Is DELL Too Cheap Not To Own ?

Negativity abounds around DELL.

Earnings warnings, 4.1 mil. laptops recall due to battery defect, SEC investigation on accounting issues, fierce competition against a reshaped Hewlett Packard and aggressive Far East boxmakers, poor customer service and depressed margins disappointed investors.

DELL shares crashed accordingly from the low forties to reach briefly a 5 years at around USD 19 in July. Since then the stock trades in a range between about $20 and $23.

Discounting weakness in business model in the foreseeable future, company is reaching today extreme low valuations.
Since 1997 DELL traded at the end of its fiscal years (ending Juanuary) at an average of 2.8 P/S ratio (min 1.28 end of FY 2006, source: MSN Money). At today current quote (around $23) DELL fetch a 0.9 P/S ratio.
Though a single rough ratio does not give a complete picture I think that at a normalized sales growth rate and profit margins, both lower than their long term average, DELL may be a safe and cheap investment at slightly below the present quote.


1) PROFILE

DELL is the world leader of PC makers. The company founded by its present president Michael Dell in his college dorm room in 1984 fetched 10.5% worldwide PC market share in FY 2000, today it reached at around 19%.
Note that Michael Dell till owns a bit more than 10% of total shares outstanding.

Excluding the networking business, DELL is the market leader in all geographical areas except Japan (no.2) and Asia-Pacific (which includes India and Cina and where DELL is no3. but gaining market share).

In U.S. DELL is the leader in all the clients segments (education, government, home, large and small business) with 34% market share.

Revenues in trailing 4 quarters are 57.4 Bil.

Business segments revenue breakdown (MRQ):
- desktops and mobility (mainly laptops): 61%
- software and peripherals: 16%
- servers and networking: 10%
- services (product warranties, training ...): 9%
- storage: about 3%
DELL does not disclose operating margins for each business line.

Geographical revenue breakdown (and year over year sales growth, MRQ):
- Americas: 65% (+3%)
- Europe: 21% (+3%)
- Asia-Pacific-Japan 14% (+17%)

Success of DELL has been driven by :
- 1) Their unique direct sale / build-to-order model which allows them to eliminate wholesalers and retailers margins and having a real-time feel on market needs and avoid inventory glut at the retailers level.
Cash from their sales is also directly reaching their coffers without being delayed in intermediate distribution channels.
- 2) An obsessive focus on continuously improving their best in class manufacturing and supply chain management practices. This manufacturing global giant is able to have an average of 5 days of inventory in stock only. They are therefore the first to introduce new components and the first to pass to their customers the savings of PC components which are in a secular downtrend prices.
They are also avoiding the high obsolescence risk in the ever changing PC business.
- 3) Concentration on standards-based technologies. Their R&D represents less than 1% sales. The reduced number of suppliers of mainstream components makes easier for them to efficiently manage their supply chain.
-4) Market share growth to preserve a strong bargaining power with their suppliers and spread their fixed costs over a large sale base.

Though their business mix is slowly making progress towards higher margin products and recurring products and services their main strength is basically being the low cost PC provider, delivering a competitive commodity product with an good service level. More on service issues and recent improvements below.


2) ROCK SOLID BALANCE SHEET, STRONG CASH FLOW AND AMAZING PROFITABILITY TRACK RECORD

Despite an historically low 4-6% operating margin investors tended recently to forget that DELL remains an amazingly solid profitable company.

DELL is sitting on a comfortable $ 10.8 Bil. cash and investments cushion. Long term debt is only $ 504 mil. However according to last quarterly conference call management advised that it will have to borrow on short term basis for his corporate/US operations. Cash hoard is increasing abroad where sales are growing a lot more than in USA. To take into account potential tax repatriation costs we will use a conservative
USD 9.0 Bil. excess cash at the end of FY 2008.

Management has always been able to squeeze prodigious amounts of cash flows despite modest operating margins.
They have a negative 44 days cash conversion cycle which means that their sales are converted in hard cash 44 days BEFORE the sale. How it is possible ? Low inventory and strong bargaining power over their suppliers on payment terms. On the other side their clients are paying cash in advance or shortly after delivery of the products.

In a trough margin environment DELL produced in trailing 12 months about $ 4.3 Bil. net free cash flows out of $ 57.4 Bil. sales. Free Cash Flows/Enteprise Value yield is around 9% for the same period.

Profitability for a product/service mix still heavily weighted on a commodity product are truly amazing.

The below figures provided by Reuters are self-explanatory.

