None of the following pages should be taken as direct investment advice. We the producers are private investors, not professional investment
advisors. Please make your own final investment decisions.
August 11, 2003
DELL, Inc.
By Brady Willett & Todd Alway
The question the investor should ask with regards to DELL is whether or not the current IT/PC industry is a mature industry or
simply a maturing industry. We do not have a crystal ball by which to answer this question, but steep declines in the total
number of employees working at DELL along with a flattening square footage total in America provide clues to what the future
may hold. The vision that emerges is of DELL trying to emulate historical domestic growth rates abroad. But can past success
in America be replicated abroad in the future?
Introduction
Founded in 1984, DELL quickly began to separate itself from the competition by using its ‘direct model’ approach.
Direct Model & Customer Service
DELL assembles, packages, and brands technology products, but it does not ‘produce’ technology products in the strictest sense
of the word. This approach enables the company to manage its inventories extremely efficiently, while keeping research and
development costs at essentially nil.
Rather than argue that DELL has benefited simply because it was using the right business model at the right time, the more
informed conclusion is that by offering superior service DELL has built upon and leveraged its reputation. Quite frankly, when
someone calls up DELL they trust that they are getting the most reliable service and technology in the business (PC Magazine
rated DELL the highest in customer service in its July 2003 consumer poll). Thus, it is the DELL name – synonymous with
service and expertise – which affords DELL products a premium over smaller sized direct model and other PC manufacturers.
Auspicious Beginnings
DELL launched its IPO on June 22, 1988 (3.5 million shares at $8.50 each). 15 years, and 7 stock splits later, DELL shares are
up by many thousands of percent. However, purchasing DELL shares at the wrong time has proven costly: from its peak in
March 2000 DELL fell by 73%, and, despite a recent rally, remains nearly 50% below its peak today.
At the end of 1Q03, DELL was the largest PC company in the world. This title has switched hands between DELL and HP
numerous times in recent quarters (see IDC). Nevertheless, from humble beginnings in 1984 DELL has leveraged its direct
model, and built its name as one of the most recognizable in the world. A PC customer could buy individual components and
assemble their PC at a cheaper price than DELL does, but few do…
Long-Term Investment Opinion
It is likely to be the case that DELL will exist and thrive in the PC Market in the future. DELL is a not only expanding globally
– number one non-Chinese PC seller in China – but it is a company that has pricing power over its competitors.
However, from an investment standpoint we do not believe that the company is attractive longer term. Rather, when taking into
account historical valuations and a rapidly and unpredictably changing tech environment, we believe that owning shares for the
long-term carries with it great risk.
We note ‘unpredictable change’ because there are some who believe that silicon based technology has a 10-year future.
Furthermore, the once thought to be ‘expert’ opinions on computer replacement cycles have proven off the mark by years. Thus,
all that is foreseeable in the near term is that many U.S. businesses will only invest new money in IT if they can readily identify
a return-on-investment opportunity. We can also forecast that DELL’s growth-rate and pricing power cannot be maintained if
this type of environment persists. However, DELL, and tech stock prices in general, seem to be anticipating a dramatic surge in
growth based on speculations relating to the ‘replacement cycle’ and/or the advent of newer technology becoming a ‘must own’
property. Calling these investors ‘experts’ may be wishful thinking.
Taking into account valuations, an unknowable tech future, and DELL’s relationship dependent enterprise, we believe that
DELL is severely overvalued.
History of Operations & Financial Valuations
Inventories
As stated, the ‘direct model’ approach helps the company keep inventories at a bare minimum, which not only limits the amount
of obsolete product the company is holding at any one moment, but also ensures that the company is offering advanced
technology to its customers. Whether or not DELL offers the ‘most advanced’ components available is debatable to those
(typically ‘gamers’) who regularly await new breakthroughs in such things as video cards (e.g. DELL has been slow to adopt
the new Geforce FX as standard fare). Nevertheless, new Intel chips find there way into DELL desktops and portables quite
quickly, and never at the cost of DELL’s other products - DELL does not sell older PCs at a loss just to clear obsolete
inventories.
