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Is This The End of Dell?
by Randy Befumo (TMF Templr)

As the last quarter is digested by investors across the globe, the inevitable question becomes: Where do we go from here? So it is with all companies, so shall it be for Dell Computer (Nasdaq: DELL) on Tuesday. Looking at the company's third quarter financial results and listening to the conference call, I have some observations that might help investors struggling to nail down the company's value over the next few years.

Unit growth was a more than respectable 54.0%, almost three times the 19.0% unit growth Dataquest gave as the industry average for the third quarter. Sequential unit growth was 13.0%, well above the 7.8% sequential unit growth of the personal computer (PC) industry at large. Although these comparisons are not entirely apples to apples, as Dell's unit numbers include the growing number of servers and workstations it sells, overall it is worth noting that Dell is growing much faster than its competitors.

Despite the rapid growth in PC units sold, Dell's average selling price (ASP) per unit has remained relatively stable. The company's ASP in the third quarter was $2,625, up about 2.0% year-over-year but down 3.0% sequentially. Both fluctuations are in line with historical norms. This means that while Dell grew revenues faster than units year-over-year, units grew faster than revenues sequentially. Given Dell's relentless price cutting that accelerated toward the end of the quarter, a 3.0% drop seems quite tame and indicates demand for Dell migrated upward to higher-priced products.

Looking at the revenue and unit growth, it seems that the sub-$1,000 PC apocalypse that many "big picture" forecasters have been getting a lot of mileage with on the idea circuit have not hit Dell yet. Even with the higher-priced workstations and servers thrown in, if demand sharply migrated to the low end of the value chain, the sequential drop on top of the price cutting would have been much more than 3.0%. While one quarter never really makes a trend either way, it is important for investors who believe that the sub-$1,000 will destroy Dell to realize that the data to support that position is in pretty short supply.

Of particular note in the quarter was the 70% to 75% year-over-year growth Dell enjoyed in the small business and consumer market. By combining its innovative leasing program with aggressive pricing, Dell saw sales growth that was two times the number Micron Electronics (Nasdaq: MUEI) has forecast in a recent press release and three times that Gateway 2000 (NYSE: GTW) recorded in its third quarter reported a few weeks ago. Although both companies are growing faster than the PC market as a whole, Dell appears to be attracting many more direct PC buyers than either of its major competitors in the small business and consumer market. Should both of these companies continue to execute poorly, the net beneficiary will be Dell. Additionally, if the sub-$1,000 PC was soaking up existing consumer demand rather than creating new demand, it is hard to see how Dell could have grown revenues in this channel at almost four times the overall industry growth rate.

All eyes are focusing on Compaq Computer (NYSE: CPQ) as the Dell-killer. There has been a lot of buzz from analysts recently that Compaq is back, competing better and ready to take on Dell on its own terms -- asset management and return on capital. Compaq's success here has been notable, particularly with regards to inventory. However, overall revenue growth for Compaq in the last quarter was 30.9% while sequential growth was 8.2%. Should Dell continue to grow at 1.5 to 2.0 times Compaq over the next year, the size differential between the two companies will close markedly. While Compaq's performance has been admirable, it is really hard to look at the income statements of both companies and conclude that Compaq is kicking Dell Computer's butt.

Loewenbaum & Co.'s Ashok Kumar and Gerard Klauer Mattison's Louis Mazzucchelli both were quoted quite negatively on CBS Marketwatch.com regarding Dell's prospects considering Compaq's success with the sub-$1,000 PC. Compaq's unit growth of 56% year-over-year was fed by the sale of these machines. Why this compares so poorly with Dell's 54% unit growth as it climbed up the value chain selling much more expensive units is hard to figure, but those are analysts for ya. Both analysts believe that as demand for these low-priced units increases, Compaq's growth rate will mash Dell's. Although it is unclear whether they were talking unit volume or sales growth, the implication is clear -- Dell is in trouble from the sub-$1,000 machine.

While this makes for great copy, actually looking at the economics of the sub-$1,000 PC market makes one come away with a different conclusion. While certainly Compaq could have a higher unit volume than Dell given the price point, it would have to sell more than three times as many units to have higher revenue growth. Currently Compaq sells 2.34 times as many units as Dell. Additionally, these revenues may not trickle down to the earnings line at all. Right now the sub-$1,000 machines only result in profits because of some rather creative accounting on Compaq's part. Instead of dividing sales costs on a simple, per-unit basis, Compaq weights the sales costs based on the sticker price of the machine. This makes the low-end units profitable, but kills margins on the high-end units.

Mazzucchelli told Marketwatch, "Compaq is doing a better job of competing." He added that "the only way Dell will keep pace with Compaq is to lower prices and enter the sub-$1,000 PC market." While Dell has traditionally attacked Compaq profit centers like servers and workstations, the company has never conceived of attacking Compaq's loss leaders. Given that the direct model sells high-end stuff well and profitably and middle- and lower-end stuff not quite as well, the assumption in Mazzucchelli's argument that is not transparent is his belief that consumer demand will migrate away from the high-end machines that Dell sells. Although investors should recognize this is a risk, the fact is there is absolutely no incremental data besides some anecdotal information from the sales channel to support this.

Next quarter it would seem that the balance sheet will remain stable and sales will probably grow roughly 7% to 15% sequentially. Dell grew sales at 8.8% sequentially in the fourth quarter of 1996 and 19.5% sequentially in the fourth quarter of 1997. While 10% is probably reasonable, given the price/performance curve with the new microprocessors and the company's plans to pass on component savings to users, there is clearly some upside unless demand migrates to the sub-$1,000 market. With margins on enterprise units ranging from 5% to 25% compared to desktop margins of 5% to 15%, any loss due to lowering prices on desktops should be made up by selling more servers and workstations. Thankfully, sub-$1,000 PCs do increase demand for servers, a potential benefit that many fail to consider.

Overall, margins should remain stable and share count should decrease slightly, putting next quarter's numbers around $0.79 EPS according to my data. This would give the company a run-rate of $3.16 EPS going into fiscal 1999 -- not all that far from current estimates. As a result, estimates for 1999 should migrate up to the $3.50 EPS range, with analysts remaining conservative as usual. The real wild card remains sub-$1,000 PC demand -- but that may be overdone. As the small Japanese compact car did not destroy the market for the American luxury automobile, until the data actually supports the doomsday scenario investors are advised to stay on alert -- but not panic. The worst thing about Dell right now is that the valuation is stretched relative to any historical standards. Given that historically the company did not convert sales into cash five days before the sale was recognized, historical ranges may be overrated and investors should set their own compasses.


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