Dell's Gloomy Outlook

Investopedia Advisor submits: Dell (DELL) was once among the hottest tech stocks. Now, the only things catching fire at the company are defective laptop batteries. Since May, when I warned against buying Dell, the stock has fallen another 13%. The past 12 months have seen the shares plunge 50%.

Despite the stock’s drastically reduced price-tag, my view on Dell remains downright gloomy. With Dell’s business model falling apart, and no turnaround in sight, investors are wise to stick with the herd.

Dell’s low-cost business model is broken. Like it or not, the company still competes on price.

But price is no longer a differentiator, as increasingly efficient rivals Hewlett Packard (HPQ) and Lenovo Group (LNVGY) position products at the cheap ‘n’ cheerful end of the computer market.

The company admits that further price reductions barely stimulate additional demand for PCs.

To counter this, Dell is investing heavily to overhaul its notoriously pesky customer service. But, with the cost of servicing PCs rising, this is decimating Dell’s margins.

In the face of falling PC prices and slowing revenues, Dell now sells all sorts of things besides PCs. Games, flat screen TVs and printers help prop-up Dell’s top line, but these items do little for the company’s profitability.

Just look at Dell’s most recent quarter. Revenues grew by just 5%, despite very aggressive pricing. Dell’s gross margin fell to 15.5% from 17.4% in the first quarter and 18.6% a year ago. Operating expenses increases increased to 11.2% of revenue. Overall, operating margins fell to 4.3%, less than half the level of year ago and the lowest experienced by Dell in over ten years.

Investors ought to be worried by management’s strategy of relying on aggressive pricing to drive market share growth. Obsessed with market share, Dell is now trapped in a price war that is ruining its profitability. Even worse, its revenue growth is stagnating and could go into reverse as the cost of servicing PCs rises.

The fact that Dell now faces the largest product recall in the history of consumer electronics is another reason to worry. Dell claims that the recall of 4.1 million defective laptop batteries will have no material financial impact. But can it really think its brand hasn’t been damaged by news of blazing laptops?

Dell trades at 20 times 2007 earnings. Earnings growth is going the wrong way and sliding profit margins are good reasons to think Dell’s valuation are more than stretched.

Dell 1-year chart:

By Ben McClure, Contributor - Investopedia Advisor

At the time of release, Ben McClure did not own any shares in any of the companies mentioned in this article.