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Dell (NASDAQ:DELL), the third-biggest player in the global PC market after HP (NYSE:HPQ) and Acer, has lately suffered an onslaught of bad press over a lawsuit alleging that it knowingly sold faulty PCs to corporate clients. Dell has so far maintained that it did not intentionally deceive its customers and that it took reasonable steps to compensate them for losses resulting from the defective units.

Even so, the resulting damage to Dell’s reputation could seriously affect the company’s hardware business, which recently started picking up. In the worst case, we estimate that Dell’s legal woes could cause an approximately 20% downside to the Trefis price estimate of $17.34 for the company’s stock. Below we trace the potential impact of Dell’s deteriorating brand image on its various product lines.

Dell’s Notebooks and Desktop Sales Could Suffer

In the most recent quarter, Dell reported a recovery in its corporate PC sales as companies replace their aging computer hardware. Dell recently projected a 14% to 19% growth in its FY 2011 revenues over FY 2010, citing increased enterprise demand as the primary reason.

As a result we expected Dell to maintain its 15% share in the global desktop market this year and increase its global notebook share from 13% in 2009 to around 14% in 2010. But because of Dell’s legal problems, many customers may now choose to buy their hardware from HP or other competitors.

You can modify the Trefis forecasts in charts below and see that a decline of 3% share in Dell’s notebook and desktop market share will result in a downside of about 14% for its stock price.

Lower PC Sales Would Hurt Dell’s IT Service Business

When companies buy IT hardware they also look for bundled offers such as service and maintenance, which help lower their cost of ownership and get the most out of their investment. This means Dell’s IT service business is very much dependent on its PC sales. New service and maintenance contracts can drop alongside PC sales, making it difficult for Dell to increase its total number of PCs serviced (usually referred to as total managed seats)

If Dell’s notebook and desktop market share were to decline by 3 percentage points in 2010 and beyond as indicated in our earlier scenario, this could result in 8.7 million fewer Dell PCs sold in 2010 and about 400,000 fewer managed seats in the same year (about 4% conversion). The impact of fewer managed seats would result in an additional downside of about 3% to Dell’s stock price.

Pressure on Dell’s Server and Storage Businesses

But wait, there’s more. Enterprises generally prefer to buy most of their IT hardware (PCs, servers, storage systems) from a single manufacturer. This has cost benefits, simplicity for IT departments (in some cases) and can help avoid compatibility problems that arise from different hardware platforms.

Companies that stop buying PCs from Dell may also curtail spending on Dell servers and storage systems. We expected Dell’s server shipments to increase from 1.64 million units in 2009 to 1.90 million units in 2010. You can modify the chart below for Dell’s server shipments and see that a 0.3 million lower unit shipments than our forecast for 2010 would result in a downside of about 3.5% for Dell’s stock

For the reasons stated above, Dell’s storage sales could also take a hit, causing additional pain for investors.

The bottom line: If Dell is not able to overcome its reputational issues, there could be a downside of 20% or more to its stock price due to weak hardware and service sales.

Disclosure: No positions

Source: Lawsuit Could Equate to 20% Downside Risk for Dell’s Stock