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Is Dell a Buy Now?

(April 27, 2006)

Dear Subscribers and Readers,

In our last mid-week commentary, I started asking our readers who are interested in individual stocks should send in a pick of theirs complete with a “big picture” analysis of why a particular stock or industry is a good (or bad) pick.  Since then, I have had a few folks who are interested – but none that had put together any kind of analysis so far.  I know not everyone of you are writers (and I don't profess to be a good writer), but please do send them in anyway and I will do my best to reconstruct your analysis (and give you full credit).  We are here to learn from one another – and forcing yourself to put your thoughts in writing is always the best way to learn.

Since the response has been a little muted so far, this author has decided to jump start our “individual stock analysis” series by writing one himself.  I have always been good with numbers in school.  I can do math in my head as quickly as anyone and I doubled-majored in Mathematics and Economics when I got my BA degree at Rice University.  I liked complex analysis, abstract algebra, and all my economic classes but my “fascination” with math pretty much ended there.  I also did very well in my accounting classes but the thought of poring through hundreds of pages of financial statements have never really appealed to me and probably never will.  As readers should know by now, I am a very big-picture guy at heart – and if there is no obvious story in either the stock market or a certain stock, I would not hesitate skipping over the 10-K.  As a result, my little synopsis on Dell will be just that – a quick and big-picture view of what I am currently looking at and thinking about.  I do not think I can add anything of value by going over the last few years of balance sheet or income statement information.  Let's first take a look at the most recent price action:

DELL has depreciated 37% in the last 9 months alone - and the 50 DMA is about to cross below the 200 DMA for the first time since October 2003.

In the short-run, DELL is definitely very oversold – as relative strength is now even lower than where it was in 2002 and as stochastics have been in oversold territory for the last six months.  However, technically speaking, DELL is still in a downtrend, given that its 50-day simple moving average is about to cross below the 200 DMA for the first time since October 2003.

So what is wrong with Dell?  Is the computer industry about to mature and even decline?  Is the sky falling?  If the sky was falling, then it is not being reflected in the following weekly chart of HPQ.  Note that the price action in HPQ has been going in the opposite direction to that of Dell's since July of last year. 

Hewlett-Packard Co. (HPQ)

So what has been causing the decline in DELL?  The stock has been mired in a downtrend since July of last year, but the latest decline has been attributed to:

  1. Rumors of slowing notebook sales in Asia - as reported by Digitimes (which interestingly, hasn't been too reliable a source in the past);

  2. However, this "rumor" is somewhat being substantiated by the latest dismal earnings report that came out of INTC. And since Dell only uses Intel microprocessors (with the exception of Alien Ware, which Dell has recently just purchased), the next earnings report from Dell shouldn't be so good either;

  3. Last Thursday morning, both the Gartner Group and IDC released their 1Q estimates for 2006 PC sales, and it wasn't too pretty for Dell. Quoting Morningstar: "... both firms reported a slide in Dell's overall global market share. IDC's "Worldwide Quarterly PC Tracker" gauged Dell's global market share at 18.1% in the first calendar quarter of 2006, down from 19% a year ago. This slide occurred in a surprisingly strong first quarter for the PC market; global PC shipments grew over 13% year over year, well ahead of expectations."

The Citigroup downgrade (from “buy” to “sell”) didn't help either – as Citigroup analyst Richard Gardner cut its rating on the stock by a whopping two notches resulting in the first “sell” rating in over a decade.  As CNN reported, “Gardner said that the company is being negatively impacted by several factors, including declining demand in its main, corporate end markets, and cost-cutting by competitors.”  Gardner's main point was that he sees Dell losing its historical cost advantage of 8% to 15% over its rivals (down to “at the most,” 3%) – and thus Dell will need to further cut costs or their prices (most likely the latter) in order to gain back market share (the IDC estimates that Dell's worldwide market share declined from 19% a year ago to 18.1% today).

Going forward in fiscal 2007 and 2008, Wall Street analysts in general estimates both revenue and net income growth to be significantly below the historical mean.  Growth estimates are expected to be 12% and 15% respectively for EPS, and 9% and 10% respectively for revenues.  As the chart below shows, the historical geometric mean over the 1998 to 2006 fiscal years were 25% and 26%, respectively – which includes the 2000 to 2002 period when the technology bubble was in the process of bursting.

Historical and Projected Annual Growth in EPS vs. Revenues (Fiscal 1998 to Fiscal 2008*) - Both of Dell's revenues and net income are expected to flat line for the foreseeable future, representing disappointing sales and income for the first time since fiscal year 2002.

