Dell Takes Steps Down The Road To Recovery Sep 29, 2005 – By Barry Zellen
Last week, Bear Stearns hosted a luncheon with Dell CEO Kevin Rollins in
Boston, and though the company did not provide a financial update, Bear
Stearns did not lose its appetite for Dell shares, coming away from its
meetings feeling "encouraged Dell is taking steps to address its growth
issues" and that Dell management "has a heightened sense of urgency to
address slowing growth." ("Dell: Focused On Internal Execution Issues; Is
Dell's Size An Issue? Maintaining Estimates And Reiterating Outperform
Rating," September 29, 2005.)
However, Bear Stearns is feeling a little indigestion, as it remains worried
"Dell's size may be emerging as an issue - hindering its ability to react
quickly as investors expect." But while the Street's estimates for Dell "may
still be bit high," Bear Stearns feels some relief that the company's
valuation "now appropriately reflects some of this risk." Citigroup agrees
with this assessment, and believes that Dell's recent negative news is
already baked into the price of its stock and as such, its recent trading
price in the mid-thirties presents an attractive entry point for investors.
>> Re-Educating Dell's Sales Force: Rollins told Bear Stearns that it's
likely going to take "a few quarters" before Dell is "back on track," and
notes this could be a "point of anxiety for investors." Bear Stearns recalls
Dell's sales teams had a "misguided perception to chase low end business in
2Q - neglecting Dell's model to pursue the most share at the highest ASPs."
Rollins suggested that their "re-education process may not be a quick fix."
However, Rollins explained that "Dell has already taken some steps to address
its problems in 2Q," and is already working on "re-educating its sales teams
on how to take share more profitably."
Rollins explains that Dell's "instilling the notion of operating expense
scalability, as it costs the same to market, service, and sell a $400 PC as
it does a $1,000 PC," and as such "it's all about focusing on selling the
right products at the right ASP with the right level of up-sell." Bear
Stearns expects that "near term, Dell's focus is squarely on the internal
execution of its model and doing it crisply." One sign of better times to
come is the fact that Rollins himself "is not concerned that Dell has grown
too large or become spread too thin," just that the company had "failed to
communicate the appropriate message to salespeople - which involves a period
of re-education."
>> Hurricane Impact Limited: An additional sign of hope is that Dell
appears to have suffered just a "limited impact from hurricanes" - and rather
than being hurt by the two storms that brought devastation to the Gulf coast,
that at a "macro level," Dell has benefited from "some disaster recovery
activity and increased spending from FEMA," though Bear Stearns expects that
"the industry could see some overall softening in unit demand as its unlikely
that the market can sustain the heady 18% unit growth as seen in 2Q-05."
>> Competitive Landscape: All in all, Rollins indicated that
"competitive conditions [are] not too different," and Bear Stearns comments
that Rollins "didn't feel anything has changed in terms of the competitive
landscape," though Bear Stearns notes "Dell's mis-execution has made its
competition look better." Rollins provided some competitive commentary on the
notebook landscape in EMEA, the printer landscape, and the server landscape:
> The Acer Challenge: With regard to competitive threats, Bear Stearns
pointed out that "Rollins was most concerned about Acer's low-margin model in
Europe." Rollins noted Acer has been successful in Europe "filling in a gap
in the channel - due to the HP/Compaq merger - and having the propensity to
accept a low operating margin" of around one or two points. And while "Lenovo
remained on Dell's radar," Bear Stearns noted that "their presence is not all
that new and Acer is the one to watch." But in the U.S. marketplace, Rollins
believes that Acer "isn't as likely to be successful," as "there isn't the
same channel gap and the market is already extremely competitive."
> Aiming for Printer Profits: As for the printing business, Bear Stearns
comments that "with an installed base of 10 million printers already, Rollins
stated that Dell is less focused on getting more volume into the marketplace
and is shifting into a phase of more balanced growth and profitability in
which Dell wants to make more profit vs. its current breakeven profile." Thus
far, Bear Stearns notes "Dell doesn't appear interested in attacking the ink
profit pool," and it notes Rollins continues to see "little reason to own
printer technology or develop in-house given their current partners' ability
to scale out their R&D/technology infrastructures with Dell's incremental
volumes."
> Intel In Stride: As for servers, Rollins believes that the "server
roadmap from Intel [is] in good shape" and Rollins expressed confidence that
Intel has "gotten its server product roadmap back on track," and as such
Rollins remains "highly committed to the relationship" and as such has no
immediate plans to "strike a deal with AMD for Opteron." Rollins explained
that "the real advantage for Opteron to date has been in higher-end, 4-way
systems which are fairly low volume relative to the 1- and 2-way market where
Dell derives the bulk of its volume," and as such "Rollins doesn't feel as
though Dell has ignored a large market opportunity."
