Dell (DELL:Nasdaq) BEARISH
Price: $21.88  |  52-Week Range: $18.95-$36.86
  • Dell's dominant market share in the U.S. means it must look elsewhere for growth.
  • As technology prices have gone down, it's had to sell more units to run in place.
  • Its latest quarterly report proves it has gone from an exciting growth name to an occasional cyclical trade.
Position: None
Hardware & PCs
Dell Becomes Just a Trade
 By Joan Lappin
RealMoney.com Contributor
8/21/2006 12:04 PM EDT
URL: http://www.thestreet.com/p/rmoney/computers/10304710.html

Michael Dell is clearly a very smart guy. As everyone knows, he dropped out of the University of Texas to pursue his vision of eliminating the middle-man retailer, building computers to order and becoming a billionaire.

He knew when to bring in professional managers, older than he, to manage years of explosive growth in the late 1990s. They built Dell (DELL) into a behemoth with the largest PC market share in America, currently hovering around 32%. And therein lies the key problem facing Dell today.

Mr. Dell, still chairman and barely past the age of 40, also knew when to pass the CEO buck to Kevin Rollins. It is Rollins who now must bear the brunt of the reality that Dell is no longer a high-growth company. It is Rollins who must stand before the investing public in repeating quarters of earnings disappointments and offer up his apologies and excuses.

Now the Securities and Exchange Commission has taken an interest in some unclear aspects of how Dell reports its revenue in an "informal investigation." (I guess that means the investigators will not show up wearing tuxedos.)

What the SEC is after must be clear to someone, but it wasn't made clear to investors on the earnings call on Aug. 17, even though the inquiry is not a recent development. Of course, the announcement was news to investors and the financial community. Management announced the news on its conference call last Thursday, infuriating analysts who follow the company and who hadn't previously been told.

Running in Place

If you are a short-term investor, often you only see the bark on any quarter's earnings tree. You lose focus and don't even see the long-term picture that is the forest surrounding that tree.

Dell has had a serious problem for many years that even Michael Dell couldn't solve if he resumed the role of CEO: technology price deflation. If PC prices dropped by say, a third, then you would have to sell 33% more machines or accessories just to run in place and match last year's revenue. (The average Dell PC sold for $3,000 several years ago; according to my latest Dell catalog, it's less than half that now. The customization factor makes it tough to nail down exact figures, but even with charges for add-ons, average selling prices are lower than they were when Dell sported higher growth.)

If you are small and can gain market share even in difficult economic times, you have that as a protection, as Dell did in the 1990s. But once you are the largest player in the market, you must look elsewhere for growth. That's what Dell did a few years ago.

Dell sells nothing proprietary. It just used to market well by driving prices lower. But this quarter, even Dell said it had to pay Intel (INTC) more than expected, and that shows that the jig is up for Dell.

Masking the Core Problem

Dell always sold monitors to go with its PCs. It made threatening moves into Hewlett-Packard's (HPQ) breadbasket when it started to sell Lexmark's (LXK) printers. But H-P invents and sells its own printers and collects a long-term annuity with its printer cartridges and supplies.

Dell sells another company's products, someone else's stuff, as it always has. In that regard, it is just like Amazon; it spends nothing on research and development. It assembles or resells all that it offers to its customers. When you don't sell anything proprietary, you can lean on your suppliers for volume discounts only so long before that option is used up.

Dell sells Dell products. But inside are Intel chips, Microsoft software, etc. It is an assembler, not an inventor, selling other people's computer equipment, TVs and MP3 players. Nothing new there.

A Third Bad Quarter

Layer poor service on top of the core issue of technology price deflation, and you have a company with a problem. Worse, Dell cut prices dramatically to take further market share in international markets, its one remaining growth opportunity! Dell's second-quarter revenue rose by $600 million over the comparable quarter last year, but its cost of revenue rose by $1 billion. Those are not winning numbers, and this is a problem unique to Dell; witness Hewlett-Packard's strength.

No matter how fast you are growing, you can treat your customers with contempt for just so long before they will shop elsewhere.

Customer service started out as a selling point for Dell, but eventually the Dell model evolved into a tiered cost structure for levels of service. If you didn't want to wait in a phone queue for as much as an hour, you had to pay a premium when you bought your machine to avoid "death hold" when you called in for help. Suddenly Dell has decided to spend $100 million to mend its poor service with online help that speaks English and knows how to fix the product.

The goal seems to be a service and support package that doesn't make customers angry. In first-quarter highlights on Dell's Web site, it reports having sold 10 million units. Annualized, that implies more than 40 million units for the January 2007 fiscal year vs. 37 million last year. Divide the $100 million by 40 million units, and Dell has committed to spend an additional $2.50 per unit sold "to improve the customer experience." I'm unimpressed.

Only a Trade Going Forward

Because Dell's market share is now so large, at 32%, it can no longer grow faster than the U.S. In fact, as Hewlett-Packard has gotten its house in order under Mark Hurd, Dell is not keeping pace at home. The corporate market where Dell is strongest has been weak, while the "soho" market (small business/home market), where it isn't so strong, has shown growth. That leaves international growth as Dell's only real option. Yet earnings were so dreadful in the second quarter because, by its own admission, Dell was overly aggressive in dropping prices to grab share abroad.

Also, AMD (AMD) microprocessors have gained in popularity, but until this year, Dell offered only "Intel inside" its machines. That reflects an element of being out of touch with and unresponsive to customers.

If management didn't lowball estimates going forward, it did the company a disservice. Dell has its work cut out for it and no longer has the wind at its back as it did a decade ago.

In 1998, Dell's shares rose fivefold and became one of the biggest gainers of that year. Because it was a darling, everyone wanted to own it. It did go ever so slightly higher in the first quarter of 2000 to its peak near $60 -- just before the Nasdaq crashed. Dell then fell below $20, where it traded again last month.

In essence, eight years later, the stock is back to 1998 levels, where it sold when the investing world was first embracing it as a high-growth, innovative company. Since then, owning Dell has been a case of chasing a prior star investment.

Now it is underperforming its peers and not even matching the growth in its industry. This is no longer an exciting growth company. It's a big company with a well-known brand that at best will offer you an occasional cyclical trading opportunity in the future.

At the time of publication, Lappin had no positions in the stocks mentioned, although holdings can change at any time.

Joan Lappin, CFA, is chairman and chief investment officer of Gramercy Capital Management Corp., a registered investment advisor based in New York City, which she founded in 1986. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Lappin appreciates your feedback; click here to send her an email.