Posted 2/19/99
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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.
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.
Charts
Past year price performance
of Seagate vs. S&P 500.
Past year price performance
of Micron vs. S&P 500.
For the companies that supply components to PC makers, the news seems
relatively positive. For the moment at least, Dell reported that prices for hard
drives, displays and memory aren't sinking. That again isn't new -- but it's a
reassuring confirmation for investors in companies such as Seagate
Technology (SEG) and Micron Technology (MU) that have taken major hits of
24% and 9%, respectively, in the last month.
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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I'll take Cisco's word for it
I've been taking a hard look at Cisco Systems to see if there are any signs
that it's headed for a tumble like Dell Computer. I can't find any. Sales at
Cisco have actually grown at a faster rate in each of the last two quarters.
Revenues grew by 40% in the company's fiscal second quarter (the period
ended Jan. 23), by 38% in the first quarter, and by 31% in the fourth quarter of
the last fiscal year. After backing out charges for acquisitions, I calculate that
Cisco shows earnings per share of $1.90 for the last four quarters. That
translates to a 50.7 P/E ratio at the recent price of $96.25 a share. That's
about the same multiple that the stock sported the last two times I calculated
a target price. Using that multiple and what I think is a conservative 26%
earnings growth rate, I project $2.39 in earnings per share for February 2000
and a target price of $121 a share for February 2000. That's a potential 26%
return. Enough to keep Cisco in Jubak's Picks for a while longer. |