> NASpirations: Bear Stearns says that Rollins "highlighted that Dell
still sees substantial opportunity in network-attached storage (NAS) -
particularly at low end," and as such expects to see a "surge in breadth of
Dell's product line in the coming year." According to Rollins, "there's no
reason its strong corporate penetration in selling servers shouldn't'
translate to similar levels for storage."
>> Maintaining Estimates: In the absence of a financial update, Bear
Stearns is maintaining its fiscal 2006 and 2007 estimate for Dell - which
include an EPS estimate of $1.58 for fiscal 2006, up from $1.29 in fiscal
2005, on revenues of $58.6 billion - with gross margins of 18.5%, expense
growth of 17%, and a tax rate of 24.25%. In fiscal 2007, Bear Stearns
estimates an EPS of $1.85 on revenues of $65.4 billion, with gross margins of
18.4%, and expense growth of 14%. For Dell's Q3-06, Bear Stearns continues to
model for an EPS of $0.40, up from $0.33 last year, on revenues of $14.39
billion - with gross margins of 18.5% - down 10 basis points sequentially,
16% expense growth, and tax rate of 24.25%, smack in the middle of Dell's
guidance range for an EPS of $0.39-0.41 on revenues of $14.1-$14.5 billion.
>> Negative News Priced Into Stock Price: Bear Stearns reiterates its
$43-44 price target for Dell shares, and expects few near-term catalysts will
drive its shares in either direction. Bear Stearns believes Dell's recent
share price weakness "is an attractive long-term buying opportunity," and
continues to believe "that revenues should stabilize with Dell's non-PC
growth engines and improved balance of growth and profitability in its client
business." Citigroup agrees with Bear Stearns' assessment, arguing much the
same that it shares maintain its "Buy" rating and that its current price of
$34 is "an attractive entry point with a one-year horizon." ("Dell: Negative
News Priced into Stock: Still a Buy at These Levels," September 29, 2005.)
Indeed, Citigroup thinks that Dell's "negative revisions [are] mostly priced
in" to its current share price" - so although "negative revisions are not a
recipe for near-term performance," with Dell's shares now trading at just 20x
Citigroup's below-consensus fiscal 12-month EPS estimate, Citigroup now finds
Dell shares are trading at "a reasonable premium to the market for a company
with 12% revenue growth, 15%-16% EPS growth, and a 45% ROIC (including all
cash in capital employed) during the next several years." However, Citigroup
concedes that "estimates may need to come down as growth in PCs slows in the
U.S. and western Europe in the coming year, Dell's cost advantage decreases,
and operating margin is pressured by other factors," and that its "prior
target fiscal 12-month multiple of 22x may be aggressive given decelerating
growth and a diminished price advantage." Citigroup nonetheless affirms that
it still believes "Dell deserves a premium multiple given its 12% revenue
growth, 15%-16% EPS growth, and 45% return on invested capital (ROIC)
(including cash). However,
>> Downside Minimal Near-Term: Citigroup believes Dell's near-term
downside is "likely to be minimal," but like Bear Stearns does not expect
Dell shares "to outperform during a period of negative EPS revisions" but
instead are more likely to trade sideways in the mid-thirties "through fiscal
year-end." However, Citigroup expects Dell shares will "likely rebound to $40
over a 12-month period," making its current price of $34 an "attractive entry
point for investors who have a 12-month horizon."
>> Mix Effects Cast Longer-Term Shadow: Citigroup does caution that
there are a "number of mix effects" that it believes "will likely place
modest negative pressure on Dell's operating margin during the next 12-18
months." These include the shift toward emerging markets "where the company's
operating margin is currently 200-300 basis points below its margin in the
Americas." As well, Citigroup is concerned with Dell's shift toward printers,
"which currently generate 0% operating margin." Citigroup says it is also
concerned about the "absence of a decline in component prices" - adding that
Dell's "lack of channel inventory provides it more flexibility on the
frequency and timing of product price adjustments than its competitors have -
a circumstance that has historically brought Dell slightly higher margin
percentages during periods of rapid component price declines." Lastly,
Citigroup is concerned that "shortages in Intel desktop chip sets could
constrain Dell's desktop shipments during the second half of calendar 2005,"
adding that "these shortages could partly explain unconfirmed reports that
Dell recently reduced desktop motherboard orders with certain suppliers."
Along with its "Buy" rating, Citigroup reiterates its 12-month target price
for Dell shares of $39, at a premium to both HP and IBM owing to Dell's
"above-market EPS growth," its "impressive management of working capital,"
and its "45% ROIC, and strong free cash flow."
Dell Takes Steps Down The Road To Recovery
