By deciding to sell liquid crystal display (LCD) and plasma TVs, Motley Fool Stock Advisor pick Dell (NASDAQ:DELL) is pitting itself against traditional Japanese consumer heavyweights like Sony (NYSE:SNE), Matsushita Electric's (NYSE:MC) Panasonic division, and Sharp. That's heady competition.
But Dell has something the others don't have: a decade of expertise selling electronics on the Web. I feel Dell's entry into this market presents an excellent opportunity for long-term investors with time horizons of three to five years.
Low-cost distribution model rocks!
The evolution of the Web, and consumers' enthusiasm for buying stuff on it, was a price- and margin-crusher for traditional computer companies like Hewlett-Packard (NYSE:HPQ) and IBM (NYSE:IBM), which carried large inventories. Computer stores with large fixed investments in retail space also suffered.
Dell, on the other hand, took the direct-sales model and elevated it to an art by selling lower-cost PCs on demand via telephone, the Internet, and catalog. Dell carries virtually no inventory and has no retail space, so it bears none of the associated staff or leasing costs. Consequently, Dell keeps operating expenses well below those of its competitors. The resulting profit margins allow it to undercut the competition. By late 1999, Dell had vaulted into first place in computer sales -- beating out the established IT hardware giants.
Dell changed the way we bought PCs in the 1990s. What it did for selling PCs into our home offices, it now plans to do for selling TVs into our living rooms.
During the past five years, the TV business has shifted to solid-state devices (such as LCDs), which are commodities in which little brand differentiation is possible. This a perfect market for Dell, with its ruthlessly efficient production and logistics management. Dell's direct-sales model should allow it to undercut competitors' TV prices and take market share, while maintaining higher margins. That's an impressive balancing act -- one its competitors are unlikely to match. It's also why Dell's move into TVs is an attractive investment opportunity.
Dell's entry into this market also hurts retailers like CircuitCity (NYSE:CC) and Best Buy (NYSE:BBY). And not just because Dell is taking revenues away. These retailers' high-rent and retail staff expense reduces their profitability and makes it difficult for them to compete with Dell, which still has no retail stores.
One up on its competitors
More sales of flat-screen TVs means a higher demand for LCD panels. Six new LCD plants are expected to come on line by the end of 2006, (all of them in Asia) including LGPhilips and Samsung. This should result in a huge decline in LCD panel prices: According to Electronic Engineering Times, companies like Dell could pay less than $1,000 wholesale for a 42-inch LCD panel by the end of 2005.
That's great news for consumers -- but not such good news for manufacturers, since it means operating margins will decline. The current 10% industry average is more attractive than the 2% to 3% operating margin for PCs. However long-term margins for TVs are no more sustainable than they were for PCs, so operating margins will fall, possibly to a low of 3% to 4%.
If operating margins decline as expected, why get so excited about Dell making TVs? After all, Gateway (NASDAQ:GTW) just exited the business as a dismal failure. But then, Gateway's logistics and production efficiencies were nowhere near Dell's.
This margin trend is unlikely to be a deal-breaker for Dell. The company's superior logistics management techniques -- proven in the PC business -- should translate well to TVs. And because TVs aren't all that different from computer monitors, it's likely Dell will maintain higher operating margins than its competitors.
Impressive financials, too
Let's consider two common metrics for measuring business performance: return on invested capital (ROIC) and free cash flow. Dell's direct-sales model is one reason Dell outperforms its competition on both metrics.
First, my definition of ROIC: after-tax earnings, divided by total assets, minus excess cash, minus non-interest-bearing current liabilities. Total assets include cash and equivalents, investments, and intangible assets. Leaving out intangibles lowers the denominator and artificially inflates the ROIC number.
Dell's ROIC is a whopping 50%-plus. Compare that with the hardware peer-group (Dell, Hewlett-Packard and IBM) average of 32%, and retailers Circuit City and Best Buy at 13% and 18%, respectively.
Why is Dell's ROIC so much higher? Remember, Dell has no retail space, which increases after-tax earnings (the numerator) and reduces total assets (the denominator). Both effects combined increase the ROIC ratio. In addition, Dell has superior working capital management: It collects from customers a staggering 40 days (on average) before it pays suppliers! None of the TV manufacturers can compete with that.
Free cash flow, too
Now for a second definition: free cash flow (FCF) equals operating cash flow, minus capital expenditures. Excluding tax benefits from options, last quarter (1Q 2006), Dell reported FCF of $0.40, as payables and accrued expenses rose and receivables declined by $125 million. Although down sequentially, this was up year over year: So the year-over-year upward trend is intact. With Dell's capital expenditures at $800 million and factoring in lower benefits from payables and accrued expenses, FCF should be around $1.85 for fiscal 2006 and possibly as high as $2.10 for 2007.
Since 2002, Dell's FCF has grown at a compound annual rate of 9.5% -- substantially higher than the 6% average for computer company stocks and both Circuit City and Best Buy, at around 4.5% and 4%, respectively.
A good long-term bet
My view is that Dell could move to $43 to $45 over the next three years. That's at least 26% price appreciation from current levels, double the 13% expected for the S&P 500 Index. Dell currently trades at 16 times 2007 earnings, a premium to its peers. So why buy it? Doesn't Dell's current premium limit its potential for additional upside?
No. Not in Dell's case. Long-term, Dell's performance should continue to improve relative to competitors'. Selling TVs will boost revenues, yet Dell is unlikely to suffer the same margin disadvantages as its competitors. Finally, selling TVs is just a first step. It is attempting to establish a beach-head in our living rooms from which to sell additional, higher-margin entertainment products like entertainment boxes.
In his article Searching for 40,000% Returns, my Foolish colleague John Reeves explains why it takes boldness and vision to recognize and stick with growth stocks.
Are you looking for more great companies like Dell? Let Motley Fool co-founders David and Tom Gardner help you find the next big winner with a free trial subscription to Motley Fool Stock Advisor.
Fool contributor Melanie Hollands does not own shares in any of the companies mentioned. The Motley Fool is investors writing for investors.
