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Dell the Merchant King

By Al Levit

Glendale, CA (March 10, 1999) --

"The rule-making strategy favors those companies that manufacture products and provide services bought every day or every week by tens of millions of people the world over. That means that I will not be focusing on the powerhouse distributors -- like Wal-Mart and Home Depot -- that have amassed fortunes for their shareholders by collecting all the merchandise known to man, stacking it in warehouses on the edge of town, and offering it to consumers at discount prices. Those are the Merchant Kings..."
- Tom Gardner (Rule Breakers, Rule Makers, p. 166)

It wasn't only the Wise that laid in on Dell Computer Corp. (Nasdaq: DELL) following the company's fourth quarter stumble (a stumble, as I noted yesterday, only by Dell's super-high standards). On February 24, Chief Fool Tom Gardner also poured it on, arguing convincingly that Dell is, in fact, not a Rule Maker. Further, he pointed out that I (and alas, it was me) declared over a year ago that Dell was not a Rule Maker (we called them Cash-Kings back then).

Within twenty-four hours of my writing that Dell wasn't a Rule Maker, Rob wrote back to say that Dell, indeed, was a Rule Maker. Technically, I was right and Rob was wrong. Practically, we needed a new category to describe great companies that amass fortunes for their shareholders year-in and year-out, but without the monopoly, patent and margin advantages of Rule Makers in our portfolio. Rob finally identified that category as Cash Presidents, and we later settled on the name Merchant King.

In the quote at the top, Tom mentioned a couple of the best Merchant Kings, but there are others, not the least of which is Dell. In fact, the three best performing Merchant Kings of the 90s (in order) have been Dell, Home-Depot (NYSE: HD), and Wal-Mart (NYSE: WMT). Of these, Dell has been the run-away winner, having returned about four times as much as Home Depot over the period. As Rob and I pointed out last year, these companies don't make their money with monopoly advantage. Rather, they are masters of getting product to customers more efficiently than their competitors. The operating word here is distribution. Incoming inventory and outgoing merchandise must move seamlessly through the organization. By definition then, the successful Merchant King is a master of efficient distribution.

The Merchant King's game is a fiercely competitive one of attaining high revenues while operating on a minimal base of assets -- otherwise known as high asset turnover. Contrast this to the less-competitive Rule Maker business model, which typically sells relatively cheap products at high margins to consumers. Through legal patent protection, marketing savvy, or manufacturing prowess, Rule Makers establish their competitive advantage -- an almost monopolistic advantage. They make the rules in their industry, and anyone else who wants to join the game must do so by the standards of the Rule Maker.

While no single company has or ever will have a monopoly on expert distribution, the time and effort involved in setting up the distribution system creates a significant barrier to entry for the leading Merchant King. In addition, even when a competitor has the resources to mobilize its own state-of-the-art distribution system, there are significant hurdles to overcome, including:

Time. Even when there is enough money, the second distributor to the party is always playing catch-up. By the time the laggard has geared up, the nimble first-comer has moved on and set a new standard.

Damage to existing relationships. The lagging distributor has built a business model based on moving its merchandise in a certain way. Many parties benefit from the existing distribution standard. When changes are made, some of these people's jobs are affected. Any time this happens, delay and extra cost can be expected.

Dell and Compaq Computer (NYSE: CPQ) provide an excellent example of how strong these barriers can be. As Dale Wettlaufer puts it in The Motley Fool Industry Focus:

"Dell has proven decisively that direct-marketing personal computers, and supply chain efficiencies that go along with that, works very well... now the entire PC world has gotten the Dell religion in one way or another."

Compaq, however, has a problem every time it leans too heavily on direct marketing because it begins to take sales away from the network of distributors that it has built up over the years. To quote Dale again from the 3/1/99 Boring Report:

"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."

Those economics are now centered on the direct-marketing model pioneered by the best performing stock in the 1990s. A PC company out of Round Rock, Texas named Dell. Tomorrow, I'll finish my review of Dell by looking at some of the "rules" that this company makes.

If you're new to Rule Maker Land, join us on our new message board: Rule Maker Beginners, where no question is a "dumb question." This board is open to any and all discussion related to the basics of investing in general and Rule Maker investing in particular. Hope to see you there!

Fool on,

Al

03/10/99 Close
Stock  Change    Bid
AXP   -  5/8   117.63
CHV   +3 5/16  83.25
CSCO  -  15/16 104.38
KO    -  1/4   62.88
GPS   -  1/4   69.50
EK    +  3/16  65.63
XON   +3 3/16  73.13
GM    -  9/16  87.88
INTC  +1 9/16  116.88
MSFT  -  7/16  161.38
PFE   +1       139.75
SGP   -  1/8   56.31
TROW  +  1/8   33.81
YHOO  +6 5/16  173.63

                   Day   Month    Year  History
        R-MAKER  +0.58%   5.74%  10.22%  39.47%
        S&P:     +0.55%   3.92%   5.01%  29.93%
        NASDAQ:  +0.55%   5.16%   9.73%  45.57%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    161.38   106.18%
    5/1/98   55 Gap Inc.      34.37     69.50   102.21%
   6/23/98   34 Cisco Syst    58.41    104.38    78.69%
    2/3/98   22 Pfizer        82.30    139.75    69.81%
   2/13/98   22 Intel         84.67    116.88    38.03%
   2/17/99   16 Yahoo Inc.   125.81    173.63    38.00%
   8/21/98   44 Schering-P    47.99     56.31    17.33%
   5/26/98   18 AmExpress    104.07    117.63    13.03%
    2/6/98   56 T. Rowe Pr    33.67     33.81     0.41%
   2/27/98   27 Coca-Cola     69.11     62.88    -9.02%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     87.88    21.37%
   3/12/98   20 Exxon         64.34     73.13    13.66%
   3/12/98   20 Eastman Ko    63.15     65.63     3.92%
   3/12/98   15 Chevron       83.34     83.25    -0.11%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3873.00  $1994.55
    5/1/98   55 Gap Inc.    1890.33   3822.50  $1932.17
   6/23/98   34 Cisco Syst  1985.95   3548.75  $1562.80
    2/3/98   22 Pfizer      1810.58   3074.50  $1263.92
   2/17/99   16 Yahoo Inc.  2013.00   2778.00   $765.00
   2/13/98   22 Intel       1862.83   2571.25   $708.42
   8/21/98   44 Schering-P   2111.7   2477.75   $366.05
   5/26/98   18 AmExpress   1873.20   2117.25   $244.05
    2/6/98   56 T. Rowe Pr  1885.70   1893.50     $7.80
   2/27/98   27 Coca-Cola   1865.89   1697.63  -$168.27

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1493.88   $262.99
   3/12/98   20 Exxon       1286.70   1462.50   $175.80
   3/12/98   20 Eastman Ko  1262.95   1312.50    $49.55
   3/12/98   15 Chevron     1250.14   1248.75    -$1.39

                              CASH    $185.03
                             TOTAL  $33556.78

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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