Can Dell Keep Beating the Odds?


By Amy Tsao The success of Dell Computer (DELL), the world's top personal-computer maker until the HP-Compaq merger, is nothing to scoff at. It has proven that a strategy built on efficient, low-cost production and direct selling in an established business is a winner. "Any technology segment that's close to maturing toward its commodity phase will be fair game for Dell, suggesting ample potential for growth," says Thomas Weisel Partners analyst Kevin Hunt.

The question is: How quickly will the $31 billion-a-year company deliver that growth? Most analysts rate the stock highly, as it has performed solidly amid a broad tech slowdown. It came in at No. 5 on BusinessWeek's annual IT 100 list, making it the top-ranked U.S. company. Dell is posting gains in unit sales of personal computers amid a flat market, and it's also building share in the server sector.

QUESTIONS OF VALUE. Sales for the fiscal quarter ended May 3, 2002, totaled $8.1 billion, and profits were $457 million (17 cents per share), about even with the previous year's levels. With Dell's promise to reduce costs by more than $1 billion over the current fiscal year, analysts are expecting earnings per share to rise to 76 cents, up from 65 cents in fiscal 2002.

"Even in soft markets, Dell manages to grow beyond the market growth rate because it's taking share," says Roger Kay, PC analyst at IDC Research. The stock also has defied the negative trends plaguing other tech companies. At its closing price on June 12 of $26.70 per share, Dell has slipped just 3% since Jan. 1. Compare that to IBM (IBM), $74.73 as of June 12's close and down 38% year-to-date, and Hewlett-Packard (HPQ), off about 17% at $17.96 per share. Yet some analysts are questioning whether Dell's stock is worth its high valuation given that it may not be able to grow as rapidly as Wall Street wants.

"They sell commodity products. What does that make them? A distributor," says Fred Hickey, editor of The High Tech Strategist, an investing newsletter. Though he likes Dell's cost-efficient products and strategy, he has a hard time getting his wallet out at right now, with the stock price at 35 times the current year's expected earnings. "I can make a case for Dell. But at that multiple it's too much," he says. In his opinion, a valuation of between 10 times and 20 times forward earnings would make more sense.

SPREADING OUT. Hickey may be right to feel cautious. True, Dell has attractive growth opportunities, and analysts predict average earnings growth of 15% per year. But actually achieving that remains a challenge in this environment.

Dell has diversified into non-PC businesses, which are already crowded. In the most recent quarter, 73% of sales came from desktops and notebooks and 27% from so-called enterprise products, such as servers, storage, and workstations. Dell has gained significant share in low-end servers and is gradually gaining a foothold in higher-end servers. Its worldwide server share grew from 15.7% to 17.8% in the first quarter of 2002, estimates Gartner Dataquest, a division of Gartner Inc. Dell is now the world's No. 2 server manufacturer and No. 1 in the U.S.

Services make up about 10% of revenues, a figure that Dell expects to rise. However, while it has mastered product-related services, it's relatively new at providing the higher-margin handholding that more sophisticated servers require, points out Mark Margevicius, research director of Gartner Inc. He believes the level of customization needed to be successful in high-end servers will prove "countercultural."

NEXT STOP: PRINTERS? Adds Tony Adams, info-tech services analyst at Gartner Inc.: "The risk in failure is [great] for a [services] vendor since it's a reputation game. These are systems that life and limb depend on. Failure would be a black eye."

Making gains in storage will take even longer, predicts Eric Rothdeustch, an analyst at Robertson Stephens. A pickup in IT spending will be critical for getting this piece of the business to grow faster. Meanwhile, the printer business, dominated by HP, is an area that Dell Chairman and CEO Michael Dell has dropped not-so-subtle hints about entering next.

Dell isn't deterred by its critics. "I think we'll continue to do what we do and prove them wrong," says spokesperson Michael Maher. He says Dell will remain in the commodity businesses it has done well in and gain share in higher-margin areas as well. And Dell has lots of leverage. With its stronghold in the nonconsumer PC market, it has been able to "crack open an account by winning the PC business first," Rothdeutsch says. "Then it can up-sell to more of the higher-ticket, higher-margin items like storage, servers, and services."

HOW MUCH GROWTH? Nevertheless, the biggest growth driver will still be increased market share in PCs, Rothdeutsch says. He expects Dell to more than double its worldwide share, to upward of 30%. Growth in the U.S., where Dell has 26% of the market, will be less dramatic. Worldwide, its PC market share is just 14.3%, according to Gartner Dataquest. But while overseas represents great growth potential, it's a long-term play. "To emerging markets, Dell is a no-name. They have a global presence that they're working on [strengthening]. That's a big deal," says Margevicius.

In the near term, while Dell clearly is being rewarded for its success, the stock price may be rich relative to its growth prospects. Dell isn't alone. The issue of high prices on tech stocks has been debated ever since the tech downturn began in 2000. "People have been assuming tech spending will pick up. If it doesn't happen, Wall Street will be disappointed, and valuations will come down," Hickey warns. And Dell likely would take a big hit in the process. Tsao covers financial markets for BusinessWeek Online in New York


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