Magement Effectiveness (%)	Company	Industry	Sector	S&P 500
Return On Assets (TTM)	12.57	10.35	11.21	8.13
Return On Assets - 5 Yr. Avg.	13.75	5.29	6.27	6.43
Return On Investment (TTM)	40.16	22.77	15.31	12.08
Return on Investment - 5 Yr. Avg.	33.44	12.57	8.91	10.01
Return On Equity (TTM)	68.75	33.13	19.46	20.05
Return On Equity - 5 Yr. Avg.	46.19	16.61	12.03	17.96

3) INDUSTRY TRENDS

PC worldwide industry is highly competitive. Through an aggressive price war this industry is slowly becoming an oligopoly where highly efficient global players put out of business or purchase the weakest PC makers (see sale of IBM PC business to LENOVO) .
Main competitors:
Hewlett-Packard with its more attractive product mix of high margin and recurrent revenues (their printer business) and their streamlined operations are a dangerous competitor. Turnaround leaded by the new CEO Mark Hurd has done a good job so far but he harvested mainly the "cutting costs" low hanging fruits and still heavily depends on H-P crown jewel printing business. Increasing revenues and profits in the next years will be more difficult. I assume recent boardroom scandal: will not have a relevant impact on company operations.

More dangerous, because traditionally less financially disciplined, is the competition of Far East competitors notably ACER and LENOVO. The last is more or less backed by the Chinese Government. It bought formed IBM PC business, and, like ACER, is aggressively pursuing market share gains pointing on price cuts notwithstanding what is believed to be a tiny (if any) real profit margin.
LENOVO is not forced to fill accounting documents according to GAAP rules. But a look at their most recent FY figures ending march 2006 is interesting. They reported the equivalent of $13.3 bil. sales and profit margin atribuable to Shareholders of the Company was the equivalent of about $13.309 mil., net profits (generously adding back restructuring charges and amortization of intangible assets) were the equivalent of about $100 mil. A meager 1.44% net margin profit compared to about 6.8% net margin of DELL during a similar period.

Price competition is expected to last at least few more quarters but, though DELL cost advantage is lower than a few years ago, they are still more efficient then their competitors.


4) CHALLENGES

Main competitors improved their supply chain management and DELL has lost part of its previous cost leadership though due to its direct sale/build-to-order it still avoids retail inventory burden. In order not to loose this critical advantage DELL cannot afford to deviate from its proven "no inventory" business model.

Poor customer service: DELL has finally recognized its weakness. They invested so far more USD 150 mil. Internal and independent customer satisfaction metrics are already improving.
The implementation of DellConnect, their new remote diagnostic tool designed to improve resolution of technical issues for free, has been used by more than 1 mil. customers and seems getting positive reviews by customers.

DELL has troubles to maintain market share in the consumer market.
Foray in flat panel TV, mp3 players has been performing poorly.
Mainstream consumer PC are priced below the USD 500 mark and are still expected to decrease further. The cost advantage at this level gets erased by the extra shipping costs of shipping unit by unit instead of bulk shipping to retail stores.
DELL is performing some tests with retail kiosks used to order PC with the assistance of a sales representative in malls, airports... I don't think that those sales will reach a meaningful amount.
Due to its "no inventory" business model, DELL is unable to match the rewarding experience of bringing back home the computer or printer you've just bought at the store. Management has repeated that they do not intend to develop a classic retail channel.
Only way to compete: investing in design and proposing more cool products, which to be fair are far to be DELL point of strength.
In September DELL added 500 new electrical, software and mechanical engineers and program managers in its central Texas product development operations to improve product quality.
Recent purchase the high-end gamers PC outfit ALIENWARE fits also the bill to improve overall product quality level: However the ALIENWARE $220 mil. yearly sales figures involved are merely a blip in DELL total turnover.

The dark side of DELL, stock options: company made an extremely liberal use of the stock options in the past. The use of capital to re-purchase stocks to avoid share dilution and shrink overall share base has been abysmal. Billions of dollars have been literally thrown out of the window to repurchase company stock which was trading at obscene valuation. On this matter there are however some improvements. Stocks options are now expensed in financial statements and taking into account by the analyst community. Issuance slowed down and in last 10K we calculated that about 80% of the outstanding options are out of money. DELL may re-price these options but they never did it in the past.

For several quarters in a row management advised that they were pricing too aggressively for a modest market share gain. My impression is that margin have been reduced due to lack of cheaper and better AMD processors in their products offering. See below.


5) OPPORTUNITIES

These last quarters AMD processors have sported better price and performance than their INTEL rivals. Since DELL was an INTEL-only shop to gain market share they have been forced to compete on price and lower their already thin margins.
Ironically, just when INTEL is proposing a competitive line of new products, DELL started to ship its first AMD powered PCs.
They will loose some support and contribution on marketing expenses from DELL but having the possibility to opportunistically play on both suppliers is in any case a long term positive for DELL.

