Last week was very surprising, with Dell’s (NASDAQ:DELL) stock price up almost 10% after the release of positive IIIQ results. The stock is up more than 30% from the lows of this summer and is trading at approximately 20 times FY2008 earnings, a significant premium to the main competitor Hewlett-Packard (NYSE:HPQ). I’ve been thinking a lot about the reason for this optimism and here’s my explanation on why investors are so positive on the stock:
1. People see a stock that last year, before the summer, was trading at around $40, 50% more than the current price. If volumes and margins recover there’s a huge upside potential.
2. Dell’s direct-to-customer, built-to-order business model revolutionized the industry and it clearly deserves a market premium for that.
I believe this is one of the most common mistakes of investors: looking at the past to predict the future! It is true that Dell dramatically changed the industry with its innovative business model. However a competitive advantage, in order to deserve a market premium, must be sustainable. And, to be honest, a model based on efficiency along the value chain can represent an advantage but it’s hard to sustain over the long term. Competitors will probably need time, maybe even years, to understand the new model and adapt their structure to it, but, eventually, they’ll reach a similar level of efficiency. Some of my other concerns:
* The company writes in its recent earnings release:
“As a result, all financial results described in this press release, as well as the previously announced financial results for the second quarter, should be considered preliminary, and are subject to change to reflect any necessary corrections or adjustments, or changes in accounting estimates, that are identified prior to the time the company is in a position to complete these filings. In addition, the preliminary results for the second and third quarters could be affected by any restatements of prior period financial statements that are required as a result of any conclusions reached by the investigations.”
Investors are clearly not paying attention to this, given that they reacted to the margin improvement in such a positive way. The quarter results are just preliminary figures.
* The margin improvement was obtained at the expenses of market share in the PC market where units growth was 4% in the IIIQ vs 34% for Acer, 15% for HP and 9% for Lenovo. It makes clear sense: in a price sensitive industry when you increase prices you obtain higher margins, but at the expenses of market share. A real improvement is when you are able to increase the margins AND maintain the market share. And Dell still has to prove this.
* Again in the earnings release: “In the near term, improvement in growth and profitability may not be linear due to a variety of factors...”. Which can be interpreted as a warning to investors not to raise expectations too much.
These days the market is growing and when the market is growing greed prevails on fear. But, sooner or later, investors will start thinking about all of the above...
DELL 1-yr chart