Despite economic headwinds, and changing consumer preference towards smartphones and media tablets, Dell's (DELL) revenues still grew by 15% over the last quarter. The company has registered a 14% increase in networking and server revenue, and its storage business showed an increase of 6% over the last one year. DELL has created a $60 million fund to enlarge its storage technologies business. This fund will invest in innovative computer servers with advanced storage facilities, and building a high data driven capacity in smartphones and media tablets.
The company derives 54% of its revenues from desktop and mobility, 17% from software and peripherals, and 29% from enterprise solutions and services. Its competitor, Hewlett-Packard (HPQ), after facing a 10% decline in the PC business, began to move into the tablet market. We believe that Dell has to follow a similar path, and should change its focus to storage technologies in order to remain attractive for investors. The company has not paid any dividends in the last 5 years, but recently, it decided to pay a dividend of 32 cents/share on an annual basis. Along with this, the management is committed to maintaining its capital allocation program for capital distribution to its shareholders of up to 35% of free cash flows.
The stock is trading at cheap valuations and has a substantial potential to bounce back. Despite the 19% and 9% revenue decreases in notebook and desktop computers over the last year, the company's transformation towards non-PC revenue growth areas will help it improve its profitability. Due to these reasons, which we discuss at length below, we advise that investors long the stock.
Dell is an IT company that is delivering a wide range of products and services across the globe. The company believes in a pull supply chain strategy of "made to order". Manufacturing takes place when customers place an order; the company has a more customer-responsive approach and a short lead time in its supply chain network. However, the company has begun placing its products at different retail outlets to ensure availability in a bid to grab a maximum market share. The company is operating in three business segments, namely Consumer, Small and Medium Business, and Public and Large Enterprise.
The company was not able to deliver in BRIC emerging markets, where it witnessed a 15% decline in sales. According to CFO Brian Gladden, the company was expecting good growth from the BRIC market, but unfortunately it faced a tough competition in the PC business. Another reason behind the declining sales is tough competition from ACER and Lenovo through their cost leadership strategy. Dell CEO Michael Dell forecasted slow growth in China, as the local economy is encountering some challenges. In the last quarter, China witnessed the weakest demand in the last three years, according to a government report published on July 13. Two other companies, Advanced Micro Devices Inc. (AMD) and Applied Materials Inc. (AMAT), have also witnessed weak demand in China. The slow Chinese growth forecast will be persistent until the transition of a new government by the end of this year.
The company is transforming its business towards enterprise solution to sustain brand equity. As its CEO recently revealed, the company has created a $60 million fund to expand its business of storage technologies. The company is consistently trying to reveal its growth philosophy. Despite the deteriorating condition of its PC sales, the company is trying to bring growth through inorganic channels; its recent acquisition of Compellent Technologies (CML) was aimed at enhancing customer value by providing a better data management facility and reducing storage cost. Furthermore, its recent acquisitions of Soni WALL, Inc., AppAssure, Clerity Solutions (CLTY), Force10 Networks, Inc. (FTEN), and SecureWorks Inc. will help the management restore its profitable position and rebuild investor trust.
The company has witnessed a decline of 8% in sales from Q2 2011 to Q2 2012. However, on the positive note, over the last quarter, the company has registered a positive trend in its sales trajectory. Moreover, the company's cash reserves have decreased by 11.4% in the last quarter. The company cut its future guidance, and decreased its estimated EPS from $2.13 to $1.7 for FY2013. Dell relaxed its credit policy, evident from its account receivables and account payables, which were increased by 5.14% and 2% respectively. The company's build-to-order manufacturing strategy means that Dell has been unable to pay its suppliers until the company receives payments from its sales. The management has increased the days' sales outstanding by 3 more days, owing to decreasing sales and cash flows. Its cash flow from operations dramatically decreased from $2,374 million to $367 million from Q2 2011 to Q2 2012, due to changing consumer preferences towards tablets. The company's long-term liabilities have slightly increased by 3.9% as of the last quarter, whereas we have witnessed a decrease of 18.12% in its short term borrowing. Due to the recent acquisitions, its short term investment has decreased from $966 million to $372 million from Q4 2011 to Q4 2012.
Direct Competitor Comparison
Qtrly Rev Growth (yoy):
Gross Margin :
Operating Margin :
Net Income :
The company has maintained its gross margin in this challenging macro environment. Dell's gross margins showed an upside of 60 basis points because of vendor settlements. As the table given above depicts, the company's gross and operating margins of 22% and 6% are at par with its competitor Hewlett-Packard's. HP opted for business restructuring after facing a dramatic decline in sales of its PC business over the years, and decided to move into the tablet market. We believe that Dell also needs to revamp its business with the changing dynamic environment. The company, with almost half the market capitalization as compared to Hewlett-Packard, has decided to put more focus on storage technologies, in which it has witnessed a 6% increase in profits over the years. Moreover, Dell's gross and operating margins are relatively higher than Lenovo Group Ltd's.
The major reason behind Lenovo's thin margins is its cost leadership strategy, which aims to capture a maximum market share with its low price and reasonable quality.
The stock is currently trading at its 52-week low, with a downside of 23% over the last one year. This bearish trend is witnessed primarily because of the decline in the computer business. Moreover, with low average selling prices and increasing sales, Lenovo's stock has shown an upside of 27.55% YoY.
Direct Competitor Comparison
PEG (5-year expected):
We have calculated our 12-month target price as $25.85 (by taking the average of the last five-years P/E of 14.5x times next year's earnings estimate of $1.77), with an upside of 130%. The average P/E of 14.5x will be realized when the company is able to successfully transform its business into enterprise solution. Apart from this, if the company penetrates in BRIC with some computer-related innovations, it will be able to restore its profitable position.
The stock is trading at P/E of 6.7x, at a significant discount when compared to LNVGY. It is trading at a slight premium when compared with Hewlett-Packard. Dell is trading at P/S of 0.33x as compared to HP's 0.28x.
Due to the 8% YoY decline in revenues, and a hit in the computer business, the company has changed its focus towards its non-PC business, which will help Dell revitalize its lost position. We believe that Dell's transformation towards its enterprise solution business segment will help the company improve its profitability situation. However, through this shift, it has thus far not been able to restore its high profitable position, since 54% of revenues are coming from the Desktop and Mobility segments. If the company brings a large turnaround in its non-PC segments like enterprise solution and services, which currently comprise around 29% of revenues and 50% of gross profit, the move will prove fruitful for the company's future growth prospects. Therefore, we recommend a long position on the stock, as it is trading at its 52-week low and has a significant potential to bounce back with this business transformation.