The Mean Season: Is Dell Winning the War, but Shooting Itself in the Foot?

To PC investors, the lesson of this earnings season seems obvious: Dell (DELL) keeps crushing the competition in a vicious price war. The evidence is hard to deny. But it's far less clear how much damage Dell itself is sustaining in the process, and how well the company's profit margins will be able to rebound when PC demand finally strengthens.

Survey the wreckage around the industry: There's Gateway (GTW), which lost money in its first quarter even before you start counting the $533 million in charges it took to close retail stores, fire employees and write off its hulking consumer loan portfolio. And there's IBM (IBM), which lost money on PCs despite having no exposure to the wilted U.S. retail market, which the company exited in late 1999.

It remains to be seen whether Hewlett-Packard (HWP), which warned again of slowing sales last month, will meet the same fate. But things don't look good, despite the assurances the company offered that it would only pursue profitable market share. H-P said that sales in its consumer business -- which includes PCs -- were tracking a massive 15 percentage points below plan. One can't help but think of Compaq (CPQ), whose PC segment ran in the red despite the company's emphatic vows that it wouldn't sacrifice profitability to fight with Dell for market share. Worse yet, Compaq said Dell also was putting serious pressure on profit margins for PC server sales, also a big business for H-P. (H-P is scheduled to report its results the week of May 14.)

Two-Front War

There are no surprises here, as far as the stock market is concerned. Since it became clear that the industry was settling into a long-term price war, investors have been betting Dell would win. For all of 2001, the thesis has been the same: Dell's well-oiled direct-sales business model, along with its unparalleled ability to keep its own inventory at extremely low levels, allows the company to manipulate its profit margins with much greater dexterity than any of its competitors. When the prices of components fall, as they generally do in this industry, Dell is able to move the price it charges for its computers lower in lock step. Companies matching those price cuts will get hit on the bottom line, while those that remain aloof risk losing market share. Right now, Dell seems to be doing damage on both fronts -- gaining market share while crushing competitors' profits.

Picking It Up Dell has been adding market share for years

Source: Dataquest

For Compaq and H-P, neither of which have a purely direct sales model, the problem of inventory is twofold: there's the inventory those companies have on their own books, and then there's the inventory that's held by the reselling partners known collectively as "the channel." Compaq, for its part, is trying hard to get channel inventories under control. It cut $100 million worth of inventories in the first quarter, and it plans to eliminate three times as much in the current quarter.

In the long term, the strategy makes sense. But in the short term, it will cost Compaq. There's only one way to reduce channel inventory: You stop selling to channel partners until they've sold their excess product. There are a number of unsavory consequences to that course of action. It could trigger costly price-protection agreements, in which a manufacturer guarantees retail distributors a given price for the PCs they sell by making up the difference if the distributor is forced to discount aging computers to get them off the shelves. On its earnings conference call last week, Compaq said that inventory reductions would cause second-quarter earnings per share to decline about 7 cents a share from the first quarter. A Compaq spokesman couldn't say how much of that 7 cents was coming from price-protection deals, though he didn't dispute that they were playing some role.

There's also the matter of lost sales, and thus market share. While manufacturers like Compaq wait for the channel to do its dirty business, Dell keeps pumping new PCs and PC servers with lower-cost components into the market. Case in point: A day after Intel (INTC) slashed prices on its 1.3-gigahertz Pentium 4 microprocessor, Dell announced commensurate discounts on Dimension desktop machines loaded with that chip.

Stalingrad

Still, not everyone is convinced that chewing up the competition in a price war is the smartest plan for Dell. Price cuts tend not to reverse themselves in a business like PCs, so any major sacrifices the company is willing to make now could keep margins under pressure well into future quarters. The vision of a future where a Hewlett-Packard, an IBM or a Compaq pulls out of the PC market entirely still seems largely fanciful; notwithstanding good intentions and public statements about only pursuing profitable market share, those companies have already shown themselves quite willing to subsidize a money-losing PC operation with their other business lines. And Gateway? Using Dataquest's figures, knocking off that company would only free up about 4% of the market for Dell.

"Yes, they've been pressuring everyone else and gaining share as a result," says ABN Amro analyst Rob Cihra. "But they're not necessarily doing themselves a favor. In the last couple years, Dell has gained a few points of market share, but their operating income has actually fallen. I'm not sold on this strategy of going after share at the expense of margins." (ABN Amro hasn't done recent underwriting for Dell.)

Giving It Back Dell's operating income is stalling

* Calendar years 1999,2000,2001 correspond to Dell's Fiscal years 2000, 2001, 2002 with period ending April 28 **ABN Amro estimate Source: TSC Research

Meanwhile, speculation has arisen to the effect that the company's decision to keep the pedal to the metal in the race for market share could very well force it to reexamine its operating expense structure again. Dell cut 1,700 jobs in February. But in a research note Monday, Robertson Stephens analyst Eric Rothdeutsch wrote that he was expecting the company to announce a new round of firings in the near future in response to falling profit margins. (Robbie Stephens hasn't done recent underwriting for Dell.)

One person familiar with the situation says that Dell has been quietly trimming senior employees for weeks. A company spokesman denies that any layoffs have happened beyond the 1,700 originally announced. But at a Merrill Lynch tech conference Thursday, Tom Meredith, senior vice president of business development and strategy, described Dell's approach to controlling its cost structure as "ruthless," and said that layoffs would "absolutely" be part of that strategy, according to Reuters.

The conventional view on Dell is the Nietzschean one: Whatever doesn't kill it makes it stronger. Nietzsche died insane. The bottom line is that cutting prices to win market share has unavoidable costs, costs that will become clearer when Dell reports two weeks from now. In the meantime, it's up to investors to decide how much they're willing to pay for the best of an increasingly bad breed. Dell trades at just over 34 times its estimated earnings for fiscal 2002. In that period, the company is expected to post declining earnings and revenue growth of only 10%, according to Multex.com.

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