Over the last 3 quarters, the negative sales trend for Dell (DELL) accelerated. The market blames the exponential tablet demand and expects this trend to continue. Tablets and smartphones have indeed taken larger chunks out of consumer budgets. The user experience of touch screens, video interfaces and longer battery life has become more important than raw computing power based on the X86 infrastructure. The old Windows-Intel iterations are replaced by ARM-processors that run iOS or Android. But consumers make up only 22% of Dell sales and have been irrelevant for the EPS line. In fact, Dell could be tempted to cut this division altogether in order to improve its profitability.
Don't blame it on the tablet market
I believe that not tablets, but the cloud computing and visualization trends are the real reason behind the sales and profit decline. These investments have shifted computing power away from the enterprise desktop to server parks. Companies now earn back these investments by lengthening the replacement cycle of desktops and laptops.
The rationale is simple. On average a desktop computer uses only a fraction of its available processing power. A server can replace the processing power of 20 to 30 desktops through better capacity utilization. The desktop is hereby reduced to a low-end user interface. Application software can be managed easier and cheaper on application servers. The processing bottleneck has now shifted to the network, but can still limit the user experience.
Dell has anticipated this trend and shifted their investment efforts to the server market. Due to the better capacity utilization, its server sales growth can not compensate for the lost desktop and laptop sales. Its Quest acquisition is highly dilutive at 2.4x sales vs. its own 0.3x valuation. However, it is the necessary evil to cement its position in that market.
The Desktop is not a Dinosaur
Despite all the bad news and tablet hype, the enterprise desktop market will not disappear. The IC insights graph below even shows some modest growth potential. The PC market now appears dead because the replacement cycle has abruptly lengthened and the cloud investments have to deliver their savings to the company IT-bill. The PC installed base has become mature and can't provide any additional growth above the replacement cycle.
Replacement cycle will normalize in 2013
Still, without the desktop or laptop, there is no end-user interface. These enterprise or government computers will still wear out as motherboards, hard disks or cooling fans tend to break down or simply because a coffee is spilled. The tablet will also take some share in the enterprise market, but the use of a keyboard is literally key to a professional environment. Working can't resemble the entertainment experience of a consumer environment. The Windows 8 tablets will have an advantage as they integrate easier in the network and office software of a company.
This will also give Dell a second chance in the tablet market. The replacement cycle of computers was already lengthening as innovation slowed down and new iterations of Windows did not automatically caused a processor upgrade. The addition of an extra year to the lifespan of a computer from 3 to 4 years causes a decline of 24% in unit sales. This is comparable to what Dell has experienced over the last 12 months. The replacement of 33% of the installed base over three year slows down to 25% over 4 years. I believe that in the course of next year, the replacement cycle will bottom out.
Dell market share is stable
Dell has not lost market share in the enterprise market and has invested in services to tighten the link to its customers. These services are low end maintenance services and will not generate high margins. Lenovo has been aggressive on pricing and has gained some market share, mainly from Acer. Dell needs a good utilization of its distribution centers to make a margin. The company has been quick on the ball to adjust its size and will not allow losses to continue for long. The consumer division will still have a tough time. I do not believe that Dell will exit this business as it still generates volume through its network and pays for part of the fixed costs of the infrastructure.
Margin will recover to 200 bps below last peak
Dell reports its segment margins only for the different client segments and not for the product groups. This makes it a bit tougher to model the shift in added value towards the server division. The table below shows a good margin resilience in the light of the strong sales declines. The large enterprise segment is hit harder as they have been more aggressive in the virtualization of their IT infrastructure. The consumer division clearly has the most negative impact on the company margin.
I believe the margin will eventually recover to 6%. This is still 200 bps below the peak in 2003. The consumer business will stay a tough environment, competing with the likes of Amazon. This company is rewarded by the market for growth and does not have to bother about making a profit. In my recent study, I expect Amazon margins to recover to 3% eventually. The market has priced in 14% margins forever. I believe a 2% margin for the Dell consumer business is a realistic assumption.
The capital investment needs are low as Dell has good working capital management and its infrastructure is relatively asset light. The company structure is actually very similar to Amazon (AMZN). It adds even a bit more value before it closes and ships the box. The valuation is, however, very different. The company is now classified as a value trap.
Although growth is something of the past, its dividend yield is sustainable and very appealing. The investor love story with topline sales growth is something that comes and goes. The internet bubble burst in 2001 and now there is again a lot of hot air in the valuation of so-called growth stocks. At the same time, value stocks like Dell just get cheaper and cheaper. At a certain point, the long term opportunity becomes too big to ignore for another 10% downside on sentiment.
DCF target = 18.7 USD.