So why isn't Dell Computer (Nasdaq: DELL) a Rule Maker? It's the dominant maker of personal computers in the industry. It pioneered a new sales model that changed the way computers are built, bought, and sold. It's one of America's most admired companies. Over the last five years its sales have grown at a compound annual rate of 37%.
Yet I'd argue it's no Rule Maker.
Let's start with a few facts. Last year, Dell wrestled the U.S. PC-vendor crown from rival Compaq Computer (NYSE: CPQ). It's PC position keeps getting stronger, plus it has already captured 25% of the U.S. server market, more than Hewlett-Packard (NYSE: HWP) and IBM (NYSE: IBM) combined, according to CEO Michael Dell. Roughly 15% of Dell's sales last year came from servers.
Here's how PC industry shipments for the top vendors looked in the first quarter. Numbers are in thousands:
Q1 00 Market% Q1 99 Market% Growth U.S. Dell 1,980 17.08% 1,454 14.61% 36.18% Compaq 1,890 16.30% 1,597 16.05% 18.34% Worldwide Compaq 3,951 12.84% 3,557 14.03% 11.07% Dell 3,189 10.37% 2,451 9.67% 30.14% Source: International Data Corp.Most impressive is how fast Dell has grown relative to Compaq over the last year, especially considering its size: Dell had $25 billion in sales in 1999.
The knock on Dell from a Rule Maker perspective is its margins -- gross margins, to be precise. We're looking for companies with gross margins above 50% and net margins above 7%. Last year, Dell's gross margins stood at a woeful 21%, while net margins, minus an acquisition charge, came in at 8%.
OK, Dell makes a commodity product and computer prices never stop falling. But take a quick look how it ranks on the other Rule Maker criteria. It has a dominant name, ranking number three on Fortune's most admired companies list. It clearly benefits from repeat purchases, has a Cash King Margin of 14%, carries virtually no debt, has almost $3.5 billion in cash on its balance sheet, and is set to grow sales at roughly 30% annually. And then, of course, it allows customers to purchase customized PCs and related products off the Web -- talk about convenience. At the end of last year, its website generated $40 million a day in sales -- almost 50% of company revenues.
Let's drill down into the bedrock of Dell's profitability. For many readers this won't be new since Fools have written on the topic many times, but it's worth repeating.
One way to look at the profitability of a company is the rate of return on assets (ROA), a measure of net income relative to total assets, independent of the financing of those assets.
There are two components of ROA: net margin (net income divided by sales) and the total assets turnover ratio (sales divided by average total assets), which measures sales relative to the assets needed to generate them.
Boosting either component increases a company's profitability. Thanks to high asset turnover, a tight focus on the management of current assets, and excellent returns on invested capital, Dell has richly rewarded shareholders for a decade.
In 1999, its asset turnover ratio stood at 2.75, meaning the company generated $2.75 in sales for every dollar of assets. By Comparison, uber-company Cisco's (Nasdaq: CSCO) total asset turnover ratio stood at 1.03 in 1999. It's not an apples-to-apples comparison since they compete in different industries, but few companies operate efficiently enough to generate $25 billion in sales off an asset base of just $11 billion as Dell does.
This is just to point out that many companies with low margin businesses have become wonderful investments. Wal-Mart (NYSE: WMT), Costco (Nasdaq: COST), and Gateway (NYSE: GTW) are just a few examples. I wouldn't, therefore, automatically exclude a company from the Rule Maker port just because it had low gross margins.
In the case of technology, however, I think the gross margin barrier is very effective in screening out companies that don't offer technology far enough upstream to insulate investors from changes at the user level. Dell is a good example. As PC growth has slowed, as the computing center has expanded to handheld and other wireless devices, Dell has scrambled to maintain its center of gravity. PC makers aren't at the center of Internet computing or the communications industry. Dell is the light bulb, not the light.
Author Geoffrey Moore and Robertson Stephens analyst Paul Johnson focus on this issue in The Gorilla Game, their book aimed at helping investors find elite technology companies. Look for companies that offer products that become a business standard -- Microsoft's (Nasdaq: MSFT) Windows operating system and Office applications, Cisco's routers and LAN technology. These are the companies with the strongest legs.
Technology stocks in the Rule Maker portfolio naturally fall into this category. Intel (Nasdaq: INTC) makes computer chips that power PCs, servers, and other Internet devices. JDS Uniphase (Nasdaq: JDSU) combines optical components into modules, adding value to the parts it sells and simplifying the assembly process for telecom equipment companies. Yahoo!'s (Nasdaq: YHOO) portal quickly became ground zero for information on the Web, though its competitive advantage comes more from stakes put in the ground years ago than its software.
Looking at the Rule Maker portfolio, I'd say Nokia (Nasdaq: NOK) faces the greatest risk of mediocrity. Not that it won't be the dominant provider of cellular phones in 2005, but what happens in three or four years when the handset business starts to mature? What's Nokia's lasting competitive advantage? It's hard to see.
This doesn't mean Nokia and Dell won't be solid, relevant companies years from now. Dell has always distinguished itself by the services it offers, and its ability to execute isn't easily copied. It's a great company. (Actually, it's one of my favorite companies.) I just don't think it's vital, and that's what being a Rule Maker is all about.
Do you see something different? Let's take it to the Rule Maker Strategy board.
For a better look under Dell's hood, check out analyst (and Rule Maker co-manager) Zeke Ashton's Fool Research Report.
