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Dell's Poised to Shine After the Storm Passes

Updated from Aug. 2

People love to bash PC stocks. It's easy. And because everyone knows the arguments against the sector, bears enjoy the pleasurable experience of belonging to a community.

I can understand that. But you might want to think twice before you get too negative on Dell (DELL), despite yesterday's warning that third-quarter sales may slow as much as 5% from the second quarter.

The bear case is well-rehearsed: The market for personal computers has become saturated. Organic growth is pretty much finished, and the replacement market that remains is incapable of sustaining the sort of growth that PC investors grew accustomed to in the 1990s. To cope with this secular downturn in demand, remaining manufacturers will duke it out on price until they abandon the business altogether. Until then, profit margins will suffer, even at Dell, which even the most bearish readily concede sells PCs better than any other company on the planet.

The secular slowdown is real. But it's easy to overestimate its gravity for Dell. Whatever long-term PC-unit growth does, it's not going to zero. And wherever the long-term growth rate should settle, you can expect Dell to grow faster, as it has been doing throughout the current downturn. Dell gained nearly 2.5 percentage points in market share in the second quarter of 2001, unseating Compaq (CPQ) as the world's No. 1 PC maker. Unit shipments grew more than 20% in the quarter, during which every other major manufacturer lost market share.

Ouch!

Dell has been able to do this, of course, by cranking the lever on price. In the short term, this strategy damages Dell's profit margins. But not nearly as much as it does to Dell's competitors, each of which labors under a significantly higher cost structure than Dell has.

Dell's competitors know this better than anyone. Compaq, for one, has been trying all year to get its bloated inventories down to a level that would let it compete profitably against Dell on price. The company has reduced the inventory on its resellers' shelves by about $1 billion so far this year, and now says it holds about six weeks of inventory in the retail channel, and 2.7 weeks in the commercial channel. Of course, Dell, with its wholly direct business model, has none in either channel, and its own inventory is just under five days.

Sooner or later, one or more of the major PC makers will pull back. That means even more market share for Dell.

Share gains are crucial, for a couple of reasons. They help Dell build production scale, which lowers per-unit costs. But they also allow Dell to increase its already gigantic base of corporate accounts, opening the door for sales of higher-margin products like servers, storage and, now, network switches.

Dell approaches each of these markets the same, targeting only the low end, selling only commoditized boxes that it can build and sell better than anyone else. Dell gets stronger as enterprise hardware becomes more commoditized. Intel's new 64-bit Itanium processor has moved the tech world a little further in that direction, as will each new iteration of Itanium. The bottom line is that whether it takes two years, five years or 10 years, it's hard to think of a company that will be better-positioned to take advantage of increasing commoditization than Dell.

To be sure, at more than 30 times forward earnings, Dell isn't cheap. And earnings estimates for the company likely will continue to fall. But when corporations start buying technology again, Dell probably will be better-positioned than any of its competitors to take advantage. Rising earnings estimates will shrink its price-earnings ratio pricetoearnings, just as today's falling estimates have inflated it. And the growth the company could post off the relatively easy comparisons of these sluggish times will make that multiple look cheaper still.

This isn't to say that Dell's a sure thing. Not at all. It's a tech stock, for gosh sake. But if you have any confidence that computer hardware isn't going to disappear -- hint: it isn't -- Dell is a risk worth taking.

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