There are really only two things that matter to most people when it comes to their computers. First, they want to know whether the machines can do what they need to do. Second, they want to be sure that they themselves can run the system. From the system-capability side of the equation, microprocessor giants Intel (NASDAQ:INTC) and Advanced Micro Devices (NASDAQ:AMD) rule the roost. As to actually using a computer, Microsoft (NASDAQ:MSFT) largely owns the look and feel. Its ubiquitous Windows software is so dominant that the company regularly finds itself considered a monopolist.
With those powerhouses owning the keys to the value chain, system manufacturers such as Dell (NASDAQ:DELL) find themselves trapped between a rock and a hard place. In fact, of the major players in the business, only Dell has found the secret to being reasonably consistently profitable. Unfortunately, that secret has been found by leading the race to the bottom -- ruthless cost-cutting and a glide path toward commoditization. Thanks to the lousy modern economics of being a system assembler, in fact, technology titan IBM (NYSE:IBM) recently bowed out of the PC business altogether. Its former PC division is now owned by Lenovo. Others, such as Hewlett-Packard (NYSE:HPQ) hold on to their PC divisions largely as a leverage opportunity to sell higher-margin printers, ink, and professional services.
Not the lowest cost
Unfortunately, even though its direct-to-consumer business has destroyed many other major players in the industry, Dell can't claim the throne of "low-cost provider." That title is still held by the generic and store-branded PCs of the world. For instance, my personal system is a PowerSpec, purchased at MicroCenter, for several hundred dollars less than a comparable Dell. In fact, it took nearly a year for Dell's prices to match MicroCenter's original price for an identical machine to the one I purchased. That's nearly a year's worth of use and the inevitable march of technology.
Dell should have lower overhead because of its store-free distribution system. Add to it its reputation for cost-cutting and the scale that its size provides, and Dell should have won that price battle, hands down. That it didn't tells me that either that it doesn't view the generics as a threat or that its internal costs have gotten out of hand. Either way, it's a dangerous place to be for a company that built its business on a reputation of delivering low-cost, high-quality merchandise. Add Lenovo and its China-based cost structure into the mix, and the pricing pressure on Dell will likely only get tougher as things go forward.
Uncertain future demand
Let's not forget, too, that the personal computers of 2006 are tremendously more powerful than the ones of just a few years ago -- so powerful, in fact, that the mandatory upgrade cycle may be starting to slow. Business productivity applications such as email, word processing, and spreadsheets run fine on modern systems. Electronic gaming is largely migrating to specialized systems such as Sony's (NYSE:SNE) PlayStation and Microsoft's Xbox, thus removing that driver of PC growth. Additionally, more and more systems and applications are networked and dependent on servers and network speeds, thereby making the local PC less of the performance bottleneck than it had been.
Given the satisfied business needs, shifting gaming platforms, and networking that's pushing computing off the local workstation, several large upgrade drivers look to be diminishing. Dell's past growth may have been terrific, but companies are valued based on their potential future performance. With no big demand drivers pushing upgrades, growth may very well begin to stagnate.
The Foolish bottom line
Sandwiched as it is between the powerhouses that make the brains and the look and feel of PCs, Dell is naturally in a very tough spot. Add a measure of lower cost competition nipping at its heels, and the picture starts to get murky. Throw in technological shifts with the potential to reduce demand for the ever-more-powerful machines that drive its business, and Dell's future appears downright risky. With Dell trading at 20 times trailing earnings and 16.8 times trailing free cash flow, even with its recent decline, there isn't enough value for me to consider investing here.
Dell and Microsoft have both been recommended in Motley Fool Inside Value . Dell is also a Stock Advisor pick.
Think you're done with the Duel? You're not! Go back and read the other three arguments, and then vote for a winner.
At the time of publication, Fool contributor Chuck Saletta owned shares of Microsoft. The Motley Fool has a disclosure policy.
