Component Price Trend Could Tell Dell's Future

For more than half a year, Dell (DELL Quote - Cramer on DELL - Stock Picks) has been dominating the PC industry like Boris Spassky in a community center chess league. But investors shouldn't get too complacent, for one of Dell's sharpest weapons could soon lose its edge.

Edgy? Dell stock this year

That weapon is sharply declining component prices. The market for things like graphics chips, microprocessors and memory started falling apart last fall along with demand for personal computers. And since then, to the astonishment of most market observers, the slide hasn't so much as paused. The standard 128-megabit DRAM chips that fetched more than $16 on the Asian spot market last September are now approaching $2. (Spot markets are markets in which goods are sold for immediate delivery.)

This scenario has been a boon for Dell, which keeps far fewer components in inventory than any of its competitors do. When the prices of components fall, Dell, which procures its parts with extremely short lead times, can pass that cost-saving on to its customers with near immediacy. If the contract price of DRAM memory falls, or if Intel (INTC Quote - Cramer on INTC - Stock Picks) discounts its Pentium chips, customers can pretty much watch the price of a Dell PC fall right before their eyes. Because they have usually paid more money for the same components, competitors that try to match Dell's price cuts do so at great peril to their profit margins.

Point of Diminishing Returns

But protecting the bottom line has its own costs when you're going up against Dell. "Pursuing profitable market share" has become an industry euphemism for flat-out losing share. In the past two quarters, with component prices plummeting across the board, Dell has been picking up share like gangbusters: Dataquest figures show that at the end of the third quarter of 2000, Dell held 19.7% of the PC market in the U.S., about 4.5 percentage points above its nearest competitor, Compaq (CPQ Quote - Cramer on CPQ - Stock Picks).

By the end of the first quarter of 2001, Dell's share had risen to 23%, and its lead over Compaq expanded to more than 6 percentage points. Between those two periods, every single one of Dell's competitors lost market share in the U.S.

Everybody Limbo Spot market price of 128-megabit DRAM memory

Source: Fechtor Detwiler

How long Dell can keep this up depends largely on how long component prices keep falling. Dell has a lot of ways of keeping its own costs down: its lean inventory management, its flexible ways of negotiating prices with suppliers. But ever-cheapening components are perhaps the single-biggest driver behind the swift and massive gains in market share Dell has made in the past several months. When that trend shifts, competitors finally will find themselves on a more even footing.

"Dell has had a heyday passing falling costs along to people," says A.G. Edwards analyst Brett Miller. "Sometimes in the middle of the day. That's what they do best. That's all they do, really. They have no technology. They have no intellectual property at all. They just pass on Intel and Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) very efficiently." (A.G. Edwards hasn't done recent underwriting for Dell.) Dell rose 84 cents Tuesday to $26.10.

Chaos Theory

It's impossible to tell when the slide in components prices will reverse itself. Industry watchers have been waiting for that to happen for months. But prices needn't rise to change the competitive dynamic in the PC market. They need only stabilize, and every day that prices continue to fall puts the market one day closer to the bottom, for the simple reason that things tend not to remain at their extremes. Something as modest as a seasonal uptick in demand -- the sort of minor change that Intel talked about in its midquarter update -- could set it off.

"Price performance is the engine driving growth in the PC industry," says J.P. Morgan analyst Walter Winnitzki. "When component prices don't go down, PC pricing becomes more stable. That's what we're likely to see. Dell may price aggressively, but less so. They'll still sacrifice their margins, but less so.

"The net result is that things will ease up a little bit," Winnitzki says. (J.P. Morgan hasn't done recent underwriting for Dell.)

That would be a welcome development for companies wearied by Dell's endgame.