What Do Dell and Ex-Planet Pluto Have in Common?

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 |  About: Dell Inc. (DELL)
by: Marc Gerstein

If you thought Pluto was having a tough year — astronomers stripped it of its status as a planet — consider Dell Inc. (NASDAQ:DELL). Its business is under intense pressure, there was the laptop battery mishap, and there's an accounting controversy that, although not well defined at this time, led the company to delay its 10-Q filing and to suspend common share repurchases. More important, perhaps, is the question of whether, when the dust settles, Dell can still be Dell or whether it, like Pluto, will be relegated to some lesser stature.

The essence of Dell has been its breathtaking ability to use much less capital to sell many more computers than others in its industry.

Given the eye-catching nature of those numbers, the accounting-uncertainty stories strike an especially raw nerve. Until the issues are settled, there's uncertainty as to whether or to what extent the capital-efficient Dell we thought we were seeing really exists.

But assuming, for now, that the company emerges from the inquiries with its essential financial flavor intact, it's still not out of the woods.

Table B shows that earnings per share estimates have come down — very, very far down — over the past 12 months, and even in the past two months.

These aren't the best of times for computer makers. Demand is sluggish and prices are being cut. Indeed, it's already been several years since Dell found it necessary to spread beyond desktop personal computers into laptops, servers, and other consumer electric products. But the magnitude of these estimate reductions seems sufficient to raise questions about the influence of structural factors above and beyond challenging industry conditions.

Morningstar's, Mark Layton, who assigns Dell a "Wide" economic moat rating, remains hopeful, subject, of course, to whatever accounting revelations may surface. In a May 9 report, Layton acknowledged challenges to the company from low-cost Asian rivals but suggested that "Dell's direct model, which eliminates middlemen and emphasizes cost-efficient production, provides a consistent pricing edge over rivals, which lack Dell's supply chain prowess and are largely locked into expensive retail distribution channels."

Layton further pointed out that Dell's "expertise has proved hard to replicate, and competitors are loath to stray from existing distribution methods, making for a sustainable competitive advantage."

Hard, maybe. But the question is whether it's impossible. A related question involves how sustainable that competitive advantage really is.

When the topic of cost-efficient production comes up, it's natural to think in terms of margin. But Table C shows this is not really Dell's area of strength.

Dell's gross margins have consistently been well below industry averages, and its operating margin comparisons have been erratic.

But with returns on capital that are so far above industry averages, as shown in Table A, Dell would have to have some other area of superiority. Table D shows where this lies: turnover, asset turnover in general and inventory turnover in particular.

This extends cost-efficient production beyond the assembly process. Dell doesn't start manufacturing until an order is received, reducing its need for raw material inventory. By immediately shipping the finished computer to the customer, finished goods inventory is minimized. And by refraining from doing as much as possible aside from order taking and assembly, it reduces the need for other kinds of infrastructure (assets).

But the model is under strain. The greater the number of different products Dell makes, the greater the different kinds of inventory it needs to manage. This would require more inventory management structure, and, perhaps, process investment. And one of the key things Dell scrimped on, customer service, may be starting to bite the company. According to Layton, "Dell's post-sale service has been a sore point with many of its customers." Addressing this, something the company is trying to do, may also require investment that doesn't translate into sales with the degree of immediacy typical of Dell's glory days.

Note, too, how industry-average turnover ratios, especially for inventory, have been edging higher over the years. So, while Dell invests to enhance its product line and improve customer service, rivals are finding ways to beef up their capital efficiency and, thus, move closer to Dell.

This is not necessarily to say Dell's future is bleak. But there do seem to be questions about how much of an economic moat Dell really has, or how sustainable its competitive advantage really is. Dell may not be done, but it may no longer be special.

At the time of publication, Marc H. Gerstein did not own shares of DELL. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.