Dell's Real Growth Won't Be in Niche Markets

Lately Dell ( DELL) has been powering into new markets right and left. Earlier this week, the boxmaker said it would start selling PCs through dealers. That follows on last month's comment from a top executive that the company may start selling its own printers as early as the end of the year. Management has also hinted it will announce plans to push into the handheld market.

Those moves may be welcome news to investors underwhelmed by the weak growth prospects of the computer business. Presumably, they'll offer a chance for Dell to graft its hard-nosed share-gain tactics onto new markets -- a worrying prospect for existing competitors.

But, really, the new niche markets don't represent any significant changes in Dell's direction. On closer inspection, they look relatively insignificant, at least in the near term, when considered in light of Dell's $31 billion in revenue.

Dell's core business is still firmly tied to PCs, which account for some 70% of revenue. And for growth, its prospects hinge on enterprise sales.

Where Dell's Real Growth Lies

"The next big thing for Dell is enterprise -- servers and storage are by far the biggest opportunity and challenge for them," says Walter Winnitzki, an analyst at First Albany.

For the last 10 quarters, sales of those products have fluctuated to account for about 20% of revenue. But rather than reflecting weakness in the enterprise division, that merely reflects the fact that Dell's PC business "did extraordinarily well," says Winnitzki. "If you look at market share data in PC servers, you'll see Dell actually scored a lot of growth, but the problem is the whole market in servers just collapsed."

Dell still fared better than competitors -- and the promising news is that the server and storage portion of its business is on the upswing again, having steadily risen from 18% two quarters ago. That puts the company in a sweet spot when companies start spending on big expensive projects again.

The PC Business

But for the time being, Dell remains a maker of PCs, first and foremost -- and the growth prospects of the computer business certainly won't light any fires for growth junkies.

Granted, its business has recently grown faster than the overall PC market. In the most recent quarter, its year-over-year shipments increased by 23% in the U.S., while industry shipments ex-Dell dropped 4%.

But there are both short- and long-term risks. Most analysts expect that the percentage growth for worldwide PC shipments will hover around the zero mark this year, possibly growing in the low single digits. Although corporate buys will pick up at some point, possibly in 2003, the longer-term prospects for computer sales aren't anything to be thrilled about.

Another potential trouble spot: the merger of PC operations between Hewlett-Packard ( HPQ) and Compaq. "We believe that H-P will strive to maintain its now number-one market share position through aggressive pricing tactics and by working off its excess inventory, which should hurt Dell in the second half of 2003," cautioned Winnitzki in a recent note.

On the positive side, though, Dell's focus on the U.S. corporate market will be a boon when IT spending eventually picks up. "We upgraded Dell on July 12 based on our feeling that we were seeing some stabilization in enterprise demand in the U.S., even as Europe and Japan were as bad if not worse" than expected a few months ago, says Lehman Brothers' Dan Niles.

Dell draws a relatively high portion of its business from the U.S., which accounts for about 70% of revenue, vs. only around 20% from Europe. So relative to other players, says Niles, Dell "will feel much more impact when the U.S. market does turn around."

The Skinny on New Markets

In market share terms, the newly announced move to push sales of unbranded PCs has plenty of potential, but the revenue possibilities aren't that huge. White boxes, or unbranded PCs, command just over half the small and medium business market, while Dell's share is about 20%. (By comparison, Dell holds over 40% of the large corporate market.)

"It remains to be seen how much they can capture with this new strategy," says Loren Loverde, director of IDC's quarterly PC tracker. "They're a large player already, so to really drive growth they would have to take a significant share of the market."

Lehman Brothers' Niles estimates Dell could pull in an additional $600 million per year through white box sales to small businesses, possibly adding slightly to margins.

As for printers, Dell will face some tough competition, particularly against H-P, which as of the second quarter held just under 50% of market share in the overall printer market, according to IDC. "The challenge there is that a lot of money is made in cartridges and supplies," explains Loverde. "The printer business is like the razor blade business. Companies don't make a lot on the actual printers; they make more on the actual cartridges." But while Dell has traditionally sold its PCs directly through the Web or telesales, ink cartridges are often purchased directly from office supply stores.

"I think their direct model is more easily applied to large products like the actual printer, not to the actual cartridges," says Loverde.

In short, it's worth keeping in mind that for all its formidable reputation, Dell won't find it a snap to push into the new markets it's considering. And for that matter, they constitute niche markets, measured against the heft of its other computer hardware lines.

But the good news is that as the growth trend of PCs slows, Dell is prowling for ways to boost growth anywhere it can. And current trends favor its sales approach. "Now that companies are purchasing more realistically, based on returns on capital, they're looking for the best price performance systems. In a day and age where standardization is occurring, which breeds commoditization, Dell's model works very well," says Winnitzki.

"The way you need to think about it," says Niles, "is these are refinements to a strategy Dell already has, as opposed to any big new pieces to the strategy. So I think here you're talking about minuscule changes to Dell's revenues over the near term. But you add half a percent here and half a percent there when you're dealing with a $30-billion-something company, and pretty soon it's real money."

To be sure, though, the recent announcements don't mean Dell is a great investment at current levels. Shares are now valued at a level well above that of the prebubble period of 1990-98, judged by measures such as forward P/E, relative P/E, and price to sales.

Investors have bid up the stock by 24% from its lows last month. Wednesday the stock closed at $28.05.

One more item to keep in mind, given all the recent attention devoted to options: If companies ever have to start expensing their stock options, Dell would be one of the hardest hit. In fiscal year 2002, expensing options would have reduced the company's profit by a whopping $694 million after taxes, on net income of $1.2 billion.

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