Description

DELL is the world's leading PC manufacturer. It has a series of structural competitive advantages that are very likely to endure, and one of the world's best financial models. It is likely to grow at a double digit rate on both the top and bottom lines over the next 4-5 years. And it is being sold at a price equal to 12 times forward fully loaded free cash flow 12 months out.

We see three primary themes for value investors in the current environment. Good and especially good large cap companies are valued in line with or lower than more challenged companies. This is especially the case for good large cap companies whose growth rates, while still substantially positive, have slowed. And balance sheets and especially cash rich balance sheets are valued too cheaply, especially for good large cap companies, and especially especially for good large cap companies in growth stock purgatory. DELL fits these themes. But we would like it regardless.

DELL makes PCs. Roughly 65% of trailing 12 month revenue comes from PCs (notebooks and desktops), with the remainder relatively evenly split between other hardware (primarily servers) and services and warranties. The services and warranties businesses are tied closely into the hardware businesses, which is mostly a PC business. Despite its many other interesting businesses, DELL in our view is essentially a PC company.

The PC is increasingly a commodity box, which we think is good for DELL, because DELL is the low cost provider of this increasingly commodity-like product. DELL, as most of you know, is the only direct manufacturer of PCs; DELL sells its product on its website, at its call center, and through its salesforce directly to its customers, as opposed to a VAR or retail channel. The direct model benefits DELL by enabling it to build to order and carry negative net inventory, while DELL's competition typically carries 4-5 weeks of positive inventory. (DELL receives payment for its product up front, and pays suppliers after product is delivered to DELL, so DELL runs its business with modestly negative working capital, and as and so long as DELL grows, its working capital is thus a small positive source of free cash flow). Since PC component costs historically have fallen by about 40-50 basis points PER WEEK, DELL's direct model provides it with 200-250 basis points of operating margin advantage versus its competition. More significantly, DELL's direct model has enabled DELL to sell PCs at higher price points and with far higher attach rates for value added services and incremental hardware product than its competition. DELL sells many more printer cables (and increasingly, printers), software and memory units, and warranties than its competition. Its customer service ranks consistently at the top of the industry. Because of the complexity of building a direct model at DELL's $55B revenue scale, barriers to entry are large. Because of the tension such a move would cause within its channel, no existing PC manufacturer has tried or likely will try to shift its indirect model toward a direct selling model. DELL's competitive advantages are significant, and very likely to endure.

So why has DELL fallen from 40 to 30 this year? Between 1995 and 2005, DELL grew revenue from $5B to $55B by growing global PC market share from 3% to 17%. DELL added 150 basis points of share per year gloablly from 2002 to 2005, growing revenue 17% annually. DELL added just 75 basis points of share in Q105 and again Q205 (on a YoY basis), growing revenue 16% and 14% in those quarters, and then in Q305, for the first time in a decade, DELL gained exactly zero share, and revenue growth slowed to 11%.

The rest of this note will discuss the sources of the share gain slowdown in 2005; some explanations for why they might recur and not recur going forward; one way to think about a reasonably conservative revenue model for DELL over the medium term; what we think the stock is worth given that model; and what the stock seems to imply here.

We think five factors influenced DELL's performance this year. First, the PC market slowed in segments where DELL's market share is greatest and where DELL's mix of revenue is most exposed. The US consumer market at the high end slowed; the US enterprise market was a little weak; the UK market was slow. Conversely, asia and especially asia ex-japan was robust. DELL's market share gains in the stronger markets was robust, and DELL's performance within the US enterprise market was reasonable. But DELL's share gains were slower in the weaker markets, lacking in one big market (the US consumer market, which we will discuss more in a minute), and the weak performance of some market segments obscured DELL's strong performance in faster growing markets. This factor suggests concerns expressed about DELL's model breaking down are overstated.

Second, DELL's competition had been executing very poorly, and their execution improved. HPQ's efforts to reduce operating expenses in the PC segment have been successful. Acer has crushed its opex to sales ratio down dramatically in the past 6 quarters. Improved competitor execution has closed DELL's pricing advantage some, and diminished its competitive advantage. We think the great majority of this factor is behind us. HPQ publicly claims nearly all incremental opex cutting, to the extent it occurs within its personal systems business segment, will fall to its bottom line in 2006 and 2007. HPQ's stock seems to imply a reasonable chance of beating its 06/07 guidance; room for more aggressive price action in PCs is scant. Such action also would stand in contrast to new HPQ managment's historical financial practice. Acer's opex % sales is now down at DELL's industry leading levels, and even at that margin, like HPQ, Acer is running its business at a 1-2% ebit margin (compared to DELL's 8.5%). Again, DELL COGS advantage is not going away. Acer's ability to get more aggressive on price is limited.

