We believe Dell offers a compelling investment opportunity with little downside risk and a high probability of upside potential of 40-60% over the next 1-2 years. Dell falls in the category of a blue chip stock that went from neglected to hated and probably fits in the apathetic category at the moment. Sell side is not highly focused on fundamentals and seems overly concerned with near term customer service problems and the fact that industry growth is currently in the consumer notebook space which is a very small part of Dell’s business. Dell has the highest market share in the corporate market in the US and Europe and they are growing their corporate share internationally. The market is discounting an operating margin of 5.6% moving forward for Dell, which we believe is a very low probability scenario given the advantages of its direct business model and competitive advantage in the higher margin corporate space.
Valuation is compelling as Dell trades at 14x 2009E EPS (net of excess cash) which is based on our base case margin assumptions (6.3% EBIT margin) and normalizes for the near term issues and 12x 2009E EPS (net of excess cash) which is based on more of an upside case and assumes a normalized operating margin of 7.1% (we think that the probability of achieving this EBIT margin is high). Keep in mind that all the data in this report is based on fiscal year end which is January 31st. In addition, Dell is a buyer of its own shares which will generate additional value given the current depressed valuation and Dell will generate FCF as it grows that is greater than EPS given its negative working capital business model and this is not accounted for in the above multiples. Dell also has a ridiculously over-capitalized balance sheet that could be used to generate additional value.
We believe that as Dell works through some of these short term issues and as EBIT margins approach the levels we have indicated above, it should trade at approximately 18-20x those more normalized earnings levels. For a business with the competitive position that it has, high single digit top line growth, and great cash flow conversion dynamics, we believe that multiple is warranted. This would imply approximately 40-60% upside over the next 1-2 years.
Many investors and sell side included, continue to think the direct business model is broken, Dell will continue to lose share due to service problems, will not experience top line growth since growth is coming from the consumer market and accounting issues have hugely inflated historical operating margins. We believe the direct model gives Dell a 500-600 bps gross margin (300bps EBIT margin) advantage over competitors implying that it should be able to maintain an EBIT margin in the 7% range given HPs 4.3% EBIT margin, customer service problems are short term and even with them, Dell continues to take share in the corporate market which will help maintain robust growth (especially int’lly) over the next several years. We have been tracking market share data for Dell in each country and broken out by individual segments and the international/emerging market share gains for Dell have been strong and consistent in the corporate space. Given the risks so well laid out in past posts in terms of whether Dell can establish a similar franchise in developing countries, we feel that tracking the market share stats will be crucial to this investment idea. As of 3Q 06, the data looks very promising.
An interesting analysis worth mentioning is to apply HP EBIT margins for each of its businesses that Dell operates in to the comparable Dell business to see what that implies in terms of a Dell operating margin:
% of DELL HP Implied
Revenues EBIT Dell
Segment 3Q 07 Margin Margin
Desktop PCs 32.6% 4.3% 1.4%
Mobility 27.1% 4.3% 1.2%
Servers/Networking 10.4% 11.0% 1.1%
Storage 4.2% 11.0% 0.5%
Enhanced Services 9.7% 12.0% 1.2%
Software/Peripherals 16.0% 17.0% 2.7%
Implied Dell EBIT Margin 8.1%
We believe that Dell has a cost advantage over HP, but even assuming it didn’t, if you look past some of the near term issues, we see no reason why Dell shouldn’t be able to get to an EBIT margin that approximates that of HP. That implies upside to our scenarios above. If Dell were to achieve an 8% operating margin (more in line with its historical EBIT margins), it would imply that it is trading at 10.5x 2009E EPS and an even lower multiple of FCF.
Dell maintains strong barriers to entry in the corporate market. Approximately 75% of Dell’s revenues and a greater percentage of its EBIT comes from its corporate business. Dell sells PCs, servers, printers, software and services to small, medium and large businesses via its own sales team and has garnered a 36% market share in the global large enterprise market and 45% market share in the US large enterprise market and has very sticky relationships. Currently, the US corporate market is experiencing low single digit growth, while the consumer market is experiencing 10%+ growth. As a result, Dell’s top line growth is coming from its taking market share in international markets that are growing by 15-20%.
When we look at the global PC market, we believe that it is very likely that Dell can grow revenues conservatively in the high single digits. The past few years, the global PC market was growing shipments by 12-15% per annum and that has now slowed to 10% shipment growth per annum in the latest quarter. The global corporate market is growing by less that 10% and the consumer market is growing by more than 10% and the corporate market in the US is growing by approximately 3-4%. This cyclical trend is causing bears to extrapolate minimal growth for Dell vs. robust growth for its competitors. Dell should be able to grow top-line in its developed markets by 3-5% (75% of revenues) and 20% in its emerging markets (25% of revenues) leading to 7-9% top line growth even with a weak corporate market in US/Europe.
We continue to believe that the direct business model allows Dell to maintain a cost advantage, although not as large as historically. Dell distributes its products direct to consumers and businesses which has historically allowed it to have a cost advantage on both the supply side and buy side. Given competitors focus on improving efficiencies in their supply chain, Dell’s just in time/direct business model no longer maintains the same cost advantage on the supply side vs. competitors. However, Dell still maintains a 500-600bps buy side gross margin advantage equivalent to the type of gross margin maintained by distributors like Tech Data or Ingram Micro. The below analysis I think highlights the fact that Dell’s business model should allow it to maintain a gross margin of approximately 18% or 300bps higher than the current gross margin and that should translate into an EBIT margin approximately 200-300bps higher than current levels. Near term problems like customer service, improving product selection, and investing in international growth will put pressure on this margin, but if you can look out 2-3 years, the economics seem to support these numbers.
2000 2001 2002 2003 2004 2005 1Q 06 2Q 06
CDW Coporate EBIT Margin 7.5% 8.3% 7.2% 8.0% 7.7% 7.8% 8.0%
Dell US Corporate Margin 8.6% 10.0% 10.0% 10.2% 10.6% NA NA
2001 2002 2003 2004 2005 1Q 06 2Q 06
Tech Data Gross Margin 5.40% 5.28%5.43%5.39%4.99% 4.55%
Ingram Micro Gross Margin 5.40% 5.50%5.50% 5.33% 5.29%
Lenovo Gross Margin 12.9% 14.0% 15.3%
Acer Gross Margin 12.1% 10.7% 10.7%
HP Estimated Gross Margin 12-13%
Average Competitor Gross Margin 12.5% 12.4% 13.0%
Average Distribution Gross Margin 5.4% 5.2% 4.9%
Implied GM for Direct Model 17.9% 17.6% 18.0%
2000 2001 2002 2003 2004 2005 1Q 06 2Q 06
Dell Gross Margin 20.2% 17.7%17.9% 18.2% 18.3% 18.4% 17.4% 15.5%
Michael Dell owns a lot of stock and is very focused on turning the business around. He is bringing in a new head of customer service, increasing investments in customer service and increasing efforts in emerging markets. He has also been bringing in new business heads for several other divisions and is obviously incentivized and focused on turning this business around. We believe that removing Kevin Rollins from the CEO position would be a positive development, but at this point seems very unlikely.
Catalysts:
Finalizing of the SEC probe
Execution on fixing customer service problems and improving product selection
Continued market share gains in the corporate space in developing markets