Jubak's Journal
Ding dong Dell, is this a warning bell?
Dell's stock plunge has more to do with high valuations than problems at the company or its industry, but it has put pressure on other "untouchable" tech stocks such as EMC, Cisco and Microsoft.
By Jim Jubak
Now we've got the numbers. But what do they mean for Dell Computer and the rest of the technology sector? Is it time to head for the hills in panic, shrug with indifference or load up on weakness?
Here's what I think. I'm certainly not buying shares of Dell (DELL) right now. I see the stock struggling and then taking another hit next quarter. If I were a long-term investor, I wouldn't panic; the company remains the class act of the PC industry. But I would start to get comfortable with the idea that this stock could lag the market for the next 12 months.
I don't think the numbers send a negative message for technology stocks as a whole. But I do expect that investors who were already nervous about the sector will now be even more inclined to take profits. The current bout of rapid selling on the slightest whiff of bad news should continue for a while yet.
How do I get to those conclusions from the numbers that Dell reported in its quarterly financial statement on Feb. 16? Let me take you through my thinking.
If Dell were typical, this would be great
Nothing in the raw numbers at the top of Dell's press release looks especially threatening to the company or its shareholders. Earnings per share hit 31 cents in the quarter ended Jan. 29, a 55% increase over earnings per share in the same quarter a year earlier. For the year, earnings per share grew by 64%. Revenue climbed 38% in the quarter and 48% for the entire year. "Dell finished another record year with strong momentum, ranking No. 1 among key competitors in return on invested capital, revenue growth and unit growth," said CEO Michael Dell in the company's press release.L I V E V O T E
Voting ends 3/19/99
Let Jim know if he's on the right track. Rate Dell Computer.
Buy 56%
Sell 10%
Hold 35%
Those would be pretty spectacular numbers for the average stock. But Dell isn't the average stock, and it closed at $81.63 on Feb. 17, down more than $20 a share since the close on Feb. 11. To understand why the stock fell rather than climbed on the news, you need to benchmark those numbers against the expectations for Dell.
Dell's earnings were exactly what analysts had expected, but that itself was a slight disappointment. Investors typically run up Dell's stock price in the days before the earnings announcement because they expect it to beat the consensus estimate, even if only by a penny or two a share. And Dell pretty consistently delivers that kind of positive surprise. Dell's stock typically sinks, too, after the announcement, when the company fails to meet the most fevered expectations on Wall Street. All things being equal, Dell's stock would have slid lower on these earnings numbers alone.
But all things weren't equal, and the shares didn't slide -- they tumbled. In recent quarters, investors and Wall Street analysts have actually been paying more attention to revenue, profit margins and the average selling price for a Dell machine than to earnings. Problems in those numbers would signal trouble at the company before earnings per share fell, analysts predicted. You can understand why Dell shareholders might be intensely interested in any indication of a future earnings problem, too. At its recent Feb. 11 high of $101.88, the stock traded at 156 times trailing 12-month earnings. With the average stock selling at a price-earnings ratio of 31.2, any sign that Dell's growth rate might be headed back to the pack would clobber the multiple and Dell's share price.
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Dell failed to clear the revenue bar by a significant margin. BancBoston Robertson Stephens analyst Dan Niles had raised a big red flag Feb. 12. According to his conversations with Dell customers, Dell's revenue was going to be well short of the $5.5 billion that he'd been projecting for the quarter. The company would report $5.2 billion in revenue on Feb. 16, Niles predicted, and the company would wind up selling about 100,000 fewer units than expected. The stock plunged $12 after Niles issued his report, and then continued falling after the quarterly financials showed revenues of $5.17 billion, a bit below Niles' forecast.
Why the revenue miss? Strangely enough, the strong numbers for gross margins and average selling price give us a clue. Dell's management confirmed in the company's conference call that it decided to hold the line on prices in the quarter even though price cuts from competitors were resulting in significant sales gains for those companies in the desktop and corporate enterprise markets. Dell's average selling price fell by just $5 to $2,350. Gross margins remained strong at 22.4%, just a tad below the 22.5% recorded in the third quarter. But the tradeoff was anemic unit growth.
Sales measured by the number of computers sold -- not in dollars -- grew by just 8% over the previous quarter. That's well below the 22% growth recorded by the PC industry as a whole. Most of the industry's unit growth took place at the sub-$1,000 end of the market, where Dell simply has declined to compete. Most analysts assume that the company will have to enter this segment and Dell left Wall Street with the impression that it would spell out the details of comprehensive plans to do so when it talks to analysts again in April.
This all adds up to one conclusion for me: Pricing has caught up to Dell. The company's extraordinarily lean business model has enabled the company to grow inordinately fast while keeping margins high. Now, it looks like Dell will have to cut prices to keep from losing sales to competitors, and to enter the market for lower margin, sub-$1,000 machines. The firming of prices for the components that go into PCs will hurt Dell's margins a little too. Because Dell had such lean inventories, the company was able to almost immediately reap the benefit of falling prices for disk drives or memory chips, for example. Buying at lower prices and selling at steady prices helped pad Dell's bottom line.
