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PC Sales Update
August 20, 1997

08/20/97: Dell Computer Q2 Call

08/18/97: Hewlett-Packard Q3 Call

08/15/97: CompUSA Q4 Call

Dueling Fools -- Dell

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PC Makers Are Today's Good Newsmakers
by Randy Befumo

PC "box" makers were the talk of the Street today as a number of factors converged to move the individual participants in the industry. Early this morning, shares of GATEWAY 2000 (NYSE: GTW) opened higher after being held and did not look back. News that the strike at United Parcel Service (UPS) was over cleared up a black cloud that had hung over the direct computer seller's head, as UPS is one of the company's main shipping partners. Gateway 2000 closed the day up $2 3/4 to $40.

Also affecting the computer manufacturers was the anticipation of DELL COMPUTER'S (Nasdaq: DELL) quarterly earnings, released minutes after the market closed. Analysts had been expecting $0.54 EPS, but Dell came through with $0.59 EPS. Unfortunately, the so-called "whisper" numbers were looking for $0.60 EPS, the highest estimate. Although the stock closed up $2 5/16 at $84 11/16, CNBC reported that the shares were down to $82 in after-hours trading. With option volume on Dell at record highs heading to the close, speculators looking to profit from an earnings surprise might be in for a treat.

Over the next few days as investors digest Dell's quarterly report, the stock may retrace any ground loss due to the unrealistic expectations set by traders as the actual financials behind the quarterly earnings are quite impressive. Contrary to the conventional wisdom talks about Dell's "commodity" business and warns of "price squeezes," Dell's average selling price for its products actually rose during the quarter as customers bought higher-end systems stacked with more and more options. With higher prices and servers contributing a record 8% of revenues, gross margins rose in the quarter to 22.2%, up from 22.1% last year. Many analysts had been anticipating that gross margins would fall as the second quarter of 1996 was characterized by very favorable component prices for Dell, making this meager 0.1% gain quite unexpected.

Going down the profit and loss statement, operating margins rose to 10.5% from 8.9% last year. The company reduced operating costs by 1.6% in spite of the fact that it added 1,600 new employees in the second quarter alone, increasing headcount to 13,300, or 11.1%. The company's sheer need for manpower to fuel its growth may be a future problem, but for right now growth in employee costs apparently can barely keep up with the growth in revenues. Breaking apart the operating costs, sales, general and administrative (SGA) expenses increased 0.7% sequentially to 10.0% of sales, but the company's research & development (R&D) expenses relative to sales dropped 0.3% to 1.7%.

The drop in R&D as a percentage of sales might signal a red-flag to many investors used to companies that actually develop technology, but as a precision electronics manufacturer, Dell is really in a different business than an Intel or a Microsoft that need to spend on R&D. One of the advantages of Dell's focus on computers instead of the technology inside is that the company's R&D cost is minimal since it is the component manufacturers in the industry that foot the bill to advance the technology, not the "box" makers. Although Dell does have to design the PCs, servers, and workstations it manufactures, it does not have to pay for the design of any of the components and is really limited in some ways by the components it can get off the shelf.

Another major misconception about Dell is that it consumes a lot of cash as a part of its operations. Although many people mistaken believe that Dell is capital-intensive, looking at the company's capital expenditures relative to the earnings before interest, taxes, depreciation and amortization (EBITDA) you get a much different picture. Dell only spends 10.7% of its EBITDA on capital expenditures, compared to 30% for Intel Corp. and 21% for Coca-Cola. Because Dell uses so little capital in its business, it can generate a return on capital in the 167% range and use excess cash to buy back shares. These share repurchases help to maximize shareholder value by using excess cash the company does not need to decrease the number of shares outstanding, increasing the earnings per share by the same proportional amount.

Dell's ability to generate cash and repurchase shares is amplified by the fact that it uses very little working capital to operate. For instance, Dell's inventory turns in the quarter were the annualized equivalent of 33 times, meaning that Dell kept approximately 11 days of inventory at any one time. At another manufacturer, money might have been tied up in keeping more days of inventory, meaning that money could not go to buy back shares. And buying back shares is something Dell knows how to do quite well. Dell Computer repurchased 5.7 million shares of stock during the quarter, bringing the total shares repurchased over the last 18 months to 59.3 million. Dell has outstanding "put" contracts to purchase another 27 million shares over the next few months, indicating that the systematic share repurchases should continue over the next three to four quarters if the company keeps up at its current rate. Dell should only have 340 to 345 million shares outstanding at the end of fiscal 1999 at the current rate of repurchase, down from the 362 million the company will probably end the year with.

To cap off the PC day, Dell competitor COMPAQ COMPUTER (NYSE: CPQ) had some positive news of its own. While Dell was growing more than three times faster than the market, slightly slower growing Compaq was meeting some very ambitious goals in the lucrative workstation market. Compaq stated that it was "on track" to sell 100,000 workstations in the first 15 months after its entry into the market -- workstations being sold at the expense of established, less efficient manufacturers like Hewlett-Packard, IBM, and Silicon Graphics. Compaq came out of nowhere to take the top market share spot in the U.K., intimating that this should be good for both Compaq and Dell Computer, which entered the workstation market this quarter. Overall, personal computer companies appear to have exceeded all but the most unreasonable expectations for growth.

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