What Could Derail Dell?

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There was a time not so long ago when

Compaq's

(CPQ)

indirect model was the envy of the PC industry. Through its worldwide roster of resellers, this Houston-based outfit became the No. 1 PC maker in the world by passing along steep savings to its business customers.

Then

Michael Dell

moseyed into town -- or at least into nearby Round Rock, Texas -- with a new way of doing business. He quickly realized that customers like to have their PCs like

Burger King Whoppers

: their way.

Dell's

(DELL) - Get Report

direct-sales model, where the company only builds its PCs after an order is placed by the customer, is now becoming de rigueur in industry circles.

Dell has become the talk of the investing world. No question, people like to buy Dell computers, but what about its stock? It's a complex issue of share performance, growth possibilities, $1,000 PCs and fanatical investors. Those who have bet against this stock in the last 18 months have been roasted. But that hasn't stopped shorts from circling. Given its high profile and powerful stock performance, Dell is becoming one of the most ferocious battlegrounds on Wall Street.

Over the last two years, the company's stock has risen 1,375%, compared with 235% for Compaq and only 178% for

Gateway

(GTW)

. With that kind of eye-popping increase, some investors see an overvalued stock -- its trailing P/E ratio is a relatively high 50 -- while others argue that its current P/E ratio is only 36 based on current analyst estimates for 1998. Another important valuation measure is its EPS growth rate, which was 89% over its last fiscal year (ended January 1998). For this year, however, analysts see only a 38% earnings growth rate for Dell.

Of course, Dell's stock doesn't act reasonably. While tech companies warned customers of decreasing Far Eastern sales thanks to the Asian economic crisis, Dell's sales in the Asia-Pacific region rose an astounding 79% year-over-year. While the Asia-Pacific region only makes up 6% of Dell's total revenues, it's a testament to the company's business model that Dell's growth rates were better there than anywhere else in the world. For its 1998 fiscal year, revenues jumped 59%, from $7.8 billion to $12.3 billion. Moreover, Dell's direct sales effort is getting a high-margin goose as the company expands Internet sales.

But the detractors lurk not far away. "Dell makes a high-end, souped-up computer while the PC market is rapidly going to the low-end," says Bill Fleckenstein, head of

Fleckenstein Capital

in Seattle. "Does this trend support a company with a $40 billion market cap? I think it's a total joke that people are still trying to buy it." Fleckenstein, who admits to shorting the stock "30 points ago," now says that he will short it again. "I'm just waiting to pull the trigger."

Fleckenstein is right about one thing: By the fourth quarter of 1997, 35% to 40% of total U.S. PC sales were in the sub-$1,000 market, according to

BancAmerica Robertson Stephens

analyst Dan Niles. Niles, who only rates Dell a market perform due to valuation concerns, believes that a $600 to $700 PC could be here as soon as this summer.

Here's the dilemma for PC makers: There is an obvious demand for these low-priced computers, but how crucial are these new incremental revenues with skimpy profit margins? So far, Dell is not competing on this level. For now, it can afford to dismiss this low-margin, high-growth market and let the

Hewlett-Packards

(HWP)

, Compaqs and Packard Bells have at it. Thus, the key figure for Dell investors is the company's average selling price (ASP). "The biggest risk factor is Dell's ASPs," says Mark Specker, an analyst with

Soundview Financial

, who rates the stock a buy. If prices fall enough, then so will profit margins, and with it Dell's stock, which is splitting next Friday for the fifth time in six years.

Dell's ASPs over the last four quarters have slid from $2,715 to $2,630. Two years ago, the company's ASP stood at $2,800. If this number continues to drop, it could become a problem. But for now, these numbers are still the highest in the industry. And according to the

Dataquest

research firm, the average worldwide selling price for a PC is expected to be $1,920 for 1998.

And if corporations start upgrading to a lower-priced computer, this could trigger a trickle-down effect, forcing prices down across the board. Again, Dell seems to have seen this price erosion coming: It entered the high-end workstation market around a year ago with its WorkStation 400 product and already is No. 3 in this field, according to

International Data

(IDC), a Framingham, Mass.-based technology market research firm.

This new product, which costs anywhere from $5,000 to $7,000, benefits not only from the corporate world's migration to the

Windows NT

platform but also from high margins. Dell's pretax margins were up more than 20% in its recently concluded fiscal year. "Seventy to 75% of our business comes from large businesses and government accounts," says Dell spokeswoman Libba Letton. Since Dell only has 6% of the overall PC market, and industry leader Compaq only garners another 12% to 14%, there is plenty of opportunity to expand market share in the future, she explains.

Acquisitions, led by the aggressive acquisition practices of Compaq, are another important trend in the industry to keep a close eye on. Last June, the company bought

Tandem

, a network server company, for over $4 billion in stock. Now the company plans to acquire

Digital Equipment

(DEC)

in a $9.6 billion deal. The Tandem move is very similar to the planned DEC purchase. Both allow Compaq to make inroads into the high-end, bigger-box PC market.

"I'm bullish on the Compaq-DEC deal, but I don't think it will have any effect on Dell's prospects," says Richard Chu, an analyst with

Cowen

, who rates Dell a strong buy. "The industry is going to continue to consolidate because Compaq's biggest strength is that it's now more than twice the size of Dell."

Among the major PC makers, however, it could be Gateway that offers Dell the most competition in the future. After all, it's Dell's business model that keeps it humming along, and Gateway also directly sells its PCs to customers. Gateway is also coming off a strong fourth quarter in which it beat earnings estimates by 14 cents. Competition from Gateway -- no matter how big Dell's people say the PC market is -- could force one or both PC makers to lower prices to remain competitive. After all, both companies offer basically similar services to customers. For Dell to stay in front, it will need to continue to find the kind of new opportunities it's now finding in the Pacific Rim.

Dell's business in Asia is one good example of why it has been able to avoid the Asian contagion. When American companies look to push their products into Asia, they set up partnerships with local contractors to sell or manufacture the product for them. And this is why so many companies have been hit: They use these foreign subcontractors that are now in deep financial trouble because of the sudden decrease in their country's currencies. "Dell, on the other hand, is free and clear of all these indirect channels," says

Hambrecht & Quist

analyst Todd Bakar.

The company has one build-to-order Asian plant in Penang, Malaysia, already and announced Tuesday that it will open up another outpost in Xiamen, China, later this year. "As long as they are able to keep up this build-to-order model, they should be fine," says Chu, who has a strong buy on Dell. "Right now, they have reduced their inventory turnaround -- better known in industry circles as days' sales of inventory (DOI) -- to seven days from 11 in its previous quarter, and no one else is even close to that level."

Compaq, on the other hand, takes anywhere from 30 to 60 days to send out a PC through one of its resellers. "About five years ago, it would be safe to say that Compaq was eating Dell's lunch," says money manager Morton Cohen, managing general partner with

Clarion Partners

. "Now it looks as if Dell's eating Compaq's."