Without Better Execution, Dell's Supposed Value Is Moot

By Stephen D. Simpson, CFA | May 25, 2012 AAA

As Dell (Nasdaq:DELL) is getting its clock cleaned in the wake of another disappointing quarter, I expect to see a bevy of articles pointing to how cheap this stock really is, and how smart investors should buy in today to reap the great future gains.

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I understand how it's easy to run the numbers on Dell and come away thinking that. Unfortunately, value rarely drives tech stocks and particularly not in the face of poor execution. Perhaps more than anything else, Dell management needs to convince the Street that there is some method to the apparent madness of its buyout binge and that the company can actually gain and hold share in markets worth having.

Disappointing Q1 Results Despite a Low Bar
Investors and analysts weren't expecting a lot from Dell's fiscal first quarter, but the company failed to deliver even that. Revenue fell 4% from the year-ago level and 10% from the prior quarter. The revenue declines were led by the PC and Mobility businesses, but frankly, there was a lot of weakness across the board.

With disappointing revenue and apparent execution missteps also came lower profits. Gross margin fell more than a point and a half from last year, but did improve 20bp on a sequential basis. Operating income, though, was even worse. On a GAAP basis, income fell almost one-third from last year and 11% from the prior quarter.

SEE: Everything Investors Need To Know About Earnings

Is the PC Business Just an Apple Problem?
A lot of analysts and investors seem willing to write off Dell's ongoing challenges in the PC business by pointing to the impact of Apple (Nasdaq:AAPL) smartphones and tablets, the lingering impact of hard drive shortages, and even anticipation of new products to be launched later this year to take advantage of new Microsoft (Nasdaq:MSFT) launches.

That's all well and good to a point. I certainly don't think Dell is doing that much worse than Hewlett-Packard (NYSE:HPQ), though we'll all know by the time this article is published. The bigger concern I have, though, is that Lenovo (OTCBB:LNVGY) continues to gain share. While Lenovo did see a sequential sales decline in the U.S. this past quarter, they're still gaining share and don't seem quite as bothered by that Apple impact.

Not a Lot of Traction in Other Businesses
It isn't apparent to me that Dell's efforts to go beyond the PC are really finding great success, either. The server business seems to be lagging IBM (NYSE:IBM), though here again we'll see what Hewlett-Packard reports with its own earnings. Likewise in storage and services - it's not so much that Dell is doing badly relative to the market or major rivals like IBM or EMC (NYSE:EMC), but they're not gaining either. That puts them in the unenviable (and uneconomic) position of being "just another competitor" as opposed to any sort of technology, market, or price leader.

If there is a bright spot, it's that Dell's small/medium-sized business (SMB) market seems to be doing well. While the consumer, public, and enterprise markets all saw double-digit year on year declines, SMB shrunk just 2% and the company saw actual sequential growth. While the SMB market can be a tricky one to serve (due at least in part to less sales and marketing leverage), it is a real market and one where Dell might be able to gain a foothold against larger companies like IBM and EMC that are often accused of overlooking and underserving their smaller customers.

The Bottom Line
Dell's management seems to be having real trouble executing on the plan it has sold to the Street, and I have to wonder if integrating still more acquired businesses represents even more potential distraction. I'm also a little concerned about the premiums that the company has been willing to pay, but I do acknowledge that the deals largely make sense from a margin and market standpoint.

It really doesn't take much effort for these shares to look like a real bargain. The barest hint of free cash flow growth suggests the stock is meaningfully undervalued, while running a discounted cash flow (DCF) analysis in reverse suggests that the current valuation implies perpetual 5% free cash flow erosion.

That's an incredible amount of skepticism for a company that, problems acknowledged, still posts a double-digit return on capital. On the flip side, though, is the reality of how the stock market works. Companies like Microsoft, Cisco (Nasdaq:CSCO) and CA (NYSE:CA) languished for quite a long time as "value stocks," and Dell is likely to do the same unless/until investors believe they can grow faster than their addressed markets.

SEE: Cheap Stocks Or Value Traps?

I'm not going to argue against my own model; I do believe Dell shares are undervalued today. But I also believe that management is making it hard to feel much confidence in the numbers, and anyone buying today has to have a lot of patience to see that underlying value come to the surface.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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