This doesn't mean that Dell is suddenly a lousy company. Dell continues to grow faster than any other firm in its industry.
This doesn't mean that Dell is suddenly a lousy company. Dell continues to grow faster than any other firm in its industry, and the Dell model of selling built-to-order machines directly to customers certainly hasn't lost its power. The company now carries just six days of inventory -- down from seven in the previous quarter. The rest of the industry continues to chase Dell.
Rivals gaining
But these numbers do show that the competition has managed to close some of the gap and that growth rates can be expected to moderate in 1999. Prudential Securities, for example, pegs revenue growth over the next 12 months at about 40%. Niles at BancBoston Robertson Stephens is projecting 35%. Most companies would sell their souls to get growth like that. But at Dell it represents a major decline from the 54% growth in revenue the company showed in mid-1998 and from the 66% it recorded in July 1997.
Dell isn't the average stock by any means -- but it now looks more average than it did in mid-1998. That should mean a contraction in the multiple that investors are willing to pay for the stock. A few weeks ago, Prudential Securities had calculated that Dell would be worth $107 a share in February 2000, based on a multiple of 53 times projected 2001 earnings of $2 a share. Now the investment firm's price target is $90 a share, based on a multiple of 45 times projected earnings.
Dell is now seen on Wall Street as a company that can stumble. The aura of perfection -- an impossible burden for any company -- is now gone.
At a multiple of 45, Dell still commands a substantial premium of about 50% to the market P/E ratio of 31.2. And some analysts want to punish the stock more severely; Donaldson, Lufkin & Jenrette has suggested that the multiple will contract to a range of 35 to 40. That results in a 12-month price target of $70 to $80.
These are all projections, and every single one of them could be wrong. But even if they are, I think these numbers are likely to weigh on the stock at least through April. Wall Street now expects that Dell will have to cut prices and lower margins, and that growth is slowing. The April quarterly report is likely to confirm those opinions since Dell has said that it will compete more aggressively on price. The company will have to prove these projections wrong with some hard numbers before Wall Street analysts are willing to raise their multiples back to the levels Dell saw in 1998. Dell is now seen on Wall Street as a company that can stumble. The aura of perfection -- an impossible burden for any company -- is now gone.
If this analysis of the problems at Dell is correct, I don't think its troubles spill out into the technology sector as a whole. For other PC companies, the results from Dell confirm the pattern of the last year -- competitors like Compaq Computer (CPQ) and IBM Corp. (IBM) have closed some of the gap between themselves and Dell, but prices in the PC business remain on a downward course. Not much new there. Hewlett-Packard (HWP), which announced its quarterly results on the same day as Dell did, also reported that it's hard to grow revenue in this business at the moment.
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For companies outside the PC industry, such Dell-centric problems as unit growth and average selling price for a PC are irrelevant. Growth at Cisco Systems (CSCO) or Lucent Technologies (LU), for example, doesn't depend at all on growth at Dell or other PC companies.
Still, I think the fallout from Dell will hit technology companies in two ways. First, it will just increase the current morbid fascination with revenue numbers. For example, on Feb. 17, SoundView Technology Group lowered its estimate for revenue growth at Sun Microsystems (SUNW) from 22% to a range of 18% to 21%. The stock fell $6 a share, even though SoundView was simply bringing its forecast in line with the Wall Street consensus and Sun Microsystem's own projections. Everyone will be looking for the first sign of another Dell -- and they'll dump the stock first and sort it out later.
Second, I think Dell's problems will increase the nervousness that investors feel about other "infallible" stocks. If Dell can stumble, what company can't? I expect to see guilt-by-association selling among the group that includes Cisco, EMC Corp. (EMC), Microsoft (MSFT) (Microsoft is the publisher of MoneyCentral) and a few other "must own" technology companies.
Everyone will be looking for the first sign of another Dell -- and they'll dump the stock first and sort it out later.
In a market like this, volatility feeds on itself. The smartest thing for short-term investors in Dell to have done recently was sell as soon as they heard the slightest rumor of a revenue shortfall. If you'd sold during the day on Feb. 12, you might have been able to get out at $93 -- still an $8-a-share loss -- but way better than waiting to sell until Dell actually announced after the market closed Feb. 16. The stock opened the next morning at $78.25.
The rush to get out -- the smart move -- caused the stock to fall faster and further than it might have otherwise, which, of course, makes the rush to the door seem even smarter. There are a lot of Dell investors out there right now kicking themselves because they didn't sell on the "news" Friday. Think they'll wait for the dust to clear next time they hear something negative about a stock?
And if Niles had been wrong, then everyone would have rushed back into the stock.
All this makes it extremely difficult to be a calm long-term investor. Price movements right now are big and fast and often seem much larger than the news justifies. A big sell-off -- $20 a share in three trading days in Dell's case -- can undermine anyone's faith in any stock. Peter Lynch's advice to know why you own each stock in your portfolio is extremely important right now. Remember what trends led you to think that a stock would be a winner. Do price targets and "what ifs." Every bit of conviction you can muster will help you to hold on to the good stuff you own when waves of selling crash over a position.
Investors who have confidence in the stocks they own sometimes buy even more at times like these, you know.
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