If you're a guy like me, those few times a year when you drag yourself to the clothing store because, surprise!, bell-bottoms are no longer in style, you head straight to the sales rack because you're looking for a bargain. As we all know, the problem with the sales rack is that it usually contains some of the ugliest clothing on the planet -- clothing they couldn't pay you to wear.
I often get the same feeling while sifting through the rubble of beaten-up and low P/E stocks. The usual suspects are businesses in dying industries (dial-up Internet, anyone?), companies with accounting irregularities (wait, assets = liabilities plus what again?), companies loaded with debt up to their eyeballs, and the typical roundup of deadbeats. But once in a while, a faint glimmer catches my eye. Wait a minute. Is that . Dell (NASDAQ:DELL) . on the 52-week low list? After encountering the once-mighty Dell sitting in the bargain bin, a few questions immediately came to mind: What happened, and who did this to you?
The evolution of a value investment
Make no mistake: Dell is a legend in the business world. From its humble beginning in Michael Dell's dorm room (is it just me, or does it seem that your company has no chance of being great unless you start it in a garage, college dorm room, or one-horse town in Arkansas?), Dell has spent decades steamrolling its competitors. The list of vanquished foes is impressive: IBM (NYSE:IBM), Apple (NASDAQ:AAPL), and Hewlett-Packard (NYSE:HPQ) are just some of the remaining competitors Dell surpassed on the way to its No. 1 market share of the global PC industry.
However, the past year or so hasn't been kind to this champion fighter, and some are wondering whether Dell is slipping. The company missed multiple consecutive earnings targets, endured sharp criticism of its customer service, saw the resurgence of arch-rival Hewlett-Packard, faced investigation into its accounting practices (still ongoing), and suffered from a tepid PC market. To top it all off, it turns out that Dell's batteries explode, and thanks to the popularity of Youtube.com, everyone and their mother has now seen the video of the exploding Dell battery.
Each successive misstep provides additional fodder to the bearish frenzy surrounding Dell. The reason why people kick a man when he's down is precisely because it's easy -- there's no fear of retribution. Bearish media, analysts, and investors grow more confident with each setback, some even calling into question whether Dell's business model even makes sense anymore. It's as if someone flipping a quarter came upon a string of 10 tails in a row and started wondering if probability theory was still valid. True value investors, however, patiently wait for someone to flip 10 tails in a row and then offer to buy the quarter for a dime.
So, is there any truth to the doomsday predictions that abound?
Probably the most salient issue revolves around Dell's customer service debacle. Dell, in the pursuit of saving a couple bucks, outsourced much of its customer service to India, and paid its call center employees by how fast they handled calls. To quote Jet Li in Romeo Must Die, "That . was a mistake!" Turns out, many customers have problems understanding foreign accents, and paying employees based on how fast they handled calls led to employees just trying to shove the quickest solution down the customer's throat in order to get them off the phone, rather than truly dealing with the situation, which left the frustrated customer with a bad customer experience. Whoops, Dell's bad.
Truth be told, Dell dropped the ball on this one, and in the long run, bad customer service will kill you. Disgruntled customers are much more destructive than happy customers are helpful. They'll complain to everyone within hearing range and basically make it their life's mission to spread the word. I'm no different, I'm still complaining about some of my bad customer experiences to anyone who'll listen (which isn't very many people).
Luckily, bad customer service is a fixable problem. Dell has relocated representatives, upped customer service expenditures by $150 million, and changed its incentives. In August, a University of Michigan survey showed that Dell's customer satisfaction rating rebounded off of eight-year lows, a small step in the right direction.
The other big concern about Dell is whether its business model still makes sense. Forgive me for sounding naive, but I still don't get why this is an issue.
Granted, HP, Lenovo, Sony (NYSE:SNE), and especially Apple have snazzier-looking products, an in-store presence in which to enjoy those snazzy-looking products, and the offer of instant gratification. However, when it comes down to it, I don't believe any of these erode Dell's ultimate competitive advantage, which is a lower cost base enabled by its direct sales model. Although competitors have become leaner and cut into Dell's cost advantage, the direct-selling business model will always be cheaper than selling through a retailer. This is due to the obvious reason that selling through a retailer results in a host of additional costs: paying rent, sales people, and warehousing costs. Because the retailer has to pay the bills and turn a profit, it charges a gross margin markup. For this simple reason, Dell's direct business model should continue to result in a competitive advantage.
Dell also has a couple of positive catalysts on the horizon, including the release of Windows Vista, the hiring of numerous designers in an attempt to make Dell products more fashionable, experiments with kiosks, and lastly, my anecdotal evidence that first-time laptop buyers might want something they can touch before they buy, but will go for lower-cost subsequently -- something I know from personal experience.
If my reasons for being bullish on Dell's long-term prospects sound simple and straightforward, it's because they are. I don't view this as rocket science, and if it was, I'd be in trouble, because I'm no rocket scientist. Warren Buffett's GEICO investments were driven by his belief in the power of a sustainable cost advantage driven by a direct sales model. I believe Dell exhibits similar characteristics and that the risk-reward rubric for investing in Dell is tilted in favor of reward.
For related Foolishness:
Dell is a Motley Fool Stock Advisor and Motley Fool Inside Value pick. For more great value tips, take Inside Value for a 30-day free trial.
Fool contributor Emil Lee is currently an analyst and a disciple of value investing. He likes to take long walks down the beach, as long as he can walk at a 40% or greater discount to its intrinsic value. He currently has a long position in Dell and appreciates comments, concerns, and complaints alike.
