SECTOR SCOPE by James A. Anderson February 18, 1999

Despite Dell's Recent Setback, '99 Should be Good for PC Makers
Business demand for new systems should push sales up 15% for the year

Y2Ks infamous D-day is just a bit more than 10 months off, and the conventional wisdom holds that personal computer stocks should be singing the millennium blues. After all, Corporate America, the PC industrys biggest customer, has a lot of software to fix. And while PCs arent the technology bete noire of 1999, they seem like one expenditure that can wait until after all the software bugs are rooted out.

By the looks of things, however, Wall Street hasnt completely bought into the bust-before-boom scenario for PC makers. As of Jan. 31, in fact, the Standard & Poors computer hardware index, which tracks stocks such as Dell, IBM, and Compaq, was up 15%, compared with a 4% increase for the S&P 500.

It's true that upon closer inspection the sector is showing mixed results so far. IBM (DELL), the groups market dynamo, which seems to disprove the conventional wisdom but also underlines the industry's vulnerability. As of Feb. 12, the Austin (Tex.) company, the industrys No. 3 producer after Compaq and IBM, had risen nearly 40% for the year. Then on Feb. 16, it reported disappointing revenue growth for its fiscal fourth quarter and promptly gave back 26 of those 40 points -- even though its profits matched analysts' estimates.

What are investors to make of it all? One lesson might be that the rocket called Dell is starting to feel the gravitational pull of the PC industry's much slower average growth rate. Another lesson could be that Dell could lose a little of its luster in 1999 -- and the overall industry could still have a very good year. "Evidence we see from disk-drive sales and semiconductor makers results is that demand is strong," says Standard & Poors analyst Megan Graham-Hackett. "What were seeing is an acceleration in spending by big corporations in the first half of the year, pretty much to get systems fixed and kick old equipment out the door," adds Mark Specker, an analyst with Soundview Technology Group.

CARROT FOR INVESTORS. Does that mean a drop-off in the latter half of the year? Hardly. Analysts feel that once large corporations finish their buying spree, it will be small and mid-size businesses turn to make hefty pre-millennium outlays on PCs. "The small and medium-size businesses really cant wait much past mid-year," says S&P's Graham-Hackett.

Put the two halves of the year together, and you should see unit growth on the order of 15% year-over-year, comparable to the increase in 1998. "Once the smaller businesses pick up the pace, you should see revenues stay steady -- a carrot that will keep investors in these stocks," says Soundviews Specker.

The new century should start off with a bang, too. For one thing, the Internets rapid expansion and the growth of intranets, or in-house corporate networks, should keep PC demand well stoked. "The Internet is growing so strongly that no company can afford to hold off on the capital spending needed to get online," says Dana Moore, a senior analyst for Globalt Inc., an Atlanta institutional investing firm. The introduction of Microsofts ballyhooed Windows 2000 operating system -- assuming that it isn't delayed -- should help stimulate corporate buying. Sub-$1,000 machines have also spurred new growth for PC makers. And for the moment, Compaq projects strong sales in Asia this year, news that prompted a rally by the group the day before Dells reversal.

SEVEN-DAY INVENTORY. If youre looking for bargains, Compaq currently looks cheap, by dint of its relatively low multiple. In fact, the stock, which fetches a little less than 24 times projected 1999 earnings, trades at a discount to the S&P 500s multiple of nearly 28. And thats for a company whose sales should grow 20% to 25% this year, says S&P's Graham-Hackett.

Compaq suffered a bumpy early 1998 because of excess inventories, but it bounced back and has since adopted some of the same direct-sales techniques that have made Dell a low-overhead favorite on Wall Street. Today, Compaqs distribution channels have perhaps three weeks of inventory, still higher than Dells enviable seven-day supply but a marked improvement over the seven weeks of product it had a year ago. "Compaqs inventories are some of its lowest historically," says Soundviews Specker.

Meanwhile, Compaqs acquisitions of Digital and Tandem are on schedule, according to Value Line analyst Phillip M. Seligman. That means the Houston company should reap benefits from cost-cutting associated with the mergers even as it enters high-end, high-margin businesses such as the server and storage businesses of Digital and Tandem. Earnings in those businesses could well grow by about 28% next year, according to Globalts Moore.

A wild card is Compaqs AltaVista Internet search engine. Other-worldly prices paid for Excite and Lycos might tempt Compaq's execs to scout out ways to cash in on the Internet stock boom. Whatever they decide, 25 of the 35 analysts who follow the company rate it a buy or strong buy. And according to a survey by Zacks Investment Research, Wall Street looks for the company to boost earnings an average 20% annually over the next five years.

Given Compaqs low p-e, Dells huge multiple of 61, based on 1999 projected earnings as tallied by Zacks, might not seem so attractive. Still, Wall Street remains enamored of the stock, with 21 of the 31 analysts who follow the Austin company rating it a buy. "Price targets for Dell dont last very long," says Soundviews Specker. "Especially when youre looking at earnings growth of 50% to 60%"

Dells direct-sales network remains the toast of the industry, and the company is working to make its sales and customer service even more appealing to corporate customers. In a new initiative, Dell has gone so far as to set up Web sites for some customers. And Dell, like Compaq, has begun a foray into the server market, a move that should garner higher margins and at the same time insulate the company from the vagaries of PC demand. Despite its stock's recent dip, says S&Ps Graham-Hackett: "Dell has made incredible inroads in gaining market share, and is really the company to beat."

James Anderson who teaches journalism for the City University of New York, writes Sector Scope every other week

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