Dell: Declining Consumer Segment Obscures Excellent Services Business

| About: Dell Inc. (DELL)

About Dell

When you mention the company Dell (NASDAQ:DELL), most people picture a manufacturer (assembler is probably a better term) of PCs targeted mostly at retail consumers. Indeed, many people have probably bought a PC from Dell at some point.

That picture, however, really isn’t what Dell does. Only 3.22% of Dell’s operating income comes from consumer retail sales. People also probably remember some of Dell’s numerous consumer flops, like their handheld PC the Axim or their Digital Jukebox music player that was killed by the iPod. While missteps like these have high visibility, they simply don’t have much effect on the bottom line. Again, the consumer segment accounts for only 3.22% of income. So, what most people think Dell does is really what Dell does not do.

What Dell actually does is provide servers, storage solutions, software, and services primarily to small and medium sized businesses. Dell is basically the IBM or HP for anyone outside the Fortune 500. Dell divides their product and service options into three client segments: large enterprise, public, and small and medium businesses (SMB).

The large enterprise segment includes national and global corporations and accounted for $819M in operating income. The public segment includes educational institutions, government, healthcare, and law enforcement agencies. It accounted for $1,361M in operating income. The small and medium sized business (SMB) segment accounted for $1,040M in operating income. Together these three segments accounted for 96.78% of Dell’s operating income.

Plan for the Future

Dell also further divides its businesses into either products (hardware) or services (including software). While revenue from products has declined, services revenue has increased from $4,980M in 2007, to $5,351M in 2008, and to $5,622M in 2009. It is important to note that not all growth has been organic; some has come from acquisitions, such as Dell’s purchase of Perot Systems. Margins have fluctuated as well.

Dell is becoming more than just a provider of commodity “boxes” and more of a well-rounded IT solutions provider in the same vein as HP (NYSE:HPQ) or IBM (NYSE:IBM). Indeed, Dell’s plans for the future include continued growth in their large enterprise segment, particularly in services.

Dell vs. the Heavyweights

With HP and IBM deeply entrenched in IT enterprise market, why would we think that Dell could succeed? Well, there are few if any barriers to entry in the markets that HP and IBM serve. There are only three types of competitive advantages incumbent firms have: supply advantages, demand advantages, and economies of scale.

There are no supply advantages as each competitor is selling products and services that perform the same function. No company has access to raw materials, be it human resources or electronic parts suppliers, at significantly lower costs than a competitor; and no company has any proprietary technology that gives it competitive protection. It is true that the companies hold many patents, but these patents do not prevent competitors from offering similar products or services.

The second competitive advantage arena, demand advantages, is a bit less clear. Certainly no companies benefit from network effects or the difficulty of finding a substitute provider. The only area that might offer some fleeting advantage, although unlikely, is the reluctance of clients to switch to Dell because of habit and the “no one ever got fired for buying IBM” mantra. This advantage is unlikely to exist as buyers are more likely to focus on price, performance, and reliability rather than brand name. Also, Dell is a well-known, well-respected brand in the field.

Choosing between IBM, HP, and Billy Ray’s Computer Superstore might give data managers pause, but choosing Dell should have little risk. If there is any initial reluctance to choose Dell, it is likely to be eroded quickly as Dell servers and storage solutions become more widely accepted in Fortune 500 datacenters.

The third area in which incumbents may have a competitive advantage is economies of scale. With economies of scale, incumbents enjoy an advantage when they have high fixed costs and low variable costs. High fixed costs, if they can be spread over a greater amount of sales, allow the incumbent to enjoy greater profit or price their product or service below what a competitor could offer. With the IT enterprise market there are no economies of scale. A majority of the costs are variable costs. Each new desktop or server sold requires that the company purchase the parts to assemble it and every x% increase in consulting hours billed requires the company hire y% more consultants.

In perfect competition, then, we would expect each firm to own an equal share of the market. Although competition is not perfect in this market, there is no reason to believe that any competitor can provide significant hurdles to Dell’s success. Instead, Dell’s success depends on the company’s own execution. Its increased profitability will depend on efficient execution. Dell’s focus on efficiency in consumer computing and its decision to drop out of the bidding war for 3PAR (NYSE:PAR) once the price got too high are good omens that management is on the right track. For a company competing in a market with no competitive advantages, one sure way to destroy shareholder value is to overpay for an acquisition.

What Is Dell Worth?

Right now Dell is trading at a depressed price for two reasons. First, Mr. Market is not really excited about the prospects of any IT hardware or services company. The triplets, HP, IBM, and Dell all trade below the historical fair value Price/EBITDA multiple for their industry, which is about 10-11. Second, out of all three companies, Mr. Market despises Dell the most, likely for the declining consumer segment and for the uncertainty involved in entering the territory of IBM and HP.

This year Dell had EBITDA of $1.55 per share. HP and IBM currently trade at an average EBITDA multiple of 7.6 (well below historical averages). That means Dell’s earnings stream is worth $11.78. Dell also has about $6.3B or $3.24 per share in excess cash on the balance sheet, so add that in for a value of $15.78. Finally, subtract the book value per share of Dell’s long-term debt, which is $1.75. That gives a fair value of $14.03 if you are using the current market multiples of HP or IBM. Dell looks cheap, but there isn’t a large margin of safety. If you used historical fair value multiples, Dell would be even cheaper. Using an EBITDA multiple of 10 rather than 7.6 would give a fair value of about $17 per share.

It’s likely that IT spending by companies will pick up in the future as a lot of expenditures have been deferred and systems will need to upgraded or replaced. This along with an improving economy is likely to boost valuation multiples closer to their historical averages. Out of the many IT hardware and services companies, Dell remains among the cheapest, giving the stock some downside protection.

Disclosure: No positions