Dell Computer has seen an incredible run since its January 1996 low of $5 3/4. Long-time Dell followers will recall that the January low came after the stock price dropped 30% in just a few days following the admission that fourth quarter gross margins would slip. Investors were spooked because the drop came as a result of a shift away from large corporate purchasers toward small buyers and followed on the heels of Intel Corp. falling more than 12% after missing its quarterly earnings estimates. At its low, Dell was trading at only 10 times trailing earnings and 7 times 1996 estimates -- estimates that proved to be way too low -- but at that time, things looked pretty grim.
Flash forward to late July of 1997 with Dell at $85 a stub, trading at 49.2 times trailing earnings and 36.7 times 1997 estimates. For a company that has historically traded at 11 to 13 times forward earnings, many consider this to be an outrageous valuation. Compound this with the fact that the PC business is universally despised as being a commoditized, low-margin affair, and you have a lot of people squawking about Dell's current valuation. Is Dell's current valuation just another case of irrational exuberance or is the company really worth more than $28.6 billion? Can shares of Dell continue to appreciate, or is this another Micron Technology-like bubble of enthusiasm ready to explode? I think it is quite possible that Dell still has upside potential. Consider these points:
1. The valuation based on trailing earnings does not properly reflect reality. Dell earned $0.27 per share four quarters ago, but nailed down $0.54 per share last quarter. Sequential earnings are growing at 23.1%, a rate most companies would kill for an annualized basis. A much more reasonable way to look at Dell's valuation on trailing earnings considering this extreme earnings velocity is to look at the run-rate (the most recent quarterly number times four), which puts it at 39.4 times trailing earnings.
2. The forward estimates are probably too low. The earnings estimates assume that Dell's operating margin will remain flat or decline and that revenue growth will moderate. The only problem with these assumptions is that there is no evidence to bear them out. Analysts have consistently made mistakes estimating Dell's forward earnings because their assumptions about the PC business as a whole are wrong.
3. Operating margin has been improving and will probably continue to improve. Operating margin has continued to climb over the past five quarters, although the increases have moderated in the last two. With Dell continuing to take market share in the higher margin server arena and Intel's recently announced 15% price cut on CPUs, clear opportunities for Dell to continue notching up its operating margin still exist.
4. Dell's revenue growth has actually been accelerating over the past few quarters. Revenue at Dell grew 40% in the second quarter of 1996, 43% in the third quarter, 57% in the fourth quarter, and 58% in the first quarter of 1997 that Dell recently reported. Can Dell continue to keep doing this? Yes, for two main reasons:
o Dell has been able to grow three times faster than the overall PC market's 18% growth over the past year because it is taking market share from the industry's number one and two players, Compaq and IBM. These two companies have more than $30 billion in combined PC and server revenues between them over the past four quarters -- all revenues that Dell continues to steal. Dell only has $8.7 billion in trailing 12-month revenues right now. If Dell were to become the number two maker of servers and PCs, overtaking IBM, that would mean it could increase revenues 50% assuming that there was no growth in the overall PC market. Dell can clearly continue to grow two times faster than the PC industry throughout the rest of the decade if it keeps taking market share.
o The Pentium MMX and Pentium II upgrade cycle this year will continue to feed the flames of PC demand while the rapid growth of the Internet mushrooms the demand for servers. The demand drivers that put PC purchases at 18% last year are even stronger in 1997 and could continue well into the year 2000, meaning that Dell has more than three years of solid growth ahead of it.
5. Dell is incorrectly perceived as a low quality business, something that still persists. This perception continues to affect the valuation negatively, particularly considering that that the company will probably earn more than what is currently being estimated for 1998. Dell's return on equity and return on invested capital are in the top tier of all public companies. Dell is growing more than three times faster than Intel Corp. and more than five times faster than the average company in the S&P 500. Giving the company a premium valuation can be justified, particularly when that valuation is still well below the actual EPS growth rate the company will generate.
CONCLUSION: Given that Dell is a quality business that I believe can earn $2.42 per share in this fiscal year and $3.51 per share in fiscal 1998, the apparent valuation problems seem to be more the product of bad assumptions about what forward margins and revenue growth will be rather than any true insight on the part of analysts or guidance on the part of Dell. Michael Dell has not been selling any of the 16% of the company he owns -- a company that trades at 35 times 1997 earnings estimates in a year it will grow 84% and 24 times 1998 estimates in a year that it will grow 45%. Assuming the company can trade at 35 times forward earnings, Dell could still appreciate 45.8% from here (24% annualized).
--Randy Befumo ([email protected])