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Why I’m Not Buying Dell

By Porter Stansberry
Wednesday, September 6, 2006

Dell is one of the best new companies of the last generation.

It has become a dominant blue chip manufacturing company and an innovator in marketing and customization. Dell has the most widely respected brand in the field. It literally put IBM out of the PC business and nearly did the same to HP.

The stock is being accumulated right now by a “who’s who” list of the world’s best investors, including: Southeast Asset Management (advisors to the Longleaf Partners Fund), Dodge and Cox, and the Legg Mason Value Trust.

From a numbers perspective, Dell looks very attractive. It’s down $20 (roughly 50%) from its post-bubble high just above $40. It’s trading for less than 10 times operating earnings to enterprise value – suggesting that the stock is cheap enough for the company to buy all the shares back. And on Wall Street there has even been talk of a private equity buyout of Dell.

Considering that Michael Dell still owns over 200 million shares (8.6% of the shares outstanding), there is a real chance that he’d take the company private at the current price, which definitely puts a floor under the share price.

What’s not so clear, though, is the upside of being an owner of a very large, very low-margin business that has attracted a large amount of global competition.

In the year ending February 2006, Dell earned (in cash) $0.08 on each dollar of revenue. That’s down from $0.10 the year before. I believe this compression will continue, despite Dell’s branding. That could spell big trouble for anyone buying the stock now.

My main concern is the recent strategic shift to Intel processors by Apple, which, to this point, hasn’t been a direct competitor to Dell. By moving to Intel x86 processors, Apple is allowing consumers to choose either Apple’s operating system or Windows XP on their Apple Computers. This greatly increases Apple’s addressable market.

Most white-collar workers use Windows XP at work. For compatibility reasons, this large category of consumers has typically bought Windows-centric computers for their homes. On the other hand, students and artistic professionals have always gravitated towards Apple, because of its superior design and more robust software.

Apple’s move to use Intel chips will allow white-collar professionals (like me) to buy Apple computers without giving up work compatibility. I’ve spoken to many people who say, “The next time I buy a computer, I’m buying an Apple, and I haven’t owned an Apple since I was in college.”

Currently Apple controls less than 5% of the market for personal computers in the United States. I think its market share will at least double in the next five years. The combination of iTunes (Apple’s music downloading website) and Intel x86 microprocessors (which can run Windows XP as well as Apple’s operating system) will make Apple personal computers the first choice among high-end consumers. This will be a major shift in the PC market. I believe the weakness in Dell’s share price reflects the market’s recognition of the Apple threat.

At the same time, Dell will face direct competition with a Chinese-based manufacturer, Lenovo, which bought IBM’s ThinkPad business. Putting together a basic computer for less than $500 – even with a flat screen – is becoming the price target. At the $500 price and with revived competition from HP, Lenovo, and even Gateway (which itself is struggling to return to growth), it’s hard to imagine how Dell will maintain its profit margin.

When you consider that Microsoft will likely price its new operating system around $200 for consumers, you realize at $500 there’s just not much money in selling computers. Can Dell’s customized model stand up to these pricing pressures? I doubt it.

What I think is happening to Dell investors right now is something that took me a long time... and a lot of money... to figure out. When you’re trying to pick cheap stocks safely, you’ve got to avoid stocks that are cheap because of industry-wide issues.

Dell is smack in the middle of a changing industry with collapsing prices. Imagine trying to pick long distance providers in 1999 because they were cheap. You would have gotten killed: long distance pricing was falling by 80% a year. That’s trouble. And even though Dell looks awfully cheap based on its historic earnings, it could certainly end up being expensive if its margins disappear.

Will Dell adapt? It’s hard to imagine the company that pioneered mass customization will be able to succeed in a high volume race to the lowest price.

Suddenly the stock doesn’t look cheap anymore, does it?'

Good investing,

Porter Stansberry

P.S. Should you buy Apple? Maybe... if you’re willing to sell quickly if anything goes wrong. For me, it’s too expensive with too much riding on whether or not consumers really will begin to buy Apple computers instead of Dell’s.

Market Notes


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