Financial Services Industry

Dell defines a weak computer market: business keeps growing, but that's not always good enough for the stock

Kiplinger's Personal Finance Magazine, August, 1998 by Ken Sheets

Until it got caught up this summer in the draft of its competitors' woes and the ill winds of Asia's economies, Dell Computer stock was hotter than the Texas sauce that folks sprinkle on their brisket sandwiches at the Bo Knows BBQ! restaurant near the company's headquarters in Round Rock, just outside Austin. The world's largest direct marketer of computers, Dell seemed impervious to the weak sales of Compaq, Hewlett-Packard and IBM.

Starting in his dorm room at the University of Texas in 1983, founder Michael Dell pioneered the strategy of controlling costs by rapidly building and shipping PCs after they had been ordered by consumers. Today, his 16% share of the company is worth $7 billion, and the stock itself has risen nearly 6,000% in the past five years (and nearly 18,000% since 1990) from a split-adjusted 47 cents to a recent price of $83.

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THE CASE FOR INVESTING

Dell is increasing sales and market share even in the midst of a PC slump. Earnings for the first quarter of 1998 rose 63% from a year earlier. Obviously, Dell cannot continue growing apace indefinitely. You can expect gains over the long term, though they'll probably be more modest and realistic.

Bill Miller, manager of Legg Mason Value fund, points out that Dell recently passed Microsoft in quarterly revenues but has a market value barely one-fourth that of Microsoft. And Dell, Miller says, can grow taster than Microsoft because the software giant already sells more than 90% of computer operating systems, while Dell can rapidly expand its relatively small share of computer sales.

Other computer makers, most notably Compaq, are trying to emulate Dell's direct-marketing, built-to-order strategy. But they have a long way to go. Dell currently enjoys a 10% production-cost advantage over its rivals. Dell maintains a week's worth of inventory, versus four to six weeks' for indirect vendors--which enables it to expand into next-generation computers faster than its rivals. Dell is taking its direct-sales approach one step further by aggressively pushing sales via the Internet.

Although the growth in computer sales has settled in at around 15% a year, Dell continues to increase its share. For example, last year Dell's domestic market share leaped to 11.8%, from 8.2% in 1996. Merrill Lynch analyst Lucianne Painter views the outlook abroad even more optimistically. More than 60% of computers are sold outside the U.S., she says, and Dell's direct-sales approach has barely penetrated those markets.

RISKS TO CONSIDER

Dell competes in an industry in which if one company sneezes, everyone gets the flu, as exemplified by recent events. Dell is particularly vulnerable to a sell-off because of its high price-earnings ratio--43 times estimated earnings of $1.95 per share in 1998 and 32 times estimated earnings of $2.60 in 1999. So should its earnings disappoint an army of highly expectant investors, its stock price could quickly deflate. Moreover, Dell's stock will remain under pressure so long as the entire technology sector is in the doldrums.