Apparently, the market is pricing in significantly slower growth, as the current price of $26.22 a share is significantly lower than the “fair value” estimate at both Morningstar and Motley Fool.  A quick “analysis” using a DCF model can confirm this.  Assuming a relatively conservative cost of capital of 12% (other major financial websites use 10% to 11%), a 12% growth rate in EPS for the next five years and a 6% terminal (nominal) growth rate thereafter, one gets a “fair value” estimate of approximately $37 a share.  Stock option dilution should bring this down to $32 a share or so – but this still gives an 18% margin of safety.  In order to get a “fair value” estimate close to $26.22 a share (and assuming cost of capital stays at 12%), one will have to use a five-year growth rate in EPS of 11% and a 5% terminal growth rate thereafter – and given that nominal GDP growth is in the 6% to 10% range in both China and India, this may be a pretty conservative figure going forward.  The question to ask is: Will Dell be able to maintain its current profit margins in the Far East?  And can they at least experience a growth rate in line with the market growth rate?

With a current price of $26.22 a share, the market is projecting revenue and EPS growth at Dell to continue to decline and for its business risks to increase at the same time (given a 12% cost of capital)!  This is definitely not unprecedented, however, as the valuation of Dell (judging by P/E ratio) is only just getting back to the levels it was experiencing prior to the late 1990s bull market.  The following weekly chart shows the action of DELL over the last ten years compared with its P/E ratio progression during that time:

Dell Weekly

Note that DELL had a P/E ratio of only 15 as recently as late 1996 – before it became the model company for online and direct sales of computers and notebooks.  Today, growth (both actual and potential) growth is significantly slower – but the company has established a brand name for itself and has been able to attract and retain valuable management and sales talent.

Again, the question is: Where is growth going to come from?  Desktop (which makes up 40% of the company) growth is literally flat, while the mobility division (which makes up 25% of the company) is “only” reporting 18% growth on a year-over-year basis.  Most are saying "services," but keep in mind that IBM, HPQ, and everyone else are trying to do the same thing. Does DELL have an edge in this space where other companies don't have? My guess is "no" but the revenue growth of its “enhanced services” division (which make up 9% of total revenues) is in the mid 30s – and so this should continue to be a profit driver for the foreseeable future.  Going forward, I believe all the years of training in India and the bad customer service (which is somewhat blown out of proportion) that we are currently enduring should pay off in the future.  They are currently working very hard to make their Indian business model work – and if anyone can conquer those “bumps in the road,” it is Dell.

Dell also has a significant presence in “software & peripherals” and “storage” – collectively combining for 18% of the company's revenues.  The growth rate is very high as well – as these divisions continue to grow in a range of 30% to 45%.  Back in the late 1980s, most folks thought that Coca-Cola's growth was already saturated, and even Buffett was ridiculed for buying his stake of KO in 1988. What most investors did not count on was the subsequent explosive growth in Asia.  Could we count on China or India "bailing out" Dell over the next three to five years? Can Dell cut down costs to a threshold where demand for its PCs and laptops will literally explode in China and India?  Like I mentioned before, can Dell establish a presence in India and sell their services locally as well as both hardware and software?  This is all assuming that the Dell brand name (just like KO's) will help them - but at this point, no other computer manufacturer has a better focus or vision than Dell.

The final question to ask is:  Besides computers and laptops, are there any other products out there that can take advantage of Dell's manufacturing processes? Perhaps at some point customers can design his or her own portable music player on Dell's website by customizing literally everything? As strange as this may sound, retail products are still very standardized by 21st century's standards.  This is definitely a question for our more thoughtful subscribers as we all continue to evaluate potential investments in the 21st century.

Bottom line for Dell: Given its current valuation, there is huge potential on the upside, while downside risk remains minimal.  The fact that capital spending in the United States has still not quite ramped up since the bursting of the technology bubble also leaves a lot of room for significant increases in business purchases of Dell's hardware, software, and services – which should overcome any slowdown on the consumer side should the U.S. enter into a “mid-cycle slowdown scenario” sometime this year.  We will continue to keep an eye on Dell, given that current technicals on the stock are still very ugly (even though they are short-term oversold) and given that the 50 DMA is about to cross below the 200 DMA for the first time since October 2003.  Both these factors imply a lot of technical damage – and it will take time for Dell to recover and base before it could challenge the $40 level again.

Please discuss the prospects of DELL in our Discussion Forum.

Signing off,

Henry K. To, CFA

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