Description

Thesis

We believe DELL is a compelling long term opportunity, with a potential return between 60-100% over the next 1 or 2 years based on our scenario and ex-cash valuations. We believe the company still holds its competitive advantages in the US, and has a great competitive position for gaining share in greater margin business as IT services.

The Business

Business Model

Direct sales model: Historically this business model was the core of DELL's moat. This enabled the company to turnover its inventories much faster than its peers and gave DELL a price advantage by eliminating indirect reseller's profits.

This business model also included a sales and marketing low-cost structure:

Sales representatives, telephone and online sales.

Mailing and e-mailing marketing publications such as catalogs and promotional publications.

Advertising in TV and print media.

When prices of PC equipment quickly deflated, DELL's efficiencies such as faster inventories turns and sales low-cost structure translated into an important cost and price advantages over its peers, giving DELL a substantial competitive moat which helped the company post one of the great growth records in the technology industry. CAGR last 22 years: Sales: 33%; Net Income: 30%; FCF: 23%.

Beside the economic impact of this business model, its direct sales allowed DELL to establish a direct relationship with its final consumers, which helped the company identify faster and more efficiently changes in the demand, consumer preferences and needs. With this advantage DELL delivered a better product with the best technology at the best prices.

This successful business model took DELL to lead the US market and to maintain this leadership untouched till today (last 7 years DELL held approximately 30% of the US computer systems market), and to report returns on capital well above its peers.

Recent history (growth stagnation). Since 2005 the company's revenue growth came to a halt, as well its FCF and profits declined. This was caused by a more competitive environment and the surge of new consumers and markets with different needs and structure.

HP emerged as a competitive player with a deep cost restructure, increasing the use of Asian outsourced manufacturers, and a wide retail distribution, suited for growth in emerging markets.

DELL's direct sales model didn't fitted for the emerging countries sales, where the growth came in the last few years.

Facing this environment, in 2007 Michael Dell decided to return to the company operations sifting dramatically to some new business strategies as: starting an aggressive retail distribution; and focusing on high margin business units such as servers and IT services.

Has the moat been eroded?

To answer the question: Is the moat eroded? We divided DELL's business in three segments.

1. US (Americas): Wide sustainable moat. DELL's leadership has been untouched in the last years, maintaining more than 30% of the market in the last 7 years.

This market accounts 46% of the company's revenues and 80% of the EBIT.

The revenue migration to higher margin business will benefit operations in this area.

2. Emerging markets: New strategies will give DELL competitive parity, no structural advantage. With the sales strategy shift, DELL's products can be found in more than 24,000 retail spots globally, including Best Buy, Wall-Mart, Staples, GOME, Carrefour and others.

3. IT Services: right steps to build a wide moat. In the last years DELL's diversification to businesses other than hardware has increased. In 2007 the sales of PCs and Notebooks accounted 62% of the companies net sales, while other higher margin businesses like servers, peripherals or services accounted the rest, and it is expected that in 2011 this PC and Notebook units together will represent only 48% of DELL's revenue.

While growing these businesses, DELL is trying to replicate its successful hardware sales model: establishing a direct channel with its clients that will give DELL the feedback to deliver a product that meet the needs of every individual client, and help the company to rapidly predict changes in demand and consumer preferences.

As well DELL is trying to simplify the IT services products to optimize its client's budget. Actually 70% of most companies' budget for IT ends in maintenance expense and only 30% in new initiatives. This new model of Customer-Driven Innovation seeks to reduce these costs by delivering a less complex product and a direct-individual service 

Investment Highlights

Clients: 81% of DELL's customers are commercial business all around the world and 96% of the companies in the Fortune 500 make business with DELL.

No single customer accounted for more than 10% DELL's revenues during any of the last 3 fiscal years.

In the April Morgan Stanley Survey to CIOs, DELL ranked as the first name in mind for the technology purchases of the surveyed companies for next year, placing DELL in a better position for eventual future sales than its main peers (HP-hardware and IBM-servers).

Cost restructure. The company is in the middle of a cost restructuring plan, which through a number of initiatives as headcount reductions and product cost optimization (the objective is to optimize 100% of the product portfolio vs. actual 40%) plans to reduce US $4B in costs by 2011. The original plan expected to generate savings of US $3B but the last quarter the company announced that it expects to achieve an additional US $1B. 

Share Repurchase. Only in the last 5 years the share repurchase is equivalent to de actual market cap of the company (US $21.4B). The repurchase of de last 10 years account US $34B.

Valuation. Our Ex-Cash Valuation threw an 8x P/E multiple for DELL, being one of the most compelling valuation for the industry (HPQ 12x; Acer 12x; AAPL 20.2x). 

Scenario Valuation:

2010E:

Bull Case: Revenue -15% YOY.

Base Case: Revenues -20% YOY.            

Bear Case: Revenues -30% YOY.

The Restructuring plan is included with an OPEX and COGS total reductions of US $ 4B.

2011E: Revenue  5% YOY

Catalyst

Valuation.

Better demand outlook, revenues decreasing at slower pace than costs.