dells current cash conversion cycle is about negative 60 days, their next competitor is a fraction of that, does Dell need to distance itself so much in terms of profitabilty? Dont get me wrong I love ROIC, its probably my most important investment criterion. But I would trade a little profit for some growth.

Also, i saw that you were a CFA, in the Sept. Confoerence Proceedings, Michael Moubassin wrote a good article called "Expectations Investing" that highlights some interesting supporting data about the EPS-ROIC trade-off....So check your mailbox! Anyway, I enjoyed your article and thoughtful analysis! JC

9/20/2006 08:36:00 PM  
Anonymous Anonymous said...

Vitaliy,

It is amazing, you really pointed out most of the DELL weaknesses.

To negative points, I would add :

1- No perspective to enlarge product spectrum due to lack of leading technologies in: PDA (Axims), LCD TV, MP3 player (Digital Jukebox), printers. OEM agreements have their own limits and, evidently, they have lower cost than DELL which lead to an additional problematic competition like Lexmark (for DELL printers), EMC (for SAN), APC (UPS), Philips/Samsung (LCD Monitor), etc.

2- No long term investment where made during the last 5 years as the Corporation focused on "producing" a financial performance (quarterly basis). Externally, Customer Service is one visible fact but, internally, you have many others like archaic Back-Office software (Gedis or Bidwatchlite), No clear internal policy for Grey Market from DELL US Business Unit in Africa, Middle-East, Asia and Russia (explaining the 32 % market share on this territory), Missing of Service Program for After-Sales support partners in most of the regions...

The only positive aspect is the AMD chips to desktop (especially Dimension) and server product ranges to consolidate increasing market shares in these critical areas.

Let's see !

11/13/2006 09:38:00 PM  

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