Boring Portfolio

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The PC Battlefield
Spreadsheet links, too

By Dale Wettlaufer (TMFRalegh@aol.com)

ALEXANDRIA, VA (March 1, 1999) -- Gosh, Compaq (NYSE: CPQ) was down again today? It's supposed to miss revenues by $300 million and that translates into more than $84 million in earnings? That's a 28% net margin on those missed revenues. There's not that much operating leverage at Compaq. This is either sales credits being given out for price protection, a little foreign exchange translation mixed in, lower-than-expected sales of higher-margin DEC and Tandem systems, lower-than-expected service revenues, or those things mixed in with Compaq lacking discipline in pricing its servers. It's not just PCs. There's no way 28% of the lost revenues goes straight to the bottom line on PCs. If you take a look at Compaq's cash flow, you can see some obvious problems.

At a recent investment conference, I went to the distributors' presentations and breakouts rather than paying as much attention to the PC companies. That's where you'll find the real truth. The distributors are having problems. The smaller ones can't deal with Compaq's price protection reductions and their inventories are too high. The larger ones are being beaten up by Dell and coming soon, Micron. Meanwhile, Compaq has problems with some Web resellers not honoring pricing agreements, so it cut those companies off for 90 days. That doesn't say to me, "Oh, look at how disciplined they are." That says to me Compaq can't deal with the economics of today's PC market.

One thing that isn't talked about much in the media right now is that the top tier companies -- IBM, Dell, Compaq, HP, and Gateway -- are still taking share from the lower tier companies and from white box assemblers. That's a secular trend that still has lots of legs. Furthermore, it's the direct PC companies -- Dell, Gateway, Micron -- that will be taking this share faster than their slower-witted peers.

Negative price inflation is the norm in the component business. The faster this happens, the better the direct companies can gang up like a bunch of hyenas on the PC companies that can't deal with it. Here's a spreadsheet that shows the various business models of these companies:

(I haven't updated Apple since Q3, as it's almost irrelevant. Micron's numbers are Q4 annualized to get a better idea of what it's doing without its EMS business, which was sold, mixed into the trailing numbers. Compaq's invested capital numbers have been distorted by the big write-off. Nevertheless, this pretty much reflects its tangible operating capital position. I treat its earnings as "earnings before all the bad stuff," which is supposed to depict cash flow on an ongoing basis.)

It takes Compaq $0.326 in invested capital to make a dollar of sales. It takes Dell, Micron, and Gateway a whole lot less, as you can see. Inversely, Compaq generates only $3.07 in sales per dollar of invested capital while Dell generates $29.07 in sales per dollar of invested capital. For every dollar of capital invested in its business, Dell creates $2.30 in return while Compaq generates $0.056 in return. Dell's cash flow is much, much larger than Compaq's (the gulf is even bigger when you look at free cash flow, as ROIC depicts) and Compaq is all over the map in the computer business. Dell has a lot more dollars in cash flow to attack the PC, server, and workstation markets than Compaq does. That's on an absolute basis and more so on a segmented basis when you look at Compaq that way.

Are PCs going the way of the TV? I'm agnostic on that. The fact can't be ignored, however, that the market works in mysterious ways and discounts far in advance. You just have to pay attention to the price you're paying for the value you receive. Nevertheless, if the industry does not die like the guy at IDC is saying (an annual rite of spring at the market research firms), the direct PC companies are the way to be involved. At what price one chooses to be involved is a totally different story.

Finally, as I said the other day, if Compaq is a rogue elephant, you don't really want to be standing next to it. Is it going to wreck the industry like a bad insurer writing policies at uneconomic rates? That's the question. It's not so much, "Can the direct PC companies compete?"

Also, as to why we went with Gateway, it's really incremental returns on capital that we're interested in. Gateway's move to increases sales dollars per PC and its improving capital management as well as investments in Gateway Country stores were the big attraction, as well as the price which we paid for the company.

In all, I find it interesting that we chose to get involved in this sector right before this nuclear meltdown in perceptions. You'd think the world is ending in the PC industry. I have zero desire to go where the big battles in the market are being fought, but having bought Gateway before the battle started, we've got to assess what we have. What we have in the market is a little too much inventory from Compaq, a product transition from Intel, and a wildcard with Y2K spending. The first two aren't big deals. And the last isn't a big deal as far as Gateway goes. I originally thought PC sales were going to be front-loaded in the first half, but maybe that won't be the case. Whatever happens, we definitely don't want Compaq and Dell to get all whicked off and start beating on Gateway's door for blood money in the consumer market.

Finally, let me direct your attention to American Bankers Insurance's balance sheet. This is another example of an insurer that is selling beneath the value of all capital invested in the business, which means the market assumes it will over the long run underperform its cost of capital. Looking at the company's track record, that would be an about-face. This is where I'll be spending my time this week.

We hope to see you on the Boring message board soon.

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03/01/99 Close
Stock  Change    Bid
BRKb  +11      2390.00
CSL   +  1/8   41.50
CSCO  +1 5/8   99.44
GTW   -1 11/16 71.00
                   Day    Month   Year  History
        BORING   +0.48%   0.48%  -3.85%  29.10%
        S&P:     -0.18%  -0.18%   0.88% 106.21%
        NASDAQ:  +0.31%   0.31%   4.67% 120.49%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     99.44   315.09%
  8/13/96  200 Carlisle C    26.32     41.50    57.65%
 12/31/98    8 Berkshire   2244.00   2390.00     6.51%
   2/9/99  100 Gateway 20    72.38     71.00    -1.90%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  22373.44 $16983.45
  8/13/96  200 Carlisle C  5264.99   8300.00  $3035.01
 12/31/98    8 Berkshire  17952.00  19120.00  $1168.00
   2/9/99  100 Gateway 20  7237.50   7100.00  -$137.50


                             CASH   $7658.52
                            TOTAL  $64551.96

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