Dell Continues Industry Outperformance (Fool On the Hill) August 19, 1999

An Investment Opinion

Dell Continues Industry Outperformance

By Dale Wettlaufer (TMF Ralegh)
August 19, 1999

You know what I'm wondering? Where the heck are all the people who were freaking out about the PC industry? At no time over the last five years have I heard more wailing than this spring, and here we are in the third quarter, with things looking like they always do at this time of the year. I'll stick with the guidance of Dell, Microsoft, Intel, and Gateway until they're wrong, and I will ignore -- until they're right or maybe have something original to say -- the perennial bears, ax-grinders, and those who have a tough time figuring out the basic economic dynamics of the PC industry. Thanks.

Once again, Dell Computer (Nasdaq: DELL) has outperformed the industry, turning in a stellar second quarter fiscal 2000 report. Dell's 42% topline growth and 47% per-share operating income growth, ending cash conversion cycle of -15 days and an average cash conversion cycle of -14 days, and $2.60 in net operating profit after taxes for every dollar of capital invested in operations (annualized) are all superlative. I've talked about the model way too much in this column and elsewhere on the Fool to expound upon it once again. In terms of the way its acquires, services, and retains its customers, in terms of its business model being optimal for its industry, and in terms of management, Dell continues to outclass everything in the PC industry and almost all publicly traded companies.

Without further elaboration, here are my notes (this isn't a direct transcript; I've also left out a couple questions) on the Q2 question and answer period from Dell's conference call. Prepared remarks are available at Dell's website.

Dell Q2 Conference Call Q&A

A substantial part of revenues are not unassisted (an unassisted sell is where the customer has no live contact with someone at Dell). Significant ramp now in unassisted service and support. Support sites "absolutely unmatched in their quality and award-winning nature."

Closer to 65% of server revenues are in the midrange to high-end.

Sales in nine European countries grew in excess of 50% and substantial success in specific countries. #1 in U.K., #3 in France. Approach in markets outside U.S. is, first, to go after small business market, which has traditionally been a source of strength for the company. Dell is #1 in small business market in numerous countries around the world. Next, the company goes after the consumer market. Not planning any retail distribution -- all ".com" stores.

IBM consistently is most aggressive, followed by Compaq and HP, in pricing.

Outgrew European market by 2x, still lots of upside there. Dell would be surprised if they do not see accelerating growth rates in Europe as it goes into Q4-Q1.

ASPs went from $2,300 last quarter to $2,200 this quarter, off a few percent, "substantially less than our closest competitors, in particular Gateway and Compaq, when you look at what was happening to their overall ASP." (Gateway's revenues per unit were down 1.7% sequentially, from $1,938 in Q1 to $1,905 in Q2). "Much more importantly, what we saw was a fairly significant move in commodity prices during the quarter, even beyond what we had expected.... We used that to drive incremental topline growth and we used that frankly to lower the bar for our competitors because we are the low-cost model...." The company was able to pick up a point or more in market share across all categories in the quarter and picked up three points of market share in servers.

Not currently interested in free-PC customers, who are highly price-sensitive and not interested in a relationship. Many times, these are low-end products with end-of-life PCs that may make consumers wonder whether they've been taken by the free-PC provider.

In the context of services, "clearly we have continued to add to our field presence, both directly and indirectly, and that cut across a broad sweep of talents, from systems consultants to systems engineers to our applications solutions centers to any number of things we've been doing... Increasingly, we'll be talking about what we'll be doing in the service arena, and it's not just a physical presence, it's a bit presence. Service is representing an increasing percentage of the company's margins and profit, although I would caution you against believing this is a replication of a historical physical model. We are certainly doing quite a bit in our factories with the Dell Plus service and we think the sweet spot of the profit opportunity for us is not necessarily in deploying arms and legs..." in taking on a legacy field infrastructure.

Dell believes Windows 2000 will be a big positive for corporate desktop and notebook sales as well as server sales, as it brings new functionality and capabilities, continuing the conversion of traditional proprietary UNIX over to the Windows base.

Many of the company's customers are finding that they can have a completely redundant Dell fibre-based (storage) solution for much less than half the cost of a well-maintained EMC solution. The company doesn't believe it must replicate older product and service propositions. Rather, Dell would prefer to be a catalyst for changing the nature of mass storage.

Stay tuned on developments on marketing of Windows 2000-equipped products.

Dell's auction site allows the company to capture maximum value for machines coming off lease, for machines that are being sold on a refurbished basis, and to make it easier for customers who have existing Dell products to sell them and make the upgrade to the latest products even sooner. "We think there are a number of ways we can tie this into, where a customer buys a PC, decides to auction it, and then applies those dollars to the purchase of a new PC. We effectively create two customers and allow ourselves to sell services to both of them at the same time."

"Clearly, we would have had more revenue..." if Dell had more supply of LCD displays. The demand is there. We've gone from a situation of oversupply to undersupply. Dell's suppliers are actively working to layer in additional capacity and Dell is using all its leverage to ensure that it gets fair and good access to that supply. To some extent, the undersupply helps on the ASP side, because there isn't downward price pressure in that component.

On devices, "the PC will be centric to whatever we're going down the path of, but there's all kinds of technologies evolving fairly rapidly that may cause us to incorporate other [products] in value propositions for enterprise-level customers to small businesses and everything in between."

Consumers are actually a higher ASP than corporate customers.

In response to a question of how much component cost declines were directed toward driving unit growth versus driving gross profits, "There are a lot of levers that Dell uses to drive its balanced performance time, and the levers start with essentially the notion that we're going to offer the best value proposition and customer experience while adding share[holder] value. In that context, what we're looking to do is make the tradeoffs necessary to drive top- and bottom-line growth, and that means units as a precondition of market share, if you will, and therefore growth in the topline, and operating margins on the bottom line. In between, we're sometimes gifted, sometimes not, a faster component cost decline, on average for the stuff that goes in our boxes. The second quarter happened to be one of those gifts, and when we see one of those opportunities, we just typically see them drive higher topline growth while still delivering earnings that are meeting or hopefully beating expectations. All that says is that it's a pretty complex business, and we're not just looking at this across one geography and one customer segment, and it varies by product, by customer, by region."

The European business is now a $6 billion run-rate business. The company has had a number of quarters over the last couple years there, growing from a $2 billion run-rate base, where year-over-year growth has been 70%-80% and higher. Dell doesn't see any reason why that business cannot achieve growth rates that are significantly higher than the market, as Dell has consistently done over its history.

Eight percent of revenues for the quarter were "untied." The company doesn't want to see that revenue line grow, as it wants to tie those revenues as much as possible to systems. Dell Plus, for example, may well have a specific requirement that would cause the company to try and tie it or not tie it. However, Dell is trying to keep profitability by customer in front of the salespeople, so they understand where the profit opportunities are and when to go for the growth. Tactically, that 8% (non-system net revenues as a percentage of total system net revenues) line isn't going to deviate much.

"We have very aggressive plans [for the consumer space], not only for the U.S. market, but around the world. We are definitely full-out after the consumer market. One thing I would highlight... our revenues in the home and small business category now are the largest of any direct company and our profitability exceeds that of our nearest competitor."