Ignore The PC: Why Dell Is A Buy

Apr.17.12 | About: Dell Inc. (DELL)

Dell (DELL) stock continues to struggle with a low valuation -- just 7.6 times trailing earnings at Monday's close of $16.13. On their face, the reasons seem obvious: Growth in the PC market continues to stagnate, as Gartner has noted. Intense competition in the consumer segment of the market has lowered prices and margins; even leader Hewlett-Packard (HPQ) strongly considered exiting the business, while Dell itself has been passed for second in market share by Chinese manufacturer Lenovo (LNVGY.PK).

As such, Dell has been tagged as a low-growth, low-margin company, befitting its role as a major PC supplier. But it's not clear that should necessarily be the case:

Dell Revenue By Segment

Quarter LE Public SMB Cons. Total ExC
4Q10 4.2 3.8 3.3 3.5 14.8 11.3
1Q11 4.2 3.9 3.5 3.2 14.8 11.6
2Q11 4.5 4.6 3.5 2.9 15.5 12.6
3Q11 4.3 4.4 3.7 3.0 15.4 12.4
4Q11 4.7 4.0 3.7 3.3 15.7 12.4
1Q12 4.5 3.8 3.8 3.0 15.1 12.1
2Q12 4.6 4.5 3.7 2.9 15.7 12.8
3Q12 4.5 4.4 3.7 2.8 15.4 12.6
4Q12 4.9 3.9 4.0 3.2 16 12.8
Growth(%) 14.3 2.6 21.2 (8.6) 8.1 13.3
CAGR 6.9 1.3 10.1 (4.4) 4.0 6.4
Click to enlarge

LE: Large Enterprise; Public: Public; SMB: Small & Medium Business; Cons.: Consumer; ExC = Dell Revenue Ex-Consumer Segment.

All figures in billion USD unless otherwise noted; fiscal year ends in January; data from Q4 earnings presentation.

As expected, sales growth in the public sector has been hard to find, with the seasonally weak fourth quarter showing very little year-over-year improvement. Similarly, the consumer segment showed declines in each of the last two years.

But Dell's business customers have showed strength. Annual growth of 6.9% and 10.1% in Large Enterprise and Small and Medium Business sales, respectively, is hardly spectacular but still an achievement for a company Dell's size.

It's important to also remember that Dell has consciously -- and publicly -- decided to sacrifice revenue in favor of profits, what CFO Brian Gladden referred to in the Q4 conference call as "pruning the low-margin elements in our portfolio." As such, growth in operating income has outpaced the top line:

Dell Operating Income By Segment
Quarter LE Public SMB Cons. Ttl ExC
4Q10 281 333 282 9 905 896
1Q11 283 298 313 17 911 894
2Q11 288 369 323 (21) 959 980
3Q11 400 451 391 0 1242 1242
4Q11 502 366 450 69 1387 1318
1Q12 504 370 463 136 1473 1337
2Q12 448 484 404 73 1409 1336
3Q12 441 463 386 76 1366 1290
4Q12 461 327 412 39 1239 1200
Growth(%) 64.0 (1.8) 49.6 333.3 36.9 33.9
CAGR(%) 28.1 (0.9) 22.3 108.2 17.0 15.7
Margin(%) 9.4 8.3 10.3 1.2 7.7 9.4
Click to enlarge

LE: Large Enterprise; Public: Public; SMB: Small & Medium Business; Cons.: Consumer; ExC = Dell Revenue Ex-Consumer Segment; Margin=4Q12 segment operating margin.

All figures in million USD unless otherwise noted; fiscal year ends in January; data from Q4 2011 and Q4 2010 earnings presentations.

The sharp growth in FY2011 was muted in the second half of FY2012, as the hard disk drive shortage due to the Thailand floods lowered margins, and increased investments in new product lines added to the company's expenses. Still, operating income growth was impressive. Earnings-per-share growth was more impressive: Non-GAAP EPS rose from 1.05 in FY10 to 1.59 in 2011 and 2.13 in 2012.

These charts are not news, perhaps, but they illustrate the key point that investors still do not seem to understand about Dell -- the PC business is becoming less and less significant to the company. As MarketWatch noted in a piece on Dell's recent acquisition spree, PC-related revenue has fallen by 5.8% over the last five years, while outside revenue has risen by some 30%.

But the key growth number is in margins and operating income. In the storage business, Dell has discontinued selling third-party storage products (mostly from EMC (EMC)) in order to focus on Dell-owned products and those of recent acquisition Compellent. The result has been flat revenues -- as sales of EMC products are mostly exchanged for Dell and Dell Compellent storage -- but increased profits from the higher-margin self-branded products.

Going forward, Dell still faces challenges for growth. The company did guide for FY13 EPS above 2012's 2.13 per share non-GAAP, but CFO Brian Gladden deflected a question on the Q4 conference call as to whether the company expected growth in operating income, or simply increased EPS due to its ongoing share buyback program. Neither the company nor analysts expect substantial revenue growth in 2013 or 2014.

But at current valuations, top-line growth doesn't appear to be necessary for reasonable appreciation in the stock price if the company can continue its margin improvement and focus on enterprise services and solutions. EPS rose 40% in FY12 despite a 1% increase in revenue. At 7.6 times trailing earnings, 0.46 times trailing sales, and less than 6 times trailing free cash flow on an enterprise basis, the PC market and revenue growth are simply not necessary drivers for Dell shareholders. Continued margin improvement and solid integration of the recent acquisitions; or perhaps a moderately successful launch in tablets or smartphones, two areas where the company has initially failed; or the institution of a dividend paid from Dell's substantial cash balance all have the possibility to drive the share price higher. In the meantime, that cash balance -- still about $1 per share on a net basis after the billion-dollar acquisition of SonicWALL last month, the ongoing share buyback programs, the low valuation, and the growing enterprise portfolio provide value investors tremendous downside cushion.

In an interview on Forbes.com, founder Michael Dell told the magazine, "We are nothing like we once were, and we are very proud of the changes we've made." He's right, but it appears as if the market has not yet caught on.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.