Dell's Rally Likely To End

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Includes: CDWC, DELL
by: Alan Brochstein, CFA

The news Thursday that Dell Incorporated (DELL) (25.99, $59 billion, S&P 500 member) will now be selling indirectly reminded me of another big strategic move in the computer industry. At the peak of the bubble, Gateway (GTW) decided to expand its “Country Stores” to sell its commodity boxes. While the decision to sell through Wal-Mart doesn’t seem to be as dead “wrong” as the Gateway decision was, what does it say about the PC industry and, more specifically, the business model of DELL, which practically invented just-in-time manufacturing? The industry is extremely competitive. It reminds me of the auto industry, except without all the debt and unfunded pension liabilities!

The news itself is certainly no reason to sell the stock. But, it does remind the investor that DELL has matured, that its engines of growth (international expansion, attached products like printers) aren’t moving the needle too much and that perhaps its maniacal focus on doing things the Dell way may have blinded the company somewhat. Personally, I used to use Dell exclusively at work and at home, but I abandoned them after too many quality issues and their lack of service. I don’t think that I am alone on that front.

Taking a look at the stock, it appears to have recovered from being oversold a year ago and is now somewhat “overbought”:

DELL

The long-term valuation chart shows that the PE was very low last July at 14.6, but be careful looking for mean-reversion for a company whose best years are behind it:

dell 2

Meanwhile, earnings estimates continue their downward spiral:

dell 3

So, why has the stock been going up? First, perhaps there is some excitement about the return of the founder to the CEO role. Speaking of Gateway, after Ted returned in early 2001, the stock did pretty well at first too- for about a day or two. Second, the company has repurchased a boat-load of stock historically, though the program was suspended in late 2006. The reduction is share-count has boosted EPS. Finally, there are a lot of pros out there betting on a turnaround.

If I were long the stock, I would consider selling it. First, technically, there is a lot of resistance overhead at 27.50. While the stock has seemingly performed well since bottoming from an all-time low PE 10 months ago, it has lagged QQQQ as well as its two closest peers, HP (NYSE:HPQ) and CDW Corp. (CDWC). The rise has been mainly a function of the market, not the company. Second, the income statement clearly shows margin deterioration. Selling through Walmart (NYSE:WMT) probably won’t help on this front. The persistently declining outlook is clear in the chart above.

Finally, the balance sheet isn’t as pristine as some might believe. They have minimal debt, but their cash isn’t really as available as it appears. The company hasn’t reported financials due to the on-going accounting investigation (perhaps another reason to be concerned), but as of their last 10-Q (for July 2006) they had $8 billion of cash and another $3.4 billion of investments.

This sounds great until one looks at their $17 billion in current liabilities. The cash is spoken for, as the current ratio is just above 1.0. This isn’t in and of itself bad, but it does point to the fact that the “value” of DELL is mainly in the earnings power, which is falling. Stripping everything out, they have earnings (if they hit the 1/09 estimate then zero growth for three years), their long-term investments of $3.4 billion (which equal the equity roughly) and their brand (which I question its value). Is it all worth $59 billion?

Conclusion: The rally in DELL is most likely nearing an end. The recent announcement of the business model change is a very late admission of the firm’s competitive disadvantage. For those who really want similar exposure, they should look at CDWC, which has a superior business model and a slightly lower valuation. Rival Hewlett-Packard also trades significantly cheaper.

Disclosure: No position in DELL or any stocks mentioned in this article