As the chart below aptly demonstrates, these advantages have increasingly become apparent: even as revenues have increased
by 42% on average annually since 1992, inventories have remained flat during the entire period. On related note, and equally
astonishing, is the fact that DELL has expanded its global square footage interests – both manufacturing and office facilities –
from less than 2 million square feet in 1995 to more than 10 million square feet in Jan 2002, while inventory levels have
decreased during this time (429 million in 1995 to 309 million in 2002.) It is difficult to find any company in any industry that
operates with these types of efficiencies.
Margins
Disregarding 31% gross margins in 1991 as being an aberration, DELL has hovered around the 20% gross margin area for more
than a decade. Moreover, and as the company battled to steal marketshare during a tough operating environment (2000current), DELL was able to maintain near 20+% margins; after a 7-year run of 20+% margins ended in 2000, gross margins
have slipped to 17.9% and 17.8% respectively over the last two years.
Although 17-20% gross margins are not overly impressive compared to Apple and Hewlett Packard – both which have
historical gross margins close to 30% - since DELL operates as a technology middle-man, the middle of its income statement
(SG&A, R&D, etc) is exceptionally ‘clean’. Thus, 17%-22.5% gross margins have led to an average of 5.3% net margins over
the last 12 years.
After this discovery the most applicable thing to do would have been to group all the PC companies together and compare
historical margins. However, HP is only now emerging from a difficult merger phase with Compaq, which makes such
comparisons spurious. Similarly, other PC companies – including Gateway and Apple - have posted losses in recent quarters
that taint such comparisons. For example, Apple handily beat DELL’s net margins for the 3-quarters ended June 29, 2002
(8.9% versus DELL’s 5.6%), but since Apple went on to lose money in each of the following two quarters, comparing margins
becomes a pointless endeavor.
Suffice it to say, DELL’s pricing ‘power’ is not that the company can raise or even maintain prices, but that the company can
continue to make money with its lean cost structure inside of any operating environment. DELL has the ‘power’ not to lose
money during the tough times.
In short, compared to industry competitors DELL’s margins are not overly impressive, but consistently impressive. No, not as
impressive as a monopoly like Microsoft or the industry leading IBM, but impressive nonetheless.
Valuations and Stock Repurchases
Inventory and operation (margin) considerations aside, some of the basic valuations on DELL stock are concerning. As the
company has become larger the premiums on p/s, p/b, and p/e have risen, and despite softening growth trends in recent years
these valuations remain extremely rich. To note: we do not highlight price/free cash flow as ‘rich’ because although DELL’s
P/FCF stats are above historical averages, if DELL elected to use all of this free cash for a dividend its yield would be roughly
4.2%. Regardless of the dilution that reducing its repurchase program would inevitably cause, the company’s historical free
cash flow is ‘sound’ (you could even argue attractive if you had faith in the so called ‘tech turnaround’).
To put these above statistics into context, consider the return-on-equity history. Owning only one pre-2000 blemish with regards
to ROE (1996), DELL’s equity growth (1992-2000) reached a high of 128%! in Y2K impacted 1999. All told, this equates to an
impressive 46% ROE average for the 8-years ended 2000. However, these ROE attributes are yesterday’s news; for the three
years ended 2002, DELL’s ROE has been +13.5%, -2.2%, and 5.5% respectively. Looking solely at the above valuations
charts, you would hardly know that DELL is becoming a larger company in a maturing industry.
Finally, we have concerns about DELL’s use of stock buy backs/stock options. DELL readily admits that buy backs are used to
stave off the dilutionary impact of exercised stock options. However, what the company does not do is expense stock options or
buybacks - in essence, the company readily admits that earnings do not take into account all regular business expenses.
After peaking at 26% of Cash from Operations in 1999, the stock options tax credits DELL receives has consistently declined
(from 22%, to 12%, to 7% for the years ended 2002 respectively). However, the company continues to aggressively buy back
stock, with nearly $8 billion in such buybacks over the last 3-years (using 70% of Cash From Operations). The days of utilizing
put options schemes to rig earnings and hiding a couple of pennies in investment gains to make future estimates may be over for
DELL, but the company continues to benefit from issuing stock options. Shareholder cash is used to ensure such stock options
never impact the income statement. This would all be fine and well if insiders – Mr. DELL included – were not rapidly
dumping stock every waking moment. To be sure, if DELL management is confident that shareholder money is best used to buy
DELL shares why doesn’t management buy some shares for themselves?
