Core competitive strength
Dell’s (NasDaq : DELL) business model is direct selling to customers, building computers to customers’ specifications, which eliminates both retail markup and inventory costs. Direct communication with customers also allows Dell to respond to their needs more quickly. Its lower cost structure has allowed it to consistently take market share from rivals, so much so that it now has the largest market share in the US PC market. Along the way, Dell has focused its research and development efforts mainly on logistics, and is now known for its super-efficient just-in-time manufacturing processes. Like Wal-Mart, Dell is also not coy about using its size to put pressure suppliers on cost and delivery time. These advantages should allow Dell to continue to maintain its lower cost structure.
Growth prospects
The central engine of growth for Dell will be the overseas PC market. While growth in the domestic PC market has slowed (in fact declining 2% from 2005 to 2006), overseas sales growth has picked up the slack allowed Dell’s revenue to increase 14% in 2006. Revenue from outside the US already makes up 41% of total revenue, and is taking an increasing share of total revenues. I predict that Dell will be able to replicate its hyper-efficient logistical processes throughout the world, eventually resembling McDonalds and Coke, companies which derive the majority of their revenue from overseas. Given that the major hardware and software components of PCs are made by US companies with which Dell is a major customer, with commensurate pricing advantages, Dell should be able to maintain its lower cost structure even overseas and fend off local competitors with greater market knowledge or lower labor costs.
In addition to applying its hyperefficient manufacturing processes in multiple countries, Dell can also apply the same processes to multiple products. Already, Dell is gearing up to introduce a range of new products, including printers, LCD TVs, and screen projectors. This may well provide a second engine of growth. We shall see if Dell manages to take market share away from HP and Xerox in the printer market, as it has done in the PC market.
Lastly, Dell is also chasing higher profit margins by going after customers who are willing to splurge on computers. To that end, it has just purchased Alienware, a boutique computer manufacturer specializing in gaming machines. It is also hiring designers in Austin and Singapore to beef up the quality of its products. Lastly, it is also experimenting with Dell kiosks where customers can touch and see new Dell computers, although those kiosks will not hold inventory and customers will still have to order online with the aid of sales staff. In this endeavour, Dell is taking a leaf from Apple, which has had great success with its retail stores.
Value from assets
From Dell’s latest 10Q, as of May 2006, Dell has about -$1.7 billion in net cash (cash + short term investments – current liabilities), or -$0.80 per share. This shows that Dell is actually running its business on other people’s money! Supppliers provide goods and wait 30 days for payment, while Dell ships finished products and receives payment within 30 days, i.e. Dell does not require working capital. Its inventories total $636 million, or a measly $0.28 per share. Its property and other long term investments amount to $4.7 billion ($2.07 per share). Its long term debt is -$1.40 per share. This totals to $0.15 a share from assets.
Value from net income
From Dell’s latest 10K, as of February 2006, Dell has net income of $3.5 billion, and free cash flow of about $4 billion. Taking the smaller number, Dell has earnings per share of $1.54. For the past two years, net income has increased by about 15% per year. Taking a discount rate of 7%, and projecting a conservative growth rate of 5% for 10 years into the future, Dell should be fairly valued at a PE ratio of 20, giving a share price of $30.80. A slightly more realistic and optimistic growth rate of 10% for 10 years gives a PE ratio of 30, and a share price of $46.20. Even taking Dell’s latest ttm earnings per share of $1.23 (which is atypical because it is occurring in a period of low sales coupled with intense price competition), Dell should be worth $24-37 per share.
Problems
Dell has a history of emphasizing on manufacturing and logistics processes at the expense of quality. I remember the time when Dell came out with its first generation laptops, which had a tendency to overheat and melt. In time, Dell recognized and overcame its build quality problems, and now its laptops are actually fairly usable (though still inferior in build quality compared to Thinkpad and Apple laptops, in my opinion). Recently, Dell suffered a spate of bad publicity over exploding batteries and bad customer service. However, Dell recognizes the quality problems, recalling its defective laptops and closing its call centers in India. Dell is spending $150 million to open a new customer service in Canada, and has pledged a new drive to surmount its customer service problems.
In my opinion, the most critical problem surrounding Dell right now is the SEC probe into its accounting. As a value investor, I rely on the accuracy of accounting reports, and this is obviously very troubling to me. Another source of worry for me is Dell Financial Services (DFS), which is 70% owned by Dell and 30% owned by Citibank. DFS is supposed to provide financing to Dell’s customers, thereby increasing sales. However, there has been reports that DFS has been using aggressive sales techniques to pressure customers into taking loans against their wishes. In addition, DFS is accounted for as a off-balance-sheet special purpose entity (SPE), which means we have no idea what liabilities and assets DFS carries. DFS is an albatross around Dell’s neck, potentially attracting large class action lawsuits against Dell while contributing marginally to Dell’s profit. I wouldn’t be surprised if DFS is the cause of the current SEC probe.
Conclusion
Because Dell’s growth will be primarily international, I think nothing short of global recession will dent Dell’s growth in the long term. The traditional bugaboo of technology companies, namely rapid technological change, has very little effect on a company which carries minimal inventory. In the short term, I believe that once Dell’s accounting problems are cleared up, and Windows Vista is released, Dell should see at least a small bump in its share price. I believe that with its share price in the low $20s, Dell has reached the bottom of its decline and can only go up from here. Hence, I bought a small position in Dell for around $22 recently.
Disclaimer : The analysis and opinions above are derived from my personal research, and I do not guarantee their accuracy. I do take a position in any stock I favorably review, so while I will not be responsible for any losses resulting from my advice, I will at least be losing money too.
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