TMO Analysis - Double Take On Dell

by , 10:00 AM EDT, October 1st, 2002

Double Take on Dell

Few people would refute the statement that Dell Computer is the fastest growing major PC company in America. Dell took the worldwide sale leadership crown from Compaq but lost the top position with the completion of the Hewlett Packard-Compaq merger. Today, Dell is close to regaining the number one spot from the combined HP-Compaq by wrestling sales away from HP, Gateway and the many makers of so-called "white boxes".

Sales of white boxes (PCs made by local or regional companies from commodity, off-brand components) comprise about thirty percent of the worldwide PC market. In total, white box makers outsell Dell and other PC industry sales leaders, leaving room for significant market share growth for the major PC manufacturers.

Dell has continued to gain market share during a time of declining sales in the PC industry by cutting costs as much as possible while purposely leading the industry into a price war. Critics complain that Dell's approach to the market has forced its competitors to slash R&D budgets in order to compete, thus significantly slowing the industry's pace of product innovation.

Issues of innovation aside, Dell's aggressive price war has indeed increased the company's market share and has compelled the company's rivals to become more efficient and exit markets in which they could not effectively compete with the Texas-based PC giant. Dell has a very efficient business operation. The company is able to effectively control costs by negotiating in large volume for the best prices from suppliers while saving money through its direct to consumer model.

Dell's price war has also reduced the company's gross margins (the difference between the amount for which the company sells a PC and the cost to manufacture the product) as it seeks growth in market share at the expense of higher profits per unit. Because Dell's gross margins are not growing at a time that the company is gaining significant market share, the rate of growth in Dell's earning per share ordinarily would have slowed because operating expenses will inevitably rise as the company expands operations to accommodate growth and makes a little bit less on each unit sold.

Further, stock options issued to employees risk a further dilution of Dell's earnings per share. More shares outstanding means less earnings per share. Consistent earnings per share growth has made Dell Computer the darling of Wall Street and helps the company maintain its extraordinarily high price to earnings ratio of 54 times its earning per share for the prior twelve months. Maintaining earnings per share growth at historical levels is a top priority for Dell's management team.

To counteract the effects of lower margins and the issuance of stock options on the rate of earnings per share growth, the company has been aggressively repurchasing its own shares. Dell's balance sheet as of August 2, 2002 reflects total share repurchases of US$3.4 billion. Dell has also used a risky stock hedge strategy in its share buyback program.

In a story in the New York Times, reporter Gretchen Morgenson takes a thorough look at Dell's balance sheet, analyzes certain less than obvious risk factors and recommends that investors take a more careful approach to Dell and its shares. Dell maintains cash and equivalents of over $4 billion, but the share buyback program has reduced the amount of cash on hand and some of the company's flexibility in the event of unforeseen problems or continued weakness in the PC market. Consumers pay Dell immediately for their products but the company uses its corporate muscle to extend payments to vendors on average to thirty-seven days.

On Friday, a Reuters Business News report also mentioned the market's concern about Dell and its aggressive stock hedge strategy.

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