Incidentally, why DELL does not declare a dividend makes little sense, especially given that the company has the money and
Bush’s new tax cut package will reduce dividend taxes. At DELL’s recent annual meeting a shareholder asked management to
declare a dividend arguing that "I'd like to get some return on my investment". Michael DELL responded, “How about a 50,000
percent return? Would that do it?"…
Given DELL’s high valuations and the maturing tech industry, the next 50,000% will not come easy for DELL. It appears Mr.
DELL already knows this though, as he has sold roughly 35 million shares without purchasing 1 share since mid-2001.
Near Term Investment Opinion
DELL shares are up 35% since February 10. This rally has been fueled largely by speculation that the company is soon about to
embark upon another super-strong period of growth. Such forecasts have proven unreliable in the past, and unless a new driver
for growth emerges (i.e. a pickup in IT spending or stronger growth in Asia) DELL shares are not likely to maintain current
‘above the band’ trading levels.
Our near-term investment opinion is that DELL should either be ‘traded’ as one of the premier momentum stocks in the world,
or purchased on severe weakness as a long-term tech/dividend leader. We note ‘dividend’ because despite the company’s
steadfast position not to declare a dividend, we believe that the company will declare a dividend by year-end 2004 - if FASB
forces companies to expense and shareholders continue to pressure management for a dividend.
From a statistical point of view a specific reevaluation price level can be calculated. Using the 4-sets of criteria below, we
arrive at a basic (fair value) price level of $25.84 a share.
Conclusions
During the mania days, attempting to make profits in the markets boiled down to accurately predicting whether or not a
company was able to beat EPS/Rev targets. It didn’t matter whether or not these targets were pro forma, stuffed with pooled
asset gains, boosted by investment gains, or shielded from off balance sheet liabilities. Rather, company ABC beats EPS target
so ABC’s stock price rises…
Given that stock options remain unexpensed, and many companies - HP in particular – still focus on pro forma financials, the
much hoped for accounting changes have been slow to materialize. However, there is hope: with FASB aggressively targeting
pooling of goodwill (2001), off balance sheet assets (2003), and unexpensed stock options/pension schemes (hopefully 2004),
shareholders can continue to hope for more meaningful financial statements in the future.
We note these accounting policies with regards to DELL because they may have a material impact on how the company reports
its financials in the coming months/years. For the sidelined investor interested in owning DELL at an attractive price, focusing
on potential stock market negatives can be helpful.
In sum, there is no denying that DELL’s incredible revenue gains since 1990 have been unprecedented in our investment
lifetime. We do not even need to begin from a low revenue base to make this comparison more attractive. In 1990 DELL was
already generating nearly $1 billion in revenues ($889 Million)…by year-end 2002 this number had jumped to more than $35
billion. More incredible still is the fact that during this same time frame annual expenditures increased from $32 million to
$305 million. How exactly does a company increase revenues by 3,882% over a twelve year period while expenditures only
increase by 853%?
The specifics of past success are many. However, it is this past that is influencing the premium investors pay for DELL shares
today. The real question is whether or not DELL’s current operations abroad will generate enough growth to justify such
premiums in the future.
DELL had 1.6 million square feet of manufacturing and office space in America in 1995 and 7 million square feet in January
2001. More than 2-years after the tech bubble went bust, DELL still has only 7 million square feet in America. DELL is
growing by inches in Europe (HP is number 1 in Europe) and, although well positioned, still taking baby steps compared to its
1990s U.S. growth rates in Asia. Clearly the domestic market for DELL is mature. The verdict is out on whether or not
international growth is readying to cannonball higher.
Sincerely,
Brady Willett & Todd Alway
Copyright © 2003. FallStreet.com.
None of the following pages should be taken as direct investment advice. We the producers are private investors, not professional investment advisors. Please
make your own final investment decisions.