Legions on Wall Street Backing Dell in PC War of Attrition

Investors are placing their bets that Dell (DELL) is going to win the PC price war.

What Price Dell? Box maker set for war

As many expected it would, Dell warned Monday morning that it would miss fourth-quarter estimates for both earnings and revenue. Thanks to the continuing softness in worldwide demand, Dell said that sales would likely fall $100 million to $200 million below the $8.7 billion figure it had forecast. Meanwhile, thanks to the price-slashing that Dell has initiated to entice customers, the company forecast earnings of between 18 and 19 cents a share.

Despite the massive scale of the expected shortfall -- the company's new earnings estimate is as much as 30% below prior guidance, which itself had already been trimmed -- Dell's stock has barely budged. It fell just 0.7%, doggedly holding onto the 45% gain it has managed to rack up in 2001 despite steadily increasing bearishness among analysts. Meanwhile, shares of competitors Hewlett-Packard (HWP), Compaq (CPQ) and Gateway (GTW) got hit hard, falling 4.4%, 4.1% and 8.6%, respectively.

What gives?

This gives: Wall Street is taking the view that Dell's aggressive pursuit of market share will hurt its competitors much worse than it will hurt Dell. The thinking goes that the company's total devotion to the direct-sales business model, along with its ability to maintain extremely low levels of inventory, will let it control costs at the same time that it cuts prices. Thus Dell will be able to manage its shrinking profit margins with surgical accuracy that can't be matched by companies like Compaq and H-P.

Meanwhile, Dell's focus on the corporate market could give it the upper hand against Gateway, which also relies on the direct model to manage costs but which depends primarily on the market seeing the fiercest price competition of all, the consumer market. With around 80% of its sales coming from businesses and other institutions, Dell may be able to play hardball against Gateway in the consumer segment without sinking the ship.

"I think they stand most able to survive with component costs declining," says Philip Treick, portfolio manager at Aesop Capital Partners, which is long Dell, though it has pared back its holdings in recent months. Pointedly, Treick's fund owns no other PC stocks. "I mean, if you had to compete in this type of environment, whose business model would you want, Compaq's or Dell's?" he asks. "You'd take Dell's every time."

The price of components like DRAM, a commodity memory chip, has been in steady decline for months now. Because Dell maintains very low DRAM inventories, it is able to continually adjust the prices of its machines in accordance with changes in the cost of that component. In other words, if the price of DRAM falls by 5%, Dell can quickly pass that reduced cost on to its finished products. Vendors whose inventory includes components purchased several weeks ago at higher prices will give up profits if they follow Dell in cutting prices.

Flexibility

The low-inventory model could also give Dell an edge in the race to shift its PCs to the Pentium IV microprocessor. Because machines loaded with those chips will carry higher selling prices than Pentium III computers, the shift could help Dell combat the problem of narrowing profit margins caused by the PC price war. "Several of the indirect players have built up inventory of older systems," says Gerard Klauer Mattison analyst David Bailey, whose firm hasn't done underwriting for Dell. "That could lead to inventory write-offs, or give more price protection to dealers."

Price-protection refers to the practice of guaranteeing retail distributors a given price for the PCs they sell. If a distributor is forced to discount computers in order to sell them, the manufacturer often makes up the difference. It's a problem Dell simply doesn't have.

Dell's competitors haven't been showing any signs that they'll back off from a price war. Gateway has been particularly vocal about its plans to fight tooth-and-nail for market share by cutting prices. It's almost certain that the entire industry, including Dell, is setting itself up for a nasty period of declining profitability. And Dell stock isn't cheap, currently trading around 24 times fiscal 2002 earnings estimates -- estimates that may come down when the company reports earnings next month and offers new forward guidance. Investors should therefore be wary of jumping on the Dell train in hopes of a decisive victory in the near future.

"They're the best positioned if pricing continues to be aggressive," says Bailey. "But if demand continues to deteriorate, it's not to anyone's benefit long term. It will still be tough sledding over the next six months."

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