Down on the Farm
Dell Computer Corp. (DELL)
by Billy Shale
May 29, 1999
Wall Street analysts have watched Dell Computer Corp. (DELL), which
recently announced first quarter results, somewhat warily in recent months.
Gary McWilliams of the Wall Street Journal, reported on May 19 that
"shares fell as investors focused on the company's eroding profit margins."
The company's decline in gross margins was larger than analysts expected,
and raised concern about a difficult pricing environment. Still, Dell's
quarterly profit rose 42%, in line with Wall Street analysts' expectations.
In other news, Dell recently settled charges concerning advertisements for
personal computers. The ads were allegedly misleading. The Federal
Trade Commission filed a complaint against Dell's Internet advertisements,
which stated consumers could purchase a new computer by making low
monthly payments.
"The complaint alleges that the advertisements failed to disclose adequately
that the monthly payments applied to a lease and not a purchase," the Wall
Street Journal reported on May 13. Dell agreed to provide clear
information about the computer-leasing program.
Analysts continue to favor Dell as a long-term investment, but they express
various concerns about the company's recent first-quarter results. Shares
of Dell recently traded at 35 3/4.
Merrill Lynch
Steven Milunovich, CFA, first vice president, and information processing
and personal computer hardware sector analyst of Merrill Lynch, and
Kirsten Campbell, the computer industry analyst at Merrill Lynch gave Dell
an ACCUMULATE investment rating after the company reported its
quarterly results. The analysts were encouraged by accelerating revenue
growth, which "should come as a relief to investors, after two quarters of
below-expectations growth….We believe Dell is successfully taking
advantage of some of the current dislocation in Compaq's business model,"
Milunovich and Campbell said in a recent research report.
According to the analysts, servers, workstations and storage sales grew to
97% for Dell in the first quarter, compared to 80% in the fourth quarter.
Desktop revenue growth and notebook revenue growth both dropped
somewhat compared to the previous quarter. However, high-end,
high-margin categories now account for 39% of system revenues as
compared to 34% last year. Dell's sales goal for this category of products
is 50% of system revenues, the analysts say.
Strong sales growth could be seen in the United States and Asia Pacific —
up 45% and 48%, respectively, according to the analysts. Sales growth in
Europe was smaller, growing 29% year over year. Although Dell displaced
IBM Corp. (IBM) for the second market share spot in the region, the
analysts believe Dell will need to improve sales in Europe if it is to maintain
high overall growth levels.
Merrill Lynch's analysts interpret Dell's lower gross margin as an indication
that the company is going after market share, which the analysts predict
will keep the net margin around 7.8%. Gross margins were down to
21.5% from 22.4% last quarter. But Internet sales, which account for 30%
of total sales, were $18 billion per day, which increased operating
efficiencies, the analysts note. "Dell generated over $1 billion in cash from
operations this quarter, leading to record cash balances as well as
particularly high interest income."
The concerns Merrill Lynch analysts express are industry-wide in scope,
rather than concerns specific to Dell. Revenue growth in the PC industry
and industry pricing pressure are the two major worries for the analysts.
However, they maintain their ACCUMULATE, LONG TERM BUY
investment opinion.
Standard & Poor's
Analysts for Standard & Poor's are also encouraged by Dell's first quarter
results and continue to recommend buying the shares. They are
encouraged by Dell's consistent reported revenue and earnings growth that
exceeds the PC industry's rate, and they expect such growth to continue.
The analysts cite "Dell's direct sales model, strong brand name, and
superior execution and cash flow management" as reasons for likely
continued strong growth for the company.
Standard & Poor's expects Dell's revenue growth to increase slightly by
the fourth quarter due to new storage offerings and consistent execution of
its direct sales model. The direct model allows Dell to match its inventories
to demand and keep inventories low while assuring their components
employ the latest technologies, according to S&P. Further, Dell can
respond quickly to customer demands for different products. "Gross
margins should remain at 22% as pricing pressures are offset by a growing
portion of sales coming from higher-margin systems (notebooks, servers),"
say the S&P analysts.
Dell's enterprise systems include workstations and servers sold under the
name PowerEdge. According to S&P, these servers can be used as a part
of a network to distribute files, applications and communication products,
and database information. The company entered the workstation market in
early 1997, creating workstations based on the Windows NT operating
system. Soon thereafter, Dell became the top workstation supplier
worldwide.
Meanwhile, Dell's desktop computer systems account for the largest
segment of the company's business — 64% of fiscal year 1999 system net
revenues. Dell offers the Optiplex line for corporate and large account
customers, Dell Dimension XPS for technologically sophisticated
businesses and users, and Dell Dimension, aimed at small-to-medium-sized
businesses and individuals. The company also offers various notebooks,
thousands of software packages and network installation and support, the
analysts say.
"While Dell's stock price appreciation has resulted in a calculation that
exceeds the high end of the range for PC vendors, its EPS growth has also
been superior, and we expect the shares to outperform the market over the
next 12 months."
Salomon Smith Barney
Analysts at Salomon Smith Barney maintain their NEUTRAL investment
opinion of Dell and list a price target of $30 in a recent research report.
Although Dell reported revenue and earnings in line with the analysts'
expectations, they were "surprised at the magnitude of this quarter's gross
margin and operating expenses margin declines. We view this as a sign of
increasingly competitive pressure."
Say the analysts: "Dell management had warned the Street prior to this
quarter that it would take advantage of operating leverage to lower gross
margin and thereby drive revenue growth and market share gains.
However, this quarter's reported gross margin was 21.5%, down 90 basis
points sequentially and 80 basis points yr/yr [year over year]. This was [a]
much sharper decline than we had expected (our estimate was 22.3%)."
The analysts explain that the decline in gross margins is one of the reasons
for their NEUTRAL rating: "We note…that this is the first quarter that we
can remember when Dell was forced to reduce total corporate gross
margins in order to maintain a price advantage. In the past, Dell was able
to use positive mix shifts toward higher margin servers, notebooks and
workstations to offset more competitive desktop pricing conditions."
Now, Dell must lower overall blended gross margins in order to maintain
its price advantage, say the analysts. They are concerned that Dell's
competitors are closing the price gap.
On a positive note, the analysts point out that operating expenses for the
company declined in the previous quarter. This was due largely to the
sharp decrease in the number of new employees hired during the quarter.
Dell hired 600 new employees last quarter, versus 1,100 in the previous
quarter, and around 2000 people in each quarter before that. Also, the
analysts believe that Dell's use of the Internet to sell computers will be
beneficial for the company because it lowers the cost of running the
business.
Wall Street analysts are generally positive about investing in Dell, based on
the company's strong fundamentals and position as the second largest
computer maker in the United States. Their concerns tend to be specific to
the cyclical shifts in the PC industry, in which top companies continue to
compete for more effective and cost efficient products and delivery
systems.
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