Does Dell Compute over the Long Haul?


By Margaret Popper If you listened to Dell Computer's second-quarter earnings announcement on Aug. 16, the company had plenty to be pleased about. The only PC manufacturer other than Apple Computer to make an operating profit in that sector last quarter, Dell (DELL) clearly has a business model that thrives in a down market. In fact, the company has used the economic downturn as an opportunity to grab market share from competitors who aren't as cost-efficient. Small wonder it has emerged as the No. 1 desktop- and notebook-PC maker in the U.S.

In spite of Dell's recent success, however, investors might do well to question the company's approach to a maturing business. Since the second-quarter results were announced, Dell's stock price has dropped from the high $20s to the low $20s. That looks to be more a skeptical reaction to CEO Michael Dell's prediction of a spring 2002 resurgence in PC demand than a comment on the company's long-term strategy. But that strategy, too, gives cause for concern.

Don't get me wrong: Investors who buy the stock at around its current $22 a share may well make good money on it over the next year, as the tech sector climbs out of its hole. In the near term, Dell stands out against other depressed tech stocks as a company that can grow by cutting itself a bigger slice of a shrinking pie. But buy-and-hold investors might want to look for other values in tech before deciding to take a long-term position in a company that could be headed for a future in the slow lane.

MARGIN SQUEEZE. Dell is undercutting competitors by passing on falling component costs to customers. But no matter how many buyers Dell grabs from its rivals, the company is still in a maturing business with ever-dropping margins. By passing on the lower costs it gets from suppliers trying to unload inventory in the economic downturn, Dell is facing what some analysts believe could be a permanent margin squeeze.

Despite management's self-congratulations for "taking all the profits for the industry" in the second quarter, those profits were dearly bought. "The company had 19% unit growth and 1% revenue growth [year over year]," points out Brett Miller, an analyst at AG Edwards. "Once the decline in component prices stabilizes, revenue growth is not going to pick up."

Indeed, while IBM (IBM) and Compaq (CPQ) are not as good at commodity selling as Dell, they're keeping up the competitive pressure by streamlining their own PC-manufacturing cost structures. In addition, they're expanding their service businesses, an area in which Dell isn't a player. Services will be big growers when the economic rebound brings corporate information technology spending to more normal levels, and clients can afford to build more customized systems around their PCs and servers.

TRADING V-6s FOR V-8s? Dell is pinning its hopes for the future on users clamoring for more powerful computers -- now that they're cheaper than ever. Dell tells analysts that "of the 450 million machines out there, less than 10% have 1 gigahertz of processing capacity." Instead of the equivalent of a V-6 engine, Dell thinks many companies will want a V-8 -- whether they need it or not.

The problem is most PCs already have more power than most software needs today. A juiced-up computer is largely irrelevant to users who mainly surf the Internet, send e-mail, and prepare personal documents -- hardly power-hungry applications. "The applications used by the average corporate user are Word, Excel, e-mail, and an Internet browser," points out AG Edwards' Miller. "It doesn't make a rat's rear-end's worth of difference whether you run those on a machine with a 500 megahertz or a gigahertz" processor.

The proof will come in the second or third quarter of 2002, when all the PCs companies bought in the first half of 1999 are due for replacement, according to the typical corporate upgrade cycle. "People can push out replacements six to nine months," Dell told analysts at the earnings call. "But unless there is a protracted economic problem, we don't see [corporate managers] going to a four- or five-year replacement cycle." If IT budgets haven't loosened by the middle of next year, corporate chief information officers might take advantage of low-priced machines to plug immediate holes in their systems.

For longer-term planning, tight-fisted IT managers will be focusing less on the sticker price of a machine than on the overall cost of ownership, which includes whether the maintenance costs are reasonable. That's not necessarily a positive for Dell. "Dell's not as strong in services and support as Compaq, IBM, or even Hewlett-Packard (HWP)," Miller says.

MOVING UPSTREAM. Still, that perception could hurt Dell in the one business that has high-margin and -growth potential -- enterprise systems. Dell has made its commodity strategy work in the server business to achieve impressive unit-shipment growth. How? By selling mostly low-end servers and storage systems to corporate clients. It shipped 33% more units in the second quarter of 2001 than the year before. That new chunk contributed 18% of Dell's revenues.

Although Dell has the biggest U.S. market share in servers, its products are mostly on the low end, as opposed to high-margin servers that can handle many users -- and generally require more systems support from the vendor. "Further upstream, deeper into the enterprise, Compaq and IBM offer a full suite of end-to-end solutions that they can deliver internationally, and Dell can't," says Eric Rothdeutsch, an analyst at Robertson Stephens. IBM and Compaq have a much higher-margin business than Dell's.

The company has publicly pledged it will focus on building its enterprise business and using it as a platform for entering higher-margin product lines and services. But analysts remain skeptical. "Dell has achieved its success by focusing on the commodity business," points out Rothdeutsch. "We'll see the company drive more into [data] storage, but the product mix will remain basically like it is." Dell declined to return phone calls for comment on this story beyond what it had already offered on Aug. 16.

COMMODITY FORMULA. On the bright side, the consensus among analysts is that on the strength of Dell's near-term strategy, the stock will be worth around $30 a share within 12 months -- a 34% upside, according to First Call. A lot of the optimism in this price target is based on the prospect of an overall tech-sector rebound. But it also shows analysts' respect for Dell's commodity-product formula, which can create earnings growth as long as it can grab market share.

Those who follow Dell expect third-quarter revenues and operating earnings per share to come in at around $7.5 billion and 15 cents, respectively, slightly down from the second quarter's $7.6 billion and 16 cents. That matches management's guidance of a zero to 5% drop in revenues and stable operating earnings for the third quarter. For 2001, analysts predict revenues of $31.3 billion will be off 2% vs. 2000. At 65 cents a share, analysts project earnings will be down 23% from last year.

If Dell meets these numbers, it will beat the pants off other PC manufacturers' results. But looking at the long-term strategy has led some analysts to give the stock a neutral or even a sell rating. "Dell has had a winning formula that should continue to work," says Rothdeutsch. "But the company has to face the fact that the PC market is maturing, and Dell won't have the growth it did in the 1990s."

Investors looking beyond 2002 may want to search for tech companies whose stocks offer good value with a more aggressive growth strategy for the long haul. Popper covers the markets for BW Online in our daily Street Wise column


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