Third, the US consumer market slowed at the high end, grew units robustly at the low end, and DELL pulled back from the low end market, complaining about the lack of profit opportunity in low end US consumer. In this market, HPQ and Acer were joined by GTW in leading the industry down the elasticity curve. Our view of this factor is that it is troubling. DELL's share of the US consumer market in 2000 was 3%. By 2004, it had grown to 33%. But since 2004, DELL has gained no share in US consumer PCs. The US consumer phenomenon did not start in Q105; it started in Q104. There is an argument that the competitive environment has eliminated the profit making potential for PC manufacturers in US consumer. Without directly addressing the argument, DELL has ceded the low end to others, and has held share overall by taking more share at the high end. In our model, we assume DELL's US consumer market share is flat for the foreseeable future.

Will this dynamic extend to other markets? 80% of DELL's revenue is in the enterprise; the US consumer market represents roughly 6% of DELL's revenue. Entry into the enterprise market is tougher than consumer markets; support, service, software and other hardware products are more important pieces of the customer proposition in the enterprise. This is why DELL's share gains have continued within the enterprise market, and why competitors like GTW and to date Lenovo have failed to generate meaningful traction even in the small business market. This is THE risk factor for DELL, but one which little evidence suggests is significant to date. This potential dynamic is NOT part of why DELL has disappointed in 2005.

Fourth, component cost declines have slowed in 2005, mitigating the competitive advantage that DELL's direct model provides DELL. Component markets are correlated to the PC markets, but imperfectly. Over the medium term, component costs should follow PC revenues. We think this factor strongly suggests DELL's 2005 performance was more of a short term blip than a long term trend.

Fifth, there is the law of large numbers. $55B is a lot of PCs. The most prominent industry analysts--IDC and Gartner--expect PC industry growth over the coming 4-5 years at GDP like rates. A model of 8-9% unit growth (largely international), 5-6% ASP declines, and 3-4% revenue growth is more conservative than either IDC or Gartner, and what we use. Because competitors are executing better, because the US consumer market is a concern, because of the law of large numbers, and in an effort to be conservative, we assume DELL gains share at ONE HALF of the rate of the past 3-4 years over the next 3-4 years. That implies 75 basis points of share gains per year. Given DELL's substantial competitive advantages--which are unchanged and which have enabled DELL to continue to gain share in all market segments but one even through 2005--such an assumption does not seem aggressive. Such market share gains imply 8% revenue growth from the 80% of DELL's revenue that is hardware (assuming servers grow at 12% versus at 16% LTM rate, and the direct model has driven very significant server share gains as well). Over the past 4 years, services and warranties per unit have grown at 10%. We assume 8% growth per unit over the next 4, which implies 17% growth for the 20% of DELL's revenue that is services and warranties. Overall, we get a 10% top line growth rate.

DELL has operated its business at a consistent 8-9% margin for the past 3-4 years. We assume no operating margin expansion. As DELL grows internationally, its tax rate declines, and we can see 50-150 basis points of net margin expansion from tax planning over the next 3-4 years, as per DELL's finance team.

When we look at DELL, we look not at GAAP eps, but at free cash flow, since we think the working capital model is vaulable. We also hit DELL for the economic impact from its stock options grants, which are far from immodest. The free cash flow per share is about $0.20 in excess of GAAP eps, and the options cost roughly the same $0.20. We estimate $1.70 in fully loaded FCF/share in calendar 2006, and $2.00 in 2007, again on 10% revenue growth. We assume DELL makes the Q405 guidance (which it looks like it will). There is $5.15/share of net cash on DELL's balance sheet, which we see growing to $7.00 before any share repurchase by year end 06. At $31 or less, mr. market is asking you to pay $24 or less for that $2.00 in 2007. That is less than 12x real cash earnings for a 12% grower with a great franchise. If you think that is cheap, they are buying stock back now to enhance your return.

A few more thoughts. I don't think it scores high on the website, but DELL is a magic formula stock. NOT removing the cash from its working capital balance, DELL's ROIC is greater than 80, and its 2006 earnings yield is 7%+. Its capital spending approximates its depreciation. Its requires little capital to grow in a huge market where it has scale and competitive advantages and there is a lot of share left to take. Does DELL deserve full credit for the $5.15 in cash on its balance sheet? Its capital allocation has improved immensely over the past 2 years, it is now a significant net repurchaser of its stock, DELL's fully diluted share count in down 6% in the past 9 months (all with the stock higher concededly), and we expect DELL has been very aggressive this quarter. Can value guys own DELL? On my reading of their 13F, DELL was the single largest investment made by Mason Hawkins and his team at Southeastern Asset Management in Q305 (again, at higher prices).

Catalyst

Growing revenue 10% annually for the next 18 months, giving the market comfort behind the $2.00 2007 number, plus $7.00 in net cash.