DFS finance arm: leasing and financing on DELL products is now handled by DFS, a joint venture with CIT. So far this financing was proposed only to match financing offerings from competitors. It represents now a small portion of earnings but it may grow in the future. After learning how to profit from lending business DELL has already in place the agreement which will allow to purchase CIT stake.
Financing may be cash draining if they decide to keep loans on their books and earnings may be hit in cases of default during the trough of business cycle or if DELL has a poor underwriting discipline (which has not been the case sofar). Overall, the finance profits over a full business cycle will be a positive contributor to their structurally low margins. Commodity producers like auto makers GENERAL MOTORS and FORD granted their survival of their main operations and a more than adequate profit margin thanks to their finance arms.

Printers and ink: printer sales are in ramp up phase when they are sold slightly below cost to earn then after a high margin on ink refills. In financial statements you see so far the investments to spread the printers. Then after ink refill margins will start to materialize.

Monetizing desktop real estate: why about 85% of internet users still use Internet Eplorer to surf the web though they are much better free alternatives like Firefox ? Because it's the default preloaded version on their Microsoft PCs and they don't bother to change it. Desktop real estate is therefore worth a lot. In a 3 years deal Google agreed to pay what is rumored to be worth up to $1 Bil. according to Forbes magazine to pre-load Google Desktop Search and Google Toolbar in about 100 mil. PCs. I expect further similar deals with other software houses or websites though most probably worth smaller amounts.

Acquisitions: Michael Dell recently said the company may pursue further "small targeted acquisitions" after its recent purchase of high-end PC company Alienware to provide new services, products and geographic areas. Cash on balance sheet is more than enough to finance acquisitions. Acquisition discipline has not been tested in the past since company focused on organic growth or joint-ventures on storage products, finance arm and printers. Terms of recent Alienware acquisition have not been disclosed. I expect however that due to its cost conscious culture (stock repurchases issue excepted) DELL will not overpay. The ideal acquisition would be one which allows either permanent margin increases in the service area for exemple, and/or introduce some kind of recurrent revenues.

Launching of Vista, the new Microsoft operating system: the long overdue, but much improved compared to last Windows XP, is widely expected among consumers and business users. The first beta versions got positive reviews and first signs points to a strong start (see


6) RECENT ISSUES: LAPTOP RECALL, ACCOUNTING RESTATEMENT, EARNINGS MISS

Laptop recall: same was due to SONY batteries defect. SONY will pay almost all recall expenses. DELL was the most proactive to acknowledge the problem and quickly provided a solution to their customers. In a Barrons' interview Michael pointed out that they bought only 18% of defective batteries. "Where are the others ?" he wondered. In fact one after the other shoes are dropping. Weeks after DELL announcement Apple, Lenovo, Toshiba, Hewlett Packard, Hitachi finally recognized the issue and took proper steps.

Accounting restatement: after an informal SEC investigation which was deemed to be not material DELL has been forced to delay their quarterly 10Q filing and interrupt their share repurchase program. Accounting expert Jack Ciesielki gave his opinion of which misrepresentation may be involved. According to the few elements leaked on the issue, the eventual restatements should not affect company normalized profitability and strong balance sheet figures.

Potential future earnings miss: Think Equity, a research and investing boutique, is on the record warning on a possible earnings miss for current quarter. As a long term value investor, as far as I'm confident on assessment of company business value, earning pre-anouncements and their consequent investor over-reaction are not an issue but an opportunity to buy on the cheap.


7) MACRO ECONOMIC RISKS

This last decade both emerging and developed countries has been growing at a fast clip with the major notable exception of the Eurozone countries. Japan which arrived late at the growth party is joining the ranks. Corporations have records of cash and ready to invest it also in technology products. Interests are low and inflation is moderate. This almost ideal environment may become less accommodating in the next years especially if the U.S. or the white-hot China economies will slow down.


8) VALUATION

I evaluate DELL business value at 15 x FY 2008 earnings (less estimated $9 Bil. excess cash) based on average 7% sales growth and a normalized 7.5% operating margin. Reasonable valuation would be therefore in the area of $21/21.5 per share.
Stock is sitting about 8% less than present quote at $23.25 on Friday Oct. 6 close.

The most aggressive value investors may want to start a position alongside the founder Michael Dell which made one of the biggest insider purchase in open market ever in U.S. stock market. He bought $70 mil. worth shares on May 24th 2006